Basel III implementation: A new challenge for Indian banks
Some of the major causes of the global financial crisis were: too much leverage, too little capital, and inadequate liquidity buffers. Other factors also responsible for this crisis were: shortcomings in risk management, corporate governance, market transparency and quality of supervision. These have pinpointed the systemic loopholes in the Basel II framework, which was considered a more risk-sensitive approach compared to its earlier version, Basel I.
Thus, Basel III was designed to address the weaknesses of the past crisis and to make the banking sector much stronger and efficient enough to face any crisis. The major thrust area of Basel III is improvement of quantity and quality of capital of banks, with stronger supervision, risk management and disclosure standards.
Impact on Banks
The new norms will definitely address the systemic loopholes in Basel II, but it will have some impact on banks. These are:
Higher Capital Requirement: Presently, in India, most banks' common equity ratio falls in the range of about 6-10 per cent. Hence, in my opinion, banks may able to comply with the higher capital requirement as per Basel III norms at least till 2014/15. This, without infusing any fresh equity, even while taking into account the marginal increase in capital requirement.
However, the increase in the minimum capital ratio, combined with loan growth outpacing internal capital generation in most government banks, will lead to a shortfall of capital. This will mount mainly between 2015/16 and 2017/18 due to introduction of a Capital Conservation Buffer (CCB). The CCB is designed to ensure that banks build up capital buffers during normal times, which can be drawn down as losses are incurred during a stressed period. The requirement of capital will be less to large private sector banks due to their higher capital ratios and stronger profitability. However, some public sector banks are likely to fall short of the revised core capital adequacy requirement and would therefore depend on government support to augment their core capital. The additional equity capital requirements in the public sector banks, mainly due to Basel III norms in the next five years, work out to around Rs 1,400-1,500 billion.
If the government holds the existing shareholding, the recapitalisation burden borne by it will be to the extent of around Rs 900-1,000 billion. This will contribute to additional government borrowing to the extent of Rs 1,000 billion. As per the analysis, on account of this extra government borrowing, the country's fiscal deficit is expected to increase further, by about 25 basis points per annum. This will widen the fiscal deficit, inflation, lower economic growth, credit offtake and thereby bank profitability.
Pressure on Return on Equity: To meet the new norms, apart from government support a significant number of banks have to raise capital from the market. This will push the interest rate up, and in turn, cost of capital will rise while return on equity (RoE) will come down. To compensate the RoE loss, banks may increase their lending rates. However, this will adversely affect the effective demand for loan and, thereby, interest income. Further, with effective cost of capital rising, the relative immobility displayed by Indian banks with respect to raising fresh capital is also likely to directly affect credit offtake in the long run. All these affect the profitability of banks.
Pressure on Yield on Assets: On account of higher deployment of funds in liquid assets that give comparatively lower returns, banks' yield on assets, and thereby their profit margins, may be under pressure. Further higher deployment of more funds in liquid assets may crowd out good private sector investments and also affect economic growth.
Action Required from Banks
To address these issues and to protect their profitability margins, banks need to look beyond regulatory compliance and take proactive actions - assessing their lines of business, level of risk profiles, economising capital and drawing up funding strategies.
In this regard the following strategies need to be adopted:
Change in Business Mix: Since retail banking has a comparatively lower risk weight compared to corporate banking (except in the case of clients who are A rated and above), the impact on higher allocation of capital will be less on retail banking. Further, in corporate banking, as chances of a default in short-term loans is less, on an average, compared to chances of a default in long-term loans, banks need to shift towards short-term/retail loans. And to take a granular approach to protect their margins under the new Basel III norms.
Change in Customer Mix: Banks need to review their capital allocation to each client segment and price it in line with the profile to ensure that capital is allocated to segments that generate higher risk-adjusted returns.
Low-Cost Funding: One of the most important factors to meet the new regulations is to have a stable low-cost deposit base. For this, banks need to focus more on having business correspondents/facilitators to reach customers as adding branches will increase costs and have an impact on the profit margin.
Improvement in systems and procedures: Refining the rating model/data cleaning/ modernisation of systems and procedures may help banks economise their risk-weighted assets, which will help reduce capital requirements to some extent.
Conclusions
It is more relevant at an economy's macro level to address issues such as systemic risk, market discipline, liquidity and transparency in the risk-management framework. It is interesting to note that though risk capital may be the necessary safety cushion for banks, capital alone may not be sufficient to protect them from any extreme unexpected loss events. In reality, risk capital will remain only a number and may not be effective if banks do not assess their risk periodically and take timely corrective action when the risk exceeds the threshold limit. Thus, whether it is Basel II or Basel III, it is crucial that a bank does not depend solely on "regulatory capital". What is needed is a dynamic risk mitigation strategy, where all employees act as risk managers in their own area. A proper risk culture needs to be developed across the organisation and " risk" should be an input for future business decision-making. Risk management should not merely be an activity to comply with regulatory requirements.
(Subhasish Roy is deputy general manager, Risk Dept, IDBI Bank, and the views expressed in this column are personal)
Thus, Basel III was designed to address the weaknesses of the past crisis and to make the banking sector much stronger and efficient enough to face any crisis. The major thrust area of Basel III is improvement of quantity and quality of capital of banks, with stronger supervision, risk management and disclosure standards.
Impact on Banks
The new norms will definitely address the systemic loopholes in Basel II, but it will have some impact on banks. These are:
Higher Capital Requirement: Presently, in India, most banks' common equity ratio falls in the range of about 6-10 per cent. Hence, in my opinion, banks may able to comply with the higher capital requirement as per Basel III norms at least till 2014/15. This, without infusing any fresh equity, even while taking into account the marginal increase in capital requirement.
However, the increase in the minimum capital ratio, combined with loan growth outpacing internal capital generation in most government banks, will lead to a shortfall of capital. This will mount mainly between 2015/16 and 2017/18 due to introduction of a Capital Conservation Buffer (CCB). The CCB is designed to ensure that banks build up capital buffers during normal times, which can be drawn down as losses are incurred during a stressed period. The requirement of capital will be less to large private sector banks due to their higher capital ratios and stronger profitability. However, some public sector banks are likely to fall short of the revised core capital adequacy requirement and would therefore depend on government support to augment their core capital. The additional equity capital requirements in the public sector banks, mainly due to Basel III norms in the next five years, work out to around Rs 1,400-1,500 billion.
If the government holds the existing shareholding, the recapitalisation burden borne by it will be to the extent of around Rs 900-1,000 billion. This will contribute to additional government borrowing to the extent of Rs 1,000 billion. As per the analysis, on account of this extra government borrowing, the country's fiscal deficit is expected to increase further, by about 25 basis points per annum. This will widen the fiscal deficit, inflation, lower economic growth, credit offtake and thereby bank profitability.
Pressure on Return on Equity: To meet the new norms, apart from government support a significant number of banks have to raise capital from the market. This will push the interest rate up, and in turn, cost of capital will rise while return on equity (RoE) will come down. To compensate the RoE loss, banks may increase their lending rates. However, this will adversely affect the effective demand for loan and, thereby, interest income. Further, with effective cost of capital rising, the relative immobility displayed by Indian banks with respect to raising fresh capital is also likely to directly affect credit offtake in the long run. All these affect the profitability of banks.
Pressure on Yield on Assets: On account of higher deployment of funds in liquid assets that give comparatively lower returns, banks' yield on assets, and thereby their profit margins, may be under pressure. Further higher deployment of more funds in liquid assets may crowd out good private sector investments and also affect economic growth.
Action Required from Banks
To address these issues and to protect their profitability margins, banks need to look beyond regulatory compliance and take proactive actions - assessing their lines of business, level of risk profiles, economising capital and drawing up funding strategies.
In this regard the following strategies need to be adopted:
Change in Business Mix: Since retail banking has a comparatively lower risk weight compared to corporate banking (except in the case of clients who are A rated and above), the impact on higher allocation of capital will be less on retail banking. Further, in corporate banking, as chances of a default in short-term loans is less, on an average, compared to chances of a default in long-term loans, banks need to shift towards short-term/retail loans. And to take a granular approach to protect their margins under the new Basel III norms.
Change in Customer Mix: Banks need to review their capital allocation to each client segment and price it in line with the profile to ensure that capital is allocated to segments that generate higher risk-adjusted returns.
Low-Cost Funding: One of the most important factors to meet the new regulations is to have a stable low-cost deposit base. For this, banks need to focus more on having business correspondents/facilitators to reach customers as adding branches will increase costs and have an impact on the profit margin.
Improvement in systems and procedures: Refining the rating model/data cleaning/ modernisation of systems and procedures may help banks economise their risk-weighted assets, which will help reduce capital requirements to some extent.
Conclusions
It is more relevant at an economy's macro level to address issues such as systemic risk, market discipline, liquidity and transparency in the risk-management framework. It is interesting to note that though risk capital may be the necessary safety cushion for banks, capital alone may not be sufficient to protect them from any extreme unexpected loss events. In reality, risk capital will remain only a number and may not be effective if banks do not assess their risk periodically and take timely corrective action when the risk exceeds the threshold limit. Thus, whether it is Basel II or Basel III, it is crucial that a bank does not depend solely on "regulatory capital". What is needed is a dynamic risk mitigation strategy, where all employees act as risk managers in their own area. A proper risk culture needs to be developed across the organisation and " risk" should be an input for future business decision-making. Risk management should not merely be an activity to comply with regulatory requirements.
(Subhasish Roy is deputy general manager, Risk Dept, IDBI Bank, and the views expressed in this column are personal)
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