Basel III implementation: A new challenge for Indian banks

Some of the major causes of the global financial crisis were: too much leverage, too little capital, and
inadequate liquidity buffers. Other factors also responsible for this crisis were: shortcomings in risk
management, corporate governance, market transparency and quality of supervision. These have
pinpointed the systemic loopholes in the Basel II framework, which was considered a more risksensitive approach compared to its earlier version, Basel I.
Thus, Basel III was designed to address the weaknesses of the past crisis and to make the banking
sector much stronger and efficient enough to face any crisis. The major thrust area of Basel III is
improvement of quantity and quality of capital of banks, with stronger supervision, risk management
and disclosure standards.
Impact on Banks
The new norms will definitely address the systemic loopholes in Basel II, but it will have some impact
on banks. These are:
Higher Capital Requirement: Presently, in India, most banks' common equity ratio falls in the range of
about 6-10 per cent. Hence, in my opinion, banks may able to comply with the higher capital
requirement as per Basel III norms at least till 2014/15. This, without infusing any fresh equity, even
while taking into account the marginal increase in capital requirement.
However, the increase in the minimum capital ratio, combined with loan growth outpacing internal
capital generation in most government banks, will lead to a shortfall of capital. This will mount mainly
between 2015/16 and 2017/18 due to introduction of a Capital Conservation Buffer (CCB). The CCB is
designed to ensure that banks build up capital buffers during normal times, which can be drawn down
as losses are incurred during a stressed period. The requirement of capital will be less to large private
sector banks due to their higher capital ratios and stronger profitability. However, some public sector
banks are likely to fall short of the revised core capital adequacy requirement and would therefore
depend on government support to augment their core capital. The additional equity capital
requirements in the public sector banks, mainly due to Basel III norms in the next five years, work out
to around Rs 1,400-1,500 billion.
If the government holds the existing shareholding, the recapitalisation burden borne by it will be to
the extent of around Rs 900-1,000 billion. This will contribute to additional government borrowing to
the extent of Rs 1,000 billion. As per the analysis, on account of this extra government borrowing, the
country's fiscal deficit is expected to increase further, by about 25 basis points per annum. This will
widen the fiscal deficit, inflation, lower economic growth, credit offtake and thereby bank
profitability.
Pressure on Return on Equity: To meet the new norms, apart from government support a
significant number of banks have to raise capital from the market. This will push the interest rate up,
and in turn, cost of capital will rise while return on equity (RoE) will come down. To compensate the
RoE loss, banks may increase their lending rates. However, this will adversely affect the effective
demand for loan and, thereby, interest income. Further, with effective cost of capital rising, the
relative immobility displayed by Indian banks with respect to raising fresh capital is also likely to
directly affect credit offtake in the long run. All these affect the profitability of banks.
Pressure on Yield on Assets: On account of higher deployment of funds in liquid assets that give
comparatively lower returns, banks' yield on assets, and thereby their profit margins, may be under
pressure. Further higher deployment of more funds in liquid assets may crowd out good private sector
investments and also affect economic growth.
Action Required from Banks

To address these issues and to protect their profitability margins, banks need to look beyond
regulatory compliance and take proactive actions - assessing their lines of business, level of risk
profiles, economising capital and drawing up funding strategies.
In this regard the following strategies need to be adopted:
Change in Business Mix: Since retail banking has a comparatively lower risk weight compared
to corporate banking (except in the case of clients who are A rated and above), the impact on higher
allocation of capital will be less on retail banking. Further, in corporate banking, as chances of a
default in short-term loans is less, on an average, compared to chances of a default in long-term loans,
banks need to shift towards short-term/retail loans. And to take a granular approach to protect their
margins under the new Basel III norms.
Change in Customer Mix: Banks need to review their capital allocation to each client segment and
price it in line with the profile to ensure that capital is allocated to segments that generate higher riskadjusted returns.
Low-Cost Funding: One of the most important factors to meet the new regulations is to have a
stable low-cost deposit base. For this, banks need to focus more on having business
correspondents/facilitators to reach customers as adding branches will increase costs and have an
impact on the profit margin.
Improvement in systems and procedures: Refining the rating model/data cleaning/
modernisation of systems and procedures may help banks economise their risk-weighted assets,
which will help reduce capital requirements to some extent.
Conclusions
It is more relevant at an economy's macro level to address issues such as systemic risk, market
discipline, liquidity and transparency in the risk-management framework. It is interesting to note that
though risk capital may be the necessary safety cushion for banks, capital alone may not be sufficient
to protect them from any extreme unexpected loss events. In reality, risk capital will remain only a
number and may not be effective if banks do not assess their risk periodically and take timely
corrective action when the risk exceeds the threshold limit. Thus, whether it is Basel II or Basel III, it
is crucial that a bank does not depend solely on "regulatory capital". What is needed is a dynamic risk
mitigation strategy, where all employees act as risk managers in their own area. A proper risk culture
needs to be developed across the organisation and " risk" should be an input for future business
decision-making. Risk management should not merely be an activity to comply with regulatory
requirements.

Basel III Shortcomings

The global financial crisis revealed the inadequacy of Basel II capital requirements for banks and
exposed its loopholes. As a result, the Basel Committee on Banking Supervision (BCBS) has come up
with proposals to overhaul Basel II, so that it can deal with a future crisis of the magnitude of the
global financial crisis. These proposals, which constitute what is commonly known as Basel III, are
unlikely to be adequate for dealing with anything of the magnitude of the global financial crisis, let
alone something bigger. The first proposal is concerned with the quality, consistency and
transparency of the capital base to ensure that high-quality capital is present to absorb losses.
Redefining capital to exclude items that do not remotely represent or resemble capital is a positive
move.
However, redefining capital does not solve the problems associated with the calculation of the capital
ratio on the basis of risk-weighted assets.
The risk weights are arbitrary, and the whole system boosts the procyclicality of the banking industry
without solving the problem of regulatory arbitrage. The proposal to widen risk coverage is meant to

strengthen the risk management of counterparty credit exposure. This sounds good but there are
problems. To control counterparty risk in derivatives, an effective course of action is to force (rather
than beg or provide incentives for) the trading of derivatives on organised exchanges or to require a
full financial back-up of transactions. Regulators should learn from the lessons of the late 1990s when
Brokesley Born, the then head of the Commodity Futures Trading Commission (the US agency in
charge of regulating derivatives), made some serious suggestions to regulate OTC derivatives.
Unfortunately, Borns proposals (which could prevent the recurrence of an AIG-type mess) did not see
the light because of opposition from the trio of Larry Summers, Alan Greenspan and Robert Rubin (at
least two of them have reformed their thoughts since the global financial crisis).
A leverage ratio is to be introduced as a supplementary measure to the Basel II risk-based
framework. However, it is rather strange to suggest that the leverage ratio is a supplementary tool,
given that when a leverage ratio is in place, it implies a corresponding capital ratio. Leverage and
capital ratios are not supplementary. Indeed they are equivalent, unless the capital ratio is measured
on the basis of risk-adjusted assets rather than total assets. Without a leverage ratio it is possible for
banks to hold a small amount of capital versus the unweighted balance sheet, which has been
symptom of a banking culture with a greater willingness to take on more risk with depositors and
taxpayers money. The leverage ratio is more objective, easier to calculate and more readily
understandable than the risk-adjusted capital ratio.
Countercyclical capital buffers will be introduced to promote the build up of capital in good times
that can be drawn upon in periods of stress (bad times), hence reducing the procyclicality of the
banking industry. The problem is that identifying good times and bad times is subjective at worst
and rather difficult at best. There is no way of coming up with a figure for the capital buffer that will
absorb losses in bad times. It is some sort of Mission Impossible to calculate (basic) regulatory
capital Basel-style, which makes the task of calculating countercyclical capital buffers Mission
Impossible 2.
The bottom line is that the banking industry is procyclical, and no-one can change this fact of life. But
at least we know what not to dothat is, boosting the procyclical tendencies of the banking industry,
which is what Basel II does and what Basel III will also do.
The objective of the liquidity proposal is to introduce a global liquidity framework that establishes
minimum standards for funding liquidity risk.
While the regulation of liquidity is a step forward, because low liquidity hampers business and may
induce bank runs, the proposed liquidity provisions are rather complex in the sense that the liquidity
ratios are difficult to measure.
More seriously, the provisions are based on liabilities rather than assets, which is inappropriate.
Instead, a simple asset-based liquidity ratio can be used to supplement the leverage ratio. A liquidity
ratio may be set in terms of deposits, total liabilities or current liabilities, with a clear-cut listing of
liquid assets. Another useful liquidity indicator is the funding gap, the difference between loans and
deposits. In short the Basel III proposals do not deal with some of the most fundamental problems of
Basel II: allowing banks to use internal models to calculate regulatory capital, reliance on rating
agencies, the implementation problems, and the exclusionary and discriminatory aspects of Basel II.
Regulation should cover banks and non-bank financial institutions because banks deal with insurance
companies and hedge funds to shift promises, which enables them to raise leverage and reduce
capital. Furthermore, there are no provisions in Basel II for resolution regimes, which leaves a lot to
be desired with respect to the (big) problem of too big to fail.
The question that remains is whether or not the way forward should be led by the Basel Committee, in
the sense that the required regulatory changes are introduced as a Basel accord and implemented
worldwide. This may not be the right thing to do because it has become quite clear that international
harmonisation of banking regulation does not work.