IIMB Management Review (2013) 25, 115e130

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ROUND TABLE

Basel III implementation: Issues and challenges for

Indian banks
M. Jayadev*
Finance and Control, Indian Institute of Management, Bannerghatta Road, Bangalore 560076, India

KEYWORDS
Basel III;
Capital regulation;
Capital management;
Indian banking

Abstract The Basel III framework, whose main thrust has been enhancing the banking
sectors safety and stability, emphasises the need to improve the quality and quantity of
capital components, leverage ratio, liquidity standards, and enhanced disclosures. This article
first lays the context of Basel III and then incorporates the views of senior executives of Indian
banks and risk management experts on addressing the challenges of implementing the Basel III
framework, especially in areas such as augmentation of capital resources, growth versus financial stability, challenges for enhanced profitability, deposit pricing, cost of credit, maintenance of liquidity standards, and strengthening of risk architecture.
2013 Indian Institute of Management Bangalore. Production and hosting by Elsevier Ltd.
All rights reserved.

Context note
In a banking entity assets are created as a process of
intermediation by accepting deposits; the basic function of
intermediation itself is a source of credit and liquidity risks
for any banking institution. Further, banks are exposed to
various market and non-market risks in performing their
functions. These risks expose banks to events, both expected and unexpected, with the potential to cause losses,
putting depositors money at risk. Expected losses may
* Tel.: 91 80 26993138.
E-mail address: [email protected]
Peer-review under responsibility of Indian Institute of Management
Bangalore

be mitigated by a combination of product pricing and

accounting loss provisions, while capital funds are expected
to meet unexpected losses. Thus the primary role of capital
in a banking institution is to meet the unexpected losses
arising out of portfolio choice of banks and to protect the
depositors money.

Basel capital accords

Banks and the regulators all over the world have been
concerned about these risks, and the formal framework for
banks capital structure was evolved in 1988 with the
introduction of the International Convergence of Capital
Measurement and Capital Standards, popularly known as
Basel I, issued by the Basel Committee on Banking Supervision (BCBS). Following Basel I banks were required to
maintain a minimum capital adequacy of 8% against risk
weighted assets (RWA). Here Basel suggested a portfolio
approach to credit risk by assigning appropriate risk weights

0970-3896 2013 Indian Institute of Management Bangalore. Production and hosting by Elsevier Ltd. All rights reserved.
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116
against each asset (for example, housing loans carry 50%
risk weight and corporate loans carry 100% risk weight). The
capital components include long term debt funds also by
categorising qualitative equity capital as Tier I and others
as Tier II. Although the Basel Accord was signed only by the
G-10 countries plus two more nations, more than 100
countries across the globe have made these norms
mandatory in their domestic banking systems. In India, the
Reserve Bank of India (RBI) implemented Basel I norms from
1992 onwards. The post 1990 scenario world over saw banks
increasing their trading activity by investing in securities
which exposed banks to price risks, and responding to this,
in 1996, the Basel Committee suggested that banks maintain capital funds against market risk by following either
the standardised measurement approach (SMA) or internal
measurement approach (IMA) to meet the unforeseen losses
arising out of market risks.
Basel I was criticised for its rigidity of one-size fits
approach and absence of risk sensitivity in estimating capital
requirements. After several discussions and revising multiple
drafts, in 2004 the BCBS came out with a comprehensive
framework of capital regulation popularly known as Basel II.
Basel II was built up on three mutually reinforcing pillars e
minimum capital requirements, supervisory review process,
and market discipline. Under Basel II, banks were required to
maintain the minimum capital requirement of 8% against the
risk weighted assets, while RWA was computed by considering the three major generic risks e credit, market, and
operational risks. To estimate the capital requirements for
credit risk and operational risk, Basel-II proposed a menu of
approaches e standardised, foundation internal ratings, and
advanced internal ratings approach. However, for market
risk Basel II continued with the 1996 framework which suggested both standardised and internal measurement models.
The European Parliament approved all the three
Basel II approaches for all European Union (EU) banks in
2005 and formally adopted the agreement in 2006. The
EU implemented the standardised and foundation approaches
as early as 2007 and the advanced approaches by 2008. In the
US, the rules apply only to the 19 largest, internationally
active core US Banks. (Core banks are those with consolidated total assets of $ 250 billion or more or with consolidated
total on-balance sheet foreign exposure of $ 10 billion or
more.) However, some banks voluntarily adopted the rules
(opt in banks). In India, from 2007 to 08 onwards, banks
have followed estimation of capital requirements by
following the standardised approach for all the three risks e
credit, market and operational risks.
Although Basel II was a very comprehensive capital
regulation framework architected on sophisticated risk
quantification models, it failed to address certain issues
which emerged during the financial crisis of 2007e08
(Fratianni and Marchionne (2009), Acharya et al. (2011),
Reddy (2009). First, Basel II, a risk sensitive framework,
proved to be pro-cyclical; in good times, when banks were
doing well, and the market was willing to invest capital in
them, Basel II did not impose additional capital requirement
on banks. On the other hand, in stressed times, when banks
required additional capital and markets were wary of
supplying that capital, Basel II required banks to bring in
more of it. During the crisis, it was the failure to bring in
additional capital that forced major international banks into

M. Jayadev
a vicious cycle of deleveraging, thereby hurtling global
financial markets into seizure and economies around the
world into recession. Second, by following value at risk (VaR)
models banks maintained capital requirements against
trading book exposures assuming that these could be liquidated, and substantial banking book assets were parked in
trading book, which helped banks to optimise the capital
requirements. These trading book exposures include the
securitised bonds, derivative products, and other toxic
assets. The third issue was the absence of any explicit
regulation governing leverage. Basel II assumed that its risk
based capital requirement would implicitly mitigate the risk
of excessive leverage. Unfortunately, excessive leverage of
banks was one of the prime causes of the crisis. The fourth
issue was that Basel II did not consider liquidity risk as part of
capital regulation. During the financial crisis unaddressed
liquidity risk cascaded into solvency risk; the data shows that
the Federal Reserve, the European Central Bank (ECB), the
Bank of England, the Bank of Japan, and the Swiss National
Bank have together injected USD 2.74 trillion to meet
liquidity requirements.1 Finally, Basel II focussed more on
individual financial institutions and ignored the systemic risk
arising from the interconnectedness across institutions and
markets, which led the crisis to spread to several financial
markets (Acharya and Richardson 2009). Since the beginning
of the financial turbulence in 2007, the total reported write
downs and losses of banks globally have exceeded 888 billion
dollars. Some estimates of the overall expected losses by
banks and other financial institutions are in the range of 2.2
trillion dollars.2
In response to the 2007e09 global financial crisis BCBS
issued Basel II.5, which was designed to estimate capital
requirements for credit risk in the trading book of a bank.
Basel II.5 was intended to prevent inappropriate placement of
securities in the book that would provide the most favourable
accounting treatment of securities at a particular point in
time. In that order, the Basel Committee issued a series of
documents to address specifically counterparty risk in derivative transactions, strengthening of liquidity standards, and
market risk framework. Consolidating all these, the BCBS
released the Basel III framework entitled Basel III: A Global
Regulatory Framework for more Resilient Banks and Banking
systems in December 2010 (revised in June 2011).
According to the BCBS, the Basel III proposals have two
main objectives:
 To strengthen global capital and liquidity regulations
with the goal of promoting a more resilient banking
sector.
 To improve the banking sectors ability to absorb shocks
arising from financial and economic stress.

Enhancements of Basel III over Basel II

The enhancements of Basel III over Basel II come primarily
in four areas: (i) augmentation in the level and quality of
1

IMF, Global Financial Stability Report Market updated, 28 Jan

2009, p-2.
2
IMF, Global Financial Stability Report Market updated, 28 Jan
2009, p-2.

Basel III implementation

Table 1

117

Minimum regulatory capital prescriptions (as % risk weighted assets).

A Z (B D)
B
C
D
E
FZCE
GZAE
H

Minimum total capital

Minimum tier 1 capital
of which:
Minimum common equity tier 1 capital
Maximum tier 2 capital (within total capital)
Capital conservation buffer (CCB)
Minimum common equity tier 1 capital CCB
Minimum total capital CCB
Leverage ratio (ratio to total assets)

Basel III

Current

Basel III

(as on
January 2019)

(Basel II)

(as on March
31, 2018)

8.00
6.00

9.00
6.00

9.00
7.00

4.50
2.00
2.50
7.00
10.5
3.00

3.64
3.00

5.5
2.00
2.5
8.00
11.5
4.55

3.60

(Source: Address by Dr. Duvvuri Subbarao, September 4, 2012).

capital; (ii) introduction of liquidity standards; (iii) modifications in provisioning norms; and (iv) introduction of
leverage ratio. These are elaborated as follows
Increased quantity and quality of capital
Basel III contains various measures aimed at improving the
quantity and quality of capital, with the ultimate aim of
improving the loss-absorption capacity in both going
concerns and liquidation scenarios. Retaining the minimum
capital adequacy ratio of 8%, the Tier I capital ratio
increased to 6% with the equity component stipulated at
4.5%3 (Table 1). The new concepts introduced by Basel III
are of capital conversion buffer and countercyclical capital
buffer (CCB). The capital conversion buffer ensures that
banks are able to absorb losses without breaching the
minimum capital requirement, and are able to carry on
business even in a downturn without deleveraging. This is
not part of the regulatory minimum. So while the 8%
minimum capital requirement remains unchanged under
Basel III, there is an added 2.5% as capital cushion buffer.
The implications of having a buffer are low dividend payout
and low bonus to employees. So if the banks go for this
buffer, the fundamental question before them is how they
are going to reward their shareholders and incentivise their
employees as the profits are likely to decrease. Banks are
already constrained in payment of dividends because there
is a statutory minimum ratio where the profits have to be
transferred. In such a case, how will banks attract more
capital? There is a trade-off for banks between being
prudent and increasing profit.
The countercyclical capital buffer is a pre-emptive
measure that requires banks to build up capital gradually
as imbalances in the credit market develop. It may be in the
range of 0e2.5% of risk weighted assets which could be
imposed on banks during periods of excess credit growth.
There is also a provision for a higher capital surcharge on
systemically important banks.
Basel III strengthens the counterparty credit risk
framework in market risk instruments. This includes the use
of stressed input parameters to determine the capital
requirement for counterparty credit default risk. A new
3

Basel II did not prescribe any minimum equity capital component

but it was generally accepted as 2%.

capital requirement known as credit valuation adjustment

(CVA) risk capital charge for over-the-counter (OTC)
derivatives has been introduced to protect banks against
the risk of decline in the credit quality of the counterparty.
Increased short term liquidity coverage
The Basel Committee has further strengthened the liquidity
framework by developing two minimum standards for
quantifying funding liquidity; Liquidity Coverage Ratio
(LCR) and Net Stable Funding Ratio (NSRF). The LCR standard aims at a bank having an adequate stock of unencumbered high quality liquid assets (HQLA) which consist of
cash or assets that can be converted into cash at little or no
loss of value in private markets to meet its liquidity
requirements in a 30 calendar day liquidity stress scenario.
The two components of LCR are stock of HQLA and the total
net cash flows over the next 30 calendar days. The NSRF is
designed to encourage and incentivise banks to use stable
sources to fund their activities. It helps to reduce dependence on short term wholesale funding during times of
buoyant market liquidity and encourages better assessment
of liquidity risk across all on- and off-balance sheet items.
Net Stable Funding Ratio requires a minimum amount of
stable sources of funding at a bank relative to the liquidity
profiles of the assets, as well as the potential for contingent
liquidity needs arising from off-balance sheet commitments, over a one-year horizon.
The implications here would pertain to the type of
current short term markets available for banks to provide
liquidity, the type of long term markets needed, the cost of
deposit, and the impact on the profitability of banks. One
issue with reference to liquidity is how the regulator would
consider the statutory liquidity ratio (SLR) securities. Banks
are already investing around 25% of their deposits in the SLR
securities which is a substantial amount. A question has also
been raised about the relevance of cash reserve ratio
(CRR). All these have implementation implications for
deposit pricing, cost of funds, and profitability.
Reduced leverage through introduction of backstop
leverage ratio
The newly introduced leverage ratio acts as a non risk
sensitive backstop measure to reduce the risk of a buildup
of excessive leverage in the institution and in the financial

118
system as a whole. The leverage ratio requirement would
hence set an all-encompassing floor to minimum capital
requirements which would limit the potential erosive
effects of gaming and model risk on capital against true
risks. A 3% minimum Tier I leverage is recommended by
Basel III. In India, banks are required to meet this norm
from January 1, 2018.
Strengthening of provisioning norms
Another issue raised by the Basel III reforms is of provisioning
norms; currently there is a standardised approach to provisioning in the banking system. It is a typical accounting
approach, wherein if a loss is incurred, banks have to make
a provision to cover it. But Basel III is talking about a move
from incurred loss approach to expected loss approach.
For an expected loss approach what should be the measure?
Spain (Saurina, 2009) introduced Dynamic Provisioning which
involves computing some portion of the fixed element, and
some portion of the dynamic moving element. The Turner
Report (FSA, 2009) also emphasised the need for Dynamic
Provisioning. The information required is credit cost data,
credit migration, and probability of default. The question is,
what method should be used? The RBI has already released
an approach paper4 on this and is working on the introduction
of a suitable framework.
Enhanced disclosures
The second pillar of Basel II is market discipline, which
involves more of disclosures. Disclosures made by banks are
essential for market participants to make more informed
decisions. Basel III further strengthens the disclosures,
where banks are required to disclose on composition of the
regulatory capital and any adjustments to the regulatory
capital.

Basel III issues for Indian banks

Additional capital
As banks go on increasing the risk weighted asset portfolio
to meet the growing economys credit requirements, they
would need additional capital funds under Basel III.
Different estimates of additional capital infusion have been
announced by various agencies. The international credit
ratings agency, Fitch, estimates this figure to be at around
USD 50 billion, while ICRA projects a figure of around USD 80
billion. Macquarie Capital Securities predicts that there will
be a USD 35 billion dilution in the existing capital of public
sector undertaking (PSU) banks subsequent to adoption of
the stringent Basel III capital accord.5 However, the RBI
Governor had recently stated that PSU banks presently have
a capital adequacy ratio of 13.4%, wherein Tier 1 capital
stood at 9.3%6 (Table 2). This is a statement on the existing
scenario, and does not take into account the imminent
capital dilution. Moreover, additional capital will be
required to address the enhanced counter party default,
especially in OTC derivatives. The RBI estimates project an
additional capital requirement of Rs 5 trillion of which non-

M. Jayadev
equity capital will be of the order of Rs 3.25 trillion while
equity capital will be of the order of Rs 1.75 trillion7 (see
Table 3 for details). The two important assumptions on
which the estimates are made are: risk weighted assets of
individual banks will increase by 20% per annum and banks
can fund 1% capital requirements through retained profits
(RBI 2012). The important questions to be addressed here
are: Can individual banks access the capital market to raise
this capital? How do current ownership structure and
valuations impact the banks capital raising proposals?
Should the government retain majority ownership? How
should the government capitalise the public sector banks?
What are the options before the government?
Growth barrier
Growth and financial stability seem to be two conflicting
goals for an economy. The Indian economy is transforming
structurally and moving towards rapid growth although
some seasonal down trends are seen. The main goal of the
12th Plan is faster, sustainable and more inclusive
growth. The Planning Commission is aiming at a total
outlay of Rs. 51.46 lakh crore in the infrastructure sector
during the 12th Plan (2012e17). Infrastructure sector
investment as percentage of the Gross Domestic Product
(GDP) is expected to rise steadily to 10.40% in the terminal
year (2016e17) of the 12th Plan. The average investment in
infrastructure sector for the 12th Plan as a whole is likely to
be about 9.14% of the GDP. The outstanding credit gap for
the micro and small and medium enterprises (MSME) sector
is estimated at 62%, which is estimated to reduce to 43% in
March 2017 with the assumption of minimum 20% year on
year (Y-o-Y) credit growth to MSME sector and 10% Y-o-Y
credit growth to medium enterprises by scheduled
commercial banks (SCBs).8 The economists projections are
that the Indian economy will see higher growth in the
manufacturing sector which enhances demand for credit.
The financial inclusion project aims to bring several millions
of the population under the ambit of the organised financial
system which will also enhance their credit requirements.
The preliminary research shows that the largest banks in
the world would raise their lending rates on an average by
16 basis points (bps) in order to increase their equity to
asset ratio by 1.3 percentage points needed to achieve the
new Basel regulation of 7% equity to new risk weighted
asset ratio. Increase in lending rate is estimated to cause
loan growth to decline by 1.3% in the long run (Cosimano &
Haura 2011). When the leverage requirement interacts with
the risk based internal ratings-based (IRB) capital requirements it might lead to less lending to low risk customers
and to increased lending to high risk customers. Such allocation effects may be counterproductive to the financial
stability effects of the leverage ratio requirement (Kiema &
Jokivoulle, 2010).
In a structurally transforming economy like India with
rapid upward mobility, credit demand will expand faster
than GDP for several reasons. First, India will shift
increasingly from services to manufacture whose credit
intensity is higher per unit of GDP. Second, increased

Discussion Paper on Introduction of Dynamic Loan Loss Provisioning Framework for Banks in India, 2012.
5
http://www.dsij.in/research/blog/month/5/year/2012.aspx
6
Subba Rao, September 4, 2012

Subba Rao, November 2012

Planning Commission, An Approach to the Twelfth Five Year Plan
(2012-17), Faster, Sustainable and More Inclusive Growth.

Basel III implementation

Table 2

119

Capital to risk weighted assets ratio (in %) under Basel I and II e bank group-wise (as at end of March).

Bank group

Public sector banks

Nationalised banks
State Bank of India group
Private sector banks
Old private sector banks
New private sector banks
Foreign banks
Scheduled commercial banks

Basel I

Basel II

2010

2011

2012

2010

2011

2012

12.1
12.1
12.1
16.7
13.8
17.3
18.1
13.6

11.78
12.15
11.01
15.15
13.29
15.55
17.71
13.02

11.88
11.84
11.97
14.47
12.47
14.9
17.31
12.94

13.3
13.2
13.5
17.4
14.9
18.0
17.3
14.5

13.08
13.47
12.25
16.46
14.55
16.87
16.97
14.19

13.23
13.03
13.7
16.21
14.12
16.66
16.74
14.24

Note: includes IDBI Bank Ltd.

Source: Based on off-site returns submitted by banks.

Table 3

A
B
C
D

Additional common equity requirements of Indian banks (Rs in billion).

Additional equity capital requirements under Basel III

Additional equity capital requirements under Basel II
Net equity capital requirements under Basel III (AeB)
Additional equity capital requirements under Basel III
for public sector banks (A)
Government share (if present shareholding pattern is maintained)
Government share (if shareholding is brought down to 51%)
Market share (if the Governments shareholding
pattern is maintained at present level)

Public sector
banks

Private sector
banks

Total

1400e1500
650e700
750e800

200e250
20e25
180e225

1600e1750
670e725
930e1025

e
e
e

e
e
e

880e910
660e690
520e590

Source: Address by Dr. Duvvuri Subbarao (September 4, 2012).

investment in infrastructure as projected by the Planning

Commission will place enormous demands on credit.
Finally, financial inclusion, which both the Government and
the RBI are driving, will bring millions of low income
households into the formal financial system with almost all
of them needing credit. What all this means is that banks
need to maintain higher capital requirements as per Basel
III at a time when credit demand is going to expand rapidly.
The concern is that this will raise the cost of credit and
hence militate against growth.9 The question here is: With
the increased demand for credit, will the Basel III capital
framework increase cost of credit? What are the options
before Indian banks?
Profitability of banks
Return on equity (ROE) is defined as the product of return
on assets (ROA) and the leverage multiplier. As the upper
limit for the leverage ratio by Basel III has been set at 3%,
the value of the leverage multiplier will come down,
resulting in a reduction in the ROE. Table 4 shows that the
higher ROE for the SBI group and nationalised banks was
associated with a higher leverage ratio, while for new
private sector banks, the higher ROE was attributable to
higher profitability of assets and lower leverage (RBI 2012).
9

Speech delivered by Dr. Duvvuri Subbarao, Governor, Reserve

Bank of India, at the First CAFRAL-BIS international conference on
Financial Sector Regulation for Growth, Equity and Stability in the
Post Crisis World, Mumbai, November 15, 2011.

On an average, Indian banks ROE is around 15% for the last

three years. The enhanced capital requirements under
Basel III regime are likely to affect the ROE of the banks and
the shareholders expectations on the minimum required
rate of return.
The questions that arise here are as follows: Do shareholders prefer less stable and more risky banks with higher
ROE or more stable and less risky banks? What is the cost of
meeting higher capital requirements for banks? Do banks
pass on these costs to depositors and borrowers? In
order to meet the mandate of higher quantum of liquid
funds, under liquidity standards of Basel III, do banks
have to go for the passive option of lending to the
Government by increasing investment portfolio, by
crowding out credit to the private sector? To meet the
challenges of declined profitability can the banks alter
their incentive structure?
Implementing the countercyclical capital buffer
A critical component of the Basel III package is implementation of countercyclical capital buffer which
mandates that banks build up a higher level of capital in
good times (that could be run down in times of economic
contraction), consistent with safety and soundness considerations. Here the foremost challenge to the RBI is identifying the inflexion point in an economic cycle which should
trigger the release of the buffers. The identification of the
inflexion point needs to be based on objective and
observable criteria; it also requires long series data on

120
Table 4

M. Jayadev
Profitability and leverage of Indian banks : 2011e12.

Bank group

Return on
equity

Profitability
of assets

Leverage

Capital to
assets ratio

SBI group
Nationalised banks
Old private sector banks
New private sector banks
Foreign banks

16.00
15.05
15.18
15.27
10.79

0.91
0.87
1.15
1.57
1.75

17.58
17.37
13.23
9.72
6.15

0.07
0.40
0.35
0.27
6.95

Source: report on Trend Progress of Banking, 2011e12, RBI.

economic cycles. In an emerging market like India, what

macroeconomic data is needed? What are the options
before the Ministry of Finance and the RBI?
Risk management
In recent years many banks have strengthened their risk
management systems which are adequate to meet the
standardised approaches of Basel II. A few banks are making
efforts in the direction of moving towards implementation of
advanced approaches. The larger banks need to migrate to
the advanced approaches, especially as they expand their
overseas presence. The adoption of advanced approaches to
risk management will enable banks to manage their capital
more efficiently and improve their profitability. This graduation to advanced approaches requires three things. First
and most important, a change in perception from looking
upon the capital framework as a compliance function to
seeing it as a necessary prerequisite for keeping the bank
sound, stable, and therefore profitable. Second, the graduation to advanced approaches requires deeper and broader
based capacity in risk management; and finally, it requires
adequate and good quality data.10 Other banks also need to
strengthen their risk management and control system so as
to allocate risk capital efficiently and improve profitability
and shareholders return. The important issues here are: On
what aspects of risk management should the banks focus?
How do they improve the risk architecture? How can banks
strengthen risk management capacities so as to generate
adequate and qualitative data?
Systemic risk
The financial crisis highlighted the importance of interconnectedness of financial institutions and the significance of
systemic risk. With the dichotomous presence of specialised
financial institutions like HDFC and several other commercial
banks, understanding the concept of systemic risk is critical in
the Indian context. At the macro level, how does one measure
systemic risk in the Indian context? In some countries, buildup
of credit to deposit ratio is considered for measuring
systematic risk, but is it relevant in the Indian context? The
consolidation phase in Indian banking is in progress. The State
Bank of India (SBI) is acquiring its associate banks and a few
private banks have been merged with other public and private
sector banks. The presence of large size banks encourages
risky behaviour in banks. Basel III seeks to mitigate this
externality by identifying both Domestic Systemically

Important Banks (D-SIBs) and Global Systemically Important

Banks (G-SIBs) and mandating them to maintain a higher level
of capital depending on their level of systemic importance.
Are there any Indian banks that can be classified as D-SIBs?
What should be the criteria for such classification?

Need for a discussion

In the above context the current round table discussion
assumes significance and raises the following issues.
 Can individual banks access the capital market to raise
capital?
 How do current ownership structure and valuations
impact the banks capital raising proposals? Should the
Government retain majority ownership?
 With the increased demand for credit, will the Basel III
capital framework increase cost of credit? What are the
options before banks?
 What is the cost of meeting higher capital requirements
for banks?
 Do banks pass on these costs to depositors and
borrowers?
 In order to meet the mandate of higher quantum of
liquid funds and liquidity standards of Basel III, do
banks have to go for the passive option of lending to
government by increasing investment portfolio, by
crowding out credit to the private sector?
 On what aspects of risk management should the banks
focus?
 How to strengthen risk management capacities so as to
generate adequate and qualitative data?
 What macroeconomic data is needed? What are the
options before the Ministry of Finance and the RBI?
 Are there any Indian banks that can be classified
as D-SIBs? What should be the criteria for such
classification?
I take pleasure in inviting the panel members representing
various stakeholders of the Indian banking system to present
their views, following which the floor is open for discussion.
Basel III implementation: Issues and challenges for
Indian banks: Discussion
Anchor
M. Jayadev
Panellists

10

(Inaugural Address by Dr. Duvvuri Subbarao, Governor, Reserve

Bank of India at the Annual FICCI - IBA Banking Conference at
Mumbai on September 04, 2012)

Gagan Deep Singh, Assistant Vice President e Treasury

Analytics, Genpact, India; [email protected].

Basel III implementation

Gobind Jain, Senior Vice President, Kotak Mahindra
Bank; [email protected]
M. K. Jain, General Manager, Syndicate Bank; mkjain@
syndicatebank.co.in.
Rajendra Prasad G., Vice President, Citi Group, Tampa/
St. Petersburg, Florida; [email protected].
Subhasish Roy, DGM, IDBI Bank, Risk Management
Department; [email protected].

M. Jayadev
Welcome to the four panelists present here and to the fifth
member who is joining us from the US. Mr. Subhasish Roy is
Deputy General Manager, Risk Department, IDBI Bank,
a public sector bank. Mr. Gobind Jain is a Senior Vice
President in Kotak Mahindra Bank. He is working with
systems, balance sheet and associated areas. Mr. Mahesh
Kumar Jain is General Manager, Syndicate Bank and is
currently in treasury operations at Mumbai. All three have
been working in the area of risk management for a long
time. Mr. Gagan Deep Singh is Assistant Vice President e
Treasury Analytics at Genpact India. He is working with
market risk models, and he is a risk management modelling
expert. The fifth panellist Mr. Rajendra Prasad is joining
from us the US. He is Vice President, Citibank at Tampa,
Florida. He has worked with several banks in consultancy
positions especially in the area of market risk and
credit risk.
Let me invite Mr M. K. Jain from Syndicate Bank to speak
first.

M. K. Jain
Basel III is a regulatory prescription necessitated by certain
flaws or lacunae observed in Basel II. Basel III has certain
implications for banks in India and across the globe.
I will first touch upon capital requirement. There has
been much discussion across the globe about Basel III, and
how the capital requirements of the G 20 countries and
India are different. There are a few differentiators
between Basel II and Basel III. In Basel II there is no
minimum requirement of common equity capital (CET) but
it is presumed as 50% of Tier I capital requirement and
hence estimated as 2% of total minimum capital requirement. Whereas in India, it is estimated as 3.6% because of
total Tier I capital requirement of 6% and restriction of
hybrid instruments to the extent of 40%. The increase of
CET from 2 to 5% for banks in advanced countries will have
large implications in raising common equity capital to the
magnitude of billions or trillions of dollars.
But in India there exist certain benefits which are not
available in other jurisdictions. Deductions from capital
have been harmonised and generally applied at the level of
common equity. These deductions will not have much
impact on Indian banks. At present, deferred tax asset
(DTA), goodwill etc. are already deducted from Tier I
capital. We do not have much of trading and over-thecounter (OTC) derivatives. Similarly, valuation of liabilities
does not exist in India. The impact of reciprocal cross
holdings will also be insignificant considering the prudential
limits fixed by RBI.

121
As far as common equity is concerned, it is not unlike
the other players in the world. In India, the market for
hybrid instruments has not been active. The question arises as to whether there will be a market for hybrid
instruments in India with non-viability clause. As a result,
most Indian banks already have no option left but the
option of raising equity. At present, Indian banks are
operating at more than 10% of the Tier I capital adequacy
ratio and 50% of the banks are operating at more than 8%
of Tier I capital. But going forward, banks will need to
raise equity capital to meet Basel III requirement and to
support credit demand.
The first question posed to me was how banks will be
able to raise the capital and whether the market is
conducive to raising that amount of capital. I can share my
views for public sector banks which hold around 70e75% of
the market share. In the past five years, Indian banks have
raised close to Rs 52,000 crores (Rs 520,000 million) as
capital. Broad estimates suggest that banks may need
capital close to rupees 500 thousand crores (Rs 5000 billion)
in next five years. Of that, around 1.5 hundred thousand
crores (Rs 1500 billion) is expected as core equity capital,
the major share of which comes for public sector banks.
Out of that, the requirement under Basel III alone comes to
around 80 thousand crores (Rs 800 billion). Nevertheless the
raising of that capital in the next five years is not a very
difficult task but will be challenging.
However, how is that capital to be raised? It is connected
to the next question, that of market capitalisation. In the
banking scenario in India, individual banks have enough
potential to access capital markets. The pricing may be
different based on the fundamental strength of the bank
and market prices of stocks. In India, market cap as
percentage of assets of the public sector banks is around
5.5, whereas for private banks, it is around 25.5 and among
the public sector banks it ranges from 2.6 (Central Bank) to
8.7 (State Bank of India). At the current market capitalisation, even if the banks dilute majority of government
holdings, it will not be sufficient to maintain CRAR (capital
to risk weighted assets ratio) at desirable level.
Even if the State Bank of India (SBI), with highest market
capitalisation among PSBs, were to dilute its equity capital
by 20%, the amount raised by it would be equivalent to less
than 2% of the assets. So the question of infusion of equity by
government versus raising from the market will arise. In that
situation, what are the options available? Should banks raise
capital from the market at low prices, which still may not be
sufficient to meet capital needs, or should banks approach
promoters? The option available with the government is to
fund the banks for capital requirement continuously. Though
it is difficult for the Government of India (GOI) to infuse
capital continuously in view of fiscal concerns, yet it makes
business sense for the government to infuse capital to the
public sector banks for two reasons. Presently all PSB stocks
are under-valued, and large value can be unlocked by GOI in
future when market capitalisation improves, given the
predictions of Indias bright future. No economy can grow
unless the banks become credit worthy. Our credit to GDP
ratio presently is 55% and credit demand will expand faster
than GDP for several reasons. First, the changing thrust of the
economy is from service to manufacturing, and the credit
intensity of manufacturing is higher than that of service. The

122
second driver will be infrastructure, and the third, financial
inclusion which has not been assessed so far but as more and
more banks reach the rural area, the credit demand will pick
up. These three factors will lead to credit growth. Hence, GOI
needs to infuse capital to meet increasing credit demand and
to achieve desirable level of GDP growth.
A valid question has been raised on growth versus cost or
growth versus stability. If stability is important, then a little
sacrifice on growth in the short term is to be accepted.
Indian banks are well placed for Basel III capital requirement and GOI has to support PSBs. It is expected that the
cost of capital may go up (on account of hybrid instruments
and loss absorbency features in the hybrid instrument) and
plough back of internal accruals will be higher resulting in
low dividend and payout ratio.
Whether the cost of capital will have an impact on the
credit growth is another pertinent question. To some
extent it will. The Basel Committee and other independent
assessments have concluded that Basel III will impact the
GDP ratio. As per assessment of the Macroeconomic
Assessment Group (MAG) GDP may decline by 0.22% over
a period of time till full implementation of Basel III
whereas a study by the IMF assessed a negative impact of
3.2% on the GDP during same period. Without going into
the merits of the different claims, the impact of Basel III
on GDP is undeniable, and whether the impact on the
banking system will be short term or long term, remains to
be seen. We personally feel that the impact will be short
term. The maximum capital impact may happen from 2015
onwards keeping in view the present level of capital of
Indian banks and higher capital requirements will start
from that period as per RBI guidelines. As rightly observed
by Professor Jayadev, credit demand will be high during
that period. So, higher capital needs to meet both regulatory requirement and higher credit growth. This will
result in increase in cost of capital and have a resultant
adverse impact on profitability.
Q: Do Indian banks (public sector) need to worry about
capital since government provides a backstop for capital
anyway, like Fannie Mae in the US? Basel is a setup more
for private sector banks where capital needs to be
provided to match risks? Does it affect public sector
banks the same way?
M K Jain: The capital that the government is going to
infuse will not be without any riders/conditionalities.
The government cannot fund unlimited capital to the
public sector banks and insist that banks demanding
capital infusion meet certain higher level of performances through MOUs, so that over a period of time
banks capital requirement may be self-sustaining.
What is the way out for banks? They have to increase
their efficiency, and reduce the intermediation cost to
offer competitive pricing, otherwise higher cost of
credit will impact growth. Basel III is not explicit on
capital; capital is an implication. The new regime seeks
greater integration of the finance and risk management
functions. This will probably drive the convergence of
the corporate objective and risk management in delivering the strategic objectives of the business.
Probably, going forward, Basel III may also affect business models and banks may be forced to change their

M. Jayadev
business strategies. It could impact both verticals of
business, retail as well as corporate. Banks may be
forced to reduce their exposure to large corporates to
optimise capital as it wont be easy to get unlimited
capital from the government.
Another point for consideration is mandatory requirement of investment in SLR (statutory liquidity ratio)
securities. The Basel Committee has not accepted the
argument of considering SLR securities as part of the
liquid funds. Bankers view is that as RBI is lender of the
last resort, investment in cash reserve ratio (CRR) and
SLR can be used to get liquidity support from the regulator in case of need and hence the same may be
considered as part of liquid assets to maintain Liquidity
Coverage Ratio (LCR) and Net Stability Funding Ratio
(NSFR) as required by Basel III. The RBI too is of the
opinion that a certain portion of SLR investment may be
allowed as part of the liquid asset. If this is not allowed
then there will be additional cost to the banks to
maintain liquid assets over and above statutory
requirements of SLR and the CRR.
M Jayadev: Thank you Mr Jain. Mr. Subhasish Roy, may I
now request you to share your views on implementation
of Basel III and the challenges for Indian banks,

Subhasish Roy
Basel II was a sought after and important risk management
framework before the financial crisis of 2008e2009. After
the crisis, Basel II which was considered a more risk
sensitive approach as compared to its earlier version Basel
I, was found wanting. Thus Basel III was designed to
overcome the systemic loopholes in the Basel II framework. In particular, Basel III was designed to address the
weaknesses of the past crisis and to make the banking
sector stronger and more efficient. The major thrust area
of Basel III is improvement of quantity and quality of
capital base of the banks with stronger supervision, risk
management and disclosure standards. The highlights of
Basel III are as follows:
 More thrust on equity capital
 Introduction of capital conservation and countercyclical buffer
 Regulatory adjustments/deductions from common equity
 Introduction of loss absorption features instruments
 Introduction of point of non-viability loss absorption
trigger point (<6.125% of risk weighted assets (RWA)
 Introduction of leverage ratio
 Introduction of liquidity coverage ratio
 Supervisory review and evaluation process (SREP) under
Pillar II covers area of unrated exposure, emphasis on
credit assessment and broader coverage of counterparty credit risk management policy.
The minimum capital requirement is 8% but when the
bank capital touches 6.125% then additional Tier one
capital will be converted to equity. This is called loss
absorption trigger point and will safeguard the bank.
Basel III has emerged as a follow up to the failure of
some international banks. In India even at a difficult time

Basel III implementation

banks did not experience that type of failure or difficulties
and the regulatory norms imposed by the RBI were much
more stringent as compared to international standards.

Issues regarding capital to PSBs

Coming to issues regarding the quantum of capital for
public sector banks (PSBs), the RBI estimates for additional
equity capital requirements under Basel III is around Rs
1500 billion. If the present government shareholding
pattern is maintained, then the governments share comes
to around Rs 910 billion. However, if the government
reduces its shareholdings to 51%, then its share will come to
around Rs 700 billion. If you take into account the recapitalisation of banks then the amount the market will have to
provide will depend on the extent to which the government
can meet the recapitalisation burden of PSBs.
Based on past track record, raising around Rs 700-billion
over the next five years may not be very difficult, considering government is the major shareholder. The actual
capability is based on individual bank specific factors such
as e branding, reputation, financial performance, operational efficiency and so on.
Profitable banks will have less capital requirements as
compared to less profitable banks. The question is whether
the government should pump such a huge amount of money
to public sector banks at this stage. There are three options
here. The first option is for the government to reduce its
shareholding to 51% so that its share will come down to
around Rs 700 billion. The second option is a merger
between the banks with very high government shareholding
and the banks whose shareholding is marginally higher than
51%. The third option would be for the government to
reduce its shareholdings in PSBs below 51% but in all
probability the government will not give up its voting rights,
so the second option seems most feasible.
There is some talk about a holding level company in
which the government will have 100% equity. The company
will raise the debt to be invested by institutions and will
give equity based on the needs of the various banks. Here
the government is only providing security backing, it does
not have the burden of raising equity and pumping it into
the individual banks. The idea is under consideration by
RBI. However, some issues like who will monitor these
companies, what will be the capital adequacy ratio, will
need to be addressed.

Impact of Basel III and the action required from

banks
How will Basel III impact the economy in general and banks
in particular?
It may result in higher government borrowing, fiscal
deficit, inflation, and pressure on GDP. Lower GDP may also
affect investments, credit off-take and banks profitability.
Particularly for banks it could mean higher cost of capital,
lower return on equity (ROE), lower yield on assets, and
pressure on credit off-take and profitability. A recent study
conducted by CARE on the banking industry11 revealed that
11

CARE Research, May 9, 2012.

123
a 1% increase in core equity ratio is expected to be met by
fall of ROE by 80e100 basis points which shows the extent
to which profitability will be affected.
Banks would have very limited scope to increase profitability or minimise cost. Banks with a very low profitability margin will be affected most because they will
require more capital as conversion from profit to capital
will be less. Under Basel III the capitalisation ratio is
arrived at by dividing equity capital by the risk weighted
assets. How can banks minimise the risk weighted assets?
Banks can change the business mix focussing more on
retail/short term loans rather than corporate. Banks need
to change their customer mix and ensure proper pricing to
maximise risk adjusted return. Banks must seek low cost
funding with a thrust on low cost stable deposit base. This
could mean opting for the business correspondent or
business facilitator model prescribed by the RBI, which
would pre-empt the need to operate full-fledged branches
while still reaching the goal of financial inclusion. Banks
must improve systems and procedures, refining their
rating model so as to obtain the proper risk weight, going
in for data cleaning and modernising systems and procedures to meet operational needs. Operational efficiency
will ensure economising on capital through the lowering of
risk weighted assets.

Crowding out credit to private sector

Let us examine the issues that are connected with crowding out of credit to the private sector. Higher deployment
of funds to liquid assets may or may not lower yield on
assets. It depends upon the individual banks ability to
deploy funds to higher risk-adjusted assets. Lending to the
private sector may depend upon the individual banks risk
appetite. Banks need to carry out cost benefit analysis in
order to decide on the cost of the banks failure in not
deploying liquid assets vis-a-vis cost of crowding out of
credit to private sector. Banks which are capable of
attracting larger deposits can lend more to the private
sector. The cash reserve ratio and statutory liquidity ratio
(CRR & SLR) investments need to be considered for liquidity
standards in India.

Measurement of systemic risk

While bank specific risk is relatively easy to identify,
systemic risk is much more difficult. In this regard, there is
a need for devising objective criteria to identify trigger
points of boom and slack in an economy. For this purpose
the following parameters need to be considered for market
study. These include










trend in credit/GDP ratio

market volatility
sectoral concentration (industry/borrower)
NPA/GDP ratio
asset price movement
inflation
banks exposure to sensitive sector
systemic liquidity index
fiscal deficit

124
It may be mentioned that to identify systemic risk there
is a need for developing a large historical macroeconomic
database for above parameters.

M. Jayadev
Table 5

Improving quantity of capital.

Sr. No

Regulatory capital

Classification of banks

Classification of domestic systemically important banks is

important since the failure of a bank can trigger a domino
effect. The RBI has decided to study two banks, SBI and
ICICI to come up with guidelines for this. The core parameters for classification could be: cross border presence or
exposure to the international market; interconnectedness
within the economy, either with other banks or financial
institutions; size; and complexity.

Ability of PSU banks to raise capital from market

6
7

Minimum common equity

tier 1 ratio
Capital conservation buffer
(common equity)
Minimum common equity
tier 1 ratio
Capital conservation buffer
(CCB) [(1)(2)]
Additional tier 1 capital
Minimum tier 1 capital
ratio [(1) (4)]
Tier 2 capital
Minimum total capital
(MTC) [(5)(6)]
MTC CCB [(7)(2)]
Pillar II ICAAP buffer
maintenance (example)
MTC CCB ICAAP Buffer
Countercyclical buffer
(between 0 and 2.5*)
Total capital requirements

Coming to the point of the ability of the banks to raise

capital, going by their track record in the last few years,
raising Rs 700 billion from the market does not seem very
difficult. Further, there is a misconception that PSBs,
because of their low PE-ratio compared to private sector
banks, will not be able to raise funds. I feel PSBs can also
raise funds from the market and this will largely depend on
the individual banks profitability, marketing/branding
strategy, their quality of management, operational efficiency and quality of assets. However their fund raising
capacity is constrained because government shareholding
cannot fall below 51%.
Having listened to the two executives from public sector
banks, let me invite Mr. Gobind Jain from a leading private
sector bank to speak on Basel III, capital efficiency and
challenges for Indian banks.

Gobind Jain
I will begin by touching upon the need for Basel III. The
global financial crisis occurred mostly in the areas of
trading book/off balance sheet derivatives/market risk
and on account of inadequate liquidity risk management.
Banks suffered heavy losses in their trading books and did
not have adequate capital to cover the losses. Banks
relied very heavily on short term wholesale funding to
build long term assets, there was an unsustainable
maturity mismatch and banks had insufficient liquidity
assets to raise finance during the stress period. The
market for liquidity dried up both on asset and liability
side during the crisis.
The RBIs proposed framework is applicable at two levels
e the standalone bank and the consolidated level
(excluding insurance and non-financial activities). The RBIs
recommendations for banks stressed improving the quality
and quantity of capital, enhancing risk coverage, creating
capital conservation buffers, supplementing capital
requirement with leverage ratio, tightening rules affecting
risk weighted assets, and aggressively implementing the
schedule vis a vis the Basel III requirements.
However the present proposals do not cover liquidity
standards (separate draft guidelines were released on 21
Feb 2012), countercyclical buffers, and standards for
systemically important financial institutions (SIFIs).

4
5

8
9
10
11
12

RBI (%
of RWAs)
5.50
2.50
8.00

1.50
7.00
2.00
9.00
11.50
2.00
13.50
2.50
16.00

Counter cyclical buffer (*) - Not clear in current RBI guidelines.

If you look at the mandated capital requirement,

(Table 5): Improving capital requirement) along with the
countercyclical buffer, banks will be required to raise
a large amount of money from the market; most of the
capital will be in the form of common equity which is
a scarce resource and investors would be reluctant to put
money in the banks. It will be really tough for the weaker
banks to raise additional common equity from the investors. Therefore, every bank has to go through a rigorous
procedure of maintaining an investor database in order to
raise that kind of money.
I have been asked to address certain specific questions
and the first question I am addressing is: Do individual
banks have the potential to access the capital market in
order to raise capital? We must bear in mind that higher
capital is not a silver bullet solution to the challenge of
ensuring financial stability and access to capital does not
necessarily ensure that banks will be financially stable.
There are other aspects which need to be looked at such as
the risk management framework, the quality of assets, the
quality of funding, diversity of funding and so on. Merely
prescribing higher capital also could push banks to take on
more risk to generate more return on the excess capital. As
per a study by CRISIL ratings,12 banks will need to raise
equity capital of Rs 1.4 trillion by March 2017 to meet their
growth requirements, while complying with the guidelines.
As per ICRA,13 out of the Rs 6 trillion capital required over
the next nine years, 70e75% would be required for public
sector banks and rest for private sector banks.
12

http://www.moneycontrol.com/news/business/transition-tobasel-iii-will-not-bechallenge-crisil_699592.html.
13
http://www.sify.com/finance/banks-will-need-rs-6-lakh-crcapital-till-2019-icra-news-banking-kjybEmgiijd.html.

Basel III implementation

Indian banks have maintained capital in excess of regulatory minimum e that is the discipline RBI has been forcing
on Indian banks. For PSBs, government support is needed to
augment core Tier 1 capital, as the government may want
to maintain 51% stake. Private banks have already raised Rs
500 billion in the last five years. It is not so difficult for
private banks to go to the market and raise the money but
the state of the capital market will be the primary deciding
factor as also the price discovery in the market. If all or
most of the banks approach the capital market simultaneously or when the markets are going through a lean
period it will be difficult for the private banks to raise
money. Much depends upon the investor base each bank is
able to nourish and the confidence it can instill in the
investor community.
The next question is: With the increased demand for
credit, will the Basel III capital framework increase cost of
credit? What are the options before the banks? Once the
capital requirements are in place, then the banks response
can be classified along operational response, tactical
response and strategic response.
Operational response will be on the lines of processes,
method and data. Examples of operational response would
be risk weighted asset (RWA) optimisation including model
refinement, process improvement, enhancement of data
quality, reducing credit exposure and through stricter
credit approval processes and potentially, through lower
limits. The banks will improve liquidity risk management
processes including stress testing and development of
contingency funding plans, so that minimal liquid assets are
maintained. Banks would also need to integrate their
subsidiaries through a consistent risk management and
capital management approach, expressed as a consistent
framework across the group to save on the capital. Banks
could also look into increasing efficiency, strategic cost
reduction, and reassessing risky processes so that operating
costs will be reduced and productivity will simultaneously
increase.
The tactical responses will be on the lines of pricing,
funding, and asset restructuring. Examples of tactical
responses include adjusting lending rates, depending on
competition within the specific segments and each
segments strategic importance for the bank, reflecting
higher capital and liquidity costs through more risk sensitive pricing (and performance measurement on that basis),
shifting to long term funding, the reduction of the securitisation exposure, lower trading book exposures and
reduced activities in areas such as derivatives, repos and
securities financing Banks will also look at longer term
funding (for instance by replacing interbank funding with
longer term debt and increasing the maturity of deposits)
rather than going for short term funding options..
The strategic responses would be along the lines of the
business model, organisational structure, and equity. Such
responses will be active approach to balance sheet
management, undertaking strategic cost reductions,
including rationalisation of branch structures, product
rationalisation or implementation of a shared services
model. Banks will have to look at the kind of equity they
can raise, the contingent capital and the amount of earnings they have to retain to reduce the need for raising
further capital. At the same time this will affect the

125
investor community because the investors look at dividends
and expect some returns from the banks every year. So its
like a trade-off between retaining capital, retaining earnings and distributing dividends. Banks also have to look at
their lines of businesses and make some hard decisions on
exiting risky businesses, and businesses that are more
capital demanding and also outsourcing or off-shoring noncore functions. Banks may consider changing group structure by buying minority. No matter what actions banks take
to reach compliance with Basel III and to restore profitability, all actions should be harmonised to create an efficient approach and achieve the best possible results.
The Reserve Bank of India has debated on the holding
structure for the banks in India. The final guidelines are still
not out but if the banks meet the holding structure guidelines, then the demand on the capital will be less. Therefore, the current deduction from Tier one and Tier two will
go away and under the new regime, all deduction will be
from the common equity and to that extent there will be
a saving of capital.
The next question is: Would shareholders prefer less
stable and more risky banks with higher ROE or more stable
and less risky banks?
My response is strengthening capital requirements is
expected to reduce the banks ROE. There are options for
banks to increase riskiness of assets or increase the risk
exposures by expanding maturity mismatches. Banks may
indulge in some risk taking practices so that they can
increase the ROE. Risky and systemically important banks
may also pose a threat to the stable economy and the
consequent risk may spill over to the real economy.
However, the regulators may not permit high risk taking by
banks. The RBI has taken a conservative approach by not
permitting banks to take a higher risk. They achieve this by
closely supervising the banks. The RBI has already created
a conglomerate cell which closely looks at the bank and its
subsidiaries, the nature of their businesses, and the kind of
risks they are taking. While this would improve the banking
sectors ability to absorb shocks and prevent the banks
from taking excessive risk it would definitely reduce the
return on equity. As far as shareholders are concerned,
they range from risk averse to risk taking, depending on the
lifecycle in which the shareholder is, whether it is
a younger shareholder or a retired person. The bank has to
nurture a mix of shareholders or try to have more foreign
investors who can invest money in India as returns in India
are definitely higher than the returns overseas. Shareholders may necessarily have to live with less risky and
more stable banks. On a risk adjusted basis the investors
may be indifferent but the absolute returns on investment
will go down.
What is the cost of meeting higher capital requirements
for the banks?
There would be a reduction in banks ROE as debt is
substituted with expensive equity. The timing of
approaching capital markets is important. Therefore, the
bank has to start planning in advance if they want to raise
capital in a timely manner and at a proper price. Unfavourable markets may mean issuing shares at a higher
discount to market price and issuing more equity shares,
thereby causing dilution of shareholding and reducing
earnings per share. Banks may be impacted by higher costs

126
of capital and lower returns making it difficult to attract
and retain investors. Again, as the cost of capital becomes
higher, banks may be unable to provide lending to SME
clients/unrated clients. If banks are not able to turn over
their assets due to capital constraints, it will impact the
GDP and economic growth as well.
Coming to the question of a few large banks vs. many
small players, the RBI will look at mergers of banks so that
capital is conserved or else there will be many small players
or new private sector banks. Whether we will see a consolidation in the banking sector or an extension of smaller
players will depend upon the perception of the regulators.
Do banks pass on these costs to the depositors and
borrowers?
Changes in capital cost, liquidity cost and long term
funding cost will impact the cost of making products and
will be factored into the pricing of those products. Banks
can mitigate the impact through cost-reduction programmes, changing internal change, adopting capital
efficiency measures, de-risking and price adjustments.
The primary impact will be on retail and corporate business segments. The price adjustments are subject to the
competitive environment, so banks may be constrained to
increase the price of products at their will. Banks may be
able to pass on some of the costs to retail customers given
the relatively high margin on these products, and that
some of these customers may fall into the risky bracket.
But it would be difficult for some markets and business
segments such as corporate lending markets are more
price sensitive and banks may not be able to pass on costs.
Corporates would normally in a position to compare the
pricing each bank offers. Again, Credit Value Adjustments
(CVAs) will impact trades with lower-rated counterparties
and trades with counterparties with limited netting
ability. So, cost compensation can be through combination
of improved collateral and netting arrangement.
In order to meet the mandate of higher quantum of
liquid funds, under liquidity standards of Basel III, do
banks have to go for a passive option of lending to
government by increasing investment portfolio, by
crowding out credit to the private sector?
My colleagues who have spoken previously have discussed this question. Indian banks could follow the model
of the Bank of New York which has primarily put its assets
under the less risky segments and generates returns
through its fee based business. But banks in India should
concentrate on their developmental role and on economic
growth, on providing development finance to not only to
the private sector but also to the corporate sector,
infrastructure, and housing. So Indian banks cannot avoid
their role as financial intermediaries. Some of the banks
can still hold excess SLR but the amount will be ascertained with reference to the liquidity coverage ratio
(LCR) e the final guidelines for this have yet to be given by
RBI. However, if banks become passive investors of funds,
they run the risk of not being able to raise capital in the
future.
M. Jayadev: Thank you Mr. Jain. Now Mr. Prasad is
joining us from Florida (USA). Prasad has rich experience in
understanding emerging markets and will give us his views
on banks and risk management. Welcome Prasad, hope we
have not disturbed your early morning sleep .

M. Jayadev

Rajendra Prasad
The first question my presentation will address is:
On what aspects of risk management should banks
focus?
Banks must focus attention on the following areas to
enhance their risk oversight capabilities.
Risk appetite: Banks need to clearly state their risk
appetite, which is the banks willingness to take on financial risks. Banks must quantify and qualify their risk seeking
behaviour
Ultimately, how much risk the bank wants to take on and
at what rate of return must be clearly defined. Conceptually, the following metrics and accompanying indicators can
assist in articulating the banks risk appetite: earnings
volatility; profitability metrics such as ROE, RAROC, RORAC,
EVA; target capital ratios; target risk profile; and zero
tolerance of risks Risk appetite should not exceed an entitys risk capacity, and in fact appetite should be well below
the capacity.
Reviewing portfolio risks in relation to risk appetite:
Banks have to assess the vulnerabilities of their portfolio at
regular intervals and determine whether the portfolio is in
line with the risk appetite
Being appraised of the material risks and related
responses: Because risks are constantly evolving, the goal
of risk management is to provide timely information about
risks arising across the organisation
Model risk management: Banks need to improve the
governance of models being used. Decisions cannot be
based on quantitative models alone. Qualitative/expert
judgement is a key parameter to minimise the model risk
Stress testing: Stress testing receives lot of significance
under Basel III
VaR does not capture catastrophic losses. Hence, Stressed
VaR is the key parameter in Basel III capital adequacy
calculation.
Strengthening enterprise risk management for strategic advantage: Implementation of enterprise risk
management (ERM) provides the opportunity to have integrated view of the risk and the cross-risk interactions
A new risk and finance management culture: Basel III is
changing the way banks manage risk and finance. Basel III
requires greater integration of the finance and risk
management functions. This will probably drive the
convergence of the responsibilities of Chief Finance Officer
(CFO) and Chief Risk Officer (CRO). Basel III provides
a framework for true enterprise risk management, which
involves covering all risks to the business
My next question pertains to improving the risk
architecture
Managing the data: In order to meet the Basel III
compliance, banks have to ensure that risk and finance teams
have quick access to centralised, clean, and consistent data.
The data management requirements of Basel III are significant. If the data is dispersed across different silos it involves
more overhead costs compared to those with a more centralised approach to collecting, consolidating, and submitting reports under Basel I, II, and III. Data has to be efficiently
managed so as to ensure that calculations for capital
adequacy, leverage, and liquidity are done accurately

Basel III implementation

Transparency/Audit-ability-data lineage: Once a regulatory report has been submitted, it is highly likely that
a regulator will follow up with the bank to clarify critical
issues about how the results were calculated and how the
rules were applied. This will require the bank to identify,
check, approve, and submit the data quickly and accurately.
This audit process will be especially difficult for banks if the
data is dispersed across multiple silos and systems, as it will
take longer to search for the relevant information. Banks
with a centralised data model will be able to respond faster
and more efficiently to these enquiries
Stress testing: This will be difficult to deliver if organisations have their data distributed across multiple silos. It
will take more effort, time and it will deliver less accurate
results, compared with having a data model where all the
critical information is held in a central repository. Placing
all the data in a central repository will allow banks to run
a wide array of complex stress tests that meet the needs of
the business
The ideal solution would be to consolidate the calculation and reporting of Basel III from a single, centralised
reporting platform. It would seamlessly integrate with the
source systems.
How to strengthen risk management capacities so as to
generate adequate and qualitative data?
There are various Enterprise Data Management tools
currently available to improve data quality. Banks need to
setup sound practices for data governance. That would
involve the following:
 Assessing the current state of data quality at your
company
 Understanding and fixing the root causes of data
contamination
 Creating standards and procedures for data quality
 Enforcing the policies and procedures that govern the
data while the data is in their custody
 Periodically monitoring (auditing) the quality of the
data in their custody
 Monitoring and advising the end users on proper usage
of their data
 Creating the awareness of criticality of data quality
What are the gaps in available macroeconomic data?
Several gaps exist in the macroeconomic statistics,
such as
 Breaks within time series economic statistical data
produced by many of the ministries and agencies
 The extent of compilation and presentation of statistical data are not in a form that are readily usable and
therefore require further analysis
 Some of the economic indicators produced by the
agencies are often in conflict with each other due to
different methodologies
 Economic statistical data is not sufficiently granular
enough to meet user needs.
How to measure systemic risk in the Indian context?
Systemic risk can be defined as joint distress of several
financial institutions. Value at risk (VaR) is widely used to
measure systemic risk. Value at risk of the financial system

127
is conditional on a set of institutions being under distress.
The financial system is modelled as the portfolio of banks
and financial institutions. A financial institutions contribution to systemic risk is the difference between the
financial system portfolio CoVar when the institution
suffers a large loss and the normal VaR of the financial
system portfolio.
Systemic risk can be addressed through various ways
such as: systemic capital requirement: Capital requirement
proportional to estimated systemic risk; systemic fees: Fees
proportional to estimated systemic risk; creating systemic
fund; and private/public systemic insurance.
M. Jayadev: Finally, I welcome Mr Gagan Deep Singh to
present the technical and consultants perspective

Gagan Deep Singh

The questions that I will address revolve around aspects of
risk management and how to improve the risk architecture
of capital market institutions. Though advanced risk
management services may not be prevalent in most organisations, we are now learning the need for effective risk
management. For example, a case study which was recently
discussed in one of our calls with the senior management,
involving credit card default by a couple to whom credit
cards had been issued separately, brought home the
importance of using the social media and improved risk
architecture such as big data and cloud services to investigate into the relationships between the people to whom we
have extended loan facilities or credit facilities.
There are ample examples in the industry of similar
phenomena. Recently, in a presentation at IIMB on credit
default swaps (CDS), the paper made the point that after
CDS was introduced, defaults increased. They should have
decreased because CDS offers insurance and provides more
liquidity in the market; they provide more information
about the default in the market. The reason for this
anomaly, as analysts of big data put forth based on statistical evidence (though they could not offer empirical
evidence), was the underlying relationships in the CDS
transactions between the companies and those who were
paying the premiums leading to fraudulent deals.
I will cite one more example of the use of big data.
During the collateralised debt obligations (CDO) market
crash in 2008, there was ample evidence based on big data
to support the fact that rating agencies which were rating
the CDO tranches, had vested interests in rating the
tranches (Under Basel II that was then prevalent, there was
a provision that an unrated tranch of CDO would get less
weight than the triple C tranch of CDO. Tranches that were
unrated defaulted earlier than the triple C tranches). So
the role of big data has become important post crisis and
given these vested interests and fraudulent deals.
Prof Jayadev asked whether regulation should be rule
based or principle based. One of the problems as revealed
in all these examples is that we are following rule based
regulation. We see risk in the form of numbers whereas
there is the relationship aspect also to risk which is very
big. I will cite one or two more examples from my own
experience, which has to do with modelling, particularly
the use and misuse of modelling techniques. In one of our

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engagements with an Australian bank, we were validating
their credit risk models. The bank had a very low default
portfolio. However, since they wanted to be Basel
compliant, they adopted the internal ratings-based (IRB)
framework as prescribed by Basel II, according to which
banks had to measure Probability of Default (PD) on their
own. They adopted statistical techniques to compute
probability of default. One of the popular statistical techniques is the logit model, a statistical model which analyses
the ratio between the defaults and no-defaults and uses
some statistical transformation to arrive at a PD number.
However, this statistical model works only when you have
ample default data and ample no-default data. If you do
not have the default data, the model will still throw out
a number but because it is based on very little data, the
number is bound to be ambiguous. We were surprised that
the bank was using the logit model despite there being very
little default. Therefore, the misuse of models is more
prevalent in todays market than the proper use of models.
Somebody said the same thing about VAR models. Value at
Risk has a match problem and that means VAR which is
measured on a portfolio is greater than the VAR measured
on individual stocks. This statistical property has been
grossly misused by traders. Further, the models which are
coming up in order to be Basel compliant are far too
complicated and are difficult to explain to the regulators.
M. Jayadev: Now the floor is open to the audience, I
welcome my faculty colleagues Professor Venkatesh Panchapagesan, Professor P. C. Narayan and others, research
students and other observers to ask questions and for
comments.

Discussion
V. Panchapagesan: Risk measurement depends a lot on the
accounting. In India, there is a gap between what is reported and the real true NPA. How does that figure in
capital risk? There is a capital requirement based on the
original. Does the capital requirement change as the
degradation happens and is the degradation on what is reported or what is the true value?
M. K. Jain: We have to look at it from two perspectives.
One, from the perspective of Income Recognition and Asset
Classification (IRAC) norms to classify the account as NPA
and the other from the perspective of capital allocation. As
per IRAC norms, provisioning against NPAs is only based on
originals but for capital requirement under Advanced
Approaches of Basel II, restructured accounts are considered as default points to estimate Probability of Default
(PD). Second point is definition of default. In Basel II definition of default is in terms of point in time, and not market
value of loan to factor migration of the ratings; so thats
again a modelling error in Basel II. In trading book, market
value is factored in to take into consideration migration of
rating but not in banking book. In banking book, it is
addressed to some extent by estimating downturn Loss
Given Default (LGD) and PD
V. Panchapagesan: There is a follow up question to this.
You know that the capital requirement is based on the risk
of the underlying assets. The risk can change dramatically

M. Jayadev
and suddenly and it may take time to raise capital. So what
does Basel tell you about the timing?
M. Jayadev: There is the capital cushion buffer that has
been suggested in Basel III. That means if banks risk is
increasing, the regulator has to determine the inflexion
point and introduce additional capital requirements.
However answers to questions such as when and how that
point is determined, the metric to be used and so on, are
not available in the Basel document.
P. C. Narayan: One of the things that we studied as part
of the banking system was the inspection by the Central
Bank. The Central Bank tended to be more rigorous with
banks whose credit book was in worse shape than others,
and banks would be asked to restate their NPA, to recompute the capital, and it would get embedded automatically into the next cycle of financial reporting by the
bank. So you suddenly find that a bad performing bank had
a capital of 12% as on March 31, 2012, and then it has
actually gone down to 10% ..
V. Panchapagesan: Thats fine when there is a government owning banks, but the moment you go to the markets
and you are raising capital with a lower NPA, then it is
bound to raise questions. A certain transparency is required
if you go to the public markets.
P. C. Narayan: You have raised a question which is very
emotional for the Indian banking system, i.e. government
ownership of banks. We are not going to solve this problem
of capital adequacy in banks unless the government takes
a firm decision and it is politically difficult. But they have to
do it, to at least bring government ownership down to 33%
from the existing 51%. After the first round of nationalisation in 1969, and the second round in 1980, we thought the
curve was going to go that way. Now, suddenly, in the
economic liberalisation of the mid 90s the government said,
we are going to reduce our ownership to 51%. That was path
breaking legislation. There is a lot of pressure building up to
reduce it from 51% to 33% but its a political issue, its not
an economic issue. I believe it will happen but like everything else in a democracy it will take time.
M. Jayadev: We always look at banks performance from
the external governance point of view, that is through
capital adequacy ratio, NPA ratio, profitability, ROA and so
on. The boards activism is not taken into account, and
most public sector banks have inactive boards. According to
corporate finance theory, board activism is more important
for financial performance. If the government focuses on
internal governance aspects and activates some of the
aspects of the corporate governance framework, some of
these issues can be solved. Otherwise banks would be
completely CEO- or CMD- driven.
M. K. Jain: Currently, there is a debate on the reason for
low market capitalisation of the public sector banks in
comparison to private sector banks. Is it only because of
fundamentals or something else? It may be due to corporate
governance issues.
P. C. Narayan: Its again coming back to the ownership
of the government, the one entity that owns 51% and they
will have the last word in what the board is going to look
like. So, any talk of corporate governance reforms has to be
preceded by a capital structure reform. There is enough
literature evidence available to establish this.

Basel III implementation

V. Panchapagesan: There was a point raised about the
change in the mix by which the banks would end moving to
either short term loans or different types of loans, to
meet the Basel requirements. Is this going to lead to
a different kind of a problem whereby the credit moves
from the banking sector to the unorganised lending
market which would cause a bigger systemic risk problem?
Non-banking finance companies, private equities and so
on are probably not held to the same Basel standards. If I
understand this legislation right, it might fundamentally
change credit generation in the system and some of the
riskier sectors would move towards more unorganised
lending which is more of a systemic risk problem.
M. Jayadev: True, we have seen such incidents of
systemic risk in microfinance where institutions have failed
due to defaults. We have also talked about few institutions
dominating , for example, HDFC, a single product company
which is unchallenged by the entire banking sector in this
country so far. Are such institutions a benchmarking
example or a risk example in the financial services?
P. C. Narayan: Clearly, we have a choice. There is
a rapidly evolving shadow banking system in this country.
We beat our chest and say that we are a well regulated
banking system; what we ignore in that process is that we
are creating an unregulated banking system and the Indian
version of the crisis that happened in the United States with
the investment banks in the hedge funds, could evolve. So,
we may actually be creating an environment where people
want to look for capital arbitrage. With Basel III they may
incentivise the capital arbitrage, that means create financial asset companies which do not have capital adequacy
requirements of the same level as a bank. Such a situation
will evolve and we had better be cautious about it.
V. Panchapagesan: In India, public sector banks had the
implicit guarantee from the government that they wont
fail because of possible injection of capital by the government in case of trouble (much like Fannie Mae in the US).
Now that implicit guarantee may be worth a lot less since
all banks, including public banks, have to maintain certain
amount of capital in their balance sheet.
M. Jayadev: True, government ownership itself is an
implicit guarantee against failure. The government being
the major owner is infusing additional capital to the capital
deficient public sector banks, which helps the banks to
meet the mandatory capital adequacy ratios and enables
their competitive strength in the international market. The
capital infusion is enhancing the value of implicit guarantee
and boosting depositors confidence. Probably this may be
the reason for lower market valuations of public sector
banks in spite of having good financial performance such as
ROA.
V. Panchapagesan : Accounting jugglery becomes an
important issue - I understand that RBI may treat banks
restructured loans also as NPAs for risk weights.but the
banks surely will be tempted to do things to hide their bad
loans (which in most cases are caused by political interference in the lending process). For e.g., there is an
amendment to the SARFAESI act now lying in the parliament which allows banks to buy foreclosed properties that
they themselves put up for auction because of loan
defaults. In other words, rather than selling at a loss and
booking the loss in the balance sheet, the banks can now

129
seemingly buy them at a price that will not show any loss,
keep the property in their balance sheet and look good.
M. Jayadev: By following prudential accounting norms
banks treat restructured assets as NPAs and are making
room for provisioning. Internal control systems should
address the issue of hiding bad loans and greening of assets.
In addition to RBI inspection, concurrent audit, internal
audit the board level interventions are to be strengthened.
An effective corporate governance mechanism is the need
of the hour; currently boards are often inactive.
Regarding the latest amendments to SARFESI and DRT
Acts, these are empowering the banks and improving the
recovery process. According to the amendments proposed,
banks and asset reconstruction companies (ARCs) will be
allowed to convert any part of the debt of the defaulting
company into equity. Such a conversion would imply that
lenders or ARCs would tend to become equity holders
rather than being creditors of the company. Further, the
amendments also allow banks to bid for any immovable
property they have put out for auction themselves. If they
do not receive any bids during the auction, banks will be
able to set off the debt against the amount paid for this
property. This enables the bank to secure the asset in part
fulfilment of the defaulted loan.
M. K. Jain: This issue is being addressed in various
forums and insurance companies are already working on
aspects such as solvency ratio. The RBI has already regulated to prevent shadow banking and issues restrictions to
prevent shadow banking.
M. Jayadev: With this we have come to the end of our
round table discussion. Thank you all for being present and
making this event a knowledgeable discussion. I thank all
the panellists for bringing the practitioners perspective to
the table. I clearly see a few research issues for Indian
banks in this context;
How will Basel III implementation affect credit growth
and loan pricing? What would be the impact of these norms
on stock returns of banks? And, finally the relevance of
systemic risk in the Indian context and its quantification.
I take this opportunity to thank all the panellists for
their valuable time.

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