B Mahapatra: Implications of Basel III for capital, liquidity and
profitability of banks
Address of Mr B Mahapatra, Executive Director of the Reserve Bank of India, at the National
Conference on Emerging Macro Environment, Regulatory Changes and Bank
Competitiveness, organized by the National Institute of Bank Management, Pune, 3 March
2012.
* * *
The contributions made by Shri Rajinder Kumar and Shri Rajnish Kumar are gratefully acknowledged.
It is heartening that the National Institute of Bank Management (NIBM), Pune is organizing a
two-day National Conference on "Emerging Macro Environment, Regulatory Changes and
Bank Competitiveness", today and tomorrow. I am indeed grateful to the NIBM for giving me
this privilege to talk to you today on a topic - Implications of Basel III for Capital, Liquidity
and Profitability of Banks - which is contemporaneous, not only in the financial circles, but
also in the larger space of public policy. My motivation for the talk on this subject is also due
to my job as a bank regulator and my association with the process of policy formulation and
implementation of Basel III for banks in India.
The Context
Let me first set the context for Basel III. Basel III is the regulatory response to the causes and
consequences of the global financial crisis. So, what were the causes of the crisis and the
consequence?
Causes of global financial crisis
From the macroeconomic perspective, the crisis has been attributed to the persistence of
global imbalances. It is often said that the solution to a previous crisis becomes the cause for
the next crisis. You may recall that the previous crisis was the Asian crisis of 1997-98, and
one of the important lessons learnt by the Asian countries was to build a war chest of foreign
exchange reserves to fight against the attack on the country's currency. Therefore, Asia and
in particular, China and some other emerging economies produced goods at a cheaper rate
and pursued a policy of export-led growth and accumulated huge foreign exchange reserves.
As a corollary, the USA and Europe consumed that produce and became net importers. The
foreign exchange reserves accumulated by the Asian and other emerging economies were
necessarily to be invested in advanced economies which have deep markets.
The huge amount of capital that flowed from the emerging economies to the advanced
economies, depressed yields in the financial markets of advanced economies. In the "search
for yield" to improve returns on investment, market players indulged in financial innovation
and engineering. They developed structured financial products like securitization and
re-securitization based on sub-prime mortgage backed securities (MBS), collateralized debt
obligations (CDOs) and CDO squared etc. Credit default swaps (CDS) were also used to
create synthetic structures which increased their illiquidity and complexity. Oblivious of the
inherent risks created by these features, securitizations continued to grow by leaps and
bounds leading to the spiraling of sub-prime lending with impending disastrous
consequences.
Another cause of the crisis was attributed to the socio-economic and political factors in the
USA. Dr. Raghuram Rajan in his book Fault Lines has highlighted that the income of average
American was stagnant for quite some time and poverty and inequality were increasing. The
politicians could not improve the income of the people but devised policies to encourage
them to fulfill the dream of owning a house by taking loans from banks and financial
institutions at the prevailing low interest rates. Thus, the birth of the toxic product "sub-prime
mortgage" took place. It was said if the poor people cannot have income for consumption,
"let them eat credit".
At the micro level, the business models of banks and financial institutions also contributed to
the fermentation of the crisis. The "originate-to-distribute" model of sub-prime mortgages did
not create any incentive for banks for better appraisal and supervision of such mortgages.
Their reliance on wholesale funding markets created gaps in liquidity risk management. Short
term funds were used for creating long term assets. The availability of plenty and cheap
funds encouraged banks to be highly leveraged, that too by borrowing short term funds.
The crisis has also been attributed to the inadequate corporate governance and
inappropriate and perverse incentive system in the financial sector. There were several
weaknesses in corporate governance in the run up to the crisis. Corporate governance
arrangements failed to curb excessive risk taking in banks and financial institutions. Studies
have shown that risk management systems failed in many cases more due to poor corporate
governance than due to the inadequacy of the mathematical models used. The Board and
even senior management, in some cases, failed to establish an informative and responsive
risk measurement and management reporting framework. The institutional arrangements in
many instances conferred importance and status on the risk takers at the expense of
independent risk managers and control personnel. Where strategy was in place, Boards did
not establish suitable metrics to monitor implementation.
Out of the many issues that have arisen in the context of the global crisis, executive pay and
compensation practices in the financial sector have perhaps invoked the maximum public
outrage. There has been wide spread criticism that incentives and pay packages were set
inappropriately, encouraged irresponsible risk taking, were inconsistent with the firm's capital
bases and focused on short-term profit maximization. Compensation for senior executives
has been perceived to be excessive with little correlation to the long term performance of the
institutions concerned. Particularly glaring was the multi-million dollar payments and bonuses
to the executives of failed firms which had received public funding. It is now widely
acknowledged that the flawed incentives framework underlying banks' compensation
structures in the advanced countries fuelled the crisis.
Banks entered the crisis with inadequate capital. The Basel requirement of common equity
was as low as 2% of risk-weighted assets (RWAs). Banks did not calculate the risk-based
capital properly. The Basel capital rules favoured lower capital for the trading book and
higher capital for the banking book. Banks exploited this loophole and parked banking book
assets in the trading book, indulging in capital arbitrage. Similarly, capital requirement for
mortgage loans was higher than capital requirement for mortgaged backed securities (MBS).
This encouraged banks to securitize their mortgage loans through a Special Investment
Vehicle (SIV) set up by them. Banks offered liquidity supports to their own SIVs which
securitized the mortgage loans and enhanced the credit rating of such instruments.
Enhanced ratings require less capital. Banks invested in such products requiring less capital.
Thus, there was an "incestuous" relation in keeping banking book assets in trading book, for
which liquidity support was given by the bank to enhance its rating and reduce capital
requirement.
The growth of "shadow banking" system in the run up to the crisis was unprecedented. One
estimate suggests that the size of shadow banking system was almost three times the formal
banking system. This coupled with their dependence on the wholesale funding market
compounded the crisis.
Supported by unprecedented innovation and engineering, the financial sector became too big
in relation to the real economy, but the regulatory and supervisory system was found
wanting. The regulators and supervisors did not look at system-wide build up of risk. They
reposed faith in free markets and believed in self-correction of market excesses. But that did
not happen. "Leaning against the wind" was considered inappropriate. The credit rating
agencies also did not perform their role as envisaged and junked themselves.
Every banking crisis has some common elements. But every time, experts say, "this time is
different". Then what was different this time? Probably, the phenomenal growth of shadow
banking system, most of which was outside the regulatory purview, and the excessive
dependence of banks and financial institutions on the wholesale funding markets, are the
"different" factors behind this crisis.
At a more philosophical level, what the crisis highlighted was the massive breakdown of trust
- trust in banks, in financial system, in rating agencies, in investment advisers and in
politicians. Trust, which takes time to build up is an important element in the functioning of
financial markets as the very nature of financial contracts requires a high level of trust.
Several questions come to mind in this context during the crisis. Was the behaviour of the
players across the chain of the financial system fair and ethical or was it influenced by the
greed to make quick profits and fat bonuses? Did the bankers and investment advisers
explain the risks in the complex financial products they sold to their clients? And what about
the credit rating agencies? Did they compromise on their standards?
The crisis has triggered an interesting, if also a soul searching debate on the role of
leadership. Leaders at the helm of affairs probably let us down. They were lulled by the
phenomenal success of modern financial engineering and the "great moderation" and got
carried away by "irrational exuberance" and could not see the "black swan".
Consequences of the global financial crisis
The consequences of the crisis are there for all of us to see. What started as a contamination
of sub-prime mortgage loans and the securitized products based on that, led to an illiquidity
spiral and soon became a solvency issue for the financial sector. The inter-connection
between banks in the financial system propagated it into a systemic crisis. Banks, starved of
liquidity, started to deleverage and stopped lending to the real sector. The financial crisis,
thus, became a full-scale economic crisis. Since banks are essential to an economy and their
failure affects the real sector, particularly when they are too big, the public authorities had no
alternative but to rescue the banks by injecting capital, guaranteeing their liabilities and
purchasing their toxic assets. This created the moral hazard issue of "privatization of profits
but socialization of losses".
However, one unintended but interesting aspect of the rescue programme was that
non-equity capital providers to the banks escaped scot free as they were required to absorb
losses only in the event of liquidation of banks and not other-wise.
There are several estimates of the cost of the crisis to the public exchequer. The amount of
support to the systemically important financial institutions (SIFIs) during the crisis was about
25% of GDP. Capital injection and asset purchase for G20 countries was US $ 653 billion or
2.1% of GDP. Fiscal cost of direct support for G20 countries averaged 2.8% of GDP, with
UK at 6.1%, Germany at 4.8% and USA at 3.6%. The Government debt of these countries is
projected to rise by 40% of GDP during 2008-15. Cumulative output loss in these countries
is estimated to about a quarter of their GDP.
Enhancement to Basel II or Introduction of Basel II.5
Post-crisis, the global initiatives to strengthen the financial regulatory system are driven by
the political leadership of the G20 under the auspices of the Financial Stability Board (FSB)
and the Basel Committee on Banking Supervision (BCBS). Immediately after the crisis, the
Basel Committee, in July 2009, came out with certain measures, also called enhancement to
Basel II or Basel II.5, to plug the loopholes in its capital rules which were exploited to
arbitrage capital by parking certain banking book positions in the trading book which required
less capital.
These measures, under Pillar 1, include introduction of an incremental risk charge (IRC) for
specific risk or credit risk in trading book under the Internal Models Approach (IMA). Capital
charge for securitization of commercial real estate was increased and that for
re-securitization introduced. The Value-at-Risk (VaR)-based measure for capital charge for
market risk under IMA has been substantially enhanced by including a stressed-VaR
element. The overall capital requirement for the trading book is expected to rise by about
3 times. Pillar 2 has been strengthened by issuing guidance on firm-wide risk management;
managing reputation risk and liquidity risk; improving valuation practices; and implementing
sound stress testing practices. Appropriate additional disclosures complementing
enhancements in Pillar 1 and 2 have also been introduced.
The Basel III
The Basel Committee published its Basel III rules in December 2010. I propose to discuss
the major features of Basel III in a little more detail. Learning the lessons from the crisis, the
objectives of Basel III are to minimise the probability of recurrence of a crisis of such
magnitude. Towards this end, the Basel III has set its objectives to improve the shock
absorbing capacity of each and every individual bank as the first order of defence and in the
worst case scenario, if it is inevitable that one or a few banks have to fail, Basel III has
measures to ensure that the banking system as a whole does not crumble and its spill-over
impact on the real economy is minimized. Therefore, Basel III will have some
micro-prudential elements so that risk is contained in each individual institution; and a
macro-prudential overlay that will "lean against the wind" to take care of issues relating to the
systemic risk.
Micro-prudential elements of Basel III
The micro-prudential elements of Basel III are (i) definition of capital; (ii) enhancing risk
coverage of capital; (iii) leverage ratio; and (iv) international liquidity framework.
Definition of capital
The existing rules require a capital adequacy ratio of 8% to the RWAs. Rules allow
Tier 1 capital at a minimum of 4% of RWAs and Tier 2 capital comprising of debt instruments
of medium term maturity of at least 5 years at a maximum of 4% of RWAs. Tier 3 capital with
short maturity of at least 2 years can also support Tier 2 capital to some extent. Common
equity in Tier 1 capital can be as low as 2% of RWAs. Innovative features such as step-up
option are allowed in capital instruments. The regulatory adjustments to capital are effected
both at Tier 1 and Tier 2 capital in equal measure.
The existing definition of capital is, thus, flawed. Capital is not only deficient in quality equity
capital, but also contains elements of debt which do not support the bank as a going
concern. As I have stated earlier, big banks entered the crisis with insufficient level and
quality of capital. Under Basel III, Tier 1 capital will be the predominant form of regulatory
capital. It will be minimum 75% of the total capital of 8%, i.e., 6%, as against 4% now, i.e.,
50% of total capital. Within Tier 1 capital, common equity will be the predominant form of
capital. It will be minimum 75% of the Tier 1 capital requirement of 6%, i.e., 4.5%, from the
existing level of 2%. You may observe that the meaning of "predominant" portion of common
equity in Tier 1 capital and Tier 1 capital portion in total capital (Tier 1 plus Tier 2) as
50% under Basel I and II has under gone a change to 75% under Basel III, improving the
overall level of high quality capital in the banks.
To my mind the most revolutionary feature of Basel III in this regard is to ensure that public
sector rescue of non-viable, but still functioning banks, does not entail absorption of losses
by the tax-payers while leaving the non-common equity capital providers unscathed.
Therefore, under Basel III, the terms and conditions of all non-common Tier 1 and
Tier 2 instruments issued by banks will have a provision that requires such instruments, at
the option of the relevant authority, to be either written off or converted into common equity
upon the bank being adjudged by the supervisory authority as having approached or
approaching the point of non-viability.
Additionally, innovative features in non-equity capital instruments are no longer acceptable.
Tier 3 capital has also been completely abolished. The regulatory adjustments or deductions
from capital presently applied at 50% to Tier 1 capital and 50% to Tier 2 capital will now be
100% from the common equity Tier 1 capital. To improve market discipline, all elements of
capital are required to be disclosed along with a detailed reconciliation to the reported
accounts. These requirements will be implemented uniformly across all jurisdictions and the
consistency in application will be ensured by the Basel Committee through a peer review
process.
Thus, the definition of capital in terms of its quality, quantity, consistency and transparency
will improve under Basel III.
Enhancing risk coverage of capital
In view of significant shortcomings noticed in the management and capitalization of
counterparty credit risk, measures have been introduced under Basel III, to strengthen the
capital requirements for counterparty credit exposures arising from banks' OTC derivatives,
repo and securities financing activities. These reforms will raise the capital set against these
exposures, reduce procyclicality and provide additional incentives to move OTC derivative
contracts to central counterparties, thus helping to reduce systemic risk across the financial
system. They also provide incentives to strengthen the risk management of counterparty
credit exposures.
Going forward, banks must determine their capital requirement for counterparty credit risk
using stressed inputs. This will address concerns about capital charges becoming too low
during periods of compressed market volatility and help address procyclicality. Banks will be
subject to a Credit Valuation Adjustment (CVA) capital charge to protect themselves against
the potential mark to market losses associated with deterioration in the creditworthiness of
the counterparty. The CVA is a measure of diminution in the fair value of a derivative position
due to deterioration in the creditworthiness of the counterparty. Standards for collateral
management and initial margining have been strengthened. Banks with large and illiquid
derivative exposures to counterparties will have to apply longer margining periods as a basis
for determining the regulatory capital requirement. Additional standards have been adopted
to strengthen collateral risk management practices.
Thus, the Basel III framework will have enhanced risk coverage. This is necessitated due to
the excessive exposures of banks to derivative products whose risks were not captured
comprehensively under Basel I or Basel II framework.
Leverage ratio
Pre-crisis, the leverage of some of the internationally active banks was at a high level of
about 50 times of the capital, even though such banks complied with capital adequacy
requirement. The risk of leverage, particularly when built up with short term borrowings, and
the consequential impact of deleveraging during periods of stress by withdrawing credit to
the real sector, accentuated the crisis. The Basel Committee has, therefore, introduced a
simple, transparent, non-risk-based leverage ratio as a supplementary "backstop" measure
to the risk-based capital requirements. The leverage ratio has both micro-prudential and
macro-prudential elements. At the micro level, it serves the purpose of containing excessive
risk, as a supplement to the risk-based capital ratio. The risk-based capital ratio does not
capture the risk of excessive leverage on account of having low risk assets. The leverage
ratio as a simple accounting measure will capture that. The Basel Committee has proposed
testing a minimum Tier 1 leverage ratio of 3% (33.33 times) to start with as a
Pillar 2 measure which will eventually be made a Pillar 1 requirement.
International liquidity framework
Despite liquidity being central to the functioning of financial markets in general and banks in
particular, liquidity regulation did not receive adequate attention until recently. There were no
internationally agreed and harmonized liquidity standards. The regulation of banking sector
during the past two decades largely revolved around Basel I and Basel II capital regulations.
Nor were there any international standards to limit excessive maturity mismatch resulting in
increasing proportions of long-dated assets being financed by short-term borrowings. The
financial crisis has highlighted the importance of robust liquidity risk management by banks.
It was observed during the crisis that even those banks which had sufficient capital base had
experienced difficulties due to imprudent liquidity management practices by excessive
dependence on wholesale funding markets. The crisis demonstrated that liquidity and
solvency are quite deeply interrelated. Illiquid banks can become insolvent in no time and
similarly an insolvent bank can become illiquid rapidly.
Basel III has introduced two new liquidity standards to improve the resilience of banks to
liquidity shocks. In the short term, banks will be required to maintain a buffer of highly liquid
securities measured by the Liquidity Coverage Ratio (LCR). This liquidity buffer is intended to
promote resilience to potential liquidity disruptions over a 30-day horizon. It will help ensure
that a global bank has sufficient unencumbered, high-quality liquid assets to offset the net
cash outflows it could encounter under an acute short-term stress scenario of 30 days. The
scenarios may include a significant downgrade of the institution's public credit rating, a partial
loss of deposits, a loss of unsecured wholesale funding, a significant increase in secured
funding haircuts and increases in derivative collateral calls and substantial calls on
contractual and non-contractual off-balance sheet exposures, including committed credit and
liquidity facilities.
Another liquidity risk measure, the Net Stable Funding Ratio (NSFR), requires a minimum
amount of stable sources of funding at a bank relative to the liquidity profiles of the assets, as
well as the potential for contingent liquidity needs arising from off-balance sheet
commitments, over a one-year horizon. The NSFR aims to limit over-reliance on short-term
wholesale funding during times of buoyant market liquidity and encourage better assessment
of liquidity risk across all on- and off-balance sheet items. The objective of the NSFR is to
promote resilience over a longer time horizon by creating additional incentives for banks to
fund their activities with more stable sources of funding on an ongoing basis.
Macro-prudential elements of Basel III
The changes in definition of capital and enhancements of capital requirement for trading
book under Basel II.5 mentioned by me earlier would raise the collective resilience of banks
and would in a way, contribute to reduction in systemic risk. However, in extreme situations
this alone would be inadequate to ensure the financial stability. Therefore, ensuring financial
stability would necessitate specific macro-prudential elements. Basel III seek to address
issues relating to systemic risk through various measures including (i) leverage ratio; (ii)
capital conservation buffer; (iii) countercyclical capital buffer; (iv) addressing procyclicality of
provisioning requirements; (v) addressing interconnectedness; (vi) addressing the
too-big-to-fail problem; and (vii) addressing reliance on external credit rating agencies.
Leverage ratio
The macro-prudential element of leverage ratio under Basel III has the objective of protecting
against system-wide build up of leverage that result in destabilizing unwinding process during
stress. It also protects against perverse incentive to pile on "low risk" assets, which may not
remain as such under extreme situations producing systemic risk.
Capital conservation buffer
Drawing lessons from the crisis that banks were distributing earnings even during periods of
stress, Basel III prescribes that a capital conservation buffer of 2.5% of RWAs, comprising
common equity Tier 1 capital, over and above the minimum common equity requirement of
4.5% and total capital requirement of 8%, needs to be built up outside periods of stress. This
can be drawn down as losses are incurred during periods of stress. When buffers have been
drawn down, banks can build them up either through a reduction in distribution of dividend,
share buyback and staff bonus payments or raising capital from the private sector.
Countercyclical capital buffer
The countercyclical capital buffer is aimed at ensuring that banking sector capital
requirements take account of the macro-financial environment in which banks operate.
National authorities will monitor credit growth and other indicators which may signal a
build-up of system-wide risk and, accordingly, they will put in place a countercyclical capital
buffer requirement as and when circumstances warrant. This requirement will be released
when system-wide risk crystallizes. The buffer will be implemented through an extension of
the capital conservation buffer and vary between zero and 2.5% of RWAs, depending on the
extent of the build-up of system-wide risks. Banks are required to meet this buffer with
common equity Tier 1 capital or other fully loss-absorbing capital. Furthermore, banks will be
subjected to the restrictions on distributions also if the capital level (capital conservation
buffer plus countercyclical buffer) falls below the required levels during the periods when the
countercyclical capital buffer is in force. Banks will have to ensure that their countercyclical
buffer requirements are calculated and publicly disclosed at least with the same frequency as
their minimum capital requirements.
Addressing procyclicality of provisioning requirements
Financial institutions are prone to business cycles. In good times, banks' borrowers do well
and service the loans in time. In bad times, borrowers tend to default in servicing interest and
principal payment. Banks' profits go down but at the same time they are required to make
higher loan loss provisions for the non-performing loans. In order to address the procyclical
issues, the Basel Committee is working closely with the International Accounting Standards
Board (IASB) towards an expected loss approach to loan loss provisioning instead of the
current practice of incurred loss approach.
Addressing interconnectedness
Interconnectedness among banks, especially the large ones, is sought to be addressed
through various measures such as enhanced regulatory framework for global systemic
important banks (G-SIBs), prescription of higher asset value correlation under the Internal
Ratings Based (IRB) Approach for exposures to large financial institutions with assets of
US $ 100 billion and with unregulated institutions.
Addressing too-big-to-fail problem
The Basel Committee will group G-SIBs into different categories of systemic importance
based on the score produced by the indicator-based measurement approach. G-SIBs will be
initially allocated into four buckets based on their scores of systemic importance, with varying
levels of additional loss absorbency requirements applied to the different buckets. Based on
policy judgment derived from various empirical analysis, the Basel Committee has
determined that the magnitude of additional loss absorbency for the highest populated
bucket should be 2.5% of risk-weighted assets at all times, with an initially empty top bucket
(fifth bucket) of 3.5% of risk-weighted assets. The magnitude of additional loss absorbency
for the lowest bucket should be 1.0% of risk-weighted assets. The magnitude of additional
loss absorbency is to be met with common equity Tier 1 capital as defined by the Basel III
framework. The G-SIBs will also be subject to tighter supervision. In addition, liquidity
standards have been introduced to reduce excessive reliance on short term wholesale
funding.
Addressing reliance on external credit ratings
To reduce the reliance on external ratings of the Basel II framework, measures have been
proposed that include requirements for banks to perform their own internal assessments of
externally rated securitization exposures, the elimination of certain "cliff effects" (sharp
increase in applicable risk weights) associated with credit risk mitigation practices, and the
incorporation of key elements of the IOSCO Code of Conduct Fundamentals for Credit
Rating Agencies into the Committee's eligibility criteria for the use of external ratings in the
capital framework.
Transition and phase-in
In view of the large scale reforms and their impact, Basel III will be phased in and
implemented over a long period of time, staring from January 1, 2013 to January 1, 2019.
Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital, will be
phased out over a ten-year period starting from 2013. The final calibration of liquidity ratios
and leverage ratio will be made after further quantitative impact study and observation.
Macroeconomic impact of Basel III
Assuming that banks may be able to raise the increased capital requirement under
Basel III from the market, questions have been raised as to its impact on economic growth
and profitability of banks. In general, the increase in equity capital requirement is likely to
increase the weighted average cost of capital. Banks would partly pass on the increase cost
of capital to the borrowers as higher lending rates. Thus, the equilibrium lending rates are
likely to be marginally higher and as a consequence, credit growth could be a little lower than
in the last few years.
However, the important question is how much? Also, after the steady state has been reached
on full implementation of Basel III, whether the cost would come down? I would try to provide
some answers to these questions based on the research done by the official sector including
the Basel Committee, and non-official or private sector institutions.
The Bank for International Settlements (BIS) and the FSB, with a view to phase-in the new
regulations in a manner that is compatible with the global economic recovery, undertook
studies to assess the macroeconomic impact of the transition to higher capital and liquidity
requirements. The Macroeconomic Assessment Group (MAG) set up by the Basel
Committee and FSB has estimated that bringing the global common equity capital ratio to a
level that would meet the agreed minimum and the capital conservation buffer, would result
in a maximum decline in GDP, relative to baseline forecasts, of 0.22%, at the end of
Basel III implementation period. The estimated maximum GDP impact per percentage point
of higher capital was 0.17%.
In addition, the Basel Committee's study on the Long-term Economic Impact (LEI) of the
stronger capital and liquidity requirements has suggested that the net benefits in terms of the
gains from reduced probability of banking crises, and the consequential loss of growth,
remain positive.
The estimates of the International Institute of Finance (IIF), a private sector body, is that level
of GDP will be 3.2% lower than it would otherwise be (i.e., relative to the baseline scenario)
after five years with an output loss of 0.7% per annum. This is several magnitudes higher
than the MAG's estimate of an output loss of 0.03% per annum. The wide difference in
estimates is attributed to different assumptions and samples.
Implications of Basel IIIon Indian banks
In general, higher capital and tighter liquidity requirements under Basel III will increase the
capital requirements in Indian banks, as in other countries. However, the actual impact would
vary in different countries depending upon the amount of exposures impacted under Basel
III, existing capital structure of banks, i.e., extent of reliance on non-common equity capital
elements, existing rules relating to regulatory adjustments, credit growth experienced by the
economies and existing credit to GDP ratio. The impact of these requirements on the
profitability of banks would depend upon sensitivity of lending rates to capital structure of
banks and sensitivity of the credit growth to the lending rates.
Capital
Under Basel III, the trading book exposures especially those having credit risk and
re-securitizations exposures in both banking and trading book attract enhanced capital
charges. The CVA for OTC derivatives will also attract additional capital. Since the trading
book and OTC derivative portfolios of Indian banks are very small and they do not have any
exposures to re-securitized instrument