Details of the Authors

Name of the Authors:

1. Girish V S

2. Dinesh Rajput

Title: Capital Punishment – Looking for Solutions beyond Basel III

Affiliation:

Department of Finance, Durgadevi Saraf Institute of Management Studies, Malad West, Mumbai

Contact Details:

v.girish@dsims.org.in; dinesh.rajput@dsims.org.in

Tel: 022 6681 2311; extn. 2342

Address: Durgadevi Saraf Institute of Management Studies, RS Campus, SV Road, Malad West, Mumbai 400064

ContentsAbstract...................................................................................................................................................3

Introduction to the Topic.........................................................................................................................4

Basel Accord and Capital.........................................................................................................................5

The Failure of Capital:..............................................................................................................................6

The Study.................................................................................................................................................8

The Indian Scenario...............................................................................................................................11

Is there an alternate to Capital?............................................................................................................12

Limitations of the Study.........................................................................................................................14

Annexure 1................................................................................................................................................15

Annexure 2................................................................................................................................................16

Annexure 3................................................................................................................................................17

Annexure 4................................................................................................................................................21

Annexure 5................................................................................................................................................22

List of TablesTable 1: Trading Revenue Data for the Year 2006.......................................................................................8

Table 2: Basel III Roadmap for India..........................................................................................................10

Table 3 Capital Adequacy Ratio for Nationalized Banks............................................................................18

Table 4: Capital Adequacy Ratio for Nationalized Banks With Basel III today............................................19

Table 5: Capital Adequacy Ratio for Private Banks....................................................................................20

Table 6: Capital Adequacy Ratio for Private Banks with Basel III Today....................................................21

Table 7: Advances projections at 20% Growth – Nationalized Banks.......................................................23

Table 8-1: Capital projections at 20% Growth – Nationalized Banks.........................................................24

Table 8-2: Capital projections at 20% Growth – Nationalized Banks.........................................................25

Table 9: Advances projections at 20% Growth – Private Banks................................................................26

Table 10 -1: Capital projections at 20% Growth – Private Banks..............................................................27

Table 10 -2: Capital projections at 20% Growth – Private Banks...............................................................28

Capital Punishment – Looking for Solutions beyond Basel III

Abstract

The collapse of Bank Haus Herstatt and the domino effect it had on the financial services system led to the setting up of the Basle Committee on banking supervision. The committee was given the task of making the banking system safer and transparent.

The Basel Committee has come out with three iterations of its proposal – The Basel I in 1988, the Basel II in 2004 and Basel III in 2010-11. The Basel III attempts to increase capital, using highly complex modeling tools that rely on a set of subjective, simplifying assumptions to align a firm's capital and risk profiles.  The core idea that runs through the Basel Accord is the acceptance of Capital as a proxy for the health of the bank. Till 2007 the banks and regulators were happy with capital. Regulators across the world – with the exception of China - embraced the Basel recommendations on capital.

The crisis of 2008 saw around 1800 banks close in the United States alone. And strangely, all them were Basle II compliant as far as capital is concerned. This leads us to question the adequacy of capital as a measure of bank stability.

Using published data from some of the most respected banks in the world, we show that either the banks underestimate their risks or overstate their revenue. In either case the risks in the balance sheet is out of line with the capital employed. As a second step, we projected the capital requirements of the banking system as per the Basel III norms and the impact it will have on the return on capital employed. We projected the capital requirements of banks if the RBI accepts all the recommendations of Basel III – the countercyclical buffer, the capital conservation buffer, the liquidity coverage ratio and the net stable funding ratio, and its impact on the banks profitability.

We go on to prove that the Basel I and Basel II are fundamentally flawed systems and the Basel III is a continuation of the same flawed approach, but in a horrendously complex way. And in conclusion we articulate an alternate measure of bank stability.

The Genesis of the Research

No one doubts the role of capital in Banking. Capital is intended to ensure that banks have a certain amount of cushion to absorb unexpected losses. The capital requirement takes into account the risk of banks’ loan exposures. Capital helps the public and the markets understand the financial condition of the bank. However, capital has its limits. As the events of the 2008 crisis reveal, even high levels of capital cannot save a bank from bad management or save it from the cumulative effects of excessive risk taking.

According to the FDIC, 469 banks were closed down by the authorities in the US since 2008. The beautiful part is that these banks were adequately capitalized as per the US regulations. In order for a bank to be considered well capitalized in the United States, it must have a leverage ratio of 5.0 percent; a tier I risk-based capital ratio of 6.0 percent; and a total risk-based capital ratio of at least 10.0 percent.1 And banks in US had more than the required capital ratio.2 And yet 469 banks failed in the US. This was the trigger that led us to undertake this research – is capital the be all and end all of a banks health. If so, what should be the parameters for defining this capital? Can there be a better measure of a banks health than capital? We set forth to address some of these concerns.

Introduction to the Topic

Over the past two decades, the global financial services sector, and particularly the banking system saw a significant growth in terms of size, complexity, and also interconnectivity. This expansion resulted in the development of newer and more complex financial products and markets that were the exclusive preserve of the “Rocket Scientists” of Wall Street. Needless to say, such complex products bring along with them new risks - to both, the financial system and the country’s economy. The sub-prime crisis and the subsequent collapse of Bear Stearns and Lehman Brothers and the government takeover of insurer AIG are an indicator of the speed and extent to which financial institutions across the globe will get affected by developments in another country. More so when you look at capital flows across the globe. The financial services firms have made it possible for one country to export its toxic assets to other countries! The collapse of Bank Haus Herstatt and its effects are nothing when compared to the potential damage that today’s institutions can effect.

The response of the regulators across the globe has been to impose higher capital charges – starting from the Basel I accord which provided capital for Credit risk in its first avatar, then expanded it to market risk, and the Basel II accord which introduced capital for Operational Risk. Basel III on the other hand prescribes capital conservation buffer, Countercyclical capital buffer and to build up a reserve. Clearly, for regulators across the globe, capital regulation is the key to a stable financial system.

Bank capital is a measure that appears on the liability side of the bank’s balance sheet. One way to think about it is that capital is what is left over when you subtract other bank liabilities (such as deposits and loans made to the bank) from bank assets. One regulatory measure of capital is tier I capital, which is defined as the sum of common equity, non-cumulative perpetual preferred stock, and minority interest. Tier II capital includes preferred shares not included in tier I capital,

1 Bank Capitalization by Ben Craig and Matthew Koepke of the Federal Reserve Bank of Cleveland

2 Refer Annexure 1 and 2 below

hybrid capital, term subordinated debt, general loan-loss reserves, and unrealized gains on equity securities. While regulators view large levels of tier I capital as an essential buffer against unexpected losses, the more risky tier II capital is generally viewed as a supplemental buffer.

In essence, Economic capital is the shareholders funds needed to cover risks a bank is running in its business without affecting its ability to honor liabilities.

Basel Accord and Capital

The Basel I accord had only five risk weights – 0%, 10%, 20%, 50% and 100%. 3 However, the pundits in the developed world felt this system was too simple and was insensitive to the actual risks. Therefore the Basel Committee on Banking Supervision (BCBS) came up with a more complex version – the Basel II accord. And then came the financial crisis. The powers that be then decided this was not enough. And Basel III came into being. The end result of all these moves was, the risk weights went from five to thousands!(We are still counting!) These newer versions raised the capital required by using a set of highly complex models that rely on a set of simplifying assumptions that aligned the banks capital with its risk profile. In the bargain they forgot that they are dealing with a complex and dynamic subject like banking.

“As a result of this risk-sensitiveness, a widespread concern about Basel II is that it might amplify business cycle fluctuations, forcing banks to restrict their lending when the economy goes into recession. Even in the old Basel I regime of essentially flat capital requirements, bank capital regulation had the potential to be pro-cyclical because bank profits may turn negative during recessions, impairing banks’ lending capacity.”(Borio et al., 2001; Gambacorta and Mistrulli, 2004)4

An alarming finding for the banking system and the economy it is intended to serve is elaborated in a paper Mitigating the pro-cyclicality of Basel II - "So concerns about Basel II are stronger than those regarding Basel I because the worsening of borrowers’ creditworthiness in recessions will significantly increase the requirement of capital for banks and might lead to a severe contraction in the supply of credit. These concerns would be exacerbated by mark-to-market accounting, which increases the cyclical movements in banks’ capital, and consequently has the potential to amplify the pro-cyclical effects of bank capital regulation."5

3 International Convergence Of Capital Measurement And Capital Standards (July 1988, Updated To April 1998)

4 There is a set of researchers who opine that the implementation of the Basel I capital requirements in the United States may have created a credit crunch in the early 1990s; see Bernanke and Lown (1991), Berger and Udell (1994), Hancock and Wilcox (1994).

5 Mitigating the pro-cyclicality of Basel II; Rafael Repullo, Jesu´ s Saurina and Carlos Trucharte; CEMFI and CEPR; Banco de Espan˜a; Banco de Espan˜a

A major issue with the Basel prescriptions is the absence of a cost benefit analysis of increased capital – a must have as the basis of any capital prescription framework. The Basel recommendations ignore this fundamental principle. We get an eight percent capital prescription (9% in India). There is no mention of any analytic framework that comes to this value. It seems the committee took an ad-hoc decision that a bank should have enough capital to cover credit losses with a 99.9% confidence level. To achieve this, banks are free to choose a risk model that captures the underlying probability distribution of loan losses. It ignores the one aspect we in India consider important – banks have a social welfare role too! Clearly, a model that ignores this should not find acceptance in India.

Basel recommendations clearly focus on the external circumstances associated with a bank failure - losses to the deposit insurer, break-up of lending relationships, disruption to other players in the financial system, etc. It ignores the fact that if the cost of capital for a bank becomes too high, banks will be reluctant to lend to projects that they find acceptable today – we will see a lot more loan rejections by banks – the hurdle rate for acceptance for projects will go up. What we need is a methodology that will balance these forces.

The result is that a few savvy banks with “Rocket Scientists” can hijack the system to create unreasonable ROCE!

The Failure of Capital:

To be useful, a capital rule must be simple, understandable and enforceable. It should reflect the firm's ability to absorb loss in good times and in crisis. It should be one that the public and shareholders can understand, that directors can monitor, that management cannot easily game, and that bank supervisors can enforce. An effective capital rule should result in a bank having capital that approximates what the market would require without the safety net in place.

Thomas M. Hoenig, Director, Federal Deposit Insurance Corporation6, “One of the most significant results has been that bank supervisors rather than the market have been left the difficult task of determining adequate capital for the industry. Unfortunately this has led to a systematic decline in bank capital levels. Between 1999 and 2007, for example, the industry's tangible equity to tangible asset ratio declined from 5.2 percent to 3.8 percent, and for the 10 largest banking firms it was only 2.8 percent in 2007. More incredible still is the fact that these 10 largest firms’ total risk-based capital ratio remained relatively high at around 11 percent, achieved by shrinking assets using ever more favorable risk weights to adjust the regulatory balance sheet……It turns out that the Basel capital rules protected no one: not the banks, not the public, and certainly not the FDIC that bore the cost of the failures or the taxpayers who funded

6 Back to Basics: A Better Alternative to Basel Capital Rules; The American Banker Regulatory Symposium; Washington, D.C. , September 14, 2012

the bailouts. The complex Basel rules hurt, rather than helped the process of measurement and clarity of information”

In a study conducted in 2006 by Mr. A V Rajwade, a noted financial consultant from Mumbai, some very interesting trends emerged. The study focused on the trading income reported by four major global banks – UBS, Citibank, HSBC and Deutsche Bank in their public disclosures.

Table 1: Trading Revenue Data for the Year 2006

Deutsche Bank UBS HSBC Citigroup

Average VaR (99%) confidence level, 1 day holding

91.7 141.0 33.3 106.0

Trading Income 3358 2979 2382 4003

BIS market risk capital (if supervisory multiple of 3 is used)

870 1338 316 1006

Return on BIS market risk Capital 386% 223% 754% 398%

The study focused on the Market Risk as reported by the banks as the average Value at Risk (VaR) with 99% confidence level and one day trading horizon and the trading income reported by these banks. Taking the regulator prescribed norm of three times the VaR, the capital required for market risk was estimated. And the Return on Capital Employed for Market Risk was assessed. The calculations show a mind numbing return percentage – the lowest being 228% and the highest a whopping 754%! Clearly something is amiss here.

In a hyper competitive international market, banks have managed to extract such returns. This can happen if and only if either or both of the following happen:

1. The Bank has underestimated its risk by a huge margin, thereby coming up with a paltry VaR number, or

2. The regulatory prescription for capital does not cover the risk adequately, which leads the banks to under provide for capital.

In hindsight, both causes were present! According to a report on Bloomberg, “Merrill's highest one-day value at risk in the third quarter was $92 million, indicating that the firm's maximum expected cost during the 63-trading day period would be $5.8 billion. In fact, the firm wrote down $8.4 billion from the value of collateralized debt obligations, sub-prime mortgages and leveraged finance commitments, 45 percent more than the worst- case scenario.”7

These observations do lend credence to our belief that regulatory capital for these banks were far less than adequate to cover the economic risks.

Another startling fact is the failure of 469 banks in the US in the six years after the crisis started. And as per the FIDC call report data, none of these banks were under capitalized as per the extant regulatory norms.

Another small example we like to cite is that in India, the regulatory capital for market risk of gross equity positions, open positions in foreign exchange and gold, is 9%. What this means that the three risks are to be treated equally - does this adequately reflect the risk of these three? We do not think so!

This leads us to the question we raise – Is capital an adequate indicator of a banks health. And as a corollary, can higher capital requirements as per the Basel III prescriptions prevent further collapses?

We are dangerously close to increasing capital far beyond what the sector can bear. For apart from the capital prescriptions in Basel II and III, we may have to incorporate interest rate risk in the banking book into our capital calculations. A truly capital punishment!

The Study

Given the above, we did a quick projection of the capital under Basel II and III regime for Indian PSU banks. As a starting point, we assessed the current scenario for Banks in India as far as capital is concerned.8 The data shows that except for Dhanalakshmi bank, which at a capital adequacy ratio of 9.49% just manages to stay within the prescribed norms, all banks, whether Nationalized or Private are comfortably above the minimum requirement.

RBI decided to introduce the Basel requirements in India - a risk asset ratio system for banks including foreign banks, as a capital adequacy measure and to adopt the framework on capital adequacy (Basel I), recommended by Basel Committee on Banking Supervision (BCBS). Under this system, the balance sheet assets, non-funded items and other off-balance sheet exposures are

7 Death of VaR Evoked as Risk-Taking Vim Meets Taleb's Black Swan; Christine Harper - January 27, 2008

8 See Annexure 3 for the current Capital adequacy for Indian Banks.

assigned risk weights and banks have to maintain unimpaired minimum capital funds equivalent to a prescribed ratio (called Capital Adequacy Ratio), on the aggregate of the risk weighted assets and other exposures, on an on-going basis.

The specific objectives of this study are:

To measure the extent of change between Basel II and Basel III CAR of different types of scheduled commercial banks in India.

To ascertain the impact of Basel III capital adequacy norms on CAR of different types of scheduled commercial banks in India.

To calculate the incremental cost of capital for banks if they have to follow the Basel III Norms.

It should be mentioned here that the increased capital is for maintaining the status quo – not to cover incremental business. This means that banks will need to raise additional capital to maintain their CAR and this additional capital will not fetch additional revenue. It will increase the cost of capital. Prudence says that banks will accept credit proposals where NPV at the discount rate equivalent to cost of capital is positive. If the cost of capital goes up, the discount factor too rises and many projects will now not get funding.

The roadmap for Basel III for Indi is given in the table below. As per this roadmap, the capital requirement for Indian Banks will rise from 9% to 11.5%. Remember, the 9% was only the lower end. Banks had to maintain at least another 3% to take care of their business growth. If the bank maintains only 9%, it cannot lend any further, till it raises capital. So effectively, banks will move from a 12% to a 14.5% - 15% capital.

Table 2: Basel III Roadmap for India

Minimum Capital Ratios

1-Jan-13

31-Mar-14

31-Mar-15

31-Mar-16

31-Mar-17

31-Mar-17

Minimum Common Equity Tier 1 (CET1)

4.5 5 5.5 5.5 5.5 5.5

Capital conservationbuffer (CCB)

- - 0.625 1.25 1.875 2.5

Minimum CET1+ CCB 4.5 5 6.125 6.75 7.375 8Minimum Tier 1 capital 6 6.5 7 7 7 7Minimum Total Capital*

9 9 9 9 9 9

Minimum Total Capital+CCB

9 9 9.625 10.25 10.875 11.5

Phase-in of alldeductions fromCET1(in%)#

20 40 60 80 100 100

*The difference between the minimum total capital requirement of 9% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital; # The same transition approach will apply to deductions from Additional Tier 1 and Tier 2 capital

We compared the capital requirement for both nationalized and private banks in India. These figures were obtained from their balance sheets, published as on 31 March 2012. We then compared their capital against the Basel III requirements if it were applicable today. The figures can be seen from Table 3 and Table 4 of Annexure 3 for nationalized Banks and Table 5 and Table 6 of Annexure 3 for Private banks. The findings are startling. With the exception of Bank of Baroda, which still will have a 3% margin, none of the nationalized banks will be comfortable. In fact Dena bank will be in deep trouble – it cannot expand its lending! The scene with Private banks is a little better – except Karnataka Bank, Laxmi Vilas Bank and Catholic Syrian Bank, all the others are quite safe today.

As the next step we projected the advances for nationalized and private banks at a 20% Y-O-Y growth. We assumed a simple 20% growth – the average for the banking system as on date. The results can be seen in Annexure 5 Table 7 and Table 9. We then projected the capital requirement as per this growth. The results can be seen in Annexure 5, Table 8 and Table 10. We assumed the normal growth in reserves and surpluses and no growth in core equity.

One mitigating factor we considered was the accrual to reserves. We considered a uniform 10% rise in reserves.

The results are startling – by 2015-16, all nationalized banks except IDBI Bank, Indian Bank and Oriental Bank of Commerce will be in need of capital infusion and by 2017-18, all nationalized banks too will need fresh equity infusion. Similarly, Bank of Baroda, Bank of India, Canara Bank, Dena Bank, Indian Bank, Oriental Bank of Commerce, Punjab National Bank, Syndicate Bank, UCO Bank, Union Bank of India, United Bank of India, Vijaya Bank, State Bank of Mysore, State Bank of Patiala and State Bank of Travancore will require Tier II Capital from 2012-13 itself. And all except IDBI Bank will need Tier II capital by 2017-18.

On the other hand, among private sector banks, Catholic Syrian Bank and South Indian Bank will need Tier I capital infusion by 2013-14, while HDFC Bank and ICICI Bank will not need any capital infusion – Tier I or Tier II at all.

Our contention is not that equity will not be infused. On the contrary, we firmly believe that capital will be available for both nationalized and private banks – the government is committed to provide the necessary capital. This is a no brainer.

Our issue is the impact of this capital on the banks return on capital – and its impact on the bank’s lending habits.

Since the Basel III phase in start this year, we will begin to see its impact on the balance sheets next year on. However, in the first year, 13-14, we will see no changes.

The Indian Scenario

At the recently concluded Bancon 2011, there were opinions expressed on the quantum of fresh capital required by the banking system in India – “from zero to infinity” as Mr. P R Ravi Mohan, CGM RBI very pithily put it. Assessing fresh capital needs, particularly when there may be impending changes to the regulatory prescriptions is an exercise in futility. There is no denying the fact that optimum use of available capital is a prudent business practice. In this respect, Indian banks are inefficient users of capital. Optimizing capital usage can free up more funds which can enable banks to increase lending. There are two broad ways by which a bank can raise its CAR – one is by increasing the numerator in the CAR equation or by lowering the denominator – the risk weighted assets! Probably, banks will need to adopt both the methods.

The easiest way to raise capital is to approach investors with a fresh issue. The problem with raising fresh capital is the prevailing low prices. This makes raising capital unattractive to the bank, though investors will love it. The bigger problem here is the dilution in shareholding. With 70% of the banking system controlled by the government, if the government cannot infuse fresh capital, government holding may slip below the 51% level – something that is not acceptable to the political class! The government has been finding it difficult to infuse fresh capital due to the constrained fiscal situation. Not a very easy task.

Two, Basel III restricts banks from paying dividend unless they meet the core Capital requirement criteria. A bank with a common equity Tier 1 capital of less than 5.125% cannot pay out any dividend. Such retained earnings will help banks boost their capital. Apart from the regulatory push, retained earnings are an easy way of boosting capital. Nearly all banks in the world do this to some extent. Are we in for some dividend skipping?

A third method to boost capital is Capital Conservation - optimizing the capital requirement by reducing the risk profile of the assets. By implementing better risk management processes and adopting the advanced approaches outlined under Basel II, banks will be able to expand their lending with the same capital base. To help in this, banks can unwind some of the riskier assets. The flip side to this is that banks may decide to invest more in government bonds, and cut lending to some of the high risk borrowers like the SME sector. This is something that does not gel well with the government’s mission to support SMEs. With priority sector targets, banks in India will not be able to do this beyond a point. Cutting credit to the real sectors will further lower the growth of the economy. European regulators are trying to pre-empt this move by setting a floor on how low the risk weights can go! India too could see this.

An option available to a few banks – like State Bank of India – is raising capital by hiving off the numerous subsidiaries and group entities it has. The flip side is pricing. The current valuations are not attractive for such divestments.

The Government of India, the majority share holder in nationalized banks is committed to maintaining adequate capital for these banks – the Union Budget for 2013-14 has an allocation of Rs. 14,000/- crores for recapitalizing nationalized banks. Yes, for banks availability of capital is not an immediate concern.

Is there an alternate to Capital?

Our projections show that all banks except two will require capital to handle growth at the current 20%. However, it is known that the banking system grows at 2.5 to 3 times the GDP growth. If India touches the 7% plus growth, we will see an additional requirement of capital for all banks. This capital will come by way of either equity infusion or other Tier I and II capital. This will push up the hurdle rate for lending above the current base rate from 9.7% – 10.5%. The rates will depend on the type of capital the banks raise and the appetite for bank stock among investors. This is a grey area as no bank has finalized capital raising plans that far ahead. A few nationalized banks are in the process of raising Tier II capital.

However, whatever be the method of raising capital, there will still be an impact on their profitability. The 2.5% extra capital that banks need to meet their Basel III requirement is a draw on their profits and will increase the cost of capital. The projections for the same are under progress at the time of writing.

To bring conclusion, Capital is used to ensure that banks have a cushion against unexpected losses in their operations. The problem here is the risks that an India bank takes on its balance sheet is vastly different from the risks that banks in the developed world take. This is evident from the fact that no bank in India was affected (except for one Bank) by the global crisis in 2008.

Basel II & III work best for banks with significant international exposure. With the exception of Bank of India, where 33% of the revenues come from overseas operations, no bank in India has a significant exposure. (Significant exposure has not been defined anywhere, but it is universally accepted at 25% of the total revenue.)

Therefore should India go in for a broad brush Basel II and III implementation? Should Indian economy be hobbled by high lending rates of Banks due to Basel III?

To do this we need to define the parameters that define capital. According to Thomas M. Hoenig, Director, Federal Deposit Insurance Corporation9 “Experience suggests that to be useful, a capital rule must be simple, understandable and enforceable. It should reflect the firm's ability to absorb loss in good times and in crisis. It should be one that the public and shareholders can understand, that directors can monitor, that management cannot easily game, and that bank supervisors can enforce. An effective capital rule should result in a bank having capital that approximates what the market would require without the safety net in place.”

The Basel regulation fails in all these aspects. So what is the alternative?

One measure that has gained credence is the Tangible equity to Tangible asset ratio, Tangible equity is equity minus goodwill, deferred taxes, minority interests and any other accounting artifact that cannot be converted to cash in case of a crisis. And Tangible asset is all assets minus intangible assets. This is a simple, universally implementable measure. The real function of a banking system is to provide leverage to the corporate entities. At the same time, it needs to ensure it too can use leverage – drawing a line between leverage and excessive leverage. The run up to the crisis saw leverage of some of the top banks in USA touch 30% to 40% levels. The tangible equity to tangible asset ratio will alert the bank to excess leverage.

And think of it – which is better – the tangible equity to tangible asset ratio or the “The Basel Accord permits a commercial bank to be judged as “adequately" capitalized if it has a Tier I leverage ratio of 4 percent, so long as the total risk weighted capital ratio is above 8 percent, and the Tier I risk weighted risk capital ratio is above 6 percent, and the common equity Tier I risk weighted capital ratio is above 4.5 percent.”

Limitations of the Study

This is a draft of the paper we are working on. We have managed to project the capital requirement for banks as per the Basel III requirements till date. However, we need to proceed to the next level, where we can project the capital requirement as per Basel II and Basel III recommendations separately and on different product lines. We then need to develop scenarios

9 Back to Basics: A Better Alternative to Basel Capital Rules; Thomas M. Hoenig, Director, Federal Deposit Insurance Corporation, The American Banker Regulatory Symposium; Washington, D.C. September 14, 2012

that will simulate asymmetric growth of the product lines. The delay here is due to the difficulty in extracting data from published sources and then verifying them.

As a next step we need to simulate the impact of these higher capital requirements on the banks ability to lend. As noted above, we believe that higher capital requirements will push the hurdle rate higher, leading to a credit crunch at the SME level. Our conversations with bankers lead us to the conclusion that banks have still to factor this in their calculations. We have not been able to complete this projection in time for this paper.

Yet another aspect we are currently evaluating is the impact of Basel III on the Indian economy. The literature survey we undertook showed some startling impact. An IIF study estimated the loss of output of 3% in G3 (US, Euro Area and Japan) on full implementation during 2011-15. Similarly, Basel Committee study showed that there is a modest impact of 0.2% on GDP for each year for 4 years for 1% increase in TCE. Similarly, for 25% increase in liquid assets, half the impact of 1% increase in TCE. We are of the opinion that long term gains will be immense.

Annexure 1

0

20

40

60

80

100

120

140

160

180

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Figure 1: Bank Failures in US: Source FIDC

Annexure 2

Figure 2:Average Tier I leverage Ratio: Source Call Report from FFIEC

Figure 3: Average total Capital ratio - Source Call Report from FFIEC

Annexure 3

Capital Adequacy Ratio for Nationalized Banks

Name of the Bank CRAR Tier 1 Ratio Tier 2 Ratio (6%) (3%)Allahabad Bank 12.83% 9.13% 3.70%Andhra Bank 13.18% 9.02% 4.16%Bank of Baroda 14.67% 10.84% 3.83%Bank of India 11.95% 8.63% 3.32%Bank of Maharashtra 12.43% 8.31% 4.12%Canara Bank 13.76% 10.35% 3.41%Central Bank of India 12.40% 7.79% 4.61%Corporation Bank 13.00% 8.33% 4.67%Dena Bank 11.51% 8.86% 2.65%IDBI Bank 14.70% 8.47% 6.23%Indian Bank 13.56% 11.28% 2.28%Indian Overseas Bank 13.32% 8.36% 4.96%Oriental Bank of Commerce 12.69% 10.12% 2.57%Punjab & Sind Bank 13.26% 8.55% 4.71%Punjab National Bank 12.63% 9.09% 3.54%Syndicate Bank 12.24% 8.94% 3.30%State Bank of India 13.86% 9.78% 4.08%UCO Bank 12.35% 8.09% 4.26%Union Bank of India 11.85% 8.37% 3.48%United Bank of India 12.69% 8.79% 3.90%Vijaya Bank 13.06% 9.69% 3.37%

Table 3 Capital Adequacy Ratio for Nationalized Banks

Capital Adequacy Ratio for Nationalized Banks with Basel III Today

Name of the Bank CRAR Tier 1 Ratio Tier 2 Ratio Basel III [6%] [3%] [11.5%]Allahabad Bank 12.83% 9.13% 3.70% 1.33Andhra Bank 13.18% 9.02% 4.16% 1.68Bank of Baroda 14.67% 10.84% 3.83% 3.17Bank of India 11.95% 8.63% 3.32% 0.45Bank of Maharashtra 12.43% 8.31% 4.12% 0.93Canara Bank 13.76% 10.35% 3.41% 2.26Central Bank of India 12.40% 7.79% 4.61% 0.9Corporation Bank 13.00% 8.33% 4.67% 1.5Dena Bank 11.51% 8.86% 2.65% 0.01IDBI Bank 14.70% 8.47% 6.23% 3.2Indian Bank 13.56% 11.28% 2.28% 2.06Indian Overseas Bank 13.32% 8.36% 4.96% 1.82Oriental Bank of Commerce 12.69% 10.12% 2.57% 1.19Punjab & Sind Bank 13.26% 8.55% 4.71% 1.76Punjab National Bank 12.63% 9.09% 3.54% 1.13Syndicate Bank 12.24% 8.94% 3.30% 0.74State Bank of India 13.86% 9.78% 4.08% 2.36UCO Bank 12.35% 8.09% 4.26% 0.85Union Bank of India 11.85% 8.37% 3.48% 0.35United Bank of India 12.69% 8.79% 3.90% 1.19Vijaya Bank 13.06% 9.69% 3.37% 1.56

Table 4: Capital Adequacy Ratio for Nationalized Banks With Basel III today

Capital Adequacy Ratio for Private Banks

Name of the Bank CRAR Tier 1 Ratio

Tier 2 Ratio

Axis Bank 13.66% 9.45% 4.21%Catholic Syrian Bank 11.08% 8.83% 2.25%City Union Bank 12.57% 11.69% 0.88%Development Credit Bank 15.41% 13.81% 1.60%Federal Bank 16.64% 15.86% 0.78%HDFC Bank 16.66% 11.67% 4.99%ICICI Bank 19.60% 12.80% 6.80%IndusInd Bank 13.85% 11.37% 2.48%ING Vysya Bank 14.00% 11.24% 2.76%Karnataka Bank 12.84% 10.86% 1.98%Karur Vysya Bank 14.33% 13.13% 1.20%Kotak Mahindra Bank 17.92% 16.54% 1.38%Lakshmi Vilas Bank 13.10% 8.86% 4.24%South Indian Bank 14.00% 11.54% 2.46%Tamilnad Mercantile Bank 14.69% 13.98% 0.71%Yes Bank 16.50% 9.65% 6.85%

Table 5: Capital Adequacy Ratio for Private Banks

Capital Adequacy Ratio for Private Banks with Basel III Today

Name of the Bank CRAR Tier 1 Ratio

Tier 2 Ratio

Basel III

Axis Bank 13.66% 9.45% 4.21% 2.16Catholic Syrian Bank 11.08% 8.83% 2.25% -0.42City Union Bank 12.57% 11.69% 0.88% 1.07Development Credit Bank 15.41% 13.81% 1.60% 3.91Federal Bank 16.64% 15.86% 0.78% 5.14HDFC Bank 16.66% 11.67% 4.99% 5.16ICICI Bank 19.60% 12.80% 6.80% 8.1IndusInd Bank 13.85% 11.37% 2.48% 2.35ING Vysya Bank 14.00% 11.24% 2.76% 2.5Karnataka Bank 12.84% 10.86% 1.98% 1.34Karur Vysya Bank 14.33% 13.13% 1.20% 2.83Kotak Mahindra Bank 17.92% 16.54% 1.38% 6.42Lakshmi Vilas Bank 13.10% 8.86% 4.24% 1.6South Indian Bank 14.00% 11.54% 2.46% 2.5Tamilnad Mercantile Bank 14.69% 13.98% 0.71% 3.19Yes Bank 16.50% 9.65% 6.85% 5

Table 6: Capital Adequacy Ratio for Private Banks with Basel III Today

Annexure 4

Source: BIS document

Annexure 5Advances projections at 20% Growth – Nationalized Banks

Name of Bank Projected Advances - at 20% Y-O-Y growth

2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18

Allahabad Bank 111,145.10 133374.12 160048.944 192058.7328 230470.4794 276564.5752 331877.49

Andhra Bank 83,641.83 100370.1929 120444.2315 144533.0777 173439.6933 208127.632 249753.16

Bank of Baroda 287,377.29 344852.748 413823.2976 496587.9571 595905.5485 715086.6583 858103.99

Bank of India 249,733.44 299680.1332 359616.1598 431539.3918 517847.2701 621416.7241 745700.07

Bank of Maharashtra 56,059.76 67271.71728 80726.06074 96871.27288 116245.5275 139494.633 167393.56

Canara Bank 232,489.82 278987.784 334785.3408 401742.409 482090.8908 578509.0689 694210.88

Central Bank of India 147,718.08 177261.696 212714.0352 255256.8422 306308.2107 367569.8528 441083.82

Corporation Bank 100,469.02 120562.824 144675.3888 173610.4666 208332.5599 249999.0718 299998.89

Dena Bank 56,692.54 68031.04512 81637.25414 97964.70497 117557.646 141069.1752 169283.01

IDBI Bank 181,158.00 217389.6 260867.52 313041.024 375649.2288 450779.0746 540934.89

Indian Bank 90,323.60 108388.3194 130065.9833 156079.1799 187295.0159 224754.0191 269704.82

Indian Overseas Bank 140,724.44 168869.3332 202643.1998 243171.8398 291806.2077 350167.4492 420200.94

Oriental Bank of Commerce 111,977.69 134373.2282 161247.8739 193497.4487 232196.9384 278636.3261 334363.59

Punjab & Sind Bank 46,151.41 55381.692 66458.0304 79749.63648 95699.56378 114839.4765 137807.37

Punjab National Bank 301,346.52 361615.824 433938.9888 520726.7866 624872.1439 749846.5726 899815.89

Syndicate Bank 123,620.18 148344.2129 178013.0555 213615.6665 256338.7999 307606.5598 369127.87

UCO Bank 115,540.01 138648.0122 166377.6147 199653.1376 239583.7652 287500.5182 345000.62

Union Bank of India 177,882.08 213458.4976 256150.1971 307380.2365 368856.2838 442627.5405 531153.05

United Bank of India 63,043.29 75651.95256 90782.34307 108938.8117 130726.574 156871.8888 188246.27

Vijaya Bank 57,903.74 69484.49136 83381.38963 100057.6676 120069.2011 144083.0413 172899.65

State Bank of India1,163,670.2

1 1396404.25 1675685.10 2010822.12 2412986.55 2895583.86 3474700.63

State Bank of Bikaner & jaipur 49,244.33 59093.19 70911.83 85094.20 102113.04 122535.64 147042.77

State Bank of Hyderabad 77,052.31 92462.77 110955.33 133146.39 159775.67 191730.80 230076.96

State Bank of Mysore 39,835.31 47802.37 57362.84 68835.41 82602.49 99122.99 118947.59

State Bank of Patiala 62,934.49 75521.39 90625.67 108750.80 130500.96 156601.15 187921.39

State Bank of Travancore 55,346.00 66415.20 79698.24 95637.89 114765.47 137718.56 165262.27

Table 7: Advances projections at 20% Growth – Nationalized Banks

Capital Deficit projections at 20% Deposit Growth and 10% reserves growth Tier 1 – Nationalized Banks

Gap - Tier I

2012-13 2013-14 2014-15 2015-16 2016-17 2017-18

Allahabad Bank 3323.13 1927.08 -8.70 -1481.86 -3371.21 -5772.16

Andhra Bank 2867.88 1822.40 371.25 -731.18 -2146.21 -3945.56

Bank of Baroda 9808.20 6448.84 1718.98 -1787.18 -6339.19 -12180.67

Bank of India 5008.98 1620.19 -3006.51 -6621.46 -11202.05 -16965.70

Bank of Maharashtra 1337.45 516.52 -588.32 -1472.67 -2581.07 -3963.06

Canara Bank 7543.08 4732.75 804.44 -2144.10 -5949.92 -10811.25

Central Bank of India 1896.17 -395.46 -3448.03 -5933.73 -9025.37 -12854.99

Corporation Bank 2531.85 1238.99 -544.85 -1913.90 -3662.91 -5878.49

Dena Bank 1144.32 353.32 -720.87 -1567.77 -2636.51 -3976.70

IDBI Bank 8083.33 5974.71 3003.06 803.80 -2053.64 -5722.74

Indian Bank 4499.99 4372.54 2973.72 1968.29 643.80 -1075.36

Indian Overseas Bank 2663.57 676.11 -2016.70 -4147.96 -6832.79 -10194.63

Oriental Bank of Commerce 5209.69 3978.23 2220.50 948.12 -722.40 -2885.05

Punjab & Sind Bank 1098.72 441.23 -448.16 -1154.01 -2042.10 -3152.97

Punjab National Bank 6275.17 2596.89 -2534.05 -6398.94 -11379.34 -17732.60

Syndicate Bank 1191.17 -665.86 -3153.63 -5160.33 -7666.75 -10782.70

UCO Bank 778.62 -1120.81 -3626.13 -5699.83 -8260.41 -11412.47

Union Bank of India 3178.68 704.57 -2657.32 -5305.19 -8648.18 -12841.86

United Bank of India 1129.04 182.88 -1084.86 -2107.15 -3384.20 -4971.96

Vijaya Bank 1629.08 739.06 -448.41 -1412.76 -2613.63 -4102.68

State Bank of India 34512.14 20613.81 1136.43 -13418.39 -32243.83 -56330.00

State Bank of Bikaner & jaipur 1289.37 675.87 -176.25 -822.84 -1653.23 -2709.61

State Bank of Mysore 1038.55 546.87 -137.38 -654.88 -1320.49 -2168.31

State Bank of Patiala 1292.86 426.95 -752.10 -1677.50 -2847.69 -4317.60

State Bank of Travancore 488.73 -294.40 -1355.10 -2195.10 -3252.99 -4577.35

Table 8-1: Capital projections at 20% Growth – Nationalized Banks

Capital Deficit projections at 20% Deposit Growth and 10% reserves growth Tier I1 – Nationalized Banks

Gap in Tier II Capital 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18

Allahabad Bank 21.80 21.80 181.85 -586.39 -1508.27 -2614.53Andhra Bank 506.70 506.70 627.15 49.02 -644.74 -1477.25

Bank of Baroda -614.42 -614.42 -200.60-

2186.95 -4570.57 -7430.92

Bank of India-

1074.03-

1074.03 -714.42-

2440.58 -4511.96 -6997.63Bank of Maharashtra 137.48 137.48 218.20 -169.28 -634.26 -1192.24

Canara Bank-

1190.79-

1190.79 -856.01-

2462.98 -4391.34 -6705.38Central Bank of India 1167.79 1167.79 1380.50 359.48 -865.76 -2336.04Corporation Bank 1330.25 1330.25 1474.92 780.48 -52.85 -1052.85

Dena Bank -700.99 -700.99 -619.35-

1011.21 -1481.44 -2045.72IDBI Bank 6862.27 6862.27 7123.14 5870.98 4368.38 2565.26

Indian Bank-

1289.27-

1289.27-

1159.20-

1783.52 -2532.70 -3431.72Indian Overseas Bank 1495.29 1495.29 1697.93 725.25 -441.98 -1842.65

Oriental Bank of Commerce-

1014.53-

1014.53 -853.28-

1627.27 -2556.06 -3670.60Punjab & Sind Bank 366.54 366.54 433.00 114.00 -268.80 -728.16

Punjab National Bank-

1075.85-

1075.85 -641.92-

2724.82 -5224.31 -8223.70

Syndicate Bank-

1224.96-

1224.96-

1046.94-

1901.41 -2926.76 -4157.19UCO Bank -7.98 -7.98 158.40 -640.22 -1598.55 -2748.55

Union Bank of India -558.19 -558.19 -302.04-

1531.57 -3006.99 -4777.50United Bank of India -84.37 -84.37 6.41 -429.34 -952.25 -1579.74Vijaya Bank -351.43 -351.43 -268.05 -668.28 -1148.56 -1724.89

State Bank of India 2952.87 2952.87 4628.56-

3414.73-

13066.68-

24649.01State Bank of Bikaner & jaipur 12.64 12.64 83.56 -256.82 -665.27 -1155.42State Bank of Mysore -122.00 -122.00 -64.64 -339.98 -670.39 -1066.88State Bank of Patiala -76.52 -76.52 14.10 -420.90 -942.90 -1569.31State Bank of Travancore -174.16 -174.16 -94.46 -477.01 -936.07 -1486.95

Table 9-2: Capital projections at 20% Growth – Nationalized Banks

Advances projections at 20% Growth – Private Banks

Name of Bank Projected Advances - at 20% Y-O-Y growth

2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18

Axis Bank 169,759.54 203,711.45 244453.74 293344.48 352013.38 422416.06 506899.27

Catholic Syrian Bank 7,663.54 9,196.25 11035.50 13242.60 15891.12 19069.35 22883.22

City Union Bank 12,137.46 14,564.95 17477.94 20973.53 25168.24 30201.89 36242.26

Development Credit Bank 5,284.42 6,341.31 7609.57 9131.48 10957.78 13149.33 15779.20

Federal Bank 47,720.00 57,264.00 68716.80 82460.16 98952.19 118742.63 142491.16

HDFC Bank 195,420.00 234,504.00 281404.80 337685.76 405222.91 486267.49 583520.99

ICICI Bank 292,125.42 350,550.50 420660.60 504792.72 605751.27 726901.52 872281.82

IndusInd Bank 35,063.95 42,076.74 50492.09 60590.51 72708.61 87250.33 104700.40

ING Vysya Bank 28,736.67 34,484.01 41380.81 49656.97 59588.36 71506.03 85807.24

Karnataka Bank 20,720.70 24,864.84 29837.81 35805.37 42966.44 51559.73 61871.68

Karur Vysya Bank 24,205.00 29,046.00 34855.20 41826.24 50191.49 60229.79 72275.74

Kotak Mahindra Bank 39,079.23 46,895.08 56274.09 67528.91 81034.70 97241.64 116689.96

Lakshmi Vilas Bank 10,188.68 12,226.42 14671.70 17606.04 21127.25 25352.70 30423.23

South Indian Bank 27,280.74 32,736.88 39284.26 47141.11 56569.33 67883.20 81459.84

Tamilnad Mercantile Bank 13,897.00 16,676.40 20011.68 24014.02 28816.82 34580.18 41496.22

Yes Bank 37,988.60 45,586.32 54703.58 65644.30 78773.16 94527.79 113433.35Table 10: Advances projections at 20% Growth – Private Banks

Capital Deficit projections at 20% Deposit Growth and 10% reserves growth Tier 1 – Private Banks

Gap - Tier IPrivate Banks 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18

Axis Bank12297.3

810710.2

2 8752.72 7601.73 5924.95 3587.69Catholic Syrian Bank 12.92 -80.34 -230.94 -351.37 -502.37 -690.73City Union Bank 509.35 388.61 202.01 68.40 -107.93 -337.13Development Credit Bank 715.88 472.61 395.74 342.37 270.89 176.91Federal Bank 2894.11 2350.59 1714.08 1295.66 719.96 -51.85

HDFC Bank18039.7

616665.5

714911.7

314136.2

512810.4

810784.8

1

ICICI Bank42636.5

741564.8

240693.8

541460.4

841597.0

740899.2

7IndusInd Bank 2805.93 2076.55 1607.46 1298.49 873.79 304.83ING Vysya Bank 2303.34 1992.20 1656.62 1457.14 1168.20 766.94Karnataka Bank 1514.21 1191.65 914.05 731.01 479.55 142.78Karur Vysya Bank 1301.92 1008.03 660.51 421.14 99.28 -325.04

Kotak Mahindra Bank11076.5

111273.2

611701.3

712403.0

213080.2

913711.8

4Lakshmi Vilas Bank 296.52 114.11 -70.96 -214.37 -396.78 -627.00

South Indian Bank 299.35 -144.17 -660.54-

1067.49-

1581.13-

2225.33Tamilnad Mercantile Bank 763.42 689.31 503.06 380.25 211.52 -14.41

Yes Bank 2121.72 1383.17 760.88 300.64 -297.52-

1065.79Table 11 -1: Capital projections at 20% Growth – Private Banks

Capital Deficit projections at 20% Deposit Growth and 10% reserves growth Tier I1 – Private Banks

Gap in Tier II CapitalPrivate Banks 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18

Axis Bank 3647.50 3647.50 3891.95 2718.57 1310.52 -379.15Catholic Syrian Bank -152.34 -152.34 -141.30 -194.27 -257.84 -334.11City Union Bank -345.31 -345.31 -327.83 -411.72 -512.40 -633.21Development Credit Bank -97.90 -97.90 -90.29 -126.82 -170.65 -223.24Federal Bank -1442.45 -1442.45 -1373.73 -1703.57 -2099.38 -2574.35HDFC Bank 5235.66 5235.66 5517.06 4166.32 2545.43 600.36ICICI Bank 19504.48 19504.48 19925.15 17905.97 15482.97 12575.36IndusInd Bank -292.25 -292.25 -241.76 -484.12 -774.96 -1123.96ING Vysya Bank -88.43 -88.43 -47.05 -245.68 -484.03 -770.05Karnataka Bank -275.95 -275.95 -246.11 -389.33 -561.19 -767.43Karur Vysya Bank -625.94 -625.94 -591.08 -758.39 -959.16 -1200.07Kotak Mahindra Bank -379.09 -379.09 -322.82 -592.93 -917.07 -1306.04Lakshmi Vilas Bank 42.02 42.02 56.69 -13.73 -98.24 -199.65South Indian Bank -564.40 -564.40 -525.11 -713.68 -939.95 -1211.49Tamilnad Mercantile Bank -418.70 -418.70 -398.69 -494.75 -610.01 -748.33Yes Bank 1586.66 1586.66 1641.36 1378.79 1063.69 685.58

Table 12 -2: Capital projections at 20% Growth – Private Banks