Basel III and its implications on the Indian Banking Sector

SIP report submitted in partial fulfillment of the requirements for the PGDM Program

By

Vasundhara Singh

2011222

Under guidance of:

Mr. Samir Bipin Doshi , V.P. , Finance and Accounts , IndusInd Ltd.

Dr. Raju Indukoori , IMT- Nagpur

Institute of Management Technology, Nagpur

2011 – 2013

Acknowledgement

I express my sincere gratitude to Mr. J.S Sridhararan , Head , Finance And MIS department ,

IndusInd Bank Ltd. , Mumbai , , for guiding me through this project and sharing his knowledge.

I also am very thankful to Mr. Samir Bipin Doshi , Vice President , Finance and Accounts

Department, IndusInd Bank Ltd. , Mumbai , for providing valuable insights and experience and

correcting my mistakes. Without his guidance and valuable insights, this project would not have

seen the light of day.

I would also like to express my sincere thanks to Mr. Pritam Mhambrey , Mr. Gagn Singh and Mr. Pravenn Kumar Dasari , for extending their support and resources for completion of this project.

A special thanks to my faculty guide, Dr. Raju Indukoori who has been the chief facilitator of this project and helped me enhance my knowledge in the field of banking sector.

Sincerely

Vasundhara Singh

2011222

IMT - Nagpur

CERTIFICATE SCANNED

Table of Contents1 Executive summary......................................................................................................................6

2 Abbreviations................................................................................................................................8

3 Introduction...................................................................................................................................9

3.1 Basel Committee on Banking Supervision..............................................................................10

3.2 U.S Sub Prime Crisis...............................................................................................................11

3.2.1 Implications For India.......................................................................................................13

4 Objectives of the Study...............................................................................................................16

5 About Banking Industry.............................................................................................................17

4.1 Different Types of Banks in India........................................................................................18

4.1.1 Public Sector Banks.......................................................................................................19

4.1.2 Co-operative Banks.......................................................................................................19

4.1.3 Private Banks.................................................................................................................20

5 About IndusInd Bank Ltd...........................................................................................................21

5.1 VISION STATEMENT OF INDUSIND BANK.................................................................23

5.2 Finance and Accounts Department......................................................................................24

6 Methodology...............................................................................................................................26

7 Basel I.........................................................................................................................................27

7.1 Purpose.................................................................................................................................27

8 Basel II........................................................................................................................................30

8.1 Credit Risk...........................................................................................................................30

8.2 Operational Risk & Market Risk.........................................................................................31

8.3 Reason for failure.................................................................................................................32

8.4 Difference in Basel II and Basel III.....................................................................................32

9 Basel III......................................................................................................................................34

9.1 Requisites for implementation of Basel III norms...............................................................34

9.2 Key Basel III Components...................................................................................................35

9.2.1 Capital...........................................................................................................................35

9.2.2 Market Risk...................................................................................................................36

9.3 Tier 1 Capital.......................................................................................................................39

9.3.1 Common Equity............................................................................................................39

9.3.1.1 Criteria for Classification as Common Shares for Regulatory Purposes...................40

9.3.2 Elements of Additional Tier 1 Capital..........................................................................40

9.3.2.1 Criteria for Classification as Additional Tier 1 Capital for Regulatory Purposes......41

9.4 Elements of Tier 2 Capital...................................................................................................41

9.4.1 General Provisions and Loss Reserves..........................................................................41

9.5 Need For Basel III................................................................................................................43

9.5.1 Improving the Quality, Consistency and Transparency of the Capital Base.................43

9.5.2 Enhancing Risk Coverage.............................................................................................44

9.5.3 Enhancing the Total Capital Requirement and Phase-in Period...................................44

9.5.4 Capital Conservation Buffer..........................................................................................45

9.5.5 Countercyclical Capital Buffer......................................................................................46

9.5.6 Regulatory Capital Ratio...............................................................................................46

9.5.7 Liquidity Coverage Ratio (LCR)...................................................................................46

9.5.8 Net Stable Funding Ratio..............................................................................................46

10 Impact of Basel III on Indian banks.........................................................................................48

11 Limitation of the Study.............................................................................................................54

12 Conclusion and Recommendations...........................................................................................55

13 References.................................................................................................................................56

List of Figures

Figure 1 : Risk Weighted assets and their Credit Ratings………………………………………15

Figure 2 : Basel II vs. Basel III…………………………………………………………………27

List of Tables

Table 1 : Key Basel III Components……………………………………………………............31

Table 2: Capital Requirements……………………………………………………………….…34

Table 3 : Risk Weighted Assets…………………………………………………..…….............40

1 Executive summary

Banks play a critical role in the economic development of an economy. They are important not

only for economic growth but also financial stability. In an economy banks has three major roles

to play i.e. First, they fulfill the financing needs of the corporate sector. Second, they cater to the

needs of the vast number of household savers, providing assured returns on their surplus funds

while maintaining liquidity and safeguarding them from financial risks. Third, they act as a

support for development of financial markets and its participants.

The project titled ‘Basel III and its implications on Indian Banking Sector’ with has been

conducted with the purpose of getting in-depth knowledge about the Basel III and its

implications upon the Indian Banking Sector.

2 Abbreviations

LOC Line of Credit

MC Management Committee

MPBF Maximum permissible Bank Finance

MCB Mid Corporate Branch

NWC Net Working Capital

NFB Non Fund Based

PMS Preventive Monitoring System

PF Provident Fund

RBI Reserve Bank of India

RMC Risk Management Committee

RMD Risk Management Division

TEV Techno-Economic Valuation

TL Term Loan

WC Working Capital

3 Introduction

BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market

liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in

2010-11.

This, the third of the Basel Accords was developed in response to the deficiencies in financial

regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital

requirements and introduces new regulatory requirements on bank liquidity and bank leverage.

For instance, the change in the calculation of loan risk in Basel II which some consider a causal

factor in the credit bubble prior to the 2007-8 collapse: in Basel II one of the principal factors of

financial risk management was out-sourced to companies that were not subject to supervision:

credit rating agencies.

Ratings of creditworthiness and of bonds, financial bundles and various other financial

instruments were conducted without supervision by official agencies, leading to AAA ratings on

mortgage-backed securities, credit default swaps and other instruments that proved in practice to

be extremely bad credit risks. In Basel III a more formal scenario analysis is applied (three

official scenarios from regulators, with ratings agencies and firms urged to apply more extreme

ones).

The OECD estimates that the implementation of Basel III will decrease annual GDP growth by

0.05-0.15%.Outside the banking industry itself, criticism was muted. Bank directors would be

required to know market liquidity conditions for major asset holdings, to strengthen

accountability for any major losses.

3.1 Basel Committee on Banking Supervision 

The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory

authorities that was established by the central bank governors of the Group of Ten countries in

1974. It provides a forum for regular cooperation on banking supervisory matters. Its objective is

to enhance understanding of key supervisory issues and improve the quality of banking

supervision worldwide. The Committee also frames guidelines and standards in different areas -

some of the better known among them are the international standards on capital adequacy, the

Core Principles for Effective Banking Supervision and the Concordat on cross-border banking

supervision

The Basel Committee formulates broad supervisory standards and guidelines and recommends

statements of best practice in banking supervision in the expectation that member authorities and

other nations' authorities will take steps to implement them through their own national systems,

whether in statutory form or otherwise.

The purpose of BCBS is to encourage convergence toward common approaches and standards.

The Committee is not a classical multilateral organization, in part because it has no founding

treaty. BCBS does not issue binding regulation; rather, it functions as an informal forum in

which policy solutions and standards are developed.

3.2 U.S Sub Prime Crisis

The U. S Subprime Mortgage Crisis

The U.S. subprime mortgage crisis was a set of events and conditions that led to the late-2000s

financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and

the resulting decline of securities backed by said mortgages.

The percentage of new lower-quality subprime mortgages rose from the historical 8% or lower

range to approximately 20% from 2004 to 2006, with much higher ratios in some parts of the

U.S. A high percentage of these subprime mortgages, over 90% in 2006 for example,

were adjustable-rate mortgages. These two changes were part of a broader trend of lowered

lending standards and higher-risk mortgage products. Further, U.S. households had become

increasingly indebted, with the ratio of debt to disposable personal income rising from 77% in

1990 to 127% at the end of 2007, much of this increase mortgage-related.

After U.S. house sales prices peaked in mid-2006 and began their steep decline

forthwith, refinancing became more difficult. As adjustable-rate mortgages began to reset at

higher interest rates (causing higher monthly payments), mortgage delinquencies soared.

Securities backed with mortgages, including subprime mortgages, widely held by financial firms,

lost most of their value. Global investors also drastically reduced purchases of mortgage-backed

debt and other securities as part of a decline in the capacity and willingness of the private

financial system to support lending. Concerns about the soundness of U.S. credit and financial

markets led to tightening credit around the world and slowing economic growth in the U.S. and

Europe.

Subprime borrowers typically have weakened credit histories and reduced repayment capacity.

Subprime loans have a higher risk of default than loans to prime borrowers. If a borrower is

delinquent in making timely mortgage payments to the loan servicer (a bank or other financial

firm), the lender may take possession of the property, in a process called foreclosure.

The crisis can be attributed to a number of factors pervasive in both housing and credit markets,

factors which emerged over a number of years. Causes proposed include the inability of

homeowners to make their mortgage payments (due primarily to adjustable-rate mortgages

resetting, borrowers overextending, predatory lending, and speculation), overbuilding during the

boom period, risky mortgage products, increased power of mortgage originators, high personal

and corporate debt levels, financial products that distributed and perhaps concealed the risk of

mortgage default, bad monetary and housing policies, international trade imbalances, and

inappropriate government regulation.

Three important catalysts of the subprime crisis were the influx of money from the private sector,

the banks entering into the mortgage bond market and the predatory lending practices of the

mortgage lenders, specifically the adjustable-rate mortgage, 2–28 loan, that mortgage lenders

sold directly or indirectly via mortgage brokers. On Wall Street and in the financial

industry, moral hazard lay at the core of many of the causes.

Estimates of impact have continued to climb. During April 2008, International Monetary

Fund (IMF) estimated that global losses for financial institutions would approach $1 trillion. One

year later, the IMF estimated cumulative losses of banks and other financial institutions globally

would exceed $4 trillion.

The U.S. Federal government's efforts to support the global financial system have resulted in

significant new financial commitments, totaling $7 trillion by November, 2008. These

commitments can be characterized as investments, loans, and loan guarantees, rather than direct

expenditures. In many cases, the government purchased financial assets such as commercial

paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in

frozen markets. As the crisis has progressed, the Fed has expanded the collateral against which it

is willing to lend to include higher-risk assets.

Low interest rates and large inflows of foreign funds created easy credit conditions for a number

of years prior to the crisis, fueling a housing market boom and encouraging debt-financed

consumption. The USA home ownership rate increased from 64% in 1994 (about where it had

been since 1980) to an all-time high of 69.2% in 2004. Subprime lending was a major contributor

to this increase in home ownership rates and in the overall demand for housing, which drove

prices higher.

Borrowers who would not be able to make the higher payments once the initial grace period

ended, were planning to refinance their mortgages after a year or two of appreciation. But

refinancing became more difficult, once house prices began to decline in many parts of the USA.

Borrowers who found themselves unable to escape higher monthly payments by refinancing

began to default.

As more borrowers stop paying their mortgage payments (this is an on-going crisis), foreclosures

and the supply of homes for sale increases. This places downward pressure on housing prices,

which further lowers homeowners' equity. The decline in mortgage payments also reduces the

value of mortgage-backed securities, which erodes the net worth and financial health of banks.

This vicious cycle is at the heart of the crisis.

3.2.1 Implications For India

Closer to home, albeit the Indian capital markets also experienced the echo, the Indian banking

system have remained fairly insulated from any direct impact of the subprime crisis in the US.

This is because the Indian banks did not have significant exposure to subprime loans in the US.

However, there was a major impact on the equity markets as many foreign institutional investors

(FIIs) sold off their investments into Indian companies to cover their huge losses. The FIIs have

and, as of date, are continuing to withdrawn from the equity markets. Going forward, any

subprime related tremors in the global markets are likely to cause further chaos in the Indian

equity markets as well. Nevertheless, the events which have unfolded in the recent months offer

valuable learnings for an emerging country like India. On the fundamental level, there is an

utmost need to strengthen the system for assessment of the borrower’s credit worthiness.

Oversight at this stage is bound to cause repercussions in future, no matter how robust the

subsequent processes are. The regulator will have to ensure that banks do not follow imprudent

and predatory lending practices by offering far too lenient lending terms than are warranted for.

On the other hand, banks need to make sure that they share the credit history of borrowers to

better assess the credit worthiness of borrowers.

The prudential policies put in place by the Reserve Bank and the relatively low presence of

foreign banks in the Indian banking sector, there was a sudden change in the external

environment following the failure of Lehman Brothers in mid-September 2008. The knock-on

effects of the global financial crisis manifested themselves not only as reversals in capital

inflows but also in adverse market expectations, causing a sharp correction in asset prices on the

back of sell-offs in the equity market by FIIs and exchange rate pressures. The withdrawal of

funds from the Indian equity markets, as in the case of other emerging market economies

(EMEs) and the reduced access of Indian entities to international market funds exerted

significant pressure on dollar liquidity in the domestic FX market.

With a view to maintaining orderly conditions in the FX market which had become very

volatile, the Reserve Bank scaled up its intervention operations, particularly in October 2008.

However, the FX market remained orderly in 2009–10 with the rupee exhibiting a two-way

movement against major currencies. Indian financial markets, particularly banks, have

continued to function normally.

However, the cumulative effect of the Reserve Bank’s operations in the FX market as well as

transient local factors such as the build-up in government balances following quarterly advance

tax payments had an adverse impact on domestic liquidity conditions in September and October

2008. Consequently, in the money market the call money rate breached the upper bound of the

informal Liquidity Adjustment Facility (LAF) corridor during mid-September–October 2008.

However, as a result of the slew of measures initiated by the Reserve Bank (referred to in detail

below) the money market rates declined and have remained below the upper bound of the LAF

corridor since November 2008. In the current financial year, the call rate has thus far hovered

around the lower bound of the informal LAF corridor.

The indirect impact of the global financial turmoil was also evident in the activity in the

certificate of deposit (CD) market. The outstanding amount of CDs issued by scheduled

commercial banks (SCBs), after increasing between March and September 2008, declined

thereafter until December 2008 as the global financial market turmoil intensified. With the

easing of liquidity conditions, the CD volumes picked up in the last quarter of 2008–09. The

weighted average discount rate (WADR) of CDs, which had increased with the tightening of

liquidity conditions, started declining from December 2008 onwards. Commercial paper market

developments were similar.

As explained above, the rates in the unsecured (call) market went above the LAF corridor from

mid-September to October 2008 as a consequence of the liquidity pressure in the domestic

market. The rates in the collateralised money market – (Collateralised Borrowing and Lending

Obligation (CBLO) and repo markets) – moved in tandem but remained below the call rate.

The Indian repo markets were broadly unaffected by the global financial crisis. Currently, only

government securities are permitted for repo and a select set of participants (regulated entities)

is permitted to participate in repos. All repo transactions are novated by the Clearing

Corporation of India and settled on a guaranteed basis. The interbank repo markets continued to

function, without freezing, during the period of global financial turmoil. During the period

June–October 2008, the repo volumes fell marginally but subsequently recovered. There was no

incidence of settlement failure during the global financial crisis.

4 Objectives of the Study

To study the various aspects and guidelines provided by the RBI for the implementation of Basel III and understand the journey from Basel I to Basel III .

Also to understand the consequences and implications of the the application of Basel III on the Indian Banking Sector.

5 About Banking Industry

Banks borrow money by accepting funds deposited on current accounts, by accepting term

deposits, and by issuing debt securities such as banknotes and bonds. Banks lend money by

making advances to customers on current accounts, by making installment loans, and by

investing in marketable debt securities and other forms of money lending.

A bank can generate revenue in a variety of different ways including interest, transaction fees

and financial advice. The main method is via charging interest on the capital it lends out to

customers. The bank profits from the differential between the level of interest it pays for deposits

and other sources of funds, and the level of interest it charges in its lending activities.

Profitability from lending activities has been cyclical and dependent on the needs and strengths

of loan customers and the stage of the economic cycle. Fees and financial advice constitute a

more stable revenue stream and banks have therefore placed more emphasis on these revenue

lines to smooth their financial performance.

Banks have expanded the use of risk-based pricing from business lending to consumer lending,

which means charging higher interest rates to those customers that are considered to be a higher

credit risk and thus increased chance of default on loans. This helps to offset the losses from bad

loans, lowers the price of loans to those who have better credit histories, and offers credit

products to high risk customers who would otherwise be denied credit.

Banking in India originated in the last decades of the 18th century. The first banks were The

General Bank of India, which started in 1786, and Bank of Hindustan, which started in 1790;

both are now defunct. The oldest bank in existence in India is the State Bank of India, which

originated in the Bank of Calcutta in June 1806, which almost immediately became the Bank of

Bengal.

The role of banks in India has changed a lot since economic reforms of 1991. These changes

came due to LPG, i.e. liberalization, privatization and globalization policy being followed by

GOI. Since then most traditional and outdated concepts, practices, procedures and methods of

banking have changed significantly. Today, banks in India have become more customer-focused

and service-oriented than they were before 1991. They now also give a lot of importance to their

rural customers. They are even willing ready to help them and serve regularly the banking needs

of country-side India.

The following points briefly highlight the changing role of banks in India.

1. Better customer service,

2. Mobile banking facility,

3. Bank on wheels scheme,

4. Portfolio management,

5. Issue of electro-magnetic cards,

6. Universal banking,

7. Automated teller machine (ATM),

8. Internet banking,

9. Encouragement to bank amalgamation,

10. Encouragement to personal loans,

11. Marketing of mutual funds,

12. Social banking, etc.

The above-mentioned points indicate the role of banks in India is changing

4.1 Different Types of Banks in India

The Reserve bank of India classifies Indian banks into three types. They are:

1. Pubic Sector Banks

2. Co-operative Banks

3. Private sector Banks

4.1.1 Public Sector Banks

Public sector banks are the public banks. The majority of shares of these banks are vested in the

hands of Government. Many of the oldest banks in India are Public sector banks. State Bank of

India, Bank of Baroda, Syndicate Bank and Canara Bank are some of the prominent banks in this

category. They are charging normal or reasonable charges for all the services offered.

Public sector banks are supported by the Government of India; therefore the depositors money is

safe. Public Provident Fund (PPF) accounts can be opened at State Bank of India branches which

offer tax free returns. The drawback of these banks is that they are not as modern as private

section banks. Many of the branches of these banks are now slowly introducing internet banking,

ATM cards and other facilities. They lack IT requirements.

4.1.2 Co-operative Banks

Co-operative banks are generally designed for the convenience of the general public , with an

option of working on Sundays. They offer a higher rate of interest compared to other

banks. Abhyudaya Bank, Bharat Co-op Bank is some of the major co-operative banks in India.

They offer a higher rate of interest compared to other banks. Most of the banks are open in the

evening. That makes it easy for working people. Mutual funds dividends can¶t be directly

credited in these banks.

If no cash deposit or withdrawal is made in the account of the customer for more than 1 year the

account becomes inactive. Co-operative banks usually charge an additional amount to reactivate

the account. Because of the mismanagement by the directors of these banks, many depositors lost

their money and many banks have shut down. The customers having accounts in such a bank

should be in touch with the bank personal or the managers so that their accounts are not

mismanaged.

4.1.3 Private Banks

Private Banks consist of IndusInd Bank Ltd. , ICICI Bank, HDFC bank , IDBI bank and UTI

bank. These banks were established less than 15 years ago.

Private Banks provides optimum use of technology like Internet banking, ATM and phone

banking. The customer can access their account from any branches in India usually at a charge.

Mutual funds can directly credit dividends, redemption amounts to customers account.The

minimum balance required for a saving account is Rs 5000 that is much higher than the other

banks in India. The customer need to maintain an average quarterly balance for three months

period and their bank charges are large-Rs 250-Rs 500.

The bank usually sent their statements by post every month or every 3 months along with

notification about their changes in bank charges.

Foreign Banks in India

Like Citibank, HSBC and Standard Chartered are some of the foreign banks operating in India.

Indian government has a strict policy of not allowing more branches to Foregin Banks.Foreign

Banks & Private Banks cover 65% of the foreign exchange transactions in India.

5 About IndusInd Bank Ltd.

IndusInd Bank derives its name and inspiration from the Indus Valley civilization -a culture

described by National Geographic as 'one of the greatest of the ancient world' combining a spirit

of innovation with sound business and trade practices.

Mr. Srichand P. Hinduja, a leading Non-Resident Indian businessman and head of the Hinduja

Group, conceived the vision of IndusInd Bank -the first of the new-generation private banks in

India -and through collective contributions from the NRI community towards India's economic

and social development, brought our Bank into being.

The Bank, formally inaugurated in April 1994 by Dr. Manmohan Singh, Honorable Prime

Minister of India who was then the country’s Finance Minister, started with a capital base of

Rs.1, 000 million (USD 32 million at the prevailing exchange rate), of which Rs.600 million was

raised through private placement from Indian Residents while the balance Rs.400 million (USD

13 million) was contributed by Non-Resident Indians.

IndusInd Bank, which commenced its operations in 1994, caters to the needs of both consumer

and corporate customers. It has a robust technology platform supporting multi-channel delivery

capabilities. IndusInd Bank has 365 branches, and 674 ATMs spread across 254 geographic

locations of the country as on December 31, 2011.The Bank also has 2 Representative offices,

one each in London and Dubai.

The Bank believes in driving its business through technology. It has multi-lateral tie-ups with

other banks providing access to their ATMs for its customers. It enjoys clearing bank status for

both major stock exchanges - BSE and NSE - and three major commodity exchanges in the

country - MCX, NCDEX, and NMCE. It also offers DP facilities for stock and commodity

segments. The Bank has been bestowed with the mandate of being a Settlement Banker for six

tea auction centers.

‘ICRA AA’ for Lower Tier II subordinates debt program and ‘ICRA AA-‘for Upper Tier II bond

program by ICRA. ‘CRISIL A1+’ for certificate of deposit program by CRISIL. ‘CARE AA’ for

Lower Tier II subordinate debt program by CARE. ‘Fitch AA-‘for Long Term Debt Instruments

and ‘Fitch A1+’ for Short Term Debt Instruments by Fitch Ratings.

It is a private sector bank in India and provides a wide range of banking and financial products

and services to individuals, large companies, medium-sized companies and small businesses. It

believes that it is a leading financier of commercial vehicles and has established strong customer

bases in the commercial and small business sectors.

In 2010, IndusInd Bank was recognized with the “Priority Sector Lending -Private Sector” award

at the Dun & Bradstreet – Polaris Software Banking Awards 2010 and the “Excellence Award”

as second-best new generation bank in Kerala by the State Forum of Bankers’ Clubs, Kerala.

Their activities are organized into the following business units:

Consumer banking;

Corporate and commercial banking;

Global markets; and

Transaction banking.

MISSION

I. World Class Indian Bank

II. Benchmarking against international standards.

III. To build sound customer franchises across distinct businesses

IV. Best practices in terms of product offerings, technology, service levels, risk management

and audit & compliance

5.1 VISION STATEMENT OF INDUSIND BANK

The INDUSIND Bank is committed to maintain the highest level of ethical standards,

professional integrity and regulatory compliance. INDUSIND Bank’s business philosophy is

based on four core values such as:-

1. Operational excellence.

2. Customer Focus.

3. Product leadership.

4. People.

The objective of the INDUSIND Bank is to provide its target market customers a full range of

financial products and banking services, giving the customer a one-step window for all his/her

requirements. The INDUSIND Bank plus and the investment advisory services programs have

been designed keeping in mind needs of customers who seeks distinct financial solutions,

information and advice on various investment avenues.

BUSINESS STRATEGY

I. Increasing market share in India’s expanding banking

II. Delivering high quality customer service

III. Maintaining current high standards for asset quality through disciplined credit risk

management

IV. Develop innovative products and services that attract targeted customers and address

inefficiencies in the Indian financial sector.

5.2 Finance and Accounts Department

In this modern era it is very easy to know how much important the finance is in the business.  As

current position of the market is totally different from ancient where it was very easy to get the

finance. But now a days it is not so, it is very difficult task to raise funds from market. As

today people are facing lot of problem and have less confidence on the market so it is difficult to

raise fund without proper planning. For the bank as it is a Financial Institution we can consider

finance as lifeblood of this business .The company should manage to get sufficient finance. The

company should use to keep proper  planning for the finance of its own and also of the large no.

of depositors who are there with the bank. We can define financial management as a task of

acquisition and utilization of funds needed in the business in a manner so that organizations goal

can be achieved. In IndusInd Bank, its chief Financial Officer and Treasurer manage the

finance. Due to proper policies and separate management the company can have proper operation

of finance.

IndusInd Bank hasline of authority and line of authority is vertical i.e. authority passes from top t

o bottom andresponsibility passes from bottom to top level management.

The Finance and Accounting Department’s core responsibility is to ensure the integrity of the

Bank’s financial information through its compliance. Finance and Accounting Department has

responsibility for the preparation of the annual budget and the tracking of adherence to the

approved budget.

There are lots of routine functions which accounting department has to do. To record the

transaction on the basis of invoice, bills and vouchers, keep bills and vouchers in safe place after

including them in files, to pay the creditors and employees, to collect and monitor debtors, to

reconcile the bank statements with his company's bank account.

To Prepare Interim Financial Statements

For different departments decisions, accounting departments prepare interim financial

statements. In these interim financial statements, we can includes trial balance, revenue

statement and balance sheet. Often these statements are prepared after three months.

To Prepare Annual Financial Statements

To prepare annual financial statements is important work of accounting department because after

auditing, it becomes proof in court and large number of decisions are affected from this. It is to

be prepared according to the current provisions of law , with all the errors being corrected and

the adjustments being done. Also everything has to be prepared with respect to the accounting

standards.

Security of Accounts

After making of accounts on computer and Internet or online mode, to secure the confidential

accounting information is also main duty of accounting department. With unethical use of

hacking, it may be possible that hackers can hack accounting information by breaking your

password.

Some of the other functions include-

Obtaining and utilizing financial data for the purpose of funds management, Obtaining

and utilizing financial data relating to Bank's investments for the purpose of accounting

Approving financial transactions entered into by Front Office with counterparties and

confirmation of the same , Consolidation and generation of various accounting

statements relating to the bank's investments

Transacting business with RBI and other banks , Correspondence with RBI, banks,

Mutual Funds, etc.

Compliance with RBI Inspection and concurrent audit observations , remittance of funds

, accounting transactions

Dealing in Derivative instruments like interest rate swaps, futures and currency swaps,

Functions related to Market Risk management and ALM- Monitoring adherence of

investment parameters, viz; deviation, value at risk, etc.- reviewing dealer-wise limits

Formal and Informal meetings with Financial Institutions conducting business with the

bank.

6 Methodology

In order to learn and observe the practical applicability and feasibility of various theories and

concepts, the following sources are being used:

Discussions with the project guide and staff members of IndusInd Bank Ltd.. Research papers and documents prepared by the bank and its related officials. Banks circulars and guidelines issued by the bank. Study of proposals and manuals. Circulars issued by RBI. Website of IndusInd Bank and other net sources.

7 Basel I

7.1 Purpose

The Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks

(including foreign banks) in India as a capital adequacy measure in line with the Capital

Adequacy Norms prescribed by Basel Committee. This circular prescribes the risk weights for

the balance sheet assets, non-funded items and other off-balance sheet exposures and the

minimum capital funds to be maintained as ratio to the aggregate of the risk weighted assets and

other exposures, as also, capital requirements in the trading book, on an ongoing basis.

The general purpose was to:

1. Strengthen the stability of international banking system. 

2. Set up a fair and a consistent international banking system in order to decrease competitive

inequality among international banks.

The basic achievement of Basel I has been to define bank capital and the so-called bank capital

ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and

governments in the world, a general definition of capital was required. Indeed, before this

international agreement, there was no single definition of bank capital. The first step of the

agreement was thus to define it.

Two-Tiered Capital

Basil I defines capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holders equity) and

declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing

out income variations. 

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on

investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e.

excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts

without guarantees), are not included in the definition of capital. 

Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks assets

weighted in relation to their relative credit risk levels. According to Basel I, the total capital

should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement

identifies three types of credit risks: 

The on-balance sheet risk .

The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign

exchange, equity derivatives and commodities.

The non-trading off-balance sheet risk. These include general guarantees, such as forward

purchase of assets or transaction-related debt assets.

Pitfalls of Basel I

Basel I Capital Accord has been criticized on several grounds. The main criticisms

include the following:

Limited differentiation of credit risk

There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1,

based on an 8% minimum capital ratio. 

Static measure of default risk 

The assumption that a minimum 8% capital ratio is sufficient to protect banks from

failure does not take into account the changing nature of default risk.

No recognition of term-structure of credit risk 

The capital charges are set at the same level regardless of the maturity of a credit

exposure. 

Simplified calculation of potential future counterparty risk

The current capital requirements ignore the different level of risks associated with

different currencies and macroeconomic risk. In other words, it assumes a common

market to all actors, which is not true in reality. 

Lack of recognition of portfolio diversification effects

In reality, the sum of individual risk exposures is not the same as the risk reduction

through portfolio diversification. Therefore, summing all risks might provide incorrect

judgment of risk. A remedy would be to create an internal credit risk model - for

example, one similar to the model as developed by the bank to calculate market risk. This

remark is also valid for all other weaknesses.

8 Basel II

Basel II, which was introduced in June 2004 for banking regulators that they can use while

creating regulations about how much capital banks need to put aside to guard against the types of

financial and operational risks that banks face., Basel II attempted to accomplish this by setting

up risk and capital management requirements designed to ensure that a bank holds capital

reserves appropriate to the risk the bank exposes itself to through its lending and investment

practices. Basel II includes of 3 pillars which talks about capital requirements of credit risk,

market risk and operation risk, internal assessment process and encourage safe and sound

practices.

8.1 Credit Risk

Previous norms prescribed single credit risk factor across a class of obligors thus ignoring the

default probability or risk rating of different obligors. This results in assigning same amount of

capital for exposures to “AAA” rated and “BB” rated corporate.

Under Basel II, Risk Weights are more risk sensitive being based on risk rating of the obligor

and tenor of the loan. E.g. AAA – 20%, AA – 30% etc.

Three approaches for computing RWAs for Credit Risk:

– Standardized Approach: Risk Weights linked to external ratings of obligors and tenor of the

loan. Range between 0% to 150%. Unrated exposures to be assigned 100% risk weight. We are

currently using this approach.

– Foundational Internal Rating Approach: Risk Weights assigned on the basis of obligator’s PD

(Probability of Default).

– Advanced Internal Rating Approach: Banks to use internal rating model for key statistical

data: credit ratings (probability of default or PD), “Loss given Default” (LGD) and “Exposure at

default” (EAD). Road map for migrating to these approaches is issued.

To start with RBI had asked all banks to follow Standardized approach and use external ratings

assigned by any of the RBI approved local and international rating agencies.

• Basel II - Risk-weighted according to the following credit ratings –

Figure 1 : Risk Weighted Credit Ratings

8.2 Operational Risk & Market Risk

Operational Risk is defined as the risk of loss arising from inadequate or failed internal

processes, people and systems or from external events. Basel II requires Banks to compute

capital charge for Operational Risk. It defines three approaches for this calculation:

- Basic Indicator Approach: Capital Charge computed at 15% of Gross Income of the Bank.

- Standardized Approach: Capital Charge ranges between 12-18% of gross income of different

business lines.

- Advanced Measurement Approach: Banks to use internal model for computing potential

operational loss.

To start with RBI has asked all banks to apply the Basic Indicator Approach. Basic Indicator

Approach is required to be implemented by all banks operating in India. Roadmap for Advanced

approaches is prescribed by RBI. We will migrate to advanced approaches in once Citi decides to

roll out advanced approaches for local jurisdictions.

Pillar One:

Minimum capital requirements similar to Basel I, i.e. 9% – except that credit risk calculation is

reformed and a new charge for Operational Risk to be added. Generally, Banks have seen a

reduction in risk weights for credit risk offset by an increase in the form of charge for

Operational Risk.

Pillar Two:

Banks have to establish Internal Capital Adequacy Assessment Process which shall be subject to

rigorous Supervisory Review Process.

Pillar Three:

Public disclosures to enhance market transparency. Specific list includes capital structure, capital

adequacy, composition of loan/credit portfolios by risk rating and detailed risk parameters for

each risk-rating category, market risk in Trading Book, Interest rate risk in the Banking Book,

Operational risk.

8.3 Reason for failure

The major reason for failure of Basel II was it focused on the regulations to guard the banks from

the risks as a result it focused safe and sound practices which restricted banks from making loans

and investments under the fear of making losses which lead neither servicing the community nor

the shareholders and employees and also the regulations employed by Basel II was leading to

increase cost and inadequacy in banking system to deploy the safety practices.

This was the reason BCBS came up with introduction of Basel III norms which were well

defined with clarity of ratios in capital adequacy and Tier1 capital and also the capital buffers to

prevent the banks from stressful conditions and to make it more transparent, clear for the banking

sector.

8.4 Difference in Basel II and Basel III

Moving from Basel II to Basel III

No change in overall capital requirement

TIER 1 Capital – 4 % to 6 %

Common Equity - 2 % to 4.5%

Capital conservation buffer – 2.5 %

figure 2 : Basel II vs. Basel III

9 Basel III

Basel III norms are the rules given by bank of international settlement committee on banking

supervision (BCBS) as these are the norms introduced for banking community as a whole. The

new banking norms or Basel III norms are intended to make the global banking industry safer

and protect economies from financial meltdowns. Basel III norms describes about how to assess

risks and how much capital banks need to kept aside to keep with the risk profile. Basel III

norms wants bank to hold more and better quality capital, more liquid assets, to limit and

mandate leverage and to build capital buffers.

Capital includes common equity and retained earnings and to restrict inclusion of deferred tax

assets, mortgage servicing rights and investment in financial institutions to not more than 15%

equity components.

9.1 Requisites for implementation of Basel III norms

For the implementation of Basel III norms banks need to maintain capital adequacy ratio

minimum at 8% and the minimum core Tier 1 capital is raised from 2-4.5% while the Tier 1

component is raised from 4% to 6%. Since Tier 1 include paid up capital, reserve and surplus

preference capital subtracting deferred tax, investments and intangibles. As the deadline is year

2015 for these ratios and also bank need to maintain 2.5% as capital conservation buffer so that

to absorb losses during the financial and economic stresses.

The Basel committee has also come out with two standards to address the acute liquidity

problems seen by banks at the start of the global financial crisis. First, it expects banks to comply

with a liquidity coverage ratio from the start of 2015, requiring them to hold sufficient high-

quality assets to withstand a 30-day period of acute stress. Meanwhile, a net stable funding ratio

will come into force from January 2018, aimed at removing long-term structural liquidity

mismatches on bank balance sheets.

9.2 Key Basel III Components

Table 1 : key Basel III components

9.2.1 Capital

The basic approach of capital adequacy framework is that a bank should have sufficient capital

to provide a stable resource to absorb any losses arising from the risks in its business.

Capital is divided into tiers according to the characteristics/qualities of each qualifying

instrument. For supervisory purposes capital is split into two categories: Tier I and Tier II. These

categories represent different instruments’ quality as capital. Tier I capital consists mainly of

share capital and disclosed reserves and it is a bank’s highest quality capital because it is fully

available to cover losses. Tier II capital on the other hand consists of certain reserves and certain

types of subordinated debt.

The loss absorption capacity of Tier II capital is lower than that of Tier I capital. When returns of

the investors of the capital issues are counter guaranteed by the bank, such investments will not

be considered as Tier I/II regulatory capital for the purpose of capital adequacy.

Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may

fail to meet its obligations in accordance with agreed terms. It is the possibility of losses

associated with diminution in the credit quality of borrowers or counterparties. In a bank’s

portfolio, losses stem from outright default due to inability or unwillingness of a customer or a

Areas Main Basel III ComponentsCapital Ratios And Targets Capital Definition

Countercyclical BufferLeverage RatioMinimum Capital StandardsSystematic Risk

RWA Requirements Counterparty Risk Trading Book and Securitization

Liquidity Standards Liquidity Coverage RatioNet Stable Funding Ratio

counterparty to meet commitments in relation to lending, trading, settlement and other financial

transactions. Alternatively, losses result from reduction in portfolio arising from actual or

perceived deterioration in credit quality.

For most banks, loans are the largest and the most obvious source of credit risk; however, other

sources of credit risk exist throughout the activities of a bank, including in the banking book and

in the trading book, and both on and off balance sheet. Banks increasingly face credit risk (or

counterparty risk) in various financial instruments other than loans, including acceptances, inter-

bank transactions, trade financing, foreign exchange transactions, financial futures, swaps,

bonds, equities, options and in guarantees and settlement of transactions.

The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by

maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit

risk inherent in the entire portfolio, as well as, the risk in the individual credits or transactions.

Banks should have a keen awareness of the need to identify measure, monitor and control credit

risk, as well as, to determine that they hold adequate capital against these risks and they are

adequately compensated for risks incurred.

9.2.2 Market Risk

Market risk refers to the risk to a bank resulting from movements in market prices in particular

changes in interest rates, foreign exchange rates and equity and commodity prices.

In simpler terms, it may be defined as the possibility of loss to a bank caused by changes in the

market variables. The Bank for International Settlements (BIS) defines market risk as “the risk

that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in

equity and interest rate markets, currency exchange rates and commodity prices”.

Thus, Market Risk is the risk to the bank’s earnings and capital due to changes in the market

level of interest rates or prices of securities, foreign exchange and equities, as well as, the

volatilities of those changes.

Components of Capital

Under the existing capital adequacy guidelines based on Basel II framework, total

regulatory capital is comprised of Tier 1 capital (core capital) and Tier 2 capital

(supplementary capital). Total regulatory capital should be at least 9% of risk weighted

assets and within this, Tier 1 capital should be at least 6% of risk weighted assets. Within

Tier 1 capital, innovative Tier 1 instruments are limited to 15% of Tier 1 capital. Further,

Perpetual Non- Cumulative Preference Shares along with Innovative Tier 1 instruments

should not exceed 40 % of total Tier 1 capital at any point of time. Also, at present, Tier

2 capital cannot be more than 100 % of Tier 1 capital and within Tier 2 capital,

subordinated debt is limited to a maximum of 50% of Tier 1 capital.

Post crisis, with a view to improving the quality and quantity of regulatory capital, it has

been decided that the predominant form of Tier 1 capital must be Common Equity; since

it is critical that banks’ risk exposures are backed by high quality capital base. Non-

equity Tier 1 and Tier 2 capital would continue to form part of regulatory capital subject

to eligibility criteria as laid down in Basel III. Accordingly, under revised guidelines

(Basel III), total regulatory capital will consist of the sum of the following categories:

(i) Tier 1 Capital (going-concern capital)

(a) Common Equity Tier 1

(b) Additional Tier 1

(ii) Tier 2 Capital (gone-concern capital)

Limits and Minima

As a matter of prudence, it has been decided that scheduled commercial banks (excluding

LABs and RRBs) operating in India shall maintain a minimum total capital (MTC) of 9%

of total risk weighted assets (RWAs) as against a MTC of 8% of RWAs as prescribed in

Basel III.

Common Equity Tier 1 capital must be at least 5.5% of risk-weighted assets (RWAs) i.e.

for credit risk + market risk + operational risk on an ongoing basis. Tier 1 capital must be

at least 7% of RWAs on an ongoing basis. Thus, within the minimum Tier 1 capital,

Additional Tier 1 capital can be admitted maximum at 1.5% of RWAs.

Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9% of RWAs on an

ongoing basis. Thus, within the minimum CRAR of 9%, Tier 2 capital can be admitted

maximum up to 2%.

If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital

ratios, then the excess Additional Tier 1 capital can be admitted for compliance with the

minimum CRAR of 9% of RWAs.

In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are

also required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in the

form of Common Equity Tier 1 capital.

The capital requirements are summarized as follows:

Regulatory Capital

As % toRWAs

(i) Minimum Common Equity Tier 1 ratio 5.5

(ii) Capital conservation buffer (comprised of Common Equity)

2.5

(iii) Minimum Common Equity Tier 1 ratio plus capital conservationbuffer [(i)+(ii)]

8.0

(iv) Additional Tier 1 Capital 1.5(v) Minimum Tier 1 capital ratio [(i) +(iv)] 7.0

(vi) Tier 2 capital 2.0

(vii) Minimum Total Capital Ratio (MTC) [(v)+(vi)] 9.0

(viii) Minimum Total Capital Ratio plus capital conservation buffer[(vii)+(ii)]

11.5

Table 1 : Capital Requirements

For the purpose of reporting Tier 1 capital and CRAR, any excess Additional Tier 1 capital and

Tier 2 capital will be recognised in the same proportion as that applicable towards minimum

capital requirements. This would mean that to admit any excess AT1 and T2 capital, the bank

should have excess CET1 over and above 8% (5.5%+2.5%). Accordingly, excess Additional Tier

1 capital above the 1.5% of RWAs can be reckoned by the bank further to the extent of 27.27%

(1.5/5.5) of Common Equity Tier 1 capital in excess of 8% RWAs. Similarly, excess Tier 2

capital above 2% of RWAs can be reckoned by the bank further to the extent of 36.36% (2/5.5)

of Common Equity Tier 1 capital in excess of 8% RWAs.

In cases where the a bank does not have minimum Common Equity Tier 1 + capital conservation

buffer of 2.5% of RWAs as required but, has excess Additional Tier 1 and / or Tier 2 capital, no

such excess capital can be reckoned towards computation and reporting of Tier 1 capital and

Total Capital.

9.3 Tier 1 Capital

9.3.1 Common Equity

Elements of Common Equity Tier 1 capital will remain the same under Basel III. Accordingly,

the Common Equity component of Tier 1 capital will comprise the following:

(i) Common shares (paid-up equity capital) issued by the bank which meet the criteria for

classification as common shares for regulatory purposes

(ii) Stock surplus (share premium) resulting from the issue of common shares;

(iii) Statutory reserves;

(iv) Capital reserves representing surplus arising out of sale proceeds of assets;

(v) Other disclosed free reserves, if any;

(vi) Balance in Profit & Loss Account at the end of the previous financial year;

(vii) While calculating capital adequacy at the consolidated level, common shares issued by

consolidated subsidiaries of the bank and held by third parties (i.e. minority interest) which meet

the criteria for inclusion in Common Equity Tier 1 capital and For the purpose of all prudential

exposure limits linked to capital funds, the ‘capital funds’ will exclude Additional Tier 1 capital

and Tier 2 capital which is not supported by proportionate amount of Common Equity Tier 1

capital as indicated in this paragraph. Accordingly, capital funds will be defined as [(Common

Equity Tier 1 capital) + (Additional Tier 1 capital and Tier 2 capital eligible for computing and

reporting CRAR of the bank)].

(viii) Less: Regulatory adjustments / deductions applied in the calculation of Common Equity

Tier 1 capital [i.e. to be deducted from the sum of items (i) to (vii)].

9.3.1.1 Criteria for Classification as Common Shares for Regulatory Purposes

The existing guidelines do not prescribe any specific criteria for inclusion of Common Equity in

Tier 1 capital. Common Equity is recognised as the highest quality component of capital and is

the primary form of funding which ensures that a bank remains solvent. Therefore, under revised

guidelines (Basel III), common shares to be included in Common Equity Tier 1 capital must

meet the certain criteria.

9.3.2 Elements of Additional Tier 1 Capital

Elements of Additional Tier 1 capital will remain the same. Additional Tier 1 capital consists of

the sum of the following elements:

(i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory

requirements

(ii) Stock surplus (share premium) resulting from the issue of instruments included in Additional

Tier 1 capital;

(iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply

with the regulatory requirements

(iv) Any other type of instrument generally notified by the Reserve Bank from time to time for

inclusion in Additional Tier 1 capital;

(v) While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments

issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria

for inclusion in Additional Tier 1 capital and

(vi) Less: Regulatory adjustments / deductions applied in the calculation of Additional Tier 1

capital [i.e. to be deducted from the sum of items (i) to (v)].

9.3.2.1 Criteria for Classification as Additional Tier 1 Capital for Regulatory Purposes

(i) Under Basel II, the differentiation of non-equity capital into going concern and gone concern

capital is not very fine. As a result, during the crisis, it was observed that non-common equity

regulatory capital could not absorb losses while allowing banks to function as going concern. It

is critical that for non common equity elements to be included in Tier 1 capital, they must also

absorb losses while the bank remains a going concern. Certain innovative features such as step-

ups, which over time, have been introduced to Tier 1 capital to lower its cost, have done so at the

expense of its quality4. In addition, the existing criteria are not sufficient to ensure that these

instruments absorb losses at the point of non-viability, particularly, in cases where public sector

intervention including in terms of injection of funds is considered essential for the survival of the

bank. These elements of capital will be phased out. Further, banks should not over-rely on non-

common equity elements of capital and so the extent to which these can be included in Tier 1

capital must be limited. Therefore, based on Basel III, the criteria for instruments to be included

in Additional Tier 1 capital have been modified to improve their loss absorbency.

9.4 Elements of Tier 2 Capital

Elements of Tier 2 capital will largely remain the same under existing guidelines except that

there will be no separate Tier 2 debt capital instruments in the form of Upper Tier 2 and

subordinated debt. Instead, there will be a single set of criteria governing all Tier 2 debt capital

instruments.

9.4.1 General Provisions and Loss Reserves

Provisions or loan-loss reserves held against future, presently unidentified losses, which are

freely available to meet losses which subsequently materialize, will qualify for inclusion within

Tier 2 capital. Accordingly, General Provisions on Standard Assets, Floating Provisions,

Provisions held for Country Exposures, Investment Reserve Account, excess provisions which

arise on account of sale of NPAs and ‘countercyclical provisioning buffer’ will qualify for

inclusion in Tier 2 capital. However, these items together will be admitted as Tier 2 capital up to

a maximum of 1.25 % of the total credit risk-weighted assets under the standardized approach.

Under Internal Ratings Based (IRB) approach, where the total expected loss amount is less than

total eligible provisions, banks may recognise the difference as Tier 2 capital up to a maximum

of 0.6 % of credit-risk weighted assets calculated under the IRB approach.

Provisions ascribed to identified deterioration of particular assets or loan liabilities, whether

individual or grouped should be excluded.

(ii) Debt Capital Instruments issued by the banks;

(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) /

Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative Preference

Shares (RCPS)] issued by the banks;

(iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2

capital;

(v) While calculating capital adequacy at the consolidated level, Tier 2 capital instruments issued

by consolidated subsidiaries of the bank and held by third parties which meet the criteria for

inclusion in Tier 2 capital

(vi) Revaluation reserves at a discount of 55%7;

(vii) Any other type of instrument generally notified by the Reserve Bankfrom time to time for

inclusion in Tier 2 capital; and

(viii) Less: Regulatory adjustments / deductions applied in the calculation of Tier 2 capital [i.e.

to be deducted from the sum of items (i) to (vii)].

9.4.1.1 Criteria for Classification as Tier 2 Capital for Regulatory Purposes

Under the existing guidelines, Tier 2 capital instruments could have step-ups which can be

construed as an incentive to redeem, thereby compromising their loss absorbency capacity8. In

addition, the existing criteria are not sufficient to ensure that these instruments absorb losses at

the point of nonviability, particularly, in cases where public sector intervention including in

terms of injection of funds is considered essential for the survival of the bank.

Therefore, under Basel III, the criteria for instruments to be included in Tier 2. These reserves

often serve as a cushion against unexpected losses, but they are less permanent in nature and

cannot be considered as ‘Core Capital’. Revaluation reserves arise from revaluation of assets that

are undervalued on the bank’s books, typically bank premises. The extent to which the

revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon

the level of certainty that can be placed on estimates of the market values of the relevant assets,

the subsequent deterioration in values under difficult market conditions or in a forced sale,

potential for actual liquidation at those values, tax consequences of revaluation, etc. Therefore, it

would be prudent to consider revaluation reserves at a discount of 55 % while determining their

value for inclusion in Tier II capital. Such reserves will have to be reflected on the face of the

Balance Sheet as revaluation reserves.

9.5 Need For Basel III

9.5.1 Improving the Quality, Consistency and Transparency of the Capital BasePresently, a bank’s capital comprises Tier 1 and Tier 2 capital with a restriction that Tier 2

capital cannot be more than 100% of Tier 1 capital. Within Tier 1 capital, innovative instruments

are limited to 15% of Tier 1 capital. Further, Perpetual Non-Cumulative Preference Shares along

with Innovative Tier 1 instruments should not exceed 40% of total Tier 1 capital at any point of

time. Within Tier 2 capital, subordinated debt is limited to a maximum of 50% of Tier 1 capital.

However, under Basel III, with a view to improving the quality of capital, the Tier 1 capital will

predominantly consist of Common Equity. The qualifying criteria for instruments to be included

in Additional Tier 1 capital outside the Common Equity element as well as Tier 2 capital will be

strengthened.

At present, the regulatory adjustments (i.e. deductions and prudential filters) to capital vary

across jurisdictions. These adjustments are currently generally applied to total Tier 1 capital or to

a combination of Tier 1 and Tier 2 capital. They are not generally applied to the Common Equity

component of Tier 1 capital. With a view to improving the quality of Common Equity and also

consistency of regulatory adjustments across jurisdictions, most of the adjustments under Basel

III will be made from Common Equity. The important modifications include the following:

(i) deduction from capital in respect of shortfall in provisions to expected losses under Internal

Ratings Based (IRB) approach for computing capital for credit risk should be made from

Common Equity component of Tier 1 capital;

(ii) Cumulative unrealized gains or losses due to change in own credit risk on fair valued

financial liabilities, if recognized, should be filtered out from Common Equity;

(iii) Shortfall in defined benefit pension fund should be deducted from Common Equity;

(iv) Certain regulatory adjustments which are currently required to be deducted 50% from Tier 1

and 50% from Tier 2 capital, instead will receive 1250% risk weight; and

(v) Limited recognition will be granted in regard to minority interest in banking subsidiaries and

investments in capital of certain other financial entities.

The transparency of capital base will be improved, with all elements of capital required to be

disclosed along with a detailed reconciliation to the published accounts. This requirement will

improve the market discipline under Pillar 3 of the Basel II framework.

9.5.2 Enhancing Risk Coverage At present, the counterparty credit risk in the trading book covers only the risk of default of the

counterparty. The reform package includes an additional capital charge for Credit Value

Adjustment (CVA) risk which captures risk of mark-to-market losses due to deterioration in the

credit worthiness of a counterparty. The risk of interconnectedness among larger financial

firms(Defined as having total assets greater than or equal to $100 billion) will be better captured

through a prescription of 25% adjustment to the asset value correlation (AVC) under IRB

approaches to credit risk. In addition, the guidelines on counterparty credit risk management with

regard to collateral, margin period of risk and central counterparties and counterparty credit risk

management requirements have been strengthened.

9.5.3 Enhancing the Total Capital Requirement and Phase-in PeriodThe minimum Common Equity, Tier 1 and Total Capital requirements will be phased-in between

January 1, 2013 and January 1, 2015, as indicated below:

As a %age to Risk

Weighted Assets (RWAs)

January 1,

2013

January 1, 2014 January 1, 2015

Minimum Common Equity

Tier 1 capital

3.5% 4.0% 4.5%

Minimum Tier 1 capital 4.5% 5.5% 6.0%

Minimum Total capital 8.0%

8.0% 8.0%

Table 2 : Risk Weighted Assets

9.5.4 Capital Conservation BufferThe capital conservation buffer (CCB) is designed to ensure that banks build up capital buffers

during normal times (i.e. outside periods of stress) which can be drawn down as losses are

incurred during a stressed period. The requirement is based on simple capital conservation rules

designed to avoid breaches of minimum capital requirements.

Therefore, in addition to the minimum total of 8% as indicated above, banks will be required to

hold a capital conservation buffer of 2.5% of RWAs in the form of Common Equity to withstand

future periods of stress bringing the total Common Equity requirement of 7% of RWAs and total

capital to RWAs to 10.5%. The capital conservation buffer in the form of Common Equity will

be phased-in over a period of four years in a uniform manner of 0.625% per year, commencing

from January 1, 2016.

9.5.5 Countercyclical Capital BufferFurther, a countercyclical capital buffer within a range of 0 – 2.5% of Common Equity or other

fully loss absorbing capital will be implemented according to national circumstances. The

purpose of countercyclical capital buffer is to achieve the broader macro-prudential goal of

protecting the banking sector from periods of excess aggregate credit growth. For any given

country, this buffer will only be in effect when there is excess credit growth that results in a

system-wide build up of risk. The countercyclical capital buffer, when in effect, would be

introduced as an extension of the capital conservation buffer range.

9.5.6 Regulatory Capital Ratio Total Regulatory Capital Ratio = Tier 1 Capital Ratio + Capital Conservation Buffer +

Countercyclical Capital Buffer + Capital for Systemically Important Banks

9.5.7 Liquidity Coverage Ratio (LCR)The ratio is intended to ensure that a bank maintains adequate levels of unencumbered high

quality assets to meet its liquidity needs. Measured as the ratio of the bank’s high quality liquid

assets , divided by its net cash outflows over a 30-day period.

The high quality assets included in the numerator include only

Cash, central bank reserves that can be accessed during times of stress, marketable securities

meeting certain criteria, and government or central bank debt .The denominator will be

calculated by taking into account certain “run-off factors”.

Liquidity Coverage Ratio=High Quality Liquid AssetsNet Cash Outflow (30 ) days

9.5.8 Net Stable Funding RatioTo promote medium to long term structural funding of assets and activities.“Stable funding” –

the portion of those types and amounts of equity and liability financing expected to be reliable

sources of funds over a one-year time horizon under conditions of extended stress.Defined as

Available amount of stable funding / Required amount of stable funding > 100%

9.5.9 Supplementing the Risk-based Capital Requirement with a Leverage Ratio

One of the underlying features of the crisis was the build-up of excessive on and off-balance

sheet leverage in the banking system. In many cases, banks built up excessive leverage while still

showing strong risk based capital ratios.

Subsequently, the banking sector was forced to reduce its leverage in a manner that not only

amplified downward pressure on asset prices, but also exacerbated the positive feedback loop

between losses, declines in bank capital and contraction in credit availability. Therefore, under

Basel III, a simple, transparent, non-risk based regulatory leverage ratio has been introduced.

Thus, the capital requirements will be supplemented by a non-risk based leverage ratio which is

proposed to be calibrated with a Tier 1 leverage ratio of 3% (the Basel Committee will further

explore to track a leverage ratio using total capital and tangible common equity). The ratio will

be captured with all assets and off balance sheet (OBS) items at their credit conversion factors

and derivatives with Basel II netting rules and a simple measure of potential future exposure

(using Current Exposure Method under Basel II framework) ensuring that all derivatives are

converted in a consistent manner to a “loan equivalent” amount. The ratio will be calculated as

an average over the quarter.

10 Impact of Basel III on Indian banksThe role of the banking sector in the credit intermediation is critical for sustainable economic

growth.

The BASEL III framework is focused on a sustained increase in capital, particularly equity

capital, to absorb the potential impact of market, credit and operational risks

With BASEL III to be introduced in 2013, this report helps assess the need for capital in the

banking sector in India.

Since the availability of credit is vital to sustain overall economic growth, the failure of the

banking system can lead to a freeze in credit markets and a severe degradation in growth

potential.

The global financial crisis of 2008 found its roots in the sustained under-estimation of risk,

coupled with deteriorating levels of equity capital. Based on the lessons drawn from this crisis,

the Basel Committee on Banking Supervision (BCBS) has drafted the BASEL III regulatory

framework.

This framework is focused on a sustained increase in capital, particularly equity capital,

to absorb the potential impact of market, credit and operational risks.

BASEL III also focuses on requiring banks to keep a sufficient stock of high-quality

liquid assets to manage short-term financial stress. With the introduction of the new

framework, the need for capital is expected to rise.

The Indian banking system is at an important crossroad — the balance between growth and the

need for additional capital.

Where credit off-take is sustained at current levels, along with a similar profitability and asset

profile, the Indian banking sector, as a whole, is likely to require significant capital infusion by

2015. Individual banks may require capital infusion as early as 2013.The Indian banking sector’s

ability to balance growth and capital requirements is dependent on the following factors:

Optimization of capital composition

With the exception of private banks, Indian banks have an underutilized base of Tier-II capital.

The ability to fully fund growth through tier-I and tier-II capital will be critical to managing

return on equity.

Sustaining and enhancing net profit margins:

The focus on enhancing balance sheet size as the cost of net margins is likely to impact growth,

as BASEL III stresses on the need for common equity i.e., paid-up share capital and free

reserves.

Retention of profits

Retaining earnings through a cautious approach towards dividend payouts is crucial to meet the

needs of common equity under BASEL III.Quicker transition to the evidence-based estimation of

risk as opposed to formula-based approaches

Lack of appropriate risk quantification has led to the overestimation of capital requirements for

credit and operational risk. The ability to allocate capital in line with evidence-based risk

quantification, as opposed to formula-based allocation, is important for the accurate estimation of

capital requirements. In general, the delay in transition to advanced approaches has potentially

led to an over-estimation of regulatory capital requirements.

Restructuring risk-return expectations from the market risk portfolio

Unlike credit and operational risk, a transition to advanced approaches for market risk is likely to

increase the requirement of regulatory capital. The need for additional capital stems from

volatility being a key measure for determining risk and a sustained increase in this volatility

across financial markets, especially equity markets.

Additional capital requirements for stress conditions and credit risk in trading portfolios are

likely to further enhance the need for regulatory capital.

The total regulatory requirement of total capital (tier 1 and tier 2) in India is 9%, higher than the

BIS norm of 8%. It will remain so under the new guidelines. Under Basel 3, two important

changes happen.

One is that the quality of the 9% capital required is higher. At present, bank capital is split almost

evenly between tier 1 and tier 2. Under Basel 3, tier 1 will constitute 7% out of the total 9%. The

other change is that banks will be required to have a capital conservation buffer, comprising

common equity, of 2.5%. That takes the total capital requirement to 11.5%. Also, between 2013

and 2017, banks will be expected to operate at a minimum tier 1 leverage ratio of 5%.

At the regulatory requirement of 9%, Indian banks were operating with a capital adequacy ratio

of 13% in 2011 (under Basel 1). At a regulatory minimum of 11.5%, banks can be expected to be

operating with capital in the range of 15-17%. This is the new bottom line where capital is

concerned. Indian banks will have to make their plans for capital accordingly. Are they equal to

the task? There are several reasons for optimism.

First, investor appetite is likely to be healthy because returns to primary issues of Indian banking

stocks, including PSB stocks, over the years have been good. Secondly, banks are seen as a play

on the economy. In putting money in banks, investors are looking at an economy with a growth

potential of 8-9% and bank loan growth upwards of 20%.

Thirdly, return on assets in Indian banking is among the highest in the world today: it has been

above 1% every year since the subprime crisis. While banking systems in the west are still

reeling under the impact of the crisis, it is almost as if no crisis happened in Indian banking.

Western bankers have expressed two big concerns about the higher capital requirements imposed

by Basel 3. One, it will depress banks' profitability. Two, it will depress economic growth

because some of the higher cost of capital will be passed on to borrowers. Neither is particularly

worrying in India.

Increases in capital have made little dent on banks' net interest income (as a proportion of assets)

over the years. Any impact in coming years will be small, if at all, because there are still

numerous high-yielding products that are still open to banks on both wholesale and retail sides:

SMEs, vehicle loans, personal loans, credit cards, etc.

Besides, PSBs have only recently woken up to the potential for fee income. Increases in fee

income will sustain return on assets even if net interest income is dented. For the same reasons,

the impact on corporate borrowers and hence on economic growth will be negligible. (Even in

western economies, BIS estimates the impact on growth to be a mere 0.04% per year).

High growth and high returns will continue to make Indian banks attractive to investors in India

and abroad. Some banks, such as HDFC Bank, are generating substantial surpluses and hence

may not need a great deal of capital from the market. Overall, capital is unlikely to be a

constraint for Indian banks in the coming years. There could be constraints arising from one or

two other factors.

One is the low prices of stocks in the Indian market: banks may not find it attractive to issue

capital at current prices. A possible answer is to raise small sums through rights issues in such

periods and approach the broader market when things look up.

A bigger constraint is the government's shareholding in PSBs. As SBI finds to its cost, the

government may not find it easy to contribute its share in order to retain its shareholding. It may

not be willing to reduce its shareholding below 51% either. If majority government ownership is

to stay, the annual budget must factor in annual requirements towards bank capital.

Basel 3 is likely to impact western and Indian banks in very different ways. Banks inthe west are

raising their capital adequacy levels through deleveraging, that is, by shrinking their balance

sheets. In India, in contrast, banks will be raising capital to finance growth.

The fear with Basel 2 was that large international banks would increase their competitive

advantage by using advanced risk management models that would lower their capital

requirement. In contrast, Basel 3, with its enhanced capital requirements, is likely to improve the

competitive advantage of banks in India and some other emerging markets.

Capital Adequacy and Tier1 Capital for Indian banks

Basel III has come up with norms which talks about capital adequacy ratio (CAR) whose

minimum requirement kept by BCBS is 8% , capital adequacy is ratio of capital fund to risk

weighted assets expressed in percentage terms and currently Indian banks are operating CAR to

13.2%. By far India is operating at more CAR than the prescribed Basel III norms. Since Basel

III norms also ask to keep tier I capital at 6% and Indian banks are usually operating their Tier 1

capital at 9.3% as Tier 1 capital ratio is the ratio of banks core equity capital to total risk

weighted assets which includes (Equity and Disclosed Reserves). According to RBI it could have

negative impact on banks making deductions from Tier 1 capital as banks do not have re-

securitization exposures and even trading books are small i.e. is banks do not have much

exposure to securitize its asset in the market again and also the trading book i.e. is portfolio of

financial instrument with bank is not huge so reducing tier 1 capital for Indian banks could be a

difficult and this would have negative impact on Indian banks.

Impact on Introduction of Capital buffers on Indian banks

Basel III norms explains about building countercyclical and additional capital buffers means the

bank needs to keep additional 2.5% as contingency for preventing itself from future losses, this

means Indian banks need to incur additional costs to meet the international standards. Since

capital buffers are required to be maintained to cover the risk but taking India’s point of view

banks are already maintaining more capital adequacy than required and moreover the Indian

banks do not go re securitization or subprime mortgages which leads to global imbalances or

high risk. So introducing capital buffer will affect Indian banks to restrict their leverage on better

prospects which will affect earnings of shareholders not good for Indian banks. Maintaining so

much high capital for covering the risks would have a negative effect on ROE i.e. return on

equity as it is expected to fall by 10% if banks fail to manage its business efficiently. India is

considering for the creation of Capital buffer somewhere between periods of January 2016 to

2019.

Impact of Liquidity standards on Indian banks

Basel III norms have introduced liquidity standards and considering its impact on Indian banks

it does not seem to have any serious issues. Most of our banks follow a retail business model and

also have a substantial amount of liquid assets, which should enable them to meet the new

standards with comfort. However, there may be some challenge due to the fact that our banks

have a limited capacity to collect the relevant data accurately and granularly, and to formulate

and predict the liquidity stress scenarios. But the phase in period for the compliance with these

ratios is fairly long up to 2019 and this challenge could be easily overcome by then.

Additionally, there is some ambiguity about the treatment of Statutory Liquidity Ratio (SLR)

under the new banking regulations. The RBI has been negotiating for taking at least the part of

the SLR in the liquidity ratios as these are government bonds against which the RBI provides

liquidity to banks.

11 Limitation of the Study

The data availability is proprietary, not readily shared for dissemination and is highly

confidential.

Financial statements of the proposed project are subject to risks and uncertainties that could

cause actual results to differ materially from those mentioned in the report. The risks and

uncertainties include, but are not limited to, the following:

(i) Changes in Indian laws

(ii) Changes in Indian in global economic conditions

(iii) Changes in government regulations

(iv) Introduction of new technologies

The staff although are very helpful but are not able to give much of their time due to their

own work constraints.

12 Conclusion and Recommendations

Basel III norms have come up with regulations taking into consideration the capital adequacy,

liquidity standards; capital buffers norms which are in context to make industry safer from

economic crunch. As far as Indian banks are concerned taking into long term perspective India

needs to infuse more capital looking into the growth and the regulation requirements as looking

at PSU banks and their of accounts being NPA i.e. nonperforming assets it shows signs of

requirement of more capital to play safer and also with RBI considering to issue new licenses for

opening of new banks require considerable amount of huge capital.

Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for

the next developments in the banking sector, and it can ensure that past excesses are avoided.

Basel III is changing the way that banks address the management of risk and finance. The new

regime seeks much greater integration of the finance and risk management functions. This will

probably drive the convergence of the responsibilities of CFOs and CROs in delivering the

strategic objectives of the business. However, the adoption of a more rigorous regulatory stance

might be hampered by a reliance on multiple data silos and by a separation of powers between

those who are responsible for finance and those who manage risk. The new emphasis on risk

management that is inherent in Basel III requires the introduction or evolution of a risk

management framework that is as robust as the existing finance management infrastructures. As

well as being a regulatory regime, Basel III in many ways provides a framework for true

enterprise risk management, which involves covering all risks to the business.

There are certain changes banks need to do in regard to capital buffer and Tier1 capital within a

stipulated period of time, other than that Indian banks are operating well and should be able to

meet the norms without much problem since Indian banks capital adequacy ratio is higher than

what is prescribed by BCBS. Also Indian banks have been able to successfully prevent

themselves from the financial crisis and economic meltdowns therefore Basel III norms should

not affect Indian banks to a large extent.

13 References

Journals

1. RBI circular on Basel I2. RBI circular on Basel II3. RBI circular on Basel III4. Placement Document IndusInd Bank Ltd. ,20095. Annual Report IndusInd Bank Ltd. , 2010

Internet Websites

1. www.investopedia.com

2. www.rbi.org.in

3. www.indusind.com