banking sector

INDIAN BANKING

SECTOR

Drishtee Capital

Indian Banking Sector 2013

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Introduction

Banks in India are classified into commercial banks comprising: 1) scheduled commercial

banks (SCBs) and non-scheduled commercial banks; and 2) co-operative credit institutions that

include various co-operative banks. SCBs are further classified into public sector banks (PSBs),

private banks, foreign banks and regional rural banks (RRBs). There are 27 public banks, 31private

banks and 38 foreign banks in India. State Bank of India is the biggest bank in India. Commercial

bank credit was around 56.5% of GDP in 2012 which indicates that the banking sector is a major

backbone of the economy.

The Reserve Bank of India regulates the banking sector in India. The population per bank

branch is around 12,300 in 2012 which clearly says that there are a lot of unbanked areas with huge

potential to expand business for Indian Banks. The RBI has taken a lot of initiatives to improve

financial inclusion which includes priority sector lending and recently inviting proposals for issuing

more banking licences.

The key issue which is plaguing the Indian Banking sector is the asset quality. The asset quality

of Indian banks have been deteriorating continuously as the Indian GDP slows down which inturn

causes a lot of strain on India Inc to pay back the loans. The public sector banks have been very poor

with Net NPA rising QoQ. The ratio of bad debt to total lending swelled to 3.6 per cent.

Key Drivers:

Economic Growth: A country‟s economic growth helps the banking sector in a big way. Current rate

of growth is hugely disappointing for the sector. Also since disposable incomes are going down,

credit growth and savings rate are going down. Hence deposits and NII will take a hit.

Monetary policy: As inflation hovers at uncomfortable levels, the interest rates and reserve ratios are

kept higher. These are adversely affecting growth and hence the banking sector too.

Infrastructure development: Huge infrastructure projects need financing and this will drive the

credit growth in emerging markets. The negative side is that it may also contribute to rise in npa if due

diligence is not done.

Asset Quality: NPA is worsening especially in public sector banks which are being reflected in their

stock performances. As BASEL III norms are implemented this will be a huge drain in capital.


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Arrival of new banks: Issuance of new licences in 2014 will bring in competition and also help in

increasing penetration in rural areas.

Financial Inclusion: Many Rural areas are unbanked. As per census 2011, only 54% of rural

households have availed banking services. So there is a huge potential to be unlocked. Huge policy

support is needed.

Technology adoption: Mobile and internet banking have huge potential since they are very cost

effective and also increases market penetration and convenience. Recent innovations include

introduction of CTS for faster clearance of Cheques and advances in risk management

systems.Aadhaar based Biometric identification, if introduced, can bring in more safety to customers

Key terms (refer http://www.rbi.org.in/scripts/Glossary.aspx for definitions)

CASA ratio

Slippage ratio

C-D ratio

Capital Adequacy Ratio or CRAR ( Capital to Risk Weighted Assets Ratio)

RoA

Net Non Performing Assets (NPA)

Net Interest Margin

Net Interest Income

Provisions

Leading Indian Banks

1. State Bank of India: The bank is huge with more than 16,000 branches and 8,500 ATMs across

India. And with revenue at $36.95 billion, it is easily India‟s biggest bank.

2. ICICI Bank: ICICI Bank is India's largest private sector bank with total assets of Rs. 5,367.95

billion (US$ 99 billion) at March 31, 2013 and profit after tax Rs. 83.25 billion (US$ 1,533 million)

for the year ended March 31, 2013. The Bank has a network of 3,529 branches and 11,063 ATMs in

India, and has a presence in 19 countries, including India. The Bank currently has subsidiaries in the

United Kingdom, Russia and Canada, branches in United States, Singapore, Bahrain, Hong Kong, Sri

Lanka, Qatar and Dubai International Finance Centre and representative offices in United Arab

Emirates, China, South Africa, Bangladesh, Thailand, Malaysia and Indonesia. The current CEO is

ChandaKochhar.

http://www.rbi.org.in/scripts/Glossary.aspx


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3. HDFC Bank: Founded in 1904, it is considered one of India‟s best banks. It has 1,500 branches

and more than 3,000 ATMs. Its revenue is about $6.87 billion.

4. Punjab Bank of India: It was founded in 1894 and has more than 37 million customers. Yearly

revenue is around $6.6 billion and it has 5,000 branches across 764 cities.

5. Bank of Baroda: The bank has 4,283 branches and more than 2,000 ATMs with annual revenue of

$5.5 billion.

6. Canara Bank: The bank has revenues of $5.4 billion and was established in 1904. It has a network

of 3564 branches and 4000 ATMs.

7. IDBI Bank: Established by an act of parliament to help develop Indian industry, the bank has

1,500 ATMs and 900 branches with yearly revenue of $4.1 billion

8. Bank of India: It was founded in 1906 and now primarily provides mobile banking and online

services. It has 4322 branches and annual revenue of $3.9 billion.

9. Union Bank of India: The Union Bank was inaugurated by Mahatma Gandhi and is one of India‟s

largest public-sector banks with around 3,025 ATMs and 27,750 employees. It has annual revenue of

$3.4 billion.

10. Axis Bank: Formerly known as the Unit Trust of India. Axis Bank is the third largest private

sector bank in India. It started operations in 1994 with annual income of about Rs. 34000 crores.The

Bank has a large footprint of 1947 domestic branches (including extension counters) and 11,245

ATMs spread across the country as on 31st March 2013. The Bank also has overseas offices in

Singapore, Hong Kong, Shanghai, Colombo, Dubai and Abu Dhabi. The current CEO is Shikha

Sharma

Overview of Basel Norms

Basel Committee

Basel Committee on banking supervision (BCBS) commonly known as Basel Committee is a

committee banking supervisory authorities that was established by the central bank governors of the

Group Of ten countries in 1975. Now it consists of 13 senior representatives of bank supervisory

authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxemburg,


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Netherlands, Spain, Sweden, Switzerland, United Kingdom and Unites States. It usually meets at the

Bank of International Settlements where the permanent secretariat is located.

The committee does not possess any formal supranational supervisory authority and its conclusions do

not and were never intended to have a legal force. Rather it formulates broad supervisory standards

and guidelines and recommends statements of best practices in the expectation that individual

authorities will take steps to implement them through detailed arrangements – statutory or otherwise –

which are best suited to their own national systems.

Basel Accord 1 In 1988 the Basel committee published a set of minimal capital requirements for banks known as

Basel Accord I. It focused primarily on credit risk and assets of the Banks were classified into four

risk buckets with risk weights of 0, 20, 50, and 100. Assets were to classified into one of these risk

buckets based on the type of counter party (sovereign, banks, public sector and others). Banks were

required to hold capital equal to 8% (in India 9%) of the risk weighted value of assets. The accord

provided definition of total capital as:

Total capital = 0.08 * Risk weighted assets

These recommendations were introduced in India through Narasimham committee recommendations.

Criticisms of Basel I

Basel I covers only credit risk and targets G-10 countries, Basel I is seen as too narrow in its

scope to ensure adequate financial stability in the international financial system. Also, Basel

I„s omission of market discipline is seen to limit the accord„s ability to influence countries

and banks to follow its guidelines.

The norms treated all borrowers alike.

Advances in technology and finance allowed banks to develop their own capital allocation

(internal) models in the 1990s. This resulted in more accurate calculations of bank capital

than possible under Basel I. Internal models allowed banks to differentiate risks of individual

loans unlike Basel I. Such deficiencies led banks to rearrange quality assets on their books

and maintain only 8% capital on assets which demanded even higher capital. This was termed

capital arbitrage.

The standards have not been able to meet one of the central objectives, viz., to make the

competitive playing field for the banks. Because imposing the same capital standards on all

institutions that differ with regard to other factors (such as taxes, accounting requirements,


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disclosure laws, implicit and explicit deposit guarantees, social overhead expenditures,

employment restrictions, and insolvency laws) is unlikely to enhance competitive equity.

Perhaps the most fundamental problem with the Basel I standards stems from the fact that

they attempt to define and measure bank portfolio risk categorically by placing different

types of bank exposures into separate buckets„. Banks are then required to maintain minimum

capital proportional to a weighted sum of the amounts of assets in the various risk buckets.

That approach incorrectly assumes, however, that risks are identical within each bucket and

that the overall risk of a bank„s portfolio is equal to thesum of the risks across the various

buckets. But, most of the times, the risk-weight classes did not match realized losses.

The 1988 standards also assign a zero risk weight to all sovereign debt issued by countries

belonging to the OECD. Although sovereign debt was not at the center of the Asian financial

crises, but it played a central role in the earlier Mexican financial and currency crisis of 1994-

1995. Illustratively, Mexico and South Korea, both of which experienced substantial bank

insolvencies, are now members of the OECD (Organization for Economic Co-operation and

Development); and hence, the bonds issued by their Governments are subject to the zero risk

weight.

Another issue was operational risk. Operational risk poses significant risk for banks. Neither

the original Basel Accord nor the 1996 Amendment required capital for operational risk.

Modification in Accord I for Market Risk

In 1996, BCBS published amendment to 1988 Basel accord to provide an explicit charge on

capital for market risk on trading book, This amendment was brought in effect in 1998 in

accordance to these guidelines, RBI on June 24, 2004 has issued guidelines on capital charge for

marker risk in a phased manner.

Basel II

The Basel Committee has issued a detailed document on capital measurement and capital

standards on 26th June, 2004. The framework of new accord consists of three pillars:

Minimum capital requirement which seeks to refine the standardized rules set in accord I

Supervisory review process not only to ensure that banks have adequate capital but also

to encourage banks to adopt better risk management techniques

Market discipline with effective use of mandatory disclosure on risk management

practices

The new accord was applicable for implementation in member countries by the year end 2006

and for advanced approach by year end 2007. However, other countries are encouraged to


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consider adopting accord at such time as they believe is consistent with their supervisory

priorities. The new accord retained the key elements of Accord I on capital adequacy i.e. the

banks are required to hold total capital equivalent to 8% (RBI has prescribed 9%) of their risk

weighted assets. The basic structure of 1996 market risk amendments regarding the treatment of

market risk and the definition of eligible capital have also been retained

Pillar I Minimum Capital Requirement

There is no change in definition of capital from the existing accord i.e.

Basel 1. The new accord has proposed significant improvement in assessment of credit risk and

additional capital charge for operational risk. No change is proposed in capital charge for Market

risk. Different approaches to measure credit risk/risk weighted loan assets under the new accord

are given here under.

Credit risk

The three alternative approaches for measurement of credit risk have been proposed. These are

Standardized approach

Internal rating based foundation (IRB Foundation) Approach

Internal Rating Based Advanced (IRB Advanced) Approach

Standardized approach

The standardized approach is similar to the current approach. Banks are required to slot their

exposures into various categories of assets based on their characteristics. Under the approach, fixed

risk weights have been assigned corresponding to each supervisory category based on ratings assigned

by rating agencies. The accord permits banks a choice between two broad methodologies for

calculating the capital requirement for credit risk. One method is to measure credit risk in a

standardized manner supported by external credit rating of assets. The alternative methodology,

subject to explicit approval of the banks supervisor would allow banks to use their internal rating

system for credit risk. All individual claims have been categorized under the following categories:

Claim on Sovereigns

Claim on non central government public sector entities

Claim on multilateral development banks

Claim on banks

Claim on security firms

Claim on corporate


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Claim included in regulatory retail portfolio

Claim secured by residential property

Claim secured by commercial assets

Past due loans

Higher risk categories

Other assets

Off balance sheet items

For claims falling under I to VI, five buckets have been proposed with risk weights of 0%, 20%, 50%,

100% and 150%. These risk weights are dependent on the ratings assigned by external credit agencies

subject to certain relaxations and restrictions by national supervisor

All retail claims subject to certain criteria shall have risk weights of 75%. (RBI has prescribed

the risk weight of 125% in the case of consumer credit banking including personal loans and

credit cards)

Fully secured loan by residential property shall have risk weight of 35%. (RBI has prescribed

a risk weight of 75% on housing loans(

All loans secured by commercial property shall have risk weight of 100%. (RBI has

prescribed risk weight of 125%)

Unsecured portion of past due loans, net of specific provisions shall have risk weight of 150%

when specific provisions are less than 20% and 100% when specific provisions are greater

than or equal to 20%

National supervisor may decide to 150% or higher if the risk is perceived to be higher in some

of the categories/assets

Off balance sheet items shall be converted into credit exposure equivalents through credit

conversion factors. The CCF for original maturity up to one year shall be 20% and above one

year shall be 50%. However in certain cases CCF can be greater than 100%

Credit risk mitigant

Basel II recognizes certain financial collaterals such as cash, gold, debt securities with certain

benchmark rating level, Debt securities not rated but complying with certain conditions, Equities

included in the main index etc to take into account the collateral available in the account. The

exposure to a counterpart shall be reduced to the extent of collateral after applying certain prescribed

discounts and the capital will be required to be maintained on the reduced exposure.


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IRB Approach

Under this approach banks use internal assessment of key risk elements called qualitative inputs as

primary input to capital calculation. The risk weight and the resultant capital charge are determined

through the combination of qualitative inputs provided by the banks and the formula provided by the

committee. Under IRB approach, banks must categorize banking book exposure into broad classes of

assets viz. Corporate, Sovereign, Banks, Retail and equity exposures.

Within the corporate asset class, five sub classes namely project finance, object finance, commodity

finance, income producing real estate and high volatility commercial real estate.

The IRB calculation of risk weighted assets for exposure to Sovereign Banks, Corporate and Retail

category of assets will depend on the following four parameters.

Probability of default – Measures the likelihood of borrower defaulting over a period of time

Loss at given default – Measures the proposition of the exposure that will be lost if the default occurs

Exposure at default – Measures the amount of the facility that is likely to be drawn in the event of

default

Maturity – Measures the remaining effective maturity of the exposure

Market Risk

There is no change in the amendment made by BCBS in 1996 for market risk and capital change

calculations have remained the same. RBI has issued guidelines on capital charge on market risk

which provide for transition period for providing capital for marker risk as under:

I. Capital securities held in for trading category, open gold position limit, open forex limit,

trading provision in derivatives for trading book exposure to be provided by March 2005

II. Capital, in addition to above, for securities included in the available for sale be provided by

March 2006

Operational Risk

Operational risk is a new inclusion in Basel II. The operational risk identification can be carried out

by three methods as under:

a. Basic indicator approach

b. Standard approach

c. Advanced Measurement approach


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The provisions of the accord are as under:

Basic Indicator Standardized AMA

Calculation of

capital charge

15% of average gross

income over three

years

Average gross income

segregated into eight business

lines viz. Corporate finance,

Trading & Sales, Retail

banking, Commercial

Banking, Payment &

Settlement, Agency services,

Asset management & retail

brokerage. The capital charge

will be a certain percentage of

the gross income (Beta factor)

for each business line. Retail

brokerage, Retail Banking

and asset management carry a

Beta of 12%, commercial;

banking agency services carry

a beta of 15%, corporate

finance, trading and sales and

payment and settlement carry

a beta of 18%.

The total capital charge is

sum of capital charged across

the business lines

Capital charge shall

depend on internally

generated measure

which will be passed

on:

Internal loss

data

External loss

data

Scenario loss

data

Business

environment &

internal control

factors


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Qualifying

criteria

None Active involvement of board

of directors and senior

management

Existence of conceptually

sound operational risk

management system

Systematic tracking of loss

data & having sufficient

resources for use of the

approach as well as in the

control & audit areas

Measurement integrated

into day to day risk

management and

measurement processes

by internal/external

audit

Minimum five years

loss data

Pillar II Supervisory review process

This is a process of supervisory review of an institution‟s internal assessment process of capital and I

ts adequacy.

This part introduces two important critical risk management concepts

a. Use of economic capital

b. Improved corporate governance

These two concepts are based on the following four principles:

I. Banks should have a process for assessing their overall capacity adequacy in relation to their

risk profile and a strategy for maintaining their capital levels

II. Supervisors should review and evaluate banks internal capacity adequacy assessment and

strategies as well as their ability to monitor and ensure their compliance with regulatory

capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied

with the result f this process

III. Supervisors should expect the banks to operate above the minimum capital ratios and should

have the ability to require banks to hold capital in excess of the minimum

IV. Supervisors should seek to intervene at an early stage to prevent from falling below the

minimum levels required to support the risk characteristics of a particular bank and should

require rapid remedial action if capital is not maintained or restored

The points I and II aim to cover other risks, which are not cover under pillar I. The supervisory review

process shall also ensure that the internal risk management system in the bank is robust enough.


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Pillar 3 Market Discipline

Guiding principle for this principle is to encourage market discipline by developing a set of disclosure

requirements which will allow market participants to assess key pieces of information on the scope of

application, capital, risk exposure, risk assessment processes and hence the capital adequacy of the

institution. The disclosures have been categorized under two categories as:

1. Core disclosures – The basic information subject to materiality. Information is regarded as

material if its omission or misstatement could change or influence the assessment or decision

of a user on that information. All institutions must disclose this information.

2. Supplementary disclosures – These disclosures are important for some, but not for all

institutions. The information depends on the nature of the institutions risk exposure, capital

adequacy and method of calculating capital requirements.

RBI in its midterm review of annual policy has decided to provide some more time to put in place

appropriate system so as to ensure full compliance with Basel II. Foreign banks operating in India and

Indian banks have presence outside India are to migrate to the Standardized Approach for credit risk

and the Basic indicator approach for operational risk under Basel II with effect from march 31, 2008.

All other scheduled commercial banks are encouraged to migrate to these approaches under Basel II

in alignment with them but in any case not later than March 31, 2009.

Criticism of Basel II

In the standardized approach for credit risk measurement, rating agencies have been assigned

a crucial role. Rating agencies move slowly, and changes in ratings lag changes in actual

credit quality, so that the ratings have a questionable ability to predict default.

Deficiencies in Basel II accord encouraged the banks to do capital arbitrage (Securitization) to

a large extent as accord assigns a negligible risk weight to rated securitization tranches. This

gave banks a strong incentive to stockpile off-balance sheet instruments in large quantities.

(Asset-backed securities grew even faster than on-balance sheet residential mortgages).

Before crisis, Bank„s strategy was to concentrate bank lending in the mortgage sector, which

added fuel to the housing bubble set off by low US interest rates. This was a response to the

reduced risk weights for residential mortgages under all approaches of Basel II. So Basel II

had underestimated the level of capital required by banks.

But when something as diabolical as what happened in 2008 came to the fore, the central bankers

started feeling the heat and realized that there is some more need for guarantying the capital


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requirements with the banks. And the consequence was the birth of the third accord Basel III. Before

getting into it, let us just briefly peep into what led to Basel III.

Sub Prime crisis

The financial crisis of 2008, originated in the US, is known as sub-prime crisis. Sub-prime is a

category of borrowers who do not have the creditworthiness of prime borrowers. In simple terms,

their credit quality is questionable. Normally, banks would avoid giving loans to such borrowers.

However, a boom in real estate prices in US in early 2000, boosted the confidence of banks to lend to

sub-prime borrowers since anyway the loans were secured by the real estate. Banks created SPVs and

securitized these loans and, hence, did not suffer from deterioration in balance sheet quality since they

did not appear on their balance sheets directly. Thus, the volume of sub-prime credit grew

substantially compared to historical levels.

When interest rates in the US started rising, the default rates in sub-prime loans also started climbing

since most of such loans were on floating rate basis. Since banks were exposed to complicated

securitized products they started getting affected in a number of ways. Even in accounting terms, they

had to book huge losses because of fair value accounting though the losses were unrealized. The real

estate prices started falling down resulting in the value of collateral that banks had was also

deteriorating. In the process, to remain liquid and avoid defaults, banks started liquidating their

positions in financial markets across the globe which led to massive fall in asset prices world over.

Banks like Lehman Brothers could not survive and had to close down the business, while some other

like Bear Sterns, Merrill Lynch were taken over by other banks while some others received bailout

packages from the government. Overall, year 2008 went in banking history as year of mounting losses

and unprecedented bank failures.

How securitization led to subprime crisis

The process of securitization works as follows. A bank creates pool of loans belonging to a particular

category, say home loans. These home loans are backed by mortgages signed by borrowers of home

loans. The bank then sells this pool of loans to special purpose vehicles (SPVs) formed for this

purpose or sells them directly to institutions willing to buy them. Most probably these institutions

have been formed in order to channelize credit in housing sector. (For example in the US, Freddie

Mac, Fannie Mae and Ginnie Mae operate in this space). Since banks are selling the loans, capital is

released to them, which can be utilized for giving further loans. The new set of loans can also be

securitized. Thus, the same capital is used or rolled over many times for giving loans, i.e., for

achieving asset growth. What happens to loans that are transferred to SPVs? SPVs create securities


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out of them and sell it to investors. These securities are called mortgage backed or asset backed

securities depending upon which type of loans are used to create pools

How did the securitization process cause the sub-prime crisis? The NRSROs (Nationally Recognized

Statistical Rating Organization) maintained triple-A ratings on thousands of nearly worthless

subprime-related instruments.

Moody's assigned AAA grades to three-quarters of the CDO's rated bonds, which invested

73.5 percent of the fund's assets in mortgages backed by loans to homeowners with bad credit

and limited income documentation.

Without those AAA ratings, the gold standard for debt, banks, insurance companies and

pension funds wouldn't have bought the products.

Moody„s in June 2008 lowered $137.3 million of the bonds initially rated Aaa to Baa2 and

the rest to speculative.

Bank writedowns and losses on the investments totaling $523.3 billion led to the collapse or

disappearance of Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co.

Wall Street underwrote $3.2 trillion of loans to homebuyers with bad credit and

undocumented incomes from 2002 to 2007.

The lesson learnt was that Basel II placed too much emphasis on the credit rating agencies. The rating

agencies became more profitable even as the quality of their ratings declined. The rating companies

earned as much as three times more for grading complex structured finance products, such as CDOs,

as they did from corporate bonds.

Basel III

The main features of Basel III are:

(a) Better Capital Quality: One of the key elements of Basel 3 is the introduction of much stricter

definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn

will mean that banks will be stronger, allowing them to better withstand periods of stress.

(b) Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required

to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to

ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of

financial and economic stress

(c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical

buffer has been introduced with the objective to increase capital requirements in good times and


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decrease the same in bad times. The buffer will slow banking activity when it overheats and will

encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%,

consisting of common equity or other fully loss-absorbing capital.

(d) Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for

common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2%

to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only

common equity but also other qualifying financial instruments, will also increase from the current

minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current

8% level, yet the required total capital will increase to 10.5% when combined with the conservation

buffer.

(e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many

assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a

leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets

(not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global

basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in

January 2018.

(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A

new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in

2015 and 2018, respectively.

(g) Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential framework,

systemically important banks will be expected to have loss-absorbing capability beyond the Basel III

requirements. Options for implementation include capital surcharges, contingent capital and bail-in-

debt.

Comparisons of capital requirements of Basel II & Basel III

Requirements Under Basel II Under Basel III

Minimum ratio of

total capital to RWA’s

8% 10.5%

Minimum ratio of

common equity to

RWA

2% 4.5%-7%


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Tier I capital to RWA 4% 4.5%-7%

Core tier I capital to

RWA’s

2% 5%

Capital conservation

buffer to RWA

None 2.5%

Leverage ratio None 3%

Countercyclical buffer None 0%-2.5%

Minimum liquidity

coverage ratio

None TBD(2015)

Minimum net stable

funding ratio

None TBD(2018)

Systematically

important financial

institution charge

None TBD(2015)

Where does India stand???

In accordance with Basel III norms, Indian banks will have to maintain their capital adequacy ratio at

9 per cent as against the minimum recommended requirement of 8 per cent.According to the recent

RBI financial stability report, Indian banks will require an additional capital of Rs.five trillion to

comply with Basel III norms, including Rs 3.25 trillion as non-equity capital and Rs 1.75 trillion in

the form of equity capital over the next five years.

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.


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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. According to a CRISIL estimate,

the average equity capital ratio and overall capital adequacy ratio of rated banks in India stand well

above 9% and 14%, respectively. As for Federal Bank, its tier 1 capital is 15.86% and its capital

adequacy stands at 16.64% as on March 31, 2012, significantly higher than the stipulated norms.

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

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.

Growth Barrier

Growth and financial stability seem to be two conflicting goals for an economy. The Indian economy

is transforming structurally and moving towards rapid growth although some seasonal down trends

are seen. The main goal of the 12th Plan is “faster, sustainable and more inclusive growth”. The

Planning Commission is aiming at a total outlay of Rs. 51.46 lakh crore in the infrastructure sector

during the 12th Plan (2012–17). Infrastructure sector investment as percentage of the Gross Domestic

Product (GDP) is expected to rise steadily to 10.40% in the terminal year (2016–17) of the 12th Plan.


Drishtee Capital 18

The average investment in infrastructure sector for the 12th Plan as a whole is likely to be about

9.14% of the GDP. The outstanding credit gap for the micro and small and medium enterprises

(MSME) sector is estimated at 62%, which is estimated to reduce to 43% in March 2017 with the

assumption of minimum 20% year on year (Y-o-Y) credit growth to MSME sector and 10% Y-o-Y

credit growth to medium enterprises by scheduled commercial banks (SCBs).8 The economists'

projections are that the Indian economy will see higher growth in the manufacturing sector which

enhances demand for credit. The financial inclusion project aims to bring several millions of the

population under the ambit of the organised financial system which will also enhance their credit

requirements.

The preliminary research shows that the largest banks in the world would raise their lending rates on

an average by 16 basis points (bps) in order to increase their equity to asset ratio by 1.3 percentage

points needed to achieve the new Basel regulation of 7% equity to new risk weighted asset ratio.

Increase in lending rate is estimated to cause loan growth to decline by 1.3% in the long run. When

the leverage requirement interacts with the risk based internal ratings-based (IRB) capital

requirements it might lead to less lending to low risk customers and to increase lending to high risk

customers. Such allocation effects may be counterproductive to the financial stability effects of the

leverage ratio requirement.

In a structurally transforming economy like India with rapid upward mobility, credit demand will

expand faster than GDP for several reasons. First, India will shift increasingly from services to

manufacture whose credit intensity is higher per unit of GDP. Second, increased investment in

infrastructure as projected by the Planning Commission will place enormous demands on credit.

Finally, financial inclusion, which both the Government and the RBI are driving, will bring millions

of low income households into the formal financial system with almost all of them needing credit.

What all this means is that banks need to maintain higher capital requirements as per Basel III at a

time when credit demand is going to expand rapidly. The concern is that this will raise the cost of

credit and hence militate against growth. The question here is: With the increased demand for credit,

will the Basel III capital framework increase cost of credit? What are the options before Indian banks?

Profitability of banks

Return on equity (ROE) is defined as the product of return on assets (ROA) and the leverage

multiplier. As the upper limit for the leverage ratio by Basel III has been set at 3%, the value of the

leverage multiplier will come down, resulting in a reduction in the ROE. Table shows that the higher

ROE for the SBI group and nationalized banks was associated with a higher leverage ratio, while for

new private sector banks, the higher ROE was attributable to higher profitability of assets and lower

leverage (RBI 2012). On an average, Indian banks' ROE is around 15% for the last three years. The


Drishtee Capital 19

enhanced capital requirements under Basel III regime are likely to affect the ROE of the banks and the

shareholders' expectations on the minimum required rate of return.

Profitability and leverage of Indian banks: 2011–12:

Bank group Return on

equity

Profitability of

assets

Leverage Capital to 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

The "critical question" for India's banking system at present is whether a fiscally squeezed

government can meet the enhanced capital needs of public sector banks under Basel III. Well the

situation is very tight. With our country already going through an economic crisis due to high fiscal

and current account deficit aggravated by high inflation and depreciation things seem to look very

dark and gloomy as of now. And with Basel III implementation, all of us just have to wait and watch

as to how and where does our economy move.

banking sector

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