5 A CRITICAL REVIEW OF BASEL-III NORMS FOR INDIAN PSU BANKS.pdf

DRIEMS Business Review - Vol. -1 No. - 1

A CRITICAL REVIEW OF BASEL-III NORMS FOR INDIAN PSU BANKS

ABSTRACT

Basel III norms are guidelines framed by a committee of central banks that is based inBasel, Switzerland. The Reserve Bank of India is also a member of this committee. Thenorms aim to toughen up the banking system in every country to withstand financialshock. They focus on the risks that banks are vulnerable to, particularly after the crisis inthe banking sector, which was triggered by the problem in the US sub-prime mortgagemarket.

Base III aims to plug the gaps in the existing Basel II guidelines. The new norms will bemade effective in a phased manner from January 1, 2013 and implemented fully fromMarch 31, 2018. The guidelines will ensure that banks are well capitalized to manageall kinds of risks. The existing norms stipulate that banks should maintain Tier-I capital,or core capital, and Tier-II capital that comprise instruments with debt-like features.

Keywords: Banking, Basel-III, Equity, Debt, Capital-Adequacy-Ratio, Tier-I, Tier-II

IntroductionThe Basel Committee on BankingSupervision (BCBS) issued a comprehensivereform package entitled "Basel III: A globalregulatory framework for more resilientbanks and banking systems" in December2010, with the objective to improve thebanking sector's ability to absorb shocksarising from financial and economic stress,whatever the source, thus reducing the riskof spill-over from the financial sector to thereal economy. The reform package relatingto capital regulation, together with theenhancements to Basel II framework andamendments to market risk frameworkissued by BCBS in July 2009, will amendcertain provisions of the existing Basel II

framework, in addition to introducingsome new concepts and requirements.Thereafter, these norms were notified forIndian banks by RBI vide its notificationdated 2nd May'2012.Basel-III is a comprehensive set of reformmeasures to strengthen the regulation,supervision and risk management of thebanking sector. These measures aim to:o Improve the banking sector's abilityto absorb shocks arising from financial andeconomic stress, whatever the sourceo Improve risk management andgovernanceo Strengthen banks' transparency anddisclosures

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Mr. Mukul Jain(SEBI Resource Person, Management

Consultant & Visiting Professor)Gurgaon, Haryana

A critical review of basel-III...


The reforms target:o Bank-level, or micro-prudentialregulation, which will help raise theresilience of individual banking institutionsto periods of stresso Macro-prudential, system wide risksthat can build up across the banking sectoras well as the pro-cyclical amplification ofthese risks over time

These two approaches to supervision arecomplementary as greater resilience at theindividual bank level reduces the risk ofsystem-wide shocks. The Committee'spackage of reforms will increase theminimum common equity requirementfrom 2% to 4.5%. In addition, banks willbe required to hold a capital conservationbuffer of 2.5% to withstand future periodsof stress bringing the total common equityrequirements to 7%. This reinforces thestronger definition of capital and the highercapital requirements for trading, derivativeand securitization activities to beintroduced at the end of 2012.

Aim of the Research PaperThis research paper would make an attemptto critically analyze the impact of Basel IIIon Indian Banks, specifically PSU (PublicSector Undertaking) Banks. On one hand,Basel III has introduced many elements ofcapital, such as a clearly defined commoncapital that measures core equity capital inrelation to its total risk-weighted assets andhence, assesses the bank's financial strengthand capital conservation buffers at variouslevels. On the other hand, the new normswill push up the capital needs of Indianbanks by $20 billion to $30 billion (1 lakh

crore to 1.5 lakh crore). Since banks willnow need additional capital for doing thesame level of business, they may see a sharpdrop in their returns on assets (ROA).

The global Basel-III requirements, whichrequire all banks to hold top-quality capitalequal to 7% of their assets, adjusted for risk,are aimed at improving financial stability.But the sharply higher capital requirementshave drawn warnings from analysts andfinanciers about their impact on bankinglending rates and wider economic growthacross the developing world. This researchpaper aims to study these viewpoints in theright perspective of Indian PSU banks.Main requirements under Basel-III1) Banks to maintain a minimum 5.5% in

common equity (as against 3.6% now)by March 31, 2015.

2) Banks must create a capital conservationbuffer (consisting of common equity) of2.5% by March 31, 2018.

3) Banks should maintain a minimumoverall capital adequacy ratio of 11.5%(against the current 9%) by March 31,2018.

Three tiers of capital have been defined:n Tier 1 Capital includes onlypermanent shareholders' equity (issued andfully paid ordinary shares and perpetualnon-cumulative preference shares) anddisclosed reserves (share premium, retainedearnings, general reserves, legal reserves)n Tier 2 Capital includes undisclosedreserves, revaluation reserves, generalprovisions and loan-loss reserves, hybrid(debt / equity) capital instruments andsubordinated term debt. A limit of 50% of

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Tier 1 is applicable for subordinated termdebt.n Tier 3 Capital is represented by short-term subordinated debt covering marketrisk. This is limited to 250% of Tier 1 capitalthat is required to support market risk.

New Capital requirementsAs per existing norms, the total minimumcapital ratio is 9%, comprising Tier-I andTier-II capital. Basel-III regulatory capitalmatrix is percentage to Risk weighted assets(RWA's):i) Minimum common equity Tier-I ratio:5.5%ii) Capital conservation buffer (comprisingcommon equity): 2.5%iii) Minimum common equity Tier-I ratio pluscapital conservation buffer [(i) + (ii)]: 8%iv) Additional Tier-I capital: 1.5%v) Minimum Tier-I capital ratio [(i) + (iv)]: 7%vi) Tier-II capital: 2%vii) Minimum total capital ratio (MTC) [(v)+ (vi)]: 9%viii) Minimum total capital ratio plus capitalconservation buffer [(vii) + (ii)]: 11.5%

Impact on Indian BanksReserve Bank of India (RBI) notified the newBasel-III norms in May'2012, which will beeffective from January'2013 in a phasedmanner and fully implemented by March2018. Basel III has introduced manyelements of capital, such as a clearly definedcommon capital that measures core equitycapital in relation to its total risk-weightedassets and hence, assesses the bank'sfinancial strength and capital conservationbuffers at various levels. Besides, risk-basedcapital ratios will have to be supplemented

with leverage ratio during a parallel run.Basel III rules propose to bring in moreclarity and eliminate grey areas in thecurrent rules by clearly defining differentkinds of capital.

As per the research report of Credit Suisse,the new norms will push up the capitalneeds of Indian banks by $20 billion to$30 billion (1 lakh crore to 1.5 lakh crore).Since banks will now need additionalcapital for doing the same level ofbusiness, they may see a sharp drop in theirreturns on assets (ROA). Further, theincremental equity requirement in theIndian banking system may go to as highas Rs. 3.2 to 4 trillion over the next sixyears. According to ratings firm ICRA, thegovernment's share in this could be Rs.1.2 to 1.7 trillion. When banks with lowcore Tier-I shore up their capital to around9% (required 8% and 1% cushion), theirreturn on equity (ROE) could drop by 1%to 4%, which they could seek tocompensate by raising their lending yields,increasing fee income, or rationalizingcosts.

As per Credit Suisse research report, about$15 billion was needed for Indian banksto support 18% growth, of which around$11-12 billion was needed by the PSU(Public sector Undertakings) banks. Afterthese norms requiring re-capitalization,banks may need another $5 billion in thenext 1 year, in addition to $3 billionneeded by private banks. Further, thetransition to Basel III is likely to result in amoderation in the return on equity ofbanks by 200-300 basis points for PSU

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Fig.: Bar chart representing minimum regulatory requirement (All figures in %)

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banks and around 100 basis points forprivate banks. Additionally, banks wouldbe required to maintain liquidity coverageratio and net stable funding ratio of above100%.

The Basel-III norms come at a time whenbanks are under pressure to set aside fundsfor a potential increase in bad loans. Forevery 1% increase in gross NPA's (Non-performing-assets), the banking system mayrequire additional Rs.25000 crore.

Movement of Capital requirement andtriggers under various scenarios

o Core Capital: Equity component of abank's capital (5.5% in all scenarios)

o Capital conservation buffer: Capitalset aside for off balance-sheettransactions (2.5% in all scenarios)

o Counter cyclical buffer: Extra capitalto cushion shocks (1% in 'High CreditGrowth Scenario'; 2.5% in 'HigherCredit Growth Scenario'; 1.5% in'Stress Situation, Higher creditGrowth Continues Scenario')

Regulatory Capital = Core Capital +Capital conservation buffer + Countercyclical buffer (when activated)


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o Actual Regulatory Core capital:• 9% in 'Normal Scenario'• 9% in 'High Credit Growth Scenario'-

Introduction of countercyclical buffer(1%)---No restriction on earningdistribution

• 9.5% in 'Higher Credit GrowthScenario'-Higher level of countercyclicalbuffer (2.5%)-Restriction on earningdistribution kicks in

• 9% in 'Stress Situation, Higher creditGrowth Continues Scenario'-Part releaseof countercyclical buffer (1.5%)-Restriction on earning distributionbecomes lower

• 7% in 'Stress Situation, Normal CreditGrowth Scenario'-Complete release ofcountercyclical buffer (0%)-Restrictionon earning distribution become higher

Difficulties with implementing Basel-IIInorms

There are worries among certain bankersthat the implementation of Basel-IIIproposals will have an adverse impact onthe return on equity and financial ratios.There are concerns that public sector banksmay not be able to grow their loans sincegovernment-dependent lenders would nothave adequate capital. Critics of Basel-IIInorms feel that just because banks wouldhave more capital, it does not mean that abank will not get into trouble. The crisesmay at best be postponed. Walter Bagehot,the former editor of 'The Economist', hadfamously said, "No capital is required for awell-run bank and no amount of capital cansave a badly-run bank!"

A taskforce of leading bankers warned inJune'2012 that the Basel III rules were toofocused on problems that occurred inEurope and the US. They argued thestandards unfairly penalise trade financeand project finance, two forms of credit thatare particularly important in developingnations. This school of thought believes thatthe Indian banking system has proved robustdue to constant monitoring by the RBI. Asper past instance, Indian Banks had carrieda huge negative net-worth for three yearswithout any problem. As per this argument,Public Sector banks do not need morecapital.Since Basel-III is an international norm,therefore, Indian banks, including PSB's(Public Sector Banks) with internationalpresence, would find it an obstacle if theyare non-compliant. One of the solutionproposed by policymakers is to go slow onimposing new capital adequacy norms forPSB's as all of them do not have a foreignpresence.However, the difficulty in increasing thecapital of PSB's is not because of theirinability to attract investors. If investors aregiven confidence, banks would be able toraise sufficient capital. But the governmentwould have to dilute its holding in the PSB's.It seems difficult because the governmentmay be unwilling to let go its majority stakein these banks. If fresh equity is to be raisedwithout diluting the government's share,huge budget allocations are required. As perestimates, about Rs.60000-75000 croredemands for capital from banks could bethere in the next six years. Again, it may notbe easy for the government, considering itsfiscal deficit.



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capital, as these would be reflected on theprofit and loss statement of banks. Thesimultaneous implementation of Basel-IIIand the so-called 'dynamic provisioning'requirements (2.4 to 3% of loans inbalance-sheet) may enlarge the difficultiesthat banks could face amid the approx. Rs.2lakh crores of loans that would have to berestructured by this fiscal end. Banks withhigh credit costs may find it tough to meetthe additional burden.

Merits of Basel-III normsAs per some of the research reports relatingto Banking industry, there is enoughevidence that the most serious economiccrisis are associated with banking sectoradversities and high public sectorinterventions. The Basel Committee's long-term impact study of crisis shows thatbanking crisis generally result in losses ineconomic output equal to about 60% ofpre-crises GDP. Moreover, there is asignificant spill-over of risk between thebanking sector and governments.

The recent experience of industrializednations shows that to save the bankingsector, governments of these nations hadto increase their debts to such an extentthat their debt-to-GDP ratios have risen by10-25% points. Therefore, people who areconcerned that tighter norms under Basel-III would impose a heavy burden on Indiangovernment in terms of infusion of capital

The government may have to work on twooptions. One is to ask PSB's to keep theirloan portfolios at current levels or evenshrink them. But it would be a retrogradestep and will affect the funds available toindustry adversely. The other is to accept adilution of its stake, may be up to 26%.

After declaring in the Parliament that everycompany -private or government, shouldhave a minimum of 25% float, the proposalwas diluted when the investment bankingcircles said it would be impossible for thegovernment to meet its disinvestment target.The implementation of capital norms areseen as unwelcome move not only in Indiabut are opposed by most bankers across theworld.

While capital is just one of the focus items,the bigger worry for Indian banks couldcome from the treatment of their pensionliabilities. This liability is still to an extentnot been quantified. With its focus on thequality of the capital after the financialcrises, RBI has proposed full recognition ofliabilities from defined benefit pensionfunds in the calculation of Common EquityTier-I to ensure it is able to absorb losses.This also eliminates the risk of this beingused to protect depositors and othercreditors.

As per Credit Suisse analysts, this could bemore harmful to their share prices than


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in Public sector banks (PSB's), should alsotake into consideration the fact that thecosts associated with the failure of PSB'swill be much higher in dimension and theirsubsequent impact. Hence, the economicbenefits of making banks more resilient toshocks are huge.

There is a concern that a higher capitalrequirement under Basel-III would reducethe profitability of PSB's and make loansmore expensive. As per RBI's estimates,there could be a marginal drop in GDPgrowth in the short-term. But given that thebanking sector stability is a preconditionof sustainable economic growth, a short-term sacrifice of growth has to be toleratedin the interest of long-term sustainablegrowth. This is a typical perplexity that anemerging economy faces.

The features of Basel-III such as higher riskcoverage, thrust on loss-absorbing capitalin periods of stress, improving liquiditystandards, creation of capital buffers ingood times and prevention of excess build-up of debt during boom times would helpcreate a resilient banking system.

ConclusionGiven the current environment, the RBI hasextended the final date for Basel-III to 2018.This is positive as PSB's will get more timefor preparation. Moreover, capitaldeduction now starts at 20% against 40%

stipulated earlier. This move is encouragingand should ensure smoother migration tothe new framework.The RBI wants to implement therecommendations of the 'Basel Committeeon Banking Supervision' to make thefinancial system safe. It is aimed atprotecting the depositors and to prevent a2008-like crises. Moreover, the'perception' of a lower standard regulatoryregime will put Indian banks at adisadvantage in global competition.RBI is currently working on operationalaspects of implementation of theCountercyclical Capital Buffer. Besides,certain other proposals viz. 'Definition ofCapital Disclosure Requirements','Capitalisation of Bank Exposures to CentralCounterparties' etc., are also engaging theattention of the Basel Committee atpresent. Therefore, as per RBI, the finalproposals of the Basel Committee on theseaspects will be considered forimplementation, to the extent applicable,in future. Further, for the financial yearending March 31, 2013, banks will haveto disclose the capital ratios computedunder the existing guidelines (Basel II) oncapital adequacy as well as thosecomputed under the Basel III capitaladequacy framework.India's struggling banking sector will facea period of lower profitability as it seeks toraise at least Rs. 5000 billion in extra capitalto meet the new Basel-III international



banking standards. The government couldconsider reducing its majority stakes in avariety of state-owned banks, as it attemptsto cut the Rs. 900 billion in recapitalization,needed to maintain present shareholdinglevels.Indian government has so far rejectedsuggestions that it might reduce itsshareholding in more than two dozenpublic sector banks, including a stake ofapproximately 60% in the State Bank ofIndia, the nation's largest lender by marketshare. The RBI governor had in the recentpast suggested that the Indian governmentcould save Rs. 200 billion in recapitalizationcosts if it reduced its stakes in all state-ownedbanks to just 51 per cent.

References

1. Redhead Keith (2008): PersonalFinance & Investments-A BehaviouralFinance Perspective, Routledge

2. Technical Analyst (2012): TechnicalAnalysis & Behavioural Finance in FundManagement, Global Markets MediaLtd.

3. M.Y. Khan (2010): Financial Services,McGraw Hill

4. Prasanna Chandra (2011): InvestmentAnalysis & Portfolio Management, TataMcGraw Hill

5. NISM & FPCIL (2011): CertifiedPersonal Financial Advisor Workbook,NISM

6. Prithvi Haldea (2010, 2011): Investor'sGuide to the Capital Market, Ministryof Corporate Affairs

7. Journals & websites: SEBI, RBI, CCI,PFRDA, IRDA, Ministry of CorporateAffairs, Ministry of Finance, NSE, BSE,FMC

8. Journal (2012) on 'Basel-III Norms' byASSOCHAM

9. Journal (2012) on 'Basel-IIIguidelines', RBI

10. NSE (2012) on 'Banking' Workbook,NSE

11. NSE (2012) on 'Commercial Banking'Workbook, NSE

12. Guidelines (2012) on 'Basel-IIINorms', RBI notifications


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5 A CRITICAL REVIEW OF BASEL-III NORMS FOR INDIAN PSU BANKS.pdf

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