Final f-309.docx

SUBMITTED TO Nusrat Khan Lecturer Department of Finance Faculty of Business Studies University of Dhaka.

Group-05 SUBMITTED BY

SLIDNAME

114-005Kazi Mohammad Selim

214-007Md. Anisur Rahman

314-067Tasfik Awal

414-141Tafiz Mahmud

514-127Khandaker Shohag

614-111Sumit Chowdhury

714-025Md. Kutubuddin Tanvir

814-035Md. Biplob Tarafder

914-117Md. Raihan Robin

1014-153Santu Kundu

31 October 2010

LETTER OF TRANSMITTAL

31 October, 2010.Nusrat khan LecturerDept. of Finance,University of Dhaka.

Subject: Letter regarding submission of Report on Implementation of BASEL Accord in Eastern Bank Ltd.

Dear Madam,

Its a great pleasure for us to have the opportunity to submit a report on Implementation of BASEL Accord in Eastern Bank Ltd which had been a great experience for us to work with such a practical & real life issue to analyze with. We tried utmost to make & let it look like a professional one. Any shortcomings are expected to have a kind view for our encouragement. Thank you for your sincere & honest try to let us make easy & get familiar with the Basel accord and its implementation in the banking sector specifically in the Eastern Bank ltd to help us make the paper a successful one.

Our efforts will be valued if this report can serve for what its been meant for & our assistance will be there for any queries.

Faithfully yours,

Students of Group-05

TABLE OF CONTENTS

ChapterTopicPage

Acknowledgement4

Executive summary5

1Introduction666777

1.0 Origin1.1 Background1.2 Objective1.3 Scope of the study1.4 Methodology & sources of data1.5 Limitation

2Basel Accord1112131415162530

2.0 What is Basel?2.1 History of Basel2.2 Objective behind Basel creation2.3 Global acceptance of Basel2.4 Application of Basel2.5 Basel II2.6 A summary of Basel iii update2.7 Conclusion

3Basel & Bangladesh3233363641

3.0 Preface of Bangladesh3.1 Banking industry of Bangladesh3.2 Implementation of Basel in Bangladesh3.3 Challenges for Basel in Bangladesh3.4 Current situation of Basel in Bangladesh

4Basel Accord in EBL

454647

4.0 Introduction to EBL4.1 Basel program in EBL4.2 Basel implementation in EBL

Concluding remarks62

Findings63

Reference64

ACKNOWLEDGEMENT

Our work on preparing a report on Eastern Bank ltd is a great experience for us in light of the course Law and practice of banking. EBL is one of the most successful banks in Bangladesh serving the individual and corporate clientele alike with remarkable success offering innovative banking services through a nationwide banking network. We strongly believe works like this will surely help us to have a clear concept about Basel accord and its implementation in banking sector. All the praise belongs to Allah the all knower & best of the helpers to make our report a practical one by providing us the mental & physical toughness in course of preparation of the report.

Our next honest & heartiest gratitude goes to Nusrat khan, lecturer & our honorable course teacher for his sincere and utmost guidance to prepare this report & to gather huge practical and realistic knowledge, to make us understand the topics, terms & make us familiar with this course.

Our special thanks also go to Soibal Paul an officer of credit risk department to maintain Basel accord in EBL according to the direction of Bangladesh Bank. Finally we also thank our entire group member to work with integrity in preparing this report.

EXECUTIVE SUMMARY

The overall work & study has been done & focused on view to get & show a proper overview of EBLs initiation, emergence & banking functions & its activities. This report has been focused on the implementation of the Basel accord in this bank. But before we have also presented an overview of our banking industry.

In the report the total overview of the Basel accord, its scope of application, the update of Basel III, the implementation, scope and limitation of Basel accord in EBL have been demonstrated.

As our main purpose of the report was to understand the ways of implementing Basel accord in banking sector especially in the EBL have been the center of attention of our report. With the varieties of products and services such as different loans, SME products, cards, deposits EBL satisfying its customers and making a significant contribution in the banking sector of Bangladesh.The impact of Basel and the influence and significance of Basel in capital and risk management is the most important part of our report. The impact of maintaining requirement of Basel in the institution is enormous and vastly connected with other section of the company as proper capital management is the root of success of any bank as well as Eastern Bank Ltd.

Clearly Basel accord plays an important role in Convergence of Capital Measurement and Capital Standards in EBL .So the proper implementation of Basel in any bank may take the bank in a higher level in capital and risk management.

Chapter-1

Introduction

1.0 Origin1.1 Background1.2 Objective1.3 Scope of the study1.4 Methodology & sources of data1.5 Limitation

1.0 ORIGINThe preparation of this report is a requirement of the course on Law And Practice of Banking (F-309) co-ordinated by Ms. Nusrat Khan, Lecturer of Finance Department at Faculty of Business Studies, University of Dhaka, who is also the course teacher of course titled Law And Practice of Banking, has assigned to the students of BBA 14th batch to prepare report on different topics & we are assigned with Is Basel Accord compatible?.

1.1 BACKGROUNDThe world of banking is increasingly becoming more and more competitive. Banking services are the main foundation of international financial system. Day by day, they are involving in highly riskier activities to make higher profit. To protect the global financial market from collapse, the BASEL ACCORD was introduced. For some of its limitation, BASEL II was implemented. The proper implementation of this Basel Accord can make the financial world more secured.1.2 OBJECTIVE OF THE REPORTThe primary objective of this study is the partial fulfillment of the course requirement. The main objectives of this report are as follows: To fulfill the partial requirement of the course Law and Practice of Banking offered in BBA program. The collateral purpose of this report is to explore about Implication of BASEL in Bangladesh. The main objective of the report is to show BASEL practices by EBL. It will also enable us to improve our skills on report writing. As corporate executives put greater value on report writing as an important element in organizational success, this part of the course will prepare us to face the future challenges of the corporate world. To meet the curiosity in this stated subject.

1.3 SCOPE OF THE STUDYThis report gives a narrative overview of BASEL practices in Bangladesh. It also gives a descriptive study of the history of BASEL. We could not include every data with illustration to prevent our report from verbosity. Our report focuses on the performance of Eastern Bank Ltd. about the requirement of Basel accord.

1.4 METHODOLOGY & SOURCES OF DATA

The information for the report was collected from both primary and secondary sources. Primary sources: All the data and information that are collected from primary sources are acquired by interviewing the officials of the Eastern Bank Ltd. Secondary sources: Secondary data have been collected from various sources like website of these organizations. We have also visited these organizations physically. We have also collected information from different journals, newspapers and magazines. The data and information collected from interviews and secondary sources have been analyzed properly.

1.5 LIMITATIONThe major limitations encountered are: The most elementary limitation of this study is the tendency of the employees to be always alright attitude hindered us to realize the overall scenario of EBL about BASEL. Time constraint of the required personnel in providing us with information was also a limitation. Lack of experience also acted as constraints in the way of exploration on the topic. The organizations were also reluctant to give some important information for their internal privacy.

Chapter-2

Basel Accord

2.0 What is Basel?2.1 History of Basel2.2 Objective behind Basel creation2.3 Global acceptance of Basel2.4 Application of Basel2.5 Basel III2.6 Conclusion

2.0 What is Basel?Basel is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by operations. The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision (BSBS). The name for the accords is derived from Basel, Switzerland, where the committee that maintains the accords meets. Basel improved on Basel I, first enacted in the 1980s, by offering more complex models for calculating regulatory capital. Essentially, the accord mandates that banks holding riskier assets should be required to have more capital on hand than those maintaining safer portfolios. Basel II also requires companies to publish both the details of risky investments and risk management practices. The full title of the accord is Basel II: The International Convergence of Capital Measurement and Capital Standards - A Revised Framework. The three essential requirements of Basel II are:1. Mandating that capital allocations by institutional managers are more risk sensitive.1. Separating credit risks from operational risks and quantifying both.1. Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment. Basel II has resulted in the evolution of a number of strategies to allow banks to make risky investments, such as the subprime mortgage market. Higher risks assets are moved to unregulated parts of holding companies. Alternatively, the risk can be transferred directly to investors by securitization, the process of taking a non-liquid asset or groups of assets and transforming them into a security that can be traded on open markets.Basel I resulted from the aim of protecting banking business as well as whole economics system of the world from unexpected collapse. But it had some shortcomings that failed to detect some complicated banking risky investments modern banks make. Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.

2.1 History of Basel

It is believed that generally the banks face credit, market, liquidity, foreign currency,Strategic, compliance, reputation, country, legal, regulatory and operational risks. Thefailures to identify and quantify the different sorts of risk entail a very high cost not onlyfor the whole banking industry, but for the entire economy as well. We know thatbanking crises can threaten macroeconomic stability through their potential effects onconfidence, savings, financial flows, monetary control and the budgetary impact of bank,rescue packages. Therefore, achieving an inclusive, efficient, sound, and stable financial system is an important, complex and a multidimensional task.

In this context globalization and closed integration between different parts of the world, the possibility of a particular banks collapse can shake the heart of the worlds economy. The major event that led to the formation of the Basel Committee on banking supervision by the group of ten nations in 1974, under the auspices of Bank of International Settlement (BIS), was the liquidation of the German Harstatt Bank. The Basel committee published a set of universal capital requirements for banks in 1988 which is known as Basel Accord or Capital Accord. It emphasized the importance of adequate capital by categorizing it into two Tiers: Tier 1, or core capital (the sum of common stock, retained earnings, capital surplus and capital reserves); Tier 2 or supplementary Capital consisted of loan loss allowances, preferred stock with maturity greater than 20 years, subordinated debt, unclosed capital reserves and hybrid capital instruments.) The Accord requires banks to hold capital equivalent to 80% of Risk weighted value of Assets. Basel I was adopted by many countries.

History of the Basel Committee and Its MembershipThe Basel Committee on Banking Supervision was established as the Committee on Banking Regulations and Supervisory Practices by the central-bank Governors of the Group of Ten Countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets (notably the failure of Bankhaus Herstatt in West Germany). The first meeting took place in February 1975 and meetings have been held regularly three or four times a year since. The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. The first chairmen of the committee were Sir George Blunden (then Executive Director, Bank of England).

Basel Committee at Present:The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. The present Chairman of the Committee is Mr Nout Wellink, President of the Netherlands Bank. The Committee encourages contacts and cooperation among its members and other banking supervisory authorities. It circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years.

2.2 Objective behind Basel Creation

The final version aims at:1. Ensuring that capital allocation is more risk sensitive;1. Separating operational risk from credit risk, and quantifying both;1. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place.

2.3 Global Acceptance of Basel

The initial capital accord of 1988 was hugely successful with more than 100 countries accepting it as a benchmark. One of the major reasons for the success of this framework was its being simple. It brought in uniformity and attempted to make regulatory capital requirement consistent with the economic capital. Reserve Bank of India introduced risk assets ratio system as a capital adequacy measure in 1992, in line with the Basel accord of 1988, which takes into account the risk element in various types of funded balance sheet items as well as non-funded off balance sheet exposures.Basel Is adaptation and implementation occurred rather smoothly in the Basel Committee states. With the exception of Japan (which, due to the severity of its banking crisis in the late 1980s, could not immediately adopt Basel Is recommendations), all Basel Committee members implemented Basel Is recommendationsincluding the 8% capital adequacy targetby the end of 1992. Japan later harmonized its policies with those if Basel I in 1996. The OECD countries: similar to the EU regime, the Basel Capital Accord was also adopted throughout most of the OECD. However, detailed features of the rules were not always the same with variations that responded to local conditions, while nonetheless observing the spirit of the Accord. Australia, for example, set risk weights for banks' different exposures that reflected a more favorable view of the creditworthiness of banks incorporated in non-OECD countries from its own region.The Developing Countries: The widespread incorporation of the capital standards of the 1988 Basel Capital Accord in the regulatory regimes of developing countries was partly due to emulation and to the promotion by the BCBS of its regulatory standards through its contacts with supervisors throughout the world. But increasingly important has also been the growing connection between the internationalization of banking and insistence on observance of regulatory standards. As a developing country, Bangladesh, initiated steps to implement Basel Accord. It has ordered all commercial banks to adopt the rules within 31 December, 2010.

2.4 Application of Basel

SECURITIES AND OTHER FINANCIAL SUBSIDIARIES To the greatest extent possible, all banking and other relevant financial activities conducted within a group containing an internationally active bank will be captured through consolidation. Thus, majority-owned or-controlled banking entities, securities entities (where subject to broadly similar regulation or where securities activities are deemed banking activities) and other financial entities should generally be fully consolidated. Consolidation with such banks may be too risky with great possibility of loss. Supervisors can assess the appropriateness of recognizing in consolidated capital the minority interests that arise from the consolidation of less than wholly owned banking.INSURANCE SUBSIDIARIES

A bank that owns an insurance subsidiary bears the full entrepreneurial risks of the subsidiary and should recognize on a group-wide basis the risks included in the whole group. When measuring regulatory capital for banks, the Committee believes that at this stage it is, in principle, appropriate to deduct banks investments in insurance subsidiaries. Alternative approaches that can be applied should, in any case, include a group-wide perspective for determining capital adequacy and avoid double counting of capital. Basel II calls for credit rating of all kinds of financial institutions hence an insurance company to be subsidies must be in good score of credit rating.

SIGNIFICANT INVESTMENTS IN COMMERCIAL ENTITIES

Significant minority and majority investments in commercial entities which exceed certain materiality levels will be deducted from banks capital. Materiality levels will be determined by national accounting and/or regulatory practices. Materiality levels of 15% of the banks capital for individual significant investments in commercial entities and 60% of the banks capital for the aggregate of such investments, or stricter levels, will be applied for calculation. So any commercial entity with higher level of dependency on a individual investment will be treated risky one.Investments in significant minority- and majority-owned and controlled commercial entities below the materiality levels noted above will be risk weighted at no lower than 100%for banks using the standardized approach.

2.5 Basel II

The widely accepted new capital accord Basel II stands on three pillars:The First pillar- Minimum Capital Requirements.The Second Pillar- Supervisory Review Process.The Third Pillar- Market Discipline.

There are separate and very elaborate rules and regulations under the title if each pillar description about which requires many times and vast knowledge. So we are trying to present a brief overview about the three pillars.

Part 1: The First Pillar Minimum Capital RequirementsCalculation of minimum capital requirements

This section discusses the calculation of the total minimum capital requirements for credit, market and operational risk. The minimum capital requirements are composed of three fundamental elements; a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets. In calculating the capital ratio, the denominator or total risk weighted assets will be determined by multiplying the capital requirements for market risks and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figures to the sum of risk-weighted assets compiled for credit risk. The ratio will be calculated in relation to the denominator, using regulatory capital as the numerator. The definition of eligible regulatory capital will remain the same as outlined in the 1988 Accord and clarified in the 27 October 1998 press release on instruments eligible for inclusion in Tier 1 capital. The ratio must be no lower than 8% for total capital. Tier 2 capital will continue to be limited to 100% of Tier 1 capital.

Credit risk the standardized approach

The Committee proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. One alternative will be to measure credit risk in a standardized manner, the alternative methodology, which is subject to the explicit approval of the banks supervisor, would allow banks to use their internal ratings systems.

THE STANDARDISED APPROACH GENERAL RULES

Under standardized approach, credit assessment will be conducted by external credit assessment institutions (ECAI) as eligible for capital purposes by the national supervisors. Risk-weight against each rating will be applied to individual credit exposure to arrive at risk-weighted asset. Before allowing ECAIs such as the rating agencies, national supervisor will have to ensure that they fulfill the following standards set by Basel Committee (2004).The external credit assessment institutions (ECAI) must fulfill some Eligibility criteria:

Objectivity:

The methodology for assigning credit assessments must be rigorous, systematic, and subject to some form of validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. Before being recognized by supervisors, an assessment methodology for each market segment, including rigorous back testing, must have been established for at least one year and preferably three.

Independence:

An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. The assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest.

International access/Transparency: The individual assessments should be available to both domestic and foreign institutions with legitimate interests and at equivalent terms. In addition, the general methodology used by the ECAI should be publicly available.

Disclosure:

An ECAI should disclose the following information: its assessment methodologies, including the definition of default, the time horizon and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the assessments, e.g. the likelihood of AAA ratings becoming AA over time.

Resources:

An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments. Such assessments should be based on methodologies combining qualitative and quantitative approaches.Credibility:

To some extent, credibility is derived from the criteria above. In addition, the reliance on an ECAI is external credit assessments by independent parties (investors, insurers, trading partners) is evidence of the credibility of the assessments of an ECAI. The credibility of an ECAI is also underpinned by the existence of internal procedures to prevent the misuse of confidential information. In order to be eligible for recognition, any ECAI does not have to assess firms in more than one country.The first pillar provides three methodologies to rate the riskiness of a banks assets. The first of these methodologies, the standardized approach, extends the approach to capital weights used in Basel I to include market-based rating agencies. Sovereign claims, instead of being discounted according to the participation of the sovereign in the OECD, are now discounted according to the credit rating assigned to a sovereigns debt by an authorized rating institutionif debt is rated from AAA to AAA-, it is assigned a 0% weight; if it is rated from A+ to A-, it is assigned a 20% weight; if it is rated from BBB+ to BBB-, it receives a 50% weight; if it is rated from BB+ to BB-, it receives a 100% weight; and if it is rated below B-, it receives a 150% weight. Unrated debt is weighted at 100%. If debt is denominated and funded in local currency, regulators can also assign a lower weight to its relative riskiness.For bank debt, authorities can choose between two risk weighting options. In the first option, authorities can risk-weight this type of debt at one step less favorable than the debt of the banks sovereign government. For example, if a sovereigns debt were rated as A+, the risk weight of the banks under its jurisdiction would be 50%. Risk is capped at 100% if the sovereigns rating is below BB+ or unrated. The other option for the risk-weighting of bank debt follows a similar external credit assessment as sovereign bonds, where AAA to AAA- debt is weighted at 20%, A+ to BBB- debt is weighted at 50%, BB+ to BB- debt is weighted at 100%, and debt rated below B- is risk-weighted at 150%. Unrated debt is weighted at 50%. Short-term bank claims with maturities of less than three months are weighted at one step lower than a sovereign bond, where BB+ debt is given a 50% weight instead of a 100% value.In the standard approach, corporate debt is weighted in the same manner as bank debt, except the 100% category is extended to include all debt that is rated between BBB+ and BB-. All debt rated below BB-is weighted at 150%; unrated debt is risk-weighted at 100%. Home mortgages are, in addition, risk-weighted at 35%, while corporate mortgages are weighted at 100%.

Credit Riskthe Internal Ratings Based Approaches

Beyond the standardized approach, Basel II proposesand incentivizestwo alternate approaches toward risk-weighting capital, each known as an Internal Ratings Based Approach, or IRB. These approaches encourage banks to create their own internal systems to rate risk with the help of regulators. By forcing banks to scale up their risk-weighted reserves by 6% if they use the standardized approach, the Basel Committee offers banks the possibility of lower reserve holdingsand thus higher profitabilityif they adopt these internal approaches. The first internal ratings based approach is known as the Foundation IRB. In this approach, banks, with the approval of regulators, can develop probability of default models that provide in-house risk weightings for their loan books. Regulators provide the assumptions in these models, namely the probability of loss of each type of asset, the exposure of a bank to an at-risk asset at the time of its default, and the maturity risk associated with each type of asset. The second internal ratings based approach, Advanced IRB, is essentially the same as Foundation IRB, except for one important difference: the banks themselvesrather than regulatorsdetermine the assumptions of proprietary credit default models. Therefore, only the largest banks with the most complex modes can use this standard.Both IRB approaches give regulators and bankers significant benefits. Firstly, they encourage banks to take on customers of all types with lower probabilities of default by allowing these customers lower risk weightings. These low risk weightings translate into lower reserve requirements, and ultimately, higher profitability for a bank. Also, the IRB approaches allow banks to engage in self-surveillance: excessive risk-taking will force them to hold more cash on hand, causing banks to become unprofitable. Moreover, if a bank does become illiquid, regulators will be less apt to close the bank if it followed standard Basel II procedures. For regulators, self-surveillance also decreases the costs of regulation and potential legal battles with banks. Furthermore, the tailoring of risk weights allows additional capital to be channeled to the private sectorbecause public debt is no longer more trusted by assumption, banks will be more apt to lend to private sources. This, in turn, increases the depth of the banking sector in a countrys economy, and in sum, encourages economic growth. Poor risks can no longer hide under a rather arbitrary risk category, preventing the tendency of banks to wiggle risks around category-based weights.

Operational Risk

Secondly, Basel II extends its scope into the assessment of and protection against operational risks. To calculate the reserves needed to adequately guard against failures in internal processes, the decision-making of individuals, equipment, and other external events, Basel II proposes three mutually exclusive methods.

The first method, known as the Basic Indicator Approach, recommends that banks hold capital equal to fifteen percent of the average gross income earned by a bank in the past three years. Regulators are allowed to adjust the 15% number according to their risk assessment of each bank.

The second method, known as the Standardized Approach, divides a bank by its business lines to determine the amount of cash it must have on hand to protect itself against operational risk. Each line is weighted by its relative size within the company to create the percentage of assets the bank must hold. Following Figure displays the reserves targets by business line. As shown in the Figure, less operationally risky business linessuch as retail bankinghave lower reserve targets, while more variable and risky business linessuch as corporate financehave higher targets.

Figure: Standardized Approach Reserve Targets(Source: Basel II Accords, 2006 Revision)

Business Line% of Profits Neededin Reserves

Corporate Finance18%

Sales & Trading 18%

Retail Banking12%

Commercial Banking15%

Settlement18%

Agency Services15%

Asset Management12%

Retail Brokerage12%

The third method, the Advanced Measurement Approach, is much less arbitrary than its rival methodologies. On the other hand, it is much more demanding for regulators and banks alike: it allows banks to develop their own reserve calculations for operational risks. Regulators, of course, must approve the final results of these models. This approach, much like the IRB approaches shown in the last section, is an attempt to bring market discipline and self-surveillance into banking legislation and a move to eliminate wiggle room where banks obey regulations in rule but not in spirit.

Market Risk

The last risk evaluated in Pillar I of the Basel II accords attempts to quantify the reserves needed to be held by banks due to market risk, i.e. the risk of loss due to movements in asset prices. In its evaluation of market risk, Basel II makes a clear distinction between fixed income and other products such as equity, commodity, and foreign exchange vehicles and also separates the two principal risks that contribute to overall market risk: interest rate and volatility risk. For fixed income assets, a proprietary risk measurement called value at risk (VAR) is first proposed alongside the lines of the IRB approaches and the Advanced Measurement Approach; banks can develop their own calculations to determine the reserves needed to protect against interest rate and volatility risk for fixed income assets on a position-by-position basis. Again, regulators must approve of such an action.For banks that cannot or chose not to adopt VAR models to protect their fixed income assets against volatility or interest rate risk, Basel II recommends two separate risk protection methodologies. For interest rate riskthe risk that interest rates may fluctuate and decrease the value of a fixed-income assetreserve recommendations are tied to the maturity of the asset. Following Figure provides an overview of the risk weights assigned to each asset given its maturity. As seen to the right, depending on the time to maturity of the fixed-income asset, Basel II recommends a bank hold anywhere between 0% and 12.5% of an assets value in reserves to protect against movements in interest rates.

Figure: Interest Rate Risk Weightings (Source: Basel II Accords, 2006 Revision)

Time to MaturityRisk Weighting

1 Month or Less0.00%

6 Months or Less0.70%

1 Year or Less1.25%

4 Years or Less2.25%

8 Years or Less3.75%

16 Years or Less5.25%

20 Years or Less7.50%

Over 20 Years12.50%

To guard against the volatility risk of fixed income assets, Basel II recommends risk weightings tied to the credit risk ratings given to underlying bank assets. For assets rated by credit-rating agencies as AAA to AA-, a 0% weighting is assigned, while for A+ to BBB rated fixed income instruments, a 0.25% weighting is given. Furthermore, for instruments receiving a BB+ to B- rating, an 8% weight is assigned, and for instruments rated below B-, a 12% weight is allowed. Unrated assets are given an 8% Risk weighting. For the final calculation of the total amount of reserves needed to protect against market risk for fixed income instruments, the value of each fixed income asset is multiplied against both risk weightings and then summed alongside all other fixed income assets.Basel IIs risk weightings for all other market-based assetssuch as stocks, commodities, currencies, and hybrid instrumentsis based on a second, separate group of methodologies. It would be exhaustive to provide a full summary of the methods used for the calculation of reserves needed to protect against market risks, but this paper will provide a short summary of the three main types of rating methodologies used to rate these assets. The first group of methodologies is called The Simplified Approach, and uses systems similar to the bucket approaches used in non-VAR fixed income reserve calculations. This group looks to divide assets by type, maturity, volatility, and origin, and assign a risk weights along a spectrum of values, from 2.25% for the least risky assets to 100% for the most risky assets.The second group of methodologies for assigning the reserves needed to protect against market risk inherent in stock, currency, commodities, and other holdings is called Scenario Analysis. Here, risk weights are not grouped according to the cosmetic features of an asset; instead, risk weights are allocated according to the possible scenarios assets may face in each countrys markets. This approach, while much more complex than the Simplified Approach, is much less conservative and therefore more profitable for a bank. The final methodological group outlined in Basel II that calculates the reserves needed to guard against market risk is known as the Internal Model Approach, or IMA. Along the lines of the VAR and IRB approaches, this methodology group encourages banks to develop their own internal models to calculate a stock, currency, or commoditys market risk on a case-by-case basis. On average, the IMA is seen to be the most complex, least conservative, and most profitable of the approaches toward market risk modeling.

Total Capital AdequacyOnce a bank has calculated the reserves it needs on hand to guard against operational and market risk and has adjusted its asset base according to credit risk, it can calculate the on-hand capital reserves it needs to achieve capital adequacy as defined by Basel II. Because of the wide range of methodologies used by banks and the diversity of bank loan books, Basel II allows a great deal of variation in its calculated reserve requirements. Additionally, no change is given to both the requirement that Tier 2 capital reserves must be equal to the amount of Tier 1 capital reserves and the 8% reserve requirement for credit-default capital adequacy, making these two regulations applicable in Basel II. In sum, a banks needed reserves for capital adequacy is calculated as follows: Reserves = .08 * Risk Weighted Assets + Operational Risk Reserves + Market Risk Reserves

Part 2: The Second Pillar Supervisory Review Process

This section discusses the key principles of supervisory review, supervisor transparency and accountability and risk management guidance produced by the Committee with respect to banking risks, including guidance pertaining to the treatment of interest rate risk in the banking book

Four Key Principles of Supervisory Review

The Committee has identified four key principles of supervisory review, which are discussed in the Supporting Document Supervisory Review Process. This pillar is less much complicate and lengthy than Pillar I. So we mentioned only the headings of these four principles without describing the rules and guidelines under the headings.

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Part 3: The Third Pillar Market Discipline

Generally, the Committee is introducing disclosure recommendations. In some instances, however, disclosure requirements are attached to the use of a particular methodology or instrument, and as such form pre-conditions for the use of that methodology or instrument for regulatory capital purposes. Pillar 3 contains disclosure recommendations and requirements for banks.

Core and Supplementary Disclosure Recommendations:

Core disclosures are those which convey vital information for all institutions and are important to the basic operation of market discipline. All institutions will be expected to disclose this basic information. Categories of supplementary disclosures are also defined. These disclosures are important for some, but not all, institutions, depending on the nature of their risk exposure, capital adequacy and methods adopted to calculate the capital requirement. The division between core and supplementary disclosures reduces the disclosure burden on institutions.

Materiality:

Materiality will drive the decision on which disclosures are made. Information is regarded as material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information. The materiality concept should not be used to manage disclosures. The reasonable investor test, i.e. in the light of particular circumstances, a reasonable investor would consider the item to be important, is a useful benchmark for ensuring that sufficient disclosure is made.

Frequency:

Generally, the disclosures set out in this paper should be made on a semi-annual basis. Information is expected to be subject to a proper verification process on at least an annual basis, probably in the context of the annual report and financial statements. In certain categories of disclosure that are subject to rapid time decay, for instance risk exposure, and in particular for internationally active banks, quarterly disclosures are expected.

Templates:

A suggested format for reporting, in the form of templates, is provided in theSupporting Document Pillar 3: Market Discipline. Banks are invited to make use of the templates in their disclosures to encourage comparability.

2.6 A SUMMARY OF BASEL III UPDATE

Basel IIIBanking is a business, all over the world, where the contribution of capital becomes very insignificant in the volume of total business thereof. Balance sheet of almost all the banks must stand as the primary evidence of the comment. In a balance sheet, capital of most of the banks is seen as a small part of the sources of fund which build the properties and assets as shown therein. General equation of any balance sheet or the affairs of any concern is that total of capital and outsiders' liabilities always become equal to its properties and assets. In other words internal liability (capital/equity) and external liability equate the total properties and assets thereof. In modern terms it also may be equated as 'sources of fund vis--vis application of fund'. For banks, sources of fund substantially consist of shareholders' and depositors' fund and both are applied or invested in properties and assets thereof. So the major category of sources of fund is divided into two: i) capital and ii) depositors' fund. In other words, it is share holders' money versus depositors/ outsiders' money. All funds are then applied in bank's assets of different forms. Assets are again mostly represented by the loans, advances, investment and other fixed assets. It is also notable that in case of banks, most of the initial capital is exhausted for office premises and other fixed assets like electronic equipment, furniture, fixture, car for executives and other pre-operative/ preliminary expenses etc. As a result, a small part of capital remains available for investment. So the very truth for a bank is that most of the loans and advances are financed by depositors' money. The amount of capital/ shareholders' money weighs too light as compared to others' fund. Bank is rich with others' (dominated by depositors') money. As the vital source of blood circulation of a bank is the depositors' money, a global standard has been designed in the Bank for International Settlements (BIS). This discipline or agreement is known as International Convergence of Capital Measurement and Capital Standards. The standard was born in Basel of Switzerland. It has got a nickname as Basel accord or just Basel a much talked about issue now-a-days in the banking industry all over the world. Again after updating, a Revised Standard known as Basel-II has now been prevailing. For further updating, particularly in the backdrop of the latest financial meltdown, resulting in fall of many, too big to fall' like Lehman Brothers, AIG and many a bailout program to save the drowning ones, Basel-III is being cooked with more stringent regulations. Appreciation for this great and giant work, to make financial institutions safer, knows no bounds. None could deny that Basel accord has vibrated the banking world to turn its eyes towards banking/bank's health. Designing three pillars as foundation of Basel to withstand against anticipated and unanticipated financial storms obviously deserves credit. Extension of the purview of risk, segregation of different risk components, prescription of different approaches to measure them, suggesting different principles, and processes for supervisory review and requirement of transparency through market discipline/public disclosure are all for a safer global financial industry. All these steps are meant for keeping the confidence of the stakeholders and interest of the depositors through a systematic and constant follow up. This measure is comparable to regular/ routine human medical checkup' for good health. There remains no doubt that in the detail of the Basel, there are so many noble prescriptions for checking the health of a bank along with the different techniques to diagnose through sophisticated pathological test like VaR (Value at Risk) technique and stress testing, including sensitivity analysis and so on. The issues of difficulty of implementation or technicality of the process or the larger volume of works or need of expertise to arrange such a technical Medicare system or other usual limitations of Basel are not the subject matters of the article. Rather this writing raises the finger towards relative emphasis on the issues or areas of concentration clustering the Basel accord.

It appears from the vibration of the concerned corners of the industry that maintenance of minimum capital has become the burning area of concentration in Basel. Here is the point of dissent in light of the facts portrayed in the beginning of the writing in respect of scenario of a bank's balance-sheet. As already stated, usually capital of a bank is insignificant as amount in the total business volume of any bank. Depositors as a whole are the substantial contributor. On the other hand, the earning asset of a bank is mostly represented by its loans and advances as a whole. Thus the portion that deserves more importance in the liabilities side should have been the 'depositors money' (as opposed to capital) and in the asset side it is the 'loans and advances'. Then in respect of importance, the desired equilibrium should have been 'depositors money' versus loans and advances', not 'capital versus loans and advances'. It is the board of directors of a bank as representative of the equity holders, who to look after their capital and sound return thereof? What the supervisor (central bank) is mostly concerned about? Of course it is the interest of the outsiders, dominated by the depositors.

Now comes the question of the reason for which interest of the depositors need be specially taken care of. The simple reply is that because the lion's share of the money, injected to the borrowers, belongs to them (depositors). Credit or lending offered to the borrowers has got inherent risk of not coming back to the bank to return to the actual source i.e. to the depositors (on demand or at maturity). All the steps to assess risk of non-recovery of credit as prescribed in the Basel standard is its real strength. The lower the risk, the higher is the probability to recover money. The higher the recovery, the higher is the Bank's ability to pay off the depositors as and when required. Thereafter comes the question of protection of the depositors' money, when recovery is not sufficient. In that case there must be fund from elsewhere to pay off the depositors. It is nothing but the money or fund which is required for meeting crisis or on demand. It is irrelevant whether it comes from capital or otherwise. Whatever might be the proportion (between capital and outsiders' money), lent money consists of both the sources, internal and external (unless capital is exhausted earlier for say preliminary expenses etc). It is also irrelevant whether the size of capital is small or big. Important is the availability of fund. Capital does never mean availability of fund. Capital does not have any such provision that it must be available in the bank's vault. So capital does not necessarily mean liquidity to meet demand for fund. While lending, bank is rather constrained to lend the whole of the deposit (by way of stipulation of mandatory maintenance provision of CRR as well as SLR); but no such restriction is there against lending the full amount of capital. There is no rule that the bank must lend only the depositors money keeping the capital intact. In case of need, as the capacity in terms of liquidity becomes the dire concern, primary precaution must be to ensure liquidity/convertibility of loans and advances of the bank i.e. the health of the loans and advances. So making stringent regulation for selecting good clients, processing and maintaining health of the credit are more important than insisting on raising equity by 1.0 per cent or say 5.0 per cent even. Because, if loan repayment is sound, depositors interest is protected by ensuring availability of fund. An increased capital is never a guarantee for making fund available for the depositors. So it is again the quality of utilization of fund which is important; not the amount of capital or the proportion of capital structure per se.Now comes the question of bearing the burden of loss, if any, despite all the measures for maintaining good health of the assets. It is clear that the pressure of loss at first hits the capital. A loss up to the tune of capital is a loss of capital itself because of limited company's rule. A loss beyond the amount of capital is the loss of the depositors or other outsiders. So again it is the amount of capital (obviously not necessarily the ratio with the Risk Weighted Asset) which determines whether the risk of loss is also to spread over the depositors. No doubt higher the capital, the higher is the capacity to absorb loss. But this capacity, in other words, is the 'mandatorily foregone claim' of the shareholders on the asset of the bank. It is never the cash available by virtue of capital fund. Capital, be it core, supplementary or even conservation buffer (as going to be imposed under ensuing Basel-III), matters very little if it is not encashable in time of need. Capital is not enough without liquidity. Both are to be ensured; rather liquidity is a must for facing insolvency for loss resulting from non-performing loans (NPL) and/or from market/operational risk of the bank. Equilibrium between profitability and liquidity needs to be ensured prudently. Amount of capital alone is not the major constrained. This refers to the latest financial meltdown which has caused global recession and is still leading to closure of many financial institutions even today. It is important to note that the key reason for failure of financial institutions is always attributable to NPL and liquidity crisis, never was it for the lower capital. Enough is enough. Crisis triggered by non-recovery of loans, widened for the same and caused death of many for the same. This is not owing to small capital. Liquidity or availability of fund is totally different from the concept of equity or capital. Reckless lending with unscrupulous super rating, biased appraisal and processing of loans created by way of so-called derivatives, having no real asset backing, going beyond means tempted by greed etc. are the key contributors for the red light. Could a bit higher capital save them without available fund? Capital and fund in terms of financial management are not synonymous.So quality of asset, parties concerned with the process of assessment of risk including the external rating companies are to be taken into account for the good health of any bank. It is fair to maintain a proportion between the capital and other liabilities and again between capital and assets. It obviously makes sense. But without maintaining the asset-quality, invested capital has a very little role to play in the course of action meant for 'salvation'. Because both deposit and capital have been invested for earning. For a safer banking industry, it needs to maintain good health of asset and the availability of fund to absorb losses in crisis. It is true that the higher the capital, the higher is the capacity to absorb loss. This is the only relevance of the capital to the interest of the depositor. But the relative term of high capital to be compared not only to the RWA (risk weighted asset), but also to deposit and above all that must have a relationship with the liquidity. Capital without liquidity is no capital at all as coverage in need of fund. Fund becomes available under two situations: i) When they are kept fully unutilized/liquid, ii) When they are invested/ injected in assets qualified for routine/ quick encashment without any loss. The former does not at all mean business as usually it earns nothing/ or the least; it rather gets the risk of decay in value, for inflation. The latter (loans, advances and investment) earns and stands well provided it is not classified. So, which to ensure is quality of asset, not the amount of capital. Capital may not make fund available. A powerful vaccine for hepatitis is not supposed to protect TB and so on. Overemphasis on the ratio of capital amid being blind to the quality/reality of assets is tantamount to vigorous labor pain of the Mountain giving birth to a mouse or at the best mice.

Again trial and error introduction of subordinated bonds in the name of Tier-2 & Tier-3 capital does not make any sense in terms of relevance to its purpose. The very purpose of capital coverage is to protect the interest of the outsiders; depositors and other creditors. But bond or other debt-holders themselves are never shareholders or contributors to capital or equity (except some Islamic products under Mudaraba or Musharaka mode where 'quasi equity' treatment is allowed). Equity is internal liability of the company whereas debt-holders are externals. So bond/debt itself does not make sense of imitated capital even. Yet, convertibility of bonds into shares is a different thing. Collecting billions of money through so-called derivative of capital to satisfy regulatory capital requirement and subsequent exclusion (prescribed for Basel-III) of such items from the components of capital is like 'Tom & Jerry' game. Such a game, in an aristocrat industry like banks, is not desirable. To fight consequence of so- called derivative loan products (through excessive financial engineering), another derivative of capital, is introduced which in turn again increases the volume of outsiders' claim against the bank. They would also seek regulators' intervention for honoring their claims. Unless the subordinate debts are converted into shares, they will be in the same platform with other creditors to ask the bank to settle their debts duly, failure of which on the part of the bank would again chase them to look for bailout at the cost of society.

To protect the interest of the depositors, it is rather better to impose discriminating SLR on the basis of quality of bank's assets. The higher the rate of NPL (non-performing loans), the higher is to be the SLR and vice versa. SLR means liquidity, SLR means fund to absorb the shock. Capital might be invisible when invited for absorbing shock of loss. But CRR and SLR would not flee. Capital of Tk.100 may once worth less than Tk.10 in terms of liquidity to address crisis but SLR of Tk.100 need not be depreciated in this way. Of course all the measures to guard against entering ill-credit or failing of credit ill must be ensured and sharpened more as the most effective suggestion of Basel accord. Moreover, in the present context of Bangladesh it would be more effective and reasonable to contain/ restrain the banks from over-investment in the unfairly extremely volatile bourses than to insist on increasing of 1.0 per cent or 2.0 per cent capital on risk weighted amount of its asset leaving the substantial amount of its balance-sheet fraught with severe risk. Besides, as a rule, speculation should not be the banking business. BASEL III (sometimes "Basel 3") refers to a new update to the Basel Accords that is under development. While the Bank for International Settlements (BIS) does not currently specify this work as "Basel III", the term appeared in the literature as early as 2005 and is now in common usage anticipating this next revision to the Basel Accords.

The draft Basel III regulations include: "Tighter definitions of Tier 1 capital; banks must hold 4.5% by January 2015, then a further 2.5%, totaling 7%. the introduction of a leverage ratio, a framework for counter-cyclical capital buffers, measures to limit counterparty credit risk, And short and medium-term quantitative liquidity ratios.

New Proposed Ratios to measure and monitor Liquidity Risk

Liquidity Coverage Ratio

Introduction of a Liquidity Coverage Ratio - to promote the short-term resiliency of the liquidity risk profile of institutions by ensuring that they have sufficient high quality liquid resources to survive an acute stress scenario lasting for one month.

Net Stable Funding Ratio

To promote resiliency over longer-term time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis. The Net Stable Funding Ratio has been developed to capture structural issues related to funding choices.

2.7 Conclusion

Implementation of Basel II has been described as a long journey rather than a destination by itself. Undoubtedly, it would require commitment of substantial capital and human resources on the part of both banks and the supervisors. RBI has decided to follow a consultative process while implementing Basel II norms and move in a gradual, sequential and co-coordinated manner. As envisaged by the Basel Committee, the Finance profession too, will make a positive contribution in this respect to make Bangladesh banking system stronger. In this context, it should be noted that appointment and permission of External Credit rating Agencies must be authentic.

Chapter-3

Basel & Bangladesh

3.0 Preface of Bangladesh3.1 Banking Industry of Bangladesh3.2 Implementation of Basel in Bangladesh3.3 Challenges for Basel II implementation in Bangladesh3.4 Current Situation of Basel in Bangladesh

3.0 Preface of Bangladesh The Country: The Peoples Republic of Bangladesh Area : 147,570 square km. (Territorial water - 12 nautical miles) Capital City: Dhaka Metropolitan Area 1528 sq.km Population : 16 core 40 lack Population Growth Rate : 1.39 percent Population Density : 979 Person per sq km Currency : Taka (Tk.) GDP at Current Price : Tk. 6149.43 billion (US$ 89.04 billion) Annual per capital GDP : US$ 621 GDP growth rate at (1995/96) constant price : 5.88 per cent Agricultural growth rate at constant price : 4.81 per cent Industrial/Mfg growth rate (% of GDP) : 5.92 per cent Large & Medium scale Industry: 5.65 percent Small scale Industry : 6.59 percent Service sector growth rate of GDP at current price: 49.67 per cent Inflation rate (12 month average) : 7.69 per cent Domestic savings rate of GDP: 20.00 per cent National savings rate of GDP: 32.40 per cent Investment rate of GDP: 24.20 per cent Foreign Exchange Reserve : US$ 6,562.93 mn Remittances : US$ 8,770.16mn Foreign InvestmentDirect: US$ 900 mn Portfolio: US$ -123 mn Bank rate: 5.0 per cent Broad Money (M2): 281,902.00 Tk.crores Total No. of Limited Co.Public Limited Co : 35,000Private Limited Co. : 23,000 Principle Industries : Garments, Pharmaceuticals, Textiles, Paper, Manufacturing, Newsprint, Fertilizer, Leather and Leather goods, Sugar, Cement, Fish processing, Steel & Chemical industries etc. Major export items: Garments, Tea, Jute, Frozen shrimps, Leather products, Newsprint, paper, Naphtha, Urea, etc. Principle imports: Fuel, Rice, Wheat, Cotton & Textile, Petroleum products, Fertilizer, Staple fibers, yarn etc.3.1 Banking Industry of Bangladesh

To be secured one needs security. To get financial security one needs bank. This is a proved truth in the present world. Now banking sector is one of the largest & important sectors in any economy specially a developing country like ours. Although Bangladeshi banks are doing inelastic business, our banking sector is one of the fastest growing sectors. Bangladeshi banking system was started mainly by two Pakistani banks & its 151 branches that were established during Pakistani period. At that time there were 1094 branches of various schedules banks & foreign banks. Bangladesh Bank is the Central Bank of Bangladesh and the chief regulatory authority in the sector. Pursuant to Bangladesh Bank Order, 1972 the Government of Bangladesh reorganized the Dhaka branch of the State Bank of Pakistan as the central bank of the country, and named it Bangladesh Bank with retrospective effect from 16 December 1971.Now the financial system of Bangladesh consists of Bangladesh Bank as the central bank, 4 State Owned Commercial Banks, 5 governments owned specialized banks, 30 domestic private banks, and 9 foreign banks. Bangladesh follows branch banking system.

Central bankBangladesh Bank

State-owned Commercial Banks1. Sonali Bank2. Janata Bank3. Agrani Bank4. Rupali Bank

Private Commercial Banks1. AB Bank Ltd2. BRAC Bank Limited3. Eastern Bank Limited4. Dutch Bangla Bank Limited5. Dhaka Bank Limited6. Islami Bank Bangladesh Ltd7. Pubali Bank Limited8. Uttara Bank Limited9. IFIC Bank Limited10. National Bank Limited11. The City Bank Limited12. United Commercial Bank Limited13. NCC Bank Limited14. Prime Bank Limited15. SouthEast Bank Limited16. Al-Arafah Islami Bank Limited17. Social Islami Bank Limited18. Standard Bank Limited19. One Bank Limited20. Exim Bank Limited21. Mercantile Bank Limited22. Bangladesh Commerce Bank Limited23. Mutual Trust Bank Limited24. First Security Islami Bank Limited25. The Premier Bank Limited26. Bank Asia Limited27. Trust Bank Limited28. Shahjalal Islami Bank Limited29. Jamuna Bank Limited30. ICB Islami Bank

Foreign Commercial Banks1. Citibank na2. HSBC3. Standard Chartered Bank4. Commercial Bank of Ceylon5. State Bank of India6. Habib Bank7. National Bank of Pakistan8. Wo Bank9. Bank Alfalah

Development Banks 1. BangladeshKrishi Bank 2. Rajshahi Krishi UnnayanBank 3. Bank ofSmall Industries & CommerceBangladesh Ltd. 4. Bangladesh Development Bank Ltd

Other 1. Ansar VDPUnnayanBank 2. BangladeshSamabaiBank Ltd (BSBL) 3. GrameenBank 4. KarmasansthanBank5. The Dhaka Mercantile Co-operative Bank ltd

SLR & CRR Now SLR is 18.5% & CRR is 5.5%. The SLR for Islamic bank is 10.5%.

Deposit & Lending RateYearBank RateCall money market Weighted Average Rates onSchedule Banks Weighted Average Rates onSpread

BorrowingLendingDepositsAdvances

20105%6.62%6.62%

20095%6.35%11.49%5.14%

Value of bank in the capital market30 commercial banks are enlisted with DSE & 29 are enlisted with CSE. Here ICB Islami bank is excluded. Among the 30 listed banks Rupali, UCBL & First security banks are Z category banks while all other banks are A category. Among 22 sectors of our capital market, banking sector is the largest sector after NBFI. A short brief is given here to consider the importance of banking sectors. The data is taken from Prothom Alo on 5th August 2010.Transaction, EPS & PE based on sectorSectorDSECSE

BankMillion tk.Total%Million tk.Total%

3653.4818.44%265.8218.73%

BankAudited EPSAudited PEAudited EPSAudited PE

DSECSEDSECSE

15.9815.9642.4742.47

3.2 Implementation of Basel in BangladeshThe recent Global Financial Crisis has forced many banks to take a more critical look at how they conduct their business in terms of the risks they accept and how they manage and are compensated for these. The collapse of several high profile banks are the signs that something had gone very badly wrong with Banks' risk management practices.The latest version of capital standards for banks worldwide is BASEL II developed by the Basel Committee on Banking Supervision (BCBS). The new BASEL II accord has been prepared on the basis of three pillars: minimum capital requirement (determined by credit risk, operation risk and market risk), supervisory review process and market discipline. Bangladesh Bank has recently directed all scheduled banks to implement capital adequacy ratio (CAR) and minimum capital requirement (MCR) in three phases that started from the first of January this year. The scheduled banks will maintain CAR not less than eight percent between January 01, 2010 and June 30. The CAR will have to increase at least to nine percent between July 2010 and June 2011 and 10 percent in July 2011 to onwards. The MCR must be eight percent of a bank's risk weighted asset by June 30, 2010, nine percent by June 2011 and 10 percent from July 2011 to onwards.

3.3 Challenges for Basel II implementation in BangladeshSome of the major issues and challenges that might arise for the Bangladeshi banking system from the adoption of the Basel II framework are being outlines below. Pre-implementation considerations -- Timing of Implementation: Although there is a widespread recognition of Basel II as more sophisticated than Basel I, there has been considerable debate around the appropriate timing of Basel II even among developed countries. While most European Union (EU) countries have followed a "2007 parallel - 2008 live" timeline, the US regulators have deferred implementation to a "2008 parallel - 2009 live" timeline. The scenario in developing world is also mixed. The implementation plans in regard to Basel II, as far as Asia-Pacific is concerned, may be broadly divided into four ranges - one, where the simplest approaches and the most advanced approaches are available at the time of first implementation (Australia, Korea, Singapore, New Zealand); second, where the simplest approaches are available initially and at least one of the most advanced approaches is available within a year or two thereafter (Hong Kong, Japan, Indonesia, Thailand); third, where the simplest approaches are allowed initially and the date of availability of the most advanced approaches is yet to be announced or are available after more than two years (India, Malaysia, and Philippines); and fourth, where countries may remain on Basel I for a longer period before migrating to Basel II (China, Bangladesh, Vietnam).Premature adoption of Basel II in countries with limited capacity could inappropriately divert resources from the more urgent priorities, ultimately weakening rather than strengthening supervision. In one of its publications, the International Monetary Fund (IMF) agreed that countries should give priority first to strengthening their financial systems comprising institutions, markets and infrastructure and focus on achieving greater level of compliance with the Basel Core Principles.With that view in mind, the Bangladesh Bank needs to decide whether the timeline that it is contemplating is an appropriate one for Basel II implementation. At a minimum the following may be recommended to be implemented before Bangladesh moves into Basel II:

Implement "Market Risk Capital" as an addition to Basel I first; Automation of regulatory return submission - developing IT infrastructure for the local bank Capacity building for Central bank Developing robust External Credit Rating Agencies (ECAIs)

Selection of approaches: As Basel II offers a range of approaches, it is important to understand the difference between them and select the right approach for initial introduction in the Bangladesh market. Bangladesh Bank has already announced that it would intend to implement simpler approaches of Basel II (i.e. Standardized for Credit Risk, Basic/Standardized for Operational Risk and Simplified approach for Market Risk), which is probably the right choice. However it is important to recognize the limitations of simpler approaches. Standardized Credit Risk approach is heavily dependent on credit ratings from external rating agencies. Simpler approaches of operational and market risk do not effectively attempt to quantify the risk of the bank - they are more ballpark addition to the capital based on Bank's size of operation. Implementation of these simpler approaches can only generate the true benefit of Basel II if the quantitative capital assessment is coupled with qualitative measures of containing risk through better risk management practices. To ensure this, regulatory supervision needs to be strengthened. Wherever banks would be found deficient in their risk management practices, there is provision in Basel II for supervisors to require additional capital as part of Pillar 2. This supervisory role needs to be executed prudently.The advanced approaches have their limitations and issues as well, and they may be more problematic for Bangladesh. When most of the international banks with the state-of-the art banking practices are struggling to comply with the requirements of advanced approaches and the supervisors in even developed countries are struggling with the task of reviewing and approving advanced models, the Bangladesh Bank has appropriately decided not to venture that route in the immediate future. Hence, challenges of simplified approaches only will be discussed later.Implementation Consideration - The Industry -- External Credit Rating Agencies (ECAIs): The Standardized Approach for credit risk leans heavily on the external credit ratings. While there are a few rating agencies operating in Bangladesh, the rating penetration in Bangladesh is rather low. It is doubtful without a solid base of ECAIs operating in country how effective the implementation will be.

There is also a consideration whether the ratings of International Credit Rating Agencies would be accepted in capital calculations. International ECAIs like Moodys, S&P usually rate the head-office of the multinational corporations. Whether that rating would be acceptable for their Bangladesh subsidiaries is a point to ponder. Furthermore, there would always be a wide gap between the rating of an International agency and a local agency. In general, International agencies have much stricter rating practices, which, if accepted as a norm, would generally result in a capital requirement significantly higher than Basel I for the Bangladeshi banks! This creates an incentive for some of the bank clients to remain unrated since such entities receive a lower risk weight of 100 per cent vis--vis 150 per cent risk weight for a lower rated client. This might specially be the case if the unrated client expects a poor rating.

Market Readiness:

The disclosure requirements under the Pillar 3 of Basel II are quite extensive in nature. They are probably designed to suit advanced markets where there are numerous analysts to analyze and understand the disclosures and take investment decisions based on that. It is doubtful whether the market of Bangladesh is at all ready to take benefit such extensive disclosures. If not, then requiring banks to adhere to of such disclosure requirements would overburden the banks without any practical benefit.Banking vs. non-banking financial institutions (NBFIs): Since only banking institutions are subject to Basel II requirements, banks may find themselves in competitive disadvantage against specialized financial institutions, especially, leasing companies, microfinance institutions, foreign exchange remittance facilitating institutions and mutual funds. More specifically where banks provide services similar to these organizations, they may find it difficult to compete due to additional capital requirement which NBFIs would not have. This may create an asymmetry in the industry. Implementation Consideration - For the regulator: Resource adequacy; Implementing even the simpler approaches of Basel II requires significant involvement of the regulators, to ensure that the banks are not misusing the new rules. Several activities may require considerable involvement of the central bank:1) Issuing detailed Basel II Guidance, including all national discretions carefully evaluating their impact on the industry.2) Evaluating and continuously monitoring approved ECAIs.3) Educating banks4) Monitoring and taking decisions on Home-Host issues for international banks through continuous dialogue with supervisors in other countries.5) Human Resource and IT Infrastructure to review and evaluate banks' capital calculations. 6) Supervising banks under Pillar 2 of Basel II.7) Deciding Pillar 3 disclosure requirements and monitoring practices.Without adequate capacity building in the central bank to perform all these tasks in a timely fashion, Basel II Implementation would definitely be hampered.Implementation Consideration - For the banks: Possible higher capital requirement; The new accord might, in some cases, lead to an increase in the overall regulatory capital requirements for the banks, particularly under the simpler approaches to be adopted in Bangladesh, if the additional capital required for the operational risk is not offset by the capital relief available for the credit risk. This would, of course, depend upon the risk profile of the banks' portfolios and also provide an incentive for better risk management but the banks would need to be prepared to augment their capital through strategic capital planning.Increased competition for better rated clients: The new framework could also intensify the competition for the best clients with high credit ratings, which attract lower capital charge. This could put pressure on the margins of the banks. The banks would, therefore, need to streamline and reorient their client acquisition and retention strategy.

Changes in banking practices: The use-test requirement of Basel II dictates that banks must use the capital calculations in their management decisions like selection of clients, pricing banking products etc. This would require changes in banking practices often resulting in over-dependence on the external ratings of the clients. The larger local banks including the nationalized banks may have a very difficult time implementing changes.Increased competition in the labor market: Most countries implementing Basel II have experienced a shortage of skilled people in the industry who can understand and implement the sophisticated Basel II requirements. So, there is an almost certain likelihood that the banks in Bangladesh may also face a similar constraint. A good number of trainings and conferences can help ease this pressure.

Expensive software:

Software solutions for Basel II calculations available in the international market are quite expensive. While international banks can probably take advantage of software solutions procured by their head office, the local banks may find it burdensome to procure or develop such software.Competitive disadvantage for smaller banks: Smaller banks with a concentration on higher risk client group may find it to their further competitive disadvantage to implement Basel II as this may require them to maintain relatively higher capital than bigger banks with less risky client base. While this is a strong incentive to improve bank's risk management practices, some of the smaller banks in the Bangladesh industry, which are already finding it challenging to operate, may be further marginalized due to Basel II requirements.Implementation Consideration - For the society: Higher cost of banking services; The possible increased capital requirement and the significant cost of implementation may ultimately result in higher cost of banking services for the society. This may be especially true for corporate clients with weaker risk profile. Since the capital requirement on such clients will be several times higher than a larger, less risky client, banks will be inclined to charge them a significantly higher price for loan-type products.Definition of SMEs and Retail: The new accord does provide some benefit for retail client base and Small & Medium Enterprises (SMEs). A lower risk weight is applicable for these clients as they provide diversification for the bank. However, the definitions suggested by BIS may not be applicable for Bangladesh and hence the Bangladesh Bank, like almost all other supervisors of the world, has to redefine the thresholds of definition of SME and retail - especially the size and the granularity criteria.These definitions should be carefully thought out since qualifying the SME definition will mean an organization's access to lower cost credit. At the same time the definitions should also be designed such that banks cannot misuse the special rule to define their significant exposures as SME and evade capital requirement.

Unique market practices:

Basel II accord may not be adequate to cover some special type of banking practices seen in Bangladesh. In the Bangladesh market, banks are encouraged to provide credit to agrarian industries and agricultural farms as well as export oriented firms. The regulators should be careful that these firms don't get at disadvantageous position due to the new accord. If necessary, special "regulatory-segment" should be defined to allow preferential risk weights to these industries.Another unique practice is Islamic Banking. While Basel Accord is silent about this important banking product, some regulators (e.g. the Malaysian Regulator-BNM) have already defined Basel II rules for Islamic Banking. The Bangladesh Bank can follow this precedence.

While it is important that we move ahead with the world by implementing Basel II, it may not be a very bad idea to go slow in this regard to allow the industry more time to prepare itself for the new accord. Especially the development of local ECAIs should be a top priority before abruptly adopting the Standardized approach of Credit Risk - which is fully dependent on external rating. At the time of the implementation, the impact on the banks, the industry and the society should be carefully evaluated. Bangladesh Bank has given utmost concentration and best possible effort through consultative approach for implementing Basel II. Bangladesh will make possible parallel run of Basel II to current regulation from early 2009. We think the new accord would provide a level playing field for banking organizations meeting in international competition.

3.5 Current situation of Basel in Bangladesh

To meet the global financial crisis, about a year ago, the Conference on Global Banking in Mumbai announced safe guarding financial stability through regulation and supervision with a note on 'altruism driven self discipline.' Bangladesh Bank governor Dr. Atiur Rahman, in his keynote address said that the on-going reforms in financial sector regulation and supervision in Bangladesh aims at convergence with the global best practice standard set by the Basel Committee/BCBS for effective bank supervision. These are financial statements of the banks in internationally accepted accounting standard. Good corporate governance should be practiced by the banks. These would consist of proper tests for directors and chief executives, their role and responsibilities and the accountability for directors prior to central bank clearance for appointment and removal of CEOs. Recently the four state-owned commercial banks have been converted to public limited companies as steps towards privatization. For sound risk management Bangladesh Bank has issued a set of guidelines for management of core risks by the banks. Limits have been set on large single borrower, limits and disclosure on loans and facilities to directors, senior management and connected interests. Further support to risk management is provided through internal control and compliance units reporting to audit committees of boards, annual external audits, on and offsite Bangladesh Bank supervision. From 2009 onwards banks are to work out their capital requirement according to Basel II capital regime along with continuing compliance of current Basel I minimum plus two percent capital requirement on risk weighted assets.Upgraded regulatory and supervisory capacities would cover CAMELS rating of banks on a set of performance indicators. Introduction of intense stress testing routine would cover the shortfalls of the commercial banks trend towards engagement in capital market activities. Banks are engaged in major program of up gradation of IT platform to enable further the process of analyzing and reporting to Bangladesh Bank. To encourage the financial sector in underserved priority areas Bangladesh Bank is engaged in supporting and promoting 'deeper engagement of financial sector in agriculture, SMEs, low cost housing, renewable energy, environmental sustainability, solar/biogas, effluent treatment plants with provision for refinance if need be.'It is significant to note that the financial return on these activities when below par will be compared with greater socio-economic benefit such as employment, more assured livelihood. 'Such long term economic engagement will be preferred over risky speculative investment in the short term.'The governor's address ended on the resounding note that ' smaller developing economies should have opportunities for representation in these global consultationGlobal dialogue for new global financial architecture should have voice of smaller economies. The new financial order should have tethering global liquidity.'This end note is significant, for the members of the Basel Committee of Banking Supervision come from all over the world including India, Indonesia and not from Bangladesh, Nepal, Myanmar, SriLanka, Pakistan,Saudi Arabia or any of the Middle eastern countries.

Basil II is an improvement in 1988, International Bank Capital Accord on Basil I 1980. It offers more complex models for calculating regulatory capital. In other words banks holding riskier assets should have more capital at hand than those maintaining safer portfolios. Basel II standard requires that financial institutions maintain enough cash reserve to cover risks incurred by operations. Also requires banks to publish details of risks investments and risk management practices. It is mandatory for institutional managers to make capital allocation more risk sensitive. It requires the separation of credit risks from operational risks, thereby reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment.According to the Credit Rating Information and Services Limited/CRISL, Bangladesh will have to follow the roadmap of Basel implementation to remain in line with the international banking system. Briefly, Bangladesh financial system consists of Bangladesh Bank as the central bank, four nationalized commercial banks, and five government owned specialized banks, 30 private banks, ten foreign banks and 28 non-bank financial institutions.

The country's 28/29 non-banking financial institutions have for long demanded that the central bank allow foreign bank borrowing. The average cost of fund of an NBFI is much higher compared to a banking company. Under the Financial Institution Act 1993 direct foreign transaction is prohibited for the NBFI. To raise their capital nearly 20 NBFIs have issued initial public offering/IPO.Recently Bangladesh Bank decided that NBFIs would come under Basel II from January 2012 aiming at consolidation of financial base of the institutions. NBFIs would calculate minimum capital requirement under Basel II on test basis from 2011 and on the draft guideline. Next would be to develop risk adjusted assets and liability portfolio and capital structure.

According to Bangladesh Bank risk is the vital issue to be addressed. Basel II will be implemented under three approaches. These consist of: standardized approach for calculating risk weighted amount against credit. Second is the standardized approach to measure market risks and the third approach is the basic indicator approach for operational risk. Feedback meeting between April-August will finalize the guideline.Bangladesh Bank circular 14, 2007 Roadmap to Basel II: For implementation of Basel II the Quantitative Impact study showed that steps are needed to strengthen the capacity building of the supervisory officials who would then be prepared to implement the Basel II the new capital accord. The initial steps are standardized approach, which is that all banks need to have the same method to calculate risk weighted amount against credit risk supported by external credit assessment institutions/ ECAIs. There is to be standardized rule to assess market risk and basic indicator approach for operational risk. Risks then are of three types: weighted, market and operational. There are standard measures for risk management. To follow the roadmap of Basel II implementation, it is necessary to remain in line with international banking system. On February 9, 2009 Sameer Dossani interviewed Noam Chomsky about the global economic crisis and its roots: Double Standard: part of the question was ' Can you talk a little about the international implications of the financial crisis ' Chomsky's answer, partly, was 'It is rather striking to notice that the consensus on how to deal with the crisis in the rich countries is almost the opposite of the consensus on how the poor should deal with similar economic crisis. When the so-called developing countries have a financial crisis the IMF rules are: raise interest rates, cut down economic growth, tighten the belt, pay off your debts (to us) privatize and so on. That's the opposite of what is prescribed here. What's prescribed here is lower interest rates, pour government money into stimulating the economy, nationalise (but don't use the word) and so on. So yes, there is one set of rules for the weak and a different set of rules for the powerful. There is nothing novel about that.'

My own thoughts on the global financial crisis take me back to my school days. I recollect a passage for prcis writing, thus: Upon a hill site there was a clear cool stream of flowing water. A huge, fearful animal, probably a lion, was drinking water in the upstream region. Quite far away from him, a timid docile creature was also drinking water from the downstream region. Suddenly the big animal pounced upon the small animal and said that he had polluted the water by drinking from the same stream. The smaller creature disagreed and said this was not possible from the downstream position. The big animal then said that then it was the father of the small animal who had polluted the water for 'he drank water before you.' shouted the big animal. For me the current crisis bears a strong semblance to the content of this passage.

Chapter-4

Basel Accord & EBL

4.0 Introduction to EBL4.1 Basel Program in EBL4.2 Basel Implementation in EBL

4.0 Introduction to EBL

Eastern Bank Limited was founded in 1992 and is headquartered in Dhaka, Bangladesh through a network of branches & centers countrywide. Eastern Bank has its presence in major cities/towns of the country including Dhaka, Chittagong, Sylhet, Khulna and Rajshahi. Tracing its origin back to 1992, EBL is serving the individual and corporate clientele alike with remarkable success offering innovative banking services since then. The company commenced its banking operation on 16 August 1992. It listed with DSE on 20 March, 1993. First online banking operation was started on 17 July, 2003. It listed with CSE on September 11, 2004. Financial Aspects Total assets TK 74864 million. Total cash and short term investments TK 9836.6 million. Total current assets TK 12622.2 million. Total equity TK 8,455.7 million. Common stock TK. 2920.8million. Retained earnings TK.2909.3 million. Gross profit TK. 1,149.7 mill