Evolution of Basel Norms Impacting Creation of ‘Banks too big to fail’- India Perspective

Posted in Finance Articles, Total Reads: 5309 , Published on 17 November 2014
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Banks are highly regulated profit making financial intermediaries where they accept money fromdepositors and lend money to borrowers at a rate of interest. These companies are highly leveraged and dealing with public money entails sufficient risk. Therefore a strong regulation of Banking system plays an important role in the holding the financial backbone of the economy. The breakdown of the Bretton Woods in 1973 led to casualties. The Franklin National Bank of New York closed down due to huge foreign exchange losses. Bankhaus Herstatt lost its license due to holding foreign exchange exposure three times the capital. These disruptions in the international financial market led to formation of a committee on banking regulation known as Basel Committee on Banking Supervision. The committee sets up minimum standards for supervising the banking business.

Image Courtesy: freedigitalphotos.net, AKARAKINGDOMS


A movement from Basel I to Basel II to Basel III : Major changes

Basel I norms were introduced in India in the year 1992 and was completed in a phased manner over the period of four years.

Basel I:

The norm mainly focussed on the credit risk that every bank face. It gave attention to the capital with respect to the risk weighted assets. It defined capital in to two tiers and calculated the capital to risk weighted assets ratio (CRAR).

 


The risk were assigned to assets as per the following table:-

Percentage of Weight Attached

Asset Type

0%

Cash and Government securities like treasury bills

20%

Cash to be received, public sector debt

50%

Residential mortgage loans

100%

Private sector debt, real estate, plant and equipment

CRAR = (Tier I capital + Tier II capital) / Risk weighted assets

Minimum CRAR requirement was set to 8% by Basel I. However RBI raised it to 9%.


Basel II:

Basel II was an improvement over Basel I. Basel I focussed only on credit risk whereas Basel II incorporated market risk and operational risk along with credit risk. It focussed on three pillars, namely:-

1. Minimum capital requirement –

Banks should maintain the minimum CRAR of 8%.

CRAR = (Tier I capital + Tier II Capital) / (credit risk + market risk + operational risk)

Asset classification was done as given in the table below:-

Percentage of Weight Attached

Asset Type

0%

Cash and Government securities like treasury bills

20%

Balances in Current Account, Claims on bank

50%

Investment in Mortgage Backed Securities which are backed by housing loans

100%

Investment in subordinated debt, real estate, plant and equipment

125%

Direct Investment in equity shares, convertible bonds

150%

Investment in Venture Capital Funds, mortgage backed securities in exposure to Commercial real estate

According to Basel II norms, banks were asked to maintain a CRAR of 8% of which tier I capital should be 4%. However RBI asked to maintain a CRAR of 9% with a tier I capital of 6% and tier II capital should not be more than 50% of tier I capital.


2. Supervisory framework –

The regulators were given the power to check bank’s risk management system and capital assessment policy


3. Market discipline –

It was made mandatory for the banks to disclose their risk taking positions and capital.


Basel III:

The financial crisis of 2008 was an eye opener for the financial regulators and experts. It showed that the current regulations were not robust enough to sustain in the times of crisis. It was realized that there was a need to further strengthen the system as banks in developed economies were highly leveraged, under-capitalized and depended on short term funding.


Capital Requiements:-

The capital requirements under the Basel III norms were changed, as follows:-

1. The minimum tier I capital was increased from 4% to 6%

a. The common equity of tier I capital was increased from 2% to 4.5%

2. The tier II capital was reduced from 4% to 2%

3. A new capital conservation buffer of 2.5% was introduced.


This increased the total CRAR from 8% to 10.5%



Capital conservation buffer:-

The capital conservation buffer was introduced to ensure that banks are able to absorb losses and still maintain the CRAR and therefore sustain even in times of crisis.


Countercyclical buffer:-

Along with the capital conservation buffer, Basel III also introduced a countercyclical capital buffer which ranges from 0 – 2.5%. This can be imposed on banks during the times of high growth.


Liquidity Risk Management:-

Banks should maintain adequate level of high quality assets which can be converted into cash to meet the liquidity requirements for the next 30days.


Leverage Ratio:-

Tier I capital should at least 3% of total assets.


‘Too Big To Fail’ approach:

This new approach of Basel committee will be set to identify a few systemically important banks which will have enough resilience and absorption capacity and failure of which would indicate the crisis to the financial system. It includes measurement in five important categories:-

1. Cross-jurisdictional activity

2. Size

3. Interconnectedness

4. Substitutability

5. Complexity


Equal weightage has been given to each category and the banks will measured on these five categories based on which they would be selected.


RBI has also decided to follow this Basel Committee approach and identify four to six such banks which will be domestically systematically important. The banks which will fall into this category will have to set aside 0.2% to 0.8% of the loan as capital buffer, i.e. if the banks was setting aside Re 1 earlier, it would have to set aside Rs 1.2 to Rs 1.8 now. Banks having a size of at least 2% of GDP will be selected in the sample. Special attention will be given to these banks and these banks will be regulated strictly as failure of these institutions can have a cascading effect of the stability of the financial system. The banks will be stable enough to survive even in times of crisis and therefore maintain the financial stability of the economy.


Issues:

The banks in India in the current scenario face threat from rising non-performing assets which are posing a serious threat to the banking operations. The maintain reason behind Indian banking system unable to adopt Basel III norms is the insufficient capital which the banks have and rising NPAs. The adoption of Basel III would require would increase liquidity in the banks by the government, which the government could not afford to do due to rising inflation in the economy. Risky assets in the book of most of the banks such as exposure to real estate also pose a threat. Therefore quality of assets are a major criteria to select the banks for the ‘too big to fail’ group.


This article has been authored by Saptarshi Chakraborty from FORE School of Management


References:-

http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/BSI04092012F.pdf

http://apps.aima.in/ejournal_new/articlesPDF/Dr.BindyaKohli.pdf

http://www.moneylife.in/article/rbi-approach-on-banks-and-financial-institutions-that-are-too-big-to-fail/35533.html

http://articles.economictimes.indiatimes.com/2014-07-23/news/51932059_1_domestic-banks-much-capital-systemic-importance

http://www.bis.org/bcbs/history.htm

http://www.investopedia.com/terms/b/basel_i.asp

http://www.livemint.com/Industry/rKdDySDJKeFYM6wo9BZlhI/RBI-to-start-announcing-toobigtofail-banks-in-Aug-2015.html

http://www.livemint.com/Industry/BhHzzPBwyzjfuwJAqJ2jUL/RBI-panel-suggests-banks-to-maintain-capital-buffer-of-25.html

http://firstbiz.firstpost.com/economy/which-are-the-too-big-to-fail-banks-of-india-here-is-a-list-of-probables-91707.html



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