Implications Of Basel 3 On The Indian Banking System

On May 30, 2012 in Banking, Economy by Prof. S. Srinivasan (External Contributor)

At the G-20 Summit in November 2010 held at Seoul, the member countries approved the Basel III framework for the international banking system. In India, the Reserve Bank of India had followed this up by issuing draft guidelines spelling out the roadmap for the implementation of the Basel III norms. This process will commence in Jan 2013 and will culminate in 2017.

Some of the major Basel III recommendations are as follows:

1.

Enhanced quantity and quality of capital The Tier 1 capital requirement has been increased to 7% of the total capital requirement of 10.5%, and many items have been removed from this category to ensure that capital is always available for loss absorption. Common equity and retained earnings will be the main components of Tier 1 capital. Items like Deferred Tax Assets (DTA), minority capital and holdings in other financial institutions have been dropped from this category. Banks are expected to phase out these components over a period of time. A capital conservation buffer of 2.5% and a counter-cyclical capital buffer have also been introduced. The quantitative norm for common equity has been increased from 2% to 4.5%.

2.

Backstop Leverage Ratio The leverage ratio has been fixed at 3%, which means that the ceiling on assets is 33 times the total capital. This is an absolute ratio, and must not be calculated on the risk weights of assets. The control on the leverage ratio will ensure that banks do not lend more than their capacity, which will provide a cushion for credit expansion through capital adequacy. In fact, it was uncontrolled leveraging by banks that had largely contributed to the sub-prime crisis and the resultant global financial meltdown.

3.

Short term and long term liquidity funding A 30-day liquidity coverage has been prescribed to introduce a stress test on the balance sheets of banks. There must be a match between the liquid assets of a bank and its cash outflows. Liquidity weightings are provided for assets, which range from 100% weight for items like cash and government bonds to 0%-50% for corporate bonds. Further, banks need to be alert to the available stable funding and the required stable funding, which is captured in the newly introduced Net Stable Funding Ratio (NSFR). Weighting factors have been set for the assets as well as liabilities of banks. For instance, Tier 1 capital, external commercial borrowings, retail deposits and borrowed funding have been assigned different weights.

4.

Rigorous credit risk management The counterparty default risk of banks adopting an internal ratings-based approach has to be calibrated to different stress scenarios. Importantly, the credit risk arising from derivative transactions has been mitigated through the Central Counter Party (CCP) and Capital Valuation Adjustment (CVA). The changing counterparty default profiles in mark-to-market transactions will be mitigated by the CVA, while all bilateral OTC transactions will be brought under the ambit of a CCP.

Impact on the Indian Banking system

A.

Profitability Subsequent to the Basel III norms, the capital of many banks will reduce by around 60% because of the phased removal of certain components of capital from Tier 1. In addition, the risk weightings are expected to grow by nearly 200%. The twin impact of these two stipulations will greatly reduce the ROE and the profitability of banks. The proposed shift from short-term to long-term liquidity will increase the cost of funds for the banking system. This will further squeeze the banks profit margins. ROE is defined as the product of ROA and the leverage multiplier . As the upper limit for the leverage ratio has been set at 3%, the value of the leverage multiplier will come down, resulting in a reduction in the ROE. This problem is more acute for Indian banks, as they are required to maintain around 24.5% as SLR and 4.5% as CRR.

B.

Capital acquisition Indian banks need to infuse additional capital over the next 5 years. Different estimates of additional capital infusion have been announced by various agencies. International credit ratings agency, Fitch, estimates this figure to be at around USD 50 billion, while ICRA projects a figure of around USD 80 billion. Macquarie Capital Securities predicts that there will be a USD 35 billion dilution in the existing capital of PSU banks subsequent to adoption of the stringent Basel III capital accord. However, the RBI Governor had recently stated that PSU banks presently have a capital adequacy ratio of 13.4%, wherein Tier 1 capital stood at 9.3%. This is a statement on the existing scenario, and does not take into account the imminent capital dilution. Moreover, additional capital will be required to address the enhanced counter party default, especially in OTC derivatives. In order to mitigate the OTC derivative risk, the concept of a central counter party (CCP) has been introduced. Recently, the SBI Chairman had announced that the entire export credit portfolio of SBI has been placed under the ECGC. Basel III emphasises another variant called the Credit Valuation Adjustment (CVA) capital to take care of the risk arising from mark-to-market deterioration in the creditworthiness of the counter party.

C.

Liquidity Needs One of the basic tenets of prudent banking is to borrow long and lend short. There must be a match between the duration of liabilities and the duration of assets, which is at the heart of asset-liability management. Prior to the financial crisis, banks exhibited a grave mismatch of their assets and liabilities. Long duration assets were acquired with short duration funding. However, it is a known fact that illiquid banks will soon become insolvent. The liquidity profiles of banks were not factored into the Basel I and II frameworks but are accounted for by Basel III . Short-term liquidity coverage for 30 days has been recommended by the Basel Committee. Under this norm, high quality liquid assets are compared to the expected cash outflows over a period of 30 days. Cash outflows need to be met with adequate liquid assets. This ratio is termed as the Liquidity Coverage Ratio (LCR). Another ratio concept introduced is the Net Stable Funding Ratio (NSFR). This ratio is intended to reduce the dependence of banks on short-term wholesale funding and increase their dependence on longterm funding. Long-term sources of funding are more available for the larger banks as compared to the smaller outfits.

D.

Limits on lending A leverage ratio of 3% has to be adhered to by all banks, which translate into a limit on assets at 33 times of the capital. Before the recent financial crisis, international banks were leveraging 50 times, but this was not captured in the risk framework as low risk assets allow higher leverage. This anomaly is sought to be removed by having a simple leverage ratio of 3%. Thereby, if a bank wishes to acquire more assets, it can do so only by increasing its capital. Presently, the leverage ratio of Indian banks is moderate, and hence, not a cause for concern. However, with capital dilution, increased risk weightings and ceilings on derivative trading, the new leverage ratio will impact the lending capability of the banks. As India is a developing economy, the shrinkage of bank credit can set in recessionary trends. Further, the developmental agenda of the Indian banks will take a backseat in such a situation. While systemic stability is welcome, it cannot be at the cost of the larger economic goals of poverty alleviation, employment generation, priority sector lending and balanced regional growth. Bank consolidation Basel III will set off a process of churning in the banking industry. Smaller banks will find it difficult to meet the new Basel guidelines, and a process of consolidation is underway. Smaller banks will find it difficult to raise more capital and meet the liquidity requirements. This will result in reduction of the scope of operations of the smaller banks, rendering them less profitable. It is expected that there will be a process of consolidation in the Indian banking industry through a process of mergers and acquisitions, which will culminate in the bigger banks acquiring the smaller ones.

E.

F.

Stability in the Banking system Basel III incorporates both micro-prudential regulations and macro-prudential regulations. Micro-prudential guidelines ensure the viability and risk compliance of individual banks, while macroprudential guidelines target the stability of the banking system as a whole. This is a major departure from the earlier two rounds of Basel norms. Earlier, the Basel regulations concentrated the capital frameworks of individual banks with the idea that regulating the parts will regulate the whole. However, the sub-prime crisis revealed inadequacies in this approach, as weaker banks can throw the entire

system into a tailspin. Further to the approach of integrating micro regulations with macro ones, Basel III identifies Systemically Important Financial Institutions (SIFIs) whose functioning is critical to the health of the entire banking system. Therefore, it is opined that the new regime of prudential regulations will result in greater stability of the banking industry in various countries. Exercising controls on the capital, liquidity and leveraging of banks will ensure that they have the ability to withstand crises.