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RBI adopts Basel III Capital Regulations

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The Reserve Bank of India (RBI) on 2nd May 2012 vide notification no. RBI/2011-12/530
DBOD.No.BP.BC.98 /21.06.201/2011-12 laid down guidelines for Indian Banks as recommended under Basel III Capital Regulations. However, the implementation of the capital adequacy guidelines based on the Basel III regulations will begin on January 1, 2013.

In 1974, The Central Bank Governors of the G10 countries established the Basel Committee on Banking and Supervision (Hereinafter referred to as The Committee.) The Committee’s members have since grown to include Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States of America. Each of the member countries are represented by their Central Bank. The present chairman of the Committee is Mr Stefan Ingves, Governor of Sveriges Riksbank. (Central Bank of Sweden)

The Committee formulates broad supervisory standards and guidelines as well as recommends statements of best practices; it does not have the power to legally bind any member to implement the guidelines. However, there is an expectation that steps to implement them will be taken through detailed arrangements, statutory or otherwise, which are best suited to their own banking systems. In this way, convergence is encouraged towards common approaches and common standards without attempting detailed harmonization of member countries’ supervisory techniques.

After the financial crisis in 2007-08, deficiencies in banking practices came to light and the Basel III was formulated in response to the deficiencies. Basel III or the third Basel accord are recommendations made by the Committee in 2010 -11 on global regulatory standard, bank capital adequacy, stress testing and Market liquidity risk. Basel III is an attempt to strengthen the overall banking system and has introduced new regulatory requirements on how Banks should now leverage. For instance, in Basel II the calculation of loan risk was out-sourced to companies that were not subject to supervision. Ratings of creditworthiness of financial instruments were conducted without the supervision of official agencies, leading to high ratings on instruments such as mortgaged securities and other instruments that proved to be very high risk and subsequently give rise to a high number of bad debts.

Basel III has laid down systematic guidelines to strengthen the overall Banking system. The main changes brought about are as follows:

Capital Base Improvement

A bank’s capital comprises Tier 1 and Tier 2 capital. Tier 1 capital, is the Banks core capital and consists primarily of Common stock, disclosed reserve and Perpetual Non-Cumulative Preference Shares. However, banks have used Innovative financial instruments such as Debt/Equity Hybrid Hedging, and Credit Default Swaps over the years to generate Tier 1 capital; these are now subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. Further, Perpetual Non-Cumulative Preference Shares along with Innovative instruments in Tier 1 should not exceed 40% of total Tier 1 capital at any point of time.

Tier 2 capital, is the banks supplementary capital, such as subordinated Debt, subordinated bonds and undisclosed reserves. Tier 2 capital has been limited to not more than 100% of Tier 1 capital. Within Tier 2 capital, subordinated debt is limited to a maximum of 50% of Tier 1 capital. The qualifying criteria for instruments to be included in additional Tier 1 capital outside the Common Equity element as well as Tier 2 capital will be strengthened.

Banking Capital, Tier 1, Tier 2 and Tier 3, were first defined in the first Basel accord and continued with the similar definition in the second Basel accord. However, restrictions added in the third Basel accord, with the removal of provision for tier 3 capital have been done with the goal of improving the quality of Capital and lowering risk. All elements of capital require to be disclosed along with a detailed reconciliation to the published accounts in order to achieve greater transparency.

In order to improve the quality of Common Equity, most of the adjustments under Basel III will be made from Common Equity. The modifications are:

(a) Deduction from capital in respect of shortfall in provisions to expected losses under Internal Ratings Based (IRB) approach for computing capital for credit risk should be made from Common Equity component of Tier 1 capital;

(b) cumulative unrealized gains or losses due to change in own credit risk on fair valued financial liabilities, if recognized, should be filtered out from Common Equity;

(c) shortfall in defined benefit pension fund should be deducted from Common Equity;

(d) certain regulatory adjustments which are currently required to be deducted 50% from Tier 1 and 50% from Tier 2 capital, instead will receive 1250% risk weight; and

(e) limited recognition has been granted in regard to minority interest in banking subsidiaries and investments in capital of certain other financial entities.

Risk Coverage

At present, the counterparty credit risk in the trading book covers only the risk of default of the counterparty. The reform package includes an additional capital charge for Credit Value Adjustment (CVA) risk, which captures risk of mark-to-market losses due to deterioration in the credit worthiness of a counterparty. The risk of interconnectedness among larger financial firms (defined as having total assets greater than or equal to $100 billion) will be better captured through a prescription of 25% adjustment to the asset value correlation (AVC) under Internal Ratings Based (IRB) approach to credit risk. In addition, the guidelines on counterparty credit risk management with regard to collateral, margin period of risk and central counterparties and counterparty credit risk management requirements have been strengthened.

Enhancing Total Capital Requirement

The Basel accord has recommended the enhancing of Total Capital Requirement in order to ensure a certain minimum amount of capital is maintained within the bank, based on a percentage of the assets, weighted by risk or Capital Risk – weighted Assets (CRAR). This ensures that the number of assets that might result in bad debts is limited. As a matter of prudence, the RBI has decided that scheduled commercial banks, excluding Local Area Banks (LABs) and Regional Rural Banks (RRBs) operating in India shall maintain a minimum total capital (MTC) of 9% of total risk weighted assets (RWAs) as against a MTC of 8% of RWAs as prescribed in Basel III.

The RBI has prescribed that Banks are required to maintain a minimum Pillar 1 CRAR of 9% on an on-going basis (other than capital conservation buffer and countercyclical capital buffer). The Reserve Bank will take into account the relevant risk factors and the internal capital adequacy assessments of each bank to ensure that the capital held by a bank is commensurate with the bank’s overall risk profile. This would include, among others, the effectiveness of the bank’s risk management systems in identifying, assessing / measuring, monitoring and managing various risks including interest rate risk in the banking book, liquidity risk, concentration risk and residual risk. Accordingly, the Reserve Bank will consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk management systems. Further, in terms of the Pillar 2 requirements of the New Capital Adequacy Framework, banks are expected to operate at a level well above the minimum requirement.

Regulatory Capita As % to RWAs
(i) Minimum Common Equity Tier 1 ratio 5.5
(ii) Capital conservation buffer (comprised of Common Equity) 2.5
(iii) Minimum Common Equity Tier 1 ratio plus capital conservation buffer [(i)+(ii)] 8.0
(iv) Additional Tier 1 Capital 1.5
(v) Minimum Tier 1 capital ratio [(i) +(iv)] 7.0
(vi) Tier 2 capital 2.0
(vii) Minimum Total Capital Ratio (MTC) [(v)+(vi)] 9.0
(viii) Minimum Total Capital Ratio plus capital conservation buffer [(vii)+(ii)] 11.5

 

Capital Conservation Buffer

The capital conservation buffer (CCB) is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress), which can be drawn down as losses are incurred during a stressed period. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements.

Therefore, in addition to the minimum total of 9% as Minimum Total capital, banks will be required to hold a capital conservation buffer of 2.5% of RWAs in the form of Common Equity to withstand future periods of stress bringing the total Common Equity requirement of 7% of RWAs and total capital to RWAs to 11.5%. The capital conservation buffer in the form of Common Equity will be phased-in over a period of four years in a uniform manner of 0.625% per year, commencing from January 1, 2016.

Countercyclical Capital Buffer

Further, a countercyclical capital buffer within a range of 0 – 2.5% of RWAs in form of Common Equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of countercyclical capital buffer is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth. This buffer will only be in effect when there is excess credit growth that results in a system-wide build-up of risk. The countercyclical capital buffer, when in effect, would be introduced as an extension of the capital conservation buffer range.

Supplementing the Risk-based Capital Requirement with a Leverage Ratio

One of the underlying features of the sub prime crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still showing strong risk based capital ratios. Subsequently, the banking sector was forced to reduce its leverage in a manner that not only amplified downward pressure on asset prices, but also exacerbated the positive feedback loop between losses, declines in bank capital and contraction in credit availability. Therefore, under Basel III, a simple, transparent, non-risk based regulatory leverage ratio has been introduced. The leverage ratio is calibrated to act as a credible supplementary measure to the risk based capital requirements. The leverage ratio is intended to achieve the following objectives:

(a) Constrain the build-up of leverage in the banking sector, helping avoid destabilising deleveraging processes which can damage the broader financial system and the economy; and

(b) reinforce the risk based requirements with a simple, non-risk based “backstop” measure.

Thus, capital requirements will be supplemented by a non-risk based leverage ratio which is proposed to be calibrated with a Tier 1 leverage ratio of 3% (the Basel Committee will further explore to track a leverage ratio using total capital and tangible common equity). The ratio will be captured with all assets and off balance sheet (OBS) items at their credit conversion factors and derivatives with Basel II netting rules and a simple measure of potential future exposure (using Current Exposure Method under Basel II framework) ensuring that all derivatives are converted in a consistent manner to a “loan equivalent” amount. The ratio will be calculated as an average over the quarter.

Possible Effects on the Economy and Banking System

The Basel III recommendations have been made with a view to strengthening the balance sheet of Banks, reducing risk and increasing liquidity as well as quality of capital. Though this move may bring in better banking practices around the world, the effects may lead to lower banking performance in India.

In order to comply with the new guidelines laid down by the RBI, Banks in India will have to raise fresh capital of upwards of $30 billion (around Rs.1.6 trillion) over the next five years. The norms come into effect starting 1 January 2013 and must to be implemented in a phased manner over a period of five years ending 31st March 2018.

Private sector banks should not have much trouble since they are well capitalized and should be able to raise fresh capital when required. However, the Union government, with a fiscal deficit of 5.9% of GDP in 2011 – 12 may find it hard to service the recapitalization required by the Public Sector banks under the new Basel III norms. Moody’s, a leading credit rating agency downgraded State Bank of India last year, because of doubts over the government’s ability to infuse fresh capital into the bank, despite having a strong balance sheet. Also, 16 of 19 public sector banks have underperformed the BANKEX over the past five years.

The RBI has been more stringent than what has been recommended by Basel III. For Indian banks, common equity should be maintained at atleast 5.5% of the asset base, whereas Basel III suggests 4.5%. Scheduled commercial banks, excluding LABs and RRBs operating in India should maintain a MTC of 9% of RWAs as against a MTC of 8% of RWAs as prescribed in Basel III.

Given the situation of the current National and International economies the government may find it hard to recapitalize the Public Sector Banks. The Basel III norms ensure less risk and the guidelines should reduce the quantum of bad debts in the banking system. However, this may have a negative effect on the overall performance of banks in India.

–        Madhukeshwar Desai

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1 Comment

  1. […] RBI adopts Basel III Capital Regulations (pxvlaw.wordpress.com) 13.006230 77.659113 Like this:LikeBe the first to like this post. […]

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