Finance Conclave, Sri Sri Unviersity (SSU), 2014

Indian Banking entering the new era of Basil III and Financial Inclusion

Narang A. and Jain U.

Abstract The Indian economy is undergoing a very critical phase. Last couple of years were marked with low

growth, policy paralysis and slow decision making. The newly elected government has shown a hope

which are evident from recent IIP and inflation numbers. The paper discusses the banking sectors

main parameter representing not only the banking health but also the economic condition: Non-

performing assets (NPA) in detail. Upcoming Basel III Norms which aims to strengthen and improve

transparency in banking system will play a key role for India which is expected to surpass Japan and

become the third largest economy on GDP by 2020. Also the endeavour of the new government to

have a make banking available even to the poorest of the poor is making banking sector undergo

major transformation where reforms are being undertaken at all levels. The major challenges in this

regards are discussed. Also we have attempted to predict the NPA level by the date agreed for

implementation of Basel 3.

Introduction India is a diverse country with rich diversity and culture. One thing which makes India a country to

look forward is its financial strength which was evident when India was had to only face reduced

effect of the 2008 crises. One of major role played in insulating India was by the banking sector.

Asia contributes approximately 75% in total’s world savings. In India the average saving rate stands

at around 30% while it is negative USA and Europe there saving rate. Out of these savings only 1% of

our savings goes in stock market which is expected to rise to 5% by 2020. While the banks are

expected to hold 60% of the saving (Sachs). On the GDP front India is expected to surpass China’s

GDP (80.02 Trillion$) and claim the top spot at 85.97 Trillion Dollar by 2050 (Assocham, 2014). There

is also a direct correlation between credit growth and GDP of a county (Assocham, 2014).

According to the 2012 edition of the wealth report, .A PWC Report on Banking

By 2050 India is also expected to become the third largest domestic banking sector after China and

USA (PWC, 2014). The China and India could have a combined share of about 35% in global banking

assets in coming decades (PWC, 2014). These facts restated the importance and the opportunities in

the Indian Banking sector.

Indian Banking Sector – Current status Indian banking is XYZ $US industry. With only 40% population Indian having a bank account. Less

than 10% of small businesses are using them as a formal lending institute, the is a huge scope of

ahead following the financial inclusion strategy. RBI has accepted the recommendations of Nachiket

Mor Committee. More consumer and payment banks will be open all the country to provide bank

accounts for all by 2016.The Jan Dhan Yojana is also working in the same direction. It assures that

cash benefit transfers under various central and state government schemes will be through these

accounts.

So the need of the hour is to achieve financial inclusion by expanding the reach of the banking

sector. This will not be possible until and unless the banking sector realizes where its strength lies,

works upon the increasing levels of stressed assets and NPA’s and plan for the future.

NPA: Critical Indicator of Banking Sector One of the key indicators to measure the efficiency of banking sector is NPA’S.

An asset, including a leased asset, becomes non-performing when it ceases to generate income for

the bank.

A non-performing asset (NPA) is a loan or an advance where;

Interest and/ or instalment of principal remain overdue for a period of more than 90 days in

respect of a term loan.

The account remains ‘out of order’ in respect of an Overdraft/Cash Credit (OD/CC), if the

outstanding balance remains continuously in excess of the sanctioned limit/drawing power.

In cases where the outstanding balance in the principal operating account is less than the

sanctioned limit / drawing power, but there are no credits continuously for 90 days as on the

date of Balance Sheet or credits are not enough to cover the interest debited during the

same period, these accounts should be treated as 'out of order'.

The bill remains overdue for a period of more than 90 days in the case of bills purchased and

discounted,

The instalment of principal or interest thereon remains overdue for two crop seasons for

short duration crops,

The instalment of principal or interest thereon remains overdue for one

Crop season for long duration crops,

The amount of liquidity facility remains outstanding for more than 90 days, in respect of a

securitisation transaction undertaken in terms of guidelines on securitisation dated February

1, 2006.

In respect of derivative transactions, the overdue receivables representing positive mark-to-

market value of a derivative contract, if these remain unpaid for a period of 90 days from

the specified due date for payment.

NPAs can are categorized by a bank or financial institution as sub-standard, doubtful or loss asset, in

accordance with the directions relating to asset classification issued by RBI.

a. Standard Assets – These are those assets which do not create any problem while paying interest/ instalments of the principal. It usually carries more than normal risk attached to the business. Banks are required to keep 0.25% of advances as a provision under this category of asset.

b. Substandard Assets – Those assets which has remained non performing for a period less than or equal to 12 months. Generally, banks are required to make 10% on total outstanding balance & 10 % on unsecured exposures as provisions.

c. Doubtful Assets – Assets remained in the sub-standard category for a period of 12 months. 100% to the extent advance not covered by realizable value of security. In case of secured portion, provision may be made in the range of 20% to 100% depending on the period of asset remaining sub-standard

d. Loss Assets – These assets are those where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. Generally 100% of the outstanding balance is kept as a provision.

NPA can be reported in two ways. Gross NPA and Net NPA. Gross NPAs are the sum total of all loan

assets that are classified as NPAs as per RBI guidelines as on Balance Sheet date. Gross NPA reflects

the quality of the loans made by banks. It consists of all the nonstandard assets like as sub-standard,

doubtful, and loss assets. Net NPA’s are the ones in which the bank has deducted the provision. Net

NPA shows the actual burden of banks. Since in India, bank balance sheets contain a huge amount of

NPAs and the process of recovery and write off of loans is very time consuming, provisions the banks

have to make against NPAs according to the RBI guidelines, are quite significant. As a consequence,

difference between gross and net NPA is very high. These are calculated as below:

Net NPAs = Gross NPAs – Provisions

Global View:NPA’s As per the world bank data of 2013 following are the NPA of the major countris in the world. This

graph shows the GDP is not the correlated with the NPA. The factors such as fiscal and monetary

policies along with the economic condition of the countries plays a major in the NPA.

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NPA ratio - 2013

NPA ratio GDP ($US trillion)

Difference in NPA calculation in different countries Different countries follow different norms to measure NPA’s. Hence, comparison of NPA’s should

not be done until both the countries data are at same level.

Some of the possible differences can be on account of:

Some countries measure Gross NPA, while some other measures Net NPA.Net NPA is arrived

at after deduction of provisions from Gross NPA.

In some countries, if 1 loan is impaired to a customer, all loans are classified as NPA’s for

that customer.

In some countries NPL definition includes some other criteria as well.eg in Romania banks

see financial performance of debtors and whether judicial enquiry has started or not.

Some countries take into account collateral securities and guarantees and some do not.

Factors influencing NPA’s: NPAs and the return on assets have a cyclical pattern and concludes that banks’ riskiness and profitability are affected by the evolution of the business cycle. Various Macroeconomic indicators play a key role in analysing the Non-performing loans.

1. GDP Growth: Analysis suggests real GDP growth was the main driver of nonperforming loan ratios during the past decade. Therefore, a drop in global economic activity remains the most important risk for bank asset quality. Below is the analysis of NPA for India from FY 2001 to 2014.

2. Foreign Exchange Rate Fluctuations: Exchange rate depreciations lead to an increase of non-performing in countries with a high degree of lending in foreign currencies to unhedged borrowers. Typically, the exposure to balance sheet effects leads to ‘fear of floating’ considerations among the authorities which therefore often maintain tightly managed exchange rates against the dollar or the euro. When such exchange rate pegs collapse during a crisis due to insufficient foreign exchange reserves, currency depreciations increases the debt servicing costs in local currency terms for borrowers with loans denominated in foreign currency. In countries without currency mismatches, on the other hand, a depreciation of the local currency could reduce non-performing loans through an increase in export volumes and thus an improvement of the financial position of the corporate sector. For emerging economies with a lower level of capital market development and a higher exposure to exchange rates our a role for the exchange rate is more relevant. This effect is

3. Stock markets: In countries with large stock markets relative to GDP, stock market levels influence the bank asset quality. For eg. decline of stock prices can negatively affect bank asset quality.

4. Lending Rates: Finally, we find that an increase in lending interest rates tends to increase nonperforming loans. The channel to non-performing loans is likely to work through a rise of debt service costs of borrowers with variable rate contracts.

5. Policy Paralysis: The recent series of scams, reallocation of coal blocks, mining ban in Orissa all indicate not a favourable environment to invest in the country. The infrastructure,mining and aircraft industry are stressed out.

6. Poor lending practices by banks: The RBI drew attention to inadequate credit appraisal process of banks where insufficient discipline and oversight approach was enforced over companies. Lending in case of Bhushan Steel by Syndicate Bank, Kingfisher reinforces this statement.

A Parliamentary panel, examining increasing incidents of NPAs, has observed that state-owned

banks should stop “ever-greening” or repeated restructuring of corporate debt to check the constant

bulging of their non-performing assets. Members of the panel were of the view that NPAs are the

result of bad economic situation, but there were also management issue of every-greening of loans,

which could be avoided by “not renewing loans, particularly of corporate”. This analysis clearly

points out that banks’ approach towards NPAs has been a reason for aggravation of bad loans.

Extending those extra helping hand can go against the financial health of banks. Banks need to be

more conservative in granting loans to sectors that have been traditionally found to be contributors

of NPAs. Infrastructure sector is one such villain causing NPAs to rise predominantly because of long

gestation period of the projects. But more than all, this credit sanctioning process of banks need to

go much more beyond the traditional analysis of financial statements and analysing the history of

promoters. There is a need to incorporate significance of economic factors in the credit assessment

process. Also, banks need to evolve strategy through which defaulters are kept out of system unless

they honour the previous payment.

NPA’S: Indian Scenarios According to the RBI, "Reduction of NPAs in the Indian banking sector should be treated as a national

priority item to make the system stronger, resilient and geared to meet the challenges of

globalisation. It is necessary that a public debate is started soon on the problem of NPAs and their

resolution."

Interest Rate Scenario in India Whereas most of the developed countries are suffering from low growth, India is in a different

situation all together. It is suffering from a twin problem of low growth and high inflation

(stagflation).

RBI has taken cues from the Urjit Patel report and has made CPI (Consumer Price Index) as basis of

inflation. The target is to achieve 6% inflation levels by January 2016.Viewing this means the

probability of drastic interest rates cut by RBI to bolster growth is not an easy task.

Public sector v/s Private Sector Public Sector banks contributes 75% of the total assets and ~85% of total NPA’s. They are also

burdened with massive manpower and lack of modern technology .Some Public Sector Banks like

United Bank of India has 10.8% of NPA. Some PSU banks have been giving loans to repay old loans to

debtors.

Impact of NPA’s

1. Opportunity cost is lost: The money if not given on credit following a proper process will lead

to a loss of opportunity cost. The money could have been invested in some other

instruments and could have yielded additional incomes.

2. Additional expenses to recover the money: Generally banks appoint different agencies to

collect money

3. Profitability erosion: The current profits of the banks are eroded because the providing of

doubtful debts and writing it off as bad debts and it limits the recycling funds

4. The interest income of banks reduced it is to be accounted only on receipt basis

5. The capital adequacy ratio is disturbed and cost of capital will go up.

Stressed Assets A stressed loan is a loan Stressed Asset and is defined as an account where principal and/or interest

remains overdue for more than 30 days. In view of recent phase of recession, the incidence of stress

in MSME Sector is showing an increasing trend. New loan that replaces the outstanding balance of

some of the stressed loans with new loans called the restructured loans (restructured asset (RA))that

is paid over a longer period, usually with a lower instalment amount. Loans are commonly

rescheduled to accommodate a borrower in financial difficulty and, thus, to avoid a default.

The total banking sector outstanding is 57.9 Trillion INR. Of this the stressed asset size is 5.91 Triilion

INR (10.2%). This can be further broken down into GNPA of 2.43 trillion INR (4.2%) and RA of 3.47

trillion INR (6.0%)

Many of the banks, in order to bring down the NPA levels in their book of accounts tend to

restructure the loans provided to different companies. So NPA levels are not the only considerations

to be kept in mind while analysing performances of banks. In fact, stressed assets (sum of GNPA and

restructured loans) give a better picture of the overall performance of the banking industry. The

focus of the newly elected government should not be only to bring down NPA’s in bank books but to

bring down the stresses assets as well.

Strengthening Measures Many recommendation have been formulated by committees till date. Considering the large size and

the current economic scenario, some of the recommendations are under implantations. Still there is

a scope for further implementations, which are discussed below.

Measures to be taken to reduce NPA RBI issued guidelines in 1993 based on recommendations of the Narasimham Committee that

mandated identification and reduction of NPAs be treated as a ‘national priority’ because the level

of NPA act as an indicator showing the bankers credit risks and efficiency of allocation of resource.

A healthy banking system is essential for any economy striving to achieve growth and remain stable

in competitive global business environment. Indian banks are favourable on growth, asset quality

and profitability; RBI and Government have made some notable changes in policies and regulation to

help strengthen the sector. These changes include strengthening prudential norms, enhancing the

payments system and integrating regulations of commercial banks. In terms of quality of assets and

capital adequacy, these banks have clean, strong and transparent balance sheets relative to other

banks in comparable economies in its region. PSBs need to strengthen institutional skill levels

especially in sales and marketing, service operations, risk management and the overall

organizational performance ethic & strengthen human capital.

Moreover the role of Basel 3 norms will play a key role to take our banking institution to the next

level. Our paper will analyse the role Basel 3 norms and credit agencies in reducing NPA’s.

Basel Norms Originally Basel Committee was formed in 1974 by a group of central bank governors from 10

countries. Earlier guidelines were known as Basel I and Basel II accords. Later on the committee was

expanded to include members from nearly 30 countries, including India. Inspite of implementation

of Basel I and II guidelines, the financial world saw the worst crisis in early 2008 and whole financial

markets tumbled.

Basel 1 The history of the Basel International codes and Standards (BIS) relating to minimum capital

adequacy for banks goes back to the developed countries' initiative in 1988 to protect the

Organization for Economic Cooperation and Development (OECD) banks from the financial crises

common during the 1980s. Basel I norms, were set out in 1988 and accepted over the years by

around 100 Central Banks across the globe under what came to be known as the Basel Accord. The

original accord, now known as Basel-I, was quite simple and adopted a straight-forward `one size fits

all approach' that does not distinguish between the differing risk profiles and risk management

standards across banks.

The Indian monetary authorities implemented the Basel I by 1999.The banks were to assess their

assets and off-balance-sheet risks taken and incorporate them on their balance-sheet. Basel norms

prescribed a minimum capital adequacy ratio (CRAR)[1] of 8 % for Banks which were signatories to

the Basel Accord. Basel I framework was confined to the prescription of only NPAs Reduction

Strategies for Commercial Banks in India’s the Basel II framework expands this approach not only to

capture certain additional risks in the minimum capital ratio but also includes two additional areas,

Supervisory Review Process and Market Discipline through increased disclosure. Thus emerged RBI

guidelines on investments and operations risk, paving the way for adoption of what have come to be

known as Basel II norms.

Basel 2 It is the second accord which focuses on operational risk along with market risk and credit risk. Basel

II tries to ensure that the anomalies existed in Basel I are corrected. The process of implementing

Basel II norms in India is being carried out in phases. The minimum capital to risk-weighted asset

ratio (CRAR) in India is placed at 9%, one percentage point above the Basel II requirement. As per

Basel I norms, Indian banks should maintain tier I capital of at least 6%. The Government of India has

emphasized that public sector banks should maintain CRAR of 12%. For this, it announced measures

to re-capitalize most of the public sector banks, as these banks cannot dilute stake further, as the

Government is required to maintain a stake of minimum 51% in these banks

Basel 3 After 2008~09 financial crisis, Basel III or Basel 3 released in December, 2010 is the third in the series

of Basel Accords. These accords deal with risk management aspects for the banking sector. In a nut

shell we can say that Basel iii is the global regulatory standard (agreed upon by the members of the

Basel Committee on Banking Supervision) on bank capital adequacy, stress testing and market

liquidity risk. This latest Accord now seeks to improve the banking sector's ability to deal with

financial and economic stress, improve risk management and strengthen the banks' transparency.

The basic structure of Basel III remains unchanged with three mutually reinforcing pillars.

Pillar 1: Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs):

Maintaining capital calculated through credit, market and operational risk areas.

Pillar 2: Supervisory Review Process: Regulating tools and frameworks for dealing with peripheral

risks that banks face.

Pillar 3: Market Discipline: Increasing the disclosures that banks must provide to increase the

transparency of banks.

Basel III has essentially been designed to address the weaknesses that become too obvious during

the 2008 financial crisis world faced. The intent of the Basel Committee seems to prepare the

banking industry for any future economic downturns. The framework enhances bank-specific

measures and includes macro-prudential regulations to help create a more stable banking sector.

Based on the 3 Pillars following are the main features:

Better Capital Quality: Better quality capital means the higher loss-absorbing capacity. This

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

Capital Conservation Buffer: 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.

Countercyclical Buffer: The countercyclical buffer has been introduced with the objective to

increase capital requirements in growth period and decrease the rescission period of the

economic cycle. The buffer will range from 0% to 2.5%, consisting of common equity or

other fully loss-absorbing capital.

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.

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). 3% leverage ratio of Tier 1 will be tested before a mandatory

leverage ratio is introduced in January 2018.

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.

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.

Following table gives the comparison of Basel II and III

Requirements Under Basel II Under Basel III As per RBI

Minimum Ratio of Total Capital To RWAs 8% 10.50%

Minimum Ratio of Common Equity to RWAs

2% 4.50% to 7.00% 5.5%

Tier I capital to RWAs 4% 6.00% 7%

Core Tier I capital to RWAs 2% 5.00% 5.5%

Capital Conservation Buffers to RWAs None 2.50% 2.5%

Leverage Ratio None 3.00% 4.5%

Countercyclical Buffer None 0% to 2.50%

Minimum Liquidity Coverage Ratio None TBD (2015)

Minimum Net Stable Funding Ratio None TBD (2018)

Systemically important Financial Institutions Charge

None TBD (2011)

Although Basel 3 implementation will strengthen the Banking structure and also give buffer in the

bad times but this will lead to other implications as well:

1. Additional capital requirement may be met by common equity or retained dividends.

2. Banks may sell the low margin assets which could reduce the prices of these assets.

3. Banks may increase the corporate wholesale deposits which are long term maturity and also

reduce the short term loans.

4. The profitability of the banks will also come down as Cost to capital will increase.

5. The NPA will reduce.

Apart from them, factors like growth of Mortgage sector to cross Rs 40 trillion by 2020; the multifold

penetration of the ATMs and the expected increase in mobile banking will lead to significant shift in

the banking style in India. It will be interesting to observe the effect of high growth in investment

banking and infrastructure financing. If coupled with adequate policy measures, these development

will lower the NPA and vice versa.

The Impact of Financial Inclusion on the NPA When we consider the financial inclusion impact of NPA, it had a severe impact in the past, despite

the loan waivers that took place a few years ago, more than half the total NPAs on the bank’s books

are attributable to this sector with an NPA ratio that is close to double that of the rest of the asset

book (N., 2013).

On contrary the special units like Self Help Groups tells a different story. Success of SEWA bank in

Gujarat shows that, low cost banking is not necessarily an unviable proposition. SBI has NPA in this

segment which is below 1 per cent is proof of the viability of such projects (V., 2007).

NABARD has gross NPA of 5.65% as on 31st March 2013 (www.nabard.org). For the Microfinance

firm, Bandhan, the net NPA is 0.1% which is pretty appreciable considering the sector they deal with.

This suggests that to execute the financial inclusion strategy he have to make a special viable, low

cost business model for the banks. As the business model in this segment is substantially different

from that of a traditional bank, (Shah. A) BCG has suggested two approached for the same. First is

the integrated tie–up model is based on the possibility that corporate business centre (which may be

permitted by law soon) which envisages a highly integrated alliance between the bank and its

corporate BC. The other is. The second is the in–house approach, which includes making financial

institutions a separate SBU with separate P&L, organization, and HR.

Prediction of the GNPA levels Considering that the NPA is dependent mainly on the economic condition of a country along the

policy factors. One of the main indicator of these factors can be considered as movement of SENSEX.

It gives a view of economic condition of the country and also the business sentiments of India. On

analysing the past 14 years data of SENSEX we observed an inverse relationship Stocks and the GNPA

(Fig).

On the basis of above regression analysis, we can predict that in 2019 the expected GNPA is around

1.2% (assuming 13.7% 1CAGR of SENSEX till 2019). Since the Basil 3 would be implemented by March

2019, GNPA is expected to go further low.

Conclusion In the last couple of years as Indian Economy has seen downward trends, Indian banks are stradelled

with high stressed assets and NPA’s. But as the economy recovers, and the Basel III norms are

implemented we will definitely see a reducing the NPA’s. Proper actions should be taken so that

Indian banks especially PSU’s are not overburdened with these stringent requirement and are able

to transcend smoothly from Basel II to Basel III. Also a major challenge will be to implement the

strategy of financial inclusion in a profitable way. We believe the new government has taken a lot of

steps to improve the economic scenario.

Bibliography Assocham. (2014). Growing NPAs in bank.

N., M. (2013). Nachiketa Mor Committee Report.

PWC. (2014). India 2050.

Sachs, G. (n.d.).

Shah. A, G. A. (n.d.). Indian Banking 2020.

1 Historical data shows 13.7% growth in SENSEX over last 10 years.

y = 9439.2x-0.828

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V., R. (2007). Financial Inclusion and Litercay and SBI initiatives.