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

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 bis central bankers ’ speeches 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