BASEL II Guidelines- Opportunity for consultants to provide facilitatory services to SMEs for securing and maintaining credit rating from accredited Credit Rating Agencies
1 NATURE OF BUSINESS AND FINANCE 1.1 BUSINESSES
Businesses are basically individuals and enterprises which sell goods or services to customers who pay for them, either in cash or on credit. The prices and terms of business transactions are determined by the prevailing economic situation, which in turn is deeply and continuously influenced by a variety of factors – natural and human. Hence, successful running of businesses is fraught with risks.
1.2 MONEY, FINANCE, AND BANKS
To start a business and to keep it going, you need money. Money is a form of paper with an embedded promise that it can be exchanged for goods and services. Banking, Insurance and Financial services provide money to businesses. They do this by bringing together borrowers and savers. That is, they take money from the savers (paying them interest on it) and lend it to business-borrowers (at higher rates of interest).
So, business is all about financial transactions, that is, a series of promises to pay/deliver money.. For successful completion of financial transactions, trust between all parties is the key. To maintain trust in the value of money, every nation has a Central Bank which functions as a currency (money) manager and as a regulator of all financial transactions.
Specifically, Central Banks monitor compliance with regulatory mechanisms, and provide economic insights by periodically measuring and classifying the outputs of goods and services. These outputs form valuable insights to policy-makers, businesses, and other stakeholders.
2 EVOLUTION OF BASEL NORMS 2.1 BACKDROP
By the mid-1980s, the world had become a global market-place. With accelerated improvements in technology and communication, trade and commerce flourished globally, the only downside being that the occurrence of any major commercial disasters in banks and financial institutions anywhere in the world carried the possibilities of adverse impacts on banks in other nations. This became a major source of concern for the major Central Banks. There was a need for inter-bank dealings to follow standardized rules in the interests of the global community.
In view of the increasingly large number of overseas banks and financial institutions collapsing on account of sudden and total erosion of capital, wrecking economies and stakeholders, a consultative committee was formed during 1988 and supervised by the Basel-based Bank for International Settlements (BIS), which studied and analyzed the various risk factors that led to these system failures .
2.2 BASEL ACCORD AND BASEL I NORMS
The BIS soon recommended certain guidelines that Central Banks could adopt to periodically monitor their banks and financial institutions’ balance sheets, and thereby mitigate the possibilities of adverse impacts on the economy. These recommendations were known as the BIS norms, and the first set of guidance rules, referred to as Basel I norms, were set out in 1988 and accepted over the years by around 100 Central Banks across the globe under what came to be known as the Basel Accord.
The signatory banks were to assess their assets and off-balance-sheet risks taken, and incorporate them on their balance-sheet. Basel I norms prescribed a minimum capital adequacy ratio (CRAR)(1) of 8 % for Banks which were signatories to the Basel Accord.
To begin with RBI assigned 0% risk-weight to cash and bank-balances, 0% risk-weight to loans and guarantees bearing sovereign guarantee, 20% to loans guaranteed by other banks, 40% for loans guaranteed by State Governments and public sector corporations, and 100 per cent risk-weight to almost all other borrowers other than staff.
Banks also adopted RBI’s guidelines on asset quality. Assets were classified under 4 categories, standard assets, sub-standard assets, doubtful assets and loss assets. Assets other than standard assets were known as non-performing assets—NPAs—which attracted provisions and impacted profitability of the banks. Soon, banks in India strove to minimize their NPAs and improve profitability.
Simultaneous measures taken by the Government of India to strengthen the legal debt-redressal systems by the introduction of Lok Adalats, streamlining the Debt Recovery Tribunals and the Board for Industrial and Financial Reconstruction mechanisms, introducing the Corporate Debt Restructuring mechanism and promulgation of the SRAFAESI Act, helped in greatly controlling the NPAs in the Banking system and thereby increasing the productivity and profitability of trade and commerce.
Soon, the apex financial regulatory authority in India—the Board for Financial Supervision (BFS)—set up similar frameworks for the financial institutions, NBFCs, co-operative banks, regional rural banks and the insurance sector. Off-site surveillance of the MIS available from the financial sector provided the regulators with valuable inputs, armed with which they could prescribe suitable monetary policies. The ‘Ketan Parekh scandal’ was exposed because of this very regulatory mechanism. A series of other stock-market ‘scams’, along with changing global market dynamics, were sure indicators to the RBI/BFS that the Basel II prescriptions were relevant, and that in addition to credit risk, ‘market risk’ and ‘operations risk’ were other critical factors to be considered while assigning risk-weights for the CRAR, which by then had been raised to 9 per cent.
Thus emerged RBI guidelines on investments and operations risk, paving the way for adoption of what have come to be known as Basel II norms.
3 BASEL II NORMS ADOPTED
It became evident to the RBI that the Basel I guidelines accepted by it, allocating 100 per cent risk-weight to ‘all loans and advances’, were inadequate (one-shoe-fits-all approach). Risk-weights on assets underwent changes, and provisions on standard assets were introduced. Initially, banks were advised to introduce and implement their own internal risk rating mechanisms to evaluate credit risk, market risk and operational risk, and suitably price their asset products. Following this, bank borrowers had their loan applications and accounts examined under banks’ internal risk-management models.
However, by the mid-1990s, the RBI/BFS became convinced that some additional measures were needed in the interests of the country and economy. Hence, RBI has accepted and introduced the Basel II guidelines and announced time-lines for their introduction and compliance. (Earlier, the RBI had not accepted these stringent guidelines.) While adopting the Basel II framework, RBI has opted for (1) the “standardized approach” towards credit risk which called for third-party credit rating, and (2) the “basic indicator approach” towards operational risk, in which case too external rating may be applied to determine capital charge for market and operations risks.
3.1 CREDIT RATING OF LOAN ASSETS INTRODUCED
RBI has prescribed credit rating of all loan assets. Credit rating agencies like ICRA, CARE, CRISIL, and Fitch India—which earlier only evaluated and rated credit and market risks for companies/entities going public, or for listed companies which raised long-term domestic and external debt—have been designated as approved agencies by the RBI for credit rating of all bank borrowers. With this measure, RBI has adopted the global practice of having ‘acceptable third-party evaluation’ of assets on banks’ books.
3.2 RBI DEADLINES AND INCENTIVES
RBI had set March 31st 2009 as the deadline for all borrowers with total limits of Rs.10 crores and above to obtain credit rating. RBI has also prescribed 150% risk weight on borrowal accounts that have not obtained such credit ratings upon expiry of this deadline. The underlying implication is that the limits below the threshold limit also need to get the credit rating done.
As an incentive to banks, the RBI had also spelt out reduced risk-weights as under for accounts rated by the accredited agencies:
20% risk-weight: AAA rated
30% risk-weight: AA rated
50% risk-weight: A rated
100% risk-weight for lower ratings
150% for unrated.
Under the above RBI prescriptions, differential risk-weights have a positive impact on a bank’s lendable surplus. This has led to banks pressurizing their loan customers to obtain credit rating.
The table below is illustrative of the situation, taking the case of a bank with total advances of Rs 100.
Particulars
Credit rating
AAA
AA
A
Lower
Unrated
Level of loans
100
100
100
100
100
Risk weight
20
30
50
100
150
CRAR-9%
Capital required to carry asset
1.80
2.70
4.50
9.00
13.50
Capital relief for bank
7.20
6.30
4.50
0.00
-4.50
The table makes it clear that if the assets of Rs 100 have the highest rating (AAA), Rs. 7.20 would accrue to the lendable surplus of the bank. At the other extreme, if the assets are not rated at all, the bank would actually have to raise Rs 4.50 by way of an additional capital charge!
Taking the argument further, assuming a lending interest rate of 12% pa., the highest rated assets would not only yield Rs.7.20 for lending, but also earn Rs.0.88 by way of interest thereby positively impacting the CRAR. At the other extreme, the borrowing cost of the unrated assets would be Rs.0.32 (if inter-bank call rates were assumed to be 7%) resulting in revenue loss and lowering the CRAR.
4 MSME SECTOR: OPPORTUNITIES
Banks have offered to pass on interest rate reductions for credit-rated SMEs.
In general, corporates have the in-house infrastructure to effectively interact with the credit rating agencies. However, it has been observed that the SME sector—in particular, the SSI sector—does not possess the required infrastructure or funds to work with credit rating agencies in order to meet the rating requirements. The NSIC has offered a subsidy to SMEs that undergo credit rating, thereby reducing the net rating fee. However, there is still a great need for facilitators to assist the SMEs in
meeting the rating agencies’ and banks’ requirements
maintaining requisite data-base and achieving compliance with bank and regulators’ requirements.
Set up quality practices to enable participation in global markets.
Aid or play a part in formation of industrial clusters to maximise the benefits.
Develop and maintain compliance software
Also thrown into focus is also the vast training and back-office opportunities that arise if there were collaboration with Small industry service institutes, district industry centres and Industrial training institutes.
4.1 RATING METHODOLOGY 4.1.1 CAMELS model for banks
Banks themselves are rated by RBI under the ‘CAMELS’ model in accordance with global practice. This model is evolving over time with the accelerating complexities of the market
Capital – structure, nature
Assets – quality
Management – structure, operations, regulatory compliance
Earnings – profitability parameters
Liquidity – composition of assets and liabilities, structural liquidity
Systems – efficiency parameters, corporate governance., operational reviews
There are huge opportunities that exist in aiding banks and financial institutions to effectively manage each one of the CAMELS areas. Such outsourcing activities should conform to the RBI Master circular on outsourcing which can be viewed on www.rbi.org
4.1.2 Structured risk assessment
The accredited credit rating agencies use the following structure in assessing/evaluating risk: of industial and business units
Quantitative analysis: cash flow, capital structure, financial flexibility
Earnings: financial analysis of historical cash flows and funds management, financial and coverage ratios.
Profitability: return on capital employed and gearing ratio, .peer-level analysis.
4.1.3 Process
The accredited credit rating agencies follow the process below.
Acceptance by borrower—rating forms/requirements furnished by agency after payment of fee.
Submission of data by borrower with enclosures.
Evaluation of data by rating committee—interaction with borrower for clarifications.
Award rating—3 to 4 weeks from submission of data.
5 CONCLUSION
Commercial disasters in banks and financial institutions anywhere in the globe carry the possibilities of adverse impacts on banks in other nations, and thereby nations’ economies – a cascade effect. This cascade effect reflects the fluid nature of money flow. As with water, the key to safeguarding against financial cascade effects hence lies in monitoring and controlling money flow – through exploration, supply, regulatory mechanisms, storage and distribution mechanisms, toll mechanisms, constant review and forecasts, periodic checks for quality, and inbuilt risk-management practices.
At every stage in monitoring money flow, there exist business opportunities for players in the services sector.
Basel II compliance has thrown up many such opportunities.
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—About our writer:
Science graduate from St. Edmund's College Shillong, R.P.Balakrishnan has experienced and survived the thorny deserts and badlands of banking, finance and the corporate sectors over an eventful span of thirty years.He is currently operating from Delhi as an independent Management consultant.
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