TOPIC – IMPLICATIONS OF BASEL III NORMS ON INDIAN BANKS
Introduction
The wave of globalization appeared on India’s shores in 1991 and to get their banking systems at par with the global standards in terms of financial health, safety and transparency, implement the Basel Norms by 1992.The Basel Committee on Banking Supervision 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. Basel I which focuses more on credit risks not on the Operational Risk, which banks have face day-to-day problems to conduct their Business. In this regard Basel -II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. The BCBS released the “International Convergence of Capital measurement and Capital standard. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Indian banking industry believes that Basel II can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.
Basel II
The Basel II Accord has its foundation on three mutually reinforcing pillars that allow banks and bank supervisors to evaluate properly the various risks that banks face and realign regulatory capital more closely with underlying risks. The first pillar is compatible with the credit risk, market risk and operational risk. The regulatory capital will be focused on these three risks. The second pillar gives the bank responsibility to exercise the best ways to manage the risk specific to that bank. Concurrently, it also casts responsibility on the supervisors to review and validate banks’ risk measurement models. The third pillar on market discipline is used to leverage the influence that other market players can bring. This is aimed at improving the transparency in banks and improves reporting.
The Basel Committee on Banking Supervision has come up with three pillars
A) Minimum Capital Requirements: - which tries to ensure that capital allocation is more risk sensitive.
B) Supervisory Review Process: - tries to separate the operational risk from credit risk
C) Market Discipline: - Economic and Regulatory Capital more closely to reduce the scope for regulatory arbitrage.
A) The First Pillar: Its sets out minimum Capital Requirement. The Basel II framework maintains minimum Capital requirement of 8% of risk assets. As per the RBI guidelines, Indian banks required to achieve Capital adequacy ratio of 9% as against the Basel Committee Stipulation.
Capital Ratio = Total capital (Tier I + Tier II + Tier III )
Risk Weighted Assets =Credit Risk +Market Risk + Operational risk
Where
Tier I =Ordering Capital + Retained Earnings & share premiums - Intangible Assets
Tier II=Undisclosed Reserves + General bad debt provision +Revaluation Reserve+ Subordinate Debt+ Redeemable Preference Shares
Tier III=Subordinates debt with a maturity of least 2 years
Credit Risk=It is an Investors Risk of loss arising from a borrower who does not make Payment as Promised.
Market Risk= It is the risk that the value of a portfolio, either an investment or a trading portfolio will decrease due to the change in value of the market risk factors.
Operational Risk= It is the risk of loss resulting from inadequate or failed internal process, people and system or from External events.
B) The Second Pillar: it gives the bank responsibility to exercise the best ways to manage the risk specific to that bank. It also casts the responsibility on the supervisor to review and validate banks risk measurement models. Pillar 2 also seeks to ensure that internal risk management process in the banks is robust enough.
C) The third pillar: The main aim of the new accord is to establish a market discipline with triple sources (Customers, regulatory bodies and the Banks). Monitoring of risk is shared among the official authorities, as well as independent audit firms. The third pillar on market discipline is used to leverage the influence that other market players can bring. It structure must be in place for supporting data collection and generating MIS2.This is aimed at improving the transparency in banks and improve reporting for such regulations.
Process of Computation of Capital Requirements:
Credit Risk :
The risk that a borrower (debtor) or an organization will be unable to make payment of money of interest or principal in a timely manner. That they owe according to the terms on which it was borrowed Basel II approaches three alternatives to measure the credit risk. These are Standardized Approach; Internal Rating based Foundation (IRB foundation) and Securitization Approach
1. Standardized Approach: It is the more Risk Sensitive than Basel I. the Bank allocates a risk weight to each of its assets and off balance sheet positions and produced a sum of risk weighted assets values. A risk weight of 100% means that an exposures is included in the calculation of risk weighted assets value which translate into a capital charge equal to 9% of that value.
Banks may use external credit ratings by institutions recognized for the purpose by the central bank for determining the risk weight. Exposure on sovereigns and their central banks could vary from zero percent to 150 percent depending on credit assessment from ‘AAA’ to below B-. Similarly, exposure on public sector entities, multilateral development banks, other banks, securities firms and corporate also may have risk weights from 20 percent to 150 percent.
Exposure on retail portfolio may carry risk weight of 75 percent.
2. Internal Rating Based approach (IRB foundation): Under the IRB approach banks will be allowed by the supervisor to use their internal estimates of risk components to assess credit risk in their portfolios. Banks must categories banking book exposure into broad classes of assets i.e. Corporate, Sovereign, Banks, Retail and Equity exposures.
3. Securitization Frame work: Under this approach Banks have to apply the securitization framework for determining regulatory capital requirement on exposure arising from securitization. Securitization exposure resulting from a securitization of retail or wholesale exposures will not be analyzed under the capital rules for retail or wholesale exposures.
Instead, a separate securitization framework will apply.
Market Risk:
It is the risk inherent in securities market or economy investment risk that is attributable to the performance of the stock market or of the economy and cannot be removed by diversification. Market Risk approach measure by Value at Risk (VaR).
Value at Risk: Value at Risk covers a technical subject in an accessible way, providing insight into risk management, as well as the potential downside of complex derivatives. It details how
VAR has evolved over the past two decades, and examines how different risk have been assumed, new risk management techniques have been developed, new regulation has come into being, and how the approach has expanded beyond finance. Value at Risk is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time. It is commonly used by security houses or investment banks to measure the market risk of their asset portfolios (market value applications. VaR is widely applied in finance for quantitative risk 10 management for many types of risks. VaR does not give any information about the severity of loss by which it is exceeded.
Operational Risk:
It is the loss occurring from the internal inadequacies of a firm or a breakdown in its control, operations or procedures. The RBI major includes the legal risk. The Basel II includes three basic approaches to calculate Operational risk and its basic objectives is measure and control risk on continuous basis.
1. Basic Indicator Approaches: In this Approach banks are required to hold capital for operational risk equal to the average over the previous three years of a fixed percentage 15% of annual gross income.
2. Standardized Approaches: Under this approach, banks activities are divided into eight Business Lines. Each business lines, gross income is considered as a broad indicator for the likely scale of operational risk. The values of betas prescribed for each business line as under:
BUSINES LINE
|
BETA FACTOR
|
Corporate Finance
|
18%
|
Trading and sales
|
18%
|
Retail Banking
|
12%
|
Commercial Banking
|
15%
|
Payment Settlement
|
18%
|
Agency Services
|
15%
|
Assets management
|
12%
|
Retail Brokerage
|
12%
|
3. Advance Measure Approach: Under this approach the regulatory capital will be equal to the measure generated by the banks internal risk measurement System.
Issues with Basel II norms:-
In Basel II there are the some major issues that concern on Indian Banking System and that issues should not be ignored by the banking industries.
Negative impact on NPAs Accord: Most of the Indian banks have improved on their capital adequacy ratio in line with the global Basel II norms but need to do more on international risk management practices in the wake of increasing pressure of non-performing assets, according to an ASSOCHAM6.
Problems to lend Small Scale industries: Implementation of Basel II norms by the banking sector will reduce credit availability to small scale industries (SSIs), besides adding to their cost of fund. Under Basel II norms, banks would be discouraged to lend to SSI that is not rated because a loan to an unrated entity will attract 100 per cent risk-weight.
Unavailable for Data: Absence of Historical Database has also the one major factor for concern Computation of probability of default, loss given default, migration mapping and supervisory validation require creation of historical database, which is a time consuming process and may require initial support from the supervisor.
Credit Risk Concern: Under the area of unrated sovereigns, banks and corporate, the prescribed risk weight is 100%, whereas in case of those entities with lowest rating, the risk weight is 150%. This may create incentive for the category of counterparties, which anticipate lower rating to remain unrated.
The Basel II is very complex and difficult to understand: It calls for revamping the entire management information system and allocation of substantial resources. Therefore, it may be out of reach for many smaller banks. As Moody's Investors Services puts it, "It is unlikely that these banks will have the financial resources, intellectual capital, skills and large scale commitment that larger competitors have to build sophisticated systems to allocate regulatory capital optimally for both credit and operational risks."
Proposed Basel III Guidelines: A Credit Positive for Indian Banks
The proposed Basel III guidelines seek to improve the ability of banks to withstand periods of economic and financial stress by prescribing more stringent capital and liquidity requirements for them. In our views the suggested capital requirement as a positive for banks as it raises the minimum core capital stipulation, introduces counter-cyclical measures, and enhances banks ‟ability to conserve core capital in the event of stress through a conservation capital buffer. The prescribed liquidity requirements, on the other hand, are aimed at bringing in uniformity in the liquidity standards followed by banks globally. This requirement, in our opinion, would help banks better manage pressures on liquidity in a stress scenario. The capital requirement as suggested by the proposed Basel III guidelines would necessitate Indian banks1 raising Rs. 600000 crore in external capitals over next nine years, besides lowering their leveraging capacity. It is the public sector banks that would require most of this capital, given that they dominate the Indian banking sector. Further, a higher level of core capital could dilute the return on equity for banks. Nevertheless, Indian banks may still find it easier to make the transition to a stricter capital requirement regime than some of their international counterparts since the regulatory norms on capital adequacy in India are already more stringent, and also because most Indian banks have historically maintained their core and overall capital well in excess of the regulatory minimum. As for the liquidity requirement, the liquidity coverage ratio as suggested under the proposed Basel III guidelines does not allow for any mismatches while also introducing a uniform liquidity definition. Comparable current regulatory norms prescribed by the Reserve Bank of India (RBI), on the other hand, permit some mismatches, within the outer limit of 28 days.
Introduction
The key elements of the proposed Basel III guidelines include the following:
1.Definition of capital made more stringent, capital buffers introduced and Loss absorptive capacity of Tier 1 and Tier 2 Capital instrument of Internationally active banks proposed to be enhanced
2. Forward looking provisioning prescribed
3. Modifications made in counterparty credit risk weights
4. New parameter of leverage ratio introduced
5. Global liquidity standard prescribed
This note seeks to assess the impact of the proposed Basel III guidelines on Indian banks ‟capitalisation profile and their liquidity position till 2018. The impact of the suggested norms relating to forward looking provisioning and counterparty risk weights are not captured in this note, since for that more granular data would be required and these are not available currently in the public domain. The norms on “leverage ratio” and “net stable funding ratio” are also not discussed in this note as they are likely to be implemented not before 2019.
Capital requirement: The new elements and their impact on Indian banks:-
The proposed Basel III guidelines seek to enhance the minimum core capital (after stringent deductions), introduce a capital conservation buffer (with defined triggers), and prescribe a countercyclical buffer (to be built up in times of excessive credit growth at the national level).
Changes in standard deductions
The proposed Basel III guidelines suggest changes in the deductions made for the computation of the capital adequacy percentages. The key changes for Indian banks include the following:
Table 2: Deductions from Capital—Proposed vs. Existing RBI Norms
Proposed Basel III guidelines
|
Existing RBI norms
|
Impact
| |
Limit on Deductions
|
Deductions to be made
only if deductibles exceed
15% of core capital at an
aggregate level, or 10% at the individual item level
|
All deductibles to be deducted
|
Positive
|
Deductions from Tier I or Tier II
|
All deductions from core capital
|
50% of the deductions from Tier I and 50% from Tier II (except DTA and intangible assets wherein 100% deduction is done from Tier I capital )
|
Negative
|
Treatment of significant investments in common shares of unconsolidated
financial institutions
|
Any investment exceeding 10% of issued share capital to be counted as significant and therefore deducted
|
For investments up to:
(i) 30%: 125% risk weight or risk weight as warranted by external rating
(ii)30-50%: 50% deduction from
Tier I and 50% from Tier II
|
Negative
|
Capital conservation buffer:-
The Basel committee suggests that a new buffer of 2.5% of risk weighted assets (over the minimum core capital requirement of 4.5%) be created by banks. Although the committee does not view the capital conservation buffer as a new minimum standard, considering the restrictions imposed on banks and also because of reputation issues, 7% is likely to become the new minimum capital requirement.
The main purpose of the proposed capital buffer is two-fold:
1. It can be dipped into in times of stress to meet the minimum regulatory requirement on core capital.
2. Once accessed, certain triggers would get activated, conserving the internally generated capital. This would happen as in this scenario, the bank would be restrained in using its earnings to make discretionary payouts (dividends, share buyback, and discretionary bonus, for instance).
Countercyclical buffer
The Basel committee has suggested that the countercyclical buffer, constituting of equity or fully loss absorbing capital, could be fixed by the national authorities concerned once a year and that the buffer could range from 0% to 2.5% of risk weighted assets, depending on changes in the credit-to-GDP ratio. The primary objective of having a countercyclical buffer is to protect the banking sector from system-wide risks arising out of excessive aggregate credit growth. This could be achieved through a pro-cyclical build up of the buffer in good times. Typically, excessive credit growth would lead to the requirement for building up higher countercyclical buffer; however, the requirement could reduce during periods of stress, thereby releasing capital for the absorption of losses or for protection of banks against the impact of potential problems.
The key features of the buffer include the following:
1. Credit-GDP gap could be used as a reference point
2. Buffer to be set at the national level every year
3. Buffer to be calculated at the same frequency as the normal capital requirement
4. Banks could be given one year to comply with the additional capital requirement
5. Reduction in buffer could take effect immediately
6. Banks not meeting the norm could be restrained from distributing the earnings (in the same manner as in the case of the capital conservation buffer)
Enhancement in Loss Absorption capacity of capital of internationally active banks
The Basel committee issued a consultative document in August 2010 to introduce a “write off clause” in all non-common Tier I and Tier II instruments issued by internationally active banks. The main features include the following:
1. Capital instruments to be written off on the occurrence of trigger event
2. In the event of write off, instrument holders could be compensated immediately in the form of common stock
3. The trigger event is the earlier of:
a) The decision to make a public injection of fund or support, without which the bank would become non-viable ( as determined by National authority)
b) A decision that write-off is necessary to prevent the bank from becoming non-viable (as determined by the National Authority)
The main purpose of the proposed contingent capital clause is to ensure that holders of capital bear the loss in a stress scenario before public money is infused and are not its (public funds‟) beneficiaries; and Reduce the possibility of public support for a bank under stress, as the bank’s core capital base would get strengthened at the expense of non-core capital (Tier I and Tier II) holders.
Comparison on Capital Requirement
Overall, with the Basel III being implemented, the regulatory capital requirement for Indian banks could go up substantially in the long run (refer Table 3). Additionally within in capital, the proportion of the more expensive core capital could also increase. Moreover, capital requirements could undergo a change in various scenarios, thereby putting restriction on bank’s ability to distribute earnings.
Table 3: Regulatory Capital Adequacy Levels—Proposed vs. Existing RBI Norm
Proposed Basel III norm
|
Existing RBI norm
| |
Common equity (after deductions)
|
4.5%
|
3.6% (9.2%)
|
Conservation buffer
|
2.5%
|
nil
|
Countercyclical buffer
|
0-2.5%
|
nil
|
Common equity + Conservation buffer + Countercyclical buffer
|
7-9.5%
|
3.6% (9.2%)
|
Tier I(including the buffer)
|
8.5-11%
|
6% (10%)
|
Total capital (including the buffers)
|
10.5-13%
|
9% (14.5%)
|
Source: Basel committee documents, RBI, Basel II disclosure of various banks; Figures in parenthesis pertain
to aggregated capital adequacy of banks covering over 95% of the total banking assets as on March 31, 2010.
Impact on return on equity:-
As discussed, the minimum core Tier I capital requirement may increase to 7-9.5% (9.5% including countercyclical buffer at the maximum level) and the overall Tier I capital to 8.5-11% (depending on the countercyclical capital buffer level). This would impact the leveraging capital of banks and therefore their return on equity (ROE). For instance, a bank generating 18% ROE on a core capital of 6% would generate around 15% ROE (3 percentage points lower) in case it were to raise its core capital to 8%. As most private sector banks and foreign banks in India are very well capitalised, transition to Basel III may not impact their earnings much, but the upside potential associated with higher leveraging would decline. As for public sector banks, those with Core Tier I less than 7% would be negatively impacted. Further, as the countercyclical buffer has to be set annually by the RBI, this could introduce an element of variation in lending rates and/or the ROE of banks.
Liquidity:-
Table 4: Liquidity Ratio—Proposed vs. Existing RBI Norm
Proposed Basel III
|
Existing RBI Norm
| |||||
Liquidity Ratios
|
Liquidity Coverage Ratio =
Stock of high quality liquid
assets/Net cash outflows
over a 30-day time period >=
100%
|
Number of days
|
1
|
2-7
|
8-14
|
15-28
|
Maximum
Permissible
gap (as %
of outflows)
|
5%
|
10%
|
15%
|
20%
| ||
Net Stable Funding Ratio
(NSFR) = Available amount
of stable funding/Required
amount of stable funding >
=100%
|
No such reforms
| |||||
The net stable funding ratio (NSFR) is likely to be implemented from 2019. But implementation of the liquidity coverage ratio (LCR) from 2015 may necessitate banks to maintain additional liquidity since the LCR requirement is more stringent; also some assumptions on the rollover rates and the required liquidity for committed lines may be more stringent. However, considering the period of one month and the fact that most Indian banks have upgraded their technology platforms, the transition to LCR may not be a very difficult one.
Basel III is BOTH a firm-specific, risk based framework and a system-wide, systemic risk-based framework.
Impact on Banks:-
Definition of Capital:-
Public sector banks (PSBs) –
¢ Marginal reduction in Tier 1 Capital. - Use of preference share capital and perpetual debt instruments.
¢ To support rapid loan-book expansion in the coming years, government supports may be required to enhance core tier 1 capital, assuming that government continue to hold 51% stake. Currently, there are only seven PSBs in which government equity is more than 65%
Countercyclical buffers:-
¢ Banks with Core Tier I less than 7% would be negatively impacted.
¢ It will have a impact on profitability and Return on equity (ROE)
Deductions:-
¢ Deductions should be from core capital may lead to reduction of amount in core capital for Indian Banks
RWA Requirements:-
¢ Banks having a huge trading book and off balance sheet derivative exposures will be impacted due to increased risk coverage (capital) on account of counterparty credit risk.
Liquidity Ratio:-
¢ The implementation of liquidity ratio (LCR/NSFR) is from 2015 can lead Indian Banks to maintain additional liquidity
Basel III impact on Public Sector Banks:-
As per the March 2010 dataset
¢ The Average Common Equity Tier 1 capital of Public Sector Banks is 7.27% and average CRAR is 13.21%.
¢ The Maximum and minimum of the core capital (common equity tier 1) are 10.50% and 4.37%.
¢ Core Capital - One Bank is below Basel III prescribed CET
¢ Tier 1 - Three Banks are falling short of Basel III prescribed Tier I capital (net of deductions).
¢ The CRAR of all the public sector banks is above 10.5%.
Basel III impact on Private Banks:-
As per the March 2010 dataset
¢ The Average Common Equity Tier 1 capital of Private Banks is 12.67% and average CRAR is 14.91%.
¢ The Private Banks are well cushioned above the Basel III defined Core (Common Equity Tier 1) capital
¢ The Maximum and minimum of the core capital (common equity tier 1) are 17.31% and 9.62%.
¢ The CRAR of all the private banks is above 10.5%.
Basel III impact on Foreign Banks:-
As per the March 2010 dataset
¢ The Average Common Equity Tier 1 capital of Foreign Banks is 13.78% and average CRAR is 16.39%.
¢ The Foreign Banks are well cushioned above the Basel III defined Core (Common Equity Tier 1) capital
¢ The Maximum and minimum of the core capital (common equity tier 1) are 17.29% and 6.72%.
¢ The CRAR of all the foreign banks is above 10.5%.
However, these are as per the March 2010 dataset and the implementations of definition of capital as per Basel III are not taken into consideration.
By:- Sumit Singh
sumitsingh17@gmail.com
