Basel III: How Much Of A Change Can It Enforce On The System

Posted in Finance Articles, Total Reads: 2866 , Published on 15 April 2014
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Besides the tremendous growth in the banking sector, banking industry has always had its ups and downs. It’s about time when the Indian banking industry starts following certain regulations which are followed globally and would also safeguard them from abnormal losses arising from economic stress. The implementation of Basel III norms would do the trick.




History:

It all began with the establishment of Bank for International Settlements (BIS) on May 17, 1930 as an agreement between various countries. BIS is headquartered in Basel, Switzerland. The sole purpose of BIS was to aid indemnifications obliged on Germany by the Treaty of Versailles at the end of World War I. The BIS conducts its tasks with the help of various subcommittees and by organizing an annual general meeting consisting of its member Central banks.


The Bank for International Settlements provided the Basel Committee on Banking Supervision (BCBS) with a seventeen member secretariats and with its aid BCBS has been successful in formulating the Basel accords for 1988 and 2004, which are known as Basel I and Basel II respectively. The Basel committee sets global benchmarks for the regulation of banks. It also provides a forum which cooperates against the issues pertinent to banking supervision. The committee’s sole objective is to strengthen the banking regulations, supervision and practices globally with the aim of improving financial stability.


About Basel III norms:

As per the Basel committee on the Banking Supervision, Basel III is set of enhanced reform measures, which were developed to strengthen bank’s supervision, regulation and risk management of the banking sector. In other words, Basel III norms emphasizes on the need to improve the enhanced disclosers, leverage ratio, maintaining liquidity and the amount of capital to keep aside. Thus, Basel III accord provides the banks with the ability to deal with financial and economic stress, enhancing the banks transparency and at the same time improving the risk management of the banking sector.


Objectives of Basel III norms:

The Objectives of Basel III accords are as follows:

1. Enhancing the bank’s ability to absorb shocks in times of financial stress

2. Enhancing the bank’s risk management

3. Enhancing the bank’s transparency


How Basel III accord is different from Basel I and II?

Basel III norms were set keeping in mind of the financial crisis that hit the world in 2008. The three pillars of Basel are still intact under Basel III norms. The intentions of the Basel Committee was to equip the entire banking industry with certain regulations that they were obliged to follow at all times providing them enough ability to cope up in times of financial and as well as economic stress.


The basic three pillars that are still maintained are:

Pillar 1: Maintaining a minimum amount of capital on the basis of their risk weighted assets.

Pillar 2: Having a strict and a well-defined supervisory review process for the banks

Pillar 3: Enhancing the disclosures that the banks must provide in order to maintain market discipline


The major changes (Refer Exhibit 1&2) that were suggested under Basel III from previous Basel accords were (Rajesh Goyal, 2012):

• Improved Capital Quality: One of the most crucial elements of Basel 3 norms was the introduction of the better capital quality. Capital quality simply means the capital capable of absorbing higher losses

• Capital Buffer: As per Basel III banks are now required to maintain a capital buffer of 2.5% of their risk weighted assets. The sole purpose of this buffer is to provide the banks with enough liquidity which can act as a cushion in times of financial stress.

• Countercyclical buffer: This buffer was introduced with the aim of decreasing the capital requirements in bad times whereas increasing the capital requirements in good times.

• Leverage ratio: As in the global financial crisis the value of the assets fell at a quicker rate. The introduction of leverage ratio in the Basel III accords would act as a shield against these problems.

• Equity requirements: The minimum equity requirements have been increased to 4.5% from 2% under the Basel II norms. Whereas the minimum aggregated capital requirements are still same as 8% but after including the capital buffer the minimum capital requirements would amount to 10.5%.


Impact of Basel III norms on the Indian Banks and the entire system:

Banks serve the most vital necessity of a society by acting as a reservoir of public savings and as well as by disbursing loans to the needy segment of the society, in place of a collateral sometimes.


Basel III norms were set up in order to save banks from the adverse impacts of crisis. Implementation of Basel III norms will bring about a revolution in the entire banking industry. As per the Basel III norms banks will set aside a large amount of capital which can act as a cushion when the economy is going through recession and thus allowing them to perform the banking operations in an efficient manner.


The implementation of Basel III framework would also lead to the reduction of systemic risk in the banking sector at the time of crises. This will be because of the presence of large capital requirements which are to be set aside coupled with enhanced liquidity measures to be followed. Also, the stipulated liquidity requirements would bring likeness in all the banks globally. Besides, as per the stringent standards on inter-banking liability limits, this would provide the banks to be independent of other banks and will also reduce the connectivity between the banks, which could lead to contagion risk during crises.


Certainly, the implementation of Basel III would reform and bring about a drastic change in the banking industry and at the time of crises. But it would also have an adverse impact on the weaker banks of the society and would finally lead to the crowding out of these banks. This could be the case as these weaker banks would find it very difficult to raise sufficient amount of capital and at the same time it would be nearly impossible for them to maintain the capital requirements as per the Basel III norms. And as a result, this will have negative impacts on the business models of these banks and would tilt the banking business in support of the leading banks which in turn would to stiff competition.


Because of high focus of the regulatory bodies on the capital and as well as the organizational structure of the banks would result in rearranging of the legal identities of these banks by the disposing portfolios or entities, mergers and acquisitions, etc.


Besides these, there are worries that the implementation of Basel III accords would lead to low Return on Equity (ROE) and other financial ratios. It is also thought that the growth of the public sector banks would be slow because of the implementation of Basel III since the lenders that are dependent on the government would not have sufficient capital.


As per the regulations employing more funds for meeting the liquidity standards which provides lower returns, the yield on assets and thus the profit margins of the banks would have a downward pressure. Also deploying more funds solely complying with the liquidity standards would mean losing on the attractive private sector investments which in turn would affect the economic growth.


Conclusion:

Complying with the Basel III norms would not only be a challenging task for the banks but also for the Government of India. Implementing Basel III might not have all positive impacts on the economy but mostly the effects will be for the betterment of banks. Thus, at an economy’s macro level it seems more pertinent to address the various complicating issues such as system risk, market discipline, etc. and hence the need arises for the implementation of Basel III norms.


Exhibit 1: Shows the changes in Basel II and Basel III norms

Minimum ratio requirements to be maintained

As per Basel II

As per Basel III

Aggregated capital to risk weighted assets

8%

10.50%

Equity to the risk weighted assets

2%

4.50% to 7%

Tier 1 capital to the risk weighted assets

4%

6%

Core Tier 1 capital to the risk weighted assets

2%

5%

Capital Conservation buffers to risk weighted assets

None

2.50%

Leverage ratio

None

3%

Countercyclical buffer

None

0 to 2.5%


Exhibit 2: Shows the Capital to Risk Weighted Assets (CRAR) of Banks



This article has been authored by Neetesh Dohare and Ayush Dwivedi from IIM Udaipur



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