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Basel III Capital Regulations are being implemented in India with effect from April 1, 2013 in a phased manner.
I request all of you to go through the Amended Master Circular - Basel III (01 July 2015) here :
"https://rbidocs.rbi.org.in/rdocs/notification/PDFs/58BS09C403D06BC14726AB61783180628D39.PDF"
Revised Framework for Leverage Ratio for Implementation of Basel III Capital Regulations in India can be better explained under the following headings.
Rationale and Objective
Definition, Minimum Requirement and Scope of Application of the Leverage Ratio
Capital Measure
Exposure Measure
Transitional arrangements
Disclosure requirements
They can be better understood in detail by going through "http://icmai.in/upload/pd/RBI-Circular-09012015.pdf". We can also discuss in details if members wants to.
Just a recollection of Basel III developments till now :
Basel III released in December, 2010 is the third in the series of Basel Accords. These accords deal with risk management aspects for the banking sector. In a nut shell we can say that Basel III is the global regulatory standard (agreed upon by the members of the Basel Committee on Banking Supervision) on bank capital adequacy, stress testing and market liquidity risk. (Basel I and Basel II are the earlier versions of the same, and were less stringent)
According to Basel Committee on Banking Supervision "Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector".
Thus, we can say that Basel III is only a continuation of effort initiated by the Basel Committee on Banking Supervision to enhance the banking regulatory framework under Basel I and Basel II. This latest Accord now seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency.
Objectives / aims of the Basel III measures
Basel III measures aim to:
→ improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source
→ improve risk management and governance
→ strengthen banks' transparency and disclosures.
Thus we can say that Basel III guidelines are aimed at to improve the ability of banks to withstand periods of economic and financial stress as the new guidelines are more stringent than the earlier requirements for capital and liquidity in the banking sector.
How Does Basel III Requirements Will Affect Indian Banks :
The Basel III which is to be implemented by banks in India as per the guidelines issued by RBI from time to time, will be challenging task not only for the banks but also for GOI. It is estimated that Indian banks will be required to rais Rs 6,00,000 crores in external capital in next nine years or so i.e. by 2020 (The estimates vary from organisation to organisation). Expansion of capital to this extent will affect the returns on the equity of these banks specially public sector banks. However, only consolation for Indian banks is the fact that historically they have maintained their core and overall capital well in excess of the regulatory minimum.
The basic structure of Basel III remains unchanged with three mutually reinforcing pillars.
Pillar 1 : Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) : Maintaining capital calculated through credit, market and operational risk areas.
Pillar 2 : Supervisory Review Process : Regulating tools and frameworks for dealing with peripheral risks that banks face.
Pillar 3: Market Discipline : Increasing the disclosures that banks must provide to increase the transparency of banks
Major Changes Proposed in Basel III over earlier Accords i.e. Basel I and Basel II
(a) Better Capital Quality : One of the key elements of Basel 3 is the introduction of much stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress.
(b) Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress.
(c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has been introduced with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.
(d) Minimum Common Equity and Tier 1 Capital Requirements : The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer.
(e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively.
(g) Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential framework, systemically important banks will be expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.
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Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk of the banking sector.
The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.
The Committee reports to the Group of Governors and Heads of Supervision (GHOS). The Committee seeks the endorsement of GHOS for its major decisions and its work programme.
The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
The Basel III reform measures aim to:
- Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source
- Improve risk management and governance
- Strengthen banks' transparency and disclosures.
The reforms target:
a. Bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.
b. Macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.
These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks.
From 1993 to 2008 the total assets of a sample of what we call global systemically important banks saw a twelve-fold increase (increasing from $2.6 trillion to just over $30 trillion). But the capital funding these assets only increased seven-fold, (from $125 billion to $890 billion). Put differently, the average risk weight declined from 70% to below 40%.
The problem was that this reduction did not represent a genuine reduction in risk in the banking system.
One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base.
At the same time, many banks were holding insufficient liquidity buffers.
The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions.
During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were rapidly transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability.
Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing taxpayers to large losses.
The effect on banks, financial systems and economies at the epicentre of the crisis was immediate. However, the crisis also spread to a wider circle of countries around the globe. For these countries the transmission channels were less direct, resulting from a severe contraction in global liquidity, cross-border credit availability and demand for exports.
Given the scope and speed with which the recent and previous crises have been transmitted around the globe as well as the unpredictable nature of future crises, it is critical that all countries raise the resilience of their banking sectors to both internal and external shocks.
The G20 Leaders at the Seoul Summit endorsed the Basel III framework and the Financial Stability Board’s (FSB) policy framework for reducing the moral hazard of systemically important financial institutions (SIFIs), including the work processes and timelines set out in the report submitted to the Summit.
SIFIs are financial institutions whose disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.
We read in the final G20 Communique:
"We endorsed the landmark agreement reached by the Basel Committee on the new bank capital and liquidity framework, which increases the resilience of the global banking system by raising the quality, quantity and international consistency of bank capital and liquidity, constrains the build-up of leverage and maturity mismatches, and introduces capital buffers above the minimum requirements that can be drawn upon in bad times.
The framework includes an internationally harmonized leverage ratio to serve as a backstop to the risk-based capital measures.
With this, we have achieved far-reaching reform of the global banking system.
The new standards will markedly reduce banks' incentive to take excessive risks, lower the likelihood and severity of future crises, and enable banks to withstand - without extraordinary government support - stresses of a magnitude associated with the recent financial crisis.
This will result in a banking system that can better support stable economic growth.
We are committed to adopt and implement fully these standards within the agreed timeframe that is consistent with economic recovery and financial stability.
The new framework will be translated into our national laws and regulations, and will be implemented starting on January 1, 2013 and fully phased in by January 1, 2019."
To ensure visibility of the implementation of reforms, the Basel Committee has been regularly publishing information about members’ adoption of Basel III to keep all stakeholders and the markets informed, and to maintain peer pressure where necessary.
It is especially important that jurisdictions that are home to global systemically important banks (G-SIBs) make every effort to issue final regulations at the earliest possible opportunity.
But simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for: full, timely and consistent implementation of Basel III. In response to this call, in 2012 the Committee initiated what has become known as the Regulatory Consistency Assessment Programme (RCAP).
The regular progress reports are simply one part of this programme, which assesses domestic regulations’ compliance with the Basel standards, and examines the outcomes at individual banks.
The RCAP process will be fundamental to ensuring confidence in regulatory ratios and promoting a level playing field for internationally-operating banks.
It is inevitable that, as the Committee begins to review aspects of the regulatory framework in far more detail than it (or anyone else) has ever done in the past, there will be aspects of implementation that do not meet the G20’s aspiration: full, timely and consistent.
The financial crisis identified that, like the standards themselves, implementation of global standards was not as robust as it should have been.
This could be classed as a failure by global standard setters.
To some extent, the criticism can be justified – not enough has been done in the past to ensure global agreements have been truly implemented by national authorities.
However, just as the Committee has been determined to revise the Basel framework to fix the problems that emerged from the lessons of the crisis, the RCAP should be seen as demonstrating the Committee’s determination to also find implementation problems and fix them.
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Basel III is divided in two main areas:
Regulatory capital
Asset and liability management
AREA 1: Regulatory Capital
Banks shall progressively reach a minimum solvency ratio of 7% as of 2019:
Solvency ratio = (Regulatory Capital) / (Risk-Weighted Assets). [RWA = Risk-Weighted Assets]
The minimum requirement used to be 2% prior to Basel 3, with many national banking authorities requiring much more leading to that most banks used to have a Tier 1 ratio exceeding 7%
According to the Basel III impact study, at the end of 2009, the average solvency ratio (Core Tier One) of large banks was 11.1%
So, what is the problem, if banks already exceed the minimum solvency ratio set by Basel III? The devil is in the details and here is where we find the problems caused to the corporate sector:
The definitions of the Regulatory Capital and the RWA have changed:
Calculated according to the Basel III definitions, the Core Tier One ratio would have been 5.7% instead of 11.1% according to the old definitions
The 87 “large banks” who answered the impact study would have been short of €600bn of equity at the end of 2009. New stress tests are disclosed regularly and the shortcomings differ, but they are still there. This means that banks will either/or have to raise more capital or decrease its present lending, which will create a crowding out of capital in the financial markets either way.
There are new definitions of core equity leading to that it is reduced with up to 40% for large banks increased the crowding out effects even further. Major changes in the definition:
Some financial instruments are not any longer eligible as Regulatory Capital
Intangibles and deferred tax assets shall be deducted from the Regulatory Capital
There are changes in how RWA is calculated in average increasing it with 23%. Major changes include:
Sharp increase of RWA amounts from trading activities (stress tests on value at risk, securitisations…) leading to many banks decreasing the trading leading to fewer banks quoting prices. This has already led to reduced liquidity and increased costs and risks for corporates in managing its financial exposure from import and export etc
This encourages particularly banks to perform their swaps through clearing houses
This may weight on complex derivatives businesses
Loan portfolios require being marked-to-market even though it is not required by accounting standards. This increases pro-cyclicality
Basel III introduces a “Leverage Ratio” such that the amounts of assets and commitments should not represent more than 33 times the Regulatory Capital, regardless of the level of their risk-weighting and of the credit commitments being drawn down or not
The Financial Stability Board recommended in July 2011 that the 29 identified systemically important financial institutions have a Core Tier 1 ratio increased between 1% and 2.5%. Of course these “SIFIs” are the main large corporates’ banking counterparts. This provision has been “enacted” by the G20 in November 2011.
The European Commission has added:
Minimum solvency ratio shall be 9% for the EU banks (instead of 7%)
The EU banks shall comply with this level in June 2012 (instead of 2019)
AREA 2: Assets and liabilities management
Banks will have to comply with two new ratios:
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
LCR: high-quality highly-liquid assets available must exceed the net cash outflows of the next 30 days:
High-quality highly-liquid assets:
Level 1 assets: Recognized at 100%: cash, sovereign debt of countries weighted at 0% (which include the PIIGS as they are part of the Eurozone), deposit at central bank. Level 1 assets shall account for at least 60% of the “high-quality highly liquid assets”
Level 2A assets: Recognized at 85% and must not represent more than 40% of the assets: sovereign debt weighted at 20% (countries rated below AA-), corporate bonds and covered bonds rated at least AA-
Level 2B assets (introduced Jan, 2013): non-financial corporate bonds rated between BBB- and A+, with a hair cut of 50%; certain unencumbered equities, with a hair cut of 50%; and certain residential mortgage-backed securities (RMBS), with a hair cut of 25%.
The Level 2B assets will not be eligible for more than 15% of the “high-quality highly liquid assets” and a total level 2 assets will not be eligible for more than 40% of the “high-quality highly liquid assets”
Changes from January 2013 provide:
To some extent, lesser cost of carry for banks on “high-quality highly-liquid assets” but still limited because of the 50% hair cut and 15% limitation
Improvement for the financing of investment graded companies (BBB and above) by banks through bonds, which will remain in competition with residential mortgage-backed securities (RBMS) with lesser hair cut and whose markets is restored with these new provisions
Level 1 assets remain at least 60% of the “high-quality highly-liquid assets”, which means that concentration risks and cost of carry remain.
Net cash outflows = cash outflows – cash inflows
NSFR: long-term financial resources must exceed long-term commitments (long term = and more than 1 year):
Stable funding:
equity and any liability maturing after one year
90% of retail deposits
50% of deposits from non-financial corporates and public entities
Long-term uses:
5% of long-term sovereign debt or equivalent with 0%-Basel II Standard approach risk-weighting (see comment above for LCR) with a residual maturity above 1 year
20% of non-financial corporate or covered bonds at least rated AA- with a residual maturity above 1 year
50% of non-financial corporate or covered bonds at least rated between A- and A+ with a residual maturity above 1 year
50% of loans to non-financial corporates or public sector
65% of residential mortgage with a residual maturity above 1 year
5% of undrawn credit and liquidity facilities
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RBI Guidelines for Implementation of Basel III Guidelines
Back Ground for Basel III :
Earlier guidelines were known as Basel I and Basel II accords. Later on the committee was expanded to include members from nearly 30 countries , including India. Inspite of implementation of Basel I and II guidelines, the financial world saw the worst crisis in early 2008 and whole financial markets tumbled. One of the major debacles was the fall of Lehman Brothers. One of the interesting comments on the Balance Sheet of Lehman Brothers read : “Whatever was on the left-hand side (liabilities) was not right and whatever was on the right-hand side (assets) was not left.” Thus, it became necessary to re-visit Basel II and plug the loopholes and make Basel norms more stringent and wider in scope.
BCBS, through Basel III, put forward norms aimed at strengthening both sides of balance sheets of banks viz.
(a) enhancing the quantum of common equity;
(b) improving the quality of capital base;
(c) creation of capital buffers to absorb shocks;
(d) improving liquidity of assets;
(e) optimising the leverage through Leverage Ratio;
(f) creating more space for banking supervision by regulators under Pillar II; and
(g) bringing further transparency and market discipline under Pillar III.
Thus, Basel III norms were released by BCBS and individual central banks were asked to implement these in a phased manner. RBI (India's central bank) too issued draft guidelines in the initial stage and then came up with the final guidelines.
Over View f the RBI Guidelines for Implementation of Basel III guidelines :
The final guidelines have been issued by Reserve Bank of India for implementation of Basel 3 guidelines on 2nd May, 2012. Full detailed guidelines can be downloaded from RBI website, by clicking on the following link : Implementation of Base III Guidelines. Major features of these guidelines are :
(a) These guidelines would become effective from January 1, 2013 in a phased manner. This means that as at the close of business on January 1, 2013, banks must be able to declare or disclose capital ratios computed under the amended guidelinesThe Basel III capital ratios will be fully implemented as on March 31, 2018
(b) The capital requirements for the implementation of Basel III guidelines may be lower during the initial periods and higher during the later years. Banks needs to keep this in view while Capital Planning;
(c) Guidelines on operational aspects of implementation of the Countercyclical Capital Buffer. Guidance to banks on this will be issued in due course as RBI is still working on these. Moreover, some other proposals viz. ‘Definition of Capital Disclosure Requirements’, ‘Capitalisation of Bank Exposures to Central Counterparties’ etc., are also engaging the attention of the Basel Committee at present. Therefore, the final proposals of the Basel
Committee on these aspects will be considered for implementation, to the extent applicable, in future.
(d) For the financial year ending March 31, 2013, banks will have to disclose the capital ratios computed under the existing guidelines (Basel II) on capital adequacy as well as those computed under the Basel III capital adequacy framework.
(e) The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against 8% (international) prescribed by the Basel Committee of Total Risk Weighted assets. This has been decided by Indian regulator as a matter of prudence. Thus, it requirement in this regard remained at the same level. However, banks will need to raise more money than under Basel II as several items are excluded under the new definition.
(f) of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs;
(g) In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (international standards require these to be only at 4.5%) banks are also required to maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital. CCB is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses are incurred during a stressed period. In case such buffers have been drawn down, the banks have to rebuild them through reduced discretionary distribution of earnings. This could include reducing dividend payments, share buybacks and staff bonus.
(h) Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has been raised to 7% under Basel III. Moreover, certain instruments, including some with the characteristics of debts, will not be now included for arriving at Tier 1 capital;
(i) The new norms do not allow banks to use the consolidated capital of any insurance or non financial subsidiaries for calculating capital adequacy.
(j) Leverage Ratio : Under the new set of guidelines, RBI has set the leverage ratio at 4.5% (3% under Basel III). Leverage ratio has been introduced in Basel 3 to regulate banks which have huge trading book and off balance sheet derivative positions. However, In India, most of banks do not have large derivative activities so as to arrange enhanced cover for counterparty credit risk. Hence, the pressure on banks should be minimal on this count.
(k) Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold enough unencumbered liquid assets to cover expected net outflows during a 30-day stress period. In India, the burden from LCR stipulation will depend on how much of CRR and SLR can be offset against LCR. Under present guidelines, Indian banks already follow the norms set by RBI for the statutory liquidity ratio (SLR) – and cash reserve ratio (CRR), which are liquidity buffers. The SLR is mainly government securities while the CRR is mainly cash. Thus, for this aspect also Indian banks are better placed over many of their overseas counterparts.
(l) Countercyclical Buffer: Economic activity moves in cycles and banking system is inherently pro-cyclic. During upswings, carried away by the boom, banks end up in excessive lending and unchecked risk build-up, which carry the seeds of a disastrous downturn. The regulation to create additional capital buffers to lend further would act as a break on unbridled bank-lending. The detailed guidelines for these are likely to be issued by RBI only at a later stage.
On the day of release of these guidelines, analysts felt that India may need at least $30 billion (i.e. around Rs 1.6 trillion) to $40 billion as capital over the next six years to comply with the new norms. It was also felt that this would impose a heavy financial burden on the government, as it will need to infuse capital in case it wants to continue its hold on these PS Banks. RBI Deputy Governor, Mr Anand Sinha viewed that the implementation of Basel II may have a negative impact on India's growth story. In FY 2012-13, Government of India is expected to provide Rs 15888 crores to recapitalize the banks. as to maintain capital adequacy of 8% under old Basel II norms.
Some Major Developments after 2nd May 2012 (i.e. the date when RBI issued Basel III guidelines) :
(a) On 30th October 2012, RBI in its Second Quarter Review of Monetary Policy 2012-13 has declared as follows :
(i) "Basel III Disclosure Requirements on Regulatory Capital Composition
The Basel Committee on Banking Supervision (BCBS) has finalised proposals on disclosure requirements in respect of the composition of regulatory capital, aimed at improving transparency of regulatory capital reporting as well as market discipline. As these disclosures have to be given effect by national authorities by June 30, 2013, it has been decided:
to issue draft guidelines on composition of capital disclosure requirements by end-December 2012.
(ii) Banks’ Exposures to Central Counterparties (CCP)
The BCBS has also issued an interim framework for determining capital requirements for bank exposures to CCPs. This framework is being introduced as an amendment to the existing Basel II capital adequacy framework and is intended to create incentives to increase the use of CCPs. These standards will come into effect on January 1, 2013. Accordingly, it has been decided:
to issue draft guidelines on capital requirements for bank exposures to central counterparties, based on the interim framework of the BCBS, by mid-November 2012.
(iii) Core Principles for Effective Banking Supervision
The Basel Committee has issued a revised version of the Core Principles in September 2012 to reflect the lessons learned during the recent global financial crisis. In this context, it is proposed:
to carry out a self-assessment of the existing regulatory and supervisory practices based on the revised Core Principles and to initiate steps to further strengthen the regulatory and supervisory mechanism.
(b) On 7th November, 2012 : RBI has issued final guidelines in respect of Liquidity Risk Management by Banks
On September 1, 2014 : RBI revised some of its rules governing instruments that qualify as bank capital under Basel-III
Revised rules make instruments more attractive and broaden the base for AT-1 bonds to include retail investors
Moodys says the amended rules will also allow banks to have a higher proportion of AT-1 in their Tier-1 capital
The major benefit is expected to accrue to public sector banks
Low capital levels are a key credit weakness for many Indian banks, particularly PSBs
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