2010 september-basel-iii (1)

ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian
Banks

Contacts:
The proposed Basel III guidelines seek to improve the ability of banks to
Vibha Batra withstand periods of economic and financial stress by prescribing more
vibha@icraindia.com stringent capital and liquidity requirements for them. ICRA views the
+91-124-4545302 suggested capital requirement as a positive for banks as it raises the
minimum core capital stipulation, introduces counter-cyclical measures,
Karthik Srinivasan, and enhances banks‟ ability to conserve core capital in the event of
karthiks@icraindia.com stress through a conservation capital buffer. The prescribed liquidity
+91-22-30470028 requirements, on the other hand, are aimed at bringing in uniformity in
the liquidity standards followed by banks globally. This requirement, in
Puneet Maheshwari ICRA‟s opinion, would help banks better manage pressures on liquidity in
puneetm@icraindia.com a stress scenario.
+91-124-4545348
The capital requirement as suggested by the proposed Basel III
Sumeet Gambhir guidelines would necessitate Indian banks1 raising Rs. 600000 crore in
sumeetg@icraindia.com external capital over next nine years, besides lowering their leveraging
+91-124-4545329 capacity. It is the public sector banks that would require most of this

September 2010
capital, given that they dominate the Indian banking sector. Further, a
Manushree Saggar higher level of core capital could dilute the return on equity for banks.
manushrees@icraindia.com Nevertheless, Indian banks may still find it easier to make the transition
+91-124-4545316 to a stricter capital requirement regime than some of their international
counterparts since the regulatory norms on capital adequacy in India are
already more stringent, and also because most Indian banks have
historically maintained their core and overall capital well in excess of the
regulatory minimum.

As for the liquidity requirement, the liquidity coverage ratio as suggested
under the proposed Basel III guidelines does not allow for any
mismatches while also introducing a uniform liquidity definition.
Comparable current regulatory norms prescribed by the Reserve Bank of
India (RBI), on the other hand, permit some mismatches, within the outer
limit of 28 days.

1
Except foreign banks

ICRA Comment Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Introduction

The key elements of the proposed Basel III guidelines include the following:
1. Definition of capital made more stringent, capital buffers introduced and Loss absorptive capacity of
Tier 1 and Tier 2 Capital instrument of Internationally active banks proposed to be enhanced
2. Forward looking provisioning prescribed
3. Modifications made in counterparty credit risk weights
4. New parameter of leverage ratio introduced
5. Global liquidity standard prescribed
The Basel committee is expected to finalise the Basel III guidelines by December 2010, following which a six-
year phase-in period beginning 2013 is likely to be prescribed. This note seeks to assess the impact of the
proposed Basel III guidelines on Indian banks‟ capitalisation profile and their liquidity position till 2018. The
impact of the suggested norms relating to forward looking provisioning and counterparty risk weights are not
captured in this note, since for that more granular data would be required and these are not available currently
in the public domain. The norms on “leverage ratio” and “net stable funding ratio” are also not discussed in this
note as they are likely to be implemented not before 2019.

Capital requirement: The new elements and their impact on Indian banks

The proposed Basel III guidelines seek to enhance the minimum core capital (after stringent deductions),
introduce a capital conservation buffer (with defined triggers), and prescribe a countercyclical buffer (to be built
up in times of excessive credit growth at the national level).

Changes in standard deductions
The proposed Basel III guidelines suggest changes in the deductions made for the computation of the capital
adequacy percentages. The key changes for Indian banks include the following:

Table 1: Deductions from Capital—Proposed vs. Existing RBI Norms
Proposed Basel III Existing RBI Norm Impact
Guideline
Limit on deductions Deductions to be made All deductibles to be deducted Positive
only if deductibles exceed
15% of core capital at an
aggregate level, or 10% at
the individual item level
Deductions2 from Tier I All deductions from core 50% of the deductions from Tier I Negative
or Tier II capital and 50% from Tier II (except DTA
and intangible assets wherein
100% deduction is done from Tier I
capital )
Treatment of significant Any investment exceeding For investments up to: Negative
investments in common 10% of issued share capital (i) 30%: 125% risk weight or risk
shares of unconsolidated to be counted as significant weight as warranted by external
financial institutions and therefore deducted rating
(ii)30-50%: 50% deduction from
Tier I and 50% from Tier II

2
These typically include intangible assets and losses, Deferred Tax assets (DTA), Any gain on sale recognized
upfront on securitization of assets, Securitization exposure, Investment in financial subsidiaries and associates
etc.

ICRA Rating Services Page 2


While the proposal to make deductions “only if such deductibles exceed 15% of core capital” would provide
some relief to Indian banks (since all such deductibles are currently reduced from the core capital), the stricter
definition of “significant interest” and the suggested 100% deduction from the core capital (instead of 50% from
Tier I and 50% from Tier II) could have a negative impact on the core capital of some banks.

Capital conservation buffer

The Basel committee suggests that a new buffer of 2.5% of risk weighted assets (over the minimum core
capital requirement of 4.5%) be created by banks. Although the committee does not view the capital
conservation buffer as a new minimum standard, considering the restrictions imposed on banks and also
because of reputation issues, 7% is likely to become the new minimum capital requirement.

The main purpose of the proposed capital buffer is two-fold:
1. It can be dipped into in times of stress to meet the minimum regulatory requirement on core capital.
2. Once accessed, certain triggers would get activated, conserving the internally generated capital. This
would happen as in this scenario, the bank would be restrained in using its earnings to make
discretionary payouts (dividends, share buyback, and discretionary bonus, for instance).

The final contours of the norm on conservation of capital would be known by December 2010. However, the
Basel committee may allow some distribution of earnings by the banks, which are in breach of the proposed
capital conservation buffer. If a bank wants to make payments in excess of the amount that the norm on capital
conservation allows, it would have the option of raising capital for such excess amount. This issue would be
discussed with the bank‟s supervisor as part of the capital planning process.

Table 2: Illustration on distributable Earnings in Various Scenarios
Actual conservation capital as Maximum Permissible earnings
percentage of required that can be distributed in the
conservation capital subsequent financial year
< 25% 0%
25% - 50% 20%
50% - 75% 40%
75% - 100% 60%
>100% 100%

Countercyclical buffer

The Basel committee has suggested that the countercyclical buffer, constituting of equity or fully loss absorbing
capital, could be fixed by the national authorities concerned once a year and that the buffer could range from
0% to 2.5% of risk weighted assets, depending on changes in the credit-to-GDP ratio. The primary objective of
having a countercyclical buffer is to protect the banking sector from system-wide risks arising out of excessive
aggregate credit growth. This could be achieved through a pro-cyclical build up of the buffer in good times.
Typically, excessive credit growth would lead to the requirement for building up higher countercyclical buffer;
however, the requirement could reduce during periods of stress, thereby releasing capital for the absorption of
losses or for protection of banks against the impact of potential problems.
The key features of the buffer include the following:
Credit-GDP gap could be used as a reference point
Buffer to be set at the national level every year
Buffer to be calculated at the same frequency as the normal capital requirement
Banks could be given one year to comply with the additional capital requirement
Reduction in buffer could take effect immediately
Banks not meeting the norm could be restrained from distributing the earnings (in the same manner as
in the case of the capital conservation buffer)



Enhancement in Loss Absorption capacity of capital of internationally active banks

The Basel committee issued a consultative document in August 2010 to introduce a “write off clause” in all
non-common Tier I and Tier II instruments issued by internationally active banks. The main features
include the following:
Capital instruments to be written off on the occurrence of trigger event
In the event of write off, instrument holders could be compensated immediately in the form of
common stock
The trigger event is the earlier of:
o The decision to make a public injection of fund or support, without which the bank would
become non-viable ( as determined by National authority)
o A decision that write-off is necessary to prevent the bank from becoming non-viable (as
determined by the National Authority)
The main purpose of the proposed contingent capital clause is to:
Ensure that holders of capital bear the loss in a stress scenario before public money is infused
and are not its (public funds‟) beneficiaries; and
Reduce the possibility of public support for a bank under stress, as the bank‟s core capital base
would get strengthened at the expense of non-core capital (Tier I and Tier II) holders.
Capital instruments with this clause are likely to increase the downside risk for potential investors; therefore the
risk premium could go up. However, price discovery may not be easy as it could be difficult to assess the
probability of conversion to equity or a principal write-down and the extent of loss after the event. Further
considering the riskier nature of these instruments, there may be a wider notching in the credit rating of such
instruments as compared to existing capital instruments.
Additionally in case this „loss absorption clause‟ is adopted, a large number of instruments would get
disqualified for inclusion under Tier I and Tier II capital. Therefore, Indian banks would need to mobilize capital
for replacing this as well; the quantum of capital to be replaced could be large as total non common Tier 1 and
Tier 2 capital of Indian bank is close to Rs. 200000 crore as on March 31, 2010 and large part of it is issued by
internationally active banks. However, transition may be not be abrupt as these instruments would be phased
out over 10 years starting 2013; their recognition would be capped at 90% in the first year and the percentage
would drop by 10% each subsequent year.

Comparison on Capital Requirement

Overall, with the Basel III being implemented, the regulatory capital requirement for Indian banks could go up
substantially in the long run (refer Table 3). Additionally within in capital, the proportion of the more expensive
core capital could also increase. Moreover, capital requirements could undergo a change in various scenarios,
thereby putting restriction on bank‟s ability to distribute earnings. Please refer to Annexure 2 for an Illustration
on the same.

Table 3: Regulatory Capital Adequacy Levels—Proposed vs. Existing RBI Norm
Proposed Basel Existing RBI
III Norm Norm
Common equity (after deductions) 4.5% 3.6% (9.2%)
Conservation buffer 2.5% Nil
Countercyclical buffer 0-2.5% Nil
Common equity + Conservation buffer + Countercyclical buffer 7-9.5% 3.6% (9.2%)
Tier I(including the buffer) 8.5-11% 6% (10%)
Total capital (including the buffers) 10.5-13% 9% (14.5%)
Source: Basel committee documents, RBI, Basel II disclosure of various banks; Figures in parenthesis pertain
to aggregated capital adequacy of banks covering over 95% of the total banking assets as on March 31, 2010.
Please refer Annexure 1 for details.

Indian banks are subjected to more stringent capital adequacy requirements than their international
counterparts. For instance, the common equity requirement for Indian banks is 3.6% , as against the 2%

Innovative perpetual debt and perpetual non-cumulative preference share cannot exceed 40% of the 6% Tier I,
thereby minimum core capital works out to be 60% of 6%, which is 3.6%



mentioned in the Basel document. At the same time, the total capital adequacy requirement for Indian banks is
9%, as against the 8% recommended under Basel II. Moreover, on an aggregate basis, the capital adequacy
position of Indian banks is comfortable, and being so, they may not need substantial capital to meet the new
norms. However, differences do exist among various banks. While most of the private sector banks and foreign
banks have core capital in excess of 9%, that is not the case with some of the public sector banks, as Chart 13
brings out.

Once Basel III comes into force, 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. In
recent times, Government of India (GOI) support has come via non-core Tier I, but this form of support may
change in favour of equity capital, especially for banks falling short on core capital.

The expected growth in the risk weighted assets along with the requirement of more stringent capital adequacy
norms would also require banks to mobilise additional capital. In a scenario of 20% annualised growth in risk-
weighted assets and in internal capital generation, the volume of additional capital that would be required by
the banking sector (excluding foreign banks) as a whole over the next nine years ending March 31, 2019 works
out to be Rs. 600000 crore (over internal capital generation). Of this, the public sector banks would require 75-
80% and private banks 20-25%. However, any variation in the assumed growth rate may lead to a change in
the volume of capital required. Further, in case some non-common Tier I and Tier II capital instruments get
disqualified for inclusion under regulatory capital, the requirement would go up. It could be a challenge to find
the investors, with higher risk appetite, to subscribe to the capital requirement of Indian banks.

* IDBI‟s Common equity% increased to 6.1% from 4.4% as on March 31, 2010 after factoring in the RS 3119 crore
equity infusion by the GOI in August-2010



Impact on return on equity

Chart 3: Return on Core Tier 1
at various levels of Core Tier 1
20.00%
18.00%
Return on Core Tier 1

16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
6.0% 7.0% 8.0% 9.0% 9.5%

Core Tier 1 Capital

As discussed, the minimum core Tier I capital requirement may increase to 7-9.5% (9.5% including
countercyclical buffer at the maximum level) and the overall Tier I capital to 8.5-11% (depending on the
countercyclical capital buffer level). This would impact the leveraging capital of banks and therefore their return
on equity (ROE). For instance, a bank generating 18% ROE on a core capital of 6% would generate around
15% ROE (3 percentage points lower) in case it were to raise its core capital to 8%.

As most private sector banks and foreign banks in India are very well capitalised, transition to Basel III may not
impact their earnings much, but the upside potential associated with higher leveraging would decline. As for
public sector banks, those with Core Tier I less than 7% would be negatively impacted. Further, as the
countercyclical buffer has to be set annually by the RBI, this could introduce an element of variation in lending
rates and/or the ROE of banks.

Liquidity

Table 4: Liquidity Ratio—Proposed vs. Existing RBI Norm
Proposed Basel III Existing RBI Norm
Liquidity Ratios Liquidity Coverage Ratio = Number of 1 2-7 8-14 15-
Stock of high quality liquid days 28
assets/Net cash outflows Maximum 5% 10% 15% 20%
over a 30-day time period >= Permissible
100% gap (as %
of outflows)
Net Stable Funding Ratio No such norm
(NSFR) = Available amount
of stable funding/Required
amount of stable funding >
=100%



The net stable funding ratio (NSFR) is likely to be implemented from 2019. But implementation of the liquidity
coverage ratio (LCR) from 2015 may necessitate banks to maintain additional liquidity since the LCR
requirement is more stringent; also some assumptions on the rollover rates and the required liquidity for
committed lines may be more stringent. However, considering the period of one month and the fact that most
Indian banks have upgraded their technology platforms, the transition to LCR may not be a very difficult one.



Annexure 1: Capitalization Profile of Top Indian Banks as on March 31, 2010

Public Sector Banks Core Tier-1 Core Tier-1 Tier-1 (net Tier-2 (net CRAR GOI
(Amount in Rs. crore) (net of (net of of of % shareholding
deductions) deductions) deductions) deductions) %
% % %

Allahabad Bank 5,876 7.72% 8.12% 5.51% 13.62% 55.23%
Andhra Bank 4,221 7.81% 8.18% 5.75% 13.93% 51.55%
Bank of Baroda 13,157 8.43% 9.20% 5.16% 14.36% 53.81%
Bank of India (Consolidated) 12,230 7.51% 8.57% 4.43% 13.0% 64.47%
Bank of Maharashtra 2,069 5.61% 6.41% 6.37% 12.78% 76.77%
Canara Bank 12,030 7.99% 8.54% 4.89% 13.43% 73.17%
Central Bank of India 4,341 4.71% 6.83% 5.40% 12.23% 80.20%
Corporation Bank 5,724 8.19% 9.25% 6.12% 15.37% 57.17%
Dena Bank 2,202 7.33% 8.16% 4.61% 12.77% 51.19%
IDBI Bank 7,952 4.37% 6.35% 5.13% 11.48% 52.67%
Indian Bank 6,603 10.50% 11.13% 1.58% 12.71% 80.00%
Indian Overseas Bank 6,095 7.68% 8.67% 6.11% 14.78% 61.23%
Oriental Bank of Commerce 7,297 8.63% 9.28% 3.25% 12.54% 51.09%
Punjab National bank 15,207 8.04% 9.11% 5.04% 14.16% 57.80%
Punjab & Sind Bank 2,127 7.14% 7.68% 5.41% 13.10% 100.0%
State Bank of India - Group 75,295 8.60% 9.28% 4.21% 13.49% 59.41%
State Bank of Bikaner & Jaipur 2,343 7.70% 8.35% 4.95% 13.30%
State Bank of Hyderabad 3,748 7.07% 8.64% 6.26% 14.90%
State Bank of Mysore 1,965 6.70% 7.59% 4.84% 12.42%
State Bank of Patiala 3,505 7.52% 8.16% 5.10% 13.26%
State Bank of Travancore 2,658 8.31% 9.24% 4.50% 13.74%
Syndicate Bank 5,206 7.17% 8.24% 4.46% 12.70% 66.47%
UCO Bank 3,482 4.90% 7.06% 6.16% 13.21% 63.59%
Union Bank 8,657 7.06% 7.91% 4.60% 12.51% 55.43%
United Bank 2,871 6.85% 8.16% 4.64% 12.80% 84.20%
Vijaya Bank 2,478 6.40% 7.69% 4.81% 12.50% 53.87%
Total - Public Sector Banks 205,119 7.66% 8.60% 4.75% 13.36%



Private Sector Banks (Amount in Rs. crore) Core Tier-1 Core Tier-1 Tier-1 (net Tier-2 (net CRAR
(net of (net of of of %
deductions) deductions) deductions) deductions)
% % %

Axis Bank 15,369 10.89% 11.18% 4.62% 15.80%
Federal Bank 4,680 16.92% 16.92% 1.44% 18.36%
HDFC Bank 20,484 13.13% 13.26% 4.20% 17.44%
ICICI Group 43,106 12.12% 12.92% 6.23% 19.15%
Indusind 2,140 9.65% 9.65% 5.68% 15.33%
ING Vysya Bank 1,972 9.62% 10.11% 4.79% 14.91%
Jammu & Kashmir Bank 2,986 12.79% 12.79% 3.10% 15.89%
Kotak Group 7,490 17.31% 17.31% 1.97% 19.28%
South Indian Bank 1,412 12.42% 12.42% 2.97% 15.39%
Yes Bank 3,020 11.84% 12.85% 7.76% 20.61%
Total - Private Sector Banks 102,659 12.42% 12.88% 5.05% 17.93%

Foreign Banks (Amount in Rs. crore) Core Tier-1 Core Tier-1 Tier-1 (net Tier-2 (net CRAR
(net of (net of of of %
% % %

Barclays Bank4 4,665 16.62% 16.62% 0.46% 17.07%
Citibank - Group 15,607 17.29% 17.29% 0.57% 17.86%
5
Deutsche Bank 4,171 16.50% 16.50% 0.71% 17.21%
HSBC Bank 9,144 16.63% 16.63% 1.40% 18.03%
RBS 1,722 6.72% 7.94% 4.56% 12.50%
Standard Chartered Bank 8,037 8.94% 8.94% 3.47% 12.41%
Total - Foreign Banks 43,346 13.80% 13.90% 1.87% 15.77%

All SCBs (Amount in Rs. crore) Core Tier-1 Core Tier-1 Tier-1 (net Tier-2 (net CRAR %
(net of (net of of of
% % %

351,124 9.19% 9.97% 4.58% 14.55%

4
Figures as on March 31, 2009
5
Figures as on December 31, 2009. Also, Core Tier-I and Tier-I are assumed to be same due to non-availability of data



Annexure 2: An illustration on movement of capital requirement and triggers under various scenarios

Regulatory Capital = Core Capital + Capital Conservation Buffer + Countercyclical buffer (if any)

Actual Regulatory Core
Capital 8%

Capital Conservation
Buffer 2.5%

Core Capital 4.5%
Complete
release of
Actual
countercycli Regulatory Actual
cal buffer Core Capital Capital Conservation
Countercylical Regulatory
6.5% Buffer 1% Core Capital
Buffer 2.5%
Normal Scenario 8%
Restriction
on earning Capital
Conservation
distribution Buffer 2.5% Introduction of
continue countercyclical buffer
(although Core Capital 4.5% No restriction on earning
restrictions distribution
are lower) Core Capital
4.5%

Stress situation, normal credit growth High credit growth scenario

Actual
Actual Regulatory
Regulatory Countercyclical Buffer Core Capital
Countercyclical
Core Capital 2.5% 8.5%
Buffer 1.5%
5.5%

Capital Capital
Conservation Conservation
Buffer 2.5% Buffer 2.5%

Core Capital
4.5% Core Capital 4.5%

Stress situation , high credit growth continues
Higher credit growth scenario

Part release of Higher level of countercyclical buffer
countercyclical buffer Restriction on earning distribution
Restriction on earning kicks in
distribution become
higher

Note: Figures in circles represent the minimum regulatory requirement



Annexure3: Time lines (shading indicates transition periods)
(All dates are as of 1 January)
2011 2012 2013 2014 2015 2016 2017 2018 As of 1
January2019
Leverage Ratio Supervisory Parallel run Migration
monitoring 1 Jan 2013-I Jan 2015 to Pillar 1
Disclosure Starts 1 Jan 2015
Minimum Common Equity 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Ratio
Capital Conservation Buffer 0.625 1.25% 1.875% 2.50%
%
Minimum common equity 3.5% 4.0% 4.5% 5.125 5.75% 6.375% 7.0%
plus capital conservation %
buffer
Phase-in of deductions 20.0% 40.0% 60.0 80.0% 100.0% 100.0%
from CET1 (including %
amounts exceeding the
limit for DTAs, MSRs and
financials)
Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus 8.0% 8.0% 8.0% 8.625 9.25% 9.875% 10.5%
conservation buffer %
Capital instruments that no Phased out over 10 year horizon beginning 2013
longer qualify as non-core
Tier 1 capital or Tier 2
capital

Liquidity coverage ratio Introduce
Observ minimum
ation standard
period
begins
Net stable funding ratio
Obser Introduce
vation minimum
period standard
begins



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