Basel I had problems where it encouraged banks to lend to riskier borrowers and inhibited pricing based on credit risk. This led to inorganic asset growth while organic capital growth was slow. Basel II focused on balance sheet management with limited capital requiring expansion to be proportionally supported. It rationed portfolio lending and required loan pricing to be based on profitability. New products also allowed for credit risk transfer. Bank profitability was measured by return on equity, risk adjusted return on capital, and economic profit which considers return beyond cost.

1. Problems inhibited in Basel Ι
• Bank’s revenue earning tendency encourages lending to lower-quality borrowers
• Higher Interest rates inhibits Credit risk within Portfolio
• Cost-based pricings are not normally considered
• Lead to inorganic Asset growth
• While earning retention (organic capital growth) has been slow
Why Balance Sheet Management?
• Limited Capital: Capital is risk adjusted, Widely Covered, Capital Raising barrier
• Less Balance Sheet Expansion: Expansion needs proportional capital support
(90:10)
• Rationed Portfolio Lending: Early, any where you can invest because single risk
weight fit for all
• Loan/Investment pricing to profitability: Economic Profit
• Allocation of capital to support business: Generally 10 times, however, through
allocation it can be up to 50 times
• Credit Risk Transfer: Introduction of Innovative products, Securitized Lending
Measuring Bank Profitability
 Return on Equity: Post Financial Year Vs. Pre-financial year. Hence, ROE is at
targeted level
 Set by board of directors for bank management
 Thereby derives budgeting for cost of and allocation of capital
Risk Adjusted Return on Capital (RAROC):
 Broadly speaking, in business enterprises, risk is traded off against
benefit.
 Co-relation between risk and return
 Economic Profit “EP” (Economic Value Added):
 Return/value addition after considering its cost