Economist Report : BASEL III- IMPLEMENTATION & CHALLENGES

 OVERVIEW

The third Basel accord is an international regulatory framework governing capital adequacy norms, stress testing and other liquidity related risks for banks around the world. It should be noted that adopting the framework is voluntary. The measures prescribed under the framework serve as a minimum standard for central banks around the globe to adopt in their home countries. The purpose of Basel-III was to strengthen the banking system and address the relevant risk factors in the wake of the 2007-08 financial crisis.

The second Basel accord had apparently lacked in the following respects-

·         Insufficient capital reserves

·         Lack of a uniform definition of capital

·         Underestimation of liquidity risk

The third accord attempts to overcome the above shortcomings as well as better address counterparty credit risk.

Basel-III was agreed upon by the members of the Basel Committee on Banking Supervision (BCBS), one of the committees of the Bank for International Settlements (BIS). BIS is of the nature of a limited international company owned by member central banks (including Reserve Bank of India). BIS is located in Basel, Switzerland. One of the purposes of BIS is to foster discussion and collaboration among central banks and serving as a banker to the central banks.

Apart from India, other members include China, South Africa, European Union, France, Germany, United States et al.

The full implementation of Basel-III is set to be completed by 31^st March, 2019.

The third Basel accord can be seen as addressing the following requirements-

·         Strengthening the global capital framework (ensuring minimum capital requirements and buffers)

·        Introduction of a global liquidity standard ( LCR-Liquidity Coverage Ratio, NSFR- Net Stable Funding Ratio)

Figure 1: The Three Pillars of BASEL III

As can be seen from the above diagram, the capital framework is based upon three pillars which include the following-

·         The Common Equity Tier 1 capital (CET 1), which includes share capital and retained earnings but excludes goodwill and deferred tax assets should be at least 4.5% of Risk Weighted Assets (RWA). If one takes into account additional tier 1 capital (which includes non-cumulative preference shares), then the total should be at least 6% of RWA at all times.

If one takes into account tier 2 capital, then the total of Tier1, Additional Tier1 and Tier2 should be at least 8% of RWA at all times. If a loss suffered by a bank is entirely absorbed by Tier1 capital, then the bank is said to be a going concern but if the spill over extends to Tier2 capital, then the bank is called a gone concern.

·         In addition to the above, we have the capital conservation buffer as well as the countercyclical buffer, the requirements of which have to be met from Tier1 capital itself. The capital conservation buffer is necessary (at 2.5% of RWA) while the latter is discretionary in nature.

RWA is essentially a bank’s exposure to different assets (such as corporate or retail loans) weighted by a risk factor. The computation is based on a number of parameters that include inter alia Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD).

There are different approaches that can be used to compute the above parameters such as STA (Standardized Approach), F-IRB (Foundation Internal Rating Based approach) and A-IRB (Advanced Internal Rating Based approach). Under the former banks are free to compute only PD and the latter allows greater freedom in terms of computing other parameters as well.

Large banks, which have the capacity would likely prefer the latter approach which could result in lower capital requirements.

·         In the case of certain securitizations, banks would be required to carry out a more rigorous credit analysis. In dealing with derivatives banks would be incentivized to central counterparties.

·         The second pillar would require the financial institution address firm wide governance issues relating to better incentive and compensation practices, corporate governance and accounting standards. The third pillar would require enhanced disclosure from the banks.

·         The liquidity aspect of the third Basel accord primarily deals with Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The former shall require banks to have adequate High Quality Liquid Assets to withstand a thirty day stressed funding scenario. The latter is to ensure that banks have stable sources of funding.

In the Indian context, HQLA would include the following (but not limited to)-

·         Cash reserves in excess of required CRR

·         Government securities in excess of the minimum SLR requirement

In the case of systemically important financial institutions, the minimum requirements may be altered to reflect their greater exposure to the system at large. Recently the Reserve Bank of India designated State Bank of India (SBI) and ICICI Bank Limited as Domestic Systemically Important Banks (D-SIBs). This shall increase their CET1 by 0.6% and 0.2% respectively.

 

CURRENT SCENARIO

In India Basel-III shall be fully implemented by March 31, 2019. As per Crisil, the state run banks shall require a total of ₹4.7 lakh crore during 2013-19 for Basel-III. The detailed break-up of the same is as follows-

Table 1: Estimated Capital Requirements

Core Equity Tier 1	₹1.3 Lakh Crore
Additional Tier 1	₹1.4 Lakh Crore
Tier 2 Capital	₹2.0 Lakh Crore
Total	₹4.7 Lakh Crore

The new capital requirements as proposed under the accord would require domestic banks to either generate the funds internally or externally. The Public Sector Banks (PSBs) in India have primarily resorted to budgetary support for the same. In terms of fulfilling the minimum capital adequacy of 10.5% of RWA, private banks are better placed than their public sector counterparts. The top three banks in this regard are ICICI, AXIS Bank and HDFC.

As per a recent plan introduced by the government to revamp PSBs-Indradhanush-₹20,000 crore shall be infused in public sector banks this by the end of this month. The following table gives a detailed break-up of the same follows-

Table 2: Equity Infusion in PSBs

BANK	₹ Crore
SBI	5,531
Bank of India	2,455
IDBI	2,229
Indian Overseas Bank	2,009
Bank of Baroda	1,786
PNB	1,732
Union Bank of India	1,080
Canara Bank	947
Corporation Bank	857
Dena Bank	407
Bank of Maharashtra	394
Andhra Bank	378
Allahabad Bank	283

The government would be infusing a total of ₹70,000 crore over the next four years in a phased manner. As per the government the PSU banks shall require ₹1.8 lakh crore in this period of which ₹1.1 lakh crore would have to be raised by banks themselves.

The above estimate of ₹1.8 lakh crore is based on an assumption of 12-15 per cent of credit growth in the next four years.

Although the capital infusion comes at the right time, there are still concerns in the area of asset quality deterioration (in particular NPAs). Also banks could face difficulty in raising additional capital due to low equity valuations. Going further there could be a consolidation in this sector with weaker banks merging or being taken over by larger ones. Alongside the fiscal issues we also have the management issues with regards to state owned banks. The government in the month of August brought in talent from the private sector to head Canara Bank and Bank of Baroda.

The RBI also released draft guidelines on the implementation of Net Stable Funding Ratio (NSFR) in the country. NSFR is the quantum of available stable funding as a ratio of the Required Stable Funding (RSF). The ratio has to be maintained at a minimum of 100 per cent on an on-going basis.

As mentioned earlier, RWAs are used to determine the amount of capital reserves for the bank. Under the Standardized Approach, credit ratings were used to determine various parameters for computation of RWA. However reliance on credit ratings could be reduced and a set of risk drivers like NPAs may be used to determine risk weights.

The implementation of IFRS 9 could also have a significant impact on how banks account for credit losses, which could add volatility to earnings (according to Fitch Ratings).

As per the latest Basel norms, the leverage ratio has been capped at 3%. The leverage ratio as defined by BIS is-

Although a reduction in the leverage ratio could be beneficial from a macro point of view, it could hurt a bank’s profitability. The return on equity is ultimately a product of return on assets (ROA) and the leverage ratio. Having a restraint on the leverage ratio would force banks to have a healthier Net Interest Margin which in turn could drive up the borrowing costs for the bank’s clients.

Higher lending rates could drive down demand from consumers, thus leading to a vicious cycle in the long term. Higher lending rates by banks could pose a problem for the Reserve Bank, which is pushing for a lower interest rate regime.

CONCLUSION

Going forward, a regime of low interest rates may increase credit offtake in the system, but accordingly increased provisioning and capital adequacy would be required by the banks in this regard. Increased efficiency can help in this regard along with an improvement in credit underwriting and recovery.

REFERENCES

1.      http://www.bis.org/publ/bcbs270.pdf

2.      http://www.bis.org/bcbs/basel3.htm

3.     http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf 

      http://www.business-standard.com/article/finance/govt-launches-mission-indradhanush-to-revamp-psu-banks-115081401145_1.html

5.      http://www.dnaindia.com/money/report-centre-to-put-rs-70000-crore-as-capital-infusion-in-public-sector-banks-in-next-4-years-2109801

About the Author

This report has been prepared by Tarun Vasnani , Member of the Economist Team of eRT CAPITAL. p He is currently pursuing his MBA from Institute of Management, Nirma University located in Ahmedabad, India.

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