Basel III - What It Spells For Indian Banks
Binu / 13 Jun 2012
‘Basel III’ to correct the flawed banking practices that led the 2008 global financial
crisis. The RBI has recently come up with its guidelines on the implementation of
the Basel III capital regulations in India. What do these norms mean for the Indian
banking sector, and how will the individual banks be impacted? Shashikant explains.
The global economy is no stranger
to financial crises. Over the
past 140 years, there have been
no less than 71 systemic banking crises
that have hit 14 countries worldwide.
However, the crisis that began in 2007
with the unfolding of the subprime
mortgage disasters was slightly different,
as the banking sectors in many
countries had built up excessive on
and off-balance sheet leverages. This
was accompanied by a gradual erosion
of the level and quality of the capital
base. Many banks were holding insufficient
liquidity buffers, and the banking
system was not able to absorb the
resultant systemic trading and credit
losses. The crisis was further amplified
by a procyclical deleveraging process
and by the interconnectedness of systemic
institutions through an array of
complex transactions.
Nonetheless, despite the financial
tsunami that the global financial
system was facing, the Indian
banking system remained largely calm.
Among the reasons for this resilience
were some very stringent controls
and the conservative regulatory
approach of the Reserve Bank of
India (RBI).
Continuing with its proactive role
to protect the Indian financial system
from any excesses and to address the
market failures revealed by the crisis,
the RBI has come up with draft guidelines
based on the Basel III norms.
These guidelines spell out a roadmap
for the implementation of the Basel III
norms by Indian banks over CY13 to
FY18. So, what are these new guidelines
and how will they impact the
banking stocks? Is the Indian banking
system well prepared for the proper
implementation of the RBI’s requirements
in order to fulfil the Basel III
norms? Here is an analysis of the questions
at hand.
Impact On The
Indian Banking System
Capital Acquisition
One of the prime reasons why the
global banking system was in a crisis
after the subprime mess came to the
fore was a shortage of adequate and
high quality capital that could have
absorbed the losses emanating from
it. Therefore, it becomes important to
strengthen the equity base of banks so
that any future financials shocks can
be absorbed in better way. Accordingly,
the Basel III norms have proposed
that the Tier I capital of banks be
increased to seven per cent of the total
capital requirement of 10.5 per cent.
The RBI has proposed even more
stringent guidelines than the Basel III
norms, and require Tier I capital to be
increased to eight per cent of the total
capital requirement of 11.5 per cent.
Under the Basel III norms, many
items have been removed from this
category of Tier I capital to ensure
that enough high quality capital is
always available for loss absorption.
Common equity and retained earnings
will be the main components of Tier I
capital. Items like Deferred Tax Assets
(DTA), minority capital and holdings
in other financial institutions have been
dropped from this category of capital,
and banks are to phase out these components
over a period of time. A capital
conservation buffer of 2.5 per cent and
a counter-cyclical capital buffer have
also been introduced.
Although the RBI’s guidelines are
more stringent and seek to achieve
the implementation in an accelerated
time frame, we believe that most banks
are comfortably placed to fulfil the
requirement by FY13 and there will be
no immediate impact on Indian banks,
barring a few public sector banks like
Central Bank, Vijaya Bank and UCO
Bank, among others.
However, from a medium-term perspective,
the Basel III guidelines imply
a significant capital shortage for the
Indian banking system. Different estimates
of additional capital infusion
have been announced by various agencies.
International credit rating agency,
Fitch, estimates this figure to be around
USD 50 billion, while ICRA projects
a figure of around USD 80 billion.
Macquarie Capital Securities predicts
that there will be a USD 35 billion dilution
in the existing capital of PSU banks
subsequent to adoption of the stringent
Basel III capital accord. On an average,
the total capital shortage will be in the
range of 14-27 per cent of the sector’s
current net worth, and this entails additional
equity requirement of 2.5-4.5
per cent for the next six years. What is
important to note is that almost 75-80
per cent of such shortage will be in the
public sector banks, and the rest will be
with private sector banks.
Profitability
With the implementation of the
Basel III norms, the capital of many
banks will reduce by around 60 per
cent because of a phased removal of
certain components being considered
to be part of the Tier I capital. In addition,
the risk weightings are expected to
grow by nearly 200 per cent. The twin
impact of these two stipulations will
greatly reduce the Return on Equity
(ROE) and profitability of banks. The
proposed shift from short-term liquidity
to long-term liquidity will increase
the cost of funds for the banking system,
and this will further squeeze their
profit margins.
ROE is defined as the product of
Return on Assets (ROA) and the leverage
multiplier. As an upper limit of
three per cent has been set for the leverage
ratio, the value of the leverage multiplier
will come down, thus resulting
in a reduction in the ROE. This problem
is more acute for Indian banks, as
they are already required to maintain
around 24.5 per cent of their capital as
a part of the SLR and 4.5 per cent as a
part of the CRR requirements.
Liquidity Needs
One of the basic tenets of prudent
banking is to borrow long and lend
short. There must be a match between
the duration of liabilities and that of
assets, which are at the heart of assetliability
management. Prior to the
financial crisis, banks exhibited a grave
mismatch in their assets and liabilities.
Long duration assets were acquired
with short duration funding.
The liquidity profiles of banks were
not factored into the Basel I and II
frameworks, but are accounted for by
Basel III. Short term liquidity coverage
for 30 days has been recommended
by the Basel Committee. Under this
norm, high quality liquid assets are
compared to the expected cash outflows
over a period of 30 days. Cash
outflows need to be met with adequate
liquid assets. This ratio is termed as the
Liquidity Coverage Ratio (LCR).
Another factor introduced is the Net
Stable Funding Ratio (NSFR). This
ratio is intended to reduce the dependence
of banks on short-term wholesale
funding and increase their dependence
on long-term funding. This will help
the smaller banks, as currently, long
term sources of funding are more easily
available for the larger banks as compared
to the smaller outfits.
The NSFR is likely to be implemented
from 2019. But since the LCR
is to be implemented from 2015, banks
may need to maintain additional liquidity
since the LCR requirement is more
stringent. Some assumptions on the
rollover rates and the required liquidity
for committed lines may also be
more stringent. However, considering
the period of 30 days and the fact that
most Indian banks have upgraded their
technology platforms, the transition to
LCR may not be a very difficult one.
Industry Consolidation
The Basel III norms may set into
motion a churning process in the
banking industry as a whole. A process
of consolidation is already underway,
as smaller banks will find it difficult
to meet the latest guidelines. They will
find it difficult to raise more capital
and meet the liquidity requirements as
suggested in the Basel III norms, which
will result in a reduction in the scope
of operations, possibly rendering them
less profitable. It is expected that there
will be a process of consolidation in
the Indian banking industry through
mergers and acquisitions, which will
culminate in the larger banks acquiring
the smaller ones.
Stability In The Banking System
The Basel III norms incorporate
both micro and macro prudential regulations.
Micro prudential guidelines ensure the viability and risk compliance
of individual banks, while macro prudential
guidelines target the stability of
the banking system as a whole. This is
a major departure from the earlier two
rounds of the norms. Basel I and II
concentrated on the capital frameworks
of individual banks, with the idea that
the regulation of the parts would regulate
the whole. However, the subprime
crisis revealed inadequacies in this
approach, as weaker banks can plunge
the entire system into a tailspin.
Further to the approach of integrating
micro regulation with macro regulation,
Basel III identifies Systemically
Important Financial Institutions (SIFIs)
whose functioning is critical to the
health of the entire banking system.
Therefore, it is opined that the new
regime of prudential regulations will
result in greater stability of the banking
industry in various countries. Controls
on the capital, liquidity and leveraging
of banks will ensure that banks have the
ability to withstand crises. We believe
that the implementation of the Basel
III norms will strengthen the overall
banking system and will help it tide
over any future financial storms in
much better way.
However, from an investment point
of view, the norms will negatively impact
the banks that are trading at an adjusted
price-to-book value of lower than 1, as
capital raising would lead to dilution in
the EPS and the book value (see table:
How The PSBs Are Placed). The problem
will be more acute in the case of public
sector banks in which the Government
of India is the largest shareholder.
On account of their adverse fiscal position,
capital raising activity could be
delayed. These fears have already been
proved right in the case of SBI, where
the government took over a year to
share its capital. This might slow down
the credit growth of these banks.
Overall though, it may be concluded
that under the new Basel III guidelines,
a strong private sector banking
space is likely to emerge in next few
years, which would be better placed to
provide good returns to investors.
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