FACULTY OF MANAGEMENT STUDIES
Basel III: Impact on Indian Banks
Table of Contents What is Basel III Key Elements of Basel III framework
Capital ratios Liquidity Ratios Constituents of Capital Leverage Ratio
New Elements of Basel III Framework
Comparison between Basel II and Basel III Effect on Banking Sector Likely Impact on Indian Banks Reasons for delay in adopting Basel III by India
What is Basel III • Developed by the members of the Basel Committee on Banking Supervision, it is a new global regulatory standard on bank capital adequacy and liquidity
• The main features of Basel 3 are: o The quality, consistency and the transparency of the capital base is increased o The risk coverage of capital framework is strengthened o Leverage ratio will be used as a supplementary measure to Basel II framework o A series of measures to promote the build up of capital buffer has been introduced
Timeline • Enhancement of Basel II framework • Revisions to market risk framework
July 2009
• Counter cycle capital proposal
• Endorsement of July agreement
• Capital and liquidity agreements with amendments
• Announcement of higher global capital standards
Dec 2009
July 2010
• Strengthening the resilience of banking sector • International framework for liquidity risk measurement
Aug 2010
• Proposal to ensure the loss absorbency of regulatory capital at point of non viability
Sept 2010
2011
• Finalization?
Key Elements of Basel 3 Framework (1/4) A. Capital Ratios • Core solvency ratio retained at 8% of risk weighted assets (“RWAs”). • Minimum “common equity” component will be 4.5% when fully phased in by 2015, increased from the current 2% minimum. • Overall Tier 1 element of the capital base (including common equity) will be 6% when fully phased in by 2015, increased from the current 4% minimum. • In addition, there will be a “capital conservation buffer” made up of common equity and amounting to 2.5% of RWAs when fully phased in by 2019; an institution with capital falling within the buffer range (i.e., with common equity of between 4.5% and 7%) will be subject to restrictions on dividend payouts, share buybacks and bonuses. In effect, most banks will be required, or othewise seek, to maintain a ratio of 7% of RWAs in common equity (4.5% minimum plus a 2.5% capital conservation buffer).
Key Elements of Basel 3 Framework (2/4) • A further “countercyclical capital buffer” may be imposed. Where required, it would be made up of common equity of up to an additional 2.5% of RWAs. This buffer is expected to be imposed at a national level only during times of excessive credit growth, and will be allowed to be released during times of credit contraction B. Liquidity Ratios • Short term liquidity – Liquidity Coverage Ratio (“LCR”) – banks will be required from 2015 to maintain a liquid assets buffer calibrated by reference to net cash outflow over a 30 day stressed period. • Longer Term liquidity – Net Stable Funding Ratio (“NSFR”) – banks will be required to have stable funding in place to address funding needs over a stressed one year period. Implementation is scheduled for 2018.
Key Elements of Basel 3 Framework (3/4) C. Constituents of Capital • The common equity component of Tier 1 will be comprised of ordinary share capital and retained profits. • Non-common equity Tier 1 (“Additional Tier 1”) will be principally made up of perpetual non-cumulative preference shares and other qualifying instruments. Mandatory write-down or conversion into common equity will apply to all Additional Tier 1 instruments in the event of the institution becoming non-viable without a bailout. • Tier 2 capital will no longer be divided into lower Tier 2 (principally, dated term preference shares and subordinated debt) and upper Tier 2 (including certain perpetual preferred instruments and subordinated debt). Instead, a single set of criteria will apply to Tier 2 capital. All Tier 2 instruments will be required to be either convertible into common equity or written down in the event of the institution becoming non-viable without a bail-out.
Key Elements of Basel 3 Framework (4/4) Tier 3 capital will be abolished. Generally speaking, Tier 3 capital was unsecured subordinated debt that is fully paid up, cannot be repaid before maturity without prior regulatory approval and with an original maturity of at least two years. •Deductions from capital (or regulatory adjustments) will be applied to the common equity Tier 1 component and not to overall capital. D. Leverage Ratio •A backstop 3% ratio of Tier 1 capital as against all of a bank’s assets and certain off-balance sheet exposures will be introduced. The assets will be treated on a non-risk adjusted basis with limited or no recognition of collateralization or credit risk mitigation associated with assets. Effectively, this would amount to a leverage ratio of 33:1.
New Elements of Basel 3 Framework New Leverage Ratio Requirement
Impact
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The leverage ratio is a “simple, transparent, non-risk based measure” intended to reduce the amount of risk in the financial system . The leverage ratio restricts the absolute level of indebtedness of a bank for a given amount of capital. It is intended to act as a safeguard against attempts to game the risk-based capital requirements and it also serves to mitigate discrepancies and/or misjudgments in risk attribution to assets. Basel III provides for a trial period a minimum leverage ratio requiring 3% of Tier 1 capital measured against gross exposures without risk adjustments. The leverage ratio will be required to be calculated as an average over each month.
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The new leverage ratio could constrain balance sheet growth for some institutions (or even possibly lead to balance sheet contraction) where raising additional capital is not a viable option. It may also push banks to favor feebased activities that do not create any exposures included in the denominator of the leverage ratio. In cases where the leverage ratio requirement (rather than the riskweighted capital requirements) acts as the effective minimum capital floor for a particular bank, the bank may perversely have incentive to acquire riskier higher yielding assets.
New Elements of Basel 3 Framework New Liquidity Requirements The Liquidity Coverage Ratio (“LCR”) •
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The LCR is intended to measure a bank’s ability to access funding for a 30 day period of acute market stress. Banks will be required to have a segregated stock of highly liquid and unencumbered assets that are at least equal to its estimated “net cash outflows” for a thirty day period during a time of acute liquidity stress. The 30 day stressed period assumes certain institution-specific and system wide liquidity shocks including a credit rating downgrade of the bank of three notches, partial loss of unsecured wholesale funding, withdrawal of some retail deposits, some committed but unfunded credit and liquidity lines provided by the bank being drawn down and general market volatility.
The Net Stable Funding Ratio (“NSFR”) •The purpose of the NSFR is to limit shortterm liquidity mismatches and encourage the use of longer term funding. A bank is required to have stable funding sources in excess of the amount of stable funding it would likely need over a one-year period of extended market stress.
•This is a longer term structural ratio that covers a bank’s entire balance sheet as well as certain off-balance sheet commitments. Essentially a sufficient amount of stable funding is required to finance those assets which are regarded as not being capable of being monetized through sale or use as collateral in secured borrowings during a liquidity event lasting one year.
Basel III Framework
The wider BASEL III Framework OTC Derivatives Market
Accounting Topics
The pure BASEL III Framework: Capital Requirements and new buffers Leverage Ratio Liquidity Ratios Higher Capital Markets for Systemic Banks
Framework for dealing with failing banks
Comparison between Basel II and Basel III (1/2) Tier 1 Capital BASEL II: Tier 1 capital ratio = 4% Core Tier 1 capital ratio = 2% The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 capital. BASEL III: Tier 1 Capital Ratio = 6% Core Tier 1 Capital Ratio (Common Equity after deductions) = 4.5% Core Tier 1 Capital Ratio (Common Equity after deductions) before 2013 = 2%, 1st January 2013 = 3.5%, 1st January 2014 = 4%, 1st January 2015 = 4.5% The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 capital.
Capital Conservation Buffer BASEL II: There is no capital conservation buffer. BASEL III: Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%. Capital Conservation Buffer of 2.5 percent, on top of Tier 1 capital, will be met with common equity, after the application of deductions. Capital Conservation Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 1st January 2017 = 1.25%, 1st January 2018 = 1.875%, 1st January 2019 = 2.5% The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress.
Comparison between Basel II and Basel III (2/2) Countercyclical Capital Buffer BASEL II: There is no Countercyclical Capital Buffer BASEL III: A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. Banks that have a capital ratio that is less than 2.5%, will face restrictions on payouts of dividends, share buybacks and bonuses. The buffer will be phased in from January 2016 and will be fully effective in January 2019. Countercyclical Capital Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 1st January 2017 = 1.25%, 1st January 2018 = 1.875%, 1st January 2019 = 2.5%
Capital for Systematically Important Banks BASEL II: There is no Capital for Systemically Important Banks BASEL III: Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt.
Basel I to Basel III
Key changes brought about by Basel I, II and III
Estimated Impact (1/3)
Estimated Impact (2/3) Breakdown of the elements that compose the deductions from Gross CET1 to Net CET1 (%)
Estimated Impact (3/3) Higher Minimum Ratios
Likely Impact on Indian Banks (1/2) • The Basel III guidelines aim to improve the banking sector's ability to endure long periods of economic and financial stress by laying down more rigorous and stringent capital and liquidity requirements for them. • Reserve Bank of India (RBI) does not see higher capital requirements under the proposed Basel III norms hitting Indian banks significantly. • The Basel Committee on Banking Supervision, under the Basel III rules, proposes that banks hold more and better quality capital, besides having more liquid assets. • The adoption of Basel III norms significantly increase the regulatory capital requirement of Indian banks.
Likely Impact on Indian Banks (2/2) • The norms will also limit banks’ leverage and make it mandatory for them to build up capital buffers in good times that can be utilised in periods of stress. • Indian banks already make most of the deductions from capital now being proposed under Basel III.
• Indian banks do not have re-securitisation exposures and their trading books are small. • There may be some negative impact arising from shifting some deductions from Tier I and Tier II capital to common equity.
Tier 1 capital requirement Regulation
Impact
The regulations increase the minimum Tier 1 capital requirement.
• This buffer needs to be met exclusively with common equity.
The regulations also introduces a new capital conservation buffer of 2.5%, which will be used to withstand losses during periods of stress.
• Banks that do not maintain such buffers will face restrictions on share buybacks, payment of dividends and bonuses. • A countercyclical buffer, within the range of 0% to 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances.
Core Capital Requirement
Regulation
Impact
• According to the proposed norms, the minimum core capital requirement is set to be raised to 4.5%. • In addition, the introduction of the conservation and countercyclical buffer means that the capital requirement would increase to between 7% and 9.5%.
• Indian banks, as per the current norms are required to maintain Tier I capital of at least 6%. • However, since innovative perpetual debt and perpetual non-cumulative preference shares cannot exceed 40% of the 6% Tier I capital, the minimum core capital is 3.6% (i.e., 60% of 6%).
Given that most Indian banks are capitalized well beyond the stipulated norms, they may not need substantial capital to meet the new stricter norms. However, there are differences among various banks. While core capital in most of the private sector banks and foreign banks exceeds 9%, there are some public sector banks that fall short of this benchmark. These public sector banks, which account for more than 70% of the assets in the banking sector and are a major source of funding for the productive sectors, are likely to face some constraints due to the implementation of the Basel III norms.
Deductions while calculating the capital adequacy percentages Regulation
Impact
Make the deductions deductible only if they exceed 15% of core capital at an aggregate level or 10% at an individual level.
• This is unlikely to have a major impact on Indian banks because, according to existing RBI guidelines, all deductibles are deducted. • Moreover, Indian banks do not have resecuritization exposures and small trading books.
Deduction from Core Capital Regulation
Impact
The new guidelines require 100% deduction from core capital
This regulation is stricter than the existing RBI guidelines that require 50% deduction from Tier I capital and 50% from Tier II capital, except in cases of intangible assets and deferred tax assets wherein 100% deduction is done from Tier I capital.
Buffer, over and above the Core Capital Requirement Regulation
Impact
• The new regulations require the creation of a new buffer of 2.5% of riskweighted assets over and above the minimum core capital requirement of 4.5%. • This buffer must be held in tangible common equity capital.
• This would effectively mean that new minimum capital requirements increase to 7%. • The banks would be able to dip into the proposed capital buffer during stress periods to adhere to the minimum requirement on core capital. • The bank would also be held back from making discretionary payments such as dividends and bonuses.
Qualitative impacts of the Basel 3 proposal Impact on Individual Banks • Weaker Banks crowded out as they will find it more difficult to raise the required capital and funding leading to a reduction in different business models and potentially in competition.
•Significant pressure on ROE and profitability
Impact on the financial system •Reduced risk of a systemic banking crisis due to enhanced capital and liquidity buffers •Reduced lending capacity due to the significant increases in the capital and liquidity requirements
•Change in demand from short term to long term funding due to introduction of two intensive liquidity ratios
•Reduced investor appetite for bank debt and equity as the dividends are likely to be reduced to allow firms to re-build capital bases
•Legal entity reorganization due to increased supervisory focus on local capitalisation and local funding, matched with the treatment of investments
•Inconsistent implementation of the Basel 3 proposals leading to international arbitrage which will be due to different ways of implementation of Basel 3 by different jurisdictions
What are Banks doing to mitigate the risk? Improving the performance of existing assessment methodologies in internal ratings based credit risk approach and internal models market risk approaches • The increased capital ratios in Basel 3 will amplify any inefficiency in existing internal modelling approaches to determining credit risk and market risk RWAs. Firms can therefore benefit from a thorough review of current methods and any associated conservatism
Legal entity reorganisation to optimise impact of capital deductions • Changes to the treatment of minority interests and investments in financial institutions within the definition of capital may encourage firms to withdraw from certain entities, dispose of certain stakes or buy-out minority interest positions to optimise the capital calculation.
Active balance sheet management and hedging strategies • Pressure on bank capital has driven investment in active capital management and active portfolio management, as banks review existing trades and consider how external protection, re-structuring into other entities, or development of structured vehicles with investment from external third party capital may help in minimising or hedging counterparty and market risk exposure.
Redesign of business model and portfolio focus • Some types of business (particularly in the trading book) will see significant increases in RWAs and therefore capital. Firms will continue to review portfolio strategy and exit or re-price certain areas of business which become unattractive on a returns basis.
Reasons for delay in adoption of Basel 3 by India Banks are expected to raise significant amount of equity or eligible capital once Basel III comes : The capital required, and, particularly, the equity component has become much larger. While the minimum CRAR remains at 8 per cent, the equity component has been raised from 2 per cent to 4.5 per cent. In addition, there is a capital conservation buffer of 2.5 per cent composed of equity. Effectively, therefore, the equity component in capital stands raised from 2 per cent to 7 per cent. In addition, two more capital components, fully composed of equity, have also been prescribed • The immediate concern is of meeting a much higher level of equity component i.e. 7 %.
The Quantitative Impact Study published in December 2010 by BCBS of 91 large banks (including 3 from India) showed a shortfall of Euro 165 bn and Euro 577 bn in equity component vis-à-vis 4.5 per cent and 7 per cent ratios, respectively.
• This is one of the reasons for an extended timeframe for implementation of Basel III from January 1, 2013 to January 1, 2019. • The other reason is to cushion the slowdown in the GDP growth during the transition period on account of much larger capital requirements.
RBI and banks would be estimating the capital requirements under Basel III once the guidelines for implementation of Basel III are finalised. • As the capital requirements, both equity and non equity, are likely to be substantial, there will, likely, be pressure on financial markets, increasing the cost of capital and lowering RoE. Government will have to find resources to infuse capital in the Public Sector Banks. Pro-cyclicality :The Basel III package includes capital buffers to contain the procyclicality of the financial sector. • Building capital buffers will entail additional costs for banks with consequent implications for investment and hence for overall growth. Apart from the general concern in this regard, in India there is an additional concern about the variable used to calibrate the countercyclical capital buffer. Credit to GDP ratio is put forward as a natural candidate for this calibration. It is not clear that this will be an appropriate indicator in the Indian context. Increasing NPA in PSU banks means higher capital requirements, hence more capital from markets.
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KPMG Report, December 2010, “Basel 3: Pressure is building” PWC Report, “Basel II Pillar 3: Challenges for banks” KPMG Report, April 2011, “Basel 3: Time for Banks to engage” Shearman & Sterling, March 2011, “The New Basel III Framework: Implications for Banking Organizations” http://www.dnaindia.com/money/report_proposed-basel-iii-rulesnot-to-impact-indian-banks-much_1434990 http://www.adbi.org/workingpaper/2011/08/04/4673.financial.regulatory.frameworks.india/imp act.of.the.basel.iii.norms.on.the.indian.banking.system/ http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?id=539 http://www.business-standard.com/india/news/rbi-to-issueguidelines-for-basel-iii-implementation/145522/
