Basel III and impact on India

Basel III is part of the continuous effort made by the Basel Committee on Banking Supervision to to improve the regulation, supervision and risk management within the banking sector. It builds on the Basel I and Basel II documents, and seeks to:
- improve the banking sector's ability to deal with financial and economic stress, 
- improve risk management and 
- strengthen the banks' transparency. 
A focus of Basel III is to foster greater resilience at the individual bank level in order to reduce the risk of system wide shocks.1

In spite of the preventive safeguards of Basel II, the world banking system went into a tailspin during the early 2008 ushering in a financial crisis that shook the world economy. This led to some quick rethinking on the part of the Basel Committee on Banking Supervision (BCBS) over the need to come out with a broadened framework of tighter standards under Basel III to restrict the banks from indulging in unhealthy and imprudent practices which could have great cascading effects on the economies around. 

The impact that Basel III can have on Indian banking system as the norms will kick-start in a phased manner from January 1, 2013.

Capital adequacy: For Indian banks, it’s easier to make the transition to a stricter capital requirement regime than some of their international counterparts since the regulatory norms set by RBI on capital adequacy are already more stringent.Besides, most Indian banks have historically maintained their core and overall capital well in excess of the regulatory minimum. 

Cost of lending: Stricter capital requirements with changes in the structure of tier 1 and tier 2 capital generally result in lower return on equity (ROE). On the flip side, as capital costs increase, loans tend to be expensive. In order to offset this, banks would have to take the route of reducing deposit interest and go in for new non-interest income streams. Yet, Basel III carries the message that Indian banks will have to start finding ways to preserve capital and use it more productively as minimum capital requirements will have to be met by March 31, 2017.

Leverage: RBI has set the leverage ratio at 4.5% (3% under Basel III).The ratio is introduced by Basel 3 to regulate banks having huge trading book and off balance sheet derivative positions. In India, however, in most of our banks, the derivative activities are not very large so as to arrange enhanced cover for counterparty credit risk. Hence, the pressure on banks should be moderate.

Liquidity norms: Indian banks conform to two liquidity buffers already: the statutory liquidity ratio (SLR) – a mandatory 24% of a bank’s net demand and time liabilities – and cash reserve ratio (CRR) of 4.75%. The SLR is mainly government securities while the CRR is mainly cash. The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold enough unencumbered liquid assets to cover expected net outflows during a 30-day stress period. In India, the burden from LCR stipulation will depend on how much of CRR and SLR can be offset against LCR. Here too, Indian banks are better placed over their overseas counterparts.

Countercyclical buffer: Economic activity moves in cycles and banking system is inherently pro-cyclic. During upswings, carried away by the boom, banks end up in excessive lending and unchecked risk build-up, which carry the seeds of a disastrous downturn. The regulation to create additional capital buffers to lend further would act as a break on unbridled bank-lending. This check will counter or smoothen wild swings in business cycles. India has witnessed moderate cycles. Yet, for countercyclical measures to be effective, our banking system has to improve its capability to sense and predict the business cycle at sectoral and systemic levels and to use tools like ‘Credit to GDP ratio’ to calibrate the level of countercyclical buffer.

All said and done, viewed from a higher perspective, factors like the quality of governance of banks, the standard of regulatory control by the apex bank and the level of public confidence banks enjoy in combination with their adherence to Basel III standards will determine the standing of Indian banking system on the world scene. 2

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As of July 2012, there were indications that India will push for deferral of the stringent banking capital requirements under Basel III norms. The government plans to take up this issue at the G-20 meeting to be held in November in case the US and the European Union do not come out with the final guidelines on Basel III by then. 

Under the Basel III guidelines issued by the RBI, the banks in India will have to maintain a minimum common equity ratio of 8% and total capital ratio of 11.5%. Staterun banks currently maintain 8% as Tier I Capital. The RBI had estimated that staterun banks would require about Rs 1 lakh crore while the entire banking sector would require an additional capital requirement of Rs 5 lakh crore to meet the norms till 2019. The Basel III framework seeks to strengthen regulation, supervision and risk management in the banking sector. 

The government stands to save about Rs 90,000 crore over the next five years if the norms are deferred, the official said on the condition of anonymity. According to the Reserve Bank of India's estimates, the government will have to allocate this amount for state-run banks over the next five years to meet the Basel III standards if it wants to retain its 58% shareholding. 

The government, however, believes that it's not a good idea to put additional burden on the banks at a time bad loans are rising, that too if the new norms are not implemented globally. 3

1. http://www.investopedia.com/terms/b/basell-iii.asp#ixzz26HP5mlOI
2. http://www.dnaindia.com/analysis/column_basel-iii-on-the-way-its-advantage-india_1692884
3. http://economictimes.indiatimes.com/news/economy/finance/government-to-push-for-basel-iii-deferral-plans-to-take-up-the-issue-at-g20-meet/articleshow/16361722.cms