Basel III on the way— it’s advantage India

In spite of the preventive safeguards of Basel II, the world banking system went into a tailspin during the early 2008 ushering in a financial crisis that shook the world economy. This led to some quick rethinking on the part of the Basel Committee on Banking Supervision (BCBS) over the need to come out with a broadened framework of tighter standards under Basel III to restrict the banks from indulging in unhealthy and imprudent practices which could have great cascading effects on the economies around.

The balance sheet of Lehman Brothers whose fall was the precursor of the meltdown, attracted the following comment: “Whatever was on the left-hand side (liabilities) was not right and whatever was on the right-hand side (assets) was not left.” It was reported that the assets of Lehman Brothers were worth only a fraction of their book value and they had little capital to tap into to pay their creditors. The comment in simple terms illustrates the rot that crept into the financial sector as a result of factors like loose lending standards, poorly underwritten subprime mortgages, shadow financing, unbridled speculation, gross asset-liability mismatches and inadequate liquidity buffers. With little owned funds left with and liquidity dried off, the banks went begging with their hats on hand to the taxpayer to bail them out. That was the scene we saw in 2008 when the financial sector in the western world went berserk. 

With the solemn aim never to see the repeat of the 2008 Crisis, the BCBS, through Basel III, put forward norms aimed at strengthening both sides of balance sheets of banks viz. a)  enhancing the quantum of common equity b) improving the quality of capital base b) creation of capital buffers to absorb shocks c) improving liquidity of assets c) optimising the leverage through Leverage Ratio d) creating more space for banking supervision by regulators under Pillar II and e) bringing further transparency and market discipline under Pillar III. Needless to stress, banks whose balance sheets can absorb the losses with resilience, will stand in the face of a financial Tsunami.

Now it is timely to take a brief look into the impact that Basel III can have on Indian banking system as the norms will kick-start in a phased manner from January 1, 2013.

Capital adequacy: For Indian banks, it’s easier to make the transition to a stricter capital requirement regime than some of their international counterparts since the regulatory norms set by RBI on capital adequacy are already more stringent.  Besides, most Indian banks have historically maintained their core and overall capital well in excess of the regulatory minimum. According to a CRISIL estimate, the average equity capital ratio and overall capital adequacy ratio of rated banks in India stand well above 9% and 14%, respectively. As for Federal Bank, its tier 1 capital is 15.86% and its capital adequacy stands at 16.64% as on March 31, 2012, significantly higher than the stipulated norms.

Cost of lending:  Stricter capital requirements with changes in the structure of tier 1 and tier 2 capital generally result in lower return on equity (ROE). On the flip side, as capital costs increase, loans tend to be expensive. In order to offset this, banks would have to take the route of reducing deposit interest and go in for new non-interest income streams. Yet, Basel III carries the message that Indian banks will have to start finding ways to preserve capital and use it more productively as minimum capital requirements will have to be met by March 31, 2017.

Leverage: RBI has set the leverage ratio at 4.5% (3% under Basel III).The ratio is introduced by Basel 3 to regulate banks having huge trading book and off balance sheet derivative positions. In India, however, in most of our banks, the derivative activities are not very large so as to arrange enhanced cover for counterparty credit risk. Hence, the pressure on banks should be moderate. 

Liquidity norms: Indian banks conform to two liquidity buffers already: the statutory liquidity ratio (SLR) – a mandatory 24% of a bank’s net demand and time liabilities – and cash reserve ratio (CRR) of 4.75%. The SLR is mainly government securities while the CRR is mainly cash. The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold enough unencumbered liquid assets to cover expected net outflows during a 30-day stress period. In India, the burden from LCR stipulation will depend on how much of CRR and SLR can be offset against LCR. Here too, Indian banks are better placed over their overseas counterparts.

Countercyclical buffer: Economic activity moves in cycles and banking system is inherently pro-cyclic. During upswings, carried away by the boom, banks end up in excessive lending and unchecked risk build-up, which carry the seeds of a disastrous downturn. The regulation to create additional capital buffers to lend further would act as a break on unbridled bank-lending. This check will counter or smoothen wild swings in business cycles. India has witnessed moderate cycles. Yet, for countercyclical measures to be effective, our banking system has to improve its capability to sense and predict the business cycle at sectoral and systemic levels and to use tools like ‘Credit to GDP ratio’ to calibrate the level of countercyclical buffer.

All said and done, viewed from a higher perspective, factors like the quality of governance of banks, the standard of regulatory control by the apex bank and the level of public confidence banks enjoy in combination with their adherence to Basel III standards will determine the standing of Indian banking system on the world scene.
The writer is executive director, Federal Bank.