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Basel III: Is It A Fad Or Need For India?

Posted in Finance Articles, Total Reads: 3373 , Published on September 27, 2012

With the financial crisis of 2008 in the hindsight, the Basel Committee on Banking Supervision has put forward the guidelines which impose stringent capital and liquidity requirements through Basel III. Basel III is focused on increase in capital, especially equity capital to absorb the impact of market, credit and operational risk. As was evident from the recent crisis, the social cost of the failure of a large bank was much larger than the loss to the owner of capital.

The shareholders of the bank have always enjoyed more than normal returns on the capital employed by taking high risks as they know that the failure of a large bank will have an adverse impact on the credit market leading to disturb the normal functioning of the economy which would force the regulators to step in. This has led to a serious issue of Moral Hazard. Although BASEL III is not really meant for Indian banks which are already stable, far less complex and well capitalized as compared to banks across the globe but would help in addressing the problems that the Indian banks would face when they transform into organizations similar to their global peers over the next decade.

The shortcomings of Basel II were exposed during the 2008 crisis. The tier 1 capital requirement of 4 % of risk weighted assets under Basel II was inadequate to withstand the huge losses incurred by banks and the responsibility of assessment of counterparty risk was given to credit rating agencies which proved to be vulnerable. The financial institutions which repackaged their loans into asset backed securities through the process of securitization were able to move them off their balance sheet, thus reducing the risk-weighting of assets. The process was detrimental for the health of the banking system as it enabled banks to increase leverage, take higher risks and also reduced the capital requirement.

So what are the additional requirements of the proposed Basel III norm over the current RBI norms? Current requirement of common equity will increase from 2% to 4.5%. Also 2 additional buffers are introduced in Basel III known as Capital conservation buffer and countercyclical buffer. Capital conservation buffer is a reserve buffer of 2.5% of risk weighted assets which would be useful for banks in periods of stress. Also once the capital conservation buffer is accessed there will be restrictions on the use of internally generated like earnings to pay out dividends etc.

Counter-cyclical buffer is meant for protecting the banks out of the risks rising out of excessive lending. This buffer could be 0-2.5% depending on the credit/GDP ratio. In periods of high credit growth the size of the buffer would increase which would be used during periods of low credit growth. Thus the requirement of core Tier1 capital has moved to 7-9.5%. This massive change has come about because of insufficient capital of banks to withstand the 2008 crisis. The increase in the core capital will ensure that the banks are more resilient to stress.

The total Tier 1 requirement is 8.5-11% against the current norm of 6% and the total capital requirement is 10.5-13% from the current norm of 9%. Basel III also requires banks to keep sufficient stock of high quality liquid assets to manage short term financial stress. Basel III requires a leverage ratio of 3%, i.e.Tier-1 capital of at least 3% of total assets without risk weighting.  Basel III will be effective from 1st January 2013 and would be implemented in a phased manner till March, 2018.The requirement of core Tier 1 capital of 4.5 % needs to be fulfilled by 2015 while the additional requirement of capital conservation buffer requirement needs to be met by 2018.

Are Indian banks ready to implement Basel III?

Most of the private sector and foreign banks are in a comfortable position since they have a core capital in excess of 9% whereas this is not the case with the public sector banks. According to an ICRA report, public and private sector banks would require an additional capital of 600000 crore, assuming a 20% growth in risk-weighted assets, which is “achievable so long as banks can find investors for the riskier additional tier I capital,” says ICRA.

Out of the total requirement 75-80% will be required by the public sector banks. Thus the burden will fall on the cash-stripped government which will need to infuse massive amount of capital to maintain its shareholding of 58%.This looks difficult to achieve seeing the current state of the government financials with high fiscal deficit of 5.9% in 2011-12 and massive subsidy burden. The government is not in a position to provide the capital nor will it allow other investors to do so because it would reduce the government’s grip on public sector banks.

The leverage ratio of 3% will not affect the Indian banks much because this is meant for banks with large trading book and exposure to off balance sheet derivatives and Indian banks don’t have much exposure to the derivatives market. Liquidity coverage Ratio (LCR) requires banks to hold enough liquid assets to cover cash outflows during a 30 day stress period. Indian banks are fairly comfortable on this front as well as they hold 24% in government securities in form of SLR(Statutory Liquidity Ratio) and 4.75% in cash in form of CRR(Cash Reserve Ratio) with the RBI.

However the ultimate LCR burden would depend on how much CRR and SLR can be offset against LCR. Basel III will also force banks to put a large part of their profit back in the balance sheet as retained earnings rather than distributing dividends. Although there is no significant improvement in capital requirement under Basel3 as compared to Basel 2 but the problem is change in way that some of the capital market instruments will be treated. Perpetual debt which is now treated as Tier 1 capital will be excluded under Basel3, putting more pressure in the requirement of core capital.

How does Basel III impact the Indian economy?

Increase in the requirement of capital will affect the ROE of the banks, financial ratios would be hurt and the public sector banks will not be able to expand their loan book due to unavailability of capital. According to ICRA, increase in the core Tier1 capital from 6% to 8% will reduce the return on equity percentage points from 18% to 15%. Public sector banks with core capital less than 7% will be severely impacted whereas the earnings of the private sector banks will not be affected much as they are already well capitalized but would reduce leveraging.

Cost of capital for the banks would increase with the increase in equity in the capital structure as equity is an expensive form of capital. As capital costs increase credit will become more expensive. Banks will impose tougher conditions for granting credit to small and medium sized firms and for start-up businesses. Also with deposit rates rising lower than expectations at 14% will put further pressure of credit costs. With the credit becoming costlier the investment activity in the country will be severely impacted thus impacting the economic growth.

Indian banks will have to learn the art of balancing growth with capital requirements. Indian banks have not utilized properly the base of Tier 2 capital, except for some private sector banks. The ability to efficiently manage the tier 1 and tier 2 capital will be critical to manage return on equity. Indian banks should move quickly to advanced approaches of risk estimation from the formula based approaches to avoid over-estimation in capital requirements for credit and operational risk.  The Basel committee is also proposing to increase the credit conversion factor of off-balance sheet items from 20% to 100%. This will mean that the banks will have to set aside more capital against asset backed loans, thus reducing their leverage and bringing in more stability in the banking sector.

This will also increase the cost of other off-balance items like Letter of Credit. Letter of Credit is a low risk product which requires detailed documentation and collaterals and the stringent norms of Basel III would have a negative impact on global trade. The increase in the cost of Letter of Credit will be passed on entirely to the customer or the bank may focus on other profitable activities by reducing the issuance of Letter of Credit. As a result of Letter of Credit becoming more expensive, traders will switch to alternative instruments of trade finance like unsecured financing in the form of forfeiting. These instruments though less expensive but add onus to the companies for counterparty and country risk evaluation.

With the implementation of BASEL III the banks will move to risk-averse mode which could severely impact the Indian economy, which needs large amounts of credit especially the infrastructure sector with requirements of 1 trillion over next five years. The big question is whether it is right to implement the same kind of stringent measures to economies which are inherently differently in their risk appetite. While the developed world aims at avoidance of the 2008 crisis, for  the developing world and the emerging markets the objective is  growth to meet the needs of increasing population.So BASEL III should provide a solution which is tailored made for the developing economies.Thus ,though  BASEL III will make banks more capable of handling a financial crisis, it will have a negative impact on the GDP of the economies like India , which should be a matter of concern.

This article has been authored by Amit Sharma & Rahul Goel from NMIMS.

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