B.M.Mittal Chief General Manager Punjab National Bank Head Office, New Delhi

1. B.M.Mittal Chief General Manager Punjab National Bank Head Office, New Delhi Indian Banks' approach to Basel II Implementation

2. Overview of the Presentation Assessment of Industry’s readiness – Survey by KPMG Opportunities, Concerns and Challenges What needs to be done to ensure effective implementation and within the RBI time frame – Action Points for effective Implementation

3. India: Ready for Basel II? A Survey by KPMG July -- Sept 06

4. India: Ready for Basel II – A Survey • Total 32 banks • 9 public sector banks • 6 new private sector banks • 12 old private sector banks • 5 foreign banks Total Banking Assets: 61% Total Profit (after tax): 68% Coverage of the Survey Key Aspects in the questionnaire

5. India: Ready for Basel II -- Survey Findings

6. India: Ready for Basel II -- Survey Findings Other Findings: 16% of the banks surveyed have commenced the process of planning for the more advanced approaches of Basel II, including collection of loss data, risk mitigation techniques and capital modelling. Compliance with regulation is driving the Basel II implementation programme in 46% of the banks surveyed. New private sector banks ranked enterprise risk management over compliance as their key driver. 89% of the banks surveyed indicated that they have a ‘dedicated team’ responsible for Basel II implementation. However, very few banks have established the position of Chief Risk Officer with a reporting line to the CEO/Board and whose role has been defined with sufficient clarity.

7. India: Ready for Basel II -- Survey Findings Credit Risk Preparedness 71% of the banks responded that they had made reasonable progress with the initial stages (in the form of establishing the team, conducting gap analysis, project planning and assessing detailed requirements) of implementing a credit risk programme. The more advanced stages of credit risk preparedness have shown minimal progress as well as varied understanding of the implementation approach.

8. India: Ready for Basel II -- Survey Findings Operational Risk Preparedness Most banks have started work on the Basic Indicator Approach (BIA) for operational risk management. However banks appear to be unclear on their time frames for adopting more advanced approaches. Appropriate guidance from the regulator could be one of the reasons. Technological adaptability could be one of the drivers that would enable banks to implement the Standardised and Advanced Measurement Approach for operational risk management. A large number of banks seem to have not yet fully understood the complexities for Basel II compliance in respect of operational risk.

9. India: Ready for Basel II -- Survey Findings Technological Preparedness There appears to be less clarity with regard to use of technology in operational risk. On a scale of 5, Credit risk technological preparedness range between 3.0 to 3.5, Market risk technological preparedness range between 3.2 to 3.5 and Operational risk technological preparedness range between 2.0 to 2.5 among various public and private sector banks. 90% of the banks intended to use a combination of in-house development as well as external consultants to build appropriate IT solutions.

10. Opportunities, Concerns and Challenges

11. Opportunities for Banks Measuring,Managing and Monitoring Risk in a scientific manner Align risk appetite and business strategy Risk Based Pricing Effective Portfolio Management Optimum utilization of Capital Enhance shareholders’ value by generating risk adjusted return on capital

12. Concerns and Challenges for Banks – General Issues Guidance and support from senior management is essential to help ensure success of Basel II project. Without their support and motivation, implementation can become difficult and time consuming. Good risk management involves a high degree of cultural changes. Embedding good risk management practices into the day to day business processes will be a daunting task. Sophisticated risk management techniques, particularly under the advanced approaches, require human resources with appropriate skill sets and proper training. With average age of 45 and above of Public Sector Bank officers, the task becomes much more challenging.

13. Concerns and Challenges for Banks – General Issues Capital requirement under Basel II will increase due to additional capital charge for operational risk and increased capital requirement for market risk (already implemented wef 31.03.2006). The scarcity of resources (of raising capital) will add to the existing competition of business growth. Highly rated corporates (needing lower amount of capital) may exert pressure on already declining interest spread. The models under advanced approaches require lot of historical data. However, with no data warehouses in the banks (especially Public Sector Banks), collection of data is a formidable task. Methodologies that work in a bank may not work in another bank. Banks have to customize and tailor make the risk products to suit their processes.

14. Challenges for Banks – Legal and Regulatory Infrastructure Steps are required for adoption of internationally accepted accounting standards, consistent, realistic and prudent rules for asset valuation and loan loss provisions reflecting realistic repayment expectations. Legal systems will require changes for speedier and effective liquidation of collaterals The laws governing supervisory confidentiality and bank secrecy would require modifications to permit disclosure envisaged under pillar III. In view of predominant Government control over public sector banks, preconditions such as operational autonomy, corporate governance etc need to be addressed.

15. Challenges for Banks – External Credit Rating Agencies Limited number of rating agencies and insignificant level of penetration of ratings. The rating agencies in India have a good background in rating “issues” such as corporate bonds, commercial papers and other marketable instruments, but not in rating issuers/bank borrowers. At present default rates are disclosed by CRISIL only and other rating agencies are yet to declare the default rates,which may create difficulties in mapping process and compliance with disclosure criterion. Other rating agencies will have to disclose the default rates if they want to be accredited by RBI.

16. Challenges for Banks – External Credit Rating Agencies In India banks/ FI’s are having stake in rating agencies that may impact the independence of rating agencies. Banks are also awaiting detailed guidelines from the regulator on matter involving regulatory discretion under Internal rating based approach. Such guidelines are required to enable the banks to start collecting the data properly and to design IRB compliant risk management systems. The capital requirements of banks under Standardised approach will be less sensitive to credit risk compared to banks on advanced approaches, may result in higher risk loans going to banks on standardised approach. This may lead to concentration of high risk assets with banks adopting standardised approach and low risk assets with banks adopting IRB approach.

17. Challenges for Banks – Development of market for Credit derivatives and other credit mitigation products Credit derivative products yet to be introduced in India. Evolution of developed market for credit derivative is required to mange credit risk effectively and to get full benefit of risk mitigation. Rigorous legal and regulatory framework and less developed secondary market for bonds/ loans etc is a major impediment in development of credit derivative markets.

18. Challenges for Banks – MIS and IT Presently, no single IT supplier can provide all-round risk management solutions. However, 100% internal development may be too costly because risk management methodologies tend to involve complex computation. Integrating various external systems into one platform is the major challenge. Flexible customization of external systems is important . System integration, dedicated software for risk assessment and management and setting up of enterprise wide integrated data warehouse shall pose a formidable challenge for Indian banks. Ensuring correct feeding of data from various sources and the validation of information stored is a major challenge to be overcome before the banks start making use of the information in the data warehouse.

19. Challenges for Banks – MIS and IT • Lack of data driven culture • Historical issues in getting reliable data. • Only data that was necessary to ease operational processes was captured. • Structured, data-backed decision-making has not been very prevalent. Most of banks are having various banking solutions across branches. Co-ordinating with multiple vendors each handling different parts of the overall solution in the present system is a daunting task. Inadequacy of relevant and reliable data to estimate risk inputs for advanced techniques – shall make the implementation difficult in Indian conditions.

20. Challenges for Banks – MIS and IT Short data history, and lesser number of data points in LGD, EAD and high impact low frequency events in operational risk may give distorted results. Effort for creation of pooled data are required to be made requiring collaborative efforts between banks and supervisor. Risk methodologies and business processes are evolving. The technologies adopted must be flexible for future changes.

21. Action Points For Effective Implementation

22. Action Points for Effective Implementation Grooming and Retaining Talent Percolating risk culture across the organisation through frequent communications, organizing seminars and training. Setting up of Data Warehouse to provide risk management solutions. Integrating risk management with operational decision making process by conducting periodic use tests. Periodic backtesting and stress testing of the existing models to test their robustness in the changing environment and make suitable amendments, if required.

23. Action Points for Effective Implementation Putting in place a comprehensive plan of action to capture risks not captured under Pillar I, through ICAAP framework. Handling interrelationship between businesses. Linkage needs to be established between Funds Transfer Pricing, Asset and Liability Management, Credit risk, Market risk and Operational risk so that cost allocation can be done in a scientific manner. For Pillar III requirements, banks should disclose information, that are easily understood by the market players and gradually move to disclosure of informations requiring advanced concepts and complex analysis. Adopting RAROC framework and moving from regulatory capital to economic capital.

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