Impact of Basel III on business of Indian Banks.pptx

INTEGRATED RISK MANAGEMENT DIVISION
HEAD OFFICE, NEW DELHI

INDEX
 The Basel Committee & the Financial Crisis
 The Limitation of Basel II
 Need for Basel III
 Basel III Objectives
 Basel III Building Blocks – Capital Reforms
 Improving quantity of capital
 Components of Common Equity Tier-I Capital
 Deductions from Capital
 Leverage Ratio
 Capital Conservation Buffer
 Counter Cyclic Buffer
 Liquidity Standards
 Systemic Risk & Interconnectedness
 Basel III – Transitional Arrangement
 RBI Draft Guidelines on Basel III
 Impact of Basel III on Business growth of Indian Banks
 Entity Level Impact of Basel III on BANKS
 Entity Level Impact of Basel III on BORROWERS
 Macro-economic Impact
 Implication of Basel III – Ernst & Young’s perspective
 Implication of Basel III – RBI perspective
 Response of Banks to mitigate the impact on Capital Ratio
 Key aspects that Banks need to address to manage growth and capital requirement.

Important Provisions of Basel III Guidelines

The Basel Committee and the Financial Crisis
 Basel II was finalized in 2004 and made fundamental changes
to the capital requirements for internationally active banks.
 It was considered more risk sensitive than the earlier one i.e.
Basel I.
 Main changes included the adoption of external credit ratings
to determine counterparty risk weights, the ability for banks to
use their own internal models to calculate capital charges for
credit risk, Introduction of Regulatory Retail, greater
recognition of credit risk mitigation techniques, new rules on
securitization and a new capital charge for operational risk.

The Limitations of Basel II
 The lack of emphasis on liquidity in the Basel II framework: Capital
requirements are concerned with solvency and aim to enable an
institution to continue trading in times of financial adversity.
However, a bank can equally fail as a result of insufficient liquidity
 Did not impose restrictions on leverage: This gave rise to incentives
for banks to engage in riskier trading activities in the relatively
benign economic conditions that prevailed prior to the onset of the
financial crisis, which boosted revenues and profits in that period,
but at the same time increased systemic risk and the possibility of
individual bank failure.
 Overlooked Systemic Risk: The focus of Basel II on capital also
resulted in regulators overlooking the growth of systemic risk as they
concentrated on the position of individual institutions.

Need for Basel-III
 The global financial crisis of 2007-2008 caused by the build up
of excessive leverage both in the on- and off-balance sheet.
 One of the major contributor to the crisis was inadequate
liquidity risk management (insufficient liquidity buffers) due to
which Banks suffered heavy losses in trading book
 Crisis exacerbated by a pro-cyclical deleveraging and the
interconnectedness of systemic institutions.
 This financial crisis highlighted the need for government and
central banks to revise banking sector regulation and to address
the issues highlighted by the latest financial crisis.

Basel-III-Objectives
 Basel Committee finalized and published following documents in December
2010 collectively known as “Basel-III”:
 Global regulatory framework for more resilient Banks and Banking system
 International Framework for liquidity risk measurement, standards and
monitoring.
 According to Basel Committee on Banking Supervision(BCBS), Basel III proposals
have two main objectives
 To Strengthen global capital and liquidity regulations with the goal of
promoting a more resilient banking sector
 To improve the banking sector’s ability to absorb shocks arising from
financial and economic stress, which, in turn would reduce the risk of a
spillover from the financial sector to the real economy

Basel-III Building Blocks
 To achieve these objectives, the Basel III proposals may
be viewed as three building blocks on the basis of areas
they address:
 Capital reforms (including quality and quantity of capital,
complete risk coverage, leverage ratio and the introduction
of capital conservation buffers, and a counter-cyclical capital
buffer)
 Liquidity reform (short-term and long-term ratios)
 Other elements relating to Systemic Risk and
Interconnectedness

Basel-III Building Blocks
Source: KPMG: Basel III issues and implications

Basel-III Building Blocks: Capital Reforms
 Existing Rules under Basel II:
 The types of regulatory capital, as well as the 8% minimum ratio of capital
to risk-weighted assets, were set by the Basel Committee in 1988. Both
were left unchanged by Basel II.
 The Basel II rules place no restriction on the amount of Tier 1 capital that a
bank can hold and Tier 2 capital is limited to 100% of a bank’s Tier 1
capital after deductions.
 At least 50% of Tier 1 capital must comprise ordinary shares and reserves,
known as core Tier 1 capital. Under the existing framework a bank could
therefore hold core Tier 1 capital representing only 2% of its risk-weighted
assets with the balance made up of hybrid capital and subordinated debt.
 In practice, banks have tended to hold higher amounts of common
equity and less Tier 2 capital than permitted by the rules, but as the
financial crisis demonstrated, the levels of capital were still inadequate.

Capital Reforms- Improving the Quantity of capital
 Improving the Quality and Quantity of Capital: In order to address the
problem highlighted, Basel III aims to increase both the quality as
well as quantity of the capital held by the bank.
 Increase in Minimum Capital requirements: Common equity component of capital
(which includes reserves) would be increased to 4.5% and the total Tier 1 ratio to
6%. This increase will be phased in as follows:

Capital Reforms- Components of Common Equity Tier 1 Capital
Improvement in Quality of Capital:
 Basel III seeks to reinforce the position of core Tier 1 capital as
the predominant form of capital. This is known as Common
Equity Capital.
 To ensure its quality and consistency across jurisdictions Basel
III sets out a list of criteria that common equity tier 1 will be
required to satisfy.
 Similarly, the criteria for Additional Tier I capital were made
more stringent by removing step up option clause and
introducing loss absorption criteria.
 Criteria for Tier II capital were also made stringent.

Capital Reforms- Deductions from Capital
 Under existing Basel-II rules the following deductions are made from
Tier 1 Capital
 Investment in own shares;
 Intangible assets (including goodwill);
 Net losses on equities in the available-for-sale asset category; and
 50% of deductions in respect of material holdings(i.e. investment in
Subsidiaries)
 Basel III will result in a radical overhaul to deductions from capital and
most of the deductions should be made from core Tier 1 capital
 The practical effect of making deductions from core Tier 1 capital is to
increase the amount of common equity and reserves that a bank must
hold.

Capital Reforms- Deductions from Capital
 Under Basel-III following deduction shall be made from core equity
capital
 Goodwill and other Intangibles
 DTAs and Liabilities
 Cash Flow Hedge Reserve
 Shortfall in Provisions
 Gain on Sale of Certain Securitization Transactions
 Gains and Losses Due to Changes in Own Credit Risk
 Pension Fund Assets and Liabilities
 Investment in Own Shares
 Reciprocal Cross-holdings
 Material Holdings and Investments in Affiliates

Capital Reforms- Leverage Ratio
 The years leading up to the financial crisis were marked by
an excessive increase in leverage.
 Once the crisis erupted, the pressure to reduce leverage
amplified downward pressure on asset prices, magnifying
mark-to-market losses and write downs against capital,
thereby leading to a significant contraction in the availability
of credit to the real economy.
 The Basel Committee therefore decided to supplement the
risk-based measurements in Basel II with a leverage ratio to
curtail the build up of leverage and risk in the financial
sector.
 Leverage ratio is defined as ratio of Tier I Capital to Total
exposure which includes both on and off balance sheet
exposure including derivatives.

Capital Reforms- Leverage Ratio
 The Measure of Capital: Presently, The capital measure used for the
leverage ratio is proposed to be Tier 1 capital.
 The Measure of Exposure: It is sum total of on balance sheet items and off
balance sheet items including derivatives.
 On-balance sheet items: All assets on balance sheet must be included
within the leverage ratio. Positive mark to market value of derivative
exposures will also be added.
 Off balance Sheet Items: All Non Market related off balance sheet
items with uniform 100% credit conversion factor except for
commitments that are unconditionally cancellable at any time by the
bank without prior notice, which shall attract 10% CCF
 The minimum Leverage ratio specified by the Basel committee is 3%.

Capital Reforms- Capital Conservation Buffer
 Under Basel III, a capital conservation buffer range will be established over and
above the regulatory minimum.
 Banks whose capital levels fall within the buffer range will be subject to quantitative
restrictions on distributions, buy-backs and staff bonus payments, but will not be
constrained in respect of their other activities (e.g. lending).
 The table below shows the minimum capital conservation ratios a bank must meet at
various levels of the Common Equity Tier 1 (CET1) capital ratios. For example, a
bank with a CET1 capital ratio in the range of 5.125% to 5.75% is required to
conserve 80% of its earnings in the subsequent financial year (i.e. payout no more
than 20% in terms of dividends, share buybacks and discretionary bonus payments).

Capital Reforms- Counter Cyclical Buffer
 Under the proposals national authorities will monitor credit growth and any other
factors that may signal a build up of system-wide risk to assess whether credit
growth is excessive. If the authorities judge this to be the case, they will announce
the imposition of a counter-cyclical buffer.
 This buffer will be added to the capital conservation buffer, increasing the overall
buffer from 2.5% to a maximum of 5% of risk-weighted assets. The buffer must be
met with common equity or “other fully loss absorbing capital”
 The Basel Committee considered that setting a buffer is likely to be appropriate
where the ratio of credit to GDP exceeds its long-term trend
 A bank that fails to satisfy the counter-cyclical buffer will be subject to the same
restrictions on distributions and discretionary payments to staff as apply to banks
that do not meet the capital conservation buffer

Basel-III Building Blocks: Liquidity Standards
 The Basel Committee has formulated two new liquidity standards:
 Liquidity Coverage Ratio(LCR) to promote short-term resilience by ensuring
that banks have sufficient high-quality liquid assets to survive a one month
significant stress; and
 Net Stable Funding Ratio (NSFR) requiring banks to fund their activities from
more stable long-term sources, providing an appropriate matching of assets
and liabilities.
 Liquidity Coverage Ratio: it is defined as the ratio of Stock of high-quality
liquid assets to Total net cash outflows over 30 day period.
 The LCR is therefore based on two elements: a definition of high-quality
liquid assets and a metric for calculating net cash outflows.

 Level 1 Assets: Level 1 assets are the best quality assets and
may be used without limit to meet a bank’s LCR. Level 1
assets are limited to:
 Cash
 central bank reserves (to the extent these can be drawn down in time
of stress);
 securities issued or guaranteed by sovereigns, central banks, public
sector entities and certain international organisations185 that:
(i) have a 0% risk weight under the Basel II standardized approach;
(ii) trade in large, deep and active repo or cash markets;
(iii) have a proven record as a reliable source of liquidity during stressed
situations;
(iv) are not issued by a financial institution or its affiliates;

Level 2 Assets: Level 2 Assets are limited to :
 securities issued or guaranteed by sovereigns, central banks,
public sector entities or multilateral development banks that:
i. have a 20% risk weight under the Basel II standardized approach;
ii. trade in large, deep and active repo or cash markets;
iii. have a proven record as a reliable source of liquidity during stressed
situations;
iv. are not issued by a financial institution or its affiliates;
 corporate bonds and covered bonds:
i. not issued by a financial institution or its affiliates
ii. not issued by the bank itself or any of its affiliates
iii. rated AA- or better;
iv. trade in large, deep and active repo or cash markets; and
v. have a proven record as a reliable source of liquidity during stressed
situations

 Total net cash outflows will be measured as the total expected cash
outflows less total expected cash inflows for the specified stress scenario.
 Cash outflows will be calculated by multiplying outstanding balances of
specified types by a percentage representing the rate at which they are
assumed to run-off or be drawn down.
 Cash inflows will be calculated by multiplying categories of receivables
by a percentage representing the rate at which they are expected to flow
in, subject to a cap of 75%
 Net Stable Funding Ratio: The second liquidity standard is the NSFR. It
will establish a minimum acceptable amount of stable funding based on
the liquidity characteristics of a bank’s assets and liabilities over a one
year period.

 The NFSR is defined as ratio of Available amount of stable funding to
Required amount of stable funding
 Stable funding under the metric is funding that is expected to be reliable
over a one year time horizon under conditions of extended stress and
includes
i. Capital;
ii. Undated or dated preference shares with a maturity of one year of more;
iii. Liabilities with an effective maturity of one year or more;
iv. That portion of deposits and/or term deposits with a maturity of less than
one year that is expected to remain with a bank over an extended period of
stress;
v. That portion of wholesale funding with a maturity of less than one year that
is expected to stay with the bank over an extended period of stress.

 For calculating available stable funding, various ASF Factors have been provided
in the Basel III guidelines
 Similarly for required stable funding calculation various RSF factors have been
provided in the guidelines.
 Both LCR and NSFR should be equal to or greater than 100%

Basel-III Building Blocks: Systemic risk and interconnectedness
 The Basel Committee and the Financial Stability Board are developing a well integrated
approach to systemically important financial institutions which could include
combinations of capital surcharges, contingent capital and bail-in debt.
 Several of the capital requirements introduced by the Committee to mitigate the risks
arising from firm-level exposures among global financial institutions will also help to
address systemic risk and interconnectedness. These include:
o Capital incentives for banks to use central counterparties for over-the-counter
derivatives;
o Higher capital requirements for trading and derivative activities, as well as complex
securitizations and off-balance sheet exposures (e.g. structured investment vehicles);
o Higher capital requirements for inter-financial sector exposures; and
o Introduction of liquidity requirements that penalize excessive reliance on short term,
interbank funding to support longer dated assets.

Basel III – Transitional Arrangements

RBI Draft Guidelines on Basel III –
Important Points

Highlights of RBI Draft Guidelines
 RBI issued draft guidelines on 30th December 2011 for
Implementation of Basel III Capital Regulations.
 Later on , the draft guidelines on Liquidity was also issued on
21st February 2012.
 RBI’s approach has been to adopt Basel III capital and
liquidity guidelines with more conservatism and at a quicker
pace.
 The important provisions of the guidelines and the impact of
the same on Indian Banks are discussed in the next slides.

 Capital Requirements: The minimum and maximum capital
requirements are placed in the table.
 # however, if the Common Equity Tier I Capital is above 5.5%, then the maximum
permissible AT 1 and Tier 2 capital may be increased on a proportionate basis.
Regulatory Capital Requirements (of RWAs)
Minimum Common Equity Tier I (CET 1) 5.50%
Maximum Additional Tier I capital 1.50%#
Minimum Tier I Capital 7.00%
Maximum Tier 2 Capital 2.00%#
Minimum Total Capital/CRAR 9.00%
Capital Conservation Buffer (CCB) comprising of Common
Equity
2.5%
Minimum total capital ratio plus CCB 11.5%
Requirement of Common Equity (of RWAs)
Minimum Common Equity Tier I 5.50%
Capital Conservation Buffer (CCB) comprising of Common
Equity
2.5%
Minimum Common Equity (Tier I ratio plus CCB) 8.00%

 Capital Conservation Buffer (CCB): The capital conservation
buffer in the form of Common Equity of 2.5% of RWAs.
 Countercyclical Capital Buffer: The range prescribed is (0-
2.5% of CET). This would be introduced as an extension of
the capital conservation buffer. However, presently RBI has
not prescribed any time limit.
 Leverage Ratio: Banks are expected to strive to operate at a
minimum Tier 1 leverage ratio of 5%.
 Adjustments from Common Equity Capital: Most of the
adjustments under Basel III will be made from Common
Equity. However, wherever applicable, phase-in deductions
are allowed from CET 1 and rest from Tier I in phased
manner.

Important Provisions for Additional Tier I instruments /
Tier 2 instruments:
 Banks should not issue AT 1 capital instruments to the retail
investors.
 Capital instruments which no longer qualify as non-common
equity Tier1 capital or Tier 2 capital (e.g. IPDI and Tier 2 debt
instruments with step-ups) will be phased out beginning January 1,
2013. Fixing the base at the nominal amount of such instruments
outstanding on January 1, 2013, their recognition will be capped at
90% from January 1, 2013, with the cap reducing by 10 %age
points in each subsequent year.
 Elements of Tier 2 will largely remain the same except that there
will be no separate Tier 2 debt instruments in the form of Upper
Tier 2 and subordinated debt.

Important Provisions for Additional Tier I instruments /
Tier 2 instruments:
 The Loss Absorption features have been introduced for Additional Tier I
Capital instruments.
 In such cases, these instruments must have principal loss absorption
through either (i) Conversion to common shares at an objective pre-
specified trigger point or (ii.) A write-down mechanism which allocates
losses to the instrument at a pre-specified trigger point.
 The write-down will have the following effects:
 Reduce the claim of the instrument in liquidation;
 Reduce the amount re-paid when a call is exercised; and
 Partially or fully reduce coupon payments on the instrument.

Transitional Arrangements:
 As per draft guidelines, the implementation period of
minimum capital requirements and deductions from
Common Equity will begin from January 1, 2013 and be fully
implemented as on March 31, 2017.
 Capital conservation buffer requirement is proposed to be
implemented between March 31, 2014 and March 31, 2017 @
0.625% of RWA each year cumulatively.
 The implementation schedule will be finalized taking into
account the feedback received on these guidelines.

Major Issues / Challenges of the Draft Guidelines
 Capital as required by RBI in response to Basel III guideline calls
for 1 % extra capital.
 The definition of capital under Basel III has also become more
stringent with focus on improving the quality.
 The restrictions imposed on the level of Additional Tier-I & Tier 2
is quite stringent.
 Due to non-recognition of some part of Tier II, there may also be
contraction in single/ group borrower exposure ceiling in the
initial years of transition to Basel III norms.
 Leverage Ratio prescribed is on higher side. As per existing RBI
guidelines, banks cannot consider their quarterly profits for capital
purposes.
 Non-addition of quarterly profits may lead to lesser Leverage ratio
during the quarter ending.

Impact of Basel-III on Business Growth of
Indian Banks

Impact of the Guidelines – Research /Analysis so far
 There has been considerable research on the topic by the official sector
including the Basel Committee, and non-official or private sector
institutions.
 The views/findings are quite diversant.
 The Macroeconomic Assessment Group (MAG) set up by the Basel
Committee and FSB has estimated that bringing the global common
equity capital ratio to a level that would meet the agreed minimum and
the capital conservation buffer, would result in a maximum decline in
GDP, relative to baseline forecasts, of 0.22%, at the end of Basel III
implementation period. The estimated maximum GDP impact per
percentage point of higher capital was 0.17%.
 In addition, the Basel Committee’s study on the Long-term Economic
Impact (LEI) of the stronger capital and liquidity requirements has
suggested that the net benefits in terms of the gains from reduced
probability of banking crises, and the consequential loss of growth,
remain positive.

Impact of the Guidelines – Research /Analysis so far
 The estimates of the International Institute of Finance (IIF), a
private sector body, is that level of GDP will be 3.2% lower than it
would otherwise be (i.e., relative to the baseline scenario) after five
years with an output loss of 0.7% per annum.
 This is several magnitudes higher than the MAG’s estimate of an
output loss of 0.03% per annum.
 The wide difference in estimates is attributed to different
assumptions and samples.
 Speaking theoretically, the likely impact of Basel III on Banks,
Borrowers and Macro economy conditions as a whole are placed
in the next slides:

Entity Level Impact of Basel-III on Banks
 Increase Funding Costs : With full implementation of Basel-III rules, every bank
will need to provide higher capital for the same level of business as compared to
existing framework i.e. Basel-II. With relatively fixed amount of funds being
chased by many hands, the overall cost of capital is bound to increase.
 Significant pressure on profitability and ROE: Increased capital requirements,
increased cost of funding, and the need to reorganize and deal with regulatory
reform will put pressure on margins and operating capacity. Investor returns will
likely to decrease at a time when firms need to encourage enhanced investment to
rebuild and restore buffers
 Reduced lending capacity: Although the extended implementation time line is
intended to mitigate the impact, significant increases to capital and liquidity
requirements may lead to a reduction in the capacity for banking activity or, at
the very least, a significant increase in the cost of provision of such lending.
 Change in demand from short-term to long-term funding: The introduction of two
liquidity ratios will likely drive firms away from sourcing shorter-term funding
arrangements and more towards longer-term funding arrangements with the
consequent impact on the pricing and margins that are achievable.

Entity Level Impact of Basel-III on Borrowers
 Increase Funding Costs : In the medium term, as banks increase their capital
ratios by reducing lending, access to credit is likely to become more difficult
and borrowing costs are liable to increase.
 Difficulty for small and medium companies: Small and medium-sized firms are
likely to experience more difficult credit conditions, as the new rules affect
mostly small financial institutions; moreover, raising equity or issuing debt will
continue to be a much more expensive option for small and medium-sized
businesses than for major companies.
 Higher Trade Financing costs: Significantly higher trade financing costs and
tighter access to traditional trade financing instruments, such as letters of
credit. Companies might find it more convenient to use other forms of trade
financing, such as overdraft, factoring, cash-in-advance terms and export credit
insurance.

Macroeconomic Impact of Basel-III
 Weaker banks crowded out: Under adverse economic conditions, with
regulatory scrutiny ever more intensive, the weaker banks will likely find it
more difficult to raise the required capital and, funding, leading to a potential
reduction in competition resulting by way of mergers and acquisitions
 Increasing role of NBFC due to regulatory capital arbitrage: The current
system of regulating banks alone under Basel rules creates capital arbitrage
opportunities in favor of NBFC ‘s which over a period have become
systematically important avenues for funding.
 Pressure on regulators to reduce risk weights on priority sector lending: As the
attitude of banks toward providing credit becomes more conservative, sources
of low cost credits are likely to diminish. With growth in mind, regulatory
intervention in determining risk weights may create an imbalance between
the actual risk potential of assets and the risk capital allocated to such assets.
 Strategic investments by banks in financial services companies: Banks shall
enter into such avenues which do not attract Basel regulations (such as
Insurance)

Macroeconomic Impact of Basel-III
 Risk-return optimization by banks with a focus on enhancing RoE: The
increased pressure on banks to deliver value to their equity holders will lead
to careful RoE-adjusted capital and economic capital allocation decision
which have so far been missing from the Indian banking system. However,
the additional pressure on banks to return value to shareholders is likely to
apply additional pressure to chase high-risk, high-return assets.
 Opportunity for the development of corporate bond markets: Banks play an
important role of intermediation between investors and borrowers. With the
high proportion of savings directed toward banks deposits in India, the role of
banks in the intermediation process has been more important than in other
geographies. Corporate bond markets provide an alternative tool for bringing
investors and borrowers together. The development of corporate bond
markets and markets for other financial instruments are likely to exceed
growth in bank credit.
 Reduced risk of a systemic banking crisis: The enhanced capital and liquidity
buffers, together with the focus on enhanced risk management standards and
capability, should lead to reduced risk of individual bank failures and reduced
interconnectivity between institutions. Reduced

Implications of Basel III on Indian Banks – E & Y’s
perspective
 The Ernst & Young Private Ltd. Has also conducted the study
on 38 Banks – 24 PSBs, Pvt. Sector Banks & 5 Foreign Banks.
 The impact assessment is based on assumptions relating to
growth in credit off-take and other assets exposed to market
risk.
 The findings of capital requirements as the E&Y study for
banks are in the next slides.

Capital Deficit of Banking Industry

Capital Deficit of Public Sector Banks

Capital Deficit of Private Sector Banks

Capital Deficit of Foreign Banks in India

Key Findings
 By 2014, the Indian banking system is expected to require
additional capital of approximately INR 83.92 billion.
 By 2019, the Indian Banking system is likely to require additional
capital of INR 4315.17 billion, of which 70% will be required in
the form of common equity i.e. share capital plus reserves,
excluding share premium.
 Public sector banks are expected to fall short of capital by 2013 and
require an infusion of common equity by 2015.
 While the Indian banking sector may not fall short of common
equity capital on a consolidated basis until 2016, individual banks
are expected to run into a capital deficit by 2013.

Implications of Basel III on Indian Banks – RBI perspective
Capital
 The average Tier 1 capital ratio of Indian banks is around 10% with
more than 85% of it comprising common equity.
 The regulatory adjustments will reduce the available equity capital
only marginally for various reasons.
 First, items such as goodwill, Deferred Tax Assets (DTAs) etc. are
already deducted from Tier 1 capital for Indian banks.
 Secondly, some other items which are subject to deduction such as
mortgage servicing rights, treasury stocks, gains on account of fair
valuation of liabilities which exist in other developed economies, do
not exist in India.
 Thirdly, reciprocal cross-holdings of capital and other investments in
the capital of banking, financial and insurance entities are
insignificant because these investments are restricted due to existing
regulatory limits.

Capital
 Thus, Indian banks will have high common equity capital ratio
even under Basel III which will stand them in good stead.
 It is worth noting that more than 50% of Indian banks have
common equity ratio of higher than 8% at present and can
implement Basel III even today without any phase-in.
 Apart from that, the trading book and OTC derivative portfolio of
the Indian bank are very small and they do not have any exposure
to re-securitized instruments, impact of these changes in capital
regulation on their balance sheets is insignificant.

Capital
 The Indian economy is expected to grow at an annual growth rate
of 8-9% for next 10 years or so. This would undoubtedly
necessitate a considerable growth in bank capital.
 However, many Indian banks have actually been operating with
equity capital ratio of 7-8% for last 5 years when the economy
continued to grow at an average rate of about 8%.
 This comforts RBI in terms of both the ability of banks to operate
at higher equity capital levels required under Basel III and also the
capacity of the Indian capital market to provide the required equity
capital to banks.
 The demand for equity from the capital market would be less (for
banks where Government shareholding is 51% but public sector
banks’ dependence on the Government for capital support will
increase.

Liquidity – Issues Related to SLR and LCR
 In India, banks are statutorily required to hold minimum reserves
of high-quality liquid assets.
 Since these reserves are part of the minimum statutory
requirement, RBI faces a dilemma whether and how much of these
reserves can be allowed to be reckoned towards the LCR.
 If these reserves are not reckoned towards the LCR and banks are
to meet the entire LCR with additional liquid assets, the proportion
of liquid assets in total assets of banks will increase substantially,
thereby lowering their income significantly.
 RBI is examining to what extent the SLR requirements could be
reckoned towards the liquidity requirement under Basel III.

Profitability
 Studies have suggested that internationally, Basel III requirements
will have a substantial impact on profitability.
 One such study conducted by McKinsey & Company suggest that
all other things being equal, Basel III would reduce return on
equity (RoE) for the average bank by about 4 percentage points in
Europe and about 3 percentage points in the United States.
 Banks are already seeking to manage RoE in the new environment
by balance-sheet restructuring and business model adjustments
 The study suggests that the balance sheet restructuring and
business-model adjustments could potentially mitigate up to 40
percent of Basel III’s RoE impact, on an average.

Lending Rates
 Suppose, a typical Indian bank has RoE of 15% and interest paid on
non-equity elements of capital is 10%.
 Further, suppose that the equity to RWAs ratio of the bank is 6%.
 Now if the bank is required to maintain an additional 1% equity,
the weighted average cost of funds would rise by 5 basis points
only.
 If the equity capital required rises by 2%, the increase in lending
rate to pass on the full increase in cost of capital to borrowers
would be 10 basis points.
 There is likely to be some increase in cost of non-equity capital as
well.
 But, all this is unlikely to push the cost of lending significantly.

Lending Rates
 Indian banks should keep in mind that their net interest margins
(NIMs) are very high as compared with their counterparts in many
other countries.
 This only indicates the need for improving efficiency and
considerable scope for bringing down the cost of intermediation.
 There is need for improving efficiency and considerable scope for
bringing down the cost of intermediation.
 The impact on their RoE is likely to be much less than 3 to 4
percentage points as observed in the case of US and European
banks.

Responses of banks to mitigate the impacts on capital ratio
 Managing the credit off-take and credit portfolio quality: Credit off take and capital
requirements are directly correlated. However, improvements in asset quality and
the allocation of capital toward lower risk weighted assets are likely to reduce
capital deficit. Focus on assets with higher margins and lower delinquency as
opposed to the balance sheet size is critical for striking a balance between growth
and capital requirements.’
 Composition and risk-return expectations from the market risk portfolio: Migration
to internal model-based approaches can be expected to increase the requirement of
market risk capital for equity and forex instruments. The allocation of market risk
capital to less volatile assets can also help manage capital requirements. Sustaining
such assets in the balance sheet will, therefore, require high returns. Banks will be
required to make important policy decisions on the size and composition of their
trading portfolios to conserve capital.
 Dividend payout policies: Retaining dividends for growth is important to manage
capital requirements. The introduction of more stringent norms to treat share
premium under BASEL III places more emphasis on the retention of profits.
 Focus on increasing fee based income: net profits have tended to be low as the size
of asset base has increased, to supplement the low margin from lending, banks will
need to focus more on more augmenting their income through fee based services.

Key aspects that banks need to address to manage growth and capital
requirements

Impact of Basel III on business of Indian Banks.pptx

Impact of Basel III on business of Indian Banks.pptx

Recommended

Recommended

More Related Content

Similar to Impact of Basel III on business of Indian Banks.pptx

Similar to Impact of Basel III on business of Indian Banks.pptx (20)

Recently uploaded

Recently uploaded (20)

Impact of Basel III on business of Indian Banks.pptx