A Study On Basel Committee Ii And Basel Committee Iii And Its Impact On India-2.docx

A study on BASEL Committee II & BASEL Committee III and Its Implication on India A Project Report-International Economic Organization

SUBMITTED BY: SHILPA SHARMA (17H78) SHUBHAM RAVAL (17F80) SIDDHARTH VYAS (17F81) SWAPNIL MACWAN(17M82) SEMESTER IV

UNDER THE GUIDANCE AND SUPERVISION OF: Dr. Yogesh C. Joshi & Dr. Mitesh Jayswal

G.H. PATEL POSTGRADUATE INSTITUTE OF BUSINESS MANAGEMENT MBA PROGRAMME (2018-2019) SARDAR PATEL UNIVERSITY, VALLABH VIDHYANAGAR

INDEX CHAPTER 1 INTRODUCTION 1.1 OBJECTIVES OF THE STUDY 1.2 INTRODUCTION 1.3 RESEARCH METHODOLOGY 1.4 DATA COLLECTION METHOD 1.5 LITERATURE REVIEW CHAPTER-2 NEED FOR BASEL II 2.1 NEED FOR BASEL II 2.1.1 The Purpose of Basel I 2.1.2 Pitfalls of BASEL I CHAPTER 3 INTRODUCTION TO BASEL II & ITS IMPLICATION ON INDIA 3.1 INTRODUCTION TO BASEL II 3.1.1 The First Pillar: Minimum Capital Requirement: 3.1.2 The Second Pillar: Supervisory Review Process: 3.1.3 The Third Pillar: Market Discipline: 3.2 Introduction of Basel Norms in Indian Banking System 3.3 Impact of Basel II Norms on Banking System 3.4 Positive Impact of Basel II on Banks in India 3.5 Negative Impact of Basel II on Banks in India CHAPTER 4 NEED FOR BASEL III 4.1 Pitfalls of BASEL II CHAPTER 5 INTRODUCTION TO BASEL III & ITS IMPLICATION ON INDIA 5.1 INTRODUCTION TO BASEL III 5.1.1 December 2017 - Finalization of the Basel III post-crisis regulatory reforms 5.2 Credit risk 5.3 The CVA framework 5.4 Operational risk 5.5 The leverage ratio 5.6 ADVENT OF BASEL III IN INDIA 5.6.1 Objectives of Adoption of Basel III for Indian Banking Industry

5.6.2 Benefits and Challenges posed by Basel III for Indian PSBs 5.7 MACRO-ECONOMIC EFFECT 5.8 EFFECT ON CAPITAL REQUIREMENTS CHAPTER 6 CONCLUSIONS 6.1 CONCLUSIONS REFERENCE

PREFACE

Theories are important for understanding any subject or fields. But learning of various aspects is much more effective to understanding any subject as a whole. The basic aim of the project report is to help the students for developing their analytical abilities and different thoughts at different angles of the situation. The Management Research Project is being very helpful to the students of MBA for enhancing themes managerial capabilities and skills. The basic motive behind of this project is to acquire knowledge about various aspects of the industry that can aid the student in their future career. With our interest, we have selected BASEL Committee II & BASEL Committee III and Its Impact on India . This report helps us to develop our skill & confidence to do better in all respect in management fields. In our analysis we have gone for analyzing by the our objectives. Future outlook of the BIS is concluded that will help us in our future career.

We have tried our best and have applied all our efforts, knowledge and sources available, in this project.

ACKNOWLEDGEMENT

With immense please we are presenting “BASEL Committee II & BASEL Committee III and Its Impact on India” Project report as part of the curriculum of ‘PGDM’. We wish to thank all the people who gave us unending support. I express my profound thanks to Prof. Dr. Yogesh C Joshi, and Prof. Dr. Mitesh Jayswal. project guide and all those who have indirectly guided and helped us in preparation of this project. I also like to extend our gratitude to all staff and our colleagues of College of Management, who provided moral support, a conductive work environment and the muchneeded inspiration to conclude the project in time and a special thanks to my friends who are integral part of the project.

Thanking you. Prof. Dr. Yogesh C. Joshi

CHAPTER 1 INTRODUCTION

1.1 OBJECTIVES OF THE STUDY 1. 2. 3. 4.

To know what is the need for BASEL committee II. To understand what is BASEL II and its impact on India. To know what is the need for BASEL committee III. To understand what is BASEL III and its impact on India.

1.2 INTRODUCTION Basel II is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by operations. The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision (BSBS). The name for the accords is derived from Basel, Switzerland, where the committee that maintains the accords meets. Basel II improved on Basel I, first enacted in the 1980s, by offering more complex models for calculating regulatory capital. Essentially, the accord mandates that banks holding riskier assets should be required to have more capital on hand than those maintaining safer portfolios. Basel II also requires companies to publish both the details of risky investments and risk management practices. The full title of the accord is Basel II: The International Convergence of Capital Measurement and Capital Standards - A Revised Framework. The three essential requirements of Basel II are: 1. Mandating that capital allocations by institutional managers are more risk sensitive. 2. Separating credit risks from operational risks and quantifying both. 3. Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment. Basel II has resulted in the evolution of a number of strategies to allow banks to make risky investments, such as the subprime mortgage market. Higher risks assets are moved to unregulated parts of holding companies. Alternatively, the risk can be transferred directly to investors by securitization, the process of taking a non-liquid asset or groups of assets and transforming them into a security that can be traded on open markets.

Basel III is an extension of the existing Basel II Framework, and introduces new capital and liquidity standards to strengthen the regulation, supervision, and risk management of the whole of the banking and finance sector. It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–2011, and was scheduled to be introduced from 2013 until 2015. However, changes made from April 2013 extended implementation until March 31, 2018. The Basel III requirements were in response to the deficiencies in financial regulation that is revealed by the 2000’s financial crisis. Basel III was intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage. The global capital framework and new capital buffers require financial institutions to hold more capital and higher quality of capital than under current Basel II rules. The new leverage ratio introduces a non risk-based measure to supplement the risk-based minimum capital requirements. The new liquidity ratios ensure that adequate funding is maintained in case there are other severe banking crises.

1.3 RESEARCH METHODOLOGY As per the research design, exploratory research as being used as the main purpose is to gain

insight and an understanding of the economic international organization named BIS.

1.4 DATA COLLECTION METHOD Data has been collected from secondary resources such as websites, journals, research papers reference books, official site of BIS, etc.

1.5 LITERATURE REVIEW 1. Integration of regulatory capital and liquidity instruments, March 2016 This working paper aims at reviewing the literature assessment of recent reforms. It consists of “three essays” on capital (Section 2), on liquidity and its interaction with capital (Section 3) and on other supervisory requirements (Section 4). Although there are many studies on the effects of capital requirements, there are relatively few on the effects of liquidity requirements and other supervisory tools. In part, this is because capital requirements have been in place for a considerable time and over more than one business cycle, while liquidity requirements and other supervisory tools, such as buffers, macroprudential policies and stress tests, have only been implemented since the recent financial crisis. 1. The Bank of International Settlements as a think tank for financial policy-making Carola Westermeier 2018, Vol. 37, no. 2, 1 –187. The Bank of International Settlements (BIS) is known to be the ‘bank of central banks ‘and a congenital place where central bankers meet to discuss policies. However, this contribution shows that it is also far more. Economic research and policy-making are closely connected within the BIS. Researchers and analysts provide knowledge for financial regulation and introduce new approaches to policy-makers who meet within the BIS-hosted bodies, such as the Basel Committee of Banking Supervision. The Monetary and Economic Department of the BIS operates like a think tank in the end of nancial policy-making. This is exampled by the introduction of macro prudential regulation, a new approach that originated within the BIS. By combining post-structural discourse theory with the concept of discourse coalition, this paper shows how macro prudential regulation became a frame of reference promising to maintain nancial stability and how the BIS benefits from this.

CHAPTER-2 NEED FOR BASEL II

2.1 NEED FOR BASEL II From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States. Bank failures were particularly prominent during the 1980s, an era that is often referred to as the "savings and loan crisis." Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate. As a result, the potential for the bankruptcy of the major international banks because grew as a result of low security. In order to prevent this risk, the Basel Committee on Banking Supervision, comprised of central banks and supervisory authorities of 10 countries, met in 1987 in Basel, Switzerland. The committee drafted a first document to set up an international "minimum amount" of capital that banks should hold. This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord was created. The Basel II Capital Accord follows as an extension of the former, and was implemented in 2007. In this article, we'll take a look at Basel I and how it impacted the banking industry. 2.1.1 The Purpose of Basel I In 1988, the Basel I Capital Accord was created. The general purpose was to: ● Strengthen the stability of international banking system. ● Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks. The basic achievement of Basel I has been to define bank capital and the so-called bank capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it. The Basel I agreement defines capital based on two tiers ● Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholder equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations. ● Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e., excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital. Credit risk is defined as the risk weighted asset, or RWA, of the bank, which are a bank's assets weighted in relation to their relative credit risk levels. According to Basel I, the total capital should represent at least 8% of the bank's credit risk (RWA).

In addition, the Basel agreement identifies three types of credit risks ● The on-balance-sheet risk (see Figure 1)

● The trading off-balance-sheet risk: These are derivatives, namely interest rates, foreign exchange, equity derivatives and commodities. ● The non-trading off-balance-sheet risk: These include general guarantees, such as forward purchase of assets or transaction-related debt assets. Let's take a look at some calculations related to RWA and capital requirement. Figure 1 displays predefined categories of on-balance-sheet exposures, such as vulnerability to loss from an unexpected event, weighted according to four relative risk categories.

Figure 1: Basel's Classification of risk weights of on-balance-sheet assets As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires a risk weight of 100%. The RWA is therefore calculated as RWA = $1,000 × 100% = $1,000. By using Formula 2, a minimum 8% capital requirement gives 8% × RWA = 8% × $1,000 = $80. In other words, the total capital holding of the firm must be $80 related to the unsecured loan of $1,000. Calculation under different risk weights for different types of assets are also presented in Table 2.

Figure 2: Calculation of RWA and capital requirement on-balance-sheet assets Market risk includes general market risk and specific risk. The general market risk refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security. There are four types of economic variables that generate market risk. These are interest rates, foreign exchanges, equities and commodities. The market risk can be calculated in two different manners: either with the standardized Basel model or with internal value at risk (VaR) models of the banks. These internal models can only be used by the largest banks that satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover, the 1996 revision also adds the possibility of a third tier for the total capital, which includes short-term unsecured debts. This is at the discretion of the central banks. (See also: Get To Know the Central Banks and What Are Central Banks?)

2.1.2 Pitfalls of BASEL I The Basel I Capital Accord has been criticized on several grounds. The main criticisms include the following: ● Limited differentiation of credit risk: There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure 1, based on an 8% minimum capital ratio. ● Static measure of default risk: The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk. ● No recognition of term-structure of credit risk: The capital charges are set at the same level regardless of the maturity of a credit exposure. ● Simplified calculation of potential future counterparty risk: The current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality. ● Lack of recognition of portfolio diversification effects: In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide an incorrect judgment of risk. A remedy would be to create an internal credit risk model—for example, one similar to the model as developed by the bank to calculate market risk. This remark is also valid for all other weaknesses. These listed criticisms have led to the creation of a new Basel Capital Accord, known as Basel II, which added operational risk and also defined new calculations of credit risk. Operational risk is the risk of loss arising from human error or management failure. The Basel II Capital Accord was implemented in 2007. The Basel I Accord, issued in 1988, has succeeded in raising the total level of equity capital in the system. Like many regulations, it also pushed unintended consequences; because it does not differentiate risks very well, it perversely encouraged risk seeking. It also promoted the loan securitization that led to the unwinding in the subprime market.

CHAPTER 3 INTRODUCTION TO BASEL II & ITS IMPLICATION ON INDIA

3.1 INTRODUCTION TO BASEL II The principal reason for adopting Basel II norms was that, it considers both credit and operational risks apart from market risk as the major sources of risks. Basel II norms direct banks to allocate adequate amounts of capital for these types of risks unlike Basel I. The revised framework i.e. Basel II norms presents an array of options for determining the capital requirements for credit risk and operational risk. This facilitates banks and supervisors to identify and implement approaches which are most suitable for their banking operations. Basel II also requires companies to publish both the details of risky investments and risk management practices. The full title of the accord is Basel II: The International Convergence of Capital Measurement and Capital Standards - A Revised Framework. The three essential requirements of Basel II are: 4. Mandating that capital allocations by institutional managers are more risk sensitive. 5. Separating credit risks from operational risks and quantifying both. 6. Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment.

The main structure of Basel II depends on 3 Pillars concept: 1. Minimum Capital Requirements 2. Supervisory Review of Capital Adequacy 3. Market Discipline 3.1.1 The First Pillar: Minimum Capital Requirement: The first pillar measures the minimum regulatory capital that needs to be maintained by banks after considering three risks namely credit risk, operational risk and market risk. 3.1.2 The Second Pillar: Supervisory Review Process: The second pillar deals with management of various risks faced by banks such as systematic risk, risks related to strategy, reputation, liquidity and legal issues. It provides banks to check and reconsider their Risk Management System by developing their own risk management techniques to administer and manage their risks. Supervisors are assigned the task of evaluating and reviewing the capital requirement of banks with respect to various risks faced by them. 3.1.3 The Third Pillar: Market Discipline: The third pillar focuses on disclosure of various important information of banks which facilitates market participants to consider aspects like risk exposure, techniques of risk assessment and capital adequacy maintained by banks. Market discipline aims to share this vital information of banks which is used to assess bank performance by market participants like investors, customers, financial experts and analysts, other banks and rating agencies. In a nutshell, all the three pillars of Basel II norms focuses on to provide greater stability in the financial system by ensuring adequate capital to manage risks faced by banks, reviewing the risk management by Supervisors and sharing the significant information by way of market disclosure. The same is described in the figure below.

3.2 Introduction of Basel Norms in Indian Banking System In response to the Basel I Accord of 1988, Reserve Bank of India issued required guidelines and instructions to all the Indian Banks for implementing the norms as per best international banking practices. RBI issued broad guidelines and directives in an attempt to execute, supervise prudential norms of credit like practices of supervision, licensing, liquidity, risk management and techniques of banking supervision on a regular basis . In India, Basel I framework was put into practice from 1992-93 which was extended for three years. Banks with branches abroad were required to conform completely by March 31, 1994 and other banks were required to abide by the rules by March 31, 1996. In response to the 1996 amendment of Basel I framework, India accepted and made necessary changes for the banks to maintain capital for market risk component, by imposing various reserves and capital charges in the beginning, for these risks between 2000 and 2002. Later on, these were replaced with capital charges as stipulated by Basel I framework in June 2004, which came into existence completely from March 2005. The Indian Banking System has shown considerable improvement on several factors due to the successful implementation of banking sector reforms since 1991. And hence the Indian Banking System is competent enough to shift to Basel II norms efficiently. Commercial banks in India began implementing Basel II framework from March 31, 2007. RBI gave instructions in October 2006 that foreign banks operating in India and Indian banks located abroad would adopt the Standardised Approach for measuring credit risk and the Basic Indicator Approach for calculating operational risk component under Basel II norms, applicable from March 31, 2008 whereas all other scheduled commercial banks are required to move to Basel II framework by March 31, 2009.

3.3 Impact of Basel II Norms on Banking System Basel II framework will increase the volatility of the capital requirements of any developing country. This is because the credit rating process and access is less in a developing country compared to a developed country, where it is very easily put into practice. The same is the case with India where credit rating is less penetrated, so majority of the proportion of bank

assets in its balance sheets are unrated claims. As per Basel II norms, less credit rating requires more capital adequacy to mitigate the risk which might arise from the assets. This also means that the operational risk requirement may increase and hence the overall capital requirement of the bank will be more. This may act as a hurdle to implement Basel II norms in some countries. Many countries across the world implemented Basel I Accord, but they had maintained a slightly higher capital than the minimum requirement of 8%. As per second pillar of review process, supervisors with their agency focus on improving the internal risk management of banks so that they can switch to IRB Approach, rather than implementing standard approach of measuring risk, like other competitor banks. Moreover, the supervisors who are in-charge of audit and review of Basel II Norms in banks should aim to check the capital adequacy, size, domestic capital markets, availability and disclosure of information, degree of measuring and monitoring the provision of loans and losses. Many countries will most likely decide to implement simpler and easier approaches of Basel II like Simplified Standardized Approach and Standardized Approach because the former uses only the ratings of official export credit guarantee agencies for sovereign risk assessment whereas the latter will use the credit ratings from private agencies. Still the developing countries faced problem in implementing alternative approaches for measuring capital as per Basel II, i.e. there are two versions of Standardized and IRB Approaches, but it does not highlight appropriate reasons or benefits to use the most risk-sensitive approach, thereby developing arbitrage possibilities. Moreover, in countries with less developed capital market and financial system, reliable credit ratings are not available for most of the assets in the bank’s credit portfolio. In such cases, the Standardized Approach will assist very little to relate risk with capital requirement and hence it would be a poor replacement of Basel I framework. Hence the capital requirement in developing countries will increase which they are not prepared for. Moreover, the regulatory and supervisory bodies in those countries are not all set to meet the challenge of second pillar of Basel II norms, due to lack of developed infrastructure, insufficient human capital etc. The implementation of Basel II framework on the Japanese Banking industry resulted in decrease of share prices and reduction of loan provisions for banks that had low capital ratios. This is because second pillar of Basel II norms enforces a large burden on minimum capital requirement to be maintained by banks. Moreover, the second pillar also increases the regulatory capital requirement of banks. Thus, in order to relate the existing literature about the implementation of Basel II in a developing country, the researcher analyzes the impact of Basel II Norms on the Indian Banking sector as India itself is a developing country and has adopted Basel II Norms in its banking system.

3.4 Positive Impact of Basel II on Banks in India Basel II Norms will have a positive impact on the Indian Banking System in the following ways: Firstly, the implementation of Basel II norms results in reduction of regulatory capital by reducing the credit risk weights, this can be done by suitably altering the bank’s portfolios. The Internal Ratings Based (IRB) Approach would provide autonomy to the individual banks to evaluate their own risk and determine the requirement of economic capital. The Standardised and Internal Ratings Based (IRB) Approaches are advanced approaches for calculating credit and operational risk component respectively as per Basel II norms. These

methods will help consider most of the risks faced by banks and hence are required to maintain lower capital which will result in lower costs following these approaches. Basel II framework considers economic risk in line with regulatory risk faced by banks. This will result in easy disbursement of loans to corporate, increase in retail loans and mortgage loans with higher margins. It will also transform the way credit risk is managed by banks because it will make sure that banks have sufficient capital to face operational risk. The other benefit to banks is the development of better risk assessments system, leading to an edge over other banks, by focusing on only those target segments, markets and customers who have high risk and high return ratio. The other advantage to banks for implementing Basel II norms is superior understanding of risk return trade-off for estimating risks for capital supporting specific business, corporate, customers, products, services and various processes. The other benefits that the banks would receive by adopting Basel II framework would be the robust risk estimation, measurement and management process, which will result in serving the customers better including small and medium sized businesses. It will lead to liquidity for those small businesses and help them for their growth and expansion needs . The second pillar of Basel II Accord considers the very important Supervisory Review Process. It brings in the concept of Economic Capital which will assist the banks to decide a minimum capital adequacy requirement based on the level of risk resulted from the transaction. It benefits the bank to achieve an improved relationship between risk and minimum capital required to be maintained by respective banks. Basel II norms will also offer banks with business benefits like improving corporate governance and allocation of capital. The risk-based pricing will help to improve the bank’s competitiveness. Capital will be saved and better decision making will allow counter parties to deal in a better way and increasing the value of stakeholders . Basel II offers the banks with several alternatives, from which they can select appropriate risk measurement approaches applicable to them. For example, large banks are expected by the market and supervisors to implement advanced risk management techniques whereas small banks with relatively easy operations may use a simple and less expensive risk management system. This is because Basel II framework is drafted flexibly to integrate any changes which may occur in future, the same principles can be included without making changes in the basic arrangement. Banks will have the autonomy in its operations but has some constraints to ensure a basic minimum capital adequacy requirement . Other additional advantages of Basel II norms are adopting a more active portfolio management system and advanced, progressive risk measurement system. The portfolio of banks is managed by taking into consideration high risk and high return assets, this is possible because banks has access to better, reliable, timelier and higher quality risk information and capital requirement in advance. The pricing of products will be more risk sensitive and proactive which results in overall improvement in the performance management of banks.

3.5 Negative Impact of Basel II on Banks in India After implementing Basel II norms, Banks in India might face certain negative aspects, which are mentioned as follows: The first disadvantage with Basel II framework is with reference to higher capital requirement by banks. The Basic Indicator Approach states that banks should maintain capital charge for operational risk component which should be equivalent to the average of the 15%

of annual positive gross income of last three years, excluding any year when the gross income was negative. It also indicates that capital required by the banks would depend on the level of Non- Performing Assets (NPAs) of banks. The second disadvantage of implementing Basel II norms deals with investment and expenditure pattern of banks. The banks in order to be risk aversive, give priority to investment in government securities rather than giving loans to small businesses. This has resulted in negatively affecting the credit disbursed to agriculture and small-scale industries . The third and the fourth negative aspect is role of rating agencies and regulatory bodies in India. As per the directives of Basel II Accord, banks are required to gather new information and the same is supposed to be disclosed to the general public as a part of Market Discipline, to make sure its transparency. There are only four rating agencies in India, initially they had common rules which will be updated to incorporate new Basel II framework. Regulatory bodies too will encounter challenge as they have to provide same level playing field in terms of jurisdiction at international level, as Basel II norms are adopted in various countries. Moreover, they have to make sure that their auditors and supervisors are sufficiently trained to evaluate banks’ compliance as per new capital rules

CHAPTER 4 NEED FOR BASEL III

4.1 Pitfalls of BASEL II The first cause was “pro-cyclical process” due to this if there is economic boom in the country then banks require less capital for recovering the risk but in case of down of economy then banks require more capital for recovering the risk. The Basel Accord II has “procyclical process” due to this if there is economic boom in the country then banks require less capital for recovering the risk but in case of down of economy then banks require more capital for recovering the risk. The second cause of failure was the lot of use the rating provided by external sources. In many organizations has no credit assessment department so they relays on credit rating provided institutions. So the external credit rating provided institutions became more important. This create the problems like the external institutions mispriced the risk due to this the conflicts were arises and that’s why we need to revise the Basel Accord. The U.S. bank’s supervisors most of the time claims that the two approaches like Advance Internal Rating Based (AIRB) and Advanced Measurement Approach (AMA) for credit and operational risk respectively are very complex so these are implemented by only large banks in U. S. So, the financial institution having $250 Billion consolidated assets are requiring that they implement the advance approaches. The Basel II impact on capital requirements is being influenced by both the utilised approach and bank’s risk profile. At a quick glance it becomes clear that the banks utilising standardised approach are at disadvantage compared to the ones employing IRB or A-IRB approaches. Considering the risk profile, the local retail banks, especially those registering large mortgage exposures, can benefit from important reductions of capital requirements while at the opposite the investment and emerging markets banks are going to be subject to additional capital requirements. On long term, Basel II should trigger a reduction of the cost for the banks (reduced capital requirements for several lines of business); however most probably we will witness negative impacts for a while due to implementation costs and/or the efforts of smaller banks to raise additional capital. Basel II has definitely added value to the prudential rules and regulations, answering in many instances to the need to promote increased safety of the financial sector. The new requirements improved the prudential framework by adding minimum capital requirements for market and operational risks, improved assessment of risk sensitivity (more classes of assets and types of exposures) and introduction of internal models for credit risk. Nevertheless real life implementation proved several negative impacts and limitations of Basel II, especially in the light of the current financial crisis. One of the main negative impacts is represented by significant reductions of capital requirements for banks utilising internal models not correlated with their ability to withstand systemic crises – an overestimation of their capacity to properly assess risks by using internal models. The “model risk”, generated by the lack of macro variables and improper internal mechanisms for risk measurement, triggered an imbalance between exposures and capital (unjustly amplifying the leverage and volatility of capital requirements) (Georgescu, 2012). Too much emphasis on the external ratings is another negative side of Basel II: rating agencies have been too optimistic in setting the ratings (basically no rules in force in this respect) and Europe (especially Eastern Europe) has benefited much later (1990s) from the

presence of external ratings and rating agencies compared to US. Basel II provisions also generated an underestimation of capital requirements in relation to the banks’ trading books by employing untested and unrealistic VAR models (Atik, 2009). Securitisation transactions have also contributed to the contagion effect and triggered systemic risks, which are not fully addressed by the current rules. One other limitation worth mentioning is represented by the fact that liquidity risk is improperly addressed by the Basel II framework on both financing side and individual asset liquidity (Georgescu, 2012). One last remark refers to the fact that Basel II generated competitive advantage for the large banks owning infrastructure and resources to implement its requirements and also for nonbanking financial institutions not subject to Basel II requirements. The seven pitfalls are: ● Waiting for the regulators to provide detailed guidance and lay out an implementation road map. ● Failing to understand the overlap among regulatory initiatives, or dealing with them in a siloed manner. ● Failing to make the link between information, technology, risk management, and the business. ● Attempting to build Basel II infrastructure without data and technical architecture road maps. ● Failing to generate the internal support needed for a smooth implementation. ● Underestimating the magnitude of cultural change that Basel II requires. ● Not correctly factoring Basel II into the institution's merger and acquisition strategy.

CHAPTER 5 INTRODUCTION TO BASEL III & ITS IMPLICATION ON INDIA

5.1 INTRODUCTION TO BASEL III 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. 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. 5.1.1 December 2017 - Finalization of the Basel III post-crisis regulatory reforms The Basel III reforms complement the initial phase of the Basel III reforms announced in 2010. The 2017 reforms seek to restore credibility in the calculation of risk weighted assets (RWAs) and improve the comparability of banks’ capital ratios. RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses. A prudent and credible calculation of RWAs is an integral element of the risk-based capital framework. The revisions seek to restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios by: ● enhancing the robustness and risk sensitivity of the standardised approaches for credit risk, credit valuation adjustment (CVA) risk and operational risk; ● constraining the use of the internal model approaches, by placing limits on certain inputs used to calculate capital requirements under the internal ratings-based (IRB) approach for credit risk and by removing the use of the internal model approaches for CVA risk and for operational risk; ● introducing a leverage ratio buffer to further limit the leverage of global systemically important banks (G-SIBs); and ● replacing the existing Basel II output floor with a more robust risk-sensitive floor based on the Committee’s revised Basel III standardised approaches.

5.2 Credit risk Credit risk accounts for the bulk of most banks’ risk-taking activities and hence their regulatory capital requirements. The standardised approach is used by the majority of banks around the world, including in non-Basel Committee jurisdictions. The Committee’s revisions to the standardised approach for credit risk enhance the regulatory framework by: ● improving its granularity and risk sensitivity. For example, the Basel II standardised

approach assigns a flat risk weight to all residential mortgages. In the revised standardised approach mortgage risk weights depend on the loan-to-value (LTV) ratio of the mortgage; ● reducing mechanistic reliance on credit ratings, by requiring banks to conduct sufficient due diligence, and by developing a sufficiently granular non-ratings-based approach for jurisdictions that cannot or do not wish to rely on external credit ratings; and ● As a result, providing the foundation for a revised output floor to internally modelled capital requirements (to replace the existing Basel I floor) and related disclosure to enhance comparability across banks and restore a level playing field. In summary, the key revisions are as follows: ● A more granular approach has been developed for unrated exposures to banks and corporates, and for rated exposures in jurisdictions where the use of credit ratings is permitted. ● For exposures to banks, some of the risk weights for rated exposures have been recalibrated. In addition, the risk-weighted treatment for unrated exposures is more granular than the existing flat risk weight. A standalone treatment for covered bonds has also been introduced. ● For exposures to corporates, a more granular look-up table has been developed. A specific risk weight applies to exposures to small and medium-sized enterprises (SMEs). In addition, the revised standardised approach includes a standalone treatment for exposures to project finance, object finance and commodities finance. ● For residential real estate exposures, more risk-sensitive approaches have been developed, whereby risk weights vary based on the LTV ratio of the mortgage (instead of the existing single risk weight) and in ways that better reflect differences in market structures. ● For retail exposures, a more granular treatment applies, which distinguishes between different types of retail exposures. For example, the regulatory retail portfolio distinguishes between revolving facilities (where credit is typically drawn upon) and transactors (where the facility is used to facilitate transactions rather than a source of credit). ● For commercial real estate exposures, approaches have been developed that are more risk sensitive than the flat risk weight which generally applies. ● For subordinated debt and equity exposures, a more granular risk weight treatment applies (relative to the current flat risk weight). ● For off-balance sheet items, the credit conversion factors (CCFs), which are used to determine the amount of an exposure to be risk-weighted, have been made more risksensitive, including the introduction of positive CCFs for unconditionally cancellable commitments (UCCs).

5.3 The CVA framework The initial phase of Basel III reforms introduced a capital charge for potential mark-to-market losses of derivative instruments as a result of the deterioration in the creditworthiness of a counterparty. This risk – known as CVA risk – was a major source of losses for banks during the global financial crisis, exceeding losses arising from outright defaults in some instances. The Committee has agreed to revise the CVA framework to: ● enhance its risk sensitivity: the current CVA framework does not cover an important driver of CVA risk, namely the exposure component of CVA. This component is

directly related to the price of the transactions that are within the scope of application of the CVA risk capital charge. As these prices are sensitive to variability in underlying market risk factors, the CVA also materially depends on those factors. The revised CVA framework takes into account the exposure component of CVA risk along with its associated hedges; ● strengthen its robustness: CVA is a complex risk, and is often more complex than the majority of the positions in banks’ trading books. Accordingly, the Committee is of the view that such a risk cannot be modelled by banks in a robust and prudent manner. The revised framework removes the use of an internally modelled approach, and consists of: (i) a standardised approach; and (ii) a basic approach. In addition, a bank with an aggregate notional amount of non-centrally cleared derivatives less than or equal to €100 billion may calculate their CVA capital charge as a simple multiplier of its counterparty credit risk charge. ● improve its consistency: CVA risk is a form of market risk as it is realised through a change in the mark-to-market value of a bank’s exposures to its derivative counterparties. As such, the standardised and basic approaches of the revised CVA framework have been designed and calibrated to be consistent with the approaches used in the revised market risk framework. In particular, the standardised CVA approach, like the market risk approaches, is based on fair value sensitivities to market risk factors and the basic approach is benchmarked to the standardised approach.

5.4 Operational risk The financial crisis highlighted two main shortcomings with the existing operational risk framework. First, capital requirements for operational risk proved insufficient to cover operational risk losses incurred by some banks. Second, the nature of these losses – covering events such as misconduct, and inadequate systems and controls – highlighted the difficulty associated with using internal models to estimate capital requirements for operational risk. The Committee has streamlined the operational risk framework. The advanced measurement approaches (AMA) for calculating operational risk capital requirements (which are based on banks’ internal models) and the existing three standardised approaches are replaced with a single risk-sensitive standardised approach to be used by all banks. The new standardised approach for operational risk determines a bank’s operational risk capital requirements based on two components: (i) a measure of a bank’s income; and (ii) a measure of a bank’s historical losses. Conceptually, it assumes: (i) that operational risk increases at an increasing rate with a bank’s income; and (ii) banks which have experienced greater operational risk losses historically are assumed to be more likely to experience operational risk losses in the future. The leverage ratio complements the risk-weighted capital requirements by providing a

safeguard against unsustainable levels of leverage and by mitigating gaming and model risk across both internal models and standardised risk measurement approaches. 5.5 The leverage ratio To maintain the relative incentives provided by both capital constraints, the finalised Basel III reforms introduce a leverage ratio buffer for G-SIBs. Such an approach is consistent with the risk-weighted G-SIB buffer, which seeks to mitigate the externalities created by GSIBs. The leverage ratio G-SIB buffer must be met with Tier 1 capital and is set at 50% of a G-SIB’s risk weighted higher-loss absorbency requirements. For example, a G-SIB subject to a 2% risk-weighted higher-loss absorbency requirement would be subject to a 1% leverage ratio buffer requirement. The leverage ratio buffer takes the form of a capital buffer akin to the capital buffers in the risk weighted framework. As such, the leverage ratio buffer will be divided into five ranges. As is the case with the risk-weighted framework, capital distribution constraints will be imposed on a G-SIB that does not meet its leverage ratio buffer requirement. The distribution constraints imposed on a G-SIB will depend on its CET1 risk-weighted ratio and Tier 1 leverage ratio. A G-SIB that meets: (i) its CET1 risk-weighted requirements (defined as a 4.5% minimum requirement, a 2.5% capital conservation buffer and the G-SIB higher loss-absorbency requirement) and; (ii) its Tier 1 leverage ratio requirement (defined as a 3% leverage ratio minimum requirement and the G-SIB leverage ratio buffer) will not be subject to distribution constraints. A G-SIB that does not meet one of these requirements will be subject to the associated minimum capital conservation requirement (expressed as a percentage of earnings). A G-SIB that does not meet both requirements will be subject to the higher of the two associated conservation requirements. The finalisation of Basel III in December 2017 represents an important milestone for the Basel Committee’s response to the global financial crisis. The full set of Basel III reforms will help enhance the resilience of the banking system. The Basel Committee will continue to exercise its mandate to strengthen the regulation, supervision and practices of banks worldwide. The agenda changes, but the purpose is constant – to safeguard and enhance financial stability The Basel Committee has agreed that jurisdictions may exercise national discretion in periods of exceptional macroeconomic circumstances to exempt central bank reserves from the leverage ratio exposure measure on a temporary basis. Jurisdictions that exercise this discretion would be required to recalibrate the minimum leverage ratio requirement commensurately to offset the impact of excluding central bank reserves, and require their banks to disclose the impact of this exemption on their leverage ratios. The Committee continues to monitor the impact of the Basel III leverage ratio’s treatment of client-cleared derivative transactions. It will review the impact of the leverage ratio on banks’ provision of clearing services and any consequent impact on the resilience of central counterparty clearing.

The Basel III framework consisting of the three Pillars namely minimum capital requirement, supervisory review process and market discipline along with the liquidity measures and SIFI‟s are depicted as per the figure below:

5.6 ADVENT OF BASEL III IN INDIA In the ambit of the Basel III Accord the Reserve Bank of India (RBI), the regulatory authority of the Indian banking industry, issued guideline on implementation of Basel III in May 2012, which are applicable to all commercial banks operating in India. The Basel III capital regulation has been implemented from April 1, 2013 in India in phases and it will be fully implemented as on March 31, 2019. Further, on a review in May 2013, the parallel run and prudential floor for implementation of Basel II vis-à-vis Basel I have been discontinued. Banks have to comply with the regulatory limits and minima as prescribed under Basel III capital regulations, on an ongoing basis. To ensure smooth transition to Basel III, appropriate transitional arrangements have been provided for meeting the minimum Basel III capital ratios, full regulatory adjustments to the components of capital etc. (RBI, 2015) The Basel III Capital Regulations guidelines issued by RBI are bifurcated into six parts: Part A: Minimum Capital Requirement (Pillar 1), Part B: Supervisory Review and Evaluation Process (Pillar 2), Part C: Market Discipline (Pillar 3), Part D: Capital Conservation Buffer Framework, Part E: Leverage Ratio Framework, Part F: Countercyclical Capital Buffer Framework. Further, the guidelines on „Liquidity Risk Management by Banks‟ were issued by RBI vide circularDBOD.BP.No.56/21.04.098/2012-13 dated November 7, 2012. Two minimum standards viz. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) for funding liquidity were prescribed by the Basel Committee for achieving two separate but complementary objectives. In addition, a set of five monitoring tools to be used for monitoring the liquidity risk exposures of banks was also prescribed in the said document. As evident from the comparative ratio‟s stated above, it can be inferred that RBI has always been conservative in stipulating the Basel norms as compared to the norms suggested by the Basel Committee. 5.6.1 Objectives of Adoption of Basel III for Indian Banking Industry The adoption of Basel III norms are intended to reduce the probability and severity of crisis in the banking industry and to enhance the financial stability of the country. India is the world‟s fastest growing major economy, coupled with this fact and the various initiatives like Make in India, the banking industry should be strong enough to provide a firm and durable foundation for economic growth. Moreover the compliance with the global standard regulations will enable the Indian banks to avoid any disadvantages in the global competition. The features of Basel-III such as higher risk coverage, thrust on loss-absorbing capital in periods of stress, improving liquidity standards, creation of capital buffers in good times and prevention of excess buildup of debt during boom times would help create a resilient banking system. (RBI, 2015) Basel III reforms strengthen the bank-level i.e. micro prudential regulation, with the intention to raise the resilience of individual banking institutions in periods of stress. Besides, the reforms have a macro prudential focus also, addressing system wide risks, which can build up across the banking sector, as well as the procyclical amplification of these risks over time. 5.6.2 Benefits and Challenges posed by Basel III for Indian PSBs Public Sector Banks (PSBs) include the banks where the Government of India is holding a

majority stake of more than 50% by way of the nationalization process. PSBs work for social, economic and at times political cause also. They are bestowed with the burden of controlling and guiding the economy at the most critical times of inflation and deflation and cannot shy away from their duties which private and foreign sector banks may deem to be unprofitable. PSBs control nearly 72 percent of the market amongst the Any new regulation is associated with various costs and benefits. Banks face the daunting task of meeting stakeholder, regulator and customer expectations while complying with stringent new regulatory requirements that are gradually taking place because of Basel III framework. The various benefits derived and the challenges faced by Indian banks through the implementation of Basel III are as enumerated below.

5.7 MACRO-ECONOMIC EFFECT (Mahapatra, 2012) 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. (BIS, 2010) The Macroeconomic Assessment Group (MAG) established in February 2010 by Financial Stability Board and BCBS to coordinate an assessment of the macro economic 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 (BIS, 2010) Historical experience suggests that, in any given country, banking crises occur on average once every 20 to 25 years, i.e. the average annual probability of a crisis is of the order of 4 to 5%. The evidence indicates that banking crises are associated with large losses in output relative to trend and that these costs extend well beyond the year in which the crisis erupts. The cumulative (discounted) output losses range from a minimum of 20% to well in excess of 100% of pre-crisis output, depending primarily on how long-lasting the effects are estimated to be. It is inferred that each 1 percentage point reduction in the annual probability of a crisis yields an expected benefit per year equal to 0.6% of output when banking crises are allowed to have a permanent effect on real activity. When crises are seen to have only a temporary effect each 1 percentage point reduction in the annual probability of a crisis yields an expected benefit per year equal to 0.2% of output. Mapping tighter capital and liquidity requirements into reductions in the probability of crises is particularly difficult. Although there is considerable uncertainty about the exact magnitude of the effect, the evidence suggests that higher capital and liquidity requirements can significantly reduce the probability of banking crises. As one would expect, the incremental benefits decline at the margin. Thus, they are relatively larger when increasing bank capital ratios from lower levels and they decline as standards are progressively tightened. More stringent capital regulation can result in a positive long-run effect on GDP growth, since the benefits of decline in the expected cost of avoiding banking crises outweigh the costs of complying with the stringent capital requirements, such as higher lending spreads

and reduction in lending. 5.8 EFFECT ON CAPITAL REQUIREMENTS The overall capital adequacy ratio proposed by RBI is at 11.50 % as against the 9.00% at present. Moreover, the additional leverage ratio has been introduced at 4.50 %. (Subbarao, 2012) Subbarao D., RBI Governor, stated in his speech in Oct 2012 that the Reserve Bank‟s estimates projectan additional capital requirement of Rs 5 trillion (i.e. Rs 5,00,000 Cr), of which non-equity capital will be of the order of Rs 3.25 trillion (i.e. Rs 3,25,000 Cr) while equity capital will be of the order of Rs 1.75 trillion (i.e. Rs 1,75,000 Cr). Majority of this requirement was to made good by the Govt of India as the PSBs are Govt Undertakings. In this endeavour, the Government of India has infused total Rs 82422 Cr in the PSB‟s since Oct 2012 till Nov 2016. The year wise break up is as follows: The Govt. of India launched the „Indradhanush‟, a seven point plan to revamp the PSB‟s in Aug 2015. In the reforms note it was stated that the PSBs are adequately capitalized and meeting all the Basel III and RBI norms. However, the Government of India wants to adequately capitalize all the banks to keep a safe buffer over and above the minimum norms of Basel III. The Govt. of India estimated that extra capital required for the FY 2016 to FY 2019 is likely to be about Rs 1,80,000 Crore, excluding the internal profit generation which is going to be available to PSBs (based on the estimates of average profit of last three years i.e. FY 2013 to FY 2015). Out of the total requirement, the Government of India proposed to make available Rs.70,000 Crores out of budgetary allocations for four years, Rs 25,000 Cr in FY 2015-16, Rs 25,000 Cr in FY 2016-17, Rs 10,000 Cr in FY 2017-18 and Rs 10,000 Cr in FY 2018-19. The residual requirement of Rs 1,10,000 Cr is proposed to be raised from market. Unfortunately the things didn‟t turn up as expected by the Govt. of India and the PSBs posted considerable losses for the FY 2015-16. (FitchRatings, 2016) Fitch Ratings, vide its press release dt 11.09.2016, stated that the progressive increase in minimum capital requirements under Basel III is likely to put nearly half of Indian banks in danger of breaching capital triggers. State banks are the most at risk, given their poor existing capital buffers and weak prospects for raising capital through market channels.(ICRA, 2016) InICRA‟s estimate, Aug 2016, PSBs will need to raise Tier 1 capital of Rs 1.7-2.1 trillion (Rs 1,72,000 – Rs 2,10,000 Crore) during FY 2017-FY 2019 to meet the higher regulatory minimum capital requirements as well as to fund growth. Of this requirement, around 40% can be made through raising of AT1 instruments; however, given the elevated risk for existing instruments and the weak investor appetite, it is unlikely that PSBs will be able to raise the required AT1 capital. Hence, their dependence on equity raising to meet minimum Tier 1 capital requirements remains very high. The present position of PSBs has discouraged the investors from investing in their shares or debt. More capital will be needed from the Govt., over and above the proposed under Indradhanush reform, to restore market confidence. Though, considering the fiscal concerns, it is difficult for Govt of India to keep on infusing capital in the banks. The Union Budget 2017-18 has kept the budgetary allocation for capital infusion in PSBs unaltered at Rs 10000 Cr. The capital crunch may lead to contraction of credit by the PSBs in general or to a specific sector carrying high risk weight like real estate, personal loans, corporate having external rating in on investment grade i.e. below BBB etc. EFFECT OF PROFITABILITY The increase in capital requirements will have a negative effect on ROE. Due to this it is

believed that Basel III will adversely effect the shareholders of banks. However, some authors believe that a decrease in ROE due to increase in capital does not lead to reduction in the value as the shareholders expect lower return by way of improved downside protection. Basel III also introduces a Leverage ratio of 3 % as the ratio of Tier 1 Capital to total exposure, the new leverage ratio maylimit banks‟ scope of action. Basel III introduced the new liquidity requirements in form of LCR and NSFR. The banks need to hold significantly more liquid low-yielding assets to comply with the LCR, which will have adverse impact on the profitability. Though, in case of PSBs the existing SLR requirements runs parallel to the LCR, which poses additional burden on banks. Considering this, RBI has reduced the SLR to 20.75 % as on Oct 2016 from 23.00 % as on April 2013, i.e. since the implementation of Basel III. A portion i.e. 7% of LCR is also available for LCR. The NSFR will necessitate the banks to change their funding preference towards long-term funding, which will also lead to higher funding cost. EFFECT ON OPERATIONAL ISSUES The PSBs need urgently to improve their systems of risk management and supervision to achieve Basel III norms. This may also necessitate the skill development of the officials at all levels to ensure capital conservation. The PSBs along with Govt and RBI need to undertake reforms related to governance-related problems in their organizations. The PSBs are consistently losing their market share to their private sector peers due to being less efficient in delivering services, low cost efficiencies and comparatively higher delinquencies. The improved efficiencies and competitiveness of PSBs will also enhance their valuations, which will enable them to raise equity capital from markets. 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. In process of complying with the Basel III guidelines, banks will be encouraged to take more calculated and strategic approach towards business decision making, asset choices and growth while allocating capital charge towards opportunities thatsuite the banks actual risk and return profile, which will lead to better asset quality. In order to meet the Basel III compliance banks have to ensure that the risk and finance teams have quick access to centralised, clean and consistent data as the data management requirement of Basel III are significant for calculating capital adequacy, leverage and liquidity effectively and accurately. It is imperative for the efficient collection, consolidation and submission of requisite reports. Better data management will also enable the banks to manage the customers in a better way and will strengthen the AML framework.

CHAPTER 6 CONCLUSIONS

6.1 CONCLUSIONS Basel II considers both credit and operational risks apart from market risk as the major sources of risks. Basel II norms direct banks to allocate adequate amounts of capital for these types of risks unlike Basel I Implementation of Basel II framework by banks in India has resulted in better performance of banks, benefitting all its stakeholders. Basel II norms results in reduction of regulatory capital by reducing the credit risk weights, this can be done by suitably altering the bank’s portfolios. The global financial crisis of 2007-08 has paved the way for Basel-III norms with emphasis on the quality of capital in the Bank balance sheet by introducing buffers to withstand situation arising out financial distress .In spite of Basel –I and Basel-II guidelines, the financial world saw the worst crisis in early 2008 and whole financial markets tambled. One of the major debacle was the fall of Lehman Brothers. 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 Government of India. It is estimated that Indian banks will be required to raise Rs 6, 00,000 crores in external capital in next nine years or so i.e. by 2020

The present study describes the understanding of Basel II norms and its impact on the Indian Banking System. The focus on the positive and negative impact of adopting Basel Accord on the banks in India. It outlines that even though there are a few loopholes in the Basel II framework which has some demerits, but it has far longer list of benefits which outweighs all the disadvantages. Hence, implementation of Basel II framework by banks in India has resulted in better performance of banks, benefitting all its stakeholders. According to Basel III monitoring report (2017) released by BCBS, which covers 210 banks (consisting of 100 internationally active banks categorised as group-1 and 110 banks categorised as group-2), all banks meet the risk based minimum capital requirements. Further 98% of the banks in group -1 and 96% of the banks in group-2 had NSFR of more than 90% (which is to be achieved to 100%). Additionally, 88 % of group-1 banks and 94% of group-2 banks had LCR of more than 100%. Thus, we can infer that there is overall good progress towards full implementation of Basel III accord internationally. However, higher capital and minimum liquidity requirements are likely to cause an adverse impact on return on equity, although coupled with LCR and NSFR, more liquidity is expected to remain in the system and growth in short tenure assets can be expected. In conclusion, it can be stated that the guidelines issued under Basel III Accord are effective in theory to protect the banking system from financial adversities; however, the real effectiveness of Basel III implementation can be analysed only after its actual implementation. Additionally, inconsistency in implementation of Basel III across nations would impact the flow of capital adversely.

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