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Understanding Banking System Basel Norms and BankingStability

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IntroductionBanking system is the backbone of any nations economy. For an economy to remain healthy and going, it isimportant that the banking system grows fast and yet be stable.

This catches the biggest dilemma of policymakers. How to achieve both the objectives simultaneously?

Over a period of time, several indicators have been developed which gauge the depth and stability of the bankingsystem. Examples can be Non-performing assets, Capital adequacy ratio (CAR) etc.

Similarly, mechanisms to ensure their stability have also been developed. Some of the examples can be CRR;SLR; Basel conventions; regular directions of the RBI; Financial Stability and Development Council etc.

In this section, we will talk about some of these indicators and mechanisms. They have also been in news forquite some time Basel III norms and Non-Performing assets (NPAs).

We will try to first clarify the related concepts; then understand the seriousness of the issue; gauge their impact onthe Indian economy and then offer some possible solutions as well as look into some of the committees reportswhich have examined the matter.

In this article (Part-1 of a two part series), we will only deal with Basel norms. NPAs will be dealt withcomprehensively in the next article.

About Basel normsBasel is a city in Switzerland which is also the headquarters of Bureau of International Settlement (BIS). BISfosters co-operation among central banks with a common goal of financial stability and common standards ofbanking regulations. Currently there are 27 member nations in the committee.

Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called the BaselCommittee on Banking Supervision (BCBS). The set of agreement by the BCBS, which mainly focuses on risks tobanks and the financial system are called Basel accord.

The purpose of the accord is to ensure that financial institutions have enough capital on account to meetobligations and absorb unexpected losses. India has accepted Basel accords for the banking system.

So, if the Basel norms are banking standards, then who has the authority to make them? Are they mandatory forevery country?

As said earlier, the Basel Committee makes these norms. The Committees decisions have no legal force. Rather,the Committee formulates supervisory standards and guidelines and recommends statements of best practice inthe expectation that individual national authorities will implement them. In this way, the Committee encouragesconvergence towards common standards and monitors their implementation, but without attempting detailedharmonisation of member countries supervisory approaches.

So, India can either accept them or reject them depending on the kind of financial system it wants. So far, we haveimplemented or wished to implement all Basel norms.

Basel IIn 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1. Itfocused almost entirely on credit risk. It defined capital and structure of risk weights for banks. Naturally if thecapital with the banks is adequate to cover the risks ( e.g. a power plant) they have invested in, then the bank issafe.

The minimum capital requirement was fixed at 8% of risk weighted assets (RWA). RWA means assets withdifferent risk profiles. For example, an asset backed by collateral would carry lesser risks as compared topersonal loans, which have no collateral. India adopted Basel 1 guidelines in 1999. The Basel norms are set upby the Basel committee on Banking supervision.

It is important to understand that the Basel accords have been the result of cooperation by the countries over theyears.

But why cooperate between member countries when banks operate within nationalboundaries?

It is because these banks lend not only to its country men but also other nations. Also, private investors andsovereign nations take loans from banks across other nations. Further, the financial system of the world is sointerconnected that one incident of a banking collapse has its repercussions all over the world. There can be nobetter example that the 2008 Global recession.

Therefore, global cooperation on banking matters is a absolute necessity in todays world. And, not onlycooperation but also adoption of some uniform standards is also important.

Again, Why uniform standards?

Bankers and investors invest over the world preferably in markets where they get best returns. The markets willgive returns only when the economy is stable. And, economy will be stable only when the banking system isstable. Hence, it is important for investors and agencies to measure the stability of the banking system. If all thenations adopt different standards, then calculating stability figures will be a big headache for investors.

Also, suppose some nations run banks on better standards i.e. better risk management, better returns, lowerexposure to volatile markets etc., then they have a better chance of getting foreign investment.

But, if all nations adopt uniform standards, then at least the investors can be attracted by only the strength of theeconomy.

Hence, it is important to have uniform standards especially when it comes to the banking system which is socomplex and vast.

The Basel norms try to achieve exactly the same. Till date three different Basel accords ( or norms) have come each with a better safeguard than the next one.

Basel IIIn 2004, Basel II guidelines were published by BCBS, which were considered to be the refined andreformed versions of Basel I accord. The guidelines were based on three parameters.

1. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets,

In India, such a practice is equivalent to maintaining a Capital Adequacy ratio (CAR).

2. Banks were needed to develop and use better risk management techniques in monitoring and managing all thethree types of risks that is credit and increased disclosure requirements.

Increased disclosure requirements raise the confidence of investors and depositors in the bank. The moretransparent a bank is, the more stable it is deemed to be.

3. Banks need to mandatorily disclose their risk exposure, etc to the central bank.

This is important so that the central bank (RBI in India) is aware of the risks that the banking system is goingthrough.

There is a practice in India to publish bi-annual Financial Stability reports by the RBI. The latest report publishedrecently is of June 2014.

Basel II norms in India and overseas are yet to be fully implemented.

You will find some technical words like risk exposure etc. in the text. We do not need to go into details. We onlyneed to know their general meaning.

Basel IIIIn 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of2008.

A need was felt to further strengthen the system as banks in the developed economies were under-capitalized,over-leveraged and had a greater reliance on short-term funding. Too much short-term funding makes the banksprone to risks. Banks generally rely on short-term funding because it is profitable.

Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. This wasbecause the banking system was growing. The world economy was growing too. Hence, what is sufficient earlierwas not sufficient now.

Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz.capital, leverage, funding and liquidity.

Again we need not go in technicalities, just the broad picture.

This is how it was broadly done.

Capital

The capital requirement (as weighed for risky assets) for Banks was more than doubled. ( e.g. 4.5% from 2% in

Basel-II accord for common equity)

Leverage

Leverage basically means buying assets with borrowed money to multiply the gain. The underlying belief is thatthe asset will return the investor more than the interest he has to pay on the loan.

Obviously doing so is risky business. Thus the Basel III puts a limit on the banks for doing this. The numbers arenot important here. Getting the concept is important.

Funding and liquidity

Banks can be subjected to a lot of risk if all depositors come and ask all their money at the same time. This is ahypothetical situation but it has happened in real with Lehman Brothers the bank whose collapse gave us the2008 recession.

So, Basel III puts a requirement for the banks to maintain some liquid assets all the time. Liquid assets are thosewhich can be easily converted to cash.

In India, this practice can be correlated with that of maintaining CRR and SLR.

Implementation of Basel III norms in IndiaThe RBI has postponed the implementation of these norms to 2019.

It is important to note that it is not easy to implement these norms as it requires several changes in the presentbanking system.

There are several challenges in the successful implementation of Basel III norms.

1. Higher capital requirement for banks The private banks have the autonomy to raise capital from themarkets. But the Public sector banks have to rely on the government mostly. The government has recentlydecided to infuse 12000 Cr. rupees in the PSBs. In the coming years even more will be required.

2. More technology deployment Implementing the norms would require much more sophisticated technologyand management styles that the Indian banks are presently using. Upgrading both will impose huge cost on thebanks and hurt their profitability in the coming years.

3.Liquidity crunch Banks would need to invest more on liquid assets. These assets do not give handsomereturns usually which would reduce the banks operating profit margin. Further higher deployment of more funds inliquid assets may crowd out good private sector investments and also affect economic growth.

The way ahead for the banksTo address these issues and to protect their profitability margins, banks need to look beyond regulatorycompliance and take proactive actions.

In this regard the following strategies need to be adopted:

1. Change in Business Mix They will need to lend more to profitable yet safe sectors. For e.g. corporate loans.But even corporate loans in India have been under a lot of stress. Banks are facing increasing NPAs (we will talkabout it in the next article). Still they are safer and more profitable than retail loans. Priority Sector lending (PSL)however limits their options.

2. Low-Cost Funding One of the most important factors to meet the new regulations is to have a stable low-

cost deposit base. For this, banks need to focus more on having business correspondents/facilitators to reachcustomers as adding branches will increase costs and have an impact on the profit margin.

The RBI is thinking of introducing UID based mobile wallets to increase the reach of the financial system. Perhapsthe banks can tie up with wallet operators based on some innovative business model. There are manyopportunities.

3. Improvement in systems and procedures Refining the systems and procedures may help bankseconomise their risk-weighted assets, which will help reduce capital requirements to some extent. It is possiblethat they would impose cost in the short-run, but they would yield great returns in the future.

ConclusionIt is clear that the banking system in the coming times will have to go through a lot of rough weather. Increasingoperational complexities, global interconnectedness and high economic growth worldwide will present severalchallenges for the banks. While strategies like Basel III will of course address these challenges, what is evenmore important is their proper implementation. More than this, the banks will need to have a wider outlook. Theymust anticipate changes in the Indian economic system and react accordingly. Indian banking regulations are oneof the most stringent and consequently one of the safest in the world. Let us evolve each time better and stronger.

Model questions

Prelims

1. Consider the following statements:

1. Basel norms are mandatory for every member nation.

2. India has not implemented Basel III norms till date.

Which of these is/are correct?

a) Only 1

b) Only 2

c) Both

d) None

Solution: b)

2. Consider the following statements key focus areas in the banking system:

1. Merger of banks

2. Regular disclosure of information to the Central bank

3. Investment in risky assets

Which of these areas are dealt with by the Basel III norms?

a) 1 and 2

b) 2 and 3

c) 1 and 3

d) All of the above

Solution: b)

Mains

1. The Indian banking system has been exposed to a lot of vulnerabilities in past few years due to the globaleconomic climate. Critically examine some of the important mechanisms available to address thesevulnerabilities in India. (300 words)

2. The Basel III norms present a much safer regulation of the banking system than Basel II, yet it has not beenimplemented in India. Examine the key issues and challenges in their implementation and offer some solutions toaddress the same. (300 words)

Copyright (C) INSIGHTS ACTIVE LEARNING

Understanding Banking System Basel Norms and Banking StabilityIntroductionAbout Basel normsBasel IBut why cooperate between member countries when banks operate within national boundaries?Again, Why uniform standards?

Basel IIBasel IIICapitalLeverageFunding and liquidity

Implementation of Basel III norms in IndiaThe way ahead for the banksConclusionModel questionsPrelimsMains