IIMB Management Review (2013) 25, 115e130

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ROUND TABLE

Basel III implementation: Issues and challenges for

Indian banks
M. Jayadev*

Finance and Control, Indian Institute of Management, Bannerghatta Road, Bangalore 560076, India

KEYWORDS Abstract The Basel III framework, whose main thrust has been enhancing the banking
Basel III; sector’s safety and stability, emphasises the need to improve the quality and quantity of
Capital regulation; capital components, leverage ratio, liquidity standards, and enhanced disclosures. This article
Capital management; first lays the context of Basel III and then incorporates the views of senior executives of Indian
Indian banking banks and risk management experts on addressing the challenges of implementing the Basel III
framework, especially in areas such as augmentation of capital resources, growth versus finan-
cial stability, challenges for enhanced profitability, deposit pricing, cost of credit, mainte-
nance of liquidity standards, and strengthening of risk architecture.
ª 2013 Indian Institute of Management Bangalore. Production and hosting by Elsevier Ltd.
All rights reserved.

Context note be mitigated by a combination of product pricing and

accounting loss provisions, while capital funds are expected
In a banking entity assets are created as a process of to meet unexpected losses. Thus the primary role of capital
intermediation by accepting deposits; the basic function of in a banking institution is to meet the unexpected losses
intermediation itself is a source of credit and liquidity risks arising out of portfolio choice of banks and to protect the
for any banking institution. Further, banks are exposed to depositor’s money.
various market and non-market risks in performing their
functions. These risks expose banks to events, both ex- Basel capital accords
pected and unexpected, with the potential to cause losses,
putting depositors’ money at risk. Expected losses may Banks and the regulators all over the world have been
concerned about these risks, and the formal framework for
banks’ capital structure was evolved in 1988 with the
* Tel.: þ91 80 26993138.
E-mail address: [email protected] introduction of the “International Convergence of Capital
Peer-review under responsibility of Indian Institute of Management Measurement and Capital Standards”, popularly known as
Bangalore Basel I, issued by the Basel Committee on Banking Super-
vision (BCBS). Following Basel I banks were required to
maintain a minimum capital adequacy of 8% against risk
weighted assets (RWA). Here Basel suggested a portfolio
approach to credit risk by assigning appropriate risk weights
0970-3896 ª 2013 Indian Institute of Management Bangalore. Production and hosting by Elsevier Ltd. All rights reserved.
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116 M. Jayadev

against each asset (for example, housing loans carry 50% a vicious cycle of deleveraging, thereby hurtling global
risk weight and corporate loans carry 100% risk weight). The financial markets into seizure and economies around the
capital components include long term debt funds also by world into recession. Second, by following value at risk (VaR)
categorising qualitative equity capital as Tier I and others models banks maintained capital requirements against
as Tier II. Although the Basel Accord was signed only by the trading book exposures assuming that these could be liqui-
G-10 countries plus two more nations, more than 100 dated, and substantial banking book assets were parked in
countries across the globe have made these norms trading book, which helped banks to optimise the capital
mandatory in their domestic banking systems. In India, the requirements. These trading book exposures include the
Reserve Bank of India (RBI) implemented Basel I norms from securitised bonds, derivative products, and other toxic
1992 onwards. The post 1990 scenario world over saw banks assets. The third issue was the absence of any explicit
increasing their trading activity by investing in securities regulation governing leverage. Basel II assumed that its risk
which exposed banks to price risks, and responding to this, based capital requirement would implicitly mitigate the risk
in 1996, the Basel Committee suggested that banks main- of excessive leverage. Unfortunately, excessive leverage of
tain capital funds against market risk by following either banks was one of the prime causes of the crisis. The fourth
the standardised measurement approach (SMA) or internal issue was that Basel II did not consider liquidity risk as part of
measurement approach (IMA) to meet the unforeseen losses capital regulation. During the financial crisis unaddressed
arising out of market risks. liquidity risk cascaded into solvency risk; the data shows that
Basel I was criticised for its rigidity of “one-size fits” the Federal Reserve, the European Central Bank (ECB), the
approach and absence of risk sensitivity in estimating capital Bank of England, the Bank of Japan, and the Swiss National
requirements. After several discussions and revising multiple Bank have together injected USD 2.74 trillion to meet
drafts, in 2004 the BCBS came out with a comprehensive liquidity requirements.1 Finally, Basel II focussed more on
framework of capital regulation popularly known as Basel II. individual financial institutions and ignored the systemic risk
Basel II was built up on three mutually reinforcing pillars e arising from the interconnectedness across institutions and
minimum capital requirements, supervisory review process, markets, which led the crisis to spread to several financial
and market discipline. Under Basel II, banks were required to markets (Acharya and Richardson 2009). Since the beginning
maintain the minimum capital requirement of 8% against the of the financial turbulence in 2007, the total reported write
risk weighted assets, while RWA was computed by consid- downs and losses of banks globally have exceeded 888 billion
ering the three major generic risks e credit, market, and dollars. Some estimates of the overall expected losses by
operational risks. To estimate the capital requirements for banks and other financial institutions are in the range of 2.2
credit risk and operational risk, Basel-II proposed a menu of trillion dollars.2
approaches e standardised, foundation internal ratings, and In response to the 2007e09 global financial crisis BCBS
advanced internal ratings approach. However, for market issued Basel II.5, which was designed to estimate capital
risk Basel II continued with the 1996 framework which sug- requirements for credit risk in the trading book of a bank.
gested both standardised and internal measurement models. Basel II.5 was intended to prevent inappropriate placement of
The European Parliament approved all the three securities in the book that would provide the most favourable
Basel II approaches for all European Union (EU) banks in accounting treatment of securities at a particular point in
2005 and formally adopted the agreement in 2006. The time. In that order, the Basel Committee issued a series of
EU implemented the standardised and foundation approaches documents to address specifically counterparty risk in deriv-
as early as 2007 and the advanced approaches by 2008. In the ative transactions, strengthening of liquidity standards, and
US, the rules apply only to the 19 largest, internationally market risk framework. Consolidating all these, the BCBS
active “core” US Banks. (Core banks are those with consoli- released the Basel III framework entitled “Basel III: A Global
dated total assets of $ 250 billion or more or with consolidated Regulatory Framework for more Resilient Banks and Banking
total on-balance sheet foreign exposure of $ 10 billion or systems” in December 2010 (revised in June 2011).
more.) However, some banks voluntarily adopted the rules According to the BCBS, the Basel III proposals have two
(“opt in” banks). In India, from 2007 to 08 onwards, banks main objectives:
have followed estimation of capital requirements by
following the standardised approach for all the three risks e  To strengthen global capital and liquidity regulations
credit, market and operational risks. with the goal of promoting a more resilient banking
Although Basel II was a very comprehensive capital sector.
regulation framework architected on sophisticated risk  To improve the banking sector’s ability to absorb shocks
quantification models, it failed to address certain issues arising from financial and economic stress.
which emerged during the financial crisis of 2007e08
(Fratianni and Marchionne (2009), Acharya et al. (2011),
Reddy (2009). First, Basel II, a risk sensitive framework, Enhancements of Basel III over Basel II
proved to be pro-cyclical; in good times, when banks were
doing well, and the market was willing to invest capital in The enhancements of Basel III over Basel II come primarily
them, Basel II did not impose additional capital requirement in four areas: (i) augmentation in the level and quality of
on banks. On the other hand, in stressed times, when banks
required additional capital and markets were wary of 1
IMF, Global Financial Stability Report Market updated, 28 Jan
supplying that capital, Basel II required banks to bring in 2009, p-2.
more of it. During the crisis, it was the failure to bring in 2
IMF, Global Financial Stability Report Market updated, 28 Jan
additional capital that forced major international banks into 2009, p-2.
Basel III implementation 117

Table 1 Minimum regulatory capital prescriptions (as % risk weighted assets).

Basel III Current Basel III
(as on (Basel II) (as on March
January 2019) 31, 2018)
A Z (B þ D) Minimum total capital 8.00 9.00 9.00
B Minimum tier 1 capital 6.00 6.00 7.00
C of which:
Minimum common equity tier 1 capital 4.50 3.64 5.5
D Maximum tier 2 capital (within total capital) 2.00 3.00 2.00
E Capital conservation buffer (CCB) 2.50 2.5
FZCþE Minimum common equity tier 1 capital þ CCB 7.00 3.60 8.00
GZAþE Minimum total capital þ CCB 10.5 11.5
H Leverage ratio (ratio to total assets) 3.00 4.55
(Source: Address by Dr. Duvvuri Subbarao, September 4, 2012).

capital; (ii) introduction of liquidity standards; (iii) modi- capital requirement known as credit valuation adjustment
fications in provisioning norms; and (iv) introduction of (CVA) risk capital charge for over-the-counter (OTC)
leverage ratio. These are elaborated as follows derivatives has been introduced to protect banks against
the risk of decline in the credit quality of the counterparty.
Increased quantity and quality of capital
Basel III contains various measures aimed at improving the Increased short term liquidity coverage
quantity and quality of capital, with the ultimate aim of The Basel Committee has further strengthened the liquidity
improving the loss-absorption capacity in both going framework by developing two minimum standards for
concerns and liquidation scenarios. Retaining the minimum quantifying funding liquidity; Liquidity Coverage Ratio
capital adequacy ratio of 8%, the Tier I capital ratio (LCR) and Net Stable Funding Ratio (NSRF). The LCR stan-
increased to 6% with the equity component stipulated at dard aims at a bank having an adequate stock of unen-
4.5%3 (Table 1). The new concepts introduced by Basel III cumbered high quality liquid assets (HQLA) which consist of
are of capital conversion buffer and countercyclical capital cash or assets that can be converted into cash at little or no
buffer (CCB). The capital conversion buffer ensures that loss of value in private markets to meet its liquidity
banks are able to absorb losses without breaching the requirements in a 30 calendar day liquidity stress scenario.
minimum capital requirement, and are able to carry on The two components of LCR are stock of HQLA and the total
business even in a downturn without deleveraging. This is net cash flows over the next 30 calendar days. The NSRF is
not part of the regulatory minimum. So while the 8% designed to encourage and incentivise banks to use stable
minimum capital requirement remains unchanged under sources to fund their activities. It helps to reduce depen-
Basel III, there is an added 2.5% as capital cushion buffer. dence on short term wholesale funding during times of
The implications of having a buffer are low dividend payout buoyant market liquidity and encourages better assessment
and low bonus to employees. So if the banks go for this of liquidity risk across all on- and off-balance sheet items.
buffer, the fundamental question before them is how they Net Stable Funding Ratio requires a minimum amount of
are going to reward their shareholders and incentivise their stable sources of funding at a bank relative to the liquidity
employees as the profits are likely to decrease. Banks are profiles of the assets, as well as the potential for contingent
already constrained in payment of dividends because there liquidity needs arising from off-balance sheet commit-
is a statutory minimum ratio where the profits have to be ments, over a one-year horizon.
transferred. In such a case, how will banks attract more The implications here would pertain to the type of
capital? There is a trade-off for banks between being current short term markets available for banks to provide
prudent and increasing profit. liquidity, the type of long term markets needed, the cost of
The countercyclical capital buffer is a pre-emptive deposit, and the impact on the profitability of banks. One
measure that requires banks to build up capital gradually issue with reference to liquidity is how the regulator would
as imbalances in the credit market develop. It may be in the consider the statutory liquidity ratio (SLR) securities. Banks
range of 0e2.5% of risk weighted assets which could be are already investing around 25% of their deposits in the SLR
imposed on banks during periods of excess credit growth. securities which is a substantial amount. A question has also
There is also a provision for a higher capital surcharge on been raised about the relevance of cash reserve ratio
systemically important banks. (CRR). All these have implementation implications for
Basel III strengthens the counterparty credit risk deposit pricing, cost of funds, and profitability.
framework in market risk instruments. This includes the use
of stressed input parameters to determine the capital Reduced leverage through introduction of backstop
requirement for counterparty credit default risk. A new leverage ratio
The newly introduced leverage ratio acts as a non risk
3
Basel II did not prescribe any minimum equity capital component sensitive backstop measure to reduce the risk of a buildup
but it was generally accepted as 2%. of excessive leverage in the institution and in the financial
118 M. Jayadev

system as a whole. The leverage ratio requirement would equity capital will be of the order of Rs 3.25 trillion while
hence set an all-encompassing floor to minimum capital equity capital will be of the order of Rs 1.75 trillion7 (see
requirements which would limit the potential erosive Table 3 for details). The two important assumptions on
effects of gaming and model risk on capital against true which the estimates are made are: risk weighted assets of
risks. A 3% minimum Tier I leverage is recommended by individual banks will increase by 20% per annum and banks
Basel III. In India, banks are required to meet this norm can fund 1% capital requirements through retained profits
from January 1, 2018. (RBI 2012). The important questions to be addressed here
are: Can individual banks access the capital market to raise
Strengthening of provisioning norms this capital? How do current ownership structure and
Another issue raised by the Basel III reforms is of provisioning valuations impact the bank’s capital raising proposals?
norms; currently there is a standardised approach to provi- Should the government retain majority ownership? How
sioning in the banking system. It is a typical accounting should the government capitalise the public sector banks?
approach, wherein if a loss is incurred, banks have to make What are the options before the government?
a provision to cover it. But Basel III is talking about a move
from “incurred loss approach” to “expected loss approach”. Growth barrier
For an expected loss approach what should be the measure? Growth and financial stability seem to be two conflicting
Spain (Saurina, 2009) introduced Dynamic Provisioning which goals for an economy. The Indian economy is transforming
involves computing some portion of the fixed element, and structurally and moving towards rapid growth although
some portion of the dynamic moving element. The Turner some seasonal down trends are seen. The main goal of the
Report (FSA, 2009) also emphasised the need for Dynamic 12th Plan is “faster, sustainable and more inclusive
Provisioning. The information required is credit cost data, growth”. The Planning Commission is aiming at a total
credit migration, and probability of default. The question is, outlay of Rs. 51.46 lakh crore in the infrastructure sector
what method should be used? The RBI has already released during the 12th Plan (2012e17). Infrastructure sector
an approach paper4 on this and is working on the introduction investment as percentage of the Gross Domestic Product
of a suitable framework. (GDP) is expected to rise steadily to 10.40% in the terminal
year (2016e17) of the 12th Plan. The average investment in
Enhanced disclosures infrastructure sector for the 12th Plan as a whole is likely to
The second pillar of Basel II is market discipline, which be about 9.14% of the GDP. The outstanding credit gap for
involves more of disclosures. Disclosures made by banks are the micro and small and medium enterprises (MSME) sector
essential for market participants to make more informed is estimated at 62%, which is estimated to reduce to 43% in
decisions. Basel III further strengthens the disclosures, March 2017 with the assumption of minimum 20% year on
where banks are required to disclose on composition of the year (Y-o-Y) credit growth to MSME sector and 10% Y-o-Y
regulatory capital and any adjustments to the regulatory credit growth to medium enterprises by scheduled
capital. commercial banks (SCBs).8 The economists’ projections are
that the Indian economy will see higher growth in the
Basel III issues for Indian banks manufacturing sector which enhances demand for credit.
The financial inclusion project aims to bring several millions
Additional capital of the population under the ambit of the organised financial
As banks go on increasing the risk weighted asset portfolio system which will also enhance their credit requirements.
to meet the growing economy’s credit requirements, they The preliminary research shows that the largest banks in
would need additional capital funds under Basel III. the world would raise their lending rates on an average by
Different estimates of additional capital infusion have been 16 basis points (bps) in order to increase their equity to
announced by various agencies. The international credit asset ratio by 1.3 percentage points needed to achieve the
ratings agency, Fitch, estimates this figure to be at around new Basel regulation of 7% equity to new risk weighted
USD 50 billion, while ICRA projects a figure of around USD 80 asset ratio. Increase in lending rate is estimated to cause
billion. Macquarie Capital Securities predicts that there will loan growth to decline by 1.3% in the long run (Cosimano &
be a USD 35 billion dilution in the existing capital of public Haura 2011). When the leverage requirement interacts with
sector undertaking (PSU) banks subsequent to adoption of the risk based internal ratings-based (IRB) capital require-
the stringent Basel III capital accord.5 However, the RBI ments it might lead to less lending to low risk customers
Governor had recently stated that PSU banks presently have and to increased lending to high risk customers. Such allo-
a capital adequacy ratio of 13.4%, wherein Tier 1 capital cation effects may be counterproductive to the financial
stood at 9.3%6 (Table 2). This is a statement on the existing stability effects of the leverage ratio requirement (Kiema &
scenario, and does not take into account the imminent Jokivoulle, 2010).
capital dilution. Moreover, additional capital will be In a structurally transforming economy like India with
required to address the enhanced counter party default, rapid upward mobility, credit demand will expand faster
especially in OTC derivatives. The RBI estimates project an than GDP for several reasons. First, India will shift
additional capital requirement of Rs 5 trillion of which non- increasingly from services to manufacture whose credit
intensity is higher per unit of GDP. Second, increased
4
Discussion Paper on Introduction of Dynamic Loan Loss Provi-
7
sioning Framework for Banks in India, 2012. Subba Rao, November 2012
5 8
http://www.dsij.in/research/blog/month/5/year/2012.aspx Planning Commission, An Approach to the Twelfth Five Year Plan
6
Subba Rao, September 4, 2012 (2012-17), Faster, Sustainable and More Inclusive Growth.
Basel III implementation 119

Table 2 Capital to risk weighted assets ratio (in %) under Basel I and II e bank group-wise (as at end of March).
Bank group Basel I Basel II
2010 2011 2012 2010 2011 2012
Public sector banks 12.1 11.78 11.88 13.3 13.08 13.23
Nationalised banks 12.1 12.15 11.84 13.2 13.47 13.03
State Bank of India group 12.1 11.01 11.97 13.5 12.25 13.7
Private sector banks 16.7 15.15 14.47 17.4 16.46 16.21
Old private sector banks 13.8 13.29 12.47 14.9 14.55 14.12
New private sector banks 17.3 15.55 14.9 18.0 16.87 16.66
Foreign banks 18.1 17.71 17.31 17.3 16.97 16.74
Scheduled commercial banks 13.6 13.02 12.94 14.5 14.19 14.24
Note: includes IDBI Bank Ltd.
Source: Based on off-site returns submitted by banks.

Table 3 Additional common equity requirements of Indian banks (Rs in billion).

Public sector Private sector Total
banks banks
A Additional equity capital requirements under Basel III 1400e1500 200e250 1600e1750
B Additional equity capital requirements under Basel II 650e700 20e25 670e725
C Net equity capital requirements under Basel III (AeB) 750e800 180e225 930e1025
D Additional equity capital requirements under Basel III
for public sector banks (A)
Government share (if present shareholding pattern is maintained) 880e910 e e
Government share (if shareholding is brought down to 51%) 660e690 e e
Market share (if the Government’s shareholding 520e590 e e
pattern is maintained at present level)
Source: Address by Dr. Duvvuri Subbarao (September 4, 2012).

investment in infrastructure as projected by the Planning On an average, Indian banks’ ROE is around 15% for the last
Commission will place enormous demands on credit. three years. The enhanced capital requirements under
Finally, financial inclusion, which both the Government and Basel III regime are likely to affect the ROE of the banks and
the RBI are driving, will bring millions of low income the shareholders’ expectations on the minimum required
households into the formal financial system with almost all rate of return.
of them needing credit. What all this means is that banks The questions that arise here are as follows: Do share-
need to maintain higher capital requirements as per Basel holders prefer less stable and more risky banks with higher
III at a time when credit demand is going to expand rapidly. ROE or more stable and less risky banks? What is the cost of
The concern is that this will raise the cost of credit and meeting higher capital requirements for banks? Do banks
hence militate against growth.9 The question here is: With pass on these costs to depositors and borrowers? In
the increased demand for credit, will the Basel III capital order to meet the mandate of higher quantum of liquid
framework increase cost of credit? What are the options funds, under liquidity standards of Basel III, do banks
before Indian banks? have to go for the passive option of lending to the
Government by increasing investment portfolio, by
Profitability of banks crowding out credit to the private sector? To meet the
Return on equity (ROE) is defined as the product of return challenges of declined profitability can the banks alter
on assets (ROA) and the leverage multiplier. As the upper their incentive structure?
limit for the leverage ratio by Basel III has been set at 3%,
the value of the leverage multiplier will come down, Implementing the countercyclical capital buffer
resulting in a reduction in the ROE. Table 4 shows that the A critical component of the Basel III package is imple-
higher ROE for the SBI group and nationalised banks was mentation of countercyclical capital buffer which
associated with a higher leverage ratio, while for new mandates that banks build up a higher level of capital in
private sector banks, the higher ROE was attributable to good times (that could be run down in times of economic
higher profitability of assets and lower leverage (RBI 2012). contraction), consistent with safety and soundness consid-
erations. Here the foremost challenge to the RBI is identi-
9
Speech delivered by Dr. Duvvuri Subbarao, Governor, Reserve fying the inflexion point in an economic cycle which should
Bank of India, at the First CAFRAL-BIS international conference on trigger the release of the buffers. The identification of the
Financial Sector Regulation for Growth, Equity and Stability in the inflexion point needs to be based on objective and
Post Crisis World, Mumbai, November 15, 2011. observable criteria; it also requires long series data on
120 M. Jayadev

Table 4 Profitability and leverage of Indian banks : 2011e12.

Bank group Return on Profitability Leverage Capital to
equity of assets assets ratio
SBI group 16.00 0.91 17.58 0.07
Nationalised banks 15.05 0.87 17.37 0.40
Old private sector banks 15.18 1.15 13.23 0.35
New private sector banks 15.27 1.57 9.72 0.27
Foreign banks 10.79 1.75 6.15 6.95
Source: report on Trend Progress of Banking, 2011e12, RBI.

economic cycles. In an emerging market like India, what Important Banks (D-SIBs) and Global Systemically Important
macroeconomic data is needed? What are the options Banks (G-SIBs) and mandating them to maintain a higher level
before the Ministry of Finance and the RBI? of capital depending on their level of systemic importance.
Are there any Indian banks that can be classified as D-SIB’s?
Risk management What should be the criteria for such classification?
In recent years many banks have strengthened their risk
management systems which are adequate to meet the Need for a discussion
standardised approaches of Basel II. A few banks are making
efforts in the direction of moving towards implementation of
In the above context the current round table discussion
advanced approaches. The larger banks need to migrate to
assumes significance and raises the following issues.
the advanced approaches, especially as they expand their
overseas presence. The adoption of advanced approaches to
 Can individual banks access the capital market to raise
risk management will enable banks to manage their capital
capital?
more efficiently and improve their profitability. This gradu-
 How do current ownership structure and valuations
ation to advanced approaches requires three things. First
impact the bank’s capital raising proposals? Should the
and most important, a change in perception from looking
Government retain majority ownership?
upon the capital framework as a compliance function to
 With the increased demand for credit, will the Basel III
seeing it as a necessary prerequisite for keeping the bank
capital framework increase cost of credit? What are the
sound, stable, and therefore profitable. Second, the gradu-
options before banks?
ation to advanced approaches requires deeper and broader
 What is the cost of meeting higher capital requirements
based capacity in risk management; and finally, it requires
for banks?
adequate and good quality data.10 Other banks also need to
 Do banks pass on these costs to depositors and
strengthen their risk management and control system so as
borrowers?
to allocate risk capital efficiently and improve profitability
 In order to meet the mandate of higher quantum of
and shareholder’s return. The important issues here are: On
liquid funds and liquidity standards of Basel III, do
what aspects of risk management should the banks focus?
banks have to go for the passive option of lending to
How do they improve the risk architecture? How can banks
government by increasing investment portfolio, by
strengthen risk management capacities so as to generate
crowding out credit to the private sector?
adequate and qualitative data?
 On what aspects of risk management should the banks
focus?
Systemic risk
 How to strengthen risk management capacities so as to
The financial crisis highlighted the importance of intercon-
generate adequate and qualitative data?
nectedness of financial institutions and the significance of
 What macroeconomic data is needed? What are the
systemic risk. With the dichotomous presence of specialised
options before the Ministry of Finance and the RBI?
financial institutions like HDFC and several other commercial
 Are there any Indian banks that can be classified
banks, understanding the concept of systemic risk is critical in
as D-SIB’s? What should be the criteria for such
the Indian context. At the macro level, how does one measure
classification?
systemic risk in the Indian context? In some countries, buildup
of credit to deposit ratio is considered for measuring
I take pleasure in inviting the panel members representing
systematic risk, but is it relevant in the Indian context? The
various stakeholders of the Indian banking system to present
consolidation phase in Indian banking is in progress. The State
their views, following which the floor is open for discussion.
Bank of India (SBI) is acquiring its associate banks and a few
Basel III implementation: Issues and challenges for
private banks have been merged with other public and private
Indian banks: Discussion
sector banks. The presence of large size banks encourages
risky behaviour in banks. Basel III seeks to mitigate this Anchor
externality by identifying both Domestic Systemically M. Jayadev
Panellists
10
(Inaugural Address by Dr. Duvvuri Subbarao, Governor, Reserve
Bank of India at the Annual FICCI - IBA Banking Conference at Gagan Deep Singh, Assistant Vice President e Treasury
Mumbai on September 04, 2012) Analytics, Genpact, India; [email protected].
Basel III implementation 121

Gobind Jain, Senior Vice President, Kotak Mahindra As far as common equity is concerned, it is not unlike
Bank; [email protected] the other players in the world. In India, the market for
M. K. Jain, General Manager, Syndicate Bank; mkjain@ hybrid instruments has not been active. The question ari-
syndicatebank.co.in. ses as to whether there will be a market for hybrid
Rajendra Prasad G., Vice President, Citi Group, Tampa/ instruments in India with non-viability clause. As a result,
St. Petersburg, Florida; [email protected]. most Indian banks already have no option left but the
Subhasish Roy, DGM, IDBI Bank, Risk Management option of raising equity. At present, Indian banks are
Department; [email protected]. operating at more than 10% of the Tier I capital adequacy
ratio and 50% of the banks are operating at more than 8%
of Tier I capital. But going forward, banks will need to
M. Jayadev raise equity capital to meet Basel III requirement and to
support credit demand.
Welcome to the four panelists present here and to the fifth The first question posed to me was how banks will be
member who is joining us from the US. Mr. Subhasish Roy is able to raise the capital and whether the market is
Deputy General Manager, Risk Department, IDBI Bank, conducive to raising that amount of capital. I can share my
a public sector bank. Mr. Gobind Jain is a Senior Vice views for public sector banks which hold around 70e75% of
President in Kotak Mahindra Bank. He is working with the market share. In the past five years, Indian banks have
systems, balance sheet and associated areas. Mr. Mahesh raised close to Rs 52,000 crores (Rs 520,000 million) as
Kumar Jain is General Manager, Syndicate Bank and is capital. Broad estimates suggest that banks may need
currently in treasury operations at Mumbai. All three have capital close to rupees 500 thousand crores (Rs 5000 billion)
been working in the area of risk management for a long in next five years. Of that, around 1.5 hundred thousand
time. Mr. Gagan Deep Singh is Assistant Vice President e crores (Rs 1500 billion) is expected as core equity capital,
Treasury Analytics at Genpact India. He is working with the major share of which comes for public sector banks.
market risk models, and he is a risk management modelling Out of that, the requirement under Basel III alone comes to
expert. The fifth panellist Mr. Rajendra Prasad is joining around 80 thousand crores (Rs 800 billion). Nevertheless the
from us the US. He is Vice President, Citibank at Tampa, raising of that capital in the next five years is not a very
Florida. He has worked with several banks in consultancy difficult task but will be challenging.
positions especially in the area of market risk and However, how is that capital to be raised? It is connected
credit risk. to the next question, that of market capitalisation. In the
Let me invite Mr M. K. Jain from Syndicate Bank to speak banking scenario in India, individual banks have enough
first. potential to access capital markets. The pricing may be
different based on the fundamental strength of the bank
M. K. Jain and market prices of stocks. In India, market cap as
percentage of assets of the public sector banks is around
Basel III is a regulatory prescription necessitated by certain 5.5, whereas for private banks, it is around 25.5 and among
flaws or lacunae observed in Basel II. Basel III has certain the public sector banks it ranges from 2.6 (Central Bank) to
implications for banks in India and across the globe. 8.7 (State Bank of India). At the current market capital-
I will first touch upon capital requirement. There has isation, even if the banks dilute majority of government
been much discussion across the globe about Basel III, and holdings, it will not be sufficient to maintain CRAR (capital
how the capital requirements of the G 20 countries and to risk weighted assets ratio) at desirable level.
India are different. There are a few differentiators Even if the State Bank of India (SBI), with highest market
between Basel II and Basel III. In Basel II there is no capitalisation among PSBs, were to dilute its equity capital
minimum requirement of common equity capital (CET) but by 20%, the amount raised by it would be equivalent to less
it is presumed as 50% of Tier I capital requirement and than 2% of the assets. So the question of infusion of equity by
hence estimated as 2% of total minimum capital require- government versus raising from the market will arise. In that
ment. Whereas in India, it is estimated as 3.6% because of situation, what are the options available? Should banks raise
total Tier I capital requirement of 6% and restriction of capital from the market at low prices, which still may not be
hybrid instruments to the extent of 40%. The increase of sufficient to meet capital needs, or should banks approach
CET from 2 to 5% for banks in advanced countries will have promoters? The option available with the government is to
large implications in raising common equity capital to the fund the banks for capital requirement continuously. Though
magnitude of billions or trillions of dollars. it is difficult for the Government of India (GOI) to infuse
But in India there exist certain benefits which are not capital continuously in view of fiscal concerns, yet it makes
available in other jurisdictions. Deductions from capital business sense for the government to infuse capital to the
have been harmonised and generally applied at the level of public sector banks for two reasons. Presently all PSB stocks
common equity. These deductions will not have much are under-valued, and large value can be unlocked by GOI in
impact on Indian banks. At present, deferred tax asset future when market capitalisation improves, given the
(DTA), goodwill etc. are already deducted from Tier I predictions of India’s bright future. No economy can grow
capital. We do not have much of trading and over-the- unless the banks become credit worthy. Our credit to GDP
counter (OTC) derivatives. Similarly, valuation of liabilities ratio presently is 55% and credit demand will expand faster
does not exist in India. The impact of reciprocal cross than GDP for several reasons. First, the changing thrust of the
holdings will also be insignificant considering the prudential economy is from service to manufacturing, and the credit
limits fixed by RBI. intensity of manufacturing is higher than that of service. The
122 M. Jayadev

second driver will be infrastructure, and the third, financial business strategies. It could impact both verticals of
inclusion which has not been assessed so far but as more and business, retail as well as corporate. Banks may be
more banks reach the rural area, the credit demand will pick forced to reduce their exposure to large corporates to
up. These three factors will lead to credit growth. Hence, GOI optimise capital as it won’t be easy to get unlimited
needs to infuse capital to meet increasing credit demand and capital from the government.
to achieve desirable level of GDP growth. Another point for consideration is mandatory require-
A valid question has been raised on growth versus cost or ment of investment in SLR (statutory liquidity ratio)
growth versus stability. If stability is important, then a little securities. The Basel Committee has not accepted the
sacrifice on growth in the short term is to be accepted. argument of considering SLR securities as part of the
Indian banks are well placed for Basel III capital require- liquid funds. Bankers’ view is that as RBI is lender of the
ment and GOI has to support PSBs. It is expected that the last resort, investment in cash reserve ratio (CRR) and
cost of capital may go up (on account of hybrid instruments SLR can be used to get liquidity support from the regu-
and loss absorbency features in the hybrid instrument) and lator in case of need and hence the same may be
plough back of internal accruals will be higher resulting in considered as part of liquid assets to maintain Liquidity
low dividend and payout ratio. Coverage Ratio (LCR) and Net Stability Funding Ratio
Whether the cost of capital will have an impact on the (NSFR) as required by Basel III. The RBI too is of the
credit growth is another pertinent question. To some opinion that a certain portion of SLR investment may be
extent it will. The Basel Committee and other independent allowed as part of the liquid asset. If this is not allowed
assessments have concluded that Basel III will impact the then there will be additional cost to the banks to
GDP ratio. As per assessment of the Macroeconomic maintain liquid assets over and above statutory
Assessment Group (MAG) GDP may decline by 0.22% over requirements of SLR and the CRR.
a period of time till full implementation of Basel III M Jayadev: Thank you Mr Jain. Mr. Subhasish Roy, may I
whereas a study by the IMF assessed a negative impact of now request you to share your views on implementation
3.2% on the GDP during same period. Without going into of Basel III and the challenges for Indian banks,
the merits of the different claims, the impact of Basel III
on GDP is undeniable, and whether the impact on the
banking system will be short term or long term, remains to Subhasish Roy
be seen. We personally feel that the impact will be short
term. The maximum capital impact may happen from 2015 Basel II was a sought after and important risk management
onwards keeping in view the present level of capital of framework before the financial crisis of 2008e2009. After
Indian banks and higher capital requirements will start the crisis, Basel II which was considered a more risk
from that period as per RBI guidelines. As rightly observed sensitive approach as compared to its earlier version Basel
by Professor Jayadev, credit demand will be high during I, was found wanting. Thus Basel III was designed to
that period. So, higher capital needs to meet both regu- overcome the systemic loopholes in the Basel II frame-
latory requirement and higher credit growth. This will work. In particular, Basel III was designed to address the
result in increase in cost of capital and have a resultant weaknesses of the past crisis and to make the banking
adverse impact on profitability. sector stronger and more efficient. The major thrust area
of Basel III is improvement of quantity and quality of
Q: Do Indian banks (public sector) need to worry about capital base of the banks with stronger supervision, risk
capital since government provides a backstop for capital management and disclosure standards. The highlights of
anyway, like Fannie Mae in the US? Basel is a setup more Basel III are as follows:
for private sector banks where capital needs to be
provided to match risks? Does it affect public sector  More thrust on equity capital
banks the same way?  Introduction of capital conservation and countercy-
M K Jain: The capital that the government is going to clical buffer
infuse will not be without any riders/conditionalities.  Regulatory adjustments/deductions from common equity
The government cannot fund unlimited capital to the  Introduction of loss absorption features instruments
public sector banks and insist that banks demanding  Introduction of point of non-viability – loss absorption
capital infusion meet certain higher level of perfor- trigger point (<6.125% of risk weighted assets (RWA)
mances through MOUs, so that over a period of time  Introduction of leverage ratio
banks capital requirement may be self-sustaining.  Introduction of liquidity coverage ratio
What is the way out for banks? They have to increase  Supervisory review and evaluation process (SREP) under
their efficiency, and reduce the intermediation cost to Pillar II covers area of unrated exposure, emphasis on
offer competitive pricing, otherwise higher cost of credit assessment and broader coverage of counter-
credit will impact growth. Basel III is not explicit on party credit risk management policy.
capital; capital is an implication. The new regime seeks
greater integration of the finance and risk management The minimum capital requirement is 8% but when the
functions. This will probably drive the convergence of bank capital touches 6.125% then additional Tier one
the corporate objective and risk management in deliv- capital will be converted to equity. This is called loss
ering the strategic objectives of the business. absorption trigger point and will safeguard the bank.
Probably, going forward, Basel III may also affect busi- Basel III has emerged as a follow up to the failure of
ness models and banks may be forced to change their some international banks. In India even at a difficult time
Basel III implementation 123

banks did not experience that type of failure or difficulties a 1% increase in core equity ratio is expected to be met by
and the regulatory norms imposed by the RBI were much fall of ROE by 80e100 basis points which shows the extent
more stringent as compared to international standards. to which profitability will be affected.
Banks would have very limited scope to increase prof-
Issues regarding capital to PSBs itability or minimise cost. Banks with a very low profit-
ability margin will be affected most because they will
Coming to issues regarding the quantum of capital for require more capital as conversion from profit to capital
public sector banks (PSBs), the RBI estimates for additional will be less. Under Basel III the capitalisation ratio is
equity capital requirements under Basel III is around Rs arrived at by dividing equity capital by the risk weighted
1500 billion. If the present government shareholding assets. How can banks minimise the risk weighted assets?
pattern is maintained, then the government’s share comes Banks can change the business mix focussing more on
to around Rs 910 billion. However, if the government retail/short term loans rather than corporate. Banks need
reduces its shareholdings to 51%, then its share will come to to change their customer mix and ensure proper pricing to
around Rs 700 billion. If you take into account the recapi- maximise risk adjusted return. Banks must seek low cost
talisation of banks then the amount the market will have to funding with a thrust on low cost stable deposit base. This
provide will depend on the extent to which the government could mean opting for the business correspondent or
can meet the recapitalisation burden of PSBs. business facilitator model prescribed by the RBI, which
Based on past track record, raising around Rs 700-billion would pre-empt the need to operate full-fledged branches
over the next five years may not be very difficult, consid- while still reaching the goal of financial inclusion. Banks
ering government is the major shareholder. The actual must improve systems and procedures, refining their
capability is based on individual bank specific factors such rating model so as to obtain the proper risk weight, going
as e branding, reputation, financial performance, opera- in for data cleaning and modernising systems and proce-
tional efficiency and so on. dures to meet operational needs. Operational efficiency
Profitable banks will have less capital requirements as will ensure economising on capital through the lowering of
compared to less profitable banks. The question is whether risk weighted assets.
the government should pump such a huge amount of money
to public sector banks at this stage. There are three options Crowding out credit to private sector
here. The first option is for the government to reduce its
shareholding to 51% so that its share will come down to Let us examine the issues that are connected with crowd-
around Rs 700 billion. The second option is a merger ing out of credit to the private sector. Higher deployment
between the banks with very high government shareholding of funds to liquid assets may or may not lower yield on
and the banks whose shareholding is marginally higher than assets. It depends upon the individual bank’s ability to
51%. The third option would be for the government to deploy funds to higher risk-adjusted assets. Lending to the
reduce its shareholdings in PSBs below 51% but in all private sector may depend upon the individual bank’s risk
probability the government will not give up its voting rights, appetite. Banks need to carry out cost benefit analysis in
so the second option seems most feasible. order to decide on the cost of the bank’s failure in not
There is some talk about a holding level company in deploying liquid assets vis-a-vis cost of crowding out of
which the government will have 100% equity. The company credit to private sector. Banks which are capable of
will raise the debt to be invested by institutions and will attracting larger deposits can lend more to the private
give equity based on the needs of the various banks. Here sector. The cash reserve ratio and statutory liquidity ratio
the government is only providing security backing, it does (CRR & SLR) investments need to be considered for liquidity
not have the burden of raising equity and pumping it into standards in India.
the individual banks. The idea is under consideration by
RBI. However, some issues like who will monitor these
companies, what will be the capital adequacy ratio, will Measurement of systemic risk
need to be addressed.
While bank specific risk is relatively easy to identify,
Impact of Basel III and the action required from systemic risk is much more difficult. In this regard, there is
a need for devising objective criteria to identify trigger
banks
points of boom and slack in an economy. For this purpose
the following parameters need to be considered for market
How will Basel III impact the economy in general and banks study. These include
in particular?
It may result in higher government borrowing, fiscal
 trend in credit/GDP ratio
deficit, inflation, and pressure on GDP. Lower GDP may also
 market volatility
affect investments, credit off-take and banks’ profitability.
 sectoral concentration (industry/borrower)
Particularly for banks it could mean higher cost of capital,
 NPA/GDP ratio
lower return on equity (ROE), lower yield on assets, and
 asset price movement
pressure on credit off-take and profitability. A recent study
 inflation
conducted by CARE on the banking industry11 revealed that
 banks’ exposure to sensitive sector
 systemic liquidity index
11
CARE Research, May 9, 2012.  fiscal deficit
124 M. Jayadev

It may be mentioned that to identify systemic risk there

Table 5 Improving quantity of capital.
is a need for developing a large historical macroeconomic
database for above parameters. Sr. No Regulatory capital RBI (%
of RWAs)
Classification of banks 1 Minimum common equity 5.50
tier 1 ratio
Classification of domestic systemically important banks is 2 Capital conservation buffer 2.50
important since the failure of a bank can trigger a domino (common equity)
effect. The RBI has decided to study two banks, SBI and 3 Minimum common equity 8.00
ICICI to come up with guidelines for this. The core param- tier 1 ratio þ
eters for classification could be: cross border presence or Capital conservation buffer
exposure to the international market; interconnectedness (CCB) [(1)þ(2)]
within the economy, either with other banks or financial 4 Additional tier 1 capital 1.50
institutions; size; and complexity. 5 Minimum tier 1 capital 7.00
ratio [(1) þ(4)]
Ability of PSU banks to raise capital from market 6 Tier 2 capital 2.00
7 Minimum total capital 9.00
Coming to the point of the ability of the banks to raise (MTC) [(5)þ(6)]
capital, going by their track record in the last few years, 8 MTC þ CCB [(7)þ(2)] 11.50
raising Rs 700 billion from the market does not seem very 9 Pillar II ICAAP buffer 2.00
difficult. Further, there is a misconception that PSBs, maintenance (example)
because of their low PE-ratio compared to private sector 10 MTC þ CCB þ ICAAP Buffer 13.50
banks, will not be able to raise funds. I feel PSBs can also 11 Countercyclical buffer 2.50
raise funds from the market and this will largely depend on (between 0 and 2.5*)
the individual bank’s profitability, marketing/branding 12 Total capital requirements 16.00
strategy, their quality of management, operational effi- Counter cyclical buffer (*) - Not clear in current RBI guidelines.
ciency and quality of assets. However their fund raising
capacity is constrained because government shareholding
If you look at the mandated capital requirement,
cannot fall below 51%.
Having listened to the two executives from public sector (Table 5): Improving capital requirement) along with the
countercyclical buffer, banks will be required to raise
banks, let me invite Mr. Gobind Jain from a leading private
a large amount of money from the market; most of the
sector bank to speak on Basel III, capital efficiency and
capital will be in the form of common equity which is
challenges for Indian banks.
a scarce resource and investors would be reluctant to put
money in the banks. It will be really tough for the weaker
Gobind Jain banks to raise additional common equity from the inves-
tors. Therefore, every bank has to go through a rigorous
I will begin by touching upon the need for Basel III. The procedure of maintaining an investor database in order to
global financial crisis occurred mostly in the areas of raise that kind of money.
trading book/off balance sheet derivatives/market risk I have been asked to address certain specific questions
and on account of inadequate liquidity risk management. and the first question I am addressing is: Do individual
Banks suffered heavy losses in their trading books and did banks have the potential to access the capital market in
not have adequate capital to cover the losses. Banks order to raise capital? We must bear in mind that higher
relied very heavily on short term wholesale funding to capital is not a silver bullet solution to the challenge of
build long term assets, there was an unsustainable ensuring financial stability and access to capital does not
maturity mismatch and banks had insufficient liquidity necessarily ensure that banks will be financially stable.
assets to raise finance during the stress period. The There are other aspects which need to be looked at such as
market for liquidity dried up both on asset and liability the risk management framework, the quality of assets, the
side during the crisis. quality of funding, diversity of funding and so on. Merely
The RBI’s proposed framework is applicable at two levels prescribing higher capital also could push banks to take on
e the standalone bank and the consolidated level more risk to generate more return on the excess capital. As
(excluding insurance and non-financial activities). The RBI’s per a study by CRISIL ratings,12 banks will need to raise
recommendations for banks stressed improving the quality equity capital of Rs 1.4 trillion by March 2017 to meet their
and quantity of capital, enhancing risk coverage, creating growth requirements, while complying with the guidelines.
capital conservation buffers, supplementing capital As per ICRA,13 out of the Rs 6 trillion capital required over
requirement with leverage ratio, tightening rules affecting the next nine years, 70e75% would be required for public
risk weighted assets, and aggressively implementing the sector banks and rest for private sector banks.
schedule vis a vis the Basel III requirements.
However the present proposals do not cover liquidity 12
http://www.moneycontrol.com/news/business/transition-to-
standards (separate draft guidelines were released on 21 basel-iii-will-not-bechallenge-crisil_699592.html.
Feb 2012), countercyclical buffers, and standards for 13
http://www.sify.com/finance/banks-will-need-rs-6-lakh-cr-
systemically important financial institutions (SIFIs). capital-till-2019-icra-news-banking-kjybEmgiijd.html.
Basel III implementation 125

Indian banks have maintained capital in excess of regu- investor community because the investors look at dividends
latory minimum e that is the discipline RBI has been forcing and expect some returns from the banks every year. So it’s
on Indian banks. For PSBs, government support is needed to like a trade-off between retaining capital, retaining earn-
augment core Tier 1 capital, as the government may want ings and distributing dividends. Banks also have to look at
to maintain 51% stake. Private banks have already raised Rs their lines of businesses and make some hard decisions on
500 billion in the last five years. It is not so difficult for exiting risky businesses, and businesses that are more
private banks to go to the market and raise the money but capital demanding and also outsourcing or off-shoring non-
the state of the capital market will be the primary deciding core functions. Banks may consider changing group struc-
factor as also the price discovery in the market. If all or ture by buying minority. No matter what actions banks take
most of the banks approach the capital market simulta- to reach compliance with Basel III and to restore profit-
neously or when the markets are going through a lean ability, all actions should be harmonised to create an effi-
period it will be difficult for the private banks to raise cient approach and achieve the best possible results.
money. Much depends upon the investor base each bank is The Reserve Bank of India has debated on the holding
able to nourish and the confidence it can instill in the structure for the banks in India. The final guidelines are still
investor community. not out but if the banks meet the holding structure guide-
The next question is: With the increased demand for lines, then the demand on the capital will be less. There-
credit, will the Basel III capital framework increase cost of fore, the current deduction from Tier one and Tier two will
credit? What are the options before the banks? Once the go away and under the new regime, all deduction will be
capital requirements are in place, then the banks’ response from the common equity and to that extent there will be
can be classified along operational response, tactical a saving of capital.
response and strategic response. The next question is: Would shareholders prefer less
Operational response will be on the lines of processes, stable and more risky banks with higher ROE or more stable
method and data. Examples of operational response would and less risky banks?
be risk weighted asset (RWA) optimisation including model My response is strengthening capital requirements is
refinement, process improvement, enhancement of data expected to reduce the banks’ ROE. There are options for
quality, reducing credit exposure and through stricter banks to increase riskiness of assets or increase the risk
credit approval processes and potentially, through lower exposures by expanding maturity mismatches. Banks may
limits. The banks will improve liquidity risk management indulge in some risk taking practices so that they can
processes including stress testing and development of increase the ROE. Risky and systemically important banks
contingency funding plans, so that minimal liquid assets are may also pose a threat to the stable economy and the
maintained. Banks would also need to integrate their consequent risk may spill over to the real economy.
subsidiaries through a consistent risk management and However, the regulators may not permit high risk taking by
capital management approach, expressed as a consistent banks. The RBI has taken a conservative approach by not
framework across the group to save on the capital. Banks permitting banks to take a higher risk. They achieve this by
could also look into increasing efficiency, strategic cost closely supervising the banks. The RBI has already created
reduction, and reassessing risky processes so that operating a conglomerate cell which closely looks at the bank and its
costs will be reduced and productivity will simultaneously subsidiaries, the nature of their businesses, and the kind of
increase. risks they are taking. While this would improve the banking
The tactical responses will be on the lines of pricing, sector’s ability to absorb shocks and prevent the banks
funding, and asset restructuring. Examples of tactical from taking excessive risk it would definitely reduce the
responses include adjusting lending rates, depending on return on equity. As far as shareholders are concerned,
competition within the specific segments and each they range from risk averse to risk taking, depending on the
segment’s strategic importance for the bank, reflecting lifecycle in which the shareholder is, whether it is
higher capital and liquidity costs through more risk sensi- a younger shareholder or a retired person. The bank has to
tive pricing (and performance measurement on that basis), nurture a mix of shareholders or try to have more foreign
shifting to long term funding, the reduction of the securi- investors who can invest money in India as returns in India
tisation exposure, lower trading book exposures and are definitely higher than the returns overseas. Share-
reduced activities in areas such as derivatives, repos and holders may necessarily have to live with less risky and
securities financing Banks will also look at longer term more stable banks. On a risk adjusted basis the investors
funding (for instance by replacing interbank funding with may be indifferent but the absolute returns on investment
longer term debt and increasing the maturity of deposits) will go down.
rather than going for short term funding options.. What is the cost of meeting higher capital requirements
The strategic responses would be along the lines of the for the banks?
business model, organisational structure, and equity. Such There would be a reduction in banks’ ROE as debt is
responses will be active approach to balance sheet substituted with expensive equity. The timing of
management, undertaking strategic cost reductions, approaching capital markets is important. Therefore, the
including rationalisation of branch structures, product bank has to start planning in advance if they want to raise
rationalisation or implementation of a shared services capital in a timely manner and at a proper price. Unfav-
model. Banks will have to look at the kind of equity they ourable markets may mean issuing shares at a higher
can raise, the contingent capital and the amount of earn- discount to market price and issuing more equity shares,
ings they have to retain to reduce the need for raising thereby causing dilution of shareholding and reducing
further capital. At the same time this will affect the earnings per share. Banks may be impacted by higher costs
126 M. Jayadev

of capital and lower returns making it difficult to attract Rajendra Prasad

and retain investors. Again, as the cost of capital becomes
higher, banks may be unable to provide lending to SME The first question my presentation will address is:
clients/unrated clients. If banks are not able to turn over On what aspects of risk management should banks
their assets due to capital constraints, it will impact the focus?
GDP and economic growth as well. Banks must focus attention on the following areas to
Coming to the question of a few large banks vs. many enhance their risk oversight capabilities.
small players, the RBI will look at mergers of banks so that Risk appetite: Banks need to clearly state their risk
capital is conserved or else there will be many small players appetite, which is the bank’s willingness to take on finan-
or new private sector banks. Whether we will see a consoli- cial risks. Banks must quantify and qualify their risk seeking
dation in the banking sector or an extension of smaller behaviour
players will depend upon the perception of the regulators. Ultimately, how much risk the bank wants to take on and
Do banks pass on these costs to the depositors and at what rate of return must be clearly defined. Conceptu-
borrowers? ally, the following metrics and accompanying indicators can
Changes in capital cost, liquidity cost and long term assist in articulating the bank’s risk appetite: earnings
funding cost will impact the cost of making products and volatility; profitability metrics such as ROE, RAROC, RORAC,
will be factored into the pricing of those products. Banks EVA; target capital ratios; target risk profile; and zero
can mitigate the impact through cost-reduction pro- tolerance of risks Risk appetite should not exceed an enti-
grammes, changing internal change, adopting capital ty’s risk capacity, and in fact appetite should be well below
efficiency measures, de-risking and price adjustments. the capacity.
The primary impact will be on retail and corporate busi- Reviewing portfolio risks in relation to risk appetite:
ness segments. The price adjustments are subject to the Banks have to assess the vulnerabilities of their portfolio at
competitive environment, so banks may be constrained to regular intervals and determine whether the portfolio is in
increase the price of products at their will. Banks may be line with the risk appetite
able to pass on some of the costs to retail customers given
Being appraised of the material risks and related
the relatively high margin on these products, and that
responses: Because risks are constantly evolving, the goal
some of these customers may fall into the “risky” bracket.
of risk management is to provide timely information about
But it would be difficult for some markets and business
risks arising across the organisation
segments such as corporate lending markets are more
Model risk management: Banks need to improve the
price sensitive and banks may not be able to pass on costs.
governance of models being used. Decisions cannot be
Corporates would normally in a position to compare the
based on quantitative models alone. Qualitative/expert
pricing each bank offers. Again, Credit Value Adjustments
judgement is a key parameter to minimise the model risk
(CVAs) will impact trades with lower-rated counterparties
Stress testing: Stress testing receives lot of significance
and trades with counterparties with limited netting
under Basel III
ability. So, cost compensation can be through combination
VaR does not capture catastrophic losses. Hence, Stressed
of improved collateral and netting arrangement.
VaR is the key parameter in Basel III capital adequacy
In order to meet the mandate of higher quantum of
calculation.
liquid funds, under liquidity standards of Basel III, do
banks have to go for a passive option of lending to Strengthening enterprise risk management for stra-
government by increasing investment portfolio, by tegic advantage: Implementation of enterprise risk
crowding out credit to the private sector? management (ERM) provides the opportunity to have inte-
My colleagues who have spoken previously have dis- grated view of the risk and the cross-risk interactions
cussed this question. Indian banks could follow the model A new risk and finance management culture: Basel III is
of the Bank of New York which has primarily put its assets changing the way banks manage risk and finance. Basel III
under the less risky segments and generates returns requires greater integration of the finance and risk
through its fee based business. But banks in India should management functions. This will probably drive the
concentrate on their developmental role and on economic convergence of the responsibilities of Chief Finance Officer
growth, on providing development finance to not only to (CFO) and Chief Risk Officer (CRO). Basel III provides
the private sector but also to the corporate sector, a framework for true enterprise risk management, which
infrastructure, and housing. So Indian banks cannot avoid involves covering all risks to the business
their role as financial intermediaries. Some of the banks My next question pertains to improving the risk
can still hold excess SLR but the amount will be ascer- architecture
tained with reference to the liquidity coverage ratio Managing the data: In order to meet the Basel III
(LCR) e the final guidelines for this have yet to be given by compliance, banks have to ensure that risk and finance teams
RBI. However, if banks become passive investors of funds, have quick access to centralised, clean, and consistent data.
they run the risk of not being able to raise capital in the The data management requirements of Basel III are signifi-
future. cant. If the data is dispersed across different silos it involves
M. Jayadev: Thank you Mr. Jain. Now Mr. Prasad is more overhead costs compared to those with a more cen-
joining us from Florida (USA). Prasad has rich experience in tralised approach to collecting, consolidating, and submit-
understanding emerging markets and will give us his views ting reports under Basel I, II, and III. Data has to be efficiently
on banks and risk management. Welcome Prasad, hope we managed so as to ensure that calculations for capital
have not disturbed your early morning sleep . adequacy, leverage, and liquidity are done accurately
Basel III implementation 127

Transparency/Audit-ability-data lineage: Once a regu- is conditional on a set of institutions being under distress.
latory report has been submitted, it is highly likely that The financial system is modelled as the portfolio of banks
a regulator will follow up with the bank to clarify critical and financial institutions. A financial institution’s contri-
issues about how the results were calculated and how the bution to systemic risk is the difference between the
rules were applied. This will require the bank to identify, financial system portfolio CoVar when the institution
check, approve, and submit the data quickly and accurately. suffers a large loss and the normal VaR of the financial
This audit process will be especially difficult for banks if the system portfolio.
data is dispersed across multiple silos and systems, as it will Systemic risk can be addressed through various ways
take longer to search for the relevant information. Banks such as: systemic capital requirement: Capital requirement
with a centralised data model will be able to respond faster proportional to estimated systemic risk; systemic fees: Fees
and more efficiently to these enquiries proportional to estimated systemic risk; creating systemic
Stress testing: This will be difficult to deliver if organi- fund; and private/public systemic insurance.
sations have their data distributed across multiple silos. It M. Jayadev: Finally, I welcome Mr Gagan Deep Singh to
will take more effort, time and it will deliver less accurate present the technical and consultant‘s perspective
results, compared with having a data model where all the
critical information is held in a central repository. Placing
all the data in a central repository will allow banks to run Gagan Deep Singh
a wide array of complex stress tests that meet the needs of
the business The questions that I will address revolve around aspects of
The ideal solution would be to consolidate the calcula- risk management and how to improve the risk architecture
tion and reporting of Basel III from a single, centralised of capital market institutions. Though advanced risk
reporting platform. It would seamlessly integrate with the management services may not be prevalent in most orga-
source systems. nisations, we are now learning the need for effective risk
How to strengthen risk management capacities so as to management. For example, a case study which was recently
generate adequate and qualitative data? discussed in one of our calls with the senior management,
There are various Enterprise Data Management tools involving credit card default by a couple to whom credit
currently available to improve data quality. Banks need to cards had been issued separately, brought home the
setup sound practices for data governance. That would importance of using the social media and improved risk
involve the following: architecture such as big data and cloud services to investi-
gate into the relationships between the people to whom we
 Assessing the current state of data quality at your have extended loan facilities or credit facilities.
company There are ample examples in the industry of similar
 Understanding and fixing the root causes of data phenomena. Recently, in a presentation at IIMB on credit
contamination default swaps (CDS), the paper made the point that after
 Creating standards and procedures for data quality CDS was introduced, defaults increased. They should have
 Enforcing the policies and procedures that govern the decreased because CDS offers insurance and provides more
data while the data is in their custody liquidity in the market; they provide more information
 Periodically monitoring (auditing) the quality of the about the default in the market. The reason for this
data in their custody anomaly, as analysts of big data put forth based on statis-
 Monitoring and advising the end users on proper usage tical evidence (though they could not offer empirical
of their data evidence), was the underlying relationships in the CDS
 Creating the awareness of criticality of data quality transactions between the companies and those who were
paying the premiums leading to fraudulent deals.
What are the gaps in available macroeconomic data? I will cite one more example of the use of big data.
Several gaps exist in the macroeconomic statistics, During the collateralised debt obligations (CDO) market
such as crash in 2008, there was ample evidence based on big data
to support the fact that rating agencies which were rating
 Breaks within time series economic statistical data the CDO tranches, had vested interests in rating the
produced by many of the ministries and agencies tranches (Under Basel II that was then prevalent, there was
 The extent of compilation and presentation of statis- a provision that an unrated tranch of CDO would get less
tical data are not in a form that are readily usable and weight than the triple C tranch of CDO. Tranches that were
therefore require further analysis unrated defaulted earlier than the triple C tranches). So
 Some of the economic indicators produced by the the role of big data has become important post crisis and
agencies are often in conflict with each other due to given these vested interests and fraudulent deals.
different methodologies Prof Jayadev asked whether regulation should be rule
 Economic statistical data is not sufficiently granular based or principle based. One of the problems as revealed
enough to meet user needs. in all these examples is that we are following rule based
regulation. We see risk in the form of numbers whereas
How to measure systemic risk in the Indian context? there is the relationship aspect also to risk which is very
Systemic risk can be defined as joint distress of several big. I will cite one or two more examples from my own
financial institutions. Value at risk (VaR) is widely used to experience, which has to do with modelling, particularly
measure systemic risk. Value at risk of the financial system the use and misuse of modelling techniques. In one of our
128 M. Jayadev

engagements with an Australian bank, we were validating and suddenly and it may take time to raise capital. So what
their credit risk models. The bank had a very low default does Basel tell you about the timing?
portfolio. However, since they wanted to be Basel M. Jayadev: There is the capital cushion buffer that has
compliant, they adopted the internal ratings-based (IRB) been suggested in Basel III. That means if bank’s risk is
framework as prescribed by Basel II, according to which increasing, the regulator has to determine the inflexion
banks had to measure Probability of Default (PD) on their point and introduce additional capital requirements.
own. They adopted statistical techniques to compute However answers to questions such as when and how that
probability of default. One of the popular statistical tech- point is determined, the metric to be used and so on, are
niques is the logit model, a statistical model which analyses not available in the Basel document.
the ratio between the defaults and no-defaults and uses P. C. Narayan: One of the things that we studied as part
some statistical transformation to arrive at a PD number. of the banking system was the inspection by the Central
However, this statistical model works only when you have Bank. The Central Bank tended to be more rigorous with
ample default data and ample no-default data. If you do banks whose credit book was in worse shape than others,
not have the default data, the model will still throw out and banks would be asked to restate their NPA, to re-
a number but because it is based on very little data, the compute the capital, and it would get embedded auto-
number is bound to be ambiguous. We were surprised that matically into the next cycle of financial reporting by the
the bank was using the logit model despite there being very bank. So you suddenly find that a bad performing bank had
little default. Therefore, the misuse of models is more a capital of 12% as on March 31, 2012, and then it has
prevalent in today’s market than the proper use of models. actually gone down to 10½% ..
Somebody said the same thing about VAR models. Value at V. Panchapagesan: That’s fine when there is a govern-
Risk has a match problem and that means VAR which is ment owning banks, but the moment you go to the markets
measured on a portfolio is greater than the VAR measured and you are raising capital with a lower NPA, then it is
on individual stocks. This statistical property has been bound to raise questions. A certain transparency is required
grossly misused by traders. Further, the models which are if you go to the public markets.
coming up in order to be Basel compliant are far too P. C. Narayan: You have raised a question which is very
complicated and are difficult to explain to the regulators. emotional for the Indian banking system, i.e. government
M. Jayadev: Now the floor is open to the audience, I ownership of banks. We are not going to solve this problem
welcome my faculty colleagues Professor Venkatesh Pan- of capital adequacy in banks unless the government takes
chapagesan, Professor P. C. Narayan and others, research a firm decision and it is politically difficult. But they have to
students and other observers to ask questions and for do it, to at least bring government ownership down to 33%
comments. from the existing 51%. After the first round of nationalisa-
tion in 1969, and the second round in 1980, we thought the
curve was going to go that way. Now, suddenly, in the
Discussion economic liberalisation of the mid 90s the government said,
we are going to reduce our ownership to 51%. That was path
V. Panchapagesan: Risk measurement depends a lot on the breaking legislation. There is a lot of pressure building up to
accounting. In India, there is a gap between what is re- reduce it from 51% to 33% but it’s a political issue, it’s not
ported and the real true NPA. How does that figure in an economic issue. I believe it will happen but like every-
capital risk? There is a capital requirement based on the thing else in a democracy it will take time.
original. Does the capital requirement change as the M. Jayadev: We always look at banks’ performance from
degradation happens and is the degradation on what is re- the external governance point of view, that is through
ported or what is the true value? capital adequacy ratio, NPA ratio, profitability, ROA and so
M. K. Jain: We have to look at it from two perspectives. on. The board’s activism is not taken into account, and
One, from the perspective of Income Recognition and Asset most public sector banks have inactive boards. According to
Classification (IRAC) norms to classify the account as NPA corporate finance theory, board activism is more important
and the other from the perspective of capital allocation. As for financial performance. If the government focuses on
per IRAC norms, provisioning against NPAs is only based on internal governance aspects and activates some of the
originals but for capital requirement under Advanced aspects of the corporate governance framework, some of
Approaches of Basel II, restructured accounts are consid- these issues can be solved. Otherwise banks would be
ered as default points to estimate Probability of Default completely CEO- or CMD- driven.
(PD). Second point is definition of default. In Basel II defi- M. K. Jain: Currently, there is a debate on the reason for
nition of default is in terms of point in time, and not market low market capitalisation of the public sector banks in
value of loan to factor migration of the ratings; so that’s comparison to private sector banks. Is it only because of
again a modelling error in Basel II. In trading book, market fundamentals or something else? It may be due to corporate
value is factored in to take into consideration migration of governance issues.
rating but not in banking book. In banking book, it is P. C. Narayan: It’s again coming back to the ownership
addressed to some extent by estimating downturn Loss of the government, the one entity that owns 51% and they
Given Default (LGD) and PD will have the last word in what the board is going to look
V. Panchapagesan: There is a follow up question to this. like. So, any talk of corporate governance reforms has to be
You know that the capital requirement is based on the risk preceded by a capital structure reform. There is enough
of the underlying assets. The risk can change dramatically literature evidence available to establish this.
Basel III implementation 129

V. Panchapagesan: There was a point raised about the seemingly buy them at a price that will not show any loss,
change in the mix by which the banks would end moving to keep the property in their balance sheet and look good.
either short term loans or different types of loans, to M. Jayadev: By following prudential accounting norms
meet the Basel requirements. Is this going to lead to banks treat restructured assets as NPAs and are making
a different kind of a problem whereby the credit moves room for provisioning. Internal control systems should
from the banking sector to the unorganised lending address the issue of hiding bad loans and greening of assets.
market which would cause a bigger systemic risk problem? In addition to RBI inspection, concurrent audit, internal
Non-banking finance companies, private equities and so audit the board level interventions are to be strengthened.
on are probably not held to the same Basel standards. If I An effective corporate governance mechanism is the need
understand this legislation right, it might fundamentally of the hour; currently boards are often inactive.
change credit generation in the system and some of the Regarding the latest amendments to SARFESI and DRT
riskier sectors would move towards more unorganised Acts, these are empowering the banks and improving the
lending which is more of a systemic risk problem. recovery process. According to the amendments proposed,
M. Jayadev: True, we have seen such incidents of banks and asset reconstruction companies (ARCs) will be
systemic risk in microfinance where institutions have failed allowed to convert any part of the debt of the defaulting
due to defaults. We have also talked about few institutions company into equity. Such a conversion would imply that
dominating –, for example, HDFC, a single product company lenders or ARCs would tend to become equity holders
which is unchallenged by the entire banking sector in this rather than being creditors of the company. Further, the
country so far. Are such institutions a benchmarking amendments also allow banks to bid for any immovable
example or a risk example in the financial services? property they have put out for auction themselves. If they
P. C. Narayan: Clearly, we have a choice. There is do not receive any bids during the auction, banks will be
a rapidly evolving shadow banking system in this country. able to set off the debt against the amount paid for this
We beat our chest and say that we are a well regulated property. This enables the bank to secure the asset in part
banking system; what we ignore in that process is that we fulfilment of the defaulted loan.
are creating an unregulated banking system and the Indian M. K. Jain: This issue is being addressed in various
version of the crisis that happened in the United States with forums and insurance companies are already working on
the investment banks in the hedge funds, could evolve. So, aspects such as solvency ratio. The RBI has already regu-
we may actually be creating an environment where people lated to prevent shadow banking and issues restrictions to
want to look for capital arbitrage. With Basel III they may prevent shadow banking.
incentivise the capital arbitrage, that means create finan- M. Jayadev: With this we have come to the end of our
cial asset companies which do not have capital adequacy round table discussion. Thank you all for being present and
requirements of the same level as a bank. Such a situation making this event a knowledgeable discussion. I thank all
will evolve and we had better be cautious about it. the panellists for bringing the practitioner’s perspective to
V. Panchapagesan: In India, public sector banks had the the table. I clearly see a few research issues for Indian
implicit guarantee from the government that they won’t banks in this context;
fail because of possible injection of capital by the govern- How will Basel III implementation affect credit growth
ment in case of trouble (much like Fannie Mae in the US). and loan pricing? What would be the impact of these norms
Now that implicit guarantee may be worth a lot less since on stock returns of banks? And, finally the relevance of
all banks, including public banks, have to maintain certain systemic risk in the Indian context and its quantification.
amount of capital in their balance sheet. I take this opportunity to thank all the panellists for
M. Jayadev: True, government ownership itself is an their valuable time.
implicit guarantee against failure. The government being
the major owner is infusing additional capital to the capital
deficient public sector banks, which helps the banks to
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