N S Vishwanathan: Basel III implementation - challenges for Indian
banking system
Inaugural address delivered by Mr N S Vishwanathan, Executive Director of the Reserve
Bank of India, on the occasion of the National Conference on "BASEL III Implementation:
Challenges for Indian banking system", organised by The Associated Chambers of
Commerce & Industry of India with support of National Institute of Bank Management
(NIBM), Mumbai, 31 August 2015.
* * *
Assistance provided by Mr. Ajay Kumar Choudhary and Mr Rajnish Kumar in preparing this speech is gratefully
acknowledged.
Accompanying charts can be found at the end of the speech.
1. I am indeed privileged to be sharing the dais with stalwarts and thank ASSOCHAM for
giving me this opportunity to speak on challenges in implementing Basel III in India.
2. Basel III framework was basically the response of the global banking regulators to deal
with the factors, more specifically those relating to the banking system that led to the global
economic crisis or the great recession. In the advanced economies, there was a huge fiscal
cost for protecting the financial system, which those governments did not want a repeat of.
The framework therefore sought to increase the capital and improve the quality thereof to
enhance the loss absorption capacity and resilience of the banks, brought in a leverage ratio
to contain balance sheet expansion in relation to capital, introduced measures to ensure
sound liquidity risk management framework in the form of liquidity coverage ratio (LCR) and
net stable funding ratio (NSFR), modified provisioning norms and of course enhanced
disclosure requirements.
3. In India, Basel III capital regulation has been implemented from April 1, 2013 in phases
and it will be fully implemented as on March 31, 2019. Further, we have also introduced
Basel III Liquidity Coverage Ratio (LCR) to be implemented by banks in India from January
1, 2015 with full implementation being effective from January 1, 2019. We have issued draft
guidelines on implementation of Net Stable Funding Ratio (NSFR). We are also working on
other areas of evolving regulations, especially those which are of critical importance from
Indian perspective.
4. As this event is on challenges in implementing Basel III let me begin with the assumption
that there are challenges. Any change, big or small, of whatever nature brings with it
challenges. The issue one must look at is whether the challenges are as onerous as one
would think them to be and whether the challenges are worth facing up to.
5. The first element in this debate was whether we needed Basel III at all for a country like
India. On this, Dr. Subba Rao, the then Governor of RBI1 made an interesting point and I
quote him:
"One view, although not explicitly spelt out in that form, is that India need not
adopt Basel III, or should adopt only a diluted version of it, so as to balance the
benefits against the putative costs. To buttress this view, it is argued that Basel III
is designed as a corrective for advanced economy banks which had gone astray,
oftentimes taking advantage of regulatory gaps and regulatory looseness, and
that Indian banks which remained sound through the crisis should not be
burdened with the "onerous" obligations of Basel III.
The Reserve Bank does not agree with this view. Our position is that India should
transit to Basel III because of several reasons. By far the most important reason
is that as India integrates with the rest of the world, as increasingly Indian banks
go abroad and foreign banks come on to our shores, we cannot afford to have a
regulatory deviation from global standards. Any deviation will hurt us both by way
of perception and also in actual practice.
The "perception" of a lower standard regulatory regime will put Indian banks at a
disadvantage in global competition, especially because the implementation of
Basel III is subject to a "peer group" review whose findings will be in the public
domain.
Deviation from Basel III will also hurt us in actual practice. We have to recognize
that Basel III provides for improved risk management systems in banks. It is
important that Indian banks have the cushion afforded by these risk management
systems to withstand shocks from external systems, especially as they deepen
their links with the global financial system going forward."
6. Once we take this postulate for granted, and in fact it needs to be, let us see what the
challenges are:
Capital
What are the factors that lead to higher capital?
7. The first set of Basel III reforms agreed in later part of 2010 tackled the issue of numerator
part of regulatory capital ratio. While minimum total capital requirements were kept
unchanged at 8% of the RWA, the definition of various components of capital and its
composition were thoroughly revised to ensure that capital performs its intended role of loss
absorption. The minimum common equity requirement was raised from 2% level, before the
application of regulatory adjustments, to 4.5% after the application of stricter adjustments.
This meant that common equity requirement was effectively raised from 1% to 4.5%. The
Tier 1 capital, which includes common equity and other qualifying financial instruments
based on stricter criteria, was increased from 4% to 6%. It has also been agreed that there
would be a capital conservation buffer of 2.5% above the regulatory minimum requirement to
be met with common equity. This effectively increases the total capital requirements from
present 8% to 10.5%. In our case, the level of capital increases from 9% to 11.5%, if capital
conservation buffer is taken into account. In this context, it may be pertinent to note that
postcrisis, major banks in advanced economies have raised their capital adequacy level
significantly. In general, globally banks have raised their CET1 ratio by almost 400 bps
during last four years. And importantly, this is mainly by way of fresh infusion of equity
capital. A comparative capital position of major Indian banks vis-à-vis major global banks as
indicated in graph 1.
As may be appreciated, capital levels of our banking system need to go up significantly if our
major banks have to compete globally. During recent years, the capacity of banks
specifically, for the PSBs to generate capital internally have adversely affected mainly due to
sharp deterioration in the asset quality. At the same time, banks have not made concerted
efforts to shore up their capital level outside of the usual budgetary support. After the
phased-in implementation of Basel III, the RBI apprised the Government of India on the need
to initiate appropriate measures to ensure that PSBs have plans and a well-defined strategy
for meeting the capital requirements from a medium-term perspective. In this context, it is
heartening to note that Government has initiated several measures such as allowing PSBs to
access market to raise capital subject to ensuring minimum shareholding of the Government
of 52% and recent unleashing of a plan for revamping PSBs called "Indra dhanush" These
measures show the intent and commitment of Government to provide additional budgetary
support to these banks to ensure that PSBs remain adequately capitalized to support
economic growth. The improvement in the equity capital and all other measures taken
together may also facilitate raising non-equity capital (AT1 and Tier 2), as the markets /
investors would be more receptive to those banks holding a higher level of common equity.
8. The second element in the capital framework is the leverage ratio. We have advised banks
that they would be monitored on a leverage ratio of 4.5%. We are watching this closely.
Leverage ratio generally does not adjust the assets for risk weights and therefore would need
the required capital for a given balance sheet. We have seen on the basis of the RW profile
of banks that the leverage ratio is not acting as the binding factor for most banks in India.
The graph 2 shows the interaction between Tier 1 leverage ratios (horizontal axis) and Tier 1
risk-based capital ratios (vertical axis) of domestic banks. The diagonal line represents the
points where the Tier 1 capital requirements would remain the same for meeting both the
ratios. Therefore, for banks above the diagonal line, the leverage ratio requires more capital
than risk-based capital ratio and vice-versa.
To ensure that the leverage ratio acts as a credible back-stop measure, the Reserve Bank
would continue to monitor the leverage ratio behaviour of Indian banks and also the
developments of other related regulatory framework before finalizing the appropriate level of
leverage ratio for Indian banks.
9. Another element that could lead to higher capital is the changes in the Risk Weighted
Assets, more specifically, on account of proposed revisions to the standardised approaches
for risk measurements. The BCBS intends to avoid reliance on credit ratings for determining
risk weights for credit risk given the lessons learnt from the crisis. Although this is work in
progress, under the proposed revised framework, banks would be required to utilise a set of
risk drivers like leverage of the entity, NPAs, etc. to determine the appropriate risk weight.
Similarly, for market risk, there would be a requirement to compute sensitivities (delta,
gamma, etc.) on a deal level for computing RWAs. For measuring counterparty credit risk
(CCR) in the derivatives, both in the OTC and exchange-traded derivatives, the existing
current exposure method (CEM) will be replaced with a revised method called standardised
approach for CCR (SA-CCR). Besides, talks are already underway to review the existing
treatment of sovereign assets under Basel framework wherein exposure to sovereign
requires zero or very little capital charge. These proposals will alter the way banks compute
RWAs. Besides, a new explicit capital charge for interest rate risk for banking book positions
is also proposed to be introduced. Further, specific to the advanced approaches for risk
measurement, the Basel Committee is undertaking a strategic framework review with a view
to enhancing simplicity, reducing complexity and at the same time ensuring that the
framework remains risk sensitive. The Committee would also examine the potential for
interaction amongst various policy prescriptions amongst themselves as well as with the
monetary policy objectives to assess whether there is any potential room for material
inconsistency which may severely undermine the overall objectives.
10. The fourth element impacting capital requirements is provisioning. IFRS 9 requires
provisioning based on expected loss provisions. The BCBS only recently put out a discussion
paper on accounting issues in estimating expected loss.
11. No doubt the new framework will need additional capital. Specific to the PSBs,
Government has announced the infusion of Rs 70000 crore over the next four years. But the
need of the hour is as much for the PSBs to improve their internal processes to enhance
efficiency, optimise the capital allocation and deal with the asset quality issue. There are
several measures internal to banks and they must look at them than just look at the external
factors. A lot can be done to improve credit underwriting, manage the credit post
disbursement and recoveries. There is thus scope for improvement of internal accruals as a
source of capital, and improving efficiency, risk management system and asset quality
management are one of the most important parts of that effort so that external capital is not
required for cleaning up balancer sheets unlike what would be happening now.
12. When capital requirement increases, there is impact on growth. There are varying
estimates of this impact. The Macroeconomic Assessment Group (MAG) established in
February 2010 by Financial Stability Board and Basel Committee on Banking Supervision to
coordinate an assessment of the macroeconomic implications of the Basel Committee's
proposed reforms, estimates that bringing the global common equity capital ratio to a level
that would meet the agreed minimum requirement and the capital conservation buffer would
result in a maximum decline in GDP, relative to baseline forecasts, of 0.22%, which would
occur after 35 quarters. In terms of growth rates, annual growth would be 0.03 percentage
points (or 3 basis points) below its baseline level during this time. This is then followed by a
recovery in GDP towards the baseline. Banks can also respond to the higher capital
requirements by reducing costs or becoming more efficient. In fact a less stable financial
system could have more deleterious consequences. The extent to which the great recession
put global economic growth back is proof enough of this.
Liquidity
13. The second Challenge comes from Liquidity Framework. The global crisis underscored
the importance of liquidity management by banks. The apparently strong banks ran into
difficulties when the interbank wholesale funding market witnessed a seizure. In fact I have
mentioned elsewhere too that for me it is only a matter of time before a liquidity risk
degenerates into a solvency risk for a bank and therefore needs to be avoided. The crisis
proved that and had it not been for central bank support, the crisis toll could have gone
beyond what we saw. The LCR and the NSFR Frameworks basically address this problem.
14. In the Indian context, any discussion on the LCR issue brings to the fore the fact that it
runs parallel to SLR requirement. We have over a period of time reduced SLR and of the
current level of 21.5%, a portion i.e.7 % is available for LCR as well. There is always the
contention that the parallel need to maintain SLR and LCR poses an additional burden on the
banks in India. We are aware of this concern and already communicated our intention to
reduce the SLR requirements in a phased manner. However, there are several factors that
would have to be addressed before we can move further to address the potential overlap.
15. The NSFR framework is draft for consultation. We are looking at the comments received
and will come out with the final guidelines taking into consideration the responses to the
extent we can accommodate them.
Technology
16. The Third challenge is technology. As I mentioned earlier, BCBS is in the process of
making significant changes in standardised approach for computing RWAs for all three risk
areas. These revised standardised approaches them selves will be quite risk sensitive and
will be dependent on a number of computational requirements. Further, BCBS has proposed
that for those banks which are under advanced approaches, RWAs based on standardised
approaches may work as some kind of floor. BCBS is working on calibration of these floors.
Banks may need to upgrade their systems and processes to be able to compute capital
requirements based on revised standardised approach.
Skill development
17. The fourth challenge is skill development. I see this as a requirement both in the
supervised entities and within the Reserve Bank. Implementation of the new capital accord
requires higher specialised skills in banks. In fact it requires a paradigm shift in risk
management. The governance process should recognise this need and make sure that the
supervised entity gears up to it. Risk awareness has to spread bank-wide, the manner of
doing business that measures risk adjusted returns needs to permeate the system. Top
management and the Human Resource Development Policy of banks thus need to get tuned
to this requirement. We in the Reserve Bank also need to hone up our skills in regulating and
supervising banks under the new system. We see this as an ongoing process and are
continuously working towards skill improvement.
Governance
18. One can have the capital, the liquid assets and the infrastructure. But corporate
governance will be the deciding factor in the ability of a bank to meet the challenges. BCBS
has added a separate principle on corporate governance in its core principles for effective
banking supervision which were revised in 2012. It is interesting to note that before 2012,
there was no separate principle on corporate governance. I think global community is
recognising the importance of corporate governance and is trying to fix the issues. Thus
while strong capital gives financial strength, it cannot assure good performance unless
backed by good corporate governance.
Element of conservatism in minimum standards
19. Several speakers mentioned about the super equivalence issue. Let me add my bit to
that discussion before I conclude. There is a general feeling that we have put in place a more
stringent framework than what Basel Norms require. Of course one would point out to the
9 percent CRAR, the 4.5 leverage ratio, the SLR running parallel with LCR, the higher CCF
for OTC derivatives and the like. We need to see this in a context. I have already dealt with
the SLR-LCR issue. On capital, all I can say is that in the ultimate analysis, on an aggregate
basis, it does not make much difference. We must also appreciate that relatively much longer
recovery process of defaulted loans, shorter history of ratings assigned by rating agencies in
Indian conditions putting certain constraint on benchmarking them against the international
standards, relatively large population of unrated borrowers especially in mid and SME
corporate sectors, market risk factors exhibiting more volatilities, etc. add challenges.
Besides, Pillar 2 process and related add-on capital requirements is also yet to be fully
stabilised. The higher prescription of 9% minimum requirements in comparison to Basel
minimum of 8% may be seen in the above context. Moreover, in an economy whose financial
system is dominated by banks, one has to build more resilience than if it were not the case.
We have also announced two banks as DSIBs based on the criteria of size,
interconnectedness, complexity and substitutability.
20. I must add here that the recent Regulatory Consistency Assessment Programme of the
BCBS did find our regulations to be fully compliant on all issues relating to capital. Such an
affirmation that the banks are working in a regulatory environment consistent with global
standards is an assurance to the international financial system that they can do business
with Indian banks like with any other. It would be instructive to quote the BCBS Chairman2
here
"I would like to remind you that the Basel framework is a minimum standard and
members are free to go beyond the minimum. We actually encourage that, and
most jurisdictions have adopted minimum requirements that exceed the global
standard. Super-equivalences are often found in developing and emerging
market economies, where banks have a higher risk profile. The local regulators
therefore set higher minimum requirements".
Incidentally, it may also be appreciated that we are not the only jurisdiction having prescribed
a higher minimum capital standards. Several other jurisdictions, particularly Asian countries,
have proposed higher capital adequacy ratios under Basel III as may be seen from Table.
21. Let me conclude now. I began by saying why it is necessary to implement Basel III in
India. I looked at the various challenges that it brings but argued that we cannot see any
challenge in isolation. The Basel rules seek to make banks more resilient and risk aware.
Such a banking system is always better than an unstable one. We cannot overlook the fact
that a crisis is better prevented than faced because the aftermath of the crisis is costlier than
the incremental cost that one incurs to prevent it. I suppose the deliberations in today's meet
would not be oblivious to this reality.
Let me thank you for your attention.
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