Capital Adequacy under Basel-I and Basel-II: Indian Experience

Traditionally, banks held capital as a buffer against insolvency, and liquid assets –
cash and securities – to guard against unexpected withdrawals by depositors or
drawdowns by borrowers (Saidenberg and Strahan, 1999). Traditional approaches to
bank regulation emphasise the positive features of capital adequacy requirements
(Dewatripont and Tirole, 1994). On the other hand, it has been argued that capital
requirements may increase risk taking behavior. If equity capital is more expensive to
raise than deposits, then an increase in risk-based capital requirements tends to reduce
banks’ willingness to screen and lend (Thakor, 1996). It has also been found that
raising capital requirements forces banks to supply fewer deposits, which reduces the
liquidity providing role of banks. Given these pros and cons, it is now argued that
capital that needs to be maintained should be consistent with the risk profile and
operating environment. The Basel II framework is a step in this direction as these
norms aim at aligning minimum capital requirements to banks’ underlying risk
profiles. The Basel I framework was confined to the minimum capital requirements
for banks, and largely focussed on the credit risk. The Basel II framework, on the
other hand expands this approach to include, inter alia, a largely new, risk-adequate
calculation of capital requirements which (for the first time) explicitly includes
operational risk in addition to market and credit risk. While Basel I required lenders to
calculate a minimum level of capital based on a single risk weight for each of the
limited number of asset classes, under Basel II, the capital requirements are more risk
sensitive. Basel II capital adequacy rules are based on a ‘menu’ approach that allows
differences in approaches in relationship in the nature of banks and the nature of
markets in which they operate. Thus, Basel II prescriptions have ushered in a
transition from capital adequacy to capital efficiency which implies that banks adopt a
more dynamic use of capital, in which capital will flow quickly to its most efficient
use. These elements of Basel II take the regulatory framework closer to the business
models employed in several large banks. All the SCBs in India have adopted the
Standardised Approach (SA) for credit risk, Basic Indicator Approach (BIA) for
operational risk and Standardised Duration approach for market risk for computing
their capital requirements under the revised framework as at end-March 2009. Banks
are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR)
of 9 per cent on an ongoing basis. The Reserve Bank will take into account the
relevant risk factors and the internal capital adequacy assessments of each bank to
ensure that the capital held by a bank is commensurate with the bank’s overall risk
profile. This would include, among others, the effectiveness of the bank’s risk
management systems in identifying, assessing / measuring, monitoring and managing
various risks including interest rate risk in the banking book, liquidity risk,
concentration risk and residual risk. Accordingly, the Reserve Bank will consider
prescribing a higher level of minimum capital ratio for each bank under the Pillar 2
framework on the basis of their respective risk profiles and their risk management
systems. Further, in terms of the Pillar 2 requirements of the New Capital Adequacy
Framework, banks are expected to operate at a level well above the minimum
requirement. Furthermore, the minimum capital maintained by banks on
implementation of the revised framework will be subjected to a prudential floor,
which shall be higher of the following amounts: a) Minimum capital required to be
maintained as per the Revised Framework; b) A specified per cent of the minimum
capital required to be maintained as per the Basel I framework for credit and market
risks. The specified per cent will progressively decline as indicated in Table 1. Data
on bank-wise CRAR based on Basel I and Basel II are available and are reported in
Appendix IV.31. Out of 80 banks, all banks except Bank Internasional Indonesia and
Sonali Bank have reported CRAR under Basel II and 14 banks have not reported
CRAR under Basel I. A frequency distribution based on data of 64 banks, which have
reported CRAR under both Basel I and Basel II, suggests that 12 per cent to 15 per
cent is the modal range of CRAR (Table 2). A bank-group wise analysis reveals that
for the State Bank of India and all its associates, the CRAR under Basel II was higher
than that under Basel I for the year 2008-09. Same trend was also observed in case of
majority of nationalised banks. On the other hand, majority of the foreign sector
banks reported higher CRAR under Basel I than that under Basel II. The private
sector banks, however reported a mixed trend (Appendix IV.31).

New capital ratio rule, extra time bring

relief to banks

Strong banks now can put excess cash to better use

Gilbert Kreijger & Steve Slater AMSTERDAM I LONDON

NEW bank capital rules agreed by global regulators brought relief to the world’s
banks on Monday although one of the architects said the sector would eventually
have to raise hundreds of billions of euros.
The new requirements, known as Basel III, will demand banks hold topquality
capital totalling 7% of their risk-bearing assets, but a long lead-in time eased
fears that lenders will have to rush to raise capital.
Europe is the most likely region for banks to need to raise funds, notable in
Germany, Spain and other weak spots.
The new capital ratio represents a substantial increase from the current
requirement of 2%, but is significantly lower than what banks had feared earlier
this year and comes with a phase-in period extending in part to January 2019.
The framework could free strong banks with excess cash to return some to
investors or look at acquisitions, analysts and investors said, although there
remains the threat that larger international banks face a capital surcharge.
“It will be hundreds of billions (of euros),” ECB Governing Council member and
head of the Basel Committee on Banking Supervision Nout Wellink said of total
capital-raising needs.
“Partly, they will have to retain profit for years which they cannot use to pay
shareholders or bonuses. For another part, this will vary from bank to bank, they
will have to get it from the capital market,” Wellink, who heads the Dutch central
bank, told Dutch NOS Radio 1 Journaal.
European bank shares rose 2% and the euro jumped 1% versus the dollar as
the prospect of a rush to raise cash receded. Banks will not be required to meet
the minimum core Tier-I capital requirement, which consists of shares and
retained earnings worth at least 4.5% of assets, until 2015. An additional 2.5%
“capital conservation buffer” will not need to be in place until 2019.
“The message is that authorities have agreed and realised they need to let the
banks recover first and start to lend to participate in the recovery,” said Guy de
Blonay, who co-runs fund manager Jupiter’s £1.4 billion ($2.2 billion) Financial
Opportunities Fund.
Top German lender Deutsche Bank is seeking a headstart on rivals such as
Commerzbank by announcing plans to raise almost € 10 billion to bolster its
capital. It said it would meet the Basel III rules by the end of 2013.
Credit Suisse analysts said they would now regard 7% as the bare minimum for
core Tier-I capital, 8% as the market standard for adequately capitalised banks
and 10% as the level at which surplus capital could be identified and potentially
returned to investors.

Indian banks are unlikely to be affected but may face some negative impact due
to shifting some deductions from Tier-I & Tier-II capital to common equity, says
RBI Governor Subbarao

What are the Basel-III norms?

These are rules written by the Bank of International Settlement’s Committee on
Banking Supervision (BCBS) whose mandate is to define the reform agenda for
the global banking community as a whole. The new rule prescribes how to assess
risks, and how much capital to set aside for banks in keeping with their risk
profile.
What are the changes which have been made to the way in which capital
is defined?
Going by the new rules, the predominant component of capital is common equity
and retained earnings. The new rules restrict inclusion of items such as deferred
tax assets, mortgage-servicing rights and investments in financial institutions to
no more than 15% of the common equity component. These rules aim to improve
the quantity and quality of the capital.
What do these new rules say?
While the key capital ratio has been raised to 7% of risky assets, according to the
new norms, Tier-I capital that includes common equity and perpetual preferred
stock will be raised from 2-4.5% starting in phases from January 2013 to be
completed by January 2015. In addition, banks will have to set aside another
2.5% as a contingency for future stress. Banks that fail to meet the buffer would
be unable to pay dividends, though they will not be forced to raise cash.
How different is the approach now?
The new norms are based on renewed focus of central bankers on macro-
prudential stability. The global financial crisis following the crisis in the US sub-
prime market has prompted this change in approach. The previous set of
guidelines, popularly known as Basel II focused on macro-prudential regulation.
In other words, global regulators are now focusing on financial stability of the
system as a whole rather than micro regulation of any individual bank.
How will these norms impact Indian banks?
According to RBI governor D Subbarao, Indian banks are not likely to be
impacted by the new capital rules. At the end of June 30, 2010, the aggregate
capital to risk-weighted assets ratio of the Indian banking system stood at
13.4%, of which Tier-I capital constituted 9.3%. As such, RBI does not expect our
banking system to be significantly stretched in meeting the proposed new capital
rules, both in terms of the overall capital requirement and the quality of capital.
There may be some negative impact arising from shifting some deductions from
Tier-I and Tier-II capital to common equity.

Implementation key to Basel III success

New Rules Are Tougher Than Basel II Which Failed To Ensure Enough
Capital
Huw Jones LONDON

THE global “Basel III” deal on bank capital standards was reached at lightning
speed by usually glacial regulators — substantive negotiations took about a year,
compared to a decade for the current Basel II rules.
But implementing the new standards consistently over the lengthy phase-in
period will be a headache for national regulators, and determine whether Basel III
succeeds better than its predecessor in reducing bank sector risk.

• The Basel III rules are much tougher than Basel II, which failed to ensure banks
held enough capital to withstand the worst financial crisis since the Great
Depression.

• Although Basel III more than triples the amount of top-quality capital that
banks will have to hold in reserve, there are several potential pitfalls in timing
and content that could undermine the reform’s effectiveness.

• The key aspects of the completed package will not all be phased in until the
start of 2019, presenting a challenge for supervisors and their political masters to
maintain momentum in their supervision of the sector. Lobbying by banks or an
eventual return to boom times could blunt the will to enforce Basel III, as
memories of the global credit crisis fade.

• The new capital conservation buffer of 2.5%, which is lower than some banks
had feared, will not be fully in place until the start of 2019. At this time, the
buffer plus the Tier-I capital requirement will total 7%; in practice this is likely to
become a solid floor for banks, because they will not want to face curbs on
payouts such as bonuses, dividends and share buybacks. Falling below 7% could
damage a bank’s reputation among investors and in the money markets.

• The new capital rules are not the only fresh burden on banks; they should be
seen in conjunction with a range of regulatory initiatives that together could have
large and unpredictable effects on banks.
Banks will have to comply with the first new global liquidity standard from
January 2015; this will increase pressure to build up reserves of cashlike assets.
Separately, regulators will introduce far tougher capital requirements on bank
trading books from the end of 2011, and these will force some institutions to
rethink whether they want to continue financial market trading.
Also, national regulators may still impose other surcharges on big, systemically
important banks as they grapple with the “too big to fail” problem; this prospect
could cause large banks to build up more capital than the Basel III rules, taken in
isolation, appear to imply. — Reuters