Basel III Advent,Risks Attached and Need for Basel IV

CRM Assignment-1
Abhay Thakur 111/2011 10/8/2012

Submitted by :Abhay Thakur(111/2011)

Advent of BASEL III There were some shortcomings in Basel II which were exposed during the 2008 crisis. The tier 1 capital requirement of 4 % of risk weighted assets under Basel II was inadequate to withstand the huge losses incurred by banks and the responsibility of assessment of counterparty risk was given to credit rating agencies which proved to be vulnerable. The financial institutions which repackaged their loans into asset backed securities through the process of securitization were able to move them off their balance sheet, thus reducing the risk-weighting of assets. The process was detrimental for the health of the banking system as it enabled banks to increase leverage, take higher risks and also reduced the capital requirement. This led to the formulation and adaptation of BASEL III norms. The additional requirements of the proposed Basel III norm over the current RBI norms are as follows Current requirement of common equity will increase from 2% to 4.5%. Also 2 additional buffers are introduced in Basel III known as Capital conservation buffer and countercyclical buffer. Capital conservation buffer is a reserve buffer of 2.5% of risk weighted assets which would be useful for banks in periods of stress. Also once the capital conservation buffer is accessed there will be restrictions on the use of internally generated like earnings to pay out dividends etc. Counter-cyclical buffer is meant for protecting the banks out of the risks rising out of excessive lending. This buffer could be 0-2.5% depending on the credit/GDP ratio. In periods of high credit growth the size of the buffer would increase which would be used during periods of low credit growth. Thus the requirement of core Tier1 capital has moved to 79.5%. This massive change has come about because of insufficient capital of banks to withstand the 2008 crisis. The increase in the core capital will ensure that the banks are more resilient to stress. The total Tier 1 requirement is 8.5-11% against the current norm of 6% and the total capital requirement is 10.5-13% from the current norm of 9%. Basel III also requires banks to keep sufficient stock of high quality liquid assets to manage short term financial stress. Basel III requires a leverage ratio of 3%, i.e.Tier-1 capital of at least 3% of total assets without risk weighting. Basel III will be effective from 1st January 2013 and would be implemented in a phased manner till March, 2018.The requirement of core Tier 1 capital of 4.5 % needs to be fulfilled by 2015 while the additional requirement of capital conservation buffer requirement needs to be met by 2018.

Submitted by :Abhay Thakur(111/2011)

Risks Attached Liquidity Risk:-Basel III requires a high level of liquidity to be maintained through a pool of unencumbered liquid assets. While Indian banks maintain a large pool of liquid assets in compliance with the Statutory Liquidity Ratio, they may not technically qualify as liquid assets under Basel III as these are not freely available to banks for liquidity purposes. Requiring banks to maintain liquid assets over and above the SLR could put them in a competitively disadvantageous position. Therefore, there is a concern as to what extent the SLR can be reckoned towards Basel III requirements for holding liquid assets. Countercyclical capital While the idea of maintaining countercyclical capital to withstand the impact of vagaries of business cycles is theoretically appealing, its implementation has certain issues. The metric Credit to GDP ratio used by BCBS framework may not be suitable in the Indian context, given our traditionally low Credit to GDP ratio and the structural changes that our economy is experiencing on the back of financial inclusion and relatively high growth. The sectoral approach that we had adopted in the past (i.e. altering the risk weights and provisioning requirement for sectors witnessing very high growth) seems more suitable. Deviations from the Basel framework are permissible in the comply or explain framework. The risk, however is that markets may interpret such deviation as non-compliance. Communication, therefore, during peer group review by Basel Committee as well as with markets assumes great significance. Leverage Ratio Basel III prescribes a leverage ratio (ratio of Tier I capital to book value of assets including off-balance sheet items) as backstop arrangement to supplement the capital adequacy ratio. Since, for Indian banks, the SLR requirements are substantial and carry little risks, these should be kept out of the leverage ratio. However, this was not accepted by BCBS. But the leverage ratio of Indian banks is modest compared to the levels being contemplated.

Implementation challenges in Basel II advanced approaches (skills, technology) While all commercial banks in India have adopted standardised approaches under Basel II by March 2009, the implementation of advanced approaches is under various stages. As the advanced approaches are technology intensive and also require highly skilled workforce, it is going to be challenging for banks going forward. Availability of data for building and testing advanced models and for building scenarios would be another serious challenge. Risk Insights The new rules will affect mostly smaller financial institutions and, as a result, credit conditions for small and medium-sized companies.

Submitted by :Abhay Thakur(111/2011)

Countries such as the US and the UK could adopt tighter regulations than recommended by Basel III, which will impact on the availability of financing in these economies. Non-bank financial institutions, such as investment banks and hedge funds, will play an increasingly active role (as the new provisions do not concern them), raising the risks associated with this sector. New rules on trade financing are likely to result in tighter trade credit conditions, encouraging companies to use less secure instruments. As trade credit conditions tighten, country risk information is set to become even more essential to companies dealing with foreign counterparties. At present, most of the financial groups in India are led by banks and organised under the Bank Subsidiary model. This model, however, puts the onus on the parent bank for corporate governance, performance and capital requirement of the subsidiaries. Besides, the parent carries very substantial reputational risk. The Working Group on Introduction of Holding Company structure in India for banks has recommended migration of major financial conglomerates to the holding company structure to address these limitations to some extent. Necessary legal amendments will have to be put in place for facilitating such migration. Building of countercyclical provisions is prudential measure which goes a long way in strengthening the resilience against the cyclical shocks. BCBS is working on an expected loss-based countercyclical provisioning methodology in consultation with IASB which is likely to take time. In India, banks have a stock of floating provisions which we have not permitted to be used, except under a situation of systemic stress. While the floating provisions may serve the purpose of countercyclical provision, a framework is necessary for allowing its use.

Is India ready for Basel III? Most of the private sector and foreign banks are in a comfortable position since they have a core capital in excess of 9% whereas this is not the case with the public sector banks. According to an ICRA report, public and private sector banks would require an additional capital of 600000 crore, assuming a 20% growth in risk-weighted assets. Out of the total requirement 75-80% will be required by the public sector banks. Thus the burden will fall on the cash-stripped government which will need to infuse massive amount of capital to maintain its shareholding of 58%.This looks difficult to achieve seeing the current state of the government financials with high fiscal deficit of 5.9% in 2011-12 and massive subsidy burden. The government is not in a position to provide the capital nor will it allow other investors to do so because it would reduce the governments grip on public sector banks. The leverage ratio of 3% will not affect the Indian banks much because this is meant for banks with large trading book and exposure to off balance sheet derivatives and Indian banks dont have much exposure to the derivatives market. Liquidity coverage Ratio (LCR) requires

Submitted by :Abhay Thakur(111/2011)

banks to hold enough liquid assets to cover cash outflows during a 30 day stress period. Indian banks are fairly comfortable on this front as well as they hold 24% in government securities in form of SLR(Statutory Liquidity Ratio) and 4.75% in cash in form of CRR(Cash Reserve Ratio) with the RBI. LCR burden would depend on how much CRR and SLR can be offset against LCR. Basel III will also force banks to put a large part of their profit back in the balance sheet as retained earnings rather than distributing dividends. Perpetual debt which is now treated as Tier 1 capital will be excluded under Basel3, putting more pressure in the requirement of core capital. According to ICRA, increase in the core Tier1 capital from 6% to 8% will reduce the return on equity percentage points from 18% to 15%. Public sector banks with core capital less than 7% will be severely impacted whereas the earnings of the private sector banks will not be affected much as they are already well capitalized but would reduce leveraging. Cost of capital for the banks would increase with the increase in equity in the capital structure as equity is an expensive form of capital. As capital costs increase credit will become more expensive. Banks will impose tougher conditions for granting credit to small and medium sized firms and for start-up businesses. Also with deposit rates rising lower than expectations at 14% will put further pressure of credit costs. With the credit becoming costlier the investment activity in the country will be severely impacted thus impacting the economic growth.

Need for Basel IV Basel III does not meaningfully address the issues of systemic risk or moral hazard. Systemic risk can be defined as the risk of collapse of the entire financial system and the related risk of disruption of essential financial services, such as deposit taking and lending to corporations and individuals, leading to massive damage to the real economy. Several factors contribute to the building of systemic risk and while some of them are addressed in BASEL III, others are not and these have to be implemented in BASEL IV: 1. The uniformity of asset holdings is the first factor: if a majority of banks acquires similar types of assets, as with the subprime mortgage crisis, this can threaten the stability of the system. It can lead to asset bubbles that can burst violently and trigger downward price spirals as all banks want to get rid of the same assets at the same time. 2. Interconnectedness is another major factor: if banks are linked to each other through a significant web of contracts then the failure of one bank to honour its obligations will lead to losses at other banks, potentially creating a domino effect that threatens the entire system. 3. The shadow banking system creates additional issues: risks located in unregulated entities cannot be monitored or curbed, and the existence of an unregulated area can incentivise banks to shift some of their assets and activities towards the shadows in order to lower their

Submitted by :Abhay Thakur(111/2011)

capital requirements. Also, as the shadow banking system is strongly interconnected with traditional banks, it can create or amplify domino effects. 4 There is still moral hazard, linked to too big to fail. The current inability to let banks fail is, in our view, a major cause of systemic risk. If a bank should fail, even with higher capital requirements and liquidity buffers, it is still extremely likely that taxpayers money would be used to prevent either a domino effect or a disruption of essential services. Banks do not like to raise capital; they will generally only do it when forced. The fair way to do this is through tough and transparent stress tests; these should be repeated in the US and on a comparable basis in other financial center countries every year. Banks should be required to hold enough capital at the peak of the cycle so that when they suffer losses (and, 2007-2010, US banks lost about 7 percent of their risk-weighted assets, they still have enough capital so that the markets do not think they will fail and therefore there is no need to dump assets in a desperate bid to survive. (Its the forced asset sales of this nature that turn financial distress at particular institutions into broader asset price declines and that can trigger panics.) BASEL IV should point towards at least 15 percent Tier 1 capital being required in good times; the most forward looking officials in G20 countries start to mention aiming for closer to 20 percent. This is what would really help make banks much safer (i.e., thus making banks stock a much less risky investment and reducing the required rate of return for all involved).