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The Journal of Indian Institute of Banking & Finance Keb[. / Vol. 86 l
DebkeÀ. / No. 1 l
pevekejer - cee®e& 2015 / January - March 2015
contents
CONTENTS From the Editor
Special Features
Capital Optimization under Basel III .........................................................................................................16

-- H. S. Sharma
Basel Accords and Regulatory Arbitrage .................................................................................................21

-- Amit Anand
Basel-III bonds - How effective are they in shoring up capital adequacy? ................................................27
-- Dr. Madhavankutty. G.
Basel-III : Implementation in Indian Banking Industry ..............................................................................32

-- Nagamani. S.
Implementation of Basel III regulations - New Generation Private Sector Banks ........................................36
-- P. S. Khandelwal
Basel III and the capital structure of Indian banks ...................................................................................46

-- Dr. P. Usha
Book Review
Credit Monitoring - A Trainer's Writings for Bankers ................................................................................53

-- S. K. Datta
SUBSCRIPTION FORM FOR BANK QUEST / IIBF VISION ..........................................................................56
Bank Quest HONORARY EDITORIAL The views expressed in the articles and
ADVISORY BOARD other features are the personal opinions of
Dr. Rupa Rege Nitsure the authors. The Institute does not accept
any responsibility for them.
Dr. Sharad Kumar
Mr. Mohan N. Shenoi
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Vol. : 86 u
No. : 1 HONORARY EDITOR ieS efJe®eejeW kesÀ efueS mebmLeeve efkeÀmeer ÒekeÀej mes GÊejoe³eer
January - March 2015
Dr. J. N. Misra veneR nesiee ~
(ISSN 0019 4921)
The Journal of Indian Institute of Banking & Finance January-March 2015 1

special feature INDIAN INSTITUTE OF BANKING & FINANCE
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MANAGEMENT
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MISSION O³es³e
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and finance professionals primarily through a
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efJeMes<e%eeW keÀes efJekeÀefmele keÀjvee nw ~
Printed by Shri J. N. Misra, published by Shri J. N. Misra on behalf of Indian Institute of Banking & Finance,
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Kirol Road, Kurla (W), Mumbai - 400 070. Editor Shri J. N. Misra.
2 January-March 2015 The Journal of Indian Institute of Banking & Finance

editorial
oday, Banks are facing various challenges and implementation of Basel-III is most
Dr. J. N. Misra
Chief Executive Officer,
IIBF, Mumbai
T critical among them. The Basel III capital regulation has been implemented from
April 1, 2013 in India in phases and it will be fully implemented as on March 31,
2019. There are various direct and related components of the Basel III framework like
increasing quality and quantity of capital, enhancing liquidity risk management framework,
leverage ratio, regulatory prescription for Domestic Systemically Important Banks, Countercyclical
Capital buffer (CCCB) framework etc. The implementation of Basel III framework will throw up
various challenges for banks. While many of the goals behind Basel III-such as greater emphasis on
Collateral, Stress Testing, CVA, VaR, Liquidity Risk, and Capital Optimization are
understandable, the implementation of such goals and measures and the resulting need for greater
consistency across the banking industry remain a major challenge. Accordingly, we have identified
'Basel III Implementation' as the theme for the current issue. The Institute has received seven articles
on different topics on the theme from practising bankers / faculty members which forms main content
of the issue. Besides, we have included a book review on a contemporary subject.
The second article is by Mr. H. S. Sharma, General Manager, Bank of Baroda. In his
article 'Capital Optimization under Basel III' the author mentions broad areas of coverage in
Basel III guidelines and explains its implications and challenges for Banks. The focus of the
article is on capital optimization strategy. He suggests important areas requiring focus for
capital optimization under Basel III such as shift in evolution of risk management from
regulatory compliance to business strategy, adoption of technology, adoption of scientific risk
management techniques, operational efficiency, portfolio optimization, exploring business model
and IT, data quality and data leverage.
The third article is on “Basel Accords and Regulatory Arbitrage' by Mr. Amit Anand, Assistant
General Manager-Economist, Bank of India. In this article, the author mentions the dependence on
regulatory capital to insulate banks from losses as one of the instruments of the banking regulations
under Basel Accords and explains how stringent capital norms in the successive Basel Accords lead to
increase in shadow banking activities across the globe. He explains the concept of regulatory capital
arbitrage and its guiding principles. The article also enumerates factors explaining shadow banking
growth. The article illustrates the impact of regulatory arbitrage through growth in securitization,
increase in shadow banking and growth of special purpose non-bank financial institutions,
discrimination of traditional banks in terms of higher capital and liquidity requirements besides
their regulatory disadvantage. The author suggests continuation of efforts on harmonization of
global standards to mitigate systemic risks.

editorial
The next article is by Dr. G. Madhavankutty, Chief Manager (Economist), Bank of India. In his
article 'Basel-III bonds - how effective are they in shoring up capital adequacy?' the author explains
the salient features of Basel-III bonds and their efficacy in supporting capital adequacy of the
banking sector. He explains key features of Tier-I and II instruments under Basel II & III and their
implications.
The fifth article is 'Basel-III : Implementation in Indian Banking Industry' by Ms. S. Nagamani,
Assistant General Manager & Faculty, State Bank Staff College. In her article she explains
conceptual issues such as building blocks of Basel III, higher capital requirements under Basel III
compared to Basel II, liquidity standards & leverage ratios, provisioning norms, disclosure
requirement, RBI guidelines on Basel III transitional arrangements etc.
The sixth article is by Mr. P. S. Khandelwal, Chief Compliance Officer & Principal Officer,
IndusInd Bank Ltd on 'Implementation of Basel III regulations - New Generation Private Sector
Banks'. He explains evolution of Basel accords over time and mentions capital ratio requirements,
leverage ratio, liquidity coverage ratio etc. He explains implementation of Basel III and different
approaches for managing risks in New Generation Private Sector Banks (NGPSBs). The author
describes challenges before NGPSBs such as additional capital requirements, impact on profitability,
risk and data managements.
The last article in this issues is by Dr. P. Usha, Faculty, NIBM. In her article 'Basel III and
capital structure of Indian banks' she analyses the immediate impact of implementation of
Basel III on the capital structure of Indian Banks. The article mainly examines the impact on
the Common Equity Tier (CET I) capital to risk weighted assets ratio (CRAR) and total CRAR
in the case of Indian Banks.
This issue carries a book review by Mr. S. K. Datta, Joint Director (Faculty), IIBF on
'Credit Monitoring : A Trainer's Writings for Bankers' written by Dr. T. C. G. Namboodiri.
In today's environment, credit monitoring part is a weak link in the total credit management
cycle. The book is therefore very apt and timely. We hope that all the articles and the book review
will be of interest to you.
We solicit your suggestions and feedback for improvement.
Dr. J. N. Misra

special feature
Salient Features of Revised Regulatory Framework for NBFCs
i) The minimum Net Owned Fund (NOF) criterion for existing NBFCs (those registered prior to April 1999) has
been increased to `20 million. NBFCs have been allowed till March 2017 to achieve the required minimum
levels.
ii) In order to harmonise and strengthen deposit acceptance regulations across all deposit taking NBFCs
(NBFCs-D) credit rating has been made compulsory for existing unrated asset finance companies (AFCs) by
March 31, 2016. Maximum limit for acceptance of deposits has been harmonised across the sector to 1.5
times of NOF.
iii) In view of the overall increase in the growth of the NBFC sector, the threshold for defining systemic significance
for non deposit taking NBFCs has been revised to `5 billion from the existing limit of `1 billion. Non-deposit taking
NBFCs shall henceforth be categorised into two broad categories : NBFCs-ND (those with assets less than `5 billion)
and NBFCs-ND-SI (those with assets of `5 billion and above - deemed as systemically important) and regulations
will be applied accordingly. NBFCs-ND will be exempt from capital adequacy and credit concentration norms while
a leverage ratio of 7 has been introduced for them.
iv) For NBFCs-ND-SI and all NBFCs-D categories, tighter prudential norms have been prescribed - minimum
Tier I capital requirement raised to 10 per cent (from earlier 7 per cent in a phased manner by end of March 2017),
asset classification norms (from 180 days to 90 days in a phased manner by the end of March 2018) in line with
that of banks and increase in provisioning requirement for standard assets to 0.40 per cent in a phased manner
by March 2018. Exemption provided to AFCs from the prescribed credit concentration norms of 5 per cent has
been withdrawn with immediate effect. Additional corporate governance standards and disclosure norms for NBFCs
have been issued for NBFCs-D and NBFCs-ND.
v) NBFCs with assets of less than `5 billion shall not be subjected to prudential norms if they are not accessing public
funds and those not having customer interface will not be subjected to conduct of business regulations.
vi) Assets of multiple NBFCs in a group shall be aggregated to determine if such consolidation falls within the
asset sizes of the two categories. Regulations as applicable to the two categories will be applicable to each of the
NBFC-ND within the group. Reporting regime has been rationalised with only an annual return prescribed for
NBFCs of assets size less than `5 billion.
Source : Financial Stability Report (Including Trend & Progress of Banking in India 2013-14) December 2014.

Contemporary
special feature
Issues in Banking
Capital Optimization under Basel III
?
H. S. Sharma *
Basel III : A Glimpse Both the buffers are required to be built by banks in
Basel III guidelines were enunciated by the Basel “good times” to be drawn upon in “bad times.”
Committee to address the inadequacies observed in vi.Grandfathering Of Existing Ineligible Capital
Basel II capital framework during the global financial Instruments : Under Basel III, the capital eligibility
crisis of 2007-2008. Unlike introduction of Basel II over of certain hybrid capital instruments with
Basel I, Basel III has been designed to supplement Basel redemption features will be gradually phased out
II rather than substitute it so as to bring about soundness from 2013 to 2021. Further, the tiering of capital
in the banking and financial system. has been greatly simplified and “loss-absorbing”
The Basel III guidelines broadly cover areas as under : is now the main, if not the sole, criterion for inclusion
in qualifying capital.
a. Enhanced Quality and Quantity of Capital :
The modification in Basel II rules are enumerated vii.Regulatory capital adjustments : Basel III requires
as under : the deduction from CET1 of items such as goodwill,
deferred tax assets, intangibles, defined benefit
i. Higher proportion of Common Equity Capital : A
pension fund assets, treasury shares. Under Basel
higher minimum Common Equity Tier 1 (CET 1)
II rules it largely remained unadjusted. Another
capital ratio of 5.5% prescribed by the Reserve
significant change is reciprocal adjustments
Bank of India (against minimum 4.5 percent of
to be made in respect of the capital invested in
common equity under BCBS rules).
unconsolidated entities (subsidiaries, insurance
ii. Tier 1 Capital : A higher minimum Tier 1 capital ratio entities, etc.) which were previously adjusted on
of 7% prescribed by the Reserve Bank of India 50:50 basis from Tier I and Tier II capital funds.
(against 6 percent under BCBS rules)
b. Enhanced Requirements of Capital for Market
iii. Total Capital : Unmodified minimum total capital and Credit Risk : For market risk, Basel III guidelines
ratio of 9 percent by the Reserve Bank of India took effect in 2011, which is popularly known as Basel
(against 8 percent under BCBS rules). II. The enhanced treatment introduces a stressed
iv.Capital Conservation Buffer : A mandatory capital Value-at-Risk (VaR) capital requirement based on a
conservation buffer in the form of CET 1 capital to continuous 12-month period of significant financial
the extent of 2.5 percent of RWA. Failure to exceed stress. It requires calculation of minimum capital on
the buffer will subject an entity to limitations on stressed Value-at-Risk (VaR).
discretionary payments out of profit like dividends, Basel III has also introduced higher capital
incentives, bonus, etc. requirements for resecuritisations in both the banking
v. Countercyclical Capital Buffer : A discretionary and the trading book. Banks will be subject to an
0-2.5 percent countercyclical capital buffer to additional capital charge for potential mark-to-market
counter the cyclicality in bank’s business due losses known as Credit Value Adjustment (CVA)
to economic cycles. which is associated with a deterioration in the credit
* General Manager, Risk Management, Bank of Baroda.

special feature
worthiness of a counterparty. While the Basel II will increase to minimum 100% as on 1st January
standard covers the risk of a counterparty default, 2019 in phased manner.
it does not address such CVA risk, which during the ii. Net Stable Funding Ratio (NSFR) will address
financial crisis was a greater source of losses than a longer horizon and will be used to promote
those arising from outright defaults. sustainable medium-and long-term maturity
A multiplier of the 1.25 to the correlation factor worked structures for assets and liabilities. The ratio is
out under the Basel II formula of Internal Rating calculated as the “available amount of stable
Based formula of credit risk capital computation has funding” divided by the “required amount of
been stipulated for large regulated financial institution stable funding,” which must be at least 100 percent
(USD 100 billion asset size and unregulated financial (when fully phased-in). It is intended to supplement
entities). New standards for the capital requirements the LCR towards soundness of liquidity. The final
against credit exposures to central counterparties BCBS guidelines have been issued on 31st October
(CCPs) have been prescribed which was hitherto 2014. The Reserve Bank of India is yet to issue
treated as risk free. RBI’s response on this aspect guidelines on it. It will become a regulatory standard
is still awaited. from 1st January 2018.
c. Leverage Ratio : Leverage Ratio has been e. Systemically Important Banks : It was observed
introduced as additional safe guard against during the recent global financial crisis that problems
excessive risk taking. It is a back-stop measure faced by certain large and highly interconnected
based on gross exposure and invariant of the level financial institutions hampered the orderly functioning
of risk of the assets. It measures leverage of the of the financial system, which in turn, negatively
balance sheet along with off-balance sheet exposures impacted the real economy. Government intervention
including undrawn commitment of the bank in credit was considered necessary to ensure financial stability
facilities (as denominator) against Tier 1 capital (as in many jurisdictions. Cost of public sector intervention
numerator). A minimum supplementary leverage ratio and consequential increase in moral hazard required
of 3 percent as per BCBS guidelines and 4.5% as per that future regulatory policies should aim at reducing the
RBI has been stipulated. probability of failure of SIBs and the impact of the failure
d. Liquidity Ratios : Basel III incorporates a framework of these banks. Under the framework G-SIB (Globally
for liquidity risk management, consisting of Liquidity Systemically Important Bank) and D-SIB (Domestic
Coverage Ratio (LCR) and Net Stable Funding Ratio Systemically Important Bank) will be identified based
(NSFR) as under : on a range of indicators. The Reserve Bank of India
has indicated that the guidelines will be effective from
i. Liquidity Coverage Ratio (LCR) has been
1st April 2016. The name of D-SIB is expected to be
introduced that will address short-term liquidity
declared for the first time in August 2015.
concerns and require banks to hold unencumbered
High-Quality Liquid Assets (HQLA) that can be f. Principle of Sound Compensation Practice :
quickly converted to cash to enable a Bank to Compensation practices at large financial institutions
survive a prescribed significant stress scenario are one factor among many that contributed to the
lasting for 30 days. The ratio is calculated as the financial crisis that began in 2007. High short-term
“stock of HQLA” divided by “total net cash outflows profits led to generous bonus payments to employees
over the next 30 calendar days,” which must be at without adequate regard to the longer-term risks they
least 100 percent (when fully phased-in). This has imposed on their firms. These incentives amplified the
been implemented in Indian banking system with excessive risk-taking that has threatened the global
minimum LCR of 60% as on 1st January 2015 which financial system and left firms with fewer resources to

special feature
absorb losses as risks materialised. The Reserve Bank implementation), a bank could maintain to meet
of India issued guidelines on sound compensation minimum capital requirements :
practices in January 2012 and is a part of Pillar Sr. No. Capital Type Basel II Basel III
3 disclosure. Private sector and foreign banks 1a Common Equity (CRAR) 2.70 5.50
operating in India are required to make disclosure 1b Capital Conservation Buffer - 2.50
on remuneration on an annual basis at the minimum, 1c Countercyclical Capital Buffer - 0 - 2.50
in their Annual Financial Statements in the prescribed 1d D-SIB - 0 - 1.00
template. 1 Total Common Equity 2.70 8.00 - 11.50
Implications and Challenges for the Banks 2 Additional Tier 1 # 1.80 1.50
The Basel III guidelines will beyond doubt strengthen the 1+2 Tier 1 4.50 9.50 - 13.00
solvency and liquidity soundness of the banks. At the 3 Tier 2 4.50 2.00
same time it will have far reaching implications and pose 1+2+3 TOTAL 9.00 11.50 - 14.00
challenges on the economy and the financial system. # AT1 cannot exceed 40% of Tier 1 under Basel II rules. Under Basel III
the maximum AT1 is 1.5 for a minimum Capital Adequacy Ratio of 9%.
The Banks will be required to maintain more capital funds
with higher cost (on account of higher loss absorbency It can be observed from the table above that the
features of non equity capital funds) in their balance leveraging capacity of the common equity to raise
sheet. In India where Public Sector banks still play a other capital instruments has reduced from as much as
dominant role in the financial system the government and 3.33 times under Basel II to ranging from 1.44 (11.5/8) to
the Reserve Bank of India are expected to play a more 1.22 (14/11.5) times under Basel III rules. This reduces
facilitating role so that the banks can conform to the new the riskiness of the Bank’s balance sheet but poses
regulatory requirements. challenges of return on the shareholders fund. Although
Further there is either no market for certain types the banks in India have high Tier-1 capital ratios (their
of instruments in India or market is shallow. Few capital structure usually comprises equity and reserve),
banks have successfully raised few thousand crores of the introduction of capital buffers and Leverage Ratio of
capital funds in the form of Perpetual Debt Instrument 4.5% will pose a significant demand. The shareholders
(PDI, Additional Tier 1 Capital). No bank has ventured will expect a market related return.
to raise Perpetual non-cumulative Preference Shares To comply with the requirements of Liquidity Coverage
(PNCPS, Additional Tier 1 Capital), Redeemable non- Ratio (LCR) the Banks will be required to deploy a part of
cumulative Preference Shares (RNCPS, Tier 2 capital) their funds in High Quality Liquid Assets where the yield
or Perpetual non-cumulative Preference Shares (PCPS, will be under pressure. Hence entire balance sheet
Tier 2 capital) from the market. The cost of Tier 2 Debt management assumes significance.
Capital Instruments, which has been the mainstay of Each of the three broad ways of boosting capital
non-equity capital instruments for Indian banks, attracts ratios - increasing retained earnings, reducing risk-
higher cost because of loss absorbency features. weighted assets and issuing new equity - have their
Raising capital overseas will have currency risks for the pros and cons. Reducing risk-weighted assets by
Banks in terms of coupon servicing and redemption. downsizing the loan portfolio will create a shortfall in
However banks with overseas operations can raise and credit lending, which in turn will make it difficult for
park it overseas. small and medium-sized enterprises to obtain loans
To understand the impact of implementation of and will have social and political repercussions. Issuing
Basel III let us have a look on the proportionate new equity or even other capital instruments may also
share of capital instruments, under the Basel II and lead to a drop in lending activities, since banks will
Basel III norms (both under RBI regulations on full have to raise lending rates to maintain the same level

special feature
of returns on equity for shareholders. The stringency counterparty risk, such as stressed value at risk
of norms intended to bring about soundness may (VaR), incremental risk charge (IRC) and credit
cause adverse impact on the economy. However the value adjustment (CVA) among others, can be
standards will be implemented gradually and the impact improved by optimizing the calculation models and
will be monitored by the guardians of the financial ensuring that the right quotes are given on real time
system and the economy to ensure that it does not basis to the customers, dealers, etc. It will help better
manifest unintended consequences. understanding of risk adjusted return of positions.
Optimization Strategy : the areas requiring focus d. Operational efficiency : IT and operations require
Under the given situation, the optimization efforts a holistic and sustained organizational focus in order
have to be focused at increasing profitability and to remain steadfast and efficient in implementing
retained earnings by achieving greater operational the core business. The system design should be
efficiency and increased income. It requires the scalable and flexible to align with new business
banks to evaluate their business model in terms of models in less time and at less cost. The use of
product offerings, Risk Management, Information intelligent systems to assist in optimizing resources
Technology, Performance Evaluation, Finance and with minimal human intervention will support
Treasury operations. The areas requiring focus in Indian improved operational risk management. Use of
Banking scenario are suggested as under: Key Risk Indicators (KRI) and Risk Control Self
Assessment (RCSA) in an automated environment
a. Paradigm Shift : The Basel III framework will
of Operational Risk management system will evolve
requires optimal utilization of the resources of the
the organization to a sound, safe and efficient
bank. Risk Management has to evolve from regulatory
business operations environment.
compliance to business strategy. The starting point
can be analysis of risk return perspective on an asset e. Portfolio optimization : Optimizing risk return
in the area of market risk and credit risk accompanied business strategy may require exiting positions that
with higher standards of corporate governance. The are capital-intensive, non-core and unrenumerative.
mental rigidity of topline and/or bottomline at any cost The regulator and the Government should clearly
has to be done away with. articulate the risk return mechanism in directed
lending and create a level playing filed in the financial
b. Adoption of technology as business drivers :
system. Adoption of advanced approaches - Internal
The availability of computer and computer enabled
Model Approach (IMA) for market risk and the Internal
devices can facilitate business with better customer
Ratings Based (IRB) approach for credit risk should
experience and cost effectiveness. Retail lending
typically enable the banks to a RWA relief. Even if
which involves higher transaction cost can be
the RWA relief is not afforded the Bank’s adoption
managed through suitable automation of the
of the qualitative requirements of these approaches
delivery process. It will require a team of business
will enable them to understand risk adjusted return in a
and risk analytics who can develop machine logic
better way and optimize the portfolio accordingly.
and artificial machine intelligence to interact with
Internal models can allow sophisticated optimization
the customer and give a reliable and business
methods for Value at Risk (VaR) such as marginal
worthy decision to them.
VaR. In addition, internal models can lead to a better
c. Adoption of scientific risk-measurement understanding and risk management of the bank’s
techniques : The classification of products and own portfolio.
the application of the correct model to each category
f. Business Model : To fulfill the new regulatory
can help reduce charges significantly. The new ratios
requirements of Basel III, especially the increased
and charges introduced to take stock of market and
capital and liquidity requirements, and to restore

special feature
profitability, a relook at the existing business model data there might be disparities among the data
and its realignment may be required. The extent formats of different entities. This can lead to
of the adjustment may depend upon the overall deficiencies in general data availability, with data
health of the bank, and the derived risk and funding used by one unit often not known by, or available
strategy within the new framework. to, other units. For example the derivatives data
Other measures might include a stronger focus in Treasury operations may not be accessible
on specific customer segments such as retail and to a branch where the same customer has loan
small and mid-sized enterprises, an adjustment of transactions and collateral related records. Again
the products and services offered, or optimization the data on credit rating may not be available
of the group structure to evaluate different options to either of these two systems. This problem of
to optimize the returns on deployed capital funds. disparate data but huge data requires a new
perspective on data management.
g. Information Technology, Data Quality and Data
Leverage : Apart from adoption of technology as ii. Clear responsibility for data ownership : Defining
business driver, as discussed above, there is a clear responsibilities for the ownership of risk
need to appreciate that we are living in the data and finance data fosters an environment in
age / information age. A tremendous amount of which new data and modifications of data can
data has flooded almost in every aspect of our life be controlled and supervised by a dedicated
due to the fact that hardware and software have unit. The Banks in India have arrived at full
become the most economic resource in our day automation with huge baggage of legacy systems.
to day life and business. This explosive growth in The data is incomplete and lacks accuracy. A
powerful data collection and storage has generated clearly spelt out strategy to clean the existing
a new discipline that can intelligently assist us in data and stop new junk data to creep in will
transforming the data deluge into information and transform this data from flood of data to goldmine
knowledge. In Indian Banking System terabytes of data. The idea is to make the data fit for
of data get generated in the computer systems descriptive, predictive and explanatory data
on daily basis. Powerful and versatile tools have mining. The starting point in this direction is to
evolved in the market to automatically uncover delegate this responsibility and authority as at a
valuable information from the tremendous amounts fairly higher level with clearly articulated powers
of data and to transform such data into organized and accountability.
knowledge. The organizations, financial or otherwise, The journey on Basel III path has just begun. The
which will have the human skill, computer system, path forward is challenging as it will start impacting
and marketing force to translate this organized return and profitability. However a clear understanding
knowledge to business strategy, will be successful of the challenges and addressing them in a consistent
ones in the so called Information Age. and strategic manner will make the players smarter
Indian Banks are sitting on deluge of data and the financial system more sound. The threat
offering immense potential for deriving business that the laggards in the system will discarded cannot
knowledge out of it. Some of the initiatives required be ruled out.
to transform the data into knowledge are suggested
as under : [
i. Unification of data formats for risk and finance
data : Due to the evolution of data requirements
and the ability of banks’ IT systems to manage

Contemporary
special feature
Issues in Banking
Basel Accords and Regulatory Arbitrage
?
Amit Anand *
Background Committee on Banking Supervision (BCBS) originated

In their much acclaimed book on financial crises, on the back of financial market turmoil which had
economists Reinhart & Rogoff (This Time is Different : followed the breakdown of the Bretton Woods system
Eight Centuries of Financial Folly, 2009) trace the history of managed exchange rates in 1973. BCBS has been
of banking & financial crises to the years before the instrumental in coordinating with member regulators and
Christ. The center point of their entire argument was that developing regulatory codes in the form of Basel Accords
the more things change in the financial world, the more since late-1980s.
they stay the same. According to them the Greek debt One of the major weapons of the banking regulations
crisis of 2010 had strong resemblance to the Mexican including Basel Accords have been reliance on
debt crisis of 1827 and the US sub-prime crisis of 2008 regulatory capital to insulate banks from losses.
has shown similar plot as those of the past modern Regulators impose capital requirements in order to help
banking crises, going back at least as far as eighteenth- ensure the safety and soundness of banks. There are
century Scotland. various reasons why safe and sound banks are good, but
In his predated account - Manias, Panics and the most direct - from the regulator's perspective - is that
Crashes (1978), Kindleberger had presented a more the government is insuring the bank's liabilities. Since the
comprehensive record of financial crises, stretching government is always a stakeholder if the bank becomes
back to before the South Sea bubble. He had argued insolvent, the regulator wants to reduce the chances of
on the similar lines that several common threads that happening - hence capital requirements.
linked these different disasters over the centuries in Successive Basel Accords have made the regulatory
almost every possible nook and corner of the financial capital requirements all the more stringent and
world. In the beginning, manias or bubbles follow some Basel III proves to be stringent of them all. In fact,
unexpected 'good news' and so reflect progress of stricter capital norms have given rise to growing
some sorts. Subsequently, new opportunities for profit 'shadow banking' activities across the globe. Shadow
are seized, and then mostly exploited to the excess. banking activities are banking activities such as
When this eventually dawns on investors, the financial credit, maturity, and liquidity transformation that take
system experiences distress and often panic. This when place outside the regulatory perimeter without having
extends to the larger economy, the sufferings percolate direct access to public sources of liquidity. Shadow
to the common man at streets. banking has expanded rapidly over the last decades
Regulations attain centre place here, as any sign of and was at the heart of the 2007-2009 financial crisis.
systemic stress needs to be addressed during early Creative Financing and growth of Shadow Banking
stages of its development. History of modern banking Shadow Banking System (SBS) includes entities
regulations, across major banking and financial centers which are generally beyond the purview of banking
globally, has been chequered. Cross-border coordinated regulator. Players such as hedge funds, money market
regulation appeared much later when the Basel funds, Structured Investment Vehicles (SIV), private
* Assistant General Manager-Economist, Risk Management, Bank of India.

special feature
equity funds, credit insurance providers, etc. may it declined in size, both in the US and in the rest of
form part of the SBS. According to the Bank for the world. In 2007 the Financial Stability Board (FSB)
International Settlements (BIS), investment banks as estimated the size of the SBS in the U.S. to be around
well as commercial banks may also conduct much of $25 trillion, but by 2011 estimates indicated a decrease
their business in the SBS, but most are not generally to $24 trillion. Globally, a study of the 11 largest national
classed as SBS institutions themselves. shadow banking systems found that they totaled to $50
A shadow banking system can be composed of a single trillion in 2007, fell to $47 trillion in 2008 but by late 2011
entity that intermediates between end-suppliers and had climbed to $51 trillion, just over its estimated size
end-borrowers of funds, or more usually it could involve before the crisis. Overall, the world wide SBS totalled to
multiple entities forming a chain of credit intermediation. about $60 trillion as of late 2011.
In the latter case, one or more of the entities in the chain Though, it is unclear to what extent various measures
might be a bank or a bank-owned entity. Banks might of the shadow banking system include activities
also be exposed to the shadow banking system through of regulated banks, such as bank borrowing in the
temporary exposures (warehousing), through the repo market and the issuance of bank-sponsored
provision of finance, or through contingent credit lines. asset-backed commercial paper. As per recent FSB
In addition, banks can be funded by entities which form estimates, by 2013 the global size of shadow banking
part of the shadow banking system (e.g., money market system had crossed $75 trillion mark. It's growing
mutual funds). at phenomenal rates in China and India and booming
Though the core activities of some of the shadow in Western banking capitals as well. The situation was
banking entities (like, investment banks) are subject found to be most pressing in Argentina, where the FSB
to regulation and monitoring by central banks and reported a 50 percent increase in 2013.
other government institutions - but it has been common Regulatory Capital Arbitrage and shadow banking
practice for these to conduct many of their transactions Regulatory Capital Arbitrage (RCA) refers to actions
in ways that do not show up on their conventional taken by banks and market participants to exploit
balance sheet accounting and so are not visible to the difference between economic risk and regulatory
regulators or unsophisticated investors. For example, requirements to reduce capital levels without reducing
prior to the 2007-2012 financial crisis, investment exposure to risk. Regulatory capital arbitrage normally
banks financed mortgages through Off-Balance Sheet involves unbundling and repackaging risks so that,
(OBS), securitizations (e.g. asset-backed commercial as measured for Risk-Based Capital (RBC) purposes,
paper programs) and hedged risk through off-balance a disproportionate amount of the portfolio's true
sheet credit default swaps. underlying credit risk is treated as lower risk-weighted
Prior to the 2008 financial crisis, major investment assets, or as having been sold to third-party investors.
banks were subject to considerably less stringent Currently, most RCA revolves around the following
regulation than depository banks. In 2008, investment three guiding principles :
banks Morgan Stanley and Goldman Sachs became Principle 1 (Concentrate credit risk and cherry
bank holding companies, Merrill Lynch and Bear pick) : Restructure positions so as to concentrate
Stearns were acquired by bank holding companies the bulk of the underlying credit risks into instruments
and Lehman Brothers declared bankruptcy, essentially having a combined Maximum Potential Credit Loss
bringing the largest investment banks into the regulated (MPCL) much smaller than that for the original portfolio.
depository sphere. By implication, the remaining instruments will entail
The volume of transactions in the shadow banking relatively low levels of credit risk, but a relatively large
system grew dramatically after the year 2000. Its growth portion of the portfolio's MPCL. Sell these low-risk
was checked by the 2008 crisis and for a short while instruments to investors (a form of 'cherry picking').

special feature
Principle 2 (Remote-origination) : Where possible, because their effects are already captured by the other
structure transactions to ensure that any retained risks explanatory variables.
under Principle 1 are treated as direct credit substitutes Institutional
l cash pools and financial
rather than as recourse. In general, this requires that the development : Stronger growth of institutional
sponsoring bank never formally own the underlying investors is associated with higher growth in
assets (remote-origination). shadow banking, consistent with complementarities
Principle 3 (Indirect credit enhancements) : Where and demand-side effects. Alternatively, this could
possible, convert credit exposures into contractual reflect a general trend in financial development.
arrangements that, while providing some investor Growing
l banking sector : Countries with higher
protection, are not recognized as financial guarantees. banking sector growth rates tend to experience
Such indirect credit enhancements typically incur no higher growth of shadow banking, again suggesting
RBC requirement. complementarities. Alternatively, the results could
RCA has been marked as one of the biggest drivers of reflect a general trend in financial deepening driven by
shadow banking globally. Although shadow banking other factors.
takes different forms around the world, the drivers of MMFs
l and investment funds : Banking growth
shadow banking growth are fundamentally very similar : is not important in explaining the growth of MMFs
shadow banking tends to flourish when tight bank and the correlation is negative for investment
regulations combine with ample liquidity and when funds, in line with the notion that the latter substitute
it serves to facilitate the development of the rest of for, rather than complement, the banking system.
the financial system. The current financial environment However, the growth of MMFs and investment funds is
in advanced economies remains conducive to further strongly associated with the growth of institutional
growth in shadow banking activities. investors, which supports the cash-pool demand
Search for higher yield, regulatory arbitrage, and hypothesis. Similarly, the compression of the term
complementarities with the rest of the financial spread (capturing search for yield) plays only a small
system play a role in the growth of shadow banking. role for MMFs and investment funds.
Though no comprehensive empirical assessment Securitization
l : The growth of private-label
of the drivers of shadow banking appears to have
securitization via SPVs is strongly associated with
been conducted yet. However, following factors are
growth of the banking sector, probably because
found to explain shadow banking growth to a greater
SPVs are frequently sponsored or owned by banks.
extent :
As expected, the growth of institutional investors
Bank regulation
l : More stringent capital requirements, is less correlated with the growth of securitization.
for example, are associated with stronger growth of Securitization growth is more strongly (and negatively)
shadow banking. This is consistent with the notion that associated with the term spread than are MMFs.
banks have an incentive to shift activities to the nonbank The impact of capital regulations is less important
sector in response to certain regulatory changes. for securitization than for MMFs.
Liquidity
l conditions : The negative correlation Regulatory arbitrage following the 1988 Basel Accord
of shadow banking growth with term spreads and spurred the growth of securitization in Europe and
interest rates becomes considerably stronger after the United States. The Basel Accord on bank capital
2008. This shift is in line with the changed role rules boosted the securitization of low-risk loan portfolios
of the term spread in the context of quantitative and the retention of high-risk loans because of a lack
monetary easing since then. However, there was no of differentiation between high- and low-quality loans.
direct evidence for the role of capital flows, possibly In the late 1980s, regulatory arbitrage also motivated

special feature
the introduction of Collateralized Debt Obligations (a) increasing the measures of regulatory capital
(CDOs) and Structured Investment Vehicles (SIVs). appearing in the numerators of these ratios, or
The growth in securitization markets strengthened in (b) decreasing the regulatory measures of total risk
the low-interest-rate environment in the mid-2000s, appearing in the denominators (e.g., total risk-weighted
in line with the econometric evidence. assets). Available evidence suggests that in the short
Heightened restrictions on banks, including on deposit run, most banks have tended to react to capital
rates, seem to be an important driver of shadow pressures in the ways broadly envisioned by the
banking in China. In response to the rapid growth of framers of the Accord. That is, by increasing their
bank lending and concerns about inflation, in 2010, the capacity to absorb unexpected losses through
Chinese government placed significant restrictions on the increased earnings retentions or new capital issues
traditional banking system (including more conservative and by lowering their assumed risks through reduction
credit quotas). The intervention slowed conventional in loans and other footings.
lending but not off-balance-sheet loan originations. Quite apart from these 'traditional' (on-balance sheet)
Regulatory arbitrage and government support adjustments, evidence also suggests that in some
encouraged the growth of special-purpose non-bank circumstances banks may attempt to boost reported
financial institutions (Sofoles) in Mexico. Similarly, capital ratios through purely 'cosmetic' adjustments,
banking activity is complemented in India by non-bank which do little to enhance underlying safety and
financing companies. These companies are seen by soundness. Broadly, such cosmetic adjustments involve
banks with less-developed branching networks as a way artificially inflating the measures of capital appearing in
to complement credit allocation in semi-urban and rural the numerators of regulatory capital ratios, or artificially
areas of the Indian economy, in particular to meet their deflating the measures of total risk appearing in the
assigned targets for lending to priority sectors. Hence, denominators.
non-bank financial institutions sometimes are more able Where permitted by applicable accounting standards
than banks to reach out to certain group of borrowers. or supervisory policies, examples of the former
While closely analyzing the regulatory landscape, (cosmetic capital adjustments) include devices such
it becomes evident that traditional banks, which as gains trading or under-provisioning for loan loss
were at a regulatory disadvantage as compared to reserves. Often such actions boost regulatory capital
shadow banks even before Basel III, will be further levels temporarily and may not correspond to any
discriminated due to the higher capital and liquidity real increase in a bank's capacity to absorb future
requirements, with investment banking divisions unexpected losses.
being most affected. As shadow banks are not the The second form of cosmetic adjustment exploits
direct subject of the regulatory initiatives, they escape shortcomings in the measures of total risk appearing in
almost unscathed. This regulatory imbalance could the denominators of regulatory capital ratios. In recent
drive more and more financial businesses from the years, securitization and other financial innovations
traditional to the shadow banking sector, where both have provided unprecedented opportunities for banks
investors and financial intermediaries can benefit to reduce substantially their regulatory measures of
from cost advantages due to less strict regulations risk, with little or no corresponding reduction in their
especially around capital and liquidity requirements. overall economic risks as a process termed Regulatory
Basel Accords and Regulatory Capital Arbitrage Capital Arbitrage (RCA). These methods are used
routinely to lower the effective RBC requirements
Arithmetically, banks attempting to boost their Risk-
against certain portfolios to levels well below the
Based Capital (RBC) ratios under the Basel Capital
Accord's minimum RBC standard. Even with the same
Accord have but two options for achieving that end :
nominal capital standard in place across banks and over

special feature
time, the avoidance of regulatory capital requirements rise to RCA under the Accord also distort bank behavior
through RCA constitutes an erosion of effective capital in other ways, such as discouraging the true hedging of
standards. economic risks.
The consequences of RCA are several. Foremost, Basel II attempted to align economic and regulatory
there is a greater likelihood that reported regulatory capital more closely to reduce the scope for regulatory
capital ratios could mask deteriorations in the true arbitrage. But, there have been huge variations across
financial conditions of banks. Competitive inequities the geographies (in approaches, deadlines, national
also may emerge to the extent that RCA is not equally discretions, etc.) which again gave rise to regulatory
accessible to all banks, possibly owing to economies arbitrage. For example, by providing at least three
of scale and scope, or international differences in alternative capital calculation methods, Basel II creates
accounting, supervisory, and legal regimes. Available differences that do not exist in Basel I. Again, the
evidence suggests that the volume of RCA activity treatment of non-investment-grade credits under
is large and growing rapidly, especially among the the standardized approach is so different from the
largest banks. treatment under the foundation or advanced Internal
Moreover, with ongoing advances in securitization Ratings Based (IRB) approach.
techniques, credit derivatives, and other financial When looking at how Basel III will increase stability
innovations working to reduce the costs of RCA, these and safety across the banking sector, it is important
trends remain unabated. Absent measures to reduce to realize that Basel III builds on the requirements of
incentives or opportunities for RCA, over time such Basel II, and as such, the existing shortcomings of
developments could undermine the usefulness of formal Basel II remains unchanged. It is believed that the
capital requirements as prudential policy tools. new Basel III framework relate to its facilitation of
Ultimately, RCA is driven by large divergences that the shadow banking system whilst constraining the
frequently arise between underlying economic risks banking sector. The new, more stringent capital and
and the notions and measures of risk embodied in liquidity requirements introduced through Basel III are
regulatory capital ratios. As discussed below, such likely to impact the more highly regulated banking
divergences create opportunities to unbundle and sector since it is likely that there will be greater incentives
repackage a portfolio's risks in ways that can reduce to transact in less stringent regulated sectors such
dramatically the effective capital requirement per dollar as the shadow banking system or through less stringent
of economic risk retained by a bank. Efforts to stem regulated capital instruments.
RCA without narrowing or eliminating these divergences Conclusion
as for example, by limiting banks' use of securitization The new capital and liquidity requirements under
and other risk unbundling technologies as would be Basel III reforms, like its predecessors, aims of
counterproductive and perhaps untenable. designing macro-prudential regulation of the financial
In some circumstances, RCA is an important 'safety- sector. Even though it is a great improvement, it still
valve' that permits banks to compete effectively (with carries many of the weaknesses of its predecessors.
non-banks) in low-risk businesses they would otherwise Therefore, a harmonized set of standards (comprising
be forced to exit owing to unreasonably high regulatory global and domestic realities), particularly at macro
capital requirements. Moreover, as evidenced through prudential level, is essential to the facilitation of
their widespread use by non-banks, securitization and coordination, as well as the aim of achieving the
other risk unbundling technologies appear to provide objectives of mitigating systemic risks, regulatory
genuine economic benefits to banks, quite apart from arbitrage practices and facilitating the vital roles of
their role in RCA. Lastly, the same shortcomings giving supervisors.

special feature
However, regulatory capital arbitrage complicates the References
problem of designing any new regulatory structure for the - This Time Is Different : Eight Centuries of Financial Folly (2009);
financial sector. It implies that capital requirements Carmen M. Reinhart and Kenneth S. Rogoff
must apply in some form to the shadow banking system - Manias, Panics, and Crashes : A History of Financial Crises
as well as the traditional banking system. Otherwise, (1978); Charles P. Kindleberger
certain forms of financial intermediation will simply shift - Emerging problems with the Basel Capital Accord : Regulatory
from the traditional to the shadow system. In addition, capital arbitrage and related issues (2000); David Jones
if the problem we want to manage is systemic risk, - Banks, Shadow Banking, and Fragility (ECB Working Paper
then focusing solely on institutions with certain types Series, August 2014); Stephan Luck and Paul Schempp
of charters will not be sufficient, especially as the - Risk Taking, Liquidity, and Shadow Banking : Curbing Excess
While Promoting Growth (Global Financial Stability Report-
unregulated ones become bigger and more numerous.
GFSR, October 2014); International Monetary Fund (IMF)
Hence, efforts may continue on 'harmonisation of global - Into the Shadows : How regulation fuels the growth of the
standards' which would fetch mitigation of systemic risks shadow banking sector and how banks need to react(2013);
through the redress of shadow banking channels and Benjamin Baur & Philipp Wackerbeck
regulatory arbitrage practices, as well as the efficient - Financial stability, new macro prudential arrangements and
functioning of new macro prudential frameworks under shadow banking: regulatory arbitrage and stringent Basel III
Basel III. This will ensure facilitating greater financial regulations (2011); Marianne Ojo
stability on a macro prudential basis and would not - In the Shadow of Basel : How Competitive Politics Bred the
Crisis (2013); Matthias Thiemann
be much prone to regulatory gaps which could foster
capital arbitrage and the building up of systemic risks. [
Real Estate Investment Trusts
Globally, units of Real Estate Investment Trusts (REITs) sell like stocks on major exchanges and they invest in
real estate directly, either in properties or mortgages. They enjoy special tax considerations and typically offer investors
high yields as well as a framework for wider investor participation in real estate. Most of the REIT earnings are distributed
to shareholders regularly as dividends. According to the European Public Real Estate Association's (EPRA) Global REIT
Survey 2014, 37 countries worldwide have REITs or 'REIT-like' legislations in place. The structure of REITs varies across
countries and it is constantly evolving. Since their introduction in Asia in the early 2000s, REITs have been adopted across
the continent, growing into a market worth over USD 140 billion.
REITs are mainly of three types : Equity REITs, Mortgage REITs and Hybrid REITs. Equity REITs invest in and own
properties and their revenues come principally from rents. Mortgage REITs invest in real estate and mortgage backed
securities and their revenues are generated primarily as interest income that they earn on the mortgage loans. Hybrid
REITs combine the investment strategies of Equity REITs and Mortgage REITs by investing in both properties and
mortgages. Like any other investment, investments in REITs have their own set of risks. Mortgage REITs (mREITs)
are involved in lending money to owners of real estate and buying (mostly agency backed) mortgage backed securities
(MBS) and their business model layers on other risks that could amplify market dislocations. Some of these are : a) Funding
and liquidity risk, b) Refinancing and rollover risk, c) Maturity mismatch risk, d) Convexity risk, e) Concentration and
correlation risk and f) Market risk. These risks, in turn, are inter-related and their presence can lead to a fire sale
event. However, in India, the current REIT regulations do not provide for mREITs and are aimed at developing the real
estate sector in a robust manner.

Contemporary
special feature
Issues in Banking
Basel-III bonds - How effective are they

in shoring up capital adequacy?
?
Dr. Madhavankutty. G. *
The aftermath of the global financial crisis that led (AT-1 and Tier II) have certain in built features aimed as
to the collapse of ‘too big to fail’ institutions exposed the a protection against excessive risk taking which were
underlying inadequacies of Basel-II framework. By now, it absent in Basel-II framework.
is amply clear that high leverage and lack of a robust and The major difference between the new bank capital
effective supervisory mechanism was the root cause for and older versions is that Basel III compliant bonds
the unfolding of the crisis of such a magnitude. A slew of can be converted into equity (shares) or even written
debates started doing the rounds as to why and how off at the discretion of regulators, if bank capital falls
the crisis originated. The greed and lust of Wall Street below a predetermined threshold known as the Point
managers were also cited as a reason. Accusations were of Non Viability (PONV) in technical jargon. This means
directed at rating agencies also. Whatever be the cause, that investors could potentially lose all of their money,
it exposed three major weaknesses of the global financial if and when a regulator determines that a specific bank
architecture in existence at that point of time, viz., the has reached the point of non-viability. The difference
fallibility of exotic instruments such as Collateralized Debt is that existing subordinated debt is written off only in
Obligations, absence of a robust supervisory mechanism the event of actual bank failure. The Basel Committee
and rampant mis-selling. on Banking Supervision (BCBS) has provided flexibility
It is also pertinent to note that entire world of finance took for regulators to determine the trigger as to when the
serious note of the crisis not the least because it led to the Point of Non Viability clause sets in.
collapse of too big to fail institutions but due to its contagious A non viable bank is one which, owing to its financial
and systemic nature. The most important lesson learnt was and other difficulties, may no longer remain a going
the extent to which institutions were vulnerable to financial concern on its own in the opinion of the regulator unless
events. The need for a viable alternative to Basel-II was appropriate measures are taken to revive its operations.
unanimously appreciated and consequently, Basel-III came In such a situation, raising the Common Equity Tier I
into force. In this article, we will bring forth the salient capital of the bank should be considered as the most
features of Basel-III bonds and their efficacy in shoring up appropriate measure. Such measures would include
capital adequacy of the banking sector. write-off / conversion of non-equity regulatory capital
Basel-III bonds- A brief Overview into common shares in combination with or without
Under Basel-II, the common forms of bond issuance by other measures as considered appropriate by the RBI.
banks were through subordinated debt bonds. Perpetual Point of Non-Viability (PONV) for all Basel III capital
debt Instruments were also available under Basel-II instruments, as stated in the former para would be the
format as Tier 1 capital. Basel-III framework also provides earlier of 1) Decision by RBI for a conversion / permanent
for raising capital through non equity instruments known write-off, without which the firm would become non-
as Additional Tier 1 (AT-1) instruments. Thus, under the viable or 2) Decision by relevant authority to make a
Basel-III regime also, both Tier 1 bonds as well as Tier II public sector injection of capital, or equivalent support,
bonds can be raised. However, Basel-III complaint bonds without which the firm would have become non-viable.
* Chief Manager (Economist), Bank of India.

special feature
According to RBI’s initial estimates, Indian banks need to Thus, banks are mandated to maintain a significantly
raise about `1.9 trn of AT1 securities by March 2019. higher Tier 1 capital under Basel-III regime. Minimum
Salient features with regard to Basel-III bonds in Total capital requirement is also higher at 11.5%
India under Basel-III vis-à-vis 9% under Basel-II framework.
RBI guidelines on Basel III introduced stringent
Before analyzing in detail Basel-III bonds and their
loss absorption clauses so that loss absorption
features, it would be pertinent to have a brief view of the
kicks in well before an actual default which
Basel-III capital requirement in India, as formulated by
necessitates injection of funds by the state. Both
the Reserve Bank of India.
Tier I and Tier II instruments have significant
Particulars Basel-II (%) Basel-III (%)
loss absorption features. However, Tier I instruments
Minimum common equity Tier 1 Ratio 3.6 5.5
are meant to absorb losses on an on going basis
Capital Conservation Buffer Nil 2.5
and hence loss absorption trigger kicks in early.
Minimum common equity Tier 1 ratio 3.6 8.0
Tier II instruments also have loss absorption features.
Additional Tier 1 capital 2.4 1.5
These are meant to be invoked only at the point of
Minimum Tier 1 capital 6.0 9.5
non-viability.
Tier II capital 3.0 2.0
Minimum total; capital ratio 9.0 11.5
Key Features of Tier I Instruments under Basel II
Source : Reserve Bank of India (RBI)
and III, and Implications
Tier 1 Bonds (Basel II) Additional Tier 1(Basel-III) Implications

Bank shall not be liable to pay interest if its Basel III capital instruments, upon the Since discretionary payments on other Tier I
capital adequacy falls below the minimum occurrence of the trigger event, at the option capital instruments would be restricted in
requirement or interest payment will result of RBI, will have to be either permanently case Common Equity falls below 8%, the
in bank’s CRAR to go below minimum written off, or converted into Common Equity. threshold for default on Basel III Tier I
regulatory requirement. However the bank Two pre-specified triggers for Basel III interest could be 8% Common Equity. This
may pay interest with prior approval of the compliant Additional Tier I (AT1) instruments; essentially marks a shift of default trigger
RBI when the impact of such payment may a lower pre-specified trigger at CET1 of 5.5% from breach of overall capital adequacy of
result in net loss or increase in net loss, of Risk Weighted Assets (RWAs) will remain 9% (under Basel II) to breach of Common
provided the CRAR remains above the effective before March 31, 2019, after which Equity Tier I of 8% and 5.5%/6.125% as the
regulatory norm. this trigger would be raised to CET1 of case may be for principal conversion or
6.125% of RWAs for all such instruments. write-off under Basel III. At a first glance
itself, the probability of breaching the
Capital Conservation (by restricting dividend
Basel III Common Equity threshold is likely
payouts etc.) to kick in once Common Equity
to be higher than that of breaching overall
Tier I drops below 8%. If a bank wants to
9% capital adequacy under Basel II.
make payments in excess of the amount
that the norm on capital conservation allows, Though Basel II provisions might well lead
it would have the option of raising capital to permanent loss on interest / coupon
for such excess amount. payments, there was no impact on principal.
Bank must have full discretion at all times However, Under Basel III, severity of loss
to cancel payments. Cancellation of is likely to be significantly higher and
discretionary payments not to be an permanent as :
event of default. 1. There may be a permanent loss on coupon
once capital conservation kicks in
2. PONV trigger could lead to Write-off /
Conversion prior to any public injection
of capital. Moreover, the loss could be
permanent on Additional Tier I when
there is public injection of funds on
PONV invocation

special feature
As the above table highlights, the loss absorption The regulatory framework has a host of implications
capacity of Additional Tier I instruments under Basel for Public Sector banks desirous of raising capital
III is higher than that of Basel II Tier I instruments. through AT 1 instruments. Traditionally, PSBs look for
While there was no clause on write-off / conversion capital support from the Government. However, as the
in the earlier instruments, the new instruments would features of AT 1 instruments suggest, the trigger would
have to be converted or written off even when the start long before an actual capital infusion by the
bank concerned is far from being totally unviable Government due to the capital conservation trigger of 8%
as the trigger starts at 5.5% / 6.125% under Basel III. and PONV trigger of 5.5 / 6.125%. For private sector
Further, the trigger for non-payment of coupon on banks also, with fairly higher capital and higher levels of
Additional Tier I may be breach of the 8% Common profitability, the probability of a drop in Common Equity
Equity unlike 9% overall capital adequacy under levels to 8% is relatively higher than the likelihood of
Basel II. Additionally, the provisions under PONV default on conventional instruments.
could translate into permanent loss for Additional By implication, banks scoring relatively low on these
Tier I investors in case of injection of public funds parameters would have a relatively higher probability
under PONV. Thus Basel-III framework is far stringent of capital erosion in future.
and imposes greater reputational risk on issuers
Key Features of Tier II Instruments under Basel II
compared to Basel-II instruments.
and III, and Implications
Lower Tier II bonds Upper Tier II bonds Basel-III Tier Ii bonds Implications
Subordinated to Bank shall not be liable to pay Basel III capital instruments upon Probability of default for Basel III
depositors on liquidation interest if its CRAR is below the the occurrence of PONV, compliant Tier II bonds is likely
minimum requirement or interest at the option of RBI, may either to be higher than that for Basel II
payment will result banks’ CRAR be written off, or converted into Lower Tier II instruments; However,
to go below minimum regulatory Common Equity. it is likely to be significantly lower
requirement. than that for Upper Tier II bonds
However, the bank may pay as the probability of PONV trigger
interest with prior RBI approval invocation is likely to be much lower
when the impact of such payment than the probability of a bank
may result in net loss or increase breaching 9% capital adequacy.
in net loss, provided the CRAR
remains above the regulatory
norm.
No clause on any loss No clause on any loss absorption PONV for all Basel III capital Under Basel III, severity of loss
absorption feature feature. instruments would be the is likely to be significantly higher
earlier of : as PONV trigger could lead to
- Decision by the RBI for write off / conversion prior to any
conversion / permanent write-off, public sector injection of capital.
without which the firm would
become non-viable;
- Decision by relevant authority

to make a public sector injection
of capital, or equivalent support,
without which the firm would
become non-viable.

special feature
The features are almost similar to that of AT-1 conservation entails, it would have the option of raising
instruments. Basel III Tier II bonds issued by banks capital for such excess amount. This issue would be
will provide to their depositors and senior creditors discussed with the bank’s supervisor as part of the
an additional layer of protection. According to the capital planning process.
Basel III guidelines issued by RBI, Basel III Now, the significant question is how effective
compliant Tier II bonds are expected to absorb losses are these instruments in capital raising. A major
when the Point of Non-Viability (PONV) trigger is advantage of these bonds is banks are able to raise
invoked. As and when the PONV trigger is invoked, capital without seeking government support. This
Tier II instruments, at the option of RBI, will be makes the instrument handy. Moreover, in a scenario
either written off or converted into Common Equity. of falling yields, these bonds would be highly attractive
Traditionally, Government of India (GoI), as a to banks, reducing their cost of funds. Moreover,
shareholder, has been a major source of financial investors would be willing to invest due to the
support to banks. Since, GOI would not like to see inherent sovereign guarantee in the case of PSBs.
PONV being breached in the case of PSBs, it is Though PONV clause is inserted, no public sector
expected to infuse equity in public sector banks well banks is expected to default on their bonds.
in advance so that their capital remains well above The recent RBI notification permitting call options
the PONV triggers. Further, considering GoI’s stance on AT-1 bonds after every five years instead of the
on maintaining 8% Tier I capital and the likely severe 10 year clause in vogue initially will further enhance
restrictions on banks’ operations in case PONV is appetite for these bonds since coupon will decline. Bank
invoked, the probability of the trigger getting breached of India and IDBI Bank have come out with Basel-III
would be quite low. bonds with issue size of `2,500 Cr which were fully
A word of two needs to be mentioned about capital subscribed. This indicates it is possible for these bonds
conservation buffers. This is a new prudential measure to have a market. The latest rules also permit banks
under Basel-III framework. According to RBI, to issue Tier 1 bonds to retail investors which were
banks are required to maintain a capital conservation not permitted earlier provided they understand the
buffer of 2.5%, within the overall Common Equity Tier I risks. Also, RBI said that if a bank has met its minimum
capital (CET 1), which is above the regulatory minimum capital requirement already, the lender will be free to
Common Equity capital requirement of 5.5%. There are admit as much of additional capital through
restrictions on the distribution of capital such as paying these instruments as they can raise. Earlier, RBI had
dividend or bonus etc. in case the conservation capital imposed a limit on raising such additional capital.
level falls below 2.5%. This is summarised below : We would be well advised to remember that these
Common equity Minimum capital bonds are at a nascent stage. Moreover, in a country
Tier 1 ratio (%) conservation buffer (%) like India where the corporate bond market is not
5.5-6.125% 100% very well developed, there is a requirement for a
>6.125-6.75% 80% proper institutional mechanism for these bonds to
>6.75-7.375% 60%
achieve optimum success. While a couple of banks
started off with their issuances, a major stumbling
>7.375-8.0% 40%
block is the absence of major players like insurance
>8.0% 0%
majors, pension and provident funds in this market
However, RBI may allow some distribution of earnings by due to restrictions imposed by their respective
banks that are in breach of the proposed capital regulators. Hence, it is imperative to have wide range
conservation buffer. If a bank wants to make payments in of deliberations to ensure that systematically important
excess of the amount that the norm on capital players are attracted to these bonds.

special feature
A significant feature of these bonds is investors will In a developing economy like India, well poised to
also share significant risks since in the event of a hit 8% growth trajectory in a couple of years, the
PONV, it may as well be written off. Thus, there is role of bank credit is extremely important. Comparative
diversification of risk away from a pure bailout which analysis of a key metric like the credit GDP ratio
involves taxpayer money. This will result in better shows that we are below other economies such
due diligence for these bonds. as China. When credit off take happens, capital
Though this is a new and novel instrument for requirement increases, making it imperative for
capital raising which imposes significant stakes for banks to provide due attention to capital raising
both the issuer and the investor, certain grey areas efforts. However, a solace would be better recoveries
still remain. For instance, there is limited international and lower non-performing assets when the economy
experience to draw lessons on the efficacy of this improves. PSBs would be better placed in this regard
instrument. Asian banks are significantly well capitalised since bulk of their exposure to infrastructure projects
than their European counterparts and may require would start earning revenues.
far lower capital. However, if the Asian banks stay The new bank debt can play a leading role in
complacent, European Banks will soon exhaust the buttressing global financial system against future
market for these bonds. Hence, there is a need to systemic risks but it also adds a layer of complexity
seize the moment. Indian banks should tap the market to the task of analysing credit quality. In addition
now as it is the most opportune time due to falling to fundamental company research, an analyst must
interest rates. factor in assumptions about regulation, jurisdiction
Though these bonds come with an in built advantage and the actions of ratings agencies. Given this
of a sovereign rating, the yields on these instruments uncertainty and the fact that Basel III-compliant
are quite high. For instance, Industrial and Commercial capital could even be written off by Asian regulators
Bank of China (ICBC) raised AT-1 bonds at a coupon in the event of “stress”, investors should be cautious
of 6%; In India, these bonds carried yields between about these bonds. In Australia, for example, many
10.6-11% at the time of issuance, signifying some of these new instruments trade on the stock
risk perception among investors. Moreover, the very exchange, sending a clear signal to investors that
fact that some of these banks received an instantly they are an equity-type investment.
high rating may not go well with some investors since Despite all the concerns, Basel-III compliant bonds
asset quality in Indian banking sector is a matter of are an additional tool for banks to raise capital
serious concern. though they come attached with more onerous
A serious area is the absence of big players such conditions. The insertion of Point of Non Viability
as pension and insurance funds in these bonds. They clause is in itself a major development. While
are constrained by regulations and unless some mandating caution among investors, this clause
leeway is offered to them, these bonds may not also imposes significant reputation risks on banks.
pick up much from the initial stage due to lack of This, in itself, should exhort banks to be cautious
market appetite. Yet another issue is the risk averse in their financial management.
nature of retail investors which is an aspect plaguing
not just Basel-III issuers but the corporate bond [
market in India in general. The permission to offer
Basel-III bonds to retail investors, is at best, only a
small step. The necessary and sufficient condition
for which is a developed corporate bond market.

Contemporary
special feature
Issues in Banking
Basel-III : Implementation in
Indian Banking Industry
?
Nagamani. S. *
Year 2014 marks the sixth anniversary of the Figure-1 : Evolution of Basel II to Basel III
collapse of Lehman Brothers which in popular
perception was the trigger for the biggest financial Basel - II
crisis of our generation. Banks and bankers have
been at the heart of crisis. Enhancing the banking
Pillar I Pillar II Pillar III
sector's safety and stability has been the thrust
of post crisis policy reforms. One segment of reforms Minimum Supervisory Disclosure
that has taken a final shape is the BASEL III framework Capital Review & Market
Requirements Process Discipline
for bank capital regulation. The final package was
approved by the G-20 and the roll out has begun.
RBI issued the BASEL III guidelines on capital
regulation in May 2012 after extensive consultations
with all the stake holders. Basel - III
Conceptual issues :
Pillar I Pillar II Pillar III
BASEL III represents an effort to fix the gaps and
lacunae in BASEL II that came to light during the Enhanced Enhanced Enhanced
crisis as also to reflect other lessons of the crisis of Minimum Supervisory Risk
2008. Basel III is an evolution rather than a revolution Capital & Review Disclosure
Liquidity Process for & Market
for many banks. The objectives of BASEL III are to Requirements Firm-wise Risk Discipline
minimize the probability of recurrence of a crisis of Management
such magnitude. BASEL III has set its objectives to and Capital
improve the shock absorbing capacity of each and Planning
every individual bank as the first order of defence.

In the worst case scenario, and if it is inevitable that (Source : A public document of Moody's Analytics)
one or a few banks have to fail, BASEL III has
It can be construed from the above that BASEL III does
measures to ensure that the banking system as
not jettison BASEL II; on the contrary, it builds on the
a whole does not crumble and its spill over impact
essence of BASEL II- the link between the risk profiles &
on the real economy is minimized. Therefore, BASEL
capital requirements of individual banks.
III has some micro-prudential elements so that risk
is contained in each individual institution; and a The Basel committee published its BASEL III rules in
macro- prudential overlay that will lean against the December 2010.The building blocks of BASEL III are :
wind to take care of issues relating to the systemic Higher & better quality capital;
l
risk. A pictorial comparison between Basel II & III is Capital

l buffers which would be built up in good times
depicted in figure-1 : so that they can be drawn down in times of stress;
* Assistant General Manager & Faculty, State Bank Staff College.

special feature
An internationally
l harmonized leverage ratio to in the range of 0 to 2.5 percent of RWA which could
constrain excessive risk taking; be imposed on banks during periods of excess credit
Minimum global liquidity standards;
l
growth. CCB will be phased-in over four years at
0.625% (0.625% X 4=2.5%) per year, commencing
Stronger
l standards for supervision, public disclosure,
from 31.03.16. Banks are required to meet this buffer
and risk management.
with Common Equity Tier 1 capital or other fully loss
Higher Capital Requirement : absorbing capital.
As a percentage of Also, there is a provision for a higher capital
Risk Weighted Assets
surcharge on Systematically Important Banks (SIB).
Basel II Basel III
Banks have to ensure that their countercyclical buffer
A=(B+D) Minimum Total Capital 8.0 8.0
requirements are calculated and publicly disclosed at
B Minimum Tier 1 Capital 4.0 6.0
least with the same frequency as their minimum capital
C Of which Minimum Common
requirement. BASEL III strengthens the counterparty
Equity Tier 1 Capital 2.0 4.5
credit risk framework in market risk instruments.
D Minimum Tier 2 Capital
(within Total Capital) 4.0 2.0 This includes the use of stressed input parameters to
E Capital Conservation determine the capital requirement for counterparty
Buffer (CCB) - 2.5 credit default risk. Ratings are seen as embodying an
F=C+E Minimum Common Equity assessment of the risk of loss due to the default of
Tier 1 Capital + CCB 2.0 7.0 the counter-party and are based on both quantitative
G=A+E Minimum Total Capital + CCB 8.0 10.5 and qualitative information. Besides, there is a new
We can see from the table above, BASEL III requires capital requirement known as CVA (Credit Valuation
higher and better quality capital. The minimum total Adjustment) risk capital charge for OTC derivatives to
capital remains unchanged at 8 percent of Risk Weighted protect banks against the risk of decline in the credit
Assets (RWA). However, BASEL III introduces a capital quality of the counter party.
conservation buffer of 2.5 percent of RWA over and Liquidity Standards & Leverage Ratios : The
above the minimum capital requirement, raising the introduction of Leverage ratio has the objective of
total capital requirement to 10.5 percent against 8.0 protecting against system-wide build-up of leverage
percent under BASEL II. This buffer is intended to that result in destabilizing unwinding process during
ensure that banks are able to absorb losses without stress. It also protects against piling up on 'low risk
breaching the minimum capital requirement, and are assets', which may not remain as such under extreme
able to carry on business even in a downturn without situations producing systemic risk. BASEL III addresses
deleveraging. This buffer is not part of regulatory both potential short terms liquidity risk and longer
minimum, however, the level of the buffer will determine term structural liquidity mismatches in banks balance
the dividend distributed to shareholders and the bonus sheets. To cover short term liquidity stress, banks
paid to staff. There are also other perceptions regarding will be required to maintain sufficient high quality
the quality of capital within the minimum total so that unencumbered liquid assets to withstand any stressed
capital is able to absorb losses, and calling upon the funding scenario over a 30 day horizon as measured
tax payers to bear the burden of bailout becomes by the Liquidity Coverage Ratio (LCR).
absolutely the last resort.
Definition of Liquidity Coverage Ratio :
Capital Buffers : (Counter Cyclical Buffer) : In addition
Liquidity Coverage Stock of high-quality liquid assets
to the capital conservation buffer, BASEL III introduces = >
_ 100
Ratio (LCR) Total Net Cash outflows over the
another capital buffer (BASEL II failed to demand
next 30 calender days
adequate loss absorbing capital to cover market risk)

special feature
To mitigate liquidity mismatches in the long term, banks Do the Indian Banks need BASEL III?
will be mandated to maintain a Net Stable Funding Ratio In the present day globalised world it is difficult for any
(NFSR). The NFSR mandates a minimum amount of local financial and economic system to completely
stable sources of funding relative to the liquidity profile of insulate itself from the global economic shocks. India
the assets, as well as the potential for contingent liquidity integrates with the rest of the world, as increasingly
needs arising from off-balance sheet commitments over Indian Banks go abroad and foreign banks come on to
a one year horizon. The NFSR is aimed at encouraging our shores; and India cannot afford to have a regulatory
banks to exploit stable sources of funding. deviation from Global Standards. Any deviation will hurt
Provisioning Norms : The Basel Committee us from both by way of perception and also in actual
recommends for the adoption of an 'expected loss' based practice.
measure of provisioning which captures actual losses more Perception
l of a lower standard regulatory regime will
transparently. It is also less pro-cyclical than the current put Indian banks at a disadvantage in global
'incurred loss' approach. The expected loss approach for competition;
provisioning will make financial reporting more useful for all
Deviation
l from BASEL III will also hurt us in actual
stake holders, including the regulators and supervisors.
practice since BASEL III provides for improved risk
Disclosure Requirements : The disclosures made by management systems in the banks.
the banks are important for market participants to make
Regulator's (RBI) view : It is important that Indian Banks
informed decisions. At present the market disclosures
have the cushion afforded by the risk management
made by banks are neither appropriate nor sufficiently
systems to withstand shocks from external systems,
transparent to make any comparative analysis. To
especially as they deepen their links with global financial
address this, BASEL III requires banks to disclose all
system going forward. It needs to be further appreciated
relevant details, including any regulatory adjustments, as
that if the implementation of BASEL III is not consistent
regards the regulatory capital of the bank.
across jurisdictions there would be a race to the bottom to
RBI's Guidelines on BASEL III Transitional make use of arbitrage opportunities which nobody wins.
Arrangements :
What banks are expected do in transition towards
In order to ensure smooth migration to BASEL III without BASEL III?
aggravating any near time stress appropriate godfathering
BASEL III is just a part of the financial sector reforms
and transitional arrangements have been suggested. In
agenda being pursued by G20. BASEL III with both
view of these large scale reforms and their impact, BASEL
micro prudential elements and a macro-prudential
committee planned to implement the changes over period
overlay will take care of individual banks and also of
of time, starting from April 2013 to March 2019 as under :
issues relating to the systemic risk. There is a need for
12.0% 10.875% 11.5% capacity building within the banks, and also in the RBI,
10.25%
10.0% 9.625% 2.0% 2.0% 2.0% which is the regulator, to efficiently implement BASEL III.
9.0% 9.0% 9.0% By far the most important reform is that there should
2.0%
8.0% 2.5% 2.5% 1.25% 1.875% 2.5% be a radical change (of perception) in banks' approach
3.0% 0.625%
6.0% 7.0% 7.0% 7.0% 7.0% 7.0% to risk management. The larger banks need to migrate
6.5%
6.0%
to the Advanced Approaches, especially as they expand
4.0%
5.5% 5.5% 5.5% 5.5% 5.5%
their overseas presence. The adoption of advanced
4.5% 5.0%
2.0% approaches to risk management will enable banks to
0.0% manage their capital more efficiently and improve their
01/04/13 FY14 FY15 FY16 FY17 FY18 FY19 profitability. This graduation to Advanced Approaches
Common Equity Tier 1 Capital conservation buffer Tier 2 has three requirements :

special feature
A change
l in perception from looking upon the as part of Operational Risk Management Framework
capital framework as a compliance function to (ORMF). In accordance with the PSMOR, banks are
seeing it as a necessary pre-requisite for keeping required to ensure that the risk management control
the bank sound, stable and therefore profitable; infrastructure is appropriate to assess inherent risk
Deeper and broad based capacity in risk management;
l of the products, activities, processes and systems
through its Change Management Framework.
Adequate and good quality data.
l
Other issues such as corporate governance,
There could be some initial cost in implementation
compensation practices, and resolution regimes;
of BASEL III, but the long-term benefits will be immense
enhancing the regulatory and supervisory framework
as it would reduce the probability of banking crises
for global and domestic Systemic Important Banks
(and unexpected failures through risk)
(SIBs); improving the OTC derivatives markets; and
SBI has been a pioneer and trend setter in the regulation of shadow banking system are engaging
transition to BASEL III in Indian Banking Industry. the attention of Financial Stability Board (FSB) and
The bank has implemented BASEL III as on 1st April Basel committee. The macro-prudential framework
2013. State Bank of India has been leading the under BASEL III is still untested and would need
banking sector in complying to BASEL II in the past continuous research, monitoring, and experience
and Basel III in the present. SBI Position as on sharing among the regulators to ensure its effective
September 2014 is as under : implementation.
Capital Basel II Capital Basel III References
Component Amount % Component Amount %
- Dr. Vighneswara Swamy, IBS Hyderabad : BASEL III,
(` in Cr) (` in Cr)
Implications for Indian Banking
CET1 1,07,384 9.53%
- The Indian Banker : BASEL III in Global and Indian Context :
AT1 997 0.09% 10 key questions
Tier 1 1,11,564 10.01% Tier 1 1,08,381 9.62% - Vinimaya : Implications of BASEL III for Capital, Liquidity and
Tier 2 31,836 2.86% Tier 2 30,600 2.71% profitability of Banks
Total CAR 1,43,400 12.87% Total CAR 1,38,980 12.33% - Reserve Bank of India Bulletin on BASEL III
Leverage 4.94% - Reserve Bank of India, Circular guidelines on BASEL III
ratio
[
One of the significant challenges posed by Basel III
apart from the increased capital standards is that of
creating a new risk management culture and effective
data management systems. The risk management
departments would require quality data that is clean
and accurate. In effect, Basel III is changing the way
the banks look at their risk management functions
and might imply them to go for robust risk
management framework to ensure a true enterprise
risk management. The guidelines issued by RBI on
Advanced Measurement Approach and Supervisory
Guidelines on Principles of Sound Management of
Operational Risk (PSMOR) issued by Basel Committee
on Banking Supervision (BCBS) have emphasized the
need to put in place Change Management Framework

Contemporary
special feature
Issues in Banking
Implementation of Basel III regulations -

New Generation Private Sector Banks
?
P. S. Khandelwal *
Over the past century, economic and financial crisis Basel II : the New Capital Framework
of global magnitude have led to new and improved In 2004, comprehensively revised framework was
regulatory approaches for bank management and released that comprised three pillars : (i) Minimum capital
supervision. Nearly four decades ago the world requirements based on expanded rules; (ii) Supervisory
economy witness breakdown of the then prevalent review of capital adequacy and internal assessment
system of exchange rates that disrupted the global process; and (iii) Disclosure requirements to strengthen
financial markets. This led to establishment of an market discipline. This was aimed at improved correlation
international forum for the purpose of coordination between regulatory capital and underlying risks in
among various nations for improvement in supervisory the environment of continuing financial innovation.
knowhow and improvement in banking supervision in The focus, however, was primarily on the banking
various nations. This forum known as Basel Committee book. In June 2006, a comprehensive framework
on Banking Supervision has over last four decades for treatment of banks' trading books was added.
worked on various areas and issued several guidelines Later, 'Principles for Sound Liquidity Risk Management
covering diverse aspects of banking supervision. Its and Supervision' were also released which ironically
most significant work is in the area of capital adequacy coincided with the failure of Lehman Brothers.
and risk management in banks.
Sub-prime Crisis
Evolvement of Basel Regulations
The widely known sub-prime crisis that brewed in
Basel I the US and grew to engulf the entire global community
During 1980s Latin American debt crisis the financial had its seeds in too much borrowing and flawed
strength of various international banks came under financial modeling. Financial products like Collateralized
stress and became weaker. Divergence in banking Mortgage Obligations (CMOs) and Credit Default Swap
regulations prevalent in different countries made the (CDS) led to widespread effects to other sectors of
situation more difficult. This led to formulation and the economy, and on financial markets as a whole. So
approval of Basel Capital Accord in 1988 that called intense was the effect of sub-prime crisis that trust
for a minimum capital ratio of capital to risk-weighted eroded sharply in the financial markets leading to severe
assets of 8% to be implemented by the end of 1992. liquidity crunch, and also a spate of bank failures
In 1996, Market Risk Amendment was added to the apart from the notable failure of Lehman Brothers, and
1988 Accord that was to take effect at the end of driving some of the largest banks to near collapse
1997. This added a capital requirement for the situation. There was a deep recession in the US and
market risks arising from banks' exposures to the global economy went into free-fall.
foreign exchange, traded debt securities, equities, The four major factors identified as the primary cause for
commodities and options, and allowed to use this situation are :
internal models (value-at-risk models), subject to i) Higher leverage increasing sensitivity of the financial
strict quantitative and qualitative standards. system.
* Chief Compliance Officer & Principal Officer, IndusInd Bank Ltd.

special feature
ii) Wider maturity mismatch in securities portfolios. Regulatory Capital As % to Phasing
RWAs
iii)Financial innovation of opaque financial instruments
(v) Minimum Tier 1 Capital Ratio 7.0 1/4/2013 to
and markets increasing information asymmetries.
[(i) +(iv)] 31/3/2015
iv) Higher proportion of incentive-based compensation. (vi) Tier 2 Capital 2.0 1/4/2013 to
31/3/2015
The crisis led to rethinking on some aspects of the Basel
(vii) Minimum Total Capital Ratio (MTC) 9.0 1/4/2013
framework, especially the measures and treatment of
[(v)+(vi)]
risk. Favored treatment to certain asset categories,
(viii) Minimum Total Capital Ratio + Capital 11.5 31/3/2016 to
internal risk measures, risk based on credit ratings all Conservation Buffer [(vii)+(ii)] 31/3/2019
were used to facilitate riskier asset allocation than that
Phasing arrangements for other additional parameters
would be acceptable to the regulators.
are as follows :
Basel III
a) Leverage Ratio : Tier I leverage ratio has been
Sub-prime crisis prompted a comprehensive relook at stipulated as min. 3% during 1/1/2013 to 1/1/2017. This
Basel framework and that led to release of 'Basel III : is proposed to be reviewed by mid - 2017 and the
International framework for liquidity risk measurement, revised threshold will be made effective from 1/1/2018.
standards and monitoring' and 'Basel III : A global
b) Liquidity Coverage Ratio : This is effective from
regulatory framework for more resilient banks and
1/1/2015 at 60%, and is required to be increased
banking systems', in December 2010. These have
gradually to 100% as on 1/1/2019.
revised and strengthened the three pillars of Basel II.
Several new features also have been introduced c) Net Stable Funding Ratio : This will be Minimum
capital conservation buffer, countercyclical capital standard to be introduced by 1/1/2018
buffer, leverage ratio, liquidity coverage ratio, and New Generation Private Sector Banks (NGPSB)
additional measures for systemically important banks. As a part of liberalization measures taken in India during
Besides certain qualitative changes have been nineties of the last century, more than four decades after
made in the capital requirements, namely certain nationalization of banks, new banks were permitted to be
capital instruments have been derecognized, some set up in the private sector. Ten banks were set up in two
new types of capital instruments have been included, batches, nearly ten years apart. Of these, three banks
and stipulations for Common Equity in addition to that viz. Global Trust Bank, Times Bank, and Centurion Bank
for Tier I capital have been added. were merged into other new generation private sector
The revised capital requirements are phased over 2013 banks as their sustainability had become difficult. One of
to 2017. Simultaneously, the capital instruments that do these banks was placed under moratorium as its financial
not qualify under the new framework will be phased out condition had deteriorated precariously. Other two banks
though over a longer period of 10 years. The capital ratio too faced merger with other banks, as their sustenance
requirements are briefly indicated below. was doubtful or challenging. One third of new generation
Regulatory Capital As % to Phasing private sector banks met an early end. Besides, by
RWAs virtue of reverse merger of IDBI with IDBI Bank it moved
(i) Minimum Common Equity Tier 1 5.5 1/4/2013 to from private sector to public sector category. Separately,
Ratio (CET 1) 31/3/2015 Development Credit Bank joined this group by virtue of
(ii) Capital Conservation Buffer 2.5 31/3/2016 to conversion of Development Co-operative Bank.
(Common Equity) 31/3/2019
(iii) Minimum CET 1 Ratio + Capital 8.0 31/3/2016 to
The aggregate total assets and total liabilities of the
Conservation Buffer [(i)+(ii)] 31/3/2019 seven new generation private sector banks had a share
(iv) Additional Tier 1 Capital (Maximum) 1.5 1/4/2013 to of 16.11% and 20.60% respectively in aggregate total
31/3/2015 assets and total liabilities of all scheduled commercial

special feature
banks (ASCB) as at 31st March 2014 was (Refer Table-1 to capital. All seven banks are compliant with the
and Chart-I). Aggregate capital of NGPSB in aggregate prescribed level of CRAR. As against the regulatory
capital of ASCB was 6.74% and the share of aggregate minimum of 9%, the CRAR for these banks ranged
reserves and surplus was 20.60%. from 12.96% to 16.64%. Of the seven banks, four had
Table-1 : Assets & Liabilities of New Generation Pvt. Sector Banks (As at 31st March 2014) (` in million)
Banks Investments Advances Total Capital Res. & Deposits Borrowings Total
Assets Sur. Liabilities
Axis Bank 11,35,484 23,00,668 38,32,449 4,698 3,77,506 28,09,446 5,02,909 38,32,449
DCB Bank 36,342 81,402 1,29,231 2,503 9,036 1,03,252 8,602 1,29,231
HDFC Bank 12,09,511 30,30,003 49,15,995 4,798 4,29,988 36,73,375 3,94,390 49,15,995
ICICI Bank 17,70,218 33,87,026 59,46,416 11,550 7,20,583 33,19,137 15,47,591 59,46,416
IndusInd Bank 2,15,630 5,51,018 8,70,259 5,256 85,173 6,05,023 1,47,620 8,70,259
Kotak Bank 2,54,845 5,30,276 8,75,853 3,852 1,18,985 5,90,723 1,28,956 8,75,853
Yes Bank 4,09,504 5,56,330 10,90,158 3,606 67,611 74,1,920 2,13,143 10,90,158
NGPSB 50,31,534 1,04,36,723 1,76,60,362 51,241 21,80,700 1,59,16,937 32,61,912 2,25,88,102
ASCB 2,88,28,533 6,73,52,316 10,96,34,745 7,60,674 72,98,320 8,53,31,381 1,10,08,185 10,96,34,745
NFPSB / ASCB (%) 17.45 15.50 16.11 6.74 29.88 18.65 29.63 20.60
NFPSB - New Generation Pvt. Sector Banks; ASCB - All Scheduled Commercial Banks
(Source : Statistical tables Relating to Banks in India as at 31st March 2014 - RBI)
Chart-I : Total Assets & Total Liabilities of Table-2 : Capital Adequacy Ratios (Solo) As at September 2014
New Generation Private Sector Banks in India (Figures are in percentage)
(As at 31st March 2014) Bank CET 1 Addl. T1 T1 T2 CRAR
`120,000,000 Prescribed (Min / Max)* 5.50 1.50 7.00 2.00 9.00
Total Assets Axis Bank 11.51 0.00 11.51 3.33 14.84
`100,000,000
Total Liabilities DCB Bank 12.16 0.00 12.16 0.88 13.04
`80,000,000 HDFC Bank 11.80 0.00 11.80 3.90 15.70
ICICI Bank 11.98 0.00 11.98 4.66 16.64
`60,000,000
IndusInd Bank 12.03 0.00 12.03 0.93 12.96
`40,000,000 Kotak Bank 15.50 0.00 15.50 0.90 16.40
Yes Bank 11.00 0.40 11.40 5.20 16.60
`20,000,000
* Effective end-March 2015. Minimum levels for CET1 and T1.
Maximum levels for Addl. T1 and T2.CET 1 - Common Equity Tier 1;
`0
Addl. T1 - Additional Tier 1; T1 - Total Tier 1; T2 - Total Tier 2; CRAR -
Axis Bank
DCB Bank
HDFC Bank
ICICI Bank
IndusInd Bank
Kotak Bank
Yes Bank
NGPSB
ASCB
Capital to Risk Weighted Assets Ratio)

(Source : Disclosures under Basle III Regulations hosted on the websites
of respective banks)
CRAR levels above 15%. Of the remaining, two banks

Pillar I had CRAR of less than 14%. Thus all these banks
Capital Adequacy currently have reasonable headway available for further
Capital Adequacy Ratio business growth under normal circumstances.
The position of capital adequacy ratios as at September Total Capital

2014 in these banks on 'solo' basis is given in Table-2 Total capital of these seven banks as at end-
(Chart-II). These ratios are post regulatory adjustments September 2014 stood at `2,671 billion prior to

special feature
Chart II - Capital Adequacy Ratios as at September 2014 Chart-III : Total Capital & Adjusted Total Capital
as at end-September 2014
20%
`1,000,000
TC
15% `800,000 TC (A)
`600,000
10%
`400,000
5% `200,000
`0
0%
Axis Bank
DCB Bank
HDFC Bank
ICICI Bank
IndusInd Bank
Kotak Bank
Yes Bank
Prescribed
(Min / Max)
Yes
Bank
Kotak
Bank
IndusInd
Bank
ICICI
Bank
HDFC
Bank
DCB
Bank
Axis
Bank
CRAR T2 T1 AddI T1 CET 1
regulatory adjustments for reckoning for capital Banks are required to phase-out certain types of capital
adequacy purposes (Table-3 - Chart-III). After instruments under different tiers of capital between end-
regulatory adjustments, the total capital works out to March 2017 to end-March 2022. However, four banks
`2,552 billion i.e. 95.56% of total capital. Thus the have worked out and disclosed exclusions on account of
impact of regulatory adjustments on the total capital such instruments.
has been 4.44% of the total capital. The impact of Composition of Capital
regulatory adjustments on total capital in case of All the banks have Common Equity Tier 1 ratios
individual banks varied widely ranging between well above the regulatory minimum of 5.5% (for
0.91% to 11%. Besides the two extreme cases of end-March 2015). CET1 ratios ranged from 11%
0.91% and 11%, for four banks the impact was between to 15.5% for these banks. Three of the banks had
3% and 4%. CET1 ratios around 12%. Except in case of one bank
Table-3 : Total Capital As at end-September 2014 that had Additional Tier 1 capital, all other banks had
(` in million) their Tier 1 capital entirely made up of CET1 capital.
Bank TC TC (A) % It is observed that CET1 levels of these banks are
Axis Bank 4,94,742 4,75,206 96.05 not only well above the Basle III stipulated level of
DCB Bank 13,140.45 11,695.16 89.00 5.5% for CET1 capital, but also adequate to cover
HDFC Bank 6,43,760.5 6,20,413.3 96.37 the Capital Conservation Buffer (CCB) (that will kick
ICICI Bank 10,65,406.7 10,03,464.6 94.19 in beginning from end-March 2016). The current
IndusInd Bank 1,01,713.18 1,00,783.46 99.09 CET1 levels measure well as against the minimum
Kotak Bank 1,96,533.7 1,90,295.4 96.83
stipulated level for CET1 plus CCB as per Basle III
Yes Bank 1,55,271 1,50,027 96.62
norms viz. 8%.
Total 26,70,567.53 25,51,884.92 95.56 The levels of Tier 2 capital in these banks have
TC - Total Capital; TC (A) - Total Capital after Regulatory Adjustments; varied in the range 0.88% to 5.2%. Three banks have
% - TC (A) as percent of TC Tier 2 ratios less than 1%, however, the remaining
(Source: Disclosures under Basle III Regulations hosted on the websites four banks have levels exceeding 2% - the maximum
of respective banks) permissible for reckoning under total capital for

special feature
capital adequacy requirements. Thus for the former Chart-IV : Capital Adequacy Ratios (Consolidate)
three banks, there is cushion of 1% available to these as at end-September 2014
banks for raising further Tier 2. 20%
Capital Adequacy - Group

Of the seven banks, two do not have any functioning 15%
group entity, and one bank had a group entity that
has been newly formed. Remaining four banks have
prepared consolidated financial accounts and capital 10%
adequacy data. The number of entities for each of
these banks is given in Table-4. In terms of Basle III
5%
norms, the number of entities consolidation for
regulatory purposes may differ from those consolidated
for accounting purposes. The capital adequacy ratios 0%
Prescribed
(Min / Max)
Kotak
Bank
ICICI
Bank
HDFC
Bank
Axis
Bank
on 'Group' basis for the four banks are shown in
Table-5 (Chart-IV). Total CRAR on 'Group' basis, of
these banks has ranged from 15.06% to 17.22%. Except
one bank, for other banks Tier 1 capital comprised CRAR T2 T1 AddI T1 CET 1
entirely CET1. Tier 1 Capital ratio for these banks ranged
New generation private sector banks have therefore
between 11,64% to 15.90%. Tier 2 Capital ratio ranged
managed their capital well and have aligned it well
between 0.80% to 4.95%.
with the changes that have been introduced under
Table-4 : Number of Entities Consolidated
Basle III norms. Capital ratios for various tiers as well
Bank Accounting Regulatory
as regulatory adjustments have been complied with.
Axis Bank 10 9
They also seem to be in a comfortable position to be
DCB Bank 0 0
able for compliance with enhanced requirements for the
HDFC Bank 6 2
ensuing year. They would need to gear up for meeting
ICICI Bank 28 18
additional capital requirements arising from any unusual
IndusInd Bank 0 0
adverse situation (in the form of Couter Cyclical Buffer),
Kotak Bank 19 18
and any specific prudential capital requirements that the
Yes Bank 1* 1*
regulator may specify based on its own risk perception
* New entity.
of the particular bank. The modality of Internal Capital
(Source : Disclosures under Basle III Regulations hosted on the websites
Adequacy Assessment Process (ICAAP) being followed
of respective banks)
by banks has been useful and has served the objective of
Table-5 : Capital Adequacy Ratios (Consolidated) making the exercise effective.
As at September 2014
Modified Treatment of Specific Items
Bank CET 1 Addl. T1 T1 T2 CRAR
Prescribed (Min/ Max) 5.50% 1.50% 7.00% 2.00% 9.00% Securitisations based transactions are now subjected
Axis Bank 11.64% 0.00% 11.64% 3.42% 15.06% to more rigorous risk assessment treatment and
HDFC Bank 11.71% 0.00% 11.71% 3.88% 15.59% capital provisions. Of the seven banks for four banks
ICICI Bank 12.17% 0.10% 12.27% 4.95% 17.22% capital requirement on account of securitization
Kotak Bank 15.90% 0.00% 15.90% 0.80% 16.70% exposure was nil, whereas other three banks had
Min. for CET1, T1 and CRAR; Max. for Addl. T1 and T2. included the capital requirement on this account in their
(Source : Disclosures under Basle III Regulations hosted on the websites total capital requirement. Similarly, special requirements
of respective banks) in respect of counterparty credit risk, exposures to

special feature
central counterparties, and also trading and derivatives Interest Rate Risk in the Banking Book (IRRBB)
activities have been built into the capital requirements Interest Rate Risk In The Banking Book (IRRBB)
assessment in line with the RBI guidelines in this regard. refers to the risk of deterioration in the positions held
Approaches for Risk Components on the banking book of an institution due to movement
Credit Risk in interest rates over time. Banks are managing the
impact of IRBBB as a part of Asset Liability Management
Capital requirement for Credit Risk is assessed based
activities, with the help of various tools i.e. gap analysis,
on the Standardised Approach. All banks have a Credit
Earning at Risk (EaR), Duration of Equity (DoE).
Policy setting out that also includes comprehensive credit
risk assessment process, including analysis of relevant Risk Management Frame work
quantitative and qualitative information to determine The capital management framework is complemented
internal credit rating of the borrower. In respect of retail by the risk management framework, which includes
borrowers the score card based procedure is followed a comprehensive assessment of material risks. The
for determining internal credit rating. Besides, in terms Boards of the banks approve various Policies, and
of the RBI guidelines external credit ratings assigned by the Risk Management Commitees of the Board. Besides,
External Credit Assessment Institutions (ECAI) that are the Risk Management Group and Finance Group carry
approved by RBI are used. For overseas customers, the out the functions related to management of various risks
ratings assigned by international credit rating agencies viz. Credit Risk, Market Risk and Operations Risk.
are used. Comprehensive approach is used for collateral An analysis of the capital adequacy position and the
valuation. risk weighted assets and an assessment of the various
Market Risk aspects of Basel III on capital and risk management as
For Market Risk capital requirement Standardised stipulated by RBI, are reported to the Board on quarterly
Duration Approach is followed for determining capital basis. Risk Management Committees periodically review
requirement. All banks have Investment Policy and various risks viz. credit risk, interest rate risk, liquidity
Derivatives Policy that have the framework for managing risk, foreign exchange risk, operational and outsourcing
Market Risk. risks and the limits framework, including stress test
limits for various risks. Besides, banks have independent
Operations Risk
groups and sub-groups that carry out independent
All banks currently determine the capital requirement for evaluation, monitoring and reporting of various risks.
Operations Risk following the Basic Indicator Approach.
Banks have also set-up Committees that have members
They also have Operational Risk Management Policy
from concerned functions to monitor specific risk areas.
that lays down the framework for managing Operations
For credit risk, there are Credit Committees to review
Risk. One of these banks have obtained approval for
developments in key industrial sectors and the Bank's
parallel run for migration to The Standardised Approach.
exposure to these sectors and various portfolios on a
Some banks have prepared themselves for Advanced
periodic basis.
Approach and are likely to seek approval for adopting
the same. These banks estimate Operational Value at The executive level committees that undertake
Risk (OpVaR) based on the principles of AMA by using supervision and review of operational risk aspects
internal loss data, scenario analysis and external loss are the Operational Risk Management Committee
data. The OpVaR is stress tested on a quarterly basis to (ORMC), Information Security Committee, Business
ensure adequacy of the capital provided for operational Continuity Steering Committee, Fraud Monitoring
risk and is compared with trends of actual losses. The Committee and Product and Process Approval
banks have Operations Risk Management Committee for Committee. ORMC is responsible for overseeing all
various functions related to managing Operations risk. material operational risks, responses to risk issues

special feature
and the adequacy and effectiveness of controls within primarily host banking supervisors. Reserve Bank
a given operational risk control area. of India participates in supervisory colleges set-up
Further, all banks have an Asset Liabilities Management for various multinational banks operating in India.
Committee (ALCO) that, inter alia, is responsible for As a measure towards aligning with international
management of the balance sheet with a view to manage supervisory regime, the RBI has set up supervisory
the market risk exposure within the risk parameters laid colleges for six Indian banks with significant
down by the Board of Directors / Risk Committee. The operations globally. Among these are two new
Asset Liability Management Group (ALMG) monitors and generation private sector banks viz. ICICI Bank and
manages the risk under the supervision of ALCO. Axis Bank.
ICAAP Concentration Risk
In pursuance of RBI guidelines, all banks have All banks have measures for managing credit
adopted internal capital adequacy assessment concentration risk mainly through the modality of
process (ICAAP) that is conducted annually for fixing prudential exposure ceilings for various
determining the adequate level of capitalisation to dimensions of credit concentration risk. Some of the
meet the regulatory norms and current and future common vectors of credit concentration risk are
business needs. The ICAAP is forward looking and industry, products, geography, underlying collateral
encompasses capital planning for a few years hence. nature and single / group borrower exposures. The
The time horizon chosen by various banks may differ. number and nature of dimensions tracked by various
One of the bank has disclosed its ICAAP covers banks are different, other than certain common
capital planning for four years, while in case of another parameters particularly those prescribed by the
bank it covered span of three years. regulator. Some of the discretionary dimensions
could be exposures in certain specific region, or a
ICAAP also covers identification and measurement
particular asset product. These exposures are
of material risks, the risk appetite of the bank, risk
regularly tracked through committees at various levels
threshholds, and adequacy of risk control framework.
including the Senior Management and the Board
It determines the relationship between risk and
levels. The organisation for risk management is
capital and also includes stress testing results. In case
widely varying depending on several factors especially
of banks that have progressed towards Advanced
the size of the bank, the major products range
Measurement Approach for Operations Risk ICAAP
and the geographical spread. Similarly liabilities
includes OpVaR.
concentration risk is monitored through tracking of
The business and capital plans and the stress testing share of largest depositors, and maturity profile of
results of the group entities are also integrated into deposits. Concentration risks in treasury operations
the ICAAP of the banks having group entities who and investment portfolios are monitored basis
are consolidated for regulatory purposes. appropriate measures like various gap limits, net
Pillar II open positions, etc.
Supervisory Colleges Stress Tests
A significant measure for global oversight of All banks have put in place a Stress Testing
multi-national financial institutions is institution of Framework with the approval of their respective
Supervisory Colleges. This is a step towards cross- Board of Directors. The coverage of stress testing
border consolidated supervision facilitating co- framework in various banks is different. As a part of
operation and information exchange between home ICAAP, it is used for assessing impact on capital. It
supervisors and the various other supervisors involved, is also used for assessment on income and profits

special feature
under adverse market conditions or critical events. All NGPSBs have adopted the enhanced disclosure
Stress testing framework also includes assessment framework under Basel III and have published these on
of impact on trading portfolios, securitized portfolios, their respective websites. The quantitative disclosures
etc. More refined stress testing framework cover where the requirements / formats have been specified
various risks like credit risk, interest rate risk, liquidity by RBI, these have been fully complied with. The
risk, foreign exchange risk, operational and outsourcing qualitative disclosures on various parameters require
risks. description of the organizational framework and salient
Compensation Policy features of various policies relevant in the context
of risk management and capital management. The
In line with the regulatory guidelines and Basle III
extent of these disclosures has been varied for
norms, banks have aligned their compensation
different banks. In a couple of cases the descriptions
policies to ensure that the performance based
provide a fairly clear picture to the reader. In some
remuneration system is designed in a manner that
cases the information provided is inadequate to form
these do not lead to excessive risk taking by their
a view on the risk management systems and capital
employees. Some of the banks have adopted
management systems of the bank.
modalities of limiting the proportion of variable pay,
deferment of part of variable pay, and also provisions Challenges
like malus and clawback. Compensation policy is Additional Capital Requirements : The most significant
approved by the Compensation Committee of the change under Basel III pertains to capital requirements.
Board that comprises only independent directors. Increase in the prescribed total capital requirements,
Pillar III changes in the composition of capital with higher
proportion of common equity, new adjustments to
Market Discipline - Disclosures
capital and enhanced risk factors cumulatively will
The third pillar of Basel II Regulations that pertains necessitate much higher capital for supporting
to Market Discipline prescribes certain disclosures increased business growth. As per the estimates
as it considered that market discipline is an effective made by a RBI project the total capital requirements
complement to the other two pillars. BCBS has up to end-March 2018 for the Indian banks is `5 trillion
developed a set of disclosure requirements which of which equity capital will be `1.75 trillion. The estimates
will allow market participants to assess key pieces for private sector banks for additional equity capital is
of information on the scope of application, capital, `250 billion under Basel III, as against `25 billion
risk exposures, risk assessment processes, and hence under Basel II. This may be easier for banks that
the capital adequacy of the institution. These have are perceived to be stronger but could pose challenge
particular relevance under the Framework, where for others. Besides this will be impacted to a great
reliance on internal methodologies gives banks more degree by the state of the primary capital market
discretion in assessing capital requirements. In and also by the demand on it from other sectors of
Basel III guidelines the disclosure requirements have the economy.
been enlarged by including certain other parameters.
Impact on Profitability : One of the prime objectives
These are mainly disclosures related to securitisation
of Basel III is reducing leveraging in banks. An
exposures and sponsorship of off-balance sheet
important implication of higher capital requirements
vehicles. Enhanced disclosures on the detail of the
under Basel III will be higher cost of funds for banks.
components of regulatory capital and their reconciliation
Thus banks will experience a dampening effect on
to the reported accounts will be required, including
their ROE to some extent, considering that it will
a comprehensive explanation of how a bank calculates
be difficult to meet the higher cost entirely by raising
its regulatory capital ratios.

special feature
the cost of credit. This may lead to realignment of Under Basel III, India has completed adoption
business strategies of these banks. Asset mix may of guidelines related to Risk based Capital
be altered to enhance the share of low risk weighted requirements. In respect of identification of Globally
assets. Besides, strategies like focusing on low Systematically Important Banks (G-SIB), no Indian
cost deposits, widening the reach through low-cost bank has been included in G-SIB. One Indian bank
channels like Business Facilitators, and renewed was among the sample banks examined for
focus on non-interest income sources may receive identification of G-SIBs. On Domestic Systematically
greater attention. Important Banks (D-SIB) the framework for the same
Risk Management : In their efforts to cope up has been finalised. On Leverage Ratio and additional
with meeting Basel III standards, compliance with disclosure requirements the revised guidelines have
associated RBI guidelines and enhanced disclosures since been issued by RBI.
both quantitative and qualitative the banks will need All NGPSBs have adopted the Basel III guidelines
to revisit their risk management strategies. Determining and have put in place the basic organizational set-up
the risk appetite realistically will be crucial. This will and policies for meeting the requirements on ongoing
vary for each of the NGPSB given the diversity among basis. Basel roadmap envisages several qualitative
them on various parameters. Risk taking capacity changes apart from rising quantitative thresholds
will be the bottom-line that will determine the risk over the next few years. On the other hand the
appetite. Ensuring that the decisions of the risk takers business environment is expected to be more
are in sync with the risk appetite so determined demanding with expected acceleration of growth
through appropriate operating parameters and control in India. In view of these, these banks will be required
mechanism will be important. Risk monitoring will to continually review their policies and systems and
need to be both extensive and frequent. Another revise these to be able to effectively meet the Basel
impact on risk management is integration of risk regulations.
management with finance function. Leverage Ratio : With effect from 1st April 2015
Data Management : Determination of capital public disclosure of leverage ratio will need to be
requirements under Basel III is more complex and made. Banks are required to maintain a leverage
calls for more detailed information to be able to factor ratio (capital / exposure) of 4.5% (as against 3%
in all required adjustments, enhancements and stipulated by BCSBI) till further changes in the
neutralization. Hence timely availability of all relevant threshold. The first disclosure will be for the quarter
data accurately at a single point would be important ending 31st March 2014. This is required to be
to ensure precision in capital assessment exercise. computed (and disclosed on quarterly basis) in
Data not being captured in the systems or being line with the RBI guidelines for determining capital
distributed in different silos will pose significant and exposure measures for this purpose. Currently
challenges. This will call for banks to have a relook meeting the leverage requirement does not seem
at their data architecture, process flows, etc. with the to pose a challenge. However it may be difficult to
objective of meeting the data related requirements. maintain the current level of leverage when the credit
Way Forward demand becomes stronger.
Basle Committee of Banking Supervision in its Liquidity Coverage Ratio (LCR) : Beginning 1st January
Seventh progress report on adoption of the Basel 2015, banks are required to maintain Liquidity
regulatory framework, published in October 2014 has Coverage Ratio at least at the prescribed level that
reported that India has completed adoption of guidelines gradually increases beginning from 60% to 100%
under Basel II and Basel 2.5. as at 1st January 2019. LCR is defined as ratio between

special feature
the stock of High Quality Liquid Assets (HQLA) and policies, systems and procedures to meet the
estimated net cash outflows over the next 30 calendar increasingly rigorous regulations alongwith tapping
days. Given certain restrictions on to the extent SLR growing business opportunities that are expected
securities can be included for LCR purposes, banks to arise with economic growth moving to a higher
will be required to realign their investment strategies trajectory.
for maintaining LCR on ongoing basis. References
Leverage Ratio : Leverage Ratio has been defined as a) Basel III in International and Indian Contexts Ten Questions
ratio of Capital Measure to Exposure Measure. Tier 1 We Should Know the Answers For (Inaugural Address by
capital is currently used as Capital Measure and Dr. Duvvuri Subbarao, Governor, Reserve Bank of India at
the Annual FICCI - IBA Banking Conference at Mumbai on
Exposure measure is a bank's total exposure viz. sum of September 04, 2012)
on-balance and off-balance sheet exposures plus b) Basel III implementation : Issues and challenges for Indian
exposures on account of derivatives and securities banks - Round Table by M. Jayadev, Indian Institute of
financing transactions. This is a non risk-based ratio and Management, Bangalore , IIMB Management Review (2013) 25
hence serves as a measure of equity stake in the total c) Seventh progress report on adoption of the Basel regulatory
exposure. framework, October 2014, Basel Committee on Banking
Supervision, Bank for International Settlements
As per RBI analysis, for the Indian banking system d) Basel III phase-in arrangements, Basel Committee on Banking
Tier 1 Leverage Ratio for Indian banking system Supervision, Bank for International Settlements
is currently at 4.5%, as against the presently e) International Convergence of Capital Measurement and
minimum 3% for the parallel run period up to 1st January Capital Standards A Revised Framework Comprehensive
Version, June 2006, Basel Committee on Banking Supervision,
2017. Beginning 1st January 2015 public disclosure
Bank for International Settlements
of Leverage Ratio is required to be made. Thus in
f) Basel III : the net stable funding ratio, October 2014, Basel
India, the banks will be required to disclose on Committee on Banking Supervision, Bank for International
quarterly basis Leverage Ration from 1st April 2015 Settlements
onwards. The position of individual banks in this g) Annual Report, 2013-14, Reserve Bank of India
regard will be known only from the next fiscal, h) Annual Reports 2013-14 of Axis Bank Ltd., DCB Bank Ltd.,
given the current proportion of Tier 1 capital in the HDFC Bank Ltd., ICICI Bank Ltd., IndusInd Bank Ltd., Kotak
Bank Ltd., and Yes Bank Ltd.
total capital, it is expected that the new generation
i) Basle III Disclosures as at 30th September 2014 Documents of
private sector banks will be in a position to meet the
Axis Bank Ltd., DCB Bank Ltd., HDFC Bank Ltd., ICICI Bank Ltd.,
current benchmark. IndusInd Bank Ltd., Kotak Bank Ltd. and Yes Bank Ltd.
Net Stable Funding Ratio (NSFR) : The Net Stable
Funding Ratio (NSFR) is a longer-term structural ratio [
designed to address liquidity mismatches. It will be
effective from 1st January 2018. It covers the entire
balance sheet and provides incentives for banks
to use stable sources of funding. The time horizon
for NSFR is one year. BCBS guidelines issued
in October 2014 stipulated that the ratio of 'Available
amount of stable funding' to 'Required amount of
stable funding' should be equal to or more than
100%.
One can expect exciting times ahead as the new
generation private sector banks further evolve their
Caveat : This article has been written by the author entirely in his personal capacity and the views expressed herein are solely his personal views
and do not in any way represent the views of the organisation he is associated with.

Contemporary
special feature
Issues in Banking
Basel III and the capital structure

of Indian banks
?
Dr. P. Usha *
Introduction 2013 and the contribution of various aspects of Basel III to

Basel III guidelines issued by the Basel Committee the variation in the CET1 CRAR and total CRAR.
on Banking Supervision (BCBS) are designed to Key elements of the guidelines
enhance the safety and stability of banks through The key initiatives of the Basel III framework includes :
the strengthening of the quality of capital, stipulating
Enhancing
l the quality and level of capital to ensure
leverage ratio and liquidity standards. “Basel III reforms
that banks are better able to absorb losses on both a
are the response of the Basel Committee on Banking
going concern and a gone concern basis1
Supervision (BCBS) to improve the banking sector's
ability to absorb shocks arising from financial and Capital
l conservation buffer and countercyclical buffer
economic stress, whatever the source, thus reducing introduced as macro prudential measures
the risk of spill over from the financial sector to the Loss absorptive capacity of non equity capital enhanced
l
real economy.” (Reserve Bank of India (RBI), July Leverage

l ratio prescribed as a backstop to the risk
2014) The stringent capital standards set by Basel III based capital measure2
focuses on the phase-in of the deductions and phase Global liquidity standard introduced
l
3
out of ineligible capital as well as introduction of

Data and Methodology
loss absorbency characteristics to the debt instruments
reckoned as capital funds by banks. Banks are Net CET 1 capital as on 31 March 2013 (prior to
expected to replace the phased out capital with similar implementation) and as on 30 September 2013 (after
or better quality capital, subject to conditions laid out implementation) compared to perceive the impact of
by the respective regulator. the new guidelines. The data have been sourced from
the Basel III disclosures as on 30th September 2013
This article examines the immediate impact of
and Basel II disclosures as on 31.03.2013 available in
implementation of Basel III guidelines on the Common
the public domain4.
Equity Tier I (CET I) capital to risk weighted assets ratio
(CRAR) and total CRAR in the case of Indian banks. Basel Analysis
III capital regulation has been implemented from April 1, The minimum total capital adequacy ratio stipulated
2013 in India in phases with the final implementation by BCBS continues to be 8 per cent, (9 per cent in
stipulated for 31 March 2019. The scope of the article is the case of Indian banks). However, the minimum
limited to the study of the impact on the CRAR as on Sep Tier I Capital to Risk weighted Assets Ratio (CRAR)
* FRM, Faculty, National Institute of Bank Management.

1. “From regulatory capital perspective, going-concern capital is the capital which can absorb losses without triggering bankruptcy of the bank.
Gone-concern capital is the capital which will absorb losses only in a situation of liquidation of the bank” (RBI, July 2014).
2. Leverage Ratio : Introduction of a simple, transparent, non-risk based, Tier I capital to exposure ratio, intended to limit build up of leverage in
the banking system. The ratio set at 3% by the Basel Committee and the Indian Regulator has set at 4.5%.
3. Global Liquidity Standards : Introduction of Liquidity Coverage Ratio and Net Stable Funding Ratio to ensure that banks maintain sufficient
high quality liquid assets to tide over stress sceanrio for one month and stable liquidity position over a period of twelve months respectively.
4. The article uses consolidated data wherever consolidated disclosures only have been made CET 1 capital as on 31st March 2013 was
computed as equity capital plus disclosed reserves less 20% of Deferred Tax Assets, wherever DTA was disclosed.

special feature
ratio was stipulated at 6 per cent (up from 4 Table-1 : CET1 of Indian Banks as on 30 September, 2013
per cent under Basel II) and share of CET 1 ratio CET 1 ratio No. of No. of No. of Total
in the Tier I ratio set at 4.5 per cent (75 per cent public new old no. of
sector private private banks
of Tier I CRAR) compared to 2 per cent under the
sector sector
Basel II framework. In order to enhance the quality, banks banks
consistency and transparency of Banks' capital 5.5 to 6% 2 Nil Nil 2
base, the CET I CRAR ratio set at 5.5 per cent in 6.01 to 7% 8 Nil Nil 8
the case of Indian banks by the regulator. In terms 7.01 to 8% 6 Nil Nil 6
of RBI guidelines on Basel III (RBI, July 2014), 8.01 to 9% 9 1 2 12
the national minima for CET 1 capital from April 1, 9.01 to 10% Nil 1 Nil 1
2013, (the date of implementation) upto March 30, Above 10% 1 5 8 14
2014 stipulated at 4.5 per cent and as on 31 March, Total 26 7 10 43
2019, the date of completion of the transition period
at 5.5 per cent. The detailed table on transitional Capital Conservation Buffer
arrangements is furnished in the annexure. In addition to enhancing the level of CET 1 capital,
When we analyse the CETI capital ratio for Indian Basel III reforms introduces the need for building
banks as on 30.09.2013, we observe that though Capital Conservation Buffer (CCB) of 2.5 per cent
the national minima stood at 4.5 per cent, the ratio (to be carved out of common equity). The CCB is
ranged from 5.66 per cent to 10.38 per cent in the designed to ensure that banks build up capital
case of public sector banks. The range differed widely buffers during normal times (i.e. outside periods of
with respect to new and old private sector banks stress) and conserve capital which can be drawn down
also. In the case of new private sector banks, the during a stressed period (systemic or idiosyncratic)
CET 1 ratio ranged from 8.1 per cent to 17.04 when losses are incurred. Banks that draw down
percent. If we consider the old private sector banks, their CCB during a stressed period should also have
the low was at 8.06 per cent and the high was at 15.1 a definite plan to replenish the buffer as part of
per cent. their Internal Capital Adequacy Assessment Process
(ICAAP). The total Common Equity requirement plus
Chart-1 : CET 1 of Banks as on 30 September, 2013
capital conservation buffer mandated by BCBS at
CET 1 CRAR (%) 7 per cent of Risk Weighted Assets (RWAs) and total
20 capital to RWAs to 10.5 per cent and for Indian banks
at 8 per cent and 11.5 per centre spectively. The
capital conservation buffer in the form of Common
15 Equity will be phased-in over a period of four years
at 0.625 per cent per year, commencing from March
1, 2016 for Indian banks (0.625 per cent as on
10 31.03.2016, 1.25 per cent as on 31.03.2017, 1.875
per cent as on 31.03.2018 and 2.5 per cent as on
31.03.2019). (See Annexure)
5
If the fully phased in Basel III capital requirements -
minimum CET 1 capital ratio of 8 per cent (CET1 of
5.5 per cent + Capital Conservation Buffer of 2.5
0 per cent) by March 2019 - are taken into consideration,
Public Public New New Old Old
Sector Sector Private Private Private Private we observe that 10 public sector banks are above

special feature
8 per cent and all the 17 private sector banks in the operational risk, banks in India being on Basic
study disclose CET 1 ratio of above 8 per cent. This is Indicator Approach, the scope for reduction in capital
not to say that these banks are adequately capitalized requirement and hence RWA is nil, unless their incomes
for the full implementation by March 2019. Given the fall drastically. Though, Banks have a scope for reducing
view that capital requirements during the initial years of RWA for market risk, the average capital allocated
implementation would be lower and may be higher during accounts for only 5.88 per cent (during the same period)
later periods, banks would need much higher levels of implying that the trading portfolio is limited, providing
capital as they proceed towards full implementation. hardly any room for downsizing the portfolio and hence
Quantitative Impact Study of BCBS (BCBS, 2009) reveals the RWA. Consequently, against the background of
that assuming full implementation, the decline in average loans and advances constituting a major proportion of
net CET 1 ratio (net of regulatory deductions) for Group 1 assets for Indian banks, growth in the loan book puts the
banks (banks with Tier 1 capital in excess of €3 billion) RWA on the whole in the upward trajectory.
was 5.4 per cent (decline from 11.1 per cent to 5.7 per Regulatory adjustments to CET 1
cent). In the case of Group 2 banks (All banks other than As said earlier, while the growth in the RWA leads to
banks in Group 1) the decline slightly muted as the fall increase in the denominator for CRAR, the regulatory
was only 2.9 per cent (from 10.7 per cent to 7.8 per cent). adjustments adversely affects the numerator and the
Comparison of CET1 ratio as on 30, September 2013 combined effect is the reduction in the CRAR. BCBS
and March 31, 2013 reveals that the ratio declined for all consultative document (BCBS, 2009) discussing about
public sector banks after the implementation of Basel III regulatory adjustments, mentions that the definition of
except for two banks. In contrast to other banks, these two capital under Basel II suffers from following 'fundamental
banks have shown improvement in CET 1 CRAR through flaws' compromising on the quality, consistency and
reduction in risk weighted assets especially for market transparency of capital :
risk, the method resorted to by some international banks. a. Regulatory adjustments are not applied to CET 1
The decline in CET 1 ratio in the case of public sector capital (but applied to the whole Tier I capital)
banks ranged from 0.08 per cent (two banks) to 1.08 per b. There is no consistent or uniform list of regulatory
cent. In the case of new private sector banks, the CET1 adjustments (across countries)
ratio declined in the case of three banks and increased
c. The disclosures on components of capital were deficient
for 4 banks though net CET 1 capital (net of regulatory
(details of composition of capital not disclosed)
adjustments) increased in the case of all the banks. As
Thus, under Basel III regime, regulatory adjustments
regards the old private sector banks, 50 per cent showed
must be applied at the level of common equity, reason
decline in the CET 1 CRAR and the rest registered an
being Tier I capital funds of insufficient quality would
increase in the ratio.
ultimately impact the common equity and banks may
The decline in CET1 CRAR may be attributed to two
disclose strong Tier I ratio, while actually possessing
reasons : (1) increase in the denominator consequent to
low levels of common equity. Hence Basel III stipulated
growth in Risk Weighted Assets (RWA) and (2) decline in
internationally consistent or 'harmonised' regulatory
the numerator as a result of fall in CET1 capital due to
adjustments that have to be adjusted from CET 1 capital
regulatory adjustments under Basel III.
and does not vary substantially across countries.
RWA for credit risk predominate for Indian banks,
The regulatory adjustments prescribed in the Basel III
accounting on an average for 87.31 per cent of total
guidelines and applicable to Indian banks were
RWA (for the period 2008-09 to 2012-13). Generally,
Deferred Tax Assets (DTA), investment in the capital
with the growth in the asset book, the risk weighted
of banking, financial and insurance entities, reciprocal
assets for credit risk is bound to increase. As regards
cross- holdings in common equity, defined-benefit

special feature
pension fund net assets and unamortized pension meant for non equity capital (during the phase-in period)
fund expenditure. from equity capital. In other words, the new private sector
In the case of Indian banks, DTA was deducted from banks could not avail the phase - in benefits during the
Tier I capital under Basel II regime also. However, under transition period. (See Table-2)
Basel III, the entire DTA to be deducted from CET 1 Table-2 : Impact of Regulatory adjustments on
capital. Phase in of deductions has been provided and CET1 ratio for Indian Banks as on Sept 30, 2013
progresses at 20 per cent per annum. Hence in the first No of banks
year of implementation, 20 per cent of DTA to be deducted Public New Old All
sector Private Private banks
from CET 1 capital, 80 per cent may be deducted from
Upto 20 bps 12 2 4 18
Additional Tier 1 (AT1) capital. In the absence of sufficient
21 - 30 bps 8 - 1 9
AT1 capital, shortfall in DTA may be deducted from CET1
31 - 40 bps 4 - 2 6
(as in the case of most private sector banks).
41 - 50 bps - 1 - 1
Regulatory Adjustments / Deductions from CET I
More than 50 bps 2 4 3 9
capital
Total 26 7 10 43
Goodwill and all other Intangible assets
l
It is interesting to note that in the case of public sector
Deferred tax assets
l
banks and old private sector banks, DTA and pension
Shortfall
l of provisions compared to expected losses related deductions account for major portion of regulatory
(under Internal Ratings Based Approach) adjustments. In fact, defined-benefit pension fund net
Defined
l Benefit Pension Fund Assets and Liabilities assets and unamortized pension fund expenditure account
and unamortized pension fund expenditure for a major share of regulatory adjustments in the case of
both public sector banks as well as the old private sector
Investment in own shares
l
banks. However, in the case of new private sector banks,
We observe from our analysis that regulatory DTA and deductions from CET 1 due to insufficient AT 1
adjustments to CET 1 capital under Basel III impacted accounts for major proportion of regulatory adjustments
CET1 CRAR of public sector banks on an average by 21 to CET 1. Deduction on account of indirect investment
bps and it ranged from 5 bps to 98 bps. Accumulated in bank's own treasury stock arising as a result of bank's
losses contributed to the high level of deductions in the investment in mutual funds was at a negligible share of
case of the bank that had the highest impact. Though 0.27 per cent in the case of public sector banks.
the mandatory deductions to CET 1 capital was not a
Table-3 : Regulatory adjustments to CET 1 capital
significant contributor immediately to the decline in CET
Items of Regulatory adjustment Public New Old
1 CRAR ratio, with the complete phasing-in of deductions
sector Private Private
from CET 1 capital, the regulatory adjustments would banks Sector Sector
have a greater negative impact on CET 1 capital. banks banks
In the case of new private sector banks, regulatory DTA 21.40 20.16 33.29
adjustments adversely affected the CET 1 CRAR by Reciprocal cross holding 2.68 0.26 2.04
52 bps on an average and in the case of old private Invt in subsidiaries 7.79 15.25 6.02
sector banks by 31 bps. It is also observed that 4 out Defined benefit pension fund net 48.95 nil 27.75
assets and unamortised pension
of 7 new private sector banks are impacted by more than
fund expenditures
50 bps compared to 2 out of 26 for public sector banks
Deduction from CET 1 due to nil 56.42 12.19
and 3 out of 10 for old private sector banks. New private insufficient AT 1 and T II
sector banks were affected more by the inadequate AT1 others 20.18 7.91 18.71
and hence ended up deducting regulatory adjustments 100.00 100.00 100.00

special feature
In fact, in the case of quiet a few banks, especially The highest capital adequacy ratio of public sector
the new private sector banks, the AT1 was insufficient banks was at 12.92 per cent but it was lower than
and the regulatory adjustments to AT 1 were also the lowest of 13.80 per cent among new private
carried out in CET 1 capital. But the new private sector banks.
sector banks had a very high share of TII capital. Table -4 : Total CRAR of banks as on 30 September, 2013
The share of non-equity capital for four out of seven No of banks
new private sector banks ranged from 28.68 per CRAR Public New Old
cent to 37.74 per cent. In the case of old private sector Private Private
sector banks, except for one Bank, other banks did sector sector
not have AT1 capital at all and had a lower share Below 10% 3 Nil Nil
of TII capital ranging from 1.78 per cent to 25.69 10.01 to 11% 11 Nil 1
per cent. 11.01 to 12% 7 Nil 1
Above 12% 5 7 8
Decline in total CRAR
All public sector banks without exception have experienced ATI and TII and the decline in total CRAR
fall in total CRAR between March and September 2013. Non-equity Capital instruments, to be Basel III
It is interesting to observe the following : compliant should incorporate following loss absorbency
Two public
l sector banks raised Tier II capital during characteristics :
April to September 2013 a) Conversion to common shares
Consequently
l the impact was minimum in the case of b) Write-down on hitting the pre-specified trigger
one bank which raised Tier II capital. (permanent or temporary).
In the case
l of another public sector bank, despite While in the case of permanent write-down, the
raising Tier II capital, decline in CRAR was maximum instrument no longer exists in the balance sheet,
among public sector banks. with temporary write-down, the value of the instrument
An old private
l sector bank could maintain the same is written down or decreased on the occurrence of
ratio of 13.22 per cent as on 31st March as well as 30th the trigger event and which may be written up or
September 2013. increased to its original value depending on the terms
and conditions of the instrument.
Table-3 : Fall in total CRAR
No of banks AT1 instruments issued prior to 31 March, 2019 will
Bps Public New Old have two triggers - 5.5 per cent CET 1 CRAR upto
sector Private Private 31 March 2019 and 6.125 per cent thereafter and
sector sector for instruments issued after 31 March 2019, the
Upto 50 bps 4 Nil 1 trigger stipulated at CET1 of 6.125 per cent of RWAs.
51 - 100 bps 7 2 1 (RBI, 01 Sep 2014).
101 - 150 bps 5 Nil 3
The write-down will have the following effects :
151 - 200 bps 9 Nil Nil
a) Reduce the claim of the instrument in liquidation
More than 200 bps 1 3 Nil
b) Reduce the amount re-paid when a call is exercised
As on 31.03.2013, the total CRAR of all public sector
banks was well above 10 per cent, though the regulatory c) Partially or fully reduce coupon / dividend payments on
minimum was at 9 per cent. However, consequent to the instrument (RBI, September 1, 2014)
the implementation of Basel III, three banks' total CRAR Non-equity capital raised prior to Basel III implementation,
has fallen to below 10 per cent, but remained above (instruments that do not include the loss absorption
9 per cent. characteristics are to be phased out and their

special feature
recognition capped at 90 per cent in the first year of and TII capital - Basel III compliant Non-equity capital,
implementation, with the cap reducing by 10 per cent that are loss absorbent. Success in raising equity as well
percentage points in each of the subsequent year. as non-equity capital from the market by the banks would
This cap will be applied to Additional Tier 1 and Tier 2 depend on the 'distance to trigger'6 or gap between
capital instruments separately and refers to the total the current CET 1 ratio compared to the trigger point of
amount of instruments outstanding which no longer 6.125 per cent CET 1 ratio. The potential distance in
meet the relevant entry criteria.5 turn may be dependent on a number of factors such
The correlation between decline in total CRAR and as, the targeted growth in the asset book, the asset
the share of non-equity capital was at a significant quality - mainly the loan book, the current level of
41 per cent in the case of both public sector banks impaired assets (NPAs and standard restructured
as well as private sector banks. It is obvious that assets), the probability of default and level of Loss Given
consequent to the phase-out and wherever banks Default of the portfolios of the bank, the productivity
held a higher share of capital funds as non-equity and profitability of the bank etc. In short all the factors
capital, the decline in total capital adequacy ratio that might result in eroding the CET 1 capital may
was also pronounced. The share of AT1 capital and have to be analysed to perceive their impact on
TII capital, had a significant impact on the decline in CET 1 ratio in future.
total CRAR. To conclude, in this article, we have analysed the
Conclusion immediate impact of Basel III implementation on
the capital structure of Indian banks. However, the
In the near term, with few exceptions, public sector
impact of the guidelines on various other aspects
banks seem to be just adequately capitalized. With
may be undertaken using empirical evidence like
the growth in asset book, decline in asset quality
the cost of regulatory compliance, the level of increase
(or rather increase in impaired assets), implementation
in the cost of capital on account of raising loss
of IRB approach for credit risk and phase out of
absorbent non-equity capital, impact on Return On
ineligible capital, banks would be required to raise
Assets (additional CET 1 and better quality non-equity
capital. While banks may be in a position to raise
capital required to undertake same business), impact
equity capital - by way of Government's budgetary
on economic growth, impact on cost of lending and
contribution, qualified Institutional Placements and
hence deposit and loan pricing etc.
public offers, challenge lies in raising AT1 capital
Annexure : Transitional Arrangements-Scheduled Commercial Banks (% of RWAs)

Minimum capital ratios April 1 March 31 March 31 March 31 March 31 March 31 March 31
2013 2014 2015 2016 2017 2018 2019
Minimum Common Equity Tier 1 (CET1) 4.5 5 5.5 5.5 5.5 5.5 5.5
Capital conservation buffer (CCB) - - - 0.625 1.25 1.875 2.5
Minimum CET1+ CCB 4.5 5 5.5 6.125 6.75 7.375 8
Minimum Tier 1 capital 6 6.5 7 7 7 7 7
Minimum Total Capital* 9 9 9 9 9 9 9
Minimum Total Capital +CCB 9 9 9 9.625 10.25 10.875 11.5
Phase-in of all deductions from CET1 (in%)# 20 40 60 80 100 100 100
5. The base should only include instruments that will be grandfathered. If an instrument is derecognized on January 1, 2013, it does not count
towards the base fixed on January 1, 2013. Also, the base for the transitional arrangements should reflect the outstanding amount which is
eligible to be included in the relevant tier of capital under the existing framework applied as on December 31, 2012. Further, for Tier 2
instruments which have begun to amortise before January 1, 2013, the base for grandfathering should take into account the amortised amount,
and not the full nominal amount. Thus, individual instruments will continue to be amortised at a rate of 20% per year while the aggregate cap will
be reduced at a rate of 10% per year.
6. For discussion on different types of trigger see Koffer, 2013

special feature
Bibliography - Koffer, Timo, “Basel III : Implications for Bank's
- Ahmed Al-Darwish, Michael Hafeman, Gregorio capital structure : What happens with hybrid capital
Impavido, Malcolm Kemp, and Padraic O'Malley., instruments”, Anchor Academic Publishing, 2013
“Possible Unintended Consequences of Basel III and - Reserve Bank of India, “Implementation of Basel III
Solvency II”, WP / 11 / 187, International Monetary Capital Regulations in India - Amendments”,
Fund, August 2011. DBOD. No. BP. BC. 38 / 21.06.201 / 2014-15 dated
- Basel Committee on Banking Supervision, September 1, 2014
Consultative Document, “Strengthening the resilience - Reserve Bank of India, “Master Circular - Basel III
of the banking sector”, Bank for International Capital Regulations”, RBI / 2014-15 / 103, DBOD. No.
Settlements, December 2009. BP. BC. 6 / 21.06.201 / 2014-15, July 01, 2014
- Basel Committee on Banking Supervision, “Results of - Reserve Bank of India, “Implementation of Basel III
the comprehensive quantitative impact study”, Bank Capital Regulations in India - Capital Planning” RBI /
for International Settlements, December 2010. 2013-14 / 538 DBOD. No. BP. BC. 102 / 21.06.201 /
- Basel Committee on Banking Supervision, “Basel III : 2013-14, March 27, 2014
A global regulatory framework for more resilient banks - Subba Rao, Duvvuri, “Basel III in International and
and banking systems”, Bank for International Indian Contexts, Ten Questions We Should Know
Settlements, December 2010 (rev June 2011) the Answers For”, Speech, Dr. Duvvuri Subbarao,
- Cosimano, Thomas F. and Hakura, Dalia S,“Bank Former Governor, Reserve Bank of India ,September
Behavior in Response to Basel III : A Cross-Country 04, 2012.
analysis” WP / 11 / 119, International Monetary Fund,
May 2011. [
Interconnectedness in the Financial System : How Vital and How Critical
The post-crisis experience of many features in the financial system which were not given due attention earlier, led to the
calibration of many new regulatory standards. More notably, in addition to keeping a tab on individual institutions, the
importance of a macro view of the financial system was acknowledged. Among the many structures that emerged was 'Too
Connected to Fail (TCTF)'. The US experience of one institution going bust leading to the failure of a dozen others due to
common exposures, led the world to come alive to the phenomenon of 'interconnectedness' that exists between financial
institutions. Subsequently, interconnectedness has been accepted by standard setting bodies as one of the parameters for
identifying systemically important financial institutions.
Why then are network models being increasingly used across the world to assess interconnectedness among financial
institutions? The answer lies in the fact that financial networks are complex and adaptive systems. They are complex because
the interconnections involved among financial institutions are massive and they are adaptive because while individual
institutions in the system always want to be in an optimal position, they are not fully informed. Such complex adaptive systems
have the potential to amplify losses manifold during crisis events. This is exactly what happened during the Lehman fallout
when many institutions shut their doors and refused liquidity to institutions just because they were suspected of being
'infected'.
To begin with, network models assist in understanding the structure and pattern of connections in a particular system. If the
institutions with high centrality scores are also heavy net borrowers in the system, then there might be potential stability issues
in the event of any such institution facing distress. These sort of indications can provide valuable inputs to a regulator in
reassessing the available redundancies in the system and initiate counteractive measures.

special feature special feature
nkers
er's Writi ngs for Ba
Monitori ng - A Train
e Bo ok : Credit
Name of th
mboodiri 0 501
. C. G. Na r District, Kerala, 67
Au thor : Dr. T PO. Kannu
Mandur,
lications , Thalakot,
Publishe r : S. S. Pub
15)
5 (Edition 20
Pages : 25
nk of India
5 nd forme r CGM, Ba
Price : `32 ctor, IIBF a
a, Joint Dir
e ing its
S. K. Datt e N P A n emesis rais
Review ed by : Mr. dia. With th t on
anks in In issue. Whils
BOOK REVIEW
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im ons an
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at steps fortune strik
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foun from their This may
ankers are hich arises sary skills.
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to monitor anks are e r hand. Th
is required , w h ile b th e o th e
be true no
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especially a lly la rg e -scale recru a s in k n o wledge. A
been equ ce, as well
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ap is M
nowledge g t of Credit
part of the k g . C o n s e q uently, a lo
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literature o d manuals
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m e
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text, that
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bette for smaller
B boodiri,
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While large m e c a n n o b y D r. T .
onitoring, th
e sa ”, authored Credit
on Credit M W ri ti n g s for Bankers rs th e fu nctions of
Trainer' s v e
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l and time
is a usefu

special feature es its
n , ti ll th e loan reach
a
ctions a lo
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- from th
end-to-end against
Monitoring n it oring - as
. Cre d it M o
clusion letely with
logical con it d eals comp rt io n towards
Credit
c a u s e t a p o
different, fi
rstly, be devote jus as how to
The book is in ly w it h Credit and bject, such
h d e a l m a o f th e s u
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u
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By reading ground-lev subject.
BOOK REVIEW
a n d le
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e
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out the
s h o w s h p p e n in g s
writing real-life hs ld be
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The autho th e b o o s s u c h , re
quoted in Monitoring
. A
examples nd Credit
Numerous ence in C re d it a
re dit Departm
ents.
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nt-lin experience
author's fro e of their own h ich bring to
gether
e to s o m ti o n s , w
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e s to s e v eral classro v id e re a d er with div
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The book y v a ri o u s p a rt ic
k is c o m p rehensive
d b hile the bo
o
experience country. W terest .
situations a rt s o f th e p th e reader's in
ri o u s p e to k e e
from va s which serv d
examples ny anecdote eduling an
rs p e rs e d w it h m a
s in g te m p o of resch
it is also inte d to increa guidelines
t ti m e s has also le c u s a n d a host of
prese n fo
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Stress in ie s a re u nder sharp is im p o rt ant for cre
ctivit e subject.
It
irectives
g. These a f India on th ith these d
restructurin e B a n k o a b re a s t w
Reserv es, to be sult in
issued by trative Offic ring will re
have been d A d m in is d it M o n it o
ches an dge of Cre sional
th, in bran ate knowle and profes
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topic. [
e in g u p to date on the
b

No. Title
Books Added to the IIBF Corporate Library
Author
special feature
Publisher & Year of Publication
1. A to Z of Banking & Finance Kishore C. Padhy & Himalaya, 2011
Rakesh Roshan Mishra
2. Alchemists : Inside the Secret World of Central Bankers Neil Irwin Headline Publishing Group, 2013
3. Anti-Money Laundering / Anti-Terrorism Financing S. S. A. Zaidi Snow White, 2013
& Know Your Customer : Bankers’ Handbook
4. Bank Marketing, 2nd Revised Edition S. M. Jha Himalaya, 2011
th
5. Banking Principles & Operations, 4 Edition M. N. Gopinath Snow White, 2013
6. Banks & Institutional Management : A New Orientation, Vasant Desai Himalaya, 2010
2nd Edition
7. Barons of Banking : Glimpses of Indian Banking History Bhaktiar K. Dadabhoy Random House (India), 2013
8. Credit Appraisal, Risk Analysis & Decision Making : D. D. Mukherjee Snow White, 2014
An Integrated Approach to on and off Balance Sheet
Lending, 8th Revised & Enlarged Edition
9. Credit Monitoring, Legal Aspects & Recovery of bank D. D. Mukherjee Snow White, 2013
loans : The Post - Approval Credit Dynamics in Banks,
2nd Edition
10. End of Competitive Advantage : How to keep your Rita Gunther McGrath Harvard Business, 2013
strategy moving as fast as your business
11. Everything Guide to Commodity Trading David Borman Adams Media, 2012
12. Financial Intelligence : A Manager’s Guide to knowing Karen Berman Harvard Business Review, 2013
what the numbers really mean, 2nd revised edition & others
13. Lean Sigma Sheila Shaffie & Tata McGraw Hill, 2012
Shahbaz Shahbazi
14. Management from the Masters : From Kautilya to Morgen Witzel Portfolio (Penguin India), 2013
Warren Buffet
15. Mergers & Acquisitions Jay M. Desai & Biztantra, 2012
Nisarg A. Joshi
16. Mergers & Acquisitions : Strategy, Valuation & Intergration Kamal Ghosh Ray Prentice Hall of India, 2011
17. Mergers, Acquisitions & Corporate Restructuring, Patrick A. Gaughan John Wiley (India), 2011
5th Edition
18. Practical Approach to NPA Management, 3rd Edition R. C. Kohli Taxmann, 2013
19. Risk Management : The New Accelerator Yerram Raju & Konark Publishers, 2013
Narasimharao V.
20. Secret of Leadership : Stories to awaken, inspire and Prakash Iyer Portfolio (Penguin India), 2013
unleash the leader within
21. Security Analysis & Portfolio Management S. Kevin Prentice Hall of india, 2012
22. Security Analysis & Portfolio Management Suyash N. Bhatt Biztantra, 2011
23. Security Analysis & Portfolio Management Falguni H. Pandya Jaico, 2013
24. Six Sigma on a Budget : Achieving more with less using Warren Brussee Tata McGraw Hill, 2010
the Principles of Six Sigma
25. Smart Trust : Creating Prosperity, Energy & Joy in Stephen M. R. Covey Simon - Schuster (India), 2012
A Low - Trust World

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IIBF Journal Bank Quest

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Capital Optimization under Basel III .........................................................................................................16

Basel Accords and Regulatory Arbitrage .................................................................................................21

Basel-III : Implementation in Indian Banking Industry ..............................................................................32

Basel III and the capital structure of Indian banks ...................................................................................46

Credit Monitoring - A Trainer's Writings for Bankers ................................................................................53

SUBSCRIPTION FORM FOR BANK QUEST / IIBF VISION ..........................................................................56

The Journal of Indian Institute of Banking & Finance January-March 2015 1

GOVERNING COUNCIL MEMBERS

Arundhati Bhattacharya Jatinderbir Singh S. K. Banerji

J. N. Misra, Chief Executive Officer

2 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 3

4 January-March 2015 The Journal of Indian Institute of Banking & Finance

Salient Features of Revised Regulatory Framework for NBFCs

The Journal of Indian Institute of Banking & Finance January-March 2015 15

Capital Optimization under Basel III

16 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 17

18 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 19

20 January-March 2015 The Journal of Indian Institute of Banking & Finance

Basel Accords and Regulatory Arbitrage

Background Committee on Banking Supervision (BCBS) originated

The Journal of Indian Institute of Banking & Finance January-March 2015 21

22 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 23

24 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 25

26 January-March 2015 The Journal of Indian Institute of Banking & Finance

Basel-III bonds - How effective are they

* Chief Manager (Economist), Bank of India.

The Journal of Indian Institute of Banking & Finance January-March 2015 27

Tier 1 Bonds (Basel II) Additional Tier 1(Basel-III) Implications

28 January-March 2015 The Journal of Indian Institute of Banking & Finance

- Decision by relevant authority

The Journal of Indian Institute of Banking & Finance January-March 2015 29

30 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 31

every individual bank as the first order of defence.

risk. A pictorial comparison between Basel II & III is Capital

* Assistant General Manager & Faculty, State Bank Staff College.

32 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 33

34 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 35

Implementation of Basel III regulations -

36 January-March 2015 The Journal of Indian Institute of Banking & Finance

The Journal of Indian Institute of Banking & Finance January-March 2015 37

Capital to Risk Weighted Assets Ratio)

CRAR levels above 15%. Of the remaining, two banks

The position of capital adequacy ratios as at September Total Capital

38 January-March 2015 The Journal of Indian Institute of Banking & Finance

CRAR T2 T1 AddI T1 CET 1

The Journal of Indian Institute of Banking & Finance January-March 2015 39

Capital Adequacy - Group

40 January-March 2015 The Journal of Indian Institute of Banking & Finance