Basel III - Its implications on Banking in India

Posted in Finance Articles, Total Reads: 2471 , Published on 26 June 2013
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Basel III norms released in 2010 by Banking Committee for Banking Supervision (BCBS) are set of reforms to maintain financial stability and common standards regulations across banks. Due to the financial crisis happened in 2008, a gap was realized in Basel II that the quality of capital under Basel I &II was not strong enough to cover the risk and there were no restriction on debt that a bank could take. As a result of crisis, banks started backing upon short term funds and were left with less capital and over leverage. Hence, Basel III norms were made with strict regulations with better risk management techniques which were focused more on funding, liquidity of banks, leverage and more stringent capital adequacy requirement based on operational, market and credit risk. Indian banks are needed to adopt these norms to have universal global standards to avoid any inconvenience in overseas transactions and to have a cushion to absorb the risk against any financial bubble.

According to Subbarao, Indian banks have to infuse an additional capital of Rs 5 lakh crore to meet the Basel III norms out of which share of equity capital has to be 1.75 lakh crore and non-equity Rs 3.25 lakh crore. The Government of India, which owns 70 per cent of the banking system, has to incorporate Rs 90,000 crore into the state-run banks to retain its shareholding in Public Sector Banks (PSBs). Failure in doing so would lead the Government to reduce its shareholding to prune the funding burden.


OECD (Organization for Economic Co-operation and Development) had estimated that the implementation of Basel III will decrease annual GDP growth by 0.05–0.15%. According to CRISIL report, the banks can comfortably raise the equity capital but non-equity Tier-1 capital would be challenging, as the instruments are riskier than under Basel II. Even C Rangarajan, chairman of PMEAC (Economic Advisory Council to the Prime Minister) said that it would be difficult to achieve the amount of required non-equity capital.


Firstly, these norms were made when India started going through the phase of slow economic growth. Now looking at the current scenario, when banks already have less capital with them, investors are circumspect about the returns and economy slowdown coupled with increasing inflation, adopting more stringent capital adequacy would lead them to borrow money for lending which will increase the cost of capital and ultimately exacerbating the slowdown. When banks cannot be trusted then it would very difficult for them to raise capital for lending. This would encumber and weaken the banks even more. Also the challenge is to provide incentives for banks to recognize losses on account of non-performing assets (NPA).


A DuPont Model of banking sector ROE (Return on Equity) illustrates:


ROE= (Total Assets/Tier 1 Capital) * (Tier 1 Capital/Common Equity) * (Net Income/Risk-Weighted Assets) * (Risk-Weighted Assets/Total Assets)


ROE of a bank is a result of multiplier effect of financial leverage, common equity margin, and return on risk-weighted assets and unit risk. Also under Basel III, the major part of Tier 1 capital would consist of common equity which includes common shares issued by banks, retained earnings, stock surplus and regulatory adjustments. The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets.  Now, if short term funding is facilitated mainly by borrowing then the proportion of risk-weighted assets (RWA) out of total assets of bank would increase. As a result unit risk would increase, financial leverage would decrease, common equity margin would decrease (due to increase in common equity) and return on risk-weighted assets would go down. Ultimately ROE would decrease. This would be the major reason of opposition of Basel III by banks.


Adaptation of Basel III would lead to significant changes in whole banking system to upgrade liquidity and capital management infrastructure. This would change the entire business model of many banks. Rest all depends on the tradeoff between high growth high risk and moderate growth moderate risk.

 

This article has been authored by Hina Singhal from IMI Delhi

 

References

  • http://blogs.cfainstitute.org/marketintegrity/2012/02/08/bank-earnings-investors-should-pay-attention-to-risk-adjusted-performance/
  • http://www.moneycontrol.com/news/economy/indian-banks-need-rs-175-trln-more-equity-for-basel-3-rbi_753149.html
  • http://www.abhinavjournal.com/images/Commerce_&_Management/Aug12/4.pdf
  • ICRA Comment : Proposed Basel III guidelines : A Credit positive for Indian Banks ICRA Limited ,2010
  • B.Mahapatra: Implications for Basel III for Capital, Liquidity and Profitability of Banks, RBI Monthly Bulletin, April 2012.

 


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