COMMENTARY

Economic & Political Weekly EPW august 31, 2013 vol xlviii no 35 17

Cost of Implementing Basel III

Subhasish Roy

The views expressed here are personal and not those of the bank.

Subhasish Roy (s.roy@idbi.co.in) is Deputy General Manager, Risk Department, IDBI Bank.

Implementing Basel III will increase government borrowing which may worsen the country’s fi scal situation, and could curtail bank credit. But Basel III is expected to provide a more stable banking system and help Indian banks compete globally through improved risk-management systems. This article proposes a strategy to minimise the pain of implementing the framework in India.

The Basel Committee on Banking Supervision (BCBS) that was set up in 1974 by a group of central

bank governors has been setting stand-ards since 1988 when the Basel I accord was signed. It emphasised the importance of adequate capital by categorising it into two – tier I (core capital) and tier II (supplementary capital). The accord re-quired banks to hold a capital equivalent to 8% of risk-weighted value of assets. Though Basel I was adopted by many countries, it had a number of fl aws. For instance, it was risk insensitive, it did not differentiate between credit risk and other types of risk, and it could easily be circumvented by regulatory arbitrage.

1 Origin of Basel II

To address these limitations, the BCBS formalised Basel II in 1999 in a consulta-tive paper, and a fi nal version of the new capital adequacy framework was released in 2004. The important features of Basel II were the following:• It aimed to align banks’ capital with their basic risk profi les and give impetus to the development of sound risk management.• The capital framework was built on three naturally reinforcing pillars. The fi rst covered regulatory capital for credit risk, market risk and operational risk. The second addressed the need of an effective supervisory review by allowing supervisors to evaluate a bank’s assessment of its own risk to determine whether it was reasonable. It thus provided implicit incentives to banks to develop their own internal models for risk evaluation. The third provided effective market discipline through greater disclosure by banks. • It addressed the issues emerging from the divergence of regulatory capital requirements and accurate economic capital calculations.

1.1 Cost of Basel II

Compared to Basel I, Basel II was highly complex, more risk sensitive, and com-prehensive. So, effective implementation

of Basel II depended on the availability of reliable, accurate and timely data, which implied more cost. In Basel II, the capital calculation was to be based on credit risk, market risk and operational risk. Due to the different calculation, the capital re-quirement in credit risk alone was higher compared to Basel I. Taking together all three risks – credit, market and operational – the total capital charge for Basel II was much higher than Basel I. Apart from the cost of higher capital, the compliance cost in Basel II was very high on account of the data, modelling, and compliance burden. The Centre for the Study of Fi-nancial Innovation (CSFI) mentioned in one of its reports that the cost of Basel II implementation in Europe was estimated to exceed $15 million. In India, to the best of my knowledge, no exclusive study has been made on the cost of compliance, but according to Reserve Bank of India (RBI) estimates, the cost of equity capital requirements was Rs 670-725 billion.

1.2 Origin of Basel III

Some of the major causes of the 2008 global fi nancial crisis were excess li-quidity, too much leverage, too little capital, and inadequate liquidity buffers. In addition, there were shortcomings in risk management, corporate governance, market transparency, and quality of supervision. This pointed to systemic loop-holes in the Basel II framework, which was considered to have a more risk-sensitive approach compared to Basel I’s “one-size-fi ts-all” approach.

The main shortcoming of Basel II was that in good times, when banks were performing well and the market was willing to invest capital in them, there were no signifi cant additional capital re-quirements. But, in diffi cult times, when banks needed more capital, the market was averse to investing capital in them. This affected many international banks, and the vicious cycle infl uenced the global fi nancial market, ultimately leading to the failure of many banks. The Basel Committee introduced a comprehensive reforms package through the Basel III framework to address both fi rm-specifi c and broader systemic risk. Learning lessons from the crisis, its aim was to minimise the probability of such a crisis

COMMENTARY

august 31, 2013 vol xlviii no 35 EPW Economic & Political Weekly18

recurring. The objectives improve the shock-absorbing capacity of each bank as the fi rst line of defence. Interestingly, Basel III does not replace Basel II, but is an enhancement of it. The enhancements of Basel III are mainly in four broad areas – (i) an increase in the level and quality of capital; (ii) an introduction of liqui dity standards; (iii) modifi cations in provisioning norms; and (iv) better and more transparent comprehensive disclosures. The details of the proposed Basel III norms as prescribed by the RBI are in Table 1.

Though Basel III has a superior approach to Basel II in terms of both systemic and bank-specifi c risk, its cost of implemen-tation will be much higher. Apart from the additional cost of net equity capital (difference between capital requirements under Basel III and Basel II) of around Rs 930 to Rs 1,025 billion, as estimated by the RBI, there will be some other costs to the economy.

2 Cost to the Economy

2.1 Higher Fiscal Defi cit

In India now, the common equity ratio of most banks falls in the range of 6% to 10%. In my opinion, banks may be able to comply with the higher capital require-ment as per Basel III norms at least until fi nancial year (FY) 2015 without infusing fresh equity, even taking into account the marginal increase in capital requirement due to pressure on return on equity (ROE). However, with increasing minimum capital ratios and loan growth outpacing internal capital generation in most public sector banks (PSBs), the shortfall of capital will mount between 2015-16 and 2017-18, mainly due to introduction of a capital conservation buffer (CCB). Some PSBs are likely to fall short of the revised core capital

adequacy requirement and will depend on government support to augment it. As around 70% of the banks in India are in the public sector, capital requirements will be more from PSBs. The additional equity capital requirement in PSBs under Basel III norms in the next fi ve years works out to around Rs 1,400-1,500 bil-lion (Table 2). The government being the major shareholder in PSBs, the main burden will be on it. The degree of the government’s fi nancial burden will de-pend on the degree of recapitalisation by the government to these banks. If the government maintains the existing share-holding pattern, its recapitalisation bur-den will be around Rs 900-1,000 billion.

Based on the estimated fi gures in Table 2, if one assumes the government continues with the existing shareholding,

its total fi nancial burden will be around Rs 910 billion (1.10% of gross domestic product; GDP) in the next fi ve years. This is expected to increase government bor-rowing requirements per year to around Rs 182 billion.

As shown in Figure 1, during the period FY 2005 to FY 2012 there was a strong positive correlation (value of R has been worked out at 0.93) between government borrowing and fi scal defi cit (FD). Con-sidering this trend, it is expected that higher government borrowing will push up the country’s FD in the future as well.

2.1.1 Estimation of Fiscal Defi cit

Considering GDP at a factor cost of Rs 82,326.52 billion in FY 2012 and a per year government borrowing requirement of Rs 182 billion (mainly due to Basel III implementation), India’s FD is expected to increase by 22 bps each year. While calculating this fi gure, the following as-sumptions have been made.(i) The government’s other borrowing requirements will not increase signifi cantly in the next fi ve years even after the Kelkar Committee’s tax/GDP ratio, growth of dis-investment receipts, and subsidies.(ii) As per the Kelkar Committee report and the latest budget estimates, India’s

Table 1: Proposed BASEL III Norms for Banks as Per RBI (%) 13 April 14 March 15 March 16 March 17 March 18 March

(a) Minimum common equity 4.50 5.0 5.5 5.5 5.5 5.5

(b) Capital conservation buffer (CCB) 0 0 0.6 1.3 1.9 2.5

(c) Minimum core equity (a + b) 4.5 5.0 6.1 6.8 7.4 8.0

(d) Additional Tier 1 capital 1.5 1.5 1.5 1.5 1.5 1.5

(e) Min Tier 1 capital (a + d) 6.0 6.5 7.0 7.0 7.0 7.0

(f) Tier 2 capital 3.0 2.5 2 2 2 2

(g) Minimum total capital (e + f) 9.0 9.0 9.0 9.0 9.0 9.0

(h) Minimum total capital (g+b) including CCB 9.0 9.0 9.6 10.3 10.9 11.5

(i) Counter cyclical buffer * NA NA NA NA NA NA

(J) Minimum total capital (h+i) 9.0 9.0 9.6 10.3 10.9 11.5

* Operational guidelines will be issued separately.Source: RBI.

Table 2: Estimated Equity Capital Requirements for Indian Banks under Basel III (Rs billion) Public Private Total Sector Banks Sector Banks

(A) Additional equity capital requirements under Basel III 1,400-1,500 200-250 1,600-1,750

(B) Additional equity capital requirements under Basel II 650-700 20-25 670-725

(C) Net equity capital requirements under Basel III (A-B) 750-800 180-225 930-1,025

(D) Of additional equity capital requirements under Basel III for public sector banks (A)

Government share (if present shareholding pattern is maintained) 880-910 – –

Government share (if shareholding is brought down to 51%) 660-690 – –

Market share (if the government’s shareholding pattern is maintained at present level) 520-590 –

Assumes risk-weighted asset growth of 20% per annum, and that internal accruals will be around 1% of risk-weighted assets.Source: RBI.

3.9 4

3.3

6 6.5

4.9

5.9

2.5

9.3

4.8

6.5

8.4 8.4

6.7 7

9.5 9.6

5.15

6.71

3.16 3.28 4.71

4.01

6.51

Figure 1: Government Borrowing and Fiscal Deficit (2005-12)7

6

5

4

3

2

1

0

Source: RBI and CMIE.

- 12

- 10

- 8

- 6

- 4

- 2

- 0 | | | | | | | | | |

Fiscal deficit

GDP

Government borrowing

2005 2006 2007 2008 2009 2010 2011 2012

COMMENTARY

Economic & Political Weekly EPW august 31, 2013 vol xlviii no 35 19

FD is estimated at 5.3% in FY 2013, 4.8% in FY 2014, and 3.9% in FY 2015. It is esti-mated to be 3% by FY 2017. (iii) India’s GDP will grow around 5.5% to 8% per annum in the next fi ve years, considering the current estimates of the RBI and targeted growth of 8% by 2015.

Based on the above assumptions and taking into account the 22 bps increase in FD per annum, it is predicted that India’s FD in FY 2017 will be above the government’s medium-term target of 3% (Table 3). It may be mentioned that if there is a delay in recovery of the world growth rate and actual growth of tax revenue and disinvestment receipts are lower than the projected fi gure, India’s FD will be much higher than 3.22% by 2017. In addition, if banks’ provisions in-crease and profi tability falls in the next fi ve years, it will increase the requirement of capital, which will further increase the country’s FD.

According to the data for the period 2005 to 2012, FD had a negative correla-tion (value of R has been worked out at -0.62) with GDP growth (Figure 1). Based on the past trend, it may be said that a higher FD could dampen future savings, investments, and GDP growth.

In the neoclassical and Keynesian views, higher FD pushes up interest rates, and this is seen in India during the period FY 2008 to FY 2013 (estimated), where FD has exhibited a positive corre-lation with long-term deposit rates (LTDR) (with a one-year lag) (Figure 2). Consid-ering this, it can be said that due to rising LTDR, banks’ average lending rates will also show an upward movement with some lag effect, which may also affect India’s credit growth and thereby the growth of the economy.

2.2 Lower Credit Offtake

To meet the new norms, a signifi cant number of public and private sector banks will have to raise capital from

Table 3: Estimates of Fiscal Deficit (2013 to 2017) FY 2013 FY 2014 FY 2015 FY 2017

FD (%) projected by the government 5.3 4.80 3.90 3.0

Estimated FD after full recapitalisation of PSBs due to Basel III 5.3 5.02 4.12 3.22Source: RBI

the market, which will further push up the interest rate. This will mean higher cost of capi-tal and lower return on equity. According to a CARE study, return on equity is expected to fall by around 80-100 bps for every 1% in-crease in common equity ratio. Consid-ering this, banks whose core equity ra-tios are low are expected to have pres-sure on return on equity in the range of 100 bps to 200 bps (Table 4).

Pressure on return on equity will be more on PSBs, whose core equity ratio in general is much lower than private

sector banks. Given that about 70% of the banks are in the public sector, the ef-fect on profi t of the banking sector could be signifi cant. To compensate for the re-turn on equity loss, banks may increase their lending rates. Further, with rising

effective cost of capital, the relative immo-bility displayed by Indian banks on raising fresh capital is also likely to directly affect credit offtake in the long run. In addition, on account of the introduction of a li-quidity coverage ratio (LCR) in Basel III, banks need to keep more funds in liquid assets (mostly government securities), which may crowd out private sector in-vestments and thereby affect the country’s growth. The credit offtake, which has declined in FY 2012 compared to FY 2011, may come down further. Thus consider-ing the positive correlation between GDP growth and credit offtake (Figure 3), it

may be said that GDP growth (Q2 of FY 2013), which is lower at 5.3, is expected to come down further in the future.

From the above, it is evident that implementing Basel III will increase gov-ernment borrowing, which may worsen

Table 4: Core Equity Ratio and Capital Adequacy Ratio (as on 31 March 2012) Core Equity Capital Adequacy Ratio Ratio

Total public sector banks (%) 7.8 13.36

Total private sector banks (%) 11.5 14.82

Source : CARE and IBA.

Figure 2: Fiscal Deficit and Long-Term Deposit Rates (2008 to 2013)

Source: RBI and CMIE.

2.5

6 6.5

4.9 5.9

6.15

8.5 9

8.5 7.75

8.75 9.25

Fiscal deficit LTDR (1 year lag)

2008 2009 2010 2011 2012 2013

10

8

6

4

2

0

Figure 3: GDP Growth and Credit Offtake

Source: RBI and CMIE.

45

35

25

15

5

0

6.5

26.7

39.6

6.7 9.3 9.6 9.5 7 8.4 8.4

28.5

23 17.8 17.1

21.3

16.8

1 2 3 4 5 6 7 8

Credit Offtake

GDP

CorrigendumAB Bank Limited

Balance Sheet and Schedule to Balance Sheet as on 31st March, 2013 for AB Bank Limited published in the edition of June 29-July 6, 2013, Vol XLVIII, Nos 26 & 27.

In the Balance Sheet as on 31st March 2013, page 368

(1) Contingent Liability - Schedule 12, the amount of “Rs 217,634,498” may be read as “Rs 329,902,748”.

In the Schedules Forming Part of Balance Sheet, page 370

(1) “Schedule 12: Contingent Liabilities: (IV) Other items for which the Bank is contingently liable – Rs 1,421,681,439” may be read as: “(IV) Other items for which the Bank is contingently liable – Forward Contracts – Rs 112,268,250”(2) Amount appearing in “TOTAL – Rs 1,639,315,937” may be read as “Rs 329,902,748”.

COMMENTARY

august 31, 2013 vol xlviii no 35 EPW Economic & Political Weekly20

the country’s fi scal situation. In addition, due to higher lending rates and crowding out of private investments, India’s growth may be severely affected as it needs more credit to achieve a higher growth path at this crucial juncture. More credit is re-quired to (i) shift the Indian economy from services to manufacture where the credit intensity is higher per unit of GDP than that for services; (ii) to double its investments in infrastructure; and (iii) to implement the government’s and RBI’s goal of fi nancial inclusion.

3 Proposed Strategy

Considering the high cost of implement-ing Basel III and its probable impact on the Indian economy and fi nances of the government, the following steps may be adopted. (1) The date of implementing a minimum common equity for PSBs could be post-poned by at least two or even three years. This is because minimum tier I capital is already much higher in private and foreign banks compared to PSBs. In the case of PSBs, the principal owner and shareholder is the government, and these banks are much more controlled. Further, in India, the playing fi eld of private banks and PSBs is not the same. Apart from normal banking business, PSBs have to comply with government directives on waiver schemes for farmers, fi nancial inclusion, directed lending, and so on. These are not so stringent for private players. Hence this move will soften the government’s burden of allocating additional amounts for capital in the immediate future, and also give some relief to PSBs to protect their profi t margin by not having any addi-tional pressure on return on equity. (2) As per Basel norms, the requirement of capital is linked to the risk-weighted assets growth of a bank. In the case of private sector banks, the capability of raising capital in Basel III is to be met by their shareholders on the basis of the perform-ance of each bank’s share price, which refl ects the bank’s profi tability. In the equity market, investors will put money on more profi table banks to maximise their earnings. However, in the case of PSBs, there are no specifi c criteria for allocat-ing capital to them. In the current set-up, a major portion of capital is allocated by

the government to PSBs based on its shareholding pattern. In this, all the banks, whether their asset books are growing at a desired rate or not and whether their return on equity is high or not, are equally eligible for capital from the government.

To recapitalise PSBs, the government has to raise around Rs 910 billion in the next few years. As capital is scarce, and the government has to borrow at a market rate without getting a proportionate return, it is important that there be specifi c criteria to allocate capital to these banks. In my opinion, allocation of capital needs to be based on two factors – asset growth, and the risk profi le of banks. The risk profi le is to be calculated taking into account the various categories of risk such as credit risk, market risk, liquidity risk, compliance risk, opera-tional risk, and earning at risk. To quan-tify the risk in each area, suitable risk parameters need to be fi xed. Based on this, the government needs to monitor the combined risk profi le of banks.

Banks that grow at the target growth rate (fi xed by the government) and whose risk profi le is below a predeter-mined trigger level will be eligible for getting the full amount of their capital. The others will get proportionately less capital. This mechanism will incenti-vise banks to grow at a desired level with a lower risk profi le, and penalise those that do not. With higher growth and a lower risk profi le, the fi nancial performance of PSBs will improve, which in turn will improve their return

on equity and share price. The govern-ment being the major shareholder, this will increase its earning.

4 Conclusion

Basel III implementation has some cost to the Indian economy in the short run. Though Indian banks remained sound through the fi nancial crisis, India is a part of the global economy and cannot fully deviate from Basel III norms. As Basel III is expected to provide a stronger and more stable banking system, it will in the long run help Indian banks compete globally through improved risk-management sys-tems. If one compares the cost of bank failure without the new framework to the cost of implementing it, it would be wise to implement Basel III in India after incorpo-rating the two measures suggested above.

References

Basel Committee on Banking Supervision (2010): “Basel Committee’s Response to the Financial Crisis: Report to the G20”, Bank for International Settlements, Basel.

Ministry of Finance (2012): “Report of the Commit-tee on Roadmap for Fiscal Consolidation (Kelkar Committee)”, Available at http://fi nmin.nic.in/reports/Kelkar_ Committee_ Report.pdf

Rangarajan, C and D K Srivastava (2004): “Fiscal Defi cits and Government Debt: Implication for Growth and Stabilisation”, Economic & Political Weekly, Vol 40, No 27.

Reserve Bank of India (2011 and 2012): “Report on Trend and Progress of Banking in India”, 2010-11 and 2011-12, RBI, Mumbai.

Roy, Subhasish (2012): “Tweak Those Basel III Norms”, Financial Express, 10 October.

Subbarao, D (2012): “Basel III in International and Indian Contexts: Ten Questions We Should Know the Answers For”, Inaugural Address at the An-nual FICCI-IBA Banking Conference, Mumbai, 4 September, available at http://www. bis.org/review/r120904b.pdf

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