Assignment #1 Impact of Basel III proposals in Indian Banks

Highlights of BASEL III Proposals

Guidelines on the implementation of BASEL III Capital Regulations were released by the Reserve Bank of India (RBI) on May 2, 2012. Implementation of these guidelines will begin January 1, 2013 and the process will be completed by March 31, 2018. Below are some of the important points of Basel III proposals that banks will have to take into account:

Banks required to maintain a minimum 5.5% in common equity (as against the current 3.6%) by March 31, 2015

Banks to create a capital conservation buffer (consisting of common equity) of 2.5% by March 31, 2018 Banks to maintain a minimum overall capital adequacy of 11.5% (against the current 9%) by March 31, 2018 Conditions stipulated to increase the loss absorption capacity of banks Additional Tier I; Banks not to issue additional Tier I capital to retail investors Risk-based capital ratios to be supplemented with a leverage ratio of 4.5% during parallel run Banks allowed to add interim profits (subject to conditions) for computation of core capital adequacy Banks to deduct the entire amount of unamortized pension and gratuity liability from common equity Tier I capital for the purpose of capital adequacy ratios from January 1, 2013

Impact of it on Indian Banks

With the introduction of Basel III norms, Indian banks minimum capital requirement, as a proportion of risk-weighted assets, is set to rise in the next six years. This could apply pressure on the return on equity of Indian banks, especially those in the public sector. Given that banks need to have core equity (shareholder funds) in excess of 8 per cent by 2018, the ability to leverage may also be limited going forward.

How are Indian Banks placed? (Both Public & Private)

As of March 2012, the tier-1 ratio of Indian banks is estimated at 9.8 per cent, predominantly driven by high capital levels of private banks which have tier-1 ratio of 11.6 per cent. PSU banks have tier-1 ratio of 9.3 per cent. Private Banks seem to be in a better position than their PSU counterparts for the following reasons:

One, most private banks have tier-1 in excess of 9.5 per cent. In comparison, 14 of the 24 public sector banks have tier-1 ratio of less than 9.5 per cent. More numbers of banks would have had lower tier-1 ratio had the government and LIC not infused capital in a few PSU banks in March 2012. Two, private banks tier-1 capital largely consists of core equity (shareholder funds). While the RBI has estimated that around 15 per cent of the tier-1 ratio of the banking system is not core equity, much of it is held by public sector banks. UCO Bank, Vijaya Bank, Central Bank of India and Bank of Maharashtra are a few banks which hold a higher proportion of non-core tier-1 capital. Three, while it is a given that both public and private banks require equity infusion from time to time, private banks arent constrained to raise equity unlike public sector banks. Public sector banks have limited ability to raise capital since the government would prefer to maintain majority share. Nine out of 21 listed banks (excluding SBIs associates) have government shareholding of less than 60 per cent. Again, a higher fiscal deficit reduces the ability of the

government to infuse capital.

This limited ability of the public sector banks may lead to lower growth in advances which may in turn lower their market shares. Further, according to Basel III requirements, all banks need to deduct unamortized pension liability from tier I capital by January 2013. Nevertheless, all is not lost for public sector banks. There is headroom worth Rs 70,100 crore for public sector banks (even at these valuations) to raise fresh equity (at current prices) and yet maintain 51 per cent of the government holding. A revival in the equity market may play a major role in raising capital. Retained earnings will play an important role in shoring up equity. For instance, in the last four years, listed public sector banks paid Rs 34,000 crore or a little over one-fifth of their profits in the form of dividends. If the banks manage to retain most of their future earnings, this would take care of some proportion of their capital-raising needs.

For all banks which pay dividends, if earnings grow by 10 per cent compounded annually from here on, they can add more than Rs 67,000 crore to core equity by not paying dividends. Additionally, given that these retained funds will also earn returns, the actual benefit may be higher.

Valuation to be impacted: Lower leverage due to these proposals can lead to a lower return on equity and valuation. Growth in earnings may also moderate given the higher equity requirement and lower growth in assets (due to conservation of capital). But, the point to note is that higher equity will make exposure less risky from a creditors point of view. Many rating agencies have pointed out that the Basel III norms are positive in terms of credit rating. This would lower the cost of borrowing in domestic and international markets (given stricter regulations and higher equity contribution than its global peers). The moderation in cost of borrowing may partly offset the decline in ROEs.

Possible Solutions
There are a couple of possible solutions to this problem of compliance to Basel III norms for Public Sector Banks. The first would be to introduce the concept of golden share for Indian Banks as Margaret Thatcher the then Prime Minister of Britain did it in the 1980s for privatizing public sector entities. As a concept golden share means, reducing the stake in a company below 50% but retaining the majority voting rights. It basically delinks voting rights from ownership. So, as a solution the government can take up golden share to retail the voting rights but bring in funds from private players and reduce their stake below 50% in public sector banks. An alternative to this is to create a banking sector holding company in which the Government will hold the majority stake, and the holding company in turn will hold majority stake in public sector banks. This was briefly outlined by the Finance Minister of India in his Union budget speech in March 2012. The Government can raise capital for the banking holding company through various means including a public offering. The modalities of the same are not clear as of now and will have to be closely watched for this to be a success. If implemented successfully this could be the biggest structural change in the Indian banking sector since nationalization in 1969 and 1980.

Looking Ahead

The way in which the Government and public sector banks in India are able to cope with this puzzle will largely shape the banking industry in India in the next five years. As the Banks in India and across the world move to Basel III compliance, the demand for Out of the Box Banking solutions for regulatory reporting and aligning their operations to meet the stringent Basel III norms will grow manifold. And the players that are ahead of the curve will be able to capture the market! References and/or bibliography:

http://www.moneycontrol.com http://www.hedgehogs.net http://www.thehindubusinessline.com http://7economy.com http://www.finextra.com