Effect of Basel III on Indian Banks

8/12/2019 Effect of Basel III on Indian Banks

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TABLE OF CONTENTS

Sr. No Topic Page No

1 Executive Summary 2

2 The Global Financial Crisis of 2008 3

3 Why Basel II Failed? 5

4 Introduction to Basel III 7

5 How is Basel III an improvement over Basel II 13

Basel III in India

6 RBI guidelines for Basel III 17

7 Study of 10 Banks in India with respect to Basel III guidelines 29

8 Impact Of Basel III Ratios On Indian Banks 41

9 Will Basel III affect profitability of Banks in India? 44

10 Will Basel III hurt growth? 45

11 Challenges in implementation of Basel III 46

12 Should Basel III be implemented in India? 50

13 Conclusion 51

14 Bibliography 52


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EXECUTIVE SUMMARY

With the implementation date of Basel III norms by RBI being 1 stApril, 2013 a lot of

challenges are in front of the Indian Banking sector in terms of raising capital, development

of IT systems in the bank, managing the increased cost of capital. Through this study an

attempt has been made to see how prepared are the banks in terms of capital.

Also attempt has been made discern the effect of Basel III on profitability and growth

in India. Finally we have tried to analyse the benefits of adopting Basel III v/s the cost

incurred in order to adopt Basel III and conclude whether Indian banks should adopt Basel III

norms.


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THE GLOBAL FINANCIAL CRISIS OF 2008

The financial crisis of 20072008, also known as The Global Financial Crisis and

2008 Financial Crisis, is considered by many economists to be the worst financial crisis

since the Great Depression of the 1930s. The crisis resulted in the threat of total collapse of

large financial institutions, the bailout of banks by national governments, and downturns in

stock markets around the world. The housing market also suffered, resulting in evictions,

foreclosures and prolonged unemployment.

The crisis saw, a series of bank and insurance company failures triggered a financial

crisis that effectively halted global credit markets and required unprecedented government

intervention. Fannie Mae (FNM) and Freddie Mac (FRE) were both taken over by the

government. Lehman Brothers declared bankruptcy on September 14 thafter failing to find a

buyer. Bank of America agreed to purchase Merrill Lynch (MER), and American

International Group (AIG) was saved by an $85 billion capital injection by the federal

government.Shortly after, on September 25th,J P Morgan Chase (JPM) agreed to purchase

the assets of Washington Mutual (WM) in what was the biggest bank failure in history. In

fact, by September 17, 2008, more public corporations had filed for bankruptcy in the U.S.

than in all of 2007. These failures caused a crisis of confidence that made banks reluctant to

lend money amongst themselves, or for that matter, to anyone.

Over the years investment banks and other lending institutes provided credit through

shadow banking system i.e. they obtained investors funds against various derivative

securities like mortgage backed securities, asset backed commercial paper etc. Due to the

collapse of housing market it became difficult to raise money against these instruments

causing the US credit market to shrink by nearly one-third.

This credit freeze brought the global financial system to the brink of collapse. The

response of the Federal Reserve, the European Central Bank, and other central banks was

immediate and dramatic. During the last quarter of 2008, these central banks purchased

US$2.5 trillion of government debt and troubled private assets from banks. This was the
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largest liquidity injection into the credit market, and the largest monetary policy action, in

world history.

The crisis caused loss of wealth of individuals, financial institutions and industries

and brought on the US recession that began in December 2007 and lasted till June 2009. In

order to prevent further collapse of US economy the Federal Government Bailout bill was

implemented. As per the bill the Troubled Assets Relief Program (TARP) was enacted. The

bill authorized $700 billion for this fund, which would be used to buy and hold troubled loan-

based assets, many of which were tied to home prices in the slumping U.S. housing market.

Through such efforts the US Government along with the Federal Reserve controlled therecession.

But the crisis led to the failure of key businesses, decline in consumer wealth

estimated in trillions of US dollars, and a downturn in economic activity which lead to the

20082012 global recession and contributed to the European sovereign-debt crisis.


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Also Basel II did not explicitly cover liquidity risk. This had particularly serious

consequences as liquidity risk when left unaddressed, could cascade into a solvency risk. This

proved to be the undoing of virtually every bank that came under stress during the crisis.

Finally the last drawback of Basel II was that it only focussed on individual financial

institutions and ignored the systemic risk arising from the interconnectedness across

institutions. This interconnectedness among institutions caused the crisis to spread rapidly

over the financial markets.

Thus due to the above mentioned loopholes present in Basel II it was unable to

prevent the 2008 financial crisis. Basel III tries to fix the gaps and lacunae in Basel II that

came to light during the crisis; it also tries to incorporate other lessons learned during the

crisis.


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INTRODUCTION TO BASEL III

Basel III (or the Third Basel Accord) is a global, voluntary regulatory standard on

bank capital adequacy, stress testing and market liquidity risk.It was agreed upon by the

members of the Basel Committee on Banking Supervision in 201011, and was scheduled to

be introduced from 2013 and to be implemented until 2019. Basel III was developed in

response to the deficiencies in financial regulation revealed by the 2008 financial crisis. Basel

III is supposed to strengthen banking system by improving quality of banks capital, banks

liquidity and banksleverage.

Basel II

Basel III

Basel II Capital

Basel III

Capital

Leverage

Systemic Risks &Interconectedness

Liquidity


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Proposal of Basel III

First, the quality, consistency, and transparency of the capital base will be raised.

Tier 1 capital: the predominant form of Tier 1 capital must be common shares and

retained earnings

Tier 2 capital instruments will be harmonised

Tier 3 capital will be eliminated

Second, the risk coverage of the capital framework will be strengthened.

Promote more integrated management of market and counterparty credit risk

Add the CVA (credit valuation adjustment)-risk due to deterioration in counterpartys

credit rating

Strengthen the capital requirements for counterparty credit exposures arising from

banksderivatives, repo and securities financing transactions

Raise the capital buffers backing these exposures

Reduce procyclicality and

Provide additional incentives to move OTC derivative contracts to central

counterparties (probably clearing houses)

Provide incentives to strengthen the risk management of counterparty credit exposures

Raise counterparty credit risk management standards by including wrong-way risk

Third, a leverage ratio will be introduced as a supplementary measure to the Basel II risk-

based framework, intended to achieve the following objectives:

Put a floor under the build-up of leverage in the banking sector

Introduce additional safeguards against model risk and measurement error by

supplementing the risk based measure with a simpler measure that is based on gross

exposures.


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Fourth, a series of measures is introduced to promote the build-up of capital buffers in good

times that can be drawn upon in periods of stress (Reducing procyclicality and promoting

countercyclical buffers).

Measures to address procyclicality:

Dampen excess cyclicality of the minimum capital requirement;

Promote more forward looking provisions;

Conserve capital to build buffers at individual banks and the banking sector that can

be used in stress; and

Achieve the broader macroprudential goal of protecting the banking sector from

periods of excess credit growth.

Requirement to use long term data horizons to estimate probabilities of default,

downturn loss-given-default estimates, recommended in Basel II, to become

mandatory

Improved calibration of the risk functions, which convert loss estimates into

regulatory capital requirements.

Banks must conduct stress tests that include widening credit spreads in recessionary

scenarios.

Promoting stronger provisioning practices (forward looking provisioning)

Advocating a change in the accounting standards towards an expected loss (EL)

approach (usually, EL amount := LGD*PD*EAD)

Fifth, a global minimum liquidity standard for internationally active banks is introduced that

includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term

structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight

panel of the Basel Committee on Banking Supervision issued a statement saying that

regulators will allow banks to dip below their required liquidity levels, the liquidity coverage

ratio, during periods of stress. In January 2013 Global central bank chiefs watered down the

liquidity measures in a bid to stave off another credit crunch

The Committee also reviewed the need for additional capital, liquidity or other supervisory

measures to reduce the externalities created by systemically important institutions.


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Capital Requirements as per Basel III

Requirements Under Basel II Under Basel III

Minimum Ratio of Total Capital To RWAs 8% 8%

Minimum Ratio of Common Equity to RWAs 2% 4.50% to 7.00%

Tier I capital to RWAs 4% 6.00%

Core Tier I capital to RWAs 2% 5.00%

Maximum Tier 2 Capital

(within Total Capital)4% 2%

Capital Conservation Buffers to RWAs (CCB) None 2.50%

Minimum Common Equity

Tier 1 Capital + CCB2% 7%

Minimum Total Capital + CCB 8% 10.5%

Leverage Ratio None 3.00%

Countercyclical Buffer None 0% to 2.50%

Minimum Liquidity Coverage Ratio None TBD (2015)

Minimum Net Stable Funding Ratio None TBD (2018)

Systemically important Financial Institutions

ChargeNone TBD (2011)


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HOW IS BASEL III AN IMPROVEMENT OVER BASEL II

Basel III tries to fill the gaps present in Basel II. Basel III builds on the essence of

Basel IIits the link between the risk profiles and capital requirements of individual banks.

In that sense, Basel III is an enhancement of Basel II.

The enhancements of Basel III over Basel II come primarily in four areas:

(i) Augmentation in the level and quality of capital;

(ii) Introduction of liquidity standards;

(iii) Modificationsin provisioning norms;

(iv) Better and more comprehensive disclosures

Higher Capital Requirement & Liquidity Standards

Basel III requires higher and better quality capital. The minimum total capital remains

unchanged at 8 per cent of risk weighted assets (RWA). However, Basel III introduces acapital conservation buffer of 2.5 per cent of RWA over and above the minimum capital

requirement, raising the total capital requirement to 10.5 per cent against 8.0 per cent under

Basel II. This buffer is intended to ensure that banks are able to absorb losses without

breaching the minimum capital requirement, and are able to carry on business even in a

downturn without deleveraging. This buffer is not part of the regulatory minimum; however,

the level of the buffer will determine the dividend distributed to shareholders and the bonus

paid to staff.

There are also other prescriptions regarding the quality of capital within the minimum

total so that capital is able to absorb losses, and calling upon taxpayers to bear the burden of

bail out becomes absolutely the last resort.

In addition to the capital conservation buffer, Basel III introduces another capital

buffer the countercyclical capital buffer in the range of 0 2.5 per cent of RWA which

could be imposed on banks during periods of excess credit growth. Also, there is a provision

for a higher capital surcharge on systemically important banks.


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To mitigate the risk of banks building up excess leverage as happened under Basel II,

Basel III institutes a leverage ratio as a backstop to the risk based capital requirement. The

Basel Committee is contemplating a minimum Tier 1 leverage ratio of 3 per cent (33.3 times)

which will eventually become a Pillar 1 requirement as of January 1, 2018.

Also, Basel II failed to demand adequate loss absorbing capital to cover market risk.

To remedy this, Basel III strengthens the counterparty credit risk framework in market risk

instruments. This includes the use of stressed input parameters to determine the capital

requirement for counterparty credit default risk. Besides, there is a new capital requirement

known as CVA (credit valuation adjustment) risk capital charge for OTC derivatives to

protect banks against the risk of decline in the credit quality of the counterparty.

To mitigate liquidity risk, Basel III addresses both potential short-term liquidity stress

and longer-term structural liquidity mismatches in banks balance sheets to cover short-term

liquidity stress, banks will be required to maintain sufficient high-quality unencumbered

liquid assets to withstand any stressed funding scenario over a 30-day horizon as measured by

the liquidity coverage ratio (LCR). To mitigate liquidity mismatches in the longer term,

banks will be mandated to maintain a net stable funding ratio (NSFR). The NSFR mandates aminimum amount of stable sources of funding relative to the liquidity profi le of the assets, as

well as the potential for contingent liquidity needs arising from off-balance sheet

commitments over a one-year horizon. In essence, the NSFR is aimed at encouraging banks

to exploit stable sources of funding.

Liquidity Standards

Ratio Basel II Basel III

Liquidity Coverage Ratio (LCR) (to

be introduced as on January 1,2015)-

Stock of high-quality liquid assets 100%

Total net cash outflows over the next 30

calendar days

Net Stable Funding Ratio (NSFR)

(to be introduced as on January 1,

2018)

-Available amount of stable funding > 100%

Required amount of stable funding


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Provisioning Norms

The Basel Committee supports the proposal for adoption of an expected loss based measure

of provisioning which captures actual losses more transparently and is also less procyclical

than the current incurred loss approach. The expected loss approach for provisioning will

make financial reporting more useful for all stakeholders, including regulators and

supervisors.

Disclosure Requirements

The disclosures made by banks are important for market participants to make informed

decisions. One of the lessons of the crisis is that the disclosures made by banks on their risky

exposures and on regulatory capital were neither appropriate nor sufficiently transparent to

afford any comparative analysis. To remedy this, Basel III requires banks to disclose all

relevant details, including any regulatory adjustments, as regards the composition of the

regulatory capital of the bank.

Thus through the above mentioned means Base II has tried to fill the lacunae present

in Basel II and also incorporate the lessons learned during the crisis in the regulatory

framework.


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BASEL III IN INDIA


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RBI GUIDELINES FOR BASEL III

Requirements As per RBI

Minimum Ratio of Total Capital To RWAs 9%

Minimum Ratio of Common Equity to RWAs 5.50%

Additional Tier 1 Capital 1.5%

Minimum Tier I capital to RWAs 7.00%

Maximum Tier 2 Capital

(within Total Capital)2%

Capital Conservation Buffer comprised of common

equity to RWAs (CCB)2.50%

Minimum Common Equity Tier 1 ratio plus capital

conservation buffer to RWAs8.00%

Minimum Total Capital + CCB 11.5%

Capital Constituents

Elements of Common Equity Tier 1

Elements of Common Equity Tier 1 CapitalIndian Banks

The Common Equity component of Tier 1 capital will comprise the following:

i. Common shares (paid-up equity capital) issued by the bank which meet the criteria

for classification as common shares for regulatory purposes

ii. Stock surplus (share premium) resulting from the issue of common shares;

iii. Statutory reserves;

iv. Capital reserves representing surplus arising out of sale proceeds of assets;

v. Other disclosed free reserves, if any;

vi. Balance in Profit & Loss Account at the end of the previous financial year;


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vii. Banks may reckon the profits in current financial year for CRAR calculation on a

quarterly basis provided the incremental provisions made for non-performing assets at

the end of any of the four quarters of the previous financial year have not deviated

more than 25% from the average of the four quarters. The amount which can be

reckoned would be arrived at by using the following formula:

ePt= {NPt0.25*D*t}

Where;

Ept = Eligible profit up to the quartert of the current financialyear; t varies from 1

to 4

NPt = Net profit up to the quartert

D= average annual dividend paid during last three years

viii. While calculating capital adequacy at the consolidated level, common shares issued

by consolidated subsidiaries of the bank and held by third parties (i.e. minority

interest) which meet the criteria for inclusion in Common Equity Tier 1 capital

Common Equity Tier 1 CapitalForeign Banks Branches

Elements of Common Equity Tier 1 Capital

Elements of Common Equity Tier 1 capital will remain the same and consist of the

following:

i. Interest-free funds from Head Office kept in a separate account in Indian books

specifically for the purpose of meeting the capital adequacy norms;

ii. Statutory reserves kept in Indian books;

iii. Remittable surplus retained in Indian books which is not repatriable so long as the

bank functions in India;

iv. Interest-free funds remitted from abroad for the purpose of acquisition of property and

held in a separate account in Indian books provided they are non-repatriable and have

the ability to absorb losses regardless of their source;


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v. Capital reserve representing surplus arising out of sale of assets in India held in a

separate account and which is not eligible for repatriation so long as the bank

functions in India; and

vi. Less: Regulatory adjustments / deductions applied in the calculation of Common

Equity Tier 1 capital

Elements of Additional Tier 1 Capital

Elements of Additional Tier 1 CapitalIndian Banks

Elements of Additional Tier 1 capital will remain the same. Additional Tier 1 capital consists

of the sum of the following elements:

i. Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the

regulatory requirements

ii. Stock surplus (share premium) resulting from the issue of instruments included in

Additional Tier 1 capital;

iii. Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which

comply with the regulatory requirementsiv. Any other type of instrument generally notified by the Reserve Bank from time to

time for inclusion in Additional Tier 1 capital;

v. While calculating capital adequacy at the consolidated level, Additional Tier 1

instruments issued by consolidated subsidiaries of the bank and held by third parties

which meet the criteria for inclusion in Additional Tier 1 and

vi. Less: Regulatory adjustments / deductions applied in the calculation of Additional

Tier 1 capital


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Elements of Additional Tier 1 CapitalForeign Banks Branches

i. Elements of Additional Tier 1 capital will remain the same as under existing

guidelines. Various elements of Additional Tier 1 capital are as follows:

ii. Head Office borrowings in foreign currency by foreign banks operating in India for

inclusion in Additional Tier 1 capital which comply with the regulatory requirements

iii. Any other item specifically allowed by the Reserve Bank from time to time for

inclusion in Additional Tier 1 capital; and

iv. Less: Regulatory adjustments / deductions applied in the calculation of Additional

Tier 1 capital

Elements of Tier 2 Capital

Elements of Tier 2 capital will largely remain the same under existing guidelines except that

there will be no separate Tier 2 debt capital instruments in the form of Upper Tier 2 and

subordinated debt. Instead, there will be a single set of criteria governing all Tier 2 debt

capital instruments.

Elements of Tier 2 CapitalIndian Banks

i. General Provisions and Loss Reserves

ii. Debt Capital Instruments issued by the banks

iii. Preference Share Capital Instruments [Perpetual Cumulative Preference Shares

(PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable

Cumulative Preference Shares (RCPS)] issued by the banks;

iv. Stock surplus (share premium) resulting from the issue of instruments included in Tier

2 capital;

v. While calculating capital adequacy at the consolidated level, Tier 2 capital

instruments issued by consolidated subsidiaries of the bank and held by third parties

which meet the criteria for inclusion in Tier 2 capital

vi. Revaluation reserves at a discount of 55%

vii. Any other type of instrument generally notified by the RBI

viii. Less: Regulatory adjustments / deductions applied in the calculation of Tier 2 capital


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Elements of Tier 2 CapitalForeign Banks Branches

i. Elements of Tier 2 capital in case of foreign banks branches will be as under:

ii. General Provisions and Loss Reserves

iii. Head Office (HO) borrowings in foreign currency received as part of Tier 2 debt

capital;

iv. Revaluation reserves at a discount of 55%; and

v. Less: Regulatory adjustments / deductions applied in the calculation of Tier 2 capital

Disclosure Requirements

In order to ensure adequate disclosure of details of the components of capital which aims at

improving transparency of regulatory capital reporting as well as improving market

discipline, banks are required to disclose the following:

i. A full reconciliation of all regulatory capital elements back to the balance sheet in the

audited financial statements;

ii. Separate disclosure of all regulatory adjustments and the items not deducted from

Common Equity Tier 1

iii. A description of all limits and minima, identifying the positive and negative elements

of capital to which the limits and minima apply;

iv. A description of the main features of capital instruments issued; and

v. Banks which disclose ratios involving components of regulatory capital (e.g. Equity

Tier 1, Core Tier 1 or Tangible Common Equity ratios) must accompany such

disclosures with a comprehensive explanation of how these ratios are calculated.

Banks are also required to make available on their websites the full terms and conditions of

all instruments included in regulatory capital. The Basel Committee will issue more detailed

Pillar 3 disclosure shortly, based on which appropriate disclosure norms under Pillar 3 will be

issued by RBI.

During the transition phase banks are required to disclose the specific components of capital,

including capital instruments and regulatory adjustments which are benefiting from thetransitional provisions.


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TRANSITIONAL ARRANGEMENT

In order to ensure smooth migration to Basel III without aggravating any near term

stress, appropriate grandfathering and transitional arrangements have been made by the

BCBS in terms of which national implementation of Basel III will begin on January 1, 2013

and will be fully phased-in on January 1, 2019.

Transitional Arrangements

(% of RWAs)

Minimum capital

ratios

April1

2013

March 31,

2014

March 31,

2015

March 31

2016

March 31,

2017

March

31, 2018

Minimum Common

Equity Tier 1 (CET1)4.5 5 5.5 5.5 5.5 5.5

Capital conservation

buffer (CCB)- - 0.625 1.25 1.875 2.5

Minimum CET1+ CCB 4.5 5 6.125 6.75 7.375 8

Minimum Tier 1 capital 6 6.5 7 7 7 7

Minimum Total Capital* 9 9 9 9 9 9

Minimum Total Capital

+CCB9 9 9.625 10.25 10.875 11.5

Phase-in of all

deductions from

CET1(in%)#

20 40 60 80 100 100

*The difference between the minimum total capital requirement of 9% and the Tier 1

requirement can be met with Tier 2 and higher forms of capital;

# The same transition approach will apply to deductions from Additional Tier 1 and Tier 2capital


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RISK COVERAGE

Modifications have been made to Basel II framework in the area of capital charge for credit

risk including counterparty credit risk, external credit assessments, credit risk mitigation and

capital charge for market risk.

SUPERVISORY REVIEW AND EVALUATION PROCESS (PILLAR 2)

Basel III also contains certain modifications to guidance on Supervisory Review and

Evaluation Process under Pillar 2 of Basel II framework. The modifications relate to use of

external ratings for risk weighting of exposures and improvements in collateral management

by banks in order to address the deficiencies observed in these areas during the financial

crisis.


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CAPITAL CONSERVATION BUFFER

Objective

The capital conservation buffer (CCB) is designed to ensure that banks build up

capital buffers during normal times (i.e. outside periods of stress) which can be drawn down

as losses are incurred during a stressed period. The requirement is based on simple capital

conservation rules designed to avoid breaches of minimum capital requirements.

Outside the period of stress, banks should hold buffers of capital above the regulatoryminimum. When buffers have been drawn down, one way banks should look to rebuild them

is through reducing discretionary distributions of earnings.

The capital conservation buffer can be drawn down only when a bank faces a

systemic or idiosyncratic stress. A bank should not choose in normal times to operate in the

buffer range simply to compete with other banks and win market share. The banks which

draw down their capital conservation buffer during a stressed period should also have a

definite plan to replenish the buffer as part of its Internal Capital Adequacy Assessment

Process and strive to bring the buffer to the desired level within a time limit agreed to with

Reserve Bank of India during the Supervisory Review and Evaluation Process.

The framework of capital conservation buffer will strengthen the ability of banks to

withstand adverse economic environment conditions, will help increase banking sector

resilience both going into a downturn, and provide the mechanism for rebuilding capital

during the early stages of economic recovery. Thus, by retaining a greater proportion of

earnings during a downturn, banks will be able to help ensure that capital remains available to

support the ongoing business operations / lending activities during the period of stress.

Therefore, this framework is expected to help reduce pro-cyclicality.


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The Framework

Banks are required to maintain a capital conservation buffer of 2.5%, comprised of

Common Equity Tier 1 capital, above the regulatory minimum capital requirement of 9%.

Banks should not distribute capital (i.e. pay dividends or bonuses in any form) in case capital

level falls within this range. However, they will be able to conduct business as normal when

their capital levels fall into the conservation range as they experience losses. Therefore, the

constraints imposed are related to the distributions only and are not related to the operations

of banks. The distribution constraints imposed on banks when their capital levels fall into the

range increase as the banks capital levels approach the minimum requirements. The Table

below shows the minimum capital conservation ratios a bank must meet at various levels of

the Common Equity Tier 1 capital ratios.

Minimum capital conservation standards for individual bank

Common Equity Tier 1 Ratio after including

the current periods retained earnings

Minimum Capital Conservation Ratios

(expressed as a %age of earnings)

5.5% - 6.125% 100%

>6.125% - 6.75% 80%

>6.75% - 7.375% 60%

>7.375% - 8.0% 40%

>8.0% 0%


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LEVERAGE RATIO

Rationale and Objective

One of the underlying features of the crisis was the build-up of excessive on- and off-balance

sheet leverage in the banking system. In many cases, banks built up excessive leverage while

still showing strong risk based capital ratios. During the most severe part of the crisis, the

banking sector was forced by the market to reduce its leverage in a manner that amplified

downward pressure on asset prices, further exacerbating the positive feedback loop betweenlosses, declines in bank capital, and contraction in credit availability. Therefore, under Basel

III, a simple, transparent, non-risk based leverage ratio has been introduced. The leverage

ratio is calibrated to act as a credible supplementary measure to the risk based capital

requirements. The leverage ratio is intended to achieve the following objectives:

(a) Constrain the build-up of leverage in the banking sector, helping avoid destabilising

deleveraging processes which can damage the broader financial system and the economy; and

(b) Reinforce the risk based requirements with a simple, non-risk based backstop measure.

Definition and Calculation of the Leverage Ratio

The provisions relating to leverage ratio contained in the Basel III document are

intended to serve as the basis for testing the leverage ratio during the parallel run period. The

Basel Committee will test a minimum Tier 1 leverage ratio of 3% during the parallel runperiod from 1 January 2013 to 1 January 2017.

During the period of parallel run, banks should strive to maintain their existing level

of leverage ratio but, in no case the leverage ratio should fall below 4.5%. A bank whose

leverage ratio is below 4.5% may endeavour to bring it above 4.5% as early as possible. Final

leverage ratio requirement would be prescribed by RBI after the parallel run taking into

account the prescriptions given by the Basel Committee.


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STUDY OF 10 BANKS IN INDIA WITH RESPECT TO BASEL III

GUIDELINES

For the study of Basel III on Indian banks, a few banks were analysed. The 10 banks

that were analysed were selected on basis of their market capitalisation. Among the top 15

banks with respect to market capitalisation 10 banks were selected. All banks were analysed

based on their 2011-2012 annual report data.

The banks that were analysed are:

NameMarket Capitalisation

(Rs. cr.)

HDFC Bank 1,56,115.33

State Bank of India 1,48,267.45

ICICI Bank 1,31,427.17

Axis Bank 65,760.51

Kotak Mahindra 50,337.36

Punjab National Bank 27,631.19

IndusInd Bank 22,799.97

Canara Bank 19,166.40

Bank of India 18,350.17

Yes Bank 17,416.11

The current capital levels and various capital to risk weighted assets ratios were

studied and the capital requirement as per Basel III were computed.
http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/hdfcbank/HDF01http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/hdfcbank/HDF01http://www.moneycontrol.com/india/stockpricequote/bankspublicsector/statebankindia/SBIhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/icicibank/ICI02http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/icicibank/ICI02http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/axisbank/AB16http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/axisbank/AB16http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/kotakmahindrabank/KMBhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/kotakmahindrabank/KMBhttp://www.moneycontrol.com/india/stockpricequote/bankspublicsector/punjabnationalbank/PNB05http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/indusindbank/IIBhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/indusindbank/IIBhttp://www.moneycontrol.com/india/stockpricequote/bankspublicsector/canarabank/CB06http://www.moneycontrol.com/india/stockpricequote/bankspublicsector/canarabank/CB06http://www.moneycontrol.com/india/stockpricequote/bankspublicsector/bankofindia/BOIhttp://www.moneycontrol.com/india/stockpricequote/bankspublicsector/bankofindia/BOIhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/yesbank/YBhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/yesbank/YBhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/yesbank/YBhttp://www.moneycontrol.com/india/stockpricequote/bankspublicsector/bankofindia/BOIhttp://www.moneycontrol.com/india/stockpricequote/bankspublicsector/canarabank/CB06http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/indusindbank/IIBhttp://www.moneycontrol.com/india/stockpricequote/bankspublicsector/punjabnationalbank/PNB05http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/kotakmahindrabank/KMBhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/axisbank/AB16http://www.moneycontrol.com/india/stockpricequote/banksprivatesector/icicibank/ICI02http://www.moneycontrol.com/india/stockpricequote/bankspublicsector/statebankindia/SBIhttp://www.moneycontrol.com/india/stockpricequote/banksprivatesector/hdfcbank/HDF01


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30

HDFC Bank

Current Capital (Rs mill)Total capital Basel II 399664.6

Tier-1 Capital 280674.9


Debt Raised as Capital During the Year 365000

Total Risk Weighted Assets 2418963.2

Cash & Balances with RBI 256752.25

Other Cash or cash equivalents 102535.96

Share Capital 4693.38

Total Reserves 294550.36Statutory Reserve 53092.77

Capital Reserves 2954.68

General Reserves 19402.72

Return on assets % 1.77

Requirements CurrentAs per RBI Under

Basel III

Ratio of Total Capital To RWAs 16.52% 9%

Ratio of Common Equity to RWAs 3.31% 5.50%

Additional Tier 1 Capital - 1.50%

Tier I capital to RWAs 11.60% 7.00%

Tier 2 Capital (within Total Capital) 4.92% 2%

Capital Conservation Buffer comprised of

common equity to RWAs (CCB)None 2.50%

Common Equity Tier 1 ratio plus capitalconservation buffer to RWAs

11.80% 8.0000%

Total Capital + CCB 16.52% 11.50%

Total Capital Requirement @ 9 % under Basel III 221126

Total Core Tier I Capital Requirement @ 5.5 % under Basel III 52899.426


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31

State Bank of India

Current Capital (Rs mill)Total capital Basel II 1522560

Tier-1 Capital 1074110


Debt Raised as Capital During the Year 40016.16

Total Risk Weighted Assets 15959487



Share Capital 6710.4Total Reserves 832801.6

Statutory Reserve 360578.5


General Reserves -


Requirements Current

As per RBI

Under Basel III








Common Equity Tier 1 ratio plus capital

conservation buffer to RWAs10.46% 8.0000%


Total Capital Requirement @ 9 % under Basel III 1003694.4



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32

ICICI Bank

Current Capital (Rs mill)Total capital Basel II 738129.2










General Reserves -



As per RBI Under

Basel III











Total Capital Requirement @ 9 % under Basel III 397340



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Axis Bank

Current Capital (Rs mill)

Total capital Basel II 316449.5












Requirements Current As per RBI UnderBasel III







common equity to RWAs (CCB) None 2.50%







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34

Kotak Mahindra Bank





Debt Raised as Capital During the Year 813.58





Total Reserves 75755.94






As per RBI Under

Basel III














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35

Punjab National Bank













General Reserves -


Requirements Current As per RBI UnderBasel III






Capital Conservation Buffer comprised ofcommon equity to RWAs (CCB)

None 2.50%







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IndusInd Bank
















Basel III






Capital Conservation Buffer comprised ofcommon equity to RWAs (CCB)

None 2.50%







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Canara Bank


Total capital Basel II 290080







Share Capital 4430


Statutory Reserve 59330


General Reserves -


CurrentAs per RBI Under

Basel III














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38

Bank of India













General Reserves -



Basel III














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39

Yes Bank











Statutory Reserve 2440

Capital Reserves 250

General Reserves 11150



Basel III





Tier 2 Capital (within Total Capital) 8% 2%


common equity to RWAs (CCB)

None 2.50%







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40

Analysis

It can be observed that in case of all the above 10 banks though the capital issufficient in terms of quantity but in terms of quality the banks will have to build their capital.

They will have to infuse Total Capital of Rs.2685322.13 million out of which Rs.960672.9327

million will have to be Core Tier 1 Capital / Common equity (i.e. Share Capital + Statutory Reserve+

Capital Reserve + Other Free Reserve)

HDFC Bank, State Bank of India, ICICI Bank, Kotak Mahindra Bank, Axis Bank & Yes

Bank have debt on their books which is classified as capital. Under Basel III loss absorbency

requirements have been levied on the non-equity regulatory capital (such as debt) willincrease its cost. This will make issuing of debt as capital more expensive. Thus overall cost

of capital will increase for banks.

Also as mentioned above all banks have cash with RBI as well as other cash and cash

equivalents in their assets. This coupled with SLR, I feel the banks will be in comfortable

position to withstand liquidity stress.

Also currently RBI has already employed sectoral lending guidelines to prevent

overheating of any particular sector of the economy this mechanism can be continued to

address the counter cyclical buffer.

RBI has also introduced the conversion of Basel II to Basel III in a phased manner

over 5yrs. This will give the above banks enough time to build up their capital to comply with

Basel III norms.

RBI has also issued capital requirements slightly higher than Basel III. This is because

Indian banks have not yet migrated to advanced risk measurement approach and the

additional capital will be like an extra cushion for the banks against stress. Other countries

like Philippines, Singapore, China & South Africa also have set the capital requirements

higher than Basel III to safeguard their banks.

Along with the above measures RBI is also awaiting guidance on the list of D-SIBs

in India. According to me banks like State Bank of India, Bank of Baroda having large assets

under management and a wide network may be classified as D-SIBs. Throughimplementation of Basel III RBI has tried to strengthen the banking system in India.


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41

IMPACT OF BASEL III RATIOS ON INDIAN BANKS

Capital Requirement

The average Tier 1 capital ratio of Indian banks is around 10 per cent with more than

85% of it comprising common equity. The regulatory adjustments will reduce the available

equity capital only marginally. Hence the task of raising capital will not be so onerous for

Indian Banks.

As quoted by RBI Governor D. Subbarao in September Indian banks would require an

additional capital of Rs.5 trillion to meet the new global banking norms. Of the total Rs.5

trillion, equity capital will be Rs.1.75 trillion, while Rs.3.25 trillion will have to come as the

non-equity portion. This capital can be raised through markets and through Government (in

PSBs)

Also under Basel III, the trading book exposures, especially those having credit risk

and resecuritisations exposures in both banking and trading book attract enhanced capital

charges. The CVA for OTC derivatives will also attract additional capital. Since the trading

book and OTC derivative portfolios of Indian banks are very small and they do not have any

exposures to re-securitised instruments, impact of these changes in capital regulation on their

balance sheets is insignificant.

Leverage Ratios

RBI already had Statuary Liquidity Ratio (SLR), as a regulatory mandate. The statutory

liquidity portfolio of Indian banks is constituted only for moderate risk i.e. Market Risk and it

is excluded from leverage ratio. The tier I capital of many Indian banks is comfortable (more

than 8% as per Basel II regulation of Tier I capital) and their derivatives activities are not

very large. So leverage ratio will not be a binding constraint for Indian Banks.


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43

Liquidity Ratio

The major challenge for banks in implementing the liquidity standards is to developthe capability to collect the relevant data accurately and to formulate them for identifying the

stress scenario with accuracy. However positive side for Indian banks, they have a substantial

amount of liquid assets which will enable them to meet requirements of Basel III.

In India, banks are statutorily required to hold minimum reserves of high-quality

liquid assets. Currently, such reserves (statutory liquidity ratio SLR) are required to be

maintained at a minimum of 24 per cent of net demand and time liabilities. Since these

reserves are part of the minimum statutory requirement, the Reserve Bank faces a dilemma

whether and how much of these reserves can be allowed to be reckoned towards the LCR. If

these reserves are not reckoned towards the LCR and banks are to meet the entire LCR with

additional liquid assets, the proportion of liquid assets in total assets of banks will increase

substantially, thereby lowering their income significantly. Thus the Reserve Bank is

examining to what extent the SLR requirements could be reckoned towards the liquidity

requirement under Basel III.

D-SIBs

DSIBs are generally considered too big to fail banks as their failure might have a

devastating cascading effect on the economy. Hence, any bank named as a D-SIB may have

higher capital requirements increasing its cost of capital. But at the same times this increased

capital will prove to be safeguard for it in times of stress and prevent it from facing a liquidity

crisis.


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44

WILL BASEL III AFFECT PROFITABILITY OF BANKS IN INDIA?

Basel III requires higher and better quality capital. The cost of this equity capital is

high. It is also likely that the loss absorbency requirements on the non-equity regulatory

capital will increase its cost. The average Return on Equity (RoE) of the Indian banking

system for the last three years has been approximately 15%. Implementation of Basel III is

expected to result in a decline in Indian banks RoE in the short-term. However, the expected

benefits arising out of a more stable and stronger banking system will largely offset the

negative impact of a lower RoE in the medium to long term. It is also fair to assume that

investors will perceive the benefits of having less risky and more stable banks, and will

therefore be willing to trade in higher returns for lower risks.

Now the point in front of the banks will be to bear the increased cost of capital

themselves or pass it to their depositors and borrowers. This trade-off needs to be assessed in

the context of the relatively higher level of net interest margins (NIMs) of Indian banks, of

approximately 3%. This higher NIM suggests that there is scope for banks to improve their

efficiency, bring down the cost of intermediation and ensure that returns are not overly

compromised even as the cost of capital may increase.

Also shifting from Standard approach to Advanced approach in risk measurement

may also help in improving profitability as total capital required would decrease. As accurate

risk measurement for each asset would enable banks to set aside only the necessary capital

rather than setting aside capital based on ratings.

Thus even though the increased capital requirement will have some impact on

profitability, the banks can reduce the effect on profitability by making their operations more

efficient (reduce NIM margin and also by implementing better risk sensitive capital

management process.

Also though Basel III will affect profitability in the short term, in the long term due to

the risk return profile; implementing Basel III will be viewed positively by investors


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45

WILL BASEL III HURT GROWTH?

Major concern in implementing Basel III is that the higher capital requirements under

Basel III will kick in at a time when credit demand in the economy will be on the rise. In a

structurally transforming economy with rapid upward mobility, credit demand will expand

faster than GDP for several reasons.

i. First, India will shift increasingly from services to manufactures, and the credit

intensity of manufacturing is higher per unit of GDP than that for services.ii. Second, we need to at least double our investment in infrastructure which will place

enormous demands on credit.

iii. Finally, financial inclusion, which both the Government and the Reserve Bank are

driving, will bring millions of low income households into the formal financial system

with almost all of them needing credit.

This means is that higher capital requirements will be imposed on banks as per Basel III

at a time when credit demand is going to expand rapidly. This may mitigate growth. But

empirical research by BIS economists shows that even if Basel III may impose some costs in

the short-term, it will secure medium to long term growth prospects. This helps to ease fears

relating to growth.


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46

CHALLENGES IN IMPLEMENTATION OF BASEL III

Indian banks have already meet the minimum capital requirements of Basel III by a

comfortable margin at an aggregate level (if we do not consider quality of capital), but some

individual banks may have to top up. Still capital adequacy today does not mean capital

adequacy going forward. Currently, the bank credit GDP ratio in India is around 55%. For

growth to accelerate, this ratio will have to go up as one of the necessary pre-conditions.

Besides, as our economy goes through a structural transformation, the share of the industry

sector will increase and the credit-GDP ratio will rise even further. This means is that Indian

banks would have been required to raise additional capital even in the absence of Basel III. In

estimating the net additional burden on account of Basel III, this factor needs to be

considered.

The size of the additional capital required to be raised by Indian banks depends on the

assumptions made, and there are various estimates floating around. The Reserve Bank too has

made some quick estimates based on the following two conservative assumptions covering

the period to March 31, 2018:

i. Risk weighted assets of individual banks will increase by 20 per cent per annum; and

ii. Internal accruals will be of the order of 1% of risk weighted assets.

Based on the above assumptions the Reserve Bank estimates an additional capital

requirement of `5 trillion, of which non-equity capital will be of the order of `3.25 trillion

while equity capital will be of the order of `1.75 trillion. This capital burden will be shared by

the markets and Government as per its discretion (in case of PSBs). Depending on the

amount of capital Government will infuse in the PSBs the market will have to providein the

range of `700 billion`1 trillion.


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47

Additional* Common Equity Requirements of Indian Banks under Basel III

(` billion Rs)

Sr.

No.

Public Sector

Banks

Private

Sector BanksTotal

1Additional Equity Capital

Requirements under Basel III

1400-1500 200-250 1600-1750

2Additional Equity Capital

Requirements under Basel II650-700 20-25 670-725

3Net Equity Capital Requirements

under Basel III {(1)-(2)}750-800 180-225 930-1025

4

Of Additional Equity Capital

Requirements under Basel III for

Public Sector Banks (1)

4.1Government Share (if present

shareholding pattern is maintained)880-910 -

4.2 Government Share (if shareholding isbrought down to 51 per cent)

660-690 -

4.3

Market Share (if the Governments

shareholding pattern is maintained at

present level)

520-590 -

*On top of internal accruals


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49

Also Basel III implementation will also hurt the smaller banks that are likely to be

hurt by the rise in weightage of inter-bank loans that will effectively price them out of the

market. Thus, banks will have to re-structure themselves if they are to survive in the new

environment.

Basel III wishes to promote improved risk management and measurement and to give

impetus to the use of internal rating system by the international banks. Hence, more and more

banks may have to use internal models Basel III wishes to promote improved risk

management and measurement and to give impetus to the use of internal rating system by the

international banks. Hence, more and more banks may have to use internal models developed

in house and their impact is uncertain. Most of these models require minimum historical bank

data that is a tedious and high cost process, as most Indian banks do not have such a database.

The technology infrastructure in terms of computerization is still in a nascent stage in

most Indian banks. Computerization of branches, especially for those banks, which have their

network spread out in far-flung areas, will be a daunting task. Penetration of information

technology in banking has been successful in the urban areas, unlike in the rural areas where

it is insignificant. Experts say that dearth of risk management expertise in the Asia Pacificregion will serve as a hindrance in laying down guidelines for a basic framework for the new

capital accord. An integrated risk management concept, which is the need of the hour to align

market, credit and operational risk, will be difficult due to significant disconnect between

business, risk managers and IT across the organizations in their existing set-up.

Implementation of the Basel III will require huge investments in technology. According to

estimates, Indian banks, especially those with a sizeable branch network, will need to spend

well over $ 50-70 Million on this.

Thus the major challenges in front of the banking system are fulfilling the capital

requirements not just at the present but in the scenario of increasing credit growth. This

challenge will be tougher for the smaller banks as compared to the larger banks. Also other

than the capital the banks would have to invest in technology to be to enjoy the benefits of

risk sensitive capital regulation.


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50

SHOULD BASEL III BE IMPLEMENTED IN INDIA?

Implementation of Basel III will face certain challenges likeneed of investment in

new IT and technology systems, the burden of raising additional capital and the costs of

complying with the new liquidity standards their impact on banks profitability, and on the

overall growth prospects of the economy. Hence, it becomes necessary to see whether its

even necessary for banks to adopt Basel III. Some are of the view that India should adopt

only a diluted version of Basel III, so as to balance the benefits against the putative costs. To

buttress this view, it is argued that Basel III is designed as a corrective for advanced economy

banks which had gone astray, often times taking advantage of regulatory gaps and regulatory

looseness, and that Indian banks which remained sound through the crisis should not be

burdened with the onerous obligations of Basel III.

The Reserve Bank does not agree with this view. Its position is that India should

transit to Basel III because of several reasons. By far the most important reason is that as

India integrates with the rest of the world, as increasingly Indian banks go abroad and foreign

banks come on to our shores, Indian banks cannot afford to have a regulatory deviation from

global standards. Any deviation will hurt us both by way of perception and also in actual

practice. The perceptionof a lower standard regulatory regime will put Indian banks at a

disadvantage in global competition, especially because the implementation of Basel III is

subject to a peer group review whose findings will be in the public domain.

Deviation from Basel III will also hurt us in actual practice. As Basel III provides for

improved risk management systems in banks, it is important that Indian banks have the

cushion afforded by these risk management systems to withstand shocks from external

systems, especially as they deepen their links with the global financial system going forward.

Hence it is desirable for Indian banks to transition from Basel II to Basel III along

with the global banking system.


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51

CONCLUSION

Both internationally and in India bankers have expressed their concerns over the

additional capital requirements under Basel III. It is feared that these additional capital

requirements, leverage ratios would hurt profitability of the bank. But studies have shown

that though the Basel III guidelines would impose short term costs on the banks in the long

term it would strengthen the financial system and make the banks more resilient against

stress. Also investors would appreciate the fact that though the returns have lowered the risk

has also reduced.

In India Basel III would make our banks compliant with global regulations, this would

help the Indian banks who wish to expand overseas. Also through Basel III would strengthen

the financial system. Capital requirements under Basel III may cause some smaller banks to

merge with the larger banks leading to consolidation of banks. In the initial stages Basel III

will require banks to incur expenditure on both capital as well as IT infrastructure for

accurate risk measurement. But adoption of a more risk sensitive approach will increase theprofitability of the banks in the long run. Also as the banks will be perceived to be more

stable and thus less risky the cost of capital will also decrease in future.

Now apart from raising capital the other challenges ahead of the banks are improving

their operational efficiency to decrease their NIM margins. Also reducing their NPA levels in

the current macroeconomic scenario will be a major challenge for the banks.

RBI will start implementation of Basel III from 1st April, 2013, now it is upon the

banks to efficiently restructure their operations so as to not only be Basel III compliant but

enjoy healthy profits in the medium and long run.


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BIBLIOGRAPHY

i. RBI website

ii. Ace Equity database

iii. Annual report of State Bank of India, Yes Bank and Punjab National Bank

iv. Wikipedia

v. KPMG consultancy paper on implication of Basel III

Effect of Basel III on Indian Banks

Documents