Basel Norms and Banking System of India- a critical anaysis

The birth of the Basel banking norms is attributed to the incorporation of the Basel Committee on Banking Supervision (BCBS), established by the central bank of the G-10 countries in 1974. This came into being under the patronage of Bank for International Settlements (BIS), Basel, Switzerland. The Committee formulates guidelines and provides recommendations on banking regulation based on capital risk, market risk and operational risk. The Committee was formed in response to the chaotic liquidation of Herstatt Bank, based in Cologne, Germany in 1974. The incident illustrated the presence of settlement risk in international finance. Historically, in 1973, the sudden failure of the Bretton Woods System resulted in the occurrence of casualties in 1974 such as withdrawal of banking license of Bankhaus Herstatt in Germany, and shut down of Franklin National Bank in New York. In 1975, three months after the closing of Franklin National Bank and other similar disruptions, the central bank governors of the G-10 countries took the initiative to establish a committee on Banking Regulations and Supervisory Practices in order to address such issues. This committee was later renamed as Basel Committee on Banking Supervision. The Committee acts as a forum where regular cooperation between the member countries takes place regarding banking regulations and supervisory practices. The Committee aims at improving supervisory knowhow and the quality of banking supervision quality worldwide. Currently there are 27 member countries in the Committee since 2009. These member countries are being represented in the Committee by the central bank and the authority for the prudential supervision of banking business. Apart from banking regulations and supervisory practices, the Committee also focuses on closing the gaps in international supervisory coverage.
The first set of Basel Accords, known as Basel I, was issued in 1988 with the primary focus on credit risk. It proposed creation of a banking asset classification system on the basis of the inherent risk of the asset. Basel II, the second set of Basel Accords, was published in June 2004 – in order to control misuse of the Basel I norms, most notably through regulatory arbitrage. The Basel II norms were intended to create a uniform international standard on the amount of capital that banks need to guard themselves against financial and operational risks. This again would be achieved through maintaining adequate capital proportional to the risk the bank exposes itself to (through its lending and investment practices). It also laid increased focus on disclosure requirements. The third installment of the Basel Accords (Basel III) was introduced in response to the global financial crisis, and is scheduled to be implemented by 2018. It calls for greater strengthening of capital requirements, bank liquidity and bank leverage. However, critics argue that these norms may further hamper the stability of the financial system by providing higher incentive to circumvent the regulations. The Indian banking system has remained largely unscathed in the global financial crisis. This is mainly amongst others, on account of the relatively robust capitalization of Indian banks. The Reserve Bank of India (RBI) had scheduled the start date for implementation of Basel III norms over a 6-year period starting April 2013. The recent requirement of infusion of additional equity in view of the low economic growth and increasing non-performing assets of Indian banks paint a gloomy picture.

The implementation of Basel III norms commenced in India from April 1, 2013 in a phased manner, with full compliance initially targeted to be achieved by March 31, 2018 but extended to March 31, 2019. The Indian banking system faces the challenge of complying with the stringent requirements of Basel III framework, while at the same time maintaining growth and profitability. The RBI prescribes a minimum Capital to Risk Weighted Asset Ratio (CRAR) at 9 percent, higher than 8 percent prescription of Basel III accord. Even though the Indian banks look well-capitalized at 13 percent CRAR, it still faces immense challenges to adopt Basel III. Banks will face increasing capital requirements due to increasing credit requirements for financing growth. Also, there will be a fiscal burden, if majority shareholding has to be retained by the Indian government. In order to comply with the Basel III norms there is a requirement to raise large amount of capital by the Indian banks in the next five years. According to the CARE’s estimate, the total equity capital requirement for Indian banks till March 2019 (when Basel III would be fully implemented) is likely to be in the range of Rs.1.5-1.8 trillion assuming that the average GDP growth will be 6 percent and the average credit growth will be in the range of 15 percent to 16 percent over the next five years. Again, it is also estimated that a return on total assets at 0.6 percent will be earned by the bank and would maintain a minimum regulatory requirement of CAR. India is working towards implementation of capital framework which warrants margin requirements for non-centrally-cleared derivatives. This is seen as a push towards central clearing.
In January 2014, an Expert Committee to Revise and Strengthen the Monetary Policy Framework recommended reduction of SLR to be consistent with Liquidity Coverage Ratio, as required under the Basel III framework. This recommendation is aimed at improving the transmission of monetary policy in India.
In addition to Basel III framework, RBI intends to employ its new Risk Based Supervision (RBS) framework, which includes an internal Supervisory Program for Assessment of Risk and Capital (SPARC) and regular stress tests. Systematically Important Financial Institutions (SIFIs) will be regulated and subject to supervision and scrutiny. The Indian Banking systemically recorded a Return on Equity of 13 percent, before implementation of Basel III. However, the same was starkly low under the stress test carried out by RBI. This underscored the importance of strengthening of the Indian banking system.
RBI had earlier issued draft regulations on Liquidity Risk Management (LRM) in February 2012. The final regulation was issued in November 2012 after incorporating comments and feedback. It was then indicated, in the regulation, that the final rules based on Basel III liquidity standards i.e. Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (January 2013) will be issued once the same has been finalized by the Basel Committee.
A crucial motive of banking sector reforms of 1990s was to bring about an improvement of profitability and operational efficiency of banks. Cost to Income ratio (CI), Net Interest Margin (NIM) and Return on Assets (RoA) indicates a decline in CI and NIM for the entire banking system over this period, but an improvement in RoA. Basel II norms indicate that banks should aim to attain CI of 40 percent, and RoA of more than 1 percent. India’s performance compares favorably in these two benchmarks in the decade starting 2000, indicating an improvement in the efficiency of the Indian banking sector in recent years.
Declining capital adequacy of public sector banks is a matter of great concern for the government, considering the fiscal implications of further capital infusion. Though the public sector banks conform to statutory CRAR target, the quality and quantity of (common equity) shall have to be improved, upon migration to Basel III norms.

Conclusion and future perspective: The Basel norms, at some level, aim to create a global banking system that is fairly homogenous. While this very aim purports to build a more robust financial system, it may actually be its undoing. In other words, such a homogeneous banking system could potentially be more vulnerable to a mass failure or collapse. Simply speaking, a diverse group is an advantage since an attack only affects a certain percentage of its constituents. A banking system that is too homogenous is, in fact, dangerous for the future of countries the world over.

Local expertise showcased on a global platform
In this context, Persaud (2000, 2001) had remarked that a market being large is not sufficient for it to be highly stable and liquid. It must also exhibit a broad range of participants having diverse objectives as one of the key characteristics. He further elucidates that local knowledge is a key competitive advantage to a bank. Moreover, a successful financial institution endeavors to know its customers better, lend to them when others would not, and withdraw from them when others do not realize the potential threat. This competitive advantage of local knowledge is completely disregarded by the Basel norms, as it attempts to bring banks globally on the same platform. The credit risk management of Grameen Bank of Bangladesh epitomizes this point, wherein the bank has been successful in lending to poor women without high non-performing assets (NPAs), despite the fact that such loans were otherwise considered high risk assets due to inadequate credit history.

National competencies in the international arena
The Basel norms also fail to consider national competencies. We have a global scenario where individual countries vastly differ in their extent of development. Given the differing development in the banking systems and economies of countries, the norms do not specifically take measures to put various countries on a level-playing field. Take, for instance, a bank branch operating locally in a particular country. In the context of that country, it could see profitability suffer. The Basel norms in general demand a high amount of capital, and are thus quite stringent. In an age where international banks are so prevalent, such differences across geographies can become tricky to deal with. The Basel accords need to incorporate, in some form, the element of national competencies so as to create a level-playing field.

Coordinated adoption and streamlined implementation
While the Basel accords aim to bring along a host of benefits, they inevitably imply high costs for adopting nations. This is especially true because countries implementing the norms earlier would need to maintain greater capital base as stipulated by the new norms. In turn, the banking systems of such countries start bearing a higher cost before others who implement the norms later do. This lack of synchronization in the adoption of the norms dilutes their efficacy. The proposal of phases and timelines for implementation should be put forth in a manner that ensures a fair amount of coordinated adoption. Of course, this needs to be looked at in conjunction with the previous paragraph to take into consideration national competencies.
Compliance with Basel norms requires a high level of capital, which brings down the competitiveness of a bank. Adoption of Basel norms in countries having inadequate resources could result in the inadvertent diversion of capital from more vital avenues.

By: Abhishek Sharma