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The View Point – BASEL III in India Building Noahs Ark for Monsoon

The View Point – BASEL III in India Building Noahs Ark for Monsoon

Bar & Bench

Bar & Bench brings to you the ninth article on ‘The Viewpoint’ series with its Knowledge Partner Luthra & Luthra. Partner Piyush Mishra of Luthra & Luthra shares his thoughts on the draft guidelines issued by the Reserve Bank of India relating to implementation of capital adequacy norms of Basel III.

By Piyush Mishra

“After the event even a fool is wise. But it is not the hindsight of a fool: it is the foresight of the reasonable man which alone can determine responsibility.”

Viscount Simonds, The Wagon Mound No 1[1]

This is a viewpoint about the draft guidelines issued by the Reserve Bank of India (RBI) relating to implementation of capital adequacy norms of Basel III. Arguably, the time is not yet ripe for implementation of Basel III in India and the changes suggested by RBI are likely to have a detrimental impact on our cost of borrowing besides dampening the Indian growth story.

 The Swan Song of Finance

Till 2007, markets had witnessed an uninterrupted run of boom for over six years.  Politicians, economists and markets were talking of a ‘new golden age’. Gordon Brown proclaimed an end of boom and bust. Unknown to them it was the eve of the credit crunch. Soon, to borrow the words of David Cameron, the boom will end and many a reputation will be bust. The financial world will resemble a tiny Gaul village (with many stinky assets) besieged by the Caesar like by products of economic crisis.

Committees have mushroomed across the world to inquire into the paternity and causes of the worst financial crisis since the Great Depression (so much for our claim that only we Indians have a penchant for committees!). The causes of crisis were many including lack of appropriate regulatory oversight (AIG, Fannie, Freddie, investment banks in general), failure of corporate governance and risk management practices (UBS, RBS, Lehman) and faulty policies (high liquidity and easy credit due to low funding rates in US and Japan, especially the steep cuts in Fed Funding Rates post dot com bubble and 9/11, and the American dream of affordable housing for all- irrespective of whether the person could afford it or not.).

Among the causalities of the crisis were various financial institutions and banks.[2] Northern Rock and RBS paid out dividends when they should have conserved capital. It obviously raised uncomfortable questions about the health of financial institutions and led to a rethink of their liquidity and capital requirements.

Banks in Crisis and the Magic Potion of Basel

The regulators were not amused since the collapsed banks were in compliance with prescribed norms for regulation, supervision and risk management of banks formulated by the Basel Committee on Banking Supervision (the Basel Norms)- then Basel II. Therefore, the Basel Committee has come up with certain revisions (Basel III) to the Basel II norms strengthening the requirements relating to capital and adding in requirements for liquidity.

Basel III[3] has tinkered with various existing requirements (risk weightage of assets, capital structure etc.) and added in a host of new ones. The capital adequacy requirement for financial institutions is 8%- comprising of Common Equity Tier 1 (4.5%), Additional Tier 1 (1.5%) and Tier 2 (2%). Among the new introductions are Capital Conservation Buffer (2.5% of risk weighted assets (RWAs))[4], the Countercyclical Buffer (0%-2.5% of total RWAs)[5], Leverage Ratio (Tier 1 Capital: Exposure > 3%)[6] and the liquidity ratios.

An Indian Inquisition

RBI has issued the Draft Guidelines on Implementation of BASEL III Capital Regulations in India (the Prudential Guidelines) on December 30, 2011. The Prudential Guidelines have prescribed more stringent thresholds than those prescribed in Basel III. These include 1% additional Common Equity Tier 1 Capital requirements (total capital is 9%), 2% higher leverage ratio for Scheduled Commercial Banks (total 5%), and a shorter period of implementation.

This dogged adherence to Basel III guidelines (let alone the add ons) in a country where financial crisis did not play out its full course is quite questionable. Unlike India, the draft guidelines on capital adequacy by the China Banking Regulatory Commission prescribe total capital requirements of 8% -with Common Equity Tier 1 as 5% and Additional Tier 1 as 1%. In its advocacy of higher thresholds in a shorter duration, RBI seems to derive comfort from the fact that Indian banks are rather well capitalized. However, the assumption overlooks certain important facts like the addition of the twin capital buffers and the change in risk weightage of assets and deductions.

Capital Conservation Buffer is a bit of an oxymoron since it is supposed to be released during stress period so that banks don’t eat into their core capital- precisely at the point of time when banks would be required to capitalize themselves better! Likely the Capital Conservation Buffer will also be seen as vital part of a banks core capital by the market. Further, prescribing a higher regulatory norm, pegged in at current market levels, might actually necessitate an increase in the capital for banks because, from a market accessibility perspective, the banks would need to hold additional discretionary capital over the prescribed minimum.

Leverage Ratio for Indian banks presents interesting issues. Firstly, the Indian banks are not as leveraged as their European counterparts. Secondly, they have constraints of priority sector lending and directed lending. Thirdly, they have stringent reserve requirements in the form of SLR and CRR. In light of these constraints, higher Leverage Ratio will further cripple their lending to the private sector and returns.

Basel III- A white elephant?

Quantitative and macro-economic analysis of impact of Basel III suggests that it may lead to an increase in cost of borrowing by a few percent, contraction in credit volumes and adversely impact the GDP growth. These studies also proclaim that the costs are offset by the benefits of avoidance of a financial crisis. The first part relating to costs and impacts of Basel III is of interest. On the attempts to draw a correlation between avoidance of financial crisis and Basel III, sufficient to say that such attempts are a tribute to the incorrigible optimism of all knowing economists whose enthusiasm for predicting the market behaviour has not been dampened by the collapse of the LTCM or the recent financial crisis.

According to ICRA the growth in RWAs coupled with stringent capital adequacy requirements are likely to result in requirement of additional capital of Rs. 6 trillion for domestic Indian banks alone.[7] When viewed in the context of data relating to public issuances, for both equity and debt[8], where the average amount raised in the past three financial years is less than Rs. 1 trillion/year, such a colossal amount is likely not to have many takers. Clearly a fiscally challenged government will not be in a position to fulfill such funding requirements on its own. Basel III is also likely to have an adverse impact on trade and project finance. This raises questions about the feasibility of implementation of Basel III at a time when the world is facing a financial turmoil. 

A Case Study of Excessive Regulatory Disorder

Just as in case of boom there is a demand for more returns, in times of crisis there is a demand for more regulations. However, regulations have to be calibrated with the associated costs. While it is good to learn from the experiences of other countries, to adopt regulations based on their experiences uncritically into our regulatory structure might stunt our growth.

Certain factors and financial products that have allegedly contributed to financial crisis (quite debatable- many are integral to the growth of financial markets), are practically non- existent in India. To examine a few:

● Exotic derivative and securitization structures– RBI has banned all exotic derivative structures.

● Risky mortgage products (alt-a and sub-prime)- RBI has issues with teaser rate loans let alone risky mortgage products.

● Failure of originate to distribute model– with market for secondary trading of debt not being very active, nascent stage of CDO market and a rudimentary approach to derivatives, where is the distribution network?

As a logical corollary, the capital adequacy requirements that are based on experiences of the developed world in the context of such products are but irrelevant in Indian context.

By asking banks to hold higher capital we will compromise on credit volumes as well as profitability of banks (unless of course banks go for investments in riskier assets with higher returns!). This in turn will result in less revenue for the government at a point of time when the government can do with every extra penny. With a slowdown in the economy (growth rate has been revised to 7%) are we really in a position to afford Basel III -especially its stronger avatar in the Prudential Guidelines?

Let’s be governed by reasonable foresight rather than try to benefit from the hindsight of developed world. At this point of time we should be more concerned about transition from a developing economy to a developed one rather than worry about putting in place an apocalyptic regulatory structure for a ‘once in a century credit tsunami’. The real challenge for the policy makers should be to stimulate growth through unlocking the value in the Indian financial sector. Increasing pressure on the banking stocks to generate higher returns through leverage and use of more sophisticated financing structures is a necessity for the smooth flow of wheels of finance and growth. Let’s first witness a credit boom and then see if we can manage to minimize its adverse impacts. Till such time, the Prudential Guidelines seem to be unduly worried about an economic crisis, much the same like the Gaulish fear of the sky falling over their head.

Piyush Mishra, is a Partner at Luthra & Luthra Law Offices. The views expressed in this article are the personal views of the author and do not represent the views of the firm. It is informational and not an expression of opinion or advice. 

The author would like to acknowledge the research assistance provided by Deep Choudhuri, Student, IV year, Gujarat National Law University, Gandhinagar and Siddhant Kant, Student, IV year, National Law University, Jodhpur.

[1] (1961) AC 388

[2] In USA alone the numbers for banks’ and thrifts’ failure are staggering- 92 in 2011, 157 in 2010 and 140 in 2009.

[3] Basel III refers to the principles enunciated by Bank for International Settlements, Basel Committee on Banking Supervision in – Basel III: A Global Regulatory Framework for more Resilient Banks and Banking Systems December 2010 (rev. June 2011) and Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring, December 2010. The norms will be introduced in tranches from 2013 to 2019 (January) with a rather long parallel run and transition period though that is of limited consequence since markets will take the norms into account sooner than that. At present we are concerned with the capital adequacy norms since RBI has not yet prescribed the liquidity requirements.

[4] Comprising of redefined common equity Tier 1 instruments with adjustments for risk weightage.

[5] Required during a period of excess credit growth leading to a build up of system- wide risk as an extension of Capital Conservation buffer comprised of Common Equity Tier 1. To be notified annually by the regulators.

[6] This is during parallel run period (1.1.2013- 1.1.2017). Average of monthly leverage ratio over the quarter.

[7] ICRA, Proposed Basel III Guidelines: A credit Positive for Indian Banks. According to CRISIL banks will need to raise some Rs. 2.7 trillion of equity capital by March, 2017 in RBI’s Basel III Guidelines to strengthen bank’s capitalization, Press Release January 3, 2012, CRISIL.

[8] IPOs, FPOS, QIPs, rights issues, preferential allotments and bond issuances as noted in SEBI’s Annual Reports for the years 2009, 2010 and 2011.