ROLE OF CAPITAL IN SECURING A STRONG BANKING SYSTEM – THE IMPERATIVES OF BASEL III ACCORD Dr.T.V.Rao, M.Com.,Ph.D., CAIIB,ACIBS(UK), Professor, B.V.Raju Insitute of Technology, Narasapur, Medak Dt., Telangana State ABSTRACT:
The stability of the Financial System largely depends on the strength and resilience of the Banking System. Indian Banks which suffered from negative capital adequacy, negative earnings and high NPAs in the Seventies and eighties are now on a robust footing thanks to the reforms brought about by the Narasimham Committee I and II and on account of the strong resolve of the Govt. and the Reserve Bank of India. It is a matter of pride that the Indian Banks have now become fully Basel II Compliant, and that they remained relatively unscathed in the face of the Global Financial Crises which lead to severe crisis of confidence among all stake holders.
Basel Committee on Banking Supervision revisited their earlier initiatives in the form of Basel I and Basel II Capital Accords and has now come out with a revised Frame work in the form of Basel III Capital Accord to ensure that the Banks remain strong and resilient and withstand the shocks of economic upheavals.
The Accord recommends very stringent measures in terms of provision of capital not only for the Credit, Market and Operational Risks but also to guard against cyclical fluctuations in the economic activities. The concept of loss absorbing capital has further been extended taking away the flexibility available in the earlier Accords viz., Basel I and II as per which Tier II Capital was helpful to conform to the overall Capital Adequacy Norms. The author critically examines the implications of the Accord especially from the point of view of the Banks operating in India. It is estimated that fresh capital to be infused by the Banks in India to become Basel III compliant by the year 2018 are over Rs.5 lakh crores. With fresh challenges unfolding in the form of rising distressed assets portfolio and higher market risks, whether it will be possible to mobilise these additional capital resources is a point which calls for carefully study and analysis.
The Article critically analyses the various issues involved and suggests ways to face these challenges.
Key Words: Capital Adequacy, Capital to Risk Weighted Assets Ratio, Counter Cyclical Reserve, Capital Conservation Reserve, Risk AbsorbingCapital, Liquidity Coverage Ratio

INTRODUCTION:
The Banking Sector in India has come a long way since the Nationalisation of Banks in 1960. The formidable challenges the system faced, and the gradual dip in their performance in terms of solvency and performance has driven them to the wall till the Government and the Regulators realised the folly of fleecing an ailing Banking System and put in place a strong reform process to strengthen the system.

Banks especially in the Govt. Sector suffered fro high NPA portfolios, abysmally low or negative capital adequacies, low or negative earnings were the major issues that called for immediate action. The measures taken on the basis of the recommendations of the Narasimham Committee I and II, and the regulatory and supervisory measures adopted by the RBI in adopting the global best practices has put the Banking system on an even keel and our Banks remained more resilient even in the face of a major crisis like the Global meltdown.
CAPITAL ADEQUACY POSITION OF THE BANKS IN INDIA
Basel Committee on Banking Supervision (BCBS) has brought in a frame work which is more popularly known as BASEL I Capital Accord which recommended a Capital to Risk Weighted Assets (CRAR) ratio of 8% which became effective from 1990. Indian Banks have become compliant with the Accord thanks to the reform process initiated much earlier. In fact the RBI has prescribed 9% as CRAR. The capital adequacy position of the Banks as at 1992 can be observed from the following tables:

PUBLIC SECTOR BANKS PERIOD | 1996 | 2002 | 2008 | No. of Banks with negative CA | 2 | -- | -- | No. of Banks with CA of below 8% | 4 | 1 | -- | No. of Banks with CA between 8-10% | 14 | 2 | 1 | No. of Banks with CA above 10% | 5 | 22 | 24 | | | | | TOTAL | 25 | 25 | 25 |

PRIVATE SECTOR BANKS PERIOD | 1996 | 2002 | 2008 | No. of Banks with negative CA | -- | -- | -- | No. of Banks with CA of below 8% | 1 | -- | -- | No. of Banks with CA between 8-10% | 4 | 1 | 1 | No. of Banks with CA above 10% | 10 | 14 | 14 | | | | | TOTAL | 15 | 15 | 15 |

FOREIGN BANKS PERIOD | 1996 | 2002 | 2008 | No. of Banks with negative CA | -- | -- | -- | No. of Banks with CA of below 8% | 1 | -- | -- | No. of Banks with CA between 8-10% | 3 | 1 | -- | No. of Banks with CA above 10% | 5 | 8 | 9 | | | | | TOTAL | 9 | 9 | 9 |

POSITION OF SCHEDULED COMMERCIAL BANKS

PERIOD | 1996 | 2002 | 2008 | No. of Banks with negative CA | 2 | -- | -- | No. of Banks with CA of below 8% | 6 | 1 | -- | No. of Banks with CA between 8-10% | 21 | 4 | 2 | No. of Banks with CA above 10% | 20 | 44 | 47 | | | | | TOTAL | 49 | 49 | 49 |

The issue of lower capital adequacy had negative connotations both nationally and internationally. The Reserve Bank of India addressed this issue on priority and convinced the Government of India to recapitalise the ailing Public Sector Banks. This process started even before the study period, and by 1996 the no. of Banks with negative capital adequacy are 2 viz., Indian Bank and Vijaya Bank in the Public Sector, while there are no Banks in the Private Sector and Foreign Banks with negative capital adequacy. During this period Banks with capital adequacy of below 8% are 4, 1and 1 in the Public Sector, Private Sector and Foreign Banks respectively. Banks with capital adequacy of between 1-10% are 14, 4, and 3 in the Public Sector, Private Sector and Foreign Banks respectively. The no. of Banks with capital Adequacy of more than 10% was 5, 10 and 5 respectively.
The benefits Prompt Corrective Action, CAMELS rating can be directly seen in this very important area of capital adequacy. By 2002 all Banks are positively capitalised, and there is only one Bank with capital below 8% viz., Indian Bank. This is the benchmark capital adequacy prescribed by Basel Accord. 4 Banks were between 8-10%, and 44 Banks have enjoyed capital adequacy of above 10%, much above the requirements of Basel Committee8% and the Reserve Bank Guidelines of 9%. The position has further improved by 2008 with all the Banks enjoying capital adequacy above the regulatory requirements. During this period 2 Banks had capital adequacy between 8-10% while the rest 47 had capital adequacy of over 10%. The Banks with highest capital adequacy during 2008 are the following Sector wise: SECTOR | NAME OF THE BANK | CAPITAL ADEQUACY PER CENT | PUBLIC SECTOR | STATE BANK OF INDIA | 13.5 | PRIVATE SECTOR | FEDERAL BANK | 22.5 | FOREIGN BANKS | ABUDABHI COMMERCIAL BANK | 51.71 | Basel II Capital Accord which came into force from 2008 has not made any change in the CRAR ratio while it refined the process of capital computation and also by taking into account the effects of Operational and Market Risks. The structure of Basel II consists of three mutually reinforcing pillars—Pillar I on Minimum Capital Requirements, Pillar II on Supervisory Review Process and Pillar III on Market Discipline.

The present position of the Public Sector and Private Sector Banks is as follows:

With a rise in non-performing assets exerting pressure on their profitability, Indian banks’ capital adequacy ratio (CAR) has fallen in the aftermath of the global economic slowdown of 2008 — to 13 per cent as of March 2014 from 13.88 per cent a year earlier, according to data compiled by the Reserve Bank of India. The ratio was 13.01 per cent as of March 2008.

Public-sector banks have been the worst hit, with their average capital adequacy ratio falling to 10.67 per cent as of the quarter ended June, compared with 11.18 per cent in March.

The situation is worrisome, as bad loans continue to mount amid a slowing economy, where interest rates have stayed elevated. Gross non-performing assets (NPAs) of public-sector banks increased to 4.1 per cent as of the end of March 2014 from 3.6 per cent a year ago. Their net NPA as a proportion of net advances were 2.2 per cent, compared with 1.7 per during the same period a year earlier.

It is in this background, that a fresh challenge has arisen in the form of BASEL III Accord.

BASEL III ACCORD:
Basel III is the revised Global Regulatory framework to strengthen capital and liquidity structure of Banking System. The accord was singed on December 16, 2010. Indian Banks are required to become Basel III compliant by 2018. However, the RBI has extended the implementation deadline by one year i.e., to March 31, 2019, in the light of the difficulties involved in migrating to the new framework.

Basel III framework lays emphasis on enhancing the banking sector’s safety and stability. For this purpose it prescribed measures to improve the quality as well as quantity of capital components through creation of Counter Cyclical Buffer and Capital Conservation Buffer. Maintenance of leverage ratio and conforming to liquidity standards by bringing transparency trough enhanced disclosures are the other measures as per Basel III.
PROVISIONS OF BASEL III:
The following are in brief, the changes that have been made to the existing frame work:
Capital
* A minimum of 7 per cent of a bank's RWAs must be core tier one capital to act as a buffer against losses. This compares with the 2 per cent required under Basel II * The definition of which liabilities can be classified as core tier one will narrow * There is a counter-cyclical buffer of 0 to 2.5 per cent, which is to be built up when the economy is strong so that it can be called upon in tougher times * Additional requirements will also be introduced for large banks deemed vital to the global financial system – so called Global Systemically Important Financial Institutions (G-SIFIs) – to hold an extra 1 to 2.5 per cent of core tier one capital
Risk Weighted Assets * In addition to increasing the quality and quantity of capital, Basel III also updates the risk weighted asset (RWA) calculation for counterparty credit risk * This will see the introduction of the Credit Valuation Adjustment (CVA) capital charge, which increases the capital held against the risk that the mark-to-market value of derivatives will deteriorate due to a change in counterparty credit worthiness * The Financial Institution Asset Value Correlation (FI AVC) will be amended to increase the RWAs for banks' exposures to large and / or unregulated financial institutions
Liquidity
* The Liquidity Coverage Ratio (LCR) defines the amount of unencumbered, low risk assets (such as cash or gilts) that banks must hold to offset forecast cash outflows during a 30-day crisis * Outflows are estimated, based on the nature of the customer relationship and the type of product Leverage * A new leverage ratio of 3 per cent is due to become mandatory in 2018. This seeks to ensure banks apply adequate capital to all their exposures, including those off balance sheets, and without applying any risk weighting
The major concepts introduced by Basel III are the capital conservation buffer and the counter-cyclical buffer. The capital conservation buffer is intended to ensure that banks are a able to absorb losses without breaching the minimum capital requirement and are able to carry on business even in a down turn.
The counter-cyclical buffer is a pre-emptive measure which requires that Banks should build capital gradually as imbalances in the credit market emerge.
Banks have been working on arrangements to secure full compliance with Basel III Accord.

CHALLENGES BEFORE THE BANKING SYSTEM:
Mobilising Additional Capital:
A major challenge before the Banks is to ascertain the quantum of the additional capital required by 2018. Different estimates of additional capital are arrived by various sources.
In his budget speech on 10th July 2014, Union Finance Minister Arun Jaitley estimated that Public Sector Banks (PSBs) will need INR 2.4 lakh crores of capital by 2018 to comply with Basel III norms. ‘To meet this huge capital requirement we need to raise additional resources to fulfil this obligation’, he said and added that ‘while preserving the public ownership, the capital of these banks will be raised by increasing the shareholding of the people in a phased manner through the sale of shares largely through retail to common citizens of this country’. The government will also consider giving greater autonomy to PSBs, which constitute roughly 70 percent of the Indian banking industry’s assets.

A sub Committee of the RBI has estimated the capital requirement for SBI group and Public Sector Banks over the next 6 years as Rs.5,47,258 crores.
Govt. is also considering various other alternatives like accessing insurance and pension funds, buying large chunk of perpetual bonds issued by state owned Banks etc. The Pension Fund and Regulatory Authority and the Insurance Regulatory and Development Authority may revisit the existing regulations and revise them to make pension funds and insurance funds to be invested in additional Tier I Capital.
CHALLENGES IN RAISING CAPITAL BY BANKS DIRECTLY:
Additional CRAR and the two Buffers viz., capital conservation buffer and counter cyclical buffer will reduce the ability of Banks to service the dividend payouts. It will also reduce their ability to pay bonuses to employees. Hence the fundamental question in raising the additional capital will be how could the Banks reward their shareholders and incentivise their employees as the profits are likely to decrease. Banks are already constrained in payment of dividend due to the obligation to transfer statutory minimum ratio of profits to the Reserves.
In the absence of raising capital from the market, the share of earnings retained by Banks for the purpose of rebuilding their capital buffers should increase.
HIGH CAPITAL COST:
As per Basel III requirements new non-equity instruments to be issued by Banks should hjave principal loss absorption feature. This would add to the overall capital cost and would impact the profitability. As per Basel III Indian Banks can issue Debt instruments overseas. However, Forex exposure is to be kept in view and any negative impact of this exposure would impact the cost of capital.
IMPACT ON RETURN ON EQUITY:
The effect of higher capital adequacies is generally considered to impact the Return on Equity. The higher the capital provision, the lower the ability of Banks in terms of achieving Return on Capital. It is estimated that a 120 basis points increase in the Capital Requirements is likely to reduce the RoE by 180 basis points.
NET INTEREST MARGIN AND IMPACT ON THE LENDING COSTS:
Higher capital costs have the effect of impacting the net interest Margins, and if the Banks decide to retain the spreads, the additional costs have to be passed on the Borrowers in the form of higher interest rates. This will have effect on the quality of the Asset Portfolio of Banks with consequential effects of raising NPAs and associated costs.
RECOMMENDED MEASURES TO COMBAT THE CHALLENGES:
Banks are required to undertake strategic capital planning. Such planning process in the Banks needs to be made more proactive to manage the Basel III requirements of higher capital. Long term view for capital budgeting is required to be taken and additional equity and non-equity to be raised well in time to consolidate the capital base. Perpetual debt instruments are a possible solution to an extent. The non-availability of markets for Basel III compliant instruments is a major challenge that will be faced by Indian Banks.
Banks should streamline the existing capital allocation process. Measures like Economic Capital and Risk Adjusted Return on Capital may have to be adopted. This would enable Banks to identify the Returns versus capital consumption for various businesses and effectively allocate capital.
Creation of a broad base of investors is very important to combat the challenge of raising Capital. Government and the Regulators are required to take the necessary steps in this regard. Government should also think of incentivising the Corporate Sector to invest in Bank’s non-equity instruments.
With the new Government lead by the Prime Minister is not averse to the idea of raising FDI participation even in strategic sectors like Defence, it may be desirable to increase the FDI levels in Banks.

BIBLIOGRAPHY: 1. Dash P.C.(2006) “Capital Adequacy Ratio-Issues in India, Banking, pp.52-54. 2. Sarma Mandira and Nikaido Yuko (2007) “Capital Adequacy Regime in India”, Indian Council for Research on International Economic Relations, Working Paper No.196. 3. Nachane Rege Pura (2005), “Basel II Norms: Emerging Market Perspectives with Indian Focus”, Economic and Political Weekly, Vol.40, No.12pp1162-1166. 4. R.K.Sinha and D.K.Chellani (2014) “Basel III Challenges for Public Sector Banks in India”Vinimaya, Vol.xxxv No.1, 2014-15 5. Neelam Dhanda and Shalu Rani (2010)”Basel I and Basel II Norms: Some Empirical Evidence for the Banks in India”, The IUP Journal of Bank Management, Vol IX, No.4, 2010.