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SUMMARY

The financial crisis of 2008 was the largest global economic crisis since the Great Depression. It brought down major institutions such as Lehman Brothers and Bear Stearns, led to a rush to bail out many other banks, and revealed a plethora of flaws in the financial system. The response of the Basel Committee and the G20 was to introduce a set of regulations that aimed to overhaul the financial industry

On September 12, 2010, the Basel Committee for banking Supervision endorsed the Basel III accord. The new regulations aspire to make the banking system safer by redressing many of the flaws that became visible in the crisis.

These regulations will force financial institutions to make considerable changes to the way they are run, because of the costs imposed not only by the increase in assets that have to be held, but also by the increased resources that many functions, but principally risk and compliance, will require to expand to meet regulatory ratios and reporting requirements. Financial institutions will need to perform more calculations and submit more data to regulators than ever before, while coming under greater pressure to raise capital, liquid assets, and collateral. With such an increase in regulations, the danger for many financial institutions is that the regulatory workload will consume an ever-greater proportion of resources, preventing functions such as risk and finance from pursuing business goals.

Financial institutions ought to consider how transitioning to Basel 3 can help them, not the regulators. To adapt to the pressure on resources and the impact of new regulations, financial institutions will therefore need to make a number of changes to improve their performance. This paper aims to explore and investigate the new capital regulations under Basel III proposed by the Basel Committee. In this project the total capital requirement and hence the CRAR ratio for 2012-2103 have been calculate according to the norms. Then in the second part of analysis the relationship between the capital adequacy ratio and its determinants. Due to the fact that the new regulations are going to be a “game changer” for the banking sector, an assessment is being done to estimate the effects of the enhanced capital requirements on the sampled banks. A quantitative analysis is done to explore the relationship between CRAR and the various factors related with three types of risk i.e. Credit Risk, Operational Risk and Market Risk. The analysis on minimal capital requirements reveals that, most banks in the study are sufficiently capitalized or are bit lower to meet the requirements. For the purpose of my project I have stick to Pillar I of Basel III mainly. However, balance sheet restructuring will have to be undertaken with a change of banks business models being considered in order to comply with the extra liquidity requirements. From the findings, Indian Banks will have to enhance their additional tier I ratio by a great deal to meet the requirement

because most of the Bank are lacking on this front. Most probably in turn, banks will pass on these costs to consumers in terms of higher lending rates and constraint lending. For PSB’s government will also have to infuse more resources and for Private Banks they might go for fresh offering of shares. They also have to bring down their risk weighted asset. The significance of Basel 3 cannot be overestimated. The measures will considerably increase the capital cushion banks must hold, impose major short-term costs on banks, and change the way banks manage themselves.

  • Thesis Objective:

    • To know the various Provisions of Basel III .

    • To see the changes between Basel II and Basel III.

    • To understand the structure of how the capitals for CRAR is calculated under Basel III.

    • To see whether Indian Banks are able to be committed by the Regulatory Capital Requirements defined by the BASEL-III framework.

    • To find a significant relationship between the capital adequacy ratio and its determinants.

    • The new rules were published in December 2009, and afterwards, Basel III was released in December 2010. In parallel, the European Commission launched a legislative process to issue its fourth Capital Requirement Directive (CRD IV), which was to be enacted in 2010.

      • Analysis

The new framework continues to build upon the three pillars as in Basel II with major changes occurring in pillar 1. In this pillar, the Committee has proposed significant changes to capital in terms of composition and capital ratios. The aim is to enhance the quality and increase the quantity of capital. Another major innovation is the introduction of global liquidity standards which has two aspects; namely Liquidity Coverage Ratio and the Net Stable Funding Ratio that banks must maintain as a minimum,

however RBI have not included in these two ratio in their directives to be followed. In the previous frameworks, the Committee only gave recommendations regarding sound liquidity risk management practices for financial institutions. The Committee further recommends changes to Pillar 2 (banks internal assessment of capital and supervisory review risk of risk management and capital assessment), and pillar 3 (market discipline). This project is basically based on Pillar I of Basel III. As for the constraint of space here the detailed explanation of norms are given in the main report submitted by me and only the explanation part is dealt here. PSU group comprises of Punjab National Bank, State Bank Of India,United Bank of India and Bank Of Baroda. The Private group comprises of ICICI Bank, HDFC Bank, Yes Bank, South Indian Bank.

The analysis is aimed at investigating the impact on bank’s capital ratios (i.e., whether the respective

banks are sufficiently capitalized to comply with the new capital ratios given their current status.)

retrieved from the respective annual financial accounts and risk reports for 2012-2013. Therefore, changes in the financial reports that occurred after this period are not taken into account. The analysis is initiated on ten large Indian Lending banks; that is, those banks that derive a larger proportion of their operating income from lending activities (either retail or wholesale). The analysis is done by dividing banks in two groups-1) PSU’s where majority of the bank’s equity is held by Government of India., 2)Private which is owned and managed by Private Promoters. PSU group comprises of Punjab National Bank, State Bank Of India,United Bank of India and Bank Of Baroda. The Private group comprises of ICICI Bank, HDFC Bank, Yes Bank, South Indian Bank.

The analysis is aimed at investigating the impact on bank’s capital ratios (i.e., whether the respective

banks are sufficiently capitalized to comply with the new capital ratios given their current status.) retrieved from the respective annual reports for 2012-2013. Therefore, changes in the financial reports that occurred after this period are not taken into account. I have decided to apply the risk-weighted assets as calculated under Basel II. This might lead to a reduction of reported risk-weighted assets for large banks, since they employ more sophisticated risk models.

There are assumption which is necessary since it is not possible to completely ascertain the given criteria to fully meet the Basel III requirements for inclusion in CET1, AT1 &Tier 2 capital. The countercyclical buffer and extra capital surcharge for systemically important banks are not put into consideration when assessing the individual banks compliance with Basel III. This is because the precise

application of the buffer is yet to be finalized . The format on which I have taken out these capital ratio is provided by the PNB to me.

  • Group 1 (PSB):

The Red Colour figures show those amounts that are below the required limit.

  • PNB

       

actual

   

amount

%

of

TOTAL

ACTUAL

according

to

%

ACTUA

ITEMS

RWA

AMOUNT

AMOUNT

Basel 3

OF RWAL

DIFFERENCE

Minimum Common Equity Tier I (CET 1)

4.50%

146074409

145221807

145221807

4.47373456

-852601.78

Maximum Additional Tier I capital

1.50%

48691469.6

20205000

20205000

0.62243962

-28486470

Minimum Tier I Capital

6.00%

194765878

 
  • 165426807 -29339071

165426807

5.09617419

 

Maximum Tier 2 Capital

2.00%

64921959.5

 
  • 115745031 64921959.46

2

50823072

Minimum Total Capital / CRAR

9.00%

292148818

 
  • 281171838 -10976980

230348766.5

7.09617419

 

Table 1: Capital Ratios of PNB

PNB is the third largest bank in India in terms of asset size. Despite this Most Of Its Ratio except Tier 2 are below required level. Good thing for them is that it is slightly less. Their core capital i.e. CET are 4.47% and the needed is 4.5% which is .03% less, which makes most of the part of Total Capital. The

basic problem for the PNB is their Additional Tier I capital, this is because their debt capital instruments are not up to the par. According to Mr. K.R. Kamath, PNB's Chairman and Managing Director, they can get some income by focusing on recovery, and other way is if the interest rate cycle reverses , the bank would be able to unlock certain treasury profits.

  • SBI

       

actual

   

amount

% of

TOTAL

ACTUAL

according to

% ACTUA OF

ITEMS

RWA

AMOUNT

AMOUNT

basel 3

RWAL

DIFFERENCE

Minimum Common Equity Tier I (CET 1)

4.50%

584711370.3

762911814

762911814

5.871449296

178200443.7

Maximum Additional Tier

         

-

I capital

1.50%

194903790.1

55578125

55578125

0.427735076

139325665.1

Minimum Tier I Capital

6.00%

779615160.3

818489939

818489939

6.299184372

38874778.65

Maximum Tier 2 Capital

2.00%

259871720.1

 
  • 3520287200 3260415480

339045970.8

2.609333333

 

Minimum Total Capital / CRAR

9.00%

1169422741

 
  • 4338777139 3169354398

1157535910

8.908517705

 

Table 2 :Capital Ratios of SBI

Although the total capital ratio is less than the required amount but this too is slightly less than the required limit. It has a very healthy CET ratio and is all set to meet its 5.5% requirement by 2018. According to experts, some of the required money will come through internal accruals and some part will have to be raised from the market. The government is likely to infuse Rs 4,000 crore into the bank this fiscal out of the Rs 14,000 crore planned towards recapitalizing the nationalized banks this fiscal.

  • BOB

       

Actual

   

Amount

%

of

TOTAL

ACTUAL

with

Basel

% ACTUA OF

ITEMS

RWA

AMOUNT

AMOUNT

3 norms

RWAL

DIFFERENCE

Minimum Common Equity Tier I (CET 1)

4.50%

137140537.5

178322315

178322315

5.85129993

196482478.7

           

-

Maximum Additional Tier I capital

1.50%

45713512.5

19117000

19117000

0.627287172

141832091.7

Minimum Tier I Capital

6.00%

182854050

 

197439315

  • 197439315 54650386.98

6.478587103

 

Maximum Tier 2 Capital

2.00%

60951350

 

79236755

  • 101917755 3257073578

2.6

 

Minimum Total Capital / CRAR

9.00%

274281075

 

276676070

  • 299357070 3311723965

9.078587103

 

Table 3 : Capital Ratios of Bank Of Baroda

As seen from the Table it’s complying with all the limits now itself thus justifying the status of second largest bank of India. Only Additional tier I capital ratio is less than prescribed., but compared to earlier two banks it’s slightly in a better position. The government has a shareholding of about 57% , so they can lay-off a small stake if needed.

UBI:

 

%

of

TOTAL

ACTUAL

 

%

ACTUA

 

ITEMS

RWA

AMOUNT

AMOUNT

OF RWAL

DIFFERENCE

Minimum Common Equity Tier I (CET 1)

4.50%

28122377.3

 

31929184

  • 31929184 3806806.699

5.109145876

 

Maximum Additional Tier I capital

1.50%

9374125.767

 

10644840.59

  • 11000000 1625874.233

1.7033

 

Minimum Tier I Capital

6.00%

37496503.07

 

41303309.77

  • 42929184 5432680.933

6.609145876

 

Maximum Tier 2 Capital

2.00%

12498834.36

 

14165345.61

  • 26970087 14471252.64

2.266666667

 

Minimum Total Capital / CRAR

9.00%

56244754.6

 
  • 69899271 55468655.37

8.875812543

13654516.4

Table 4 : Capital Ratios for united Bank Of India

Though a small bank in terms of operations, it is the only bank which is complying with all the ratio, except the total capital requirement , that too by a small margin but that can be settled by the additional capital in tier II and additional tier I capital. This can be done because Basel has allowed it. United Bank of India has also raised R500 crore through tier-2 bonds for complying with the Basel-III guidelines

  • GROUP 2 (Private) :

    • HDFC

       

ACTUAL

amt

     

%

of

REQUIREDTOTAL

according

to

ACTUAL %

%

ITEMS

RWA

AMOUNT

ACTUAL

Basel 3

RWA

DIFFERENCE

DIFFERENCE

Minimum

             

(CET 1)

4.50%

137645500.5

165,468,748

165,468,748

  • 5.41 27,823,248

20.2136992

Maximum

           

-

AT 1 capital

1.50%#

45881833.5

2000000

2000000

  • 0.07 -43,881,834

95.6409763

Minimum

           

-

Tier1 Cap

6.00%

183527334

167,468,748

167,468,748

  • 5.48 -16,058,586

8.74996964

Maximum

             

Tier2 Cap

2.00%#

61175778

165852776

73546879.77

  • 2.40 12,371,102

20.2222222

Minimum

             

TotalCapital/

CRAR

9.00%

275291001

333,321,524

241,015,628

  • 7.88 -12.450597

-34,275,373

Table 5:Capital ratios for HDFC

HDFC is complying with the CET I ratio limit but is not very comfortable with other ratios. Here also we can see that Rs 43,881,834 thousands are needed only for additional tier I, which is 95% less than the required. Although the Tier II capital does some balancing act but still the total required capital is around 12.45% less than required amount.

  • YES Bank

Although with a strong prospect the bank seems to be struggling to comply with the Basel III ratio, with non of its ratio in line with the norms. This could happen because Bank is still in growing phase and the risk weighted asset are high to increase growth. The major reason for their non compliance is their CET

ratio which is way below required level, though their tier II ratio are pretty good which can handle the pressure a bit but they seriously need to build up their CET 1and Additional tier I ratio.

 

%

of

TOTAL

ACTUAL

 

% ACTUA

 

ITEMS

RWA

AMOUNT

AMOUNT

OF RWAL

DIFFERENCE

Minimum Common Equity

         

-

Tier I (CET 1)

4.50%

30254552.91

13279535

13279535

1.975171

16975017.91

Maximum

Additional

Tier

I

           

capital

1.50%

10084850.97

7781425

7781425

1.157393

-2303425.97

           

-

Minimum Tier I Capital

 

6.00%

40339403.88

21060960

21060960

3.132564

19278443.88

Maximum Tier 2 Capital

 

2.00%

13446467.96

85995984

13446468

2

0

Minimum

Total

Capital

/

         

-

CRAR

9.00%

60509105.82

107056944

34507428

5.132564

26001677.86

Table 6:Capital ratios for YES Bank

  • ICICI Bank

       

actual

   

amount

%

of

TOTAL

ACTUAL

according to

%

ACTUA

ITEMS

RWA

AMOUNT

AMOUNT

Basel 3

OF RWAL

DIFFERENCE

Minimum Common Equity Tier I (CET 1)

4.50%

198874800

276692391

276692791

6.260811121

77817991

Maximum

Additional

Tier

I

           

capital

1.50%

66291600

13010000

2.086666667

  • 92218981.33 25927381.33

Minimum Tier I Capital

 

6.00%

265166400

289702391

 

8.347477788

  • 368911772.3 103745372.3

 

Maximum Tier 2 Capital

 

2.00%

88388800

387063837

 

2.782222222

  • 122958641.8 34569841.78

 

Minimum Total Capital / CRAR

 

9.00%

397749600

676766228

 

11.12970001

  • 491870414.1 94120814.11

 

Table 7:Capital ratios for ICICI Bank

With all the ratio sitting nicely above the required amount ICICI is very much set to implement the full fledged Basel III norms by 2018. But they also have to go to investor for raising capital.

  • South Indian Bank

 

%

of

TOTAL

ACTUAL

%

ACTUA

 

ITEMS

RWA

AMOUNT

AMOUNT

OF RWAL

DIFFERENCE

Minimum Common Equity Tier I (CET 1)

4.50%

10360837.53

1344730

0.584053652

-9016108

Maximum Additional Tier I capital

1.50%

3453612.509

0

0

-3453613

Minimum Tier I Capital

6.00%

13814450.04

1344730

  • 0.584053652 -12469720

 

Maximum Tier 2 Capital

2.00%

4604816.679

4604816.679

2

0

Minimum Total Capital / CRAR

9.00%

20721675.05

5949546.679

  • 2.584053652 -14772128

 

Table 8 :Capital ratios for South Indian Bank

The compliance issue with the Basel Norms is one of the biggest issue they have right now because except Tier II ratio, no other Ratio are complying with the Basel norms. The two major reason for this are very low CET1 ratio and Nil Additional Tier capital.

  • Regression Analysis:

In the second part of the analysis I have a taken a model to see the relationship the factors that determine the key capital ratio the CRAR in Indian banks.The Independent variable here is CRAR (Capital Risk Adjusted Ratio) and Independent variables which show three types of Risk(market risk, credit risk and operational risk) are CRAR, Deposits, Number Branches, Business Per Employee, Profit per employee, Advances, Return on Equity, Net Non Performing Asset,Capital, Credit deposit Ratio

The purpose of regression is to find those variables among the given variables on which influence CRAR, so that banks can concentrate on these variables to improve CRAR.

Model Summary

 

Model

R

R Square

Adjusted R Square

Std.

Error

of

the

 

Estimate

 

1

.935 a

.874

.820

1.58512

 

a. Predictors: (Constant), Cap, deposits, Off_emp, NNPA, Bus_emp, OFFICE.

 

R square is equal to 0.874, so we can say that 87.4% of the variations in the model can be explained by the variables. So we can say that model is apt to explain the relationship.

Coefficients

 

Model

Unstandardized Coefficients

Standardized

t

Sig.

 

Coefficients

B

Std. Error

Beta

 

(Constant)

15.658

1.895

 

8.265

.000

deposits

.017

.007

.630

2.336

.035

OFFICE

-.002

.001

-.916

-2.688

.018

1

Bus_emp

-.766

.134

-.879

-5.731

.000

Prof_emp

71.051

10.081

1.008

7.048

.000

NNPA

.001

.000

.367

1.958

.070

Cap

.003

.001

.263

2.332

.035

a. Dependent Variable: CRAR

From the above table we get the equation:

CRAR= 15.678 + .017(deposits) - 0.002(Office) - 0.766(Business per Employee) + 71.051(Profit per Employee) + 0.001(NNPA ) + 0.003 (Capital)

This model means that if deposits increase by 1thousand crores the CRAR will increase by .017., similarly if number of office increases by 100 branches the CRAR will decrease by .002, and so on. The negative sign of the coefficients for the Number of Offices and Business Per Employee clearly indicate how larger number of offices and more business per employee can also contribute to operational risk. From the profitability point of view Profit Per employee is the most significant factor in influencing CRAR. If profit per employee increase by .1 then CRAR increases by 71.051, as we can see Profit per employee has most significant effect on CRAR. As we can see NNPA is having a small but positive effect on the CRAR. This can be explained as NNPA increases banks increase their Capital and hence CRAR ratio to be on safer side. The significance level taken for the analysis is 1%. By seeing this equation Banks can concentrate on these six factors for improving their CRAR.

This model means that if deposits increase by 1thousand crores the CRAR will increase by .017.,

Recommendations:-

Conclusion:

Apart from just attaining compliance with the new regulations, banks especially those with high internal standards and demands will go beyond compliance and take measures to restore profitability. Numerous actions with different duration and range are available to achieve these objectives. The basic mode of action which can be taken are divide under three important headings but dealt in detail in the main report submitted.

  • Operational Responses

Basel III creates incentives for banks to improve their operating processes not only to meet

requirements but to increase efficiency and lower costs.

  • Tactical Responses

Besides the rather short-term operational responses banks have a number of more far-reaching tactical actions they can take to respond, especially to profitability concerns. The focus of tactical responses should be on the areas of pricing, funding and asset restructuring. While tactical responses by definition

do not address long-term strategic issues, they may be extremely helpful in relieving pressure on profitability.

  • Strategic Responses

In reviewing their strategic responses to Basel III and to the dangers of reduced profitability, banks have

the opportunity to effect major changes throughout all areas of the institution. These include fairly straightforward initiatives such as retaining earnings to increase Tier 1 Capital but also encompass a broad range of far reaching possibilities explained in main report.

Besides above for raising Capital banks can do the following :

  • The first would be to introduce the concept of golden share for Indian banks as Margaret Thatcher the then Prime Minister of Britain did it in the 1980’s for privatizing public sector entities. As a concept

golden share means, reducing the stake in a company below 50% but retaining the majority voting rights. It basically delinks voting rights from ownership. So, as a solution the government can take up

golden share to retain the voting rights but bring in funds from private players and reduce their stake below 50% in public sector banks.

  • An alternative to this is to create a banking sector holding company in which the Government will hold the majority stake, and the holding company in turn will hold majority stake in public sector banks. This was briefly outlined by the Finance Minister of India in his Union budget speech in March 2012. The Government can raise capital for the banking holding company through various means including a public offering. If implemented successfully this could be the biggest structural change in the Indian banking sector since nationalization in 1969 and 1980. Indian banks will have to learn the art of balancing growth with capital requirements. The ability to efficiently manage the tier 1 and tier 2 capital will be critical to manage return on equity. Indian banks should move quickly to advanced approaches of risk estimation from the formula based approaches to avoid over-estimation in capital requirements for credit and operational risk. The Basel committee is also proposing to increase the credit conversion factor of off-balance sheet items from 20% to 100%. This will mean that the banks will have to set aside more capital against asset backed loans, thus reducing their leverage and bringing in more stability in the banking sector.

golden share means, reducing the stake in a company below 50% but retaining the majority voting

Learning and conclusion:

In this thesis I have studied the Basel frameworks and gained particular insight in to the Basel III

framework. Since the new liquidity and capital standards are still in its initial stage I found it interesting and relevant to make a quantitative assessment of Indian Banking institutions’

ability to comply with the Basel Committee’s proposals. The liquidity requirements were not possible to assess on individual banks. The reduction is tied to the unfavorable treatment of mortgage bonds as liquid assets. The mortgage bond market is important for the Moreover, the analysis shows that the Banking institutions need to restructure their balance sheets and change the maturity structure of their liabilities and issued bonds. In the end it can be expected that there will be more expensive to finance activities.

Furthermore, the institutions’ flexibility in obtaining funds will be reduced.

The quantitative assessment of the ability to comply with the capital requirements reveals that the majority of the banks in the study are almost sufficiently capitalized. However, capital levels will be reduced as most institutions include hybrid capital and subordinate debt in their capital base. The policy of holding buffer capital as an extra precautionary measure indicates a counter cyclical focus by banks. However, that is at the cost of the size of business. Banks need to grow sufficiently to balance the pressure of additional buffer capital. Retaining higher capital is costly, but for some countries like India and Indonesia where bank lending is growing at 20-25 percent per annum banks can fund additional capital required.

For other types of hybrid and subordinate capital there is still some uncertainty on the eligibility as regulatory capital. Nevertheless, there is no doubt that credit institutions will have lower capital levels with the new Basel rules effective. How much additional capital the institutions need to raise will to some extend depend on individual solvency needs and own capital targets. Moreover, external investors and rating agencies may require the banks to hold capital levels that are higher than the requirements set out

by the Committee. The government’s large fiscal deficit will limit its ability to inject capital into government-owned banks, which currently have less capital adequacy than the private and foreign banks operating in India According to an ICRA report, public and private sector banks would require an additional capital of 600000 crore, assuming a 20% growth in risk-weighted assets. Out of the total requirement 75-80% will be required by the public sector banks. Thus the burden will fall on the cash-stripped government which will need to infuse massive amount of capital to maintain its shareholding of 58%.This looks difficult to achieve seeing the current state of the government financials with high fiscal deficit of 4.8% in 2012-13 and massive subsidy burden. Reserve Bank of India had estimated total capital requirement (including tier-1 and tier-2) for the Indian banks at Rs 5 lakh crore. It had estimated Rs 3.25 lakh crore of equity capital and Rs 1.75 lakh crore of nonequity capital for Basel-3 requirements. With the implementation of BASEL III the banks will move to risk-averse mode which could severely impact the Indian economy, which needs large amounts of credit especially the infrastructure sector with requirements of 1 trillion over next five years. The big question is whether it is right to implement the same kind of stringent measures to economies which are inherently differently in their risk appetite. While the developed world aims at avoidance of the 2008 crisis, for the developing world and the emerging markets the objective is growth to meet the needs of increasing population.So BASEL III should provide a solution which is tailored made for the developing economies.Thus ,though BASEL III will make banks more capable of handling a financial crisis, it will have a negative impact on the GDP of the economies like India , which should be a matter of concern. It should be noted that the analysis is based on the Basel framework as it was presented in December

  • 2010. Moreover, the Basel Committee has announced that the framework is subject to calibration. Credit

institutions should anyway prepare for stricter legislation and start to consider ways to comply with

capital and liquidity requirements.