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Unit 9: Commercial Banking Services

other major categories of risk such as market risk, interest rate risk in the banking books and Notes
operating risk and develop explicit capital charge.

Supervisory Review Process

The supervisory review of capital adequacy will seek to ensure that a bank's capital position is
consistent with its overall risk profile and with its overall strategy and encourage supervisory
intervention, if the capital does not provide sufficient buffer against risk. Bank managements
can develop an internal capital assessment process and set targets for capital that are
commensurate with the bank's specific risk profile and control environment. The internal process
would then be subjected to supervisory review and intervention where appropriate.

Market Discipline

Market discipline according to BCBS is a lever to strengthen the safety and soundness of the
banking system.
A close correspondence between the inherent riskiness of assets and the associated capital charge
will lead to changes in the assessment of the risk and return characteristics of financial assets. A
more precise allocation of banks risk capital could reduce the pricing differential between loans
and debt securities.

The proposals are likely to reduce regulatory capital arbitrage. Banks for example have been
economizing on the relatively high capital cost of corporate loans by securitising their highest
quality assets. Existing capital charges have encouraged them to hold a greater proportion of
lower quality assets. The existing rules may have created a bias in favour of short-term lending
to banks in emerging countries. Lastly, the proposals might have an impact on OTC derivatives
market since the 50% maximum risk weight that has been applied to off-balance sheet credit risk
exposures is likely to be replaced by a graduated scale based on credit ratings.

CRR and SLR on Interbank Deposits

The Sodhani Group (1995) identified the reserve requirement as the major impediment for the
development of the term interbank money market and recommended that it should be lifted.
The Group has also suggested that commercial banks should be permitted to deposit/borrow
short-term dollars abroad, up to the limits specified by the RBI.
The Reserve Bank of India, through its slack season credit policy announced on April 15, 1997 has
removed CRR and SLR on interbank liabilities. A term money market among banks, besides
engendering a rupee yield curve, is likely to emerge. Banks will no longer be forced to square
off their borrowing from other banks within the same fortnight. The interbank market which
was restricted to call and 14 day deposits/borrowing can now extend to 1-6 months term money
which will have beneficial impact on the availability and cost and volatility would be reduced.
Further, the freedom given to banks to borrow and invest funds in overseas money market
instruments up to $10 million through the credit policy announced on April 15, 1997 will not
only link the money and exchange markets but will augment the supply and demand for funds
and relate interest to the forward margin.

9.13 Nature of Primary Reserve in Commercial Banks

The term primary reserve is an analytical term used commonly in banking to refer to absolutely
non-earning liquid assets held by a commercial bank. The aggregate of cash holdings by bank
with itself and with the central bank and other commercial banks is designated as the primary
reserve. It consists of cash in hand, the balance with RBI and demand deposits with other banks.

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