Basel III - What It Spells For Indian Banks

The Basel Committee on Banking Supervision issued a comprehensive reforms package ‘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.

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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).

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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.

(With inputs from Prof. S. Srinivasan, IFIM Business School)