BASEL III Norms : The Road Ahead.

What are Basel Accords?

The Basel Accords refer to the banking supervision Accords Basel I, Basel II and Basel III issued by the Basel Committee on Banking Supervision (BCBS). The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1974. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Committee also frames guidelines and standards in different areas - some of the better known among them are the international standards on capital adequacy, the Core Principles for Effective Banking Supervision and the Concordat on cross-border banking supervision.

What were the previous Accords?

The first of the accords was BASEL-I, introduced in 1988. It specified some minimum capital requirements for banks to maintain. It mainly focused on credit risk. Basel II is the second of the Basel Accords. Initially published in June 2004, it was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

Why BASEL-III?
BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11. This, the third of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. For instance, the change in the calculation of loan risk in Basel II which some consider a causal factor in the credit bubble prior to the 2007-8 collapse: in Basel II one of the principal factors of financial risk management was out-sourced to companies that were not subject to supervision: credit

rating agencies. Ratings of creditworthiness and of bonds, financial bundles and various other financial instruments were conducted without supervision by official agencies, leading to AAA ratings on mortgage-backed securities, credit default swaps and other instruments that proved in practice to be extremely bad credit risks. In Basel III a more formal scenario analysis is applied. We will go into the details in the later part of the article. What are the changes under BASEL III? The key elements of the proposed Basel III guidelines include the following: Definition of capital made more stringent, Loss absorptive capacity of Tier 1 and Tier 2 Capital instruments of internationally active banks proposed to be enhanced The Accord states that it is critical that banks risk exposures are backed by a high quality capital base. The 2008 financial crisis demonstrated that credit losses and write downs come out of retained earnings, which is part of banks tangible common equity base. It also revealed the inconsistency in the definition of capital across jurisdictions and the lack of disclosure that would have enabled the market to fully assess and compare the quality of capital between institutions. To help this, major portion of the Tier-I capital must be common shares and retained earnings, as can be seen in the table given below. The remainder of the Tier 1 capital base must be comprised of instruments that are subordinated, have fully discretionary noncumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. Hence, the hybrid instruments will be phased out. Introduction of Capital Buffers - The Committee is introducing a framework to promote the conservation of capital and the build-up of adequate buffers above the minimum that can be drawn down in periods of stress. It is introducing a framework that will give supervisors stronger tools to promote capital conservation in the banking sector. Implementation of the framework through internationally agreed capital conservation standards will help increase sector resilience going into a downturn and will provide the mechanism for rebuilding capital during the economic recovery. The Capital conservation buffer: It is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. The Minimum requirements have been provided in the Table below. The Countercyclical Buffer: Losses incurred in the banking sector can be extremely large when a downturn is preceded by a period of excess credit growth. These losses can destabilise the banking sector and spark a vicious circle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses.

New parameter of leverage ratio introduced - One of the underlying features of the crisis was the build up of excessive on- and off-balance sheet leverage in the banking system. The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Constrain leverage in the banking sector, thus helping to mitigate the risk of the destabilising deleveraging processes which can damage the financial system and the economy; and Introduce additional safeguards against model risk and measurement error by Supplementing the risk-based measure with a simple, transparent, independent measure of risk. Forward looking provisioning prescribed - The Committee is promoting stronger provisioning practices through three related initiatives. First, it is advocating a change in the accounting standards towards an expected loss (EL) approach. The goal is to improve the usefulness and relevance of financial reporting for stakeholders, including prudential regulators. EL approach captures actual losses more transparently and is also less pro
cyclical than the current incurred loss approach.

3. Modifications made in counterparty credit risk weights

Global liquidity standard prescribed - A strong liquidity base reinforced through robust supervisory standards is of high importance. The Basel Committee is therefore introducing internationally harmonised global liquidity standards. As with the global capital standards, the liquidity standards will establish minimum requirements and will promote an international level playing field to help prevent a competitive race to the bottom. Two ratios have been introduced for this purpose: Liquidity Coverage Ratio: This standard aims to ensure that a bank maintains an adequate level of unencumbered, high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30 calendar day time horizon under a significantly severe liquidity stress scenario specified by supervisors. At a minimum, the stock of liquid assets should enable the bank to survive until Day 30 of the stress scenario, by which time it is assumed that appropriate corrective actions can be taken by management and/or supervisors, and/or the bank can be resolved in an orderly way.
Stock of high-quality liquid assets Total net cash outflows over the next 30 calendar days

>= 100%

The total net cash outflows for the scenario are to be calculated for 30 calendar days into the future. The standard requires that the value of the ratio be no lower than 100% (ie the stock of high-quality liquid assets should at least equal total net cash outflows). Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high-quality liquid assets as a defence against the potential onset of severe liquidity stress

Net Stable funding Ratio: To promote more medium and long-term funding of the assets and
activities of banking organisations, the Committee has developed the Net Stable Funding Ratio

(NSFR). In particular, the NSFR standard is structured to ensure that long term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles. The NSFR aims to limit over-reliance on short-term wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on- and off-balance sheet items.
Available amount of stable funding > 100% Required amount of stable funding

Stable funding is defined as the portion of those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.

The minimum capital requirements under BASEL-III are:

Capital Type Core Tier - I Additional Tier - I Minimum Tier-I capital Tier - 2 Capital MinimumTotal capital Capital conservation buffer Minimum Total including CCB BASEL-II 2% 2% 4% 4% 8% 0 8% BASEL-III 4.50% 1.50% 6% 2% 8% 2% 10%

What are RBIs BASEL-III norms for Indian banks? The Reserve Bank of India has increased the capital that banks need to maintain to 11.5% of risk weighted assets from 9% currently and said that bulk of Tier-I capital must be common equity. Banks will have to reach the 11.5% capital level in phases over a period of six years. Minimum total capital to be maintained by banks will remain 9% for 2012-13 and 20132014. Banks will have to maintain total capital of 9.62% as on March 31, 2015, increase it to 10.25% as on March 31, 2016, to 10.87% as on March 31, 2017 and finally to 11.50% as on March 31 of 2018. In the final phase, of the minimum capital of 11.5%, 2.5% will be in the form of counter-cyclical buffer capital. The central bank has prescribed a Tier-I capital of 8% of risk weighted assets, entirely out of common equity. The central bank said that banks cannot issue additional Tier-I capital to retail investors. The Leverage ratio shall be maintained at a minimum of 4.5% of the risk weighted assets. What is the Impact on Indian banks and on the economy? The 2012-13 budget has allotted 15888 crore rupees towards recapitalization of public sector banks. This is tax payers hard earned money being used by the government. And this is not the first time, ever since India accepted BASEL norms, the finance ministers have been

providing money for this purpose. But, the amount set aside this fiscal is more than double of what was done last year. It is 25 times the amount allotted for the ministry of statistics and programme implementation. No wonder the IIP and other indicators are so appalling. The amount allocated to MNREGA scheme is around 33000 crore and that for the revenue expenditure is around 35000 crore. It means that bank capitalisation quota is half of these utmost importance areas of investment. Amazingly, this money is just a paltry amount when we compare it to the amount needed by the banks to ensure conformity with RBIs BASEL-III norms. Indian banks might need around 1.5-2 trillion rupees of common equity capital in the next 5-6 years to achieve the target. All this money could instead go towards : strengthening our badly-stretched police force and our court infrastructure to make the justice delivery system work better, improve our primary health care and primary education systems, beef up our statistical machinery, improve infrastructure and storage facilities, etc. Lets see why Indian Banks need capital in the first place. With the new norms, Indian banks need to maintain a capital adequacy ratio of 9%, which includes core tier I capital of 5.5%, noncore- tier- I of 2.5% and tier-II capital of 2%. This means that a bank has a limit to its credit giving facility at around 22 times its its Tier-I capital(equity + reserves). On expiration of which, new equity needs to be raised to give fresh loans. Other options could be of retaining profits, which would mean lower dividends for the government, which will never be an option!!!. In a developing country, funds are required in plenty for future growth, and hence the need for capital infusion. Consider. In 2010-11, the government set aside . 20,157 crore to help banks maintain their tier-I capital at 8% and increase government equity in some banks to 58%. In 2009-10, the amount was less . 6,000 crore but over the five-year period to 2012-13, the government would have spent over . 45,000 crore on recapitalisation of banks. Is this the best use of money for a cash-strapped government?

Source : Economic Times Does it make sense for government to pump in money when its own finances are in such dire straits and it has so many calls on its limited resources? The fiscal deficit is already 5.9% of GDP, government borrowing for the year at 5.79 trillion, which is a 60,000 crore increase over the previous year.

As stated above, Indian banks might need 1.5-2 trillion of common equity in the next 6 years, majority of which will be needed by Public Sector Banks. With the government having high shareholdings in these banks, the capital will have to be infused by them, which will be taxpayers money. These arguments are for the economy. Talking of the banks, with higher equity, the Return on equity and assets will be affected by the huge capital infusion. Also, their lending capacity will be affected. Banks will try to compensate their ROE by increasing lending yields, fee incomes etc, which will affect the economy Also certain non-equity instruments not qualifying as a regulatory capital instrument will have to be phased out in the next 10 years. Non-equity capital instruments issued by Indian banks such as perpetual non-cumulative preference shares (PNCPS), innovative perpetual debt (IPD), and upper and lower Tier II bonds can be written off or converted into common equity upon the occurrence of the trigger event, called the 'Point of Non-Viability' (PONV) Trigger The quantum of equity required to be raised to meet the capital requirement would hinge critically upon the market appetite for non-equity capital instruments such as subordinated debt, IPD (innovative perpetual debt) and PNCPS (perpetual non cumulative preference share). The write-off clause would increase the risk perception of these instruments and would, hence, affect the demand for them. The cost of the capital would also go up as the returns on these instruments have to be commensurate with the enhanced risk. Private banks are strong Are Public Sector Banks up for it? As of March 2011, nearly 35 per cent of the total capital of public sector banks and 27 per cent of total capital of private banks is in the form of non-equity instruments. Non-equity capital (including innovative instruments) worth Rs 1613 billion and Rs 431 billion has to be phased out in the next 10 years for public sector banks and private sector banks respectively. Of this, 50 per cent will be needed to be phased out by March 2017.Private banks are better placed to face this situation with a capital adequacy ratio(CAR) at around

16.5%,

as

compared

to

13%

of

PSBs

as

of

March

2011.

Public Sector Banks

9 8 7 6 5 4 3 2 1 0 12 10 Number of Banks 8 6 4 2 0 Number Of banks

Private banks

8.5-10% 10-11% 11-15% Tier-I capital Ratio Tier-I capital ratio

15%+

These graphs clearly suggest that private banks are much better off and may not face many issues unlike Public banks. To maintain high ROEs public sector banks may have to increase their lending yields, while private banks being comfortable could be at an advantage with lower lending rates. Also, private banks have the option of tapping the capital markets for fresh equity, an option the PSBs do not have because of the minimum Government stake of 58%. What the government can do to help the Public sector banks? The government has perhaps realised this which is why the FM announced in his Budget speech that the government is examining the possibility of creating a financial holding company that will raise resources to meet the capital requirements of PSBs. Though this is infinitely better than government funding PSBs directly, it is only marginally so if public sector entities are forced to subscribe to the holding company. Government should relax its shareholding limit to 26% in Public sector Banks form the existing 58%. This will help these banks to raise capital from the markets, and save tax payers money. The already cash-strapped government can use that cash for other important areas. The Road Ahead Rating Agency Moodys has said that these norms are positive for Indian banks as it will improve the capital quality. RBI's finalised standards specify that minimum Tier-I capital ratios are 1 percentage point higher than Basel III standards, and require that Tier 1 capital is of higher quality than the BIS mandates. The agency thinks that this is credit positive for Indian banks in the longer run.

Incremental equity requirements appear achievable so long as banks can find investors for the riskier Additional Tier I capital. Indian banks would need Rs. 3.9-5 trillion capital over the next six years. A sizeable part (around 80%) of the common equity requirement(1.5-2 trillion) relates to Public Sector Banks (PSBs). Of the PSBs total equity requirement, the Government of Indias (GOIs) share would be Rs. 0.3 to 0.8 trillion. Considering past trends, this equity infusion looks feasible. Indian banks raised over Rs. 1 trillion in equity during the period 2007-08 to 2011-12, of which around 54% was mobilised by PSBs and 46% by private banks. While the equity target may appear easy at first glance, it may not prove to be so eventually, given that the RBI has also introduced loss-absorption features in Additional Tier I capital instruments. These features could well limit investor appetite for these instruments as it would be difficult to assess the probability of their conversion into equity or of a principal write-down in a stress scenario (and the extent of the resultant loss). In case banks are unable to mobilise the required Additional Tier I and the gap is bridged by raising common equity, the incremental equity requirement may go up to as high as Rs. 3.2-4 trillion over the next six years; in this, the GoIs share could be a staggering Rs. 1.2-1.7 trillion. Basel III implementation may also have a negative impact on Indias growth, RBI deputy governor Anand Sinha says. Although the BASEL III norms look at strengthening the Indian financial sector, The regulators should make sure, it does not hinder the Growth of the same and of the Indian economy.