Basel III orms : Implications on Banking System

- S S  Murthy
Sr. Vice-President,
Indian Banks' Association, Mumbai

- Bhaskar Sharma
Chief Manager,
Risk Management Department,
Bank of Baroda, Mumbai
Basel III guidelines are bold, innovative and have been well drafted. The standards will be
implemented gradually and the impact will also be monitored by the guardians of
financial systems and economy.
After the Herstatt failure of 1974, the regulators world over have been working to design
regulatory framework to make the financial system safe. Bank for International
Settlement (BIS) published Basel I papers in July 1988, which was the first internationally
accepted framework of banking risk regulation. Basel I was drafted at a time when banks
were only carrying out the core function of accepting deposits for the purpose of lending.
However, when later on the banking functions went into a metamorphosis by retaining the
core functions, the Basel I principles suffered from many deficiencies and the risk
measurement framework was found to be inadequate with the changes in the banking
landscape. Basel II, published finally in June 2006, was a well deliberated and calibrated
framework to address the changed scenario. No sooner Basel II framework was published
and implemented the global financial system had to witness collapse and bankruptcy of
financial giants posing systemic threat to the financial system. The policy makers started
debating and brainstorming on how to redesign the global financial system so that another
destructive and devastating crisis does not occur again. Basel III guidelines are intended
to achieve this objective. Basel Committee on Banking Supervision (BCBS) issued
several revisions and enhancements after the June 2006 guidelines. BCBS set of rules
encompassing revisions and enhancements after this publication is commonly known as
Basel III Framework. Basel II was a self-contained complete guideline over Basel I. On
the contrary, Basel III guidelines on the one hand, supplements Basel II guidelines and on
the other also addresses certain macro prudential regulation by identifying systemic risk
as an important risk.
Basel III guidelines can be summarized as under:
• Basel III guidelines aim to improve the banking sectors' ability to absorb shocks
arising from financial and economic stress by strengthening of resilience of the
banking sector against future shocks, supplementing the current recovery process
and reducing the risk spillover to the real economy. New standards of Market
Risk, Credit Risk and Liquidity Risk have been stipulated.
• The definition of capital has been rationalized. Tier 1 capital will include only
Common Equity (share capital and retained earnings) and Perpetual Preferred
Stock (Perpetual Non-Cumulative Preference Shares—PNCPS). The attributes of
Tier II debt capital will be more akin to capital than as debt when compared to the
earlier regime.
 • Some banks were observed to game around the rules of Capital Adequacy
computation. BCBS has introduced Leverage Ratio as another regulatory measure
of risk in the banks' balance sheet over and above Capital Adequacy Ratio.

Basel Iii guidelines

Basel III guidelines revolve around the following issues of Risk Management:
• Enhanced quality and quantity of capital instruments
• Revision in credit risk weights (securitization, resecuritization and counterparty
credit risk)
• Enhanced market risk capital charge
• Introduction of new global liquidity standards
• Principles of sound compensation practices
• Leverage ratio

Enhanced quality and quantity of capital instruments

BCBS had expressed concern and commitment to enhance the quality, quantity and
consistency of capital requirements. On September 12, 2010, BIS released a press
statement on requirement of enhanced capital requirement. The BIS guidelines vis-à-vis
existing guidelines of the Reserve Bank of India (RBI) are shown in Table 1:

The existing Capital Adequacy framework has been strengthened by introducing

additional requirements as under:
Capital Conservation Buffer: Basel III norms mandate that banks will have to set aside
buffers of 2.50% towards capital conservation. Banks have to start creating this capital
from January 01, 2016 and create 2.50% on or before January 01, 2019. This capital
conservation buffer would have to be set aside from the bank's net profit/earnings. This
requirement would be over and above the 8% CRAR prescribed by BIS (9% in case of
Indian banks). This would mean that banks would have to maintain minimum 10.50%
CRAR. The banks below the buffer range will face Prompt Corrective Action (PCA) from
the regulator. Banks not fulfilling the minimum requirement will be restricted from
paying dividends.
Countercyclical Buffer: The public outrage that followed from high bonus payments
from banks that had received state support like Royal Bank of Scotland, Hypo Real Estate
Bank AG of Germany, etc., forced the BCBS to additionally prescribe countercyclical
buffer (0 to 2.50% as decided by the National Supervisor) over and above capital
conservation buffer as mentioned above. This capital will be required to be built in under
situations of excessive credit growth which will be benchmarked to the long-term trend of
credit to GDP growth. The capital will be released in situations of recession. The
guidelines aim to balance between the economic scenarios of boom and recession faced
by the banks.
Downturn in the economy generally leads to deterioration of asset quality of the banks,
leading to increase in the NPA levels. Higher NPA leads to creation of increased
provision by the banks. To avoid this, banks slowdown their lending. Further, tightening
of the credit again leads to deteriorating borrowers' financial position, thus making the
general economy still worse.
Contrary to the above, when the business cycle experiences a boom, majority of the
borrowers perform well, banks lend more by easing credit terms and make lesser
provision because of lower NPAs. The economy is spurred into the fast economic growth
(leads to high GDP growth). Easy credit approach during the boom period results in poor
loan selection (example of subprime crisis), leading to higher NPAs when the cycle turns
into recession (whereas the loans made during recession are of superior quality as banks
are very careful and hence need lesser provision). This behavior of the economy and
financial system tends to amplify the impact of the economic cycle (boom leading to more
boom and recession leading to further recession). To counter the adverse impact of such a
phenomenon, a countercyclical capital buffer approach has been introduced under which
banks will be required to build up reserves during good times when their earnings are
higher and the accumulated reserves can be used during the economic slow down.
The implementation of this buffer capital requirement is left to the discretion of the
National Supervisors.
Systemically Important Financial Institutions (SIFIs): The revised BCBS guidelines
require more intensive supervision of the SIFIs and also an additional capital charge for
these institutions, which come under the "Too big to fail" theory. Basel III urges that
SIFIs should have `loss absorbing capacity' beyond the existing Basel II standards to
ensure financial stability. It requires that in case of public bail out of SIFIs, capital other
than common equity capital should also absorb losses either by way of write-off or
conversion to equity shares. The step is welcome but is going to raise the cost of debt-
oriented Tier I and Tier II capital of the banks as they will become more risky. It may be a
challenge to find the investors, with higher risk appetite, to subscribe to the capital
requirement of Indian banks. BCBS is yet to define the criteria of categorizing a SIFI.
Revision in certain credit risk weights
Credit Risk for Securitization, Resecuritization Exposures: Learning from the experience
of subprime crisis, BCBS has prescribed higher risk weights for securitization and
resecuritization exposures. In case of securitization liquidity facilities, the Credit
Conversion Factor (CCF) norms have been made more stringent. The guidelines have
already been implemented by RBI through its circular dated February 08, 2010. The
guidelines will not have significant impact on Indian banks since the securitization
transactions constitute an insignificant portion of Indian financial system.
Counterparty Credit Risk: In case of counterparty credit exposures in derivative
transactions, the guidelines encourage engagement of Central Counterparty (CCP), such
as CCIL in India, for OTC transactions. The guideline prescribes higher risk weights for
bilateral transactions and zero risk weights for truncations through centralized clearing
house.

Enhanced market risk capital charge

As per these guidelines, additional capital charge in the form of Incremental Risk Capital
(IRC) charge is to be allocated which includes Default Risk as well as Migration Risk, for
interest rate related instruments. Under Internal Model approach, it has also included the
concept of Stressed VaR. Capital Charge has to be the sum of Normal VaR and Stressed
VaR. The guidelines also propose that the regulators retain the ability to require
adjustments to the current value beyond those made for financial reporting standards, in
particular for those positions where the current realizable value is uncertain due to
illiquidity. Such an adjustment is to be made by deducting it from Tier I capital while
computing CRAR. RBI issued guidelines on illiquidity capital charge on February 08,
2010 but later on deferred the same in view of difficulties faced by the banks. RBI has
appointed a Working Committee to finalize the nuances of implementation of illiquidity
capital charge framework. Putting in place systems and procedures for computation of
IRC will pose challenge for the banks. However, Indian banks may not be affected largely
due to these changes, as their trading sizes and volumes are less.

Introduction of new global liquidity standards

BCBS had observed that one of the factors for the recent financial crises was inaccurate
and ineffective management of liquidity risk. To overcome this, BCBS had come out with
the following liquidity standards to be observed by the banks:
The Liquidity Coverage Ratio (LCR): This ratio ensures enough liquid assets to survive
an acute stress scenario lasting for 30 days i.e., the banks will be required to hold highly
liquid assets to cover 30 days of net cash outflows. This ratio is set to be introduced from
January 01, 2015, after an observation period beginning in 2011.
The et Funding Stable Ratio (FSR): This ratio aims at promoting medium to long-
term structure funding of assets and activities of the banks. BCBS aims to trial this ratio
from 2012 and make it mandatory in January 2018.

Principles of sound compensation practices

The remuneration of managers depends on the profit generated by them whereas the
regulators want to ensure long-term sustainability of the institution. One of the reasons
attributed to the credit crisis was undue risk assumed by the managers to reap short-term
benefits. In the long-term, the risks started manifesting beyond the risk appetite of the
bank. BCBS issued guidelines in January 2010 to avert such a situation. It provides
guidance to the supervisors on following terms:
• Effective governance of compensation
 • Effective alignment of compensation with prudent risk taking
• Effective supervisory oversight and engagement by stakeholders.
These guidelines have been incorporated by RBI in its master circular issued on February
08, 2010 wherein it highlights that the compensation policies must be linked to long-term
capital preservation and financial strength of the firm and should consider risk adjusted
performance measures. In its review of the credit policy on November 02, 2010, RBI has
indicated that it will issue detailed guidelines on the subject by December 2010.
Leverage ratio as supplemental measure of firm-wide risk
BCBS has observed that certain banks had built up excessive on and off-balance sheet
leverages and still showed strong Capital Adequacy Ratio. In December 2009,
consultative document (strengthening the resilience of the banking sector), BCBS, apart
from stipulating standards on capital and countercyclical capital framework, also
introduced Leverage Ratio as a measure of risk of the bank along with CRAR. Leverage
ratio is seen as a safeguard against risk of gaming with Capital Adequacy guidelines and
build up of hidden risk. The guidelines envisage introduction of leverage ratio as a
backstop measure based on gross exposure and is risk-invariant. The ratio will be
subjected to supervisory monitoring in 2011 and 2012 with parallel run in 2013 to 2017
and is then proposed to be part of Pillar I measurement from 2018. The leverage ratio is to
be tested with Tier I ratio of 3.0%. Indian banks are to be the least affected by these
guidelines as leverage ratio is quite moderate in all Indian banks. The US banks and
European banks are likely to be affected as their build up of off-balance sheet exposures is
huge.
RBI put forth before the BCBS that statutory liquidity ratio of the banks, which is a
regulatory mandate, should be excluded from the calculation of leverage ratio as this
carries only market risk and not credit risk. However, BCBS has not subscribed to this
standpoint and took an in-principle stand that no assets, including cash which obviously
has the least risk, should be excluded from the measurement of the leverage ratio.
Since the Tier I capital of many Indian banks is comfortable (more than 8% as per BIS
and 9% as per RBI) and their derivatives activities are also not very large, RBI does not
expect leverage ratio to be a binding constraint for Indian banks.

Impact on international banks

The guidelines will bring about a radical change for the European banks which have been
operating at common equity ratio of 2%. For these banks, graduating to the new regime
will also affect their return on equity. Even for the US banks, as per the recent report
(released on November 23, 2010), the Basel III banking rules will leave the biggest US
banks short of equity capital somewhere between $100 bn and $150 bn, with 90% of the
shortfall concentrated in the top six banks.
To meet the Basel III regulations banks will be required to either increase their capital
through retained earnings or issuing fresh equity; else they will have to cut down their
riskier assets. Internationally, the banks feel that the global economy is still fragile and
implementation of Basel III guidelines may retard the economy and affect the recoveries.
Even though, BCBS has given graded approach to adopt the new standards, the banks and
regulators will face challenges to implement it.
Impact on Indian banks
Indian banks are least to be affected since major funding of their Tier I capital is by way
of common equity capital. Secondly, RBI requirement of Tier I capital at 6% is way
above the revised minimum requirement of 4.50% by BCBS. Since the capital of many
Indian banks is comfortable (more than 8% as per BIS and 9% as per RBI) and their
derivatives activities are also not very large, RBI does not foresee any constraint
implementing Basel III in Indian banks.
RBI governor opined (in his speech dated September 7, 2010) that the Indian banks are
not likely to be significantly impacted by the proposed new capital Basel III rules. He
gave further details on the subject:
• Indian banks are already making most of the deductions from capital that is now
being proposed under Basel III. However, RBI cautioned that there could be some
negative impact arising from shifting some deductions from Tier I and Tier II
capital to common equity.
• The proposed changes relating to the counterparty credit risk framework are likely
to have capital adequacy implications for some Indian banks having large over the
counter (OTC) bilateral derivatives positions.
RBI governor corroborated the above facts once again in his speech dated December 03,
2010 at the BANCON Conference held in Mumbai as given under:
Our assessment is that at the aggregate level Indian banks will not have any problem in
adjusting to the new capital rules both in terms of quantum and quality. A quick estimate
of the capital ratios of the banking system after taking into account the regulatory
adjustments under Basel III is indicated in Table 2.
Finally, RBI summed up stating that the impact would be quite moderate for the Indian
banking system.

ICRA, an Indian rating agency and an associate of international Moody's Investors

Service, arrived at a figure of Rs 6,00,000 cr for the Indian banks to raise the capital over
a period of nine years. The study further reveals that:
• It is the PSBs that would require most of the capital, given that they dominate the
Indian banking sector.
• Indian banks may still find it easier to make the transition to a stricter capital
requirement regime than some of their international counterparts since the
 regulatory norms on CRAR in India are already more stringent and also because
most Indian banks have historically maintained their core and overall capital well
in excess of the regulatory minimum.

Suggestions for India

RBI before implementing Basel III may consider the additional strengths that are already
built up in our system such as:
• When BCBS has stipulated Capial Adequacy Ratio of 8%, RBI has stipulated the
same at the level of 9%.
• As per RBI's New Capital Adequacy Framework (NCAF), banks have to maintain
a Tier I CRAR of at least 6% at both solo and consolidated level.
• RBI has already come out with a NPA provisioning norm which ranges from 10%
to 100% (for unsecured portion).
• The Provision Coverage Ratio (PCR) on NPA has to be increased to 70% before
March 2010.
One of the suggestions that RBI may consider is that the PCR may be hiked to 75%
during the boom time and reduced to 50% during recession.

Conclusion
Basel III guidelines are bold, innovative and have been well drafted after conducting
Quantitative Impact Survey (QIS) of each of the measures. Some circles have expressed
apprehensions that the norms are so stringent that it will have adverse impact on supply of
credit and will stifle the economy. However, the standards will be implemented gradually
and the impact will also be monitored by the guardians of financial systems and economy.
The transition has been carefully drafted to ensure that the banks meet new standards
maintaining sound credit and lending activities and does not hamper the fair risk taking
abilities of the banks. BCBS has also assured that the standards will suitably be modified
wherever it manifests unintended consequences.
The views expressed here are the authors' and do not in any way reflect those of the
organization they belong to.
Reference # 01M-2011-01-09-01.