FORE School of Management

A DISSERTATION REPORT ON

Impact of Basel III norms on select Indian & European banks

Submitted By: DEEPANSHU CHANDRA, 053009
FORE SCHOOL OF MANAGEMENT, DELHI

A Report submitted in partial fulfilment of the requirement of Post Graduate Diploma Program in Management

SUBMITTED TO:

Faculty Guide: Prof. Sanghamitra Buddhapriya FORE School of Management

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CERTIFICATE

This is to certify that Mr. Deepanshu Chandra has completed his Dissertation under my guidance and has submitted this project report entitled Impact of Basel III norms on select Indian and European banks towards partial fulfilment of the requirements for the award of the Post Graduate Diploma Program in Management (FORE, Delhi) 2011-2013. This Report is the result of his own work and to the best of our knowledge. This project was carried out under my overall supervision.

Date: Place: ----------------------------------

Prof. Sanghamitra Buddhapriya (Faculty Guide) FORE School of Management

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ACKNOWLEDGEMENT

I would like to take this opportunity to thank all those who helped me in the successful completion of my Dissertation. To start with, I would like to thank the organization FORE School of Management for providing me the chance to undertake this Dissertation.

I wish to place on records, my deep sense of gratitude and sincere appreciation to my Mentor, Prof. Sanghamitra Buddhapriya, Faculty, FORE School of Management, Delhi who suggested and prepared the frame work of the project. I would also like to thank Prof. Vinay Dutta and Prof. Kanhaiya Singh, for their continuous support, advice and encouragement, throughout the course of this project. I would also like to extend a special thanks to my friends for helping me throughout my Project.

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Contents
Executive Summary................................................................................................................................. 6 Introduction ............................................................................................................................................ 7 Evolution of Basel III norms ................................................................................................................ 8 Basel III & Europe .............................................................................................................................. 12 Basel III norms & its impact on Asian countries................................................................................ 13 Objectives of the study: .................................................................................................................... 14 Literature review................................................................................................................................... 15 Methodology:........................................................................................................................................ 17 Universe of Study: ............................................................................................................................. 17 Sample: ............................................................................................................................................. 17 Sources of Data: ................................................................................................................................ 18 Basel III & its Impact on Indian public & private sector banks............................................................. 19 Profitability........................................................................................................................................ 23 Benefits of Effective Implementation of Basel III ............................................................................. 24 Challenges with the Indian Banking Industry.................................................................................... 25 Basel III norms & its Impact on European Bank .................................................................................... 27 Capital Impact ................................................................................................................................... 27 Funding Impact ................................................................................................................................. 28 Profitability........................................................................................................................................ 32 Implication of Basel III norms on Indian & European banks ................................................................. 33 Capital Requirements ........................................................................................................................ 33 Tier I capital ................................................................................................................................... 34 Tier II Capital ................................................................................................................................. 36 Capital conservation buffer........................................................................................................... 36 Status of Capital Adequacy Standards .............................................................................................. 38 Comparison of Indian & European Banks ......................................................................................... 39 Conclusion ............................................................................................................................................. 41 References ............................................................................................................................................ 42

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List of Figures:
Figure 1: Common Equity and tier I ratio’s of different banks _______________________ 34 Figure 2: Additional tier ratio of banks _________________________________________ 35 Figure 3: Tier II ratio of banks ________________________________________________ 36 Figure 4: Capital conservation buffer __________________________________________ 37

List of Tables:

Table 1: CRAR level of Indian Banking Groups ___________________________________ 19 Table 2: CAR level & Government holdings of Indian public sector banks ______________ 21 Table 3: Proposed Guidelines for Basel III norms _________________________________ 33 Table 4: CAR ratio of Indian banking groups 2004-05 to 2011-12 ____________________ 38 Table 5: Anova results for Indian Banking groups _________________________________ 39

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Executive Summary
This report presents the impact of Basel III norms on Indian banks in comparison of European banks. Basel III norms are to be introduced from year 2013 and attempt to reconstruct the banking system on more solid foundations after the global financial crisis. After the financial crisis banking industry must improve their asset quality in order to deal with stress condition. A list of select banks was chosen among Indian public and private banks as well as European banks to analyze the impact on capital and profitability. A total of 9 banks were considered for the study; which included 3 from each Indian public, private and European banks. The report analyses the impact of new capital requirement on these banks and the capital decencies in each component. It also compares public sector banks and private sector banks on grounds of implementation of these capital requirements. Finally the effects of these new capital requirements on the profitability of these banks have been calculated. The report also covers the following items:

Changes to bank capital ratios under the new requirements, and estimates of any capital deficiencies relative to fully phased-in minimum and target capital requirements. Changes to the definition of capital that result from the new capital standard, referred to as common equity Tier 1 (CET1), including a reallocation of deductions to CET1, and changes to the eligibility criteria for Additional Tier 1 and Tier 2 capital. As a result of high tier I and tier II capital, almost all banks would be able to meet increase in core equity capital requirement under BASEL III without issuing any fresh equity. Due to high common equity Indian banks as there would be no additional equity requirement for maintenance of countercyclical capital buffer. The Return on equity of banks are likely to be hampered due to high capital requirements.

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Introduction
The foundation of sustainable economic growth is a strong and resilient banking system, which act as a financial intermediary between depositors and loan takers. Also the banks provide essential services to corporate firms, governments, small and medium enterprises and retail players who do their daily activity at national and international level. The main reason the economic and financial crisis which originated in 2007 became so severe that the banking sectors of many countries had built up excessive on and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the banking system. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were rapidly transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability. Ultimately the government had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing taxpayers to large losses. The financial crisis in 2008-09 which affected the entire global financial system prompted the Basel Committee on Banking Supervision to introduce Basel III reform package. In redesigning of the Basel framework the central concern were not only the emerging markets but also the European Union‘s new member states that were exposed to new international regulations. Though the crisis originated in developed economies and affected the western banks, Basel III norms are designed to address the liquidity and stability of global financial system. The Basel III norms were introduced to strengthen the regulation, supervision and risk management of banking sector. The focus was given on the risk absorption capacity arising from economical and financial stress.

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Evolution of Basel III norms
Basel norms are a result of Basel Committee, group of eleven countries formed after the collapse of Herstatt Bank. They decided to form a cooperative to standardize the banking standards and regulation within the member states. Their goal was to ―…extend regulatory coverage, promote adequate banking supervision, and ensure that no foreign banking establishment can escape supervision‖ In Basel, Switzerland it was decided to form a quarterly committee consisting of each member country‘s central banker.

After the formation of Basel Committee, it started a formal discussion to proper capitalize internationally banks. Since all the member countries were developed so the standards set in Basel I was designed for them only. Basel I gave regulatory control to central bank and considered domestic currency and debt as most reliable financial instrument. It was formulated only to provide adequate capital to guard against the creditworthiness of bank loans. It has no such guide lines to protect against nation‘s currency, change in interest rate and economic downfalls. It also proposes a minimum capital requirement and suggests central banks to be more conservative. Basel I consist of four pillars Constituents of capital, Risk Weighting, Target standard ratio and Transitional and implementing agreements. The problem with Basel I was that it only covered credit risk and was restricted to member countries only. There was also a lot of criticism on the implementation of these norms by central banks. Due to the banking crises of the 1990s and strong criticisms of Basel I, the Basel Committee decided to draft a new, more comprehensive capital adequacy accord in 1999. This accord was known formally as A Revised Framework on International Convergence of Capital Measurement and Capital Standards and informally as ―Basel II‖. While keeping the ―pillar‖ framework of Basel I, each pillar is greatly expanded in Basel II to cover new approaches to credit risk, adapt to the securitization of bank assets, cover market, operational, and interest rate risk. The first pillar of Basel II was Minimum capital requirement was a more comprehensive and filled the gaps of Basel I. It also provided assessment and protection operational risks. Basel also evaluated market risk i.e. loss due to movement in asset prices. Pillar II & III are less complex than Pillar I and include regulatory bank interaction extending the rights of the regulator in bank supervision and dissolution. Two additional mandates also widen the breath of regulator power in Basel II. Firstly, regulators are allowed to create a ―buffer‖ capital requirement in addition to the minimum capital requirements.
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The principle criticism of Basel II in terms of emerging market economies is that, once again, the Basel Committee has expressly stated that its recommendations are for its G-10 member states and not for developing economies. Given that Basel II is intended for G-10 economies, its regulations have several possible adverse effects on emerging market economies. Firstly, the strong responsibilities given to regulators and the great amount of regulatory variation allowed the banks in their calculation of loan reserves may overwhelm the regulatory systems of many emerging market economies. Basel III The proposed Basel III guidelines improve the ability of banks to withstand periods of economic and financial stress by implementing more stringent capital and liquidity requirements. The capital requirement for banks is a positive step; it raises the minimum core capital through a capital conservation buffer, which improves the banks‘ ability in stressed situation. The main elements of Basel III norms are: 1. Capital The capital consist of two components o Tier I capital  Common equity Tier 1

Common Equity Tier 1 capital consists of the sum of the following elements: Common shares issued by the banks that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies); Stock surplus (share premium) resulting from the issue of instruments included Common Equity Tier 1; Retained earnings and common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e minority interest) that meet the criteria for in      Additional Tier 1

Additional Tier 1 capital consists of the sum of the following elements: Instruments issued by the bank that meet the criteria for inclusion in Additional Tier 1 capital (and are not included in Common Equity Tier 1); Stock surplus (share premium) resulting from the issue of instruments included in Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in Additional Tier 1 capital

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o Tier II capital Tier 2 capital consists of the sum of the following elements:    Instruments issued by the bank that meet the criteria for inclusion in Tier 2 capital that are not included in Tier 1 capital Stock surplus (share premium) resulting from the issue of instruments included in Tier 2 capital Instruments issued by consolidated subsidiaries of the bank and held by third parties.

Proposed measures in capital The common Equity Tier 1 must be at least 4.5% of risk-weighted assets at all times. Tier 1 Capital must be at least 6.0% of risk-weighted assets at all times. Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9.0% of risk weighted assets at all times. Within Tier 1 capital, innovative instruments are limited to 15% of Tier 1 capital. Further, Perpetual Non-Cumulative Preference Shares along with Innovative Tier 1 instruments should not exceed 40% of total Tier 1 capital at any point of time. Within Tier 2 capital, subordinated debt is limited to a maximum of 50% of Tier 1 capital.

2. Risk Coverage Counterparty credit risk Basel III also addressed further deficiencies that financial crisis revealed, mainly repurchase agreements, securities and over the counter derivatives.

These included default and credit downgrades occurred at time when market volatility, and therefore counter party exposures, mark-to-market losses due to credit adjustments. Basel III seeks to address these problems by raising capital requirements. They will be required to determine the capital requirement for counterparty credit risk on repurchase agreements, securities and over the counter derivatives. The intention was to address concerns that existing capital became too low during period of low volatility.

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3. Capital conservation buffer

This outlines the operation of the capital conservation buffer, which is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements. Outside of periods of stress, banks should hold buffers of capital above the regulatory minimum. When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, share-backs and staff bonus payments. Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital. A capital conservation buffer of 2.5% comprised of Common Equity Tier 1 bringing the total Tier 1 Capital reserves required to 7%.

4. Countercyclical buffer The countercyclical buffer aims to ensure that banking sector capital requirements take into account of the macro-financial environment in which banks operate. It is deployed by government when excess aggregate credit growth is associated with a build-up of systemwide risk to ensure the banking system has a buffer of capital to protect it against future potential losses. According to the Basel III regulators are not only responsible for controlling banks‘ compliance with the Basel requirements but also for regulating credit volume in their economies. If credit is expanding faster than GDP, bank regulators can increase their capital requirements with the help of the Countercyclical Buffer. Varying between 0% - 2.5% it can thus, preserve economies from excess credit growth.

5. Leverage ratio In many cases, banks built up excessive leverage while still showing strong risk based capital ratios. During the most severe part of the crisis, the banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices. Therefore, the Committee agreed to introduce a simple, transparent, non-risk based leverage ratio that is calibrated to act as a credible supplementary measure to the risk based capital requirements.
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According to Basel III; Tier 1 Capital has to be at least 3% of Total Assets even where there is no risk weighting. The Basel III rules agree to test a minimum Tier 1 leverage ratio of 3% during the parallel run period by 2017.

Basel III & Europe
In Europe, the financial sector Industry sees the requirements adopted within Basel framework a threat to their banking system. Capital requirements have been relatively defensive especially to small and medium sized enterprises (SME). Early implementation could derail the credit growth in the region. The financial markets of Europe are marked by short duration of financial contracts, superficial local capital markets. Also central and eastern Europe has a deep integration within the European Union for capital a financial services which has been reflected by funding relationships across national banks groups called as internal capital market. Due to these reasons the European banking model practised in the region is vulnerable to stringent capital requirements under Basel III, which is being applied on a national and consolidated level.

European commission has translated the Basel requirements further into European requirements by revision of the capital requirements legislation. These revisions are drafted as the Capital requirement directive IV (CRD IV).

Thus, the implementation of Basel norms will be supported by the framework setup by the EU institutions. A new body, a European Banking Authority (EBA) is setup to monitor the implementation of the requirements and identifying systematic risk arising from the financial institutions. The implementation of Basel framework in the form of CRD IV represents a vital step in dealing with the vulnerabilities that caused the financial crisis both within individual institution and the financial system. However there are still some discretion at national level in determination of ratios such as liquidity and determining the counter cyclical buffers. Uncertainty will further complicate the matter for capital budgeting and treasury management.

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Basel III norms & its impact on Asian countries
The situation in the west is more related to regulatory flaws and leverage while that in east came from its dependence on its export and volatility. Asia has a different set of problems than west. This is due to the fact that it began de-leveraging and tightening banking regulation after the Asian Financial Crisis in 1997-98. Despite being under represented at global level Asian banks are among the highly regulated banks in world. This is also the reason why the banking products in Asia are less risky and complex. The research carried out by BCBS classified banks in two Groups, Group 1 those with Tier 1 capital of more than $4 billion and Group 2 with capital less than $4 billion. The Japanese would be hurt most since their Banking system has the lowest capital in the whole region. According to BCBS, nine of the banks could face a drop of 5.4% points in Common equity tier I and another seven 2.9% points decline in Group 1 and 2 respectively. China has five banks in each of the Groups which fall short of the prescribed limit of Common Equity tier I limit while Korea has 5 in Group 1 and 3 in Group 2. Woori bank has the lowest Tier I capital in Korea but it has sufficient funds to cover up the shortfall. Indonesia and Thailand on the other hand maintain a well capitalized and sufficient liquidity and are well prepared for Basel III. Their large deposit franchises and high profitability allows them to utilize their 100% retained earnings. Malaysia, a non-member country, stands to be more heavily impacted than the others by this rule change mainly because of the popularity of hybrid Tier 1 equity in their overall capital structures. Public Bank, in particular, could see capital drop below the stipulated levels with the new standards, and has already indicated the possibility of raising capital rather than reducing capital wastage by building capital-light business models and lowering dividend payments. More generally, as banks will need to hold more capital and liquidity, the net effect on impeded lending activities would be to lower return on equity (ROE).

Banks in the region-especially Australian lenders, which tend to have huge portfolios of low yielding, relatively low risk, residential mortgages will need to adjust the focus of their businesses. It is quite likely that banks might want to shift their portfolio balance away from these low-yielding assets towards high yielding assets in order to boost the ROE; ironically, this could have the effect of moderating them towards more risk business activities that seek additional gain
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Also, lenders may reconsider being in certain business lines such as extending credit to SMEs, and start pushing into less capital-intensive activities such as wealth management, especially targeting the wealthy in Asia‘s booming economies, as the cost of doing business goes up. Indian Banks face a relatively easy to shift towards Basel III stricter capital requirement than their European counterparts since banking regulation norms set up by RBI are already very stringent. Also Indian banks have maintained excess capital in minimum capital requirement. The average equity capital and overall capital adequacy ratio (CRISIL, 2011) is 9% and 14% respectively. According to Basel-III norms, Indian banks have to maintain a capital adequacy ratio of at least nine per cent, in addition to a capital conservation buffer, which would be in the form of common equity of 2.5 per cent of risk-weighted assets. In other words, banks‘ minimum capital adequacy ratio should be 11.5 per cent. Currently, Indian banks have to maintain a capital adequacy ratio of at least nine per cent. However most Indian banks are well capitalized beyond the stipulated norms and don‘t need any fresh capital but difference exist between various public and private sector banks. While core capital of private sector banks exceeds 9%, some of the public sector banks miss the benchmark. The public sector banks accounts for more than 70-72% of the total assets in the banking system. They are the major source of funding for many priority sectors and thus likely to face constraint in Basel III implementation. These public sector banks have more than 50% government holding with six banks having more than 70% holding.

Objectives of the study:
The dissertation study aims to find out the impact of Basel III requirements on Indian and European banks. The objectives of the study are:    To find the out the additional capital requirement of Indian banks & European banks. To study how will the banks raise the additional capital requirement of Basel III norms. To ascertain the impact of new capital requirements on bank‘s profitability and Return on Equity

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Literature review
To build the conceptual framework for capital adequacy norms and practices in scheduled commercial banks in India and Europe, different researches were conducted across globe. Some tried to find out the capital requirements while other seeks to find out the challenges faced by the banking industry in its implementation. Other studies the found out how Basel II affected the Indian banks after its implementation. Raghavan (2008) outlined the concept of Basel II norms for Indian banks. The study concluded that Basel II principles should be viewed more from the angle of fine tuning one‘s risk management capabilities through constant mind searching rather than as regulatory guidelines to be complied with. Dhanda and Rani(2010) in ‗Basel I and Basel II Norms: Some Empirical Evidence for the Banks in India‘ talks about how the economic crisis in 2008 and failure of Banking system has exposed public at large and forced policy makers to look at the possible reasons of failure. While comparing CRAR figures of all banks, it was observed that the mean value CRAR of ‗Other public sector banks‘ has been highest. Through ANOVA it was found that there is a significant difference in CAR of Nationalized banks, Old Public Sector, New Private Sector and Foreign bank. By looking at the past CAR data it was observed that CAR has increased for almost all banks under Basel II norms. Therefore it was concluded that there was no adverse impact of Base II norms on Public Sector Banks. Whereas in case of Foreign Banks the CAR was less in Basel II norms than Basel I. Ernst and Young in their survey in (2008) revealed that Basel II has changed the competitive landscape for banking. Those organizations with better risk systems are expected to benefit at the expense of those which have been slower to absorb change due to increased use of risk transfer instruments. It also concluded that portfolio risk management would become more active, driven by the availability of better and more timely risk information as well as the differential capital requirements resulting from Basel II. This could improve the profitability of some banks relative to others, and encourage the trend towards consolidation in the sector. Lehmann, Levi and Tabak (2011) highlights that adoption of Basel III could be a threat to Banking model and could derail recovery in credit and growth. The Basel committee should gradually implement the reform and ensure that banks ensure that the banking sector can meet the higher capital standards through reasonable earning retention and capital raising,
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while still supporting the economy. He emphasized that key concern of the Basel Committee was to raise the quality of bank capital that will henceforth be a measure of regulatory capital adequacy. Overall upgrading the quality of regulatory capital will likely have a relatively minor effect – a finding which was in contrast to the quantitative impact study on additional capital requirements for EU banks as a whole, which found substantial reduction in Tier 1 common equity for both small banks (a drop of 33 per cent) and large banks (42 per cent). Under the new accord ―highest quality‖ capital – basically common equity and retained earnings – is to assume the primary role in defining capital ratios. According to CARE research Banks will be able to meet the capital requirements under Basel III till 2015 without issuing any fresh capital. But after that Banks will have to raise $25bn equity capital because equity requirements are set to rise from 3% in 2015 to 9% in 2016. Also banks have restraints on dividend payments, share buybacks and discretionary bonus payments to staff if capital conversion buffer falls below required levels. Although Indian banks maintains CCB above required levels, we believe dividend payout ratio to decline in the coming years as banks would prefer to retain profit in order to reduce issuance of fresh equity to meet higher capital requirement. Härle and Erik Lüders (2010) points that European Banking sector will need about €1.1 trillion of additional Tier 1 capital, €1.3 trillion of short-term liquidity, and about €2.3 trillion of long-term funding to meet the requirements. Capital requirements in Europe are expected to increase to about €1.2 trillion, short-term liquidity requirements to €1.7 trillion, and longterm funding needs to about €3.4 trillion. Meeting these requirements will affect the profitability of the banks. Basel III would also reduce the Return on Equity (ROE) by 4% in Europe.

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Methodology:
The project would be carried would be out in a phased manner, first analyzing the difference between Basel II norms and Basel III norms. Then it would cover studying Annual Report of select Banks and analyzing the effect of Basel III on their different components.

Universe of Study:
In accordance with the above mentioned objectives, the dissertation has been carried out on select Indian Public sector, private sector and foreign banks. Though the norms will affect all the banks but it will most hurt those banks which will be less capitalised. The study has been restricted to select banks in each of the category. Sampling: Judgemental sampling technique has been used to select the banks as the Tier I banks have enough capital to implement the Basel III norms. These banks have enough capital adequacy ratios to meet the Basel III norms. Therefore after careful examination of Tier II banks and private and foreign banks, the sample has been drawn.

Sample:
The Scheduled commercial banks in India are categorized into the following groups: Nationalized Banks, Other Public Sector Banks, State Bank Group, Indian Private Sector Banks (further categorized as Old Private Sector Banks and New Private Sector Banks) and Foreign Banks. The sample of nine banks has been taken such that it represents a mixture of both Indian banks (private as well as public) and European banks. The banks selected range from SBI ltd, largest bank of India to Central bank, having least capital Adequacy ratio among Indian banks, Axis bank, well capitalised to Dhanlaxmi and Citi to Duetsche bank. This is done to see the variation of impact of Basel III norms on Indian as well as European banks. The sample consists of the following banks: Indian Public Sector: SBI Bank, Central bank of India, Union Bank of India Indian Private Sector: Axis Ban ltd., HDFC, Dhanlaxmi Bank European bank: Deutsche Bank, RBS, Citi Bank

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Sources of Data:
For the study, secondary data has been collected. Secondary data has been collected from the annual reports of the RBI and other publications, including Report on Trend and Progress of Banking in India, statistical tables related to the banks in India, and report on currency and finance. Articles and papers relating to capital adequacy norms published in different business journals, magazines, newspapers, periodicals and data collected from the Internet and other sources have also been used. Major guidelines issued by the RBI from time to time were studied in-depth. Along with this, reports of various committees constituted by the government and other bodies were also studied to know the recommendations made by them. The main source of data would be secondary source. It would include: o o o o o o Company‘s financial, RBI report, BCBS report, Finance journals and Research papers Websites e.g. http://data.worldbank.org/, www.iba.org.in/, www.indiastat.com/banksandfinancialinstitutions 18

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Basel III & its Impact on Indian public & private sector banks
Although Basel III norms have introduced new capital requirements, RBI proposes that Indian banks are less likely to be impacted by new requirements. The aggregate risk-weighted assets of public sector banks are at 12.1% level. Therefore, meeting these requirements will not be uphill task for them in terms of both capital requirement and quality of capital. However, Banks in Public and Private sector will raise Rs 6 lakh crore in external capital over 9 years to comply with Basel III norms, according to credit rating agency ICRA, International Credit Rating Agency. In comparison to the mandated limit of 9 per cent CRAR posed by the Basel II, the average capital adequacy ratio of commercial banks went up to 14.2% per cent in FY 12 from 13 per cent in the 2010.

CRAR Level of Indian Banking Group Year Nationalized State Bank Bank Group Other Public Sector Banks 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 10.2 10.9 12.2 13.1 13.2 12.3 12.4 12.1 12.1 12.5 13.47 13.03 12.7 13.3 13.4 13.4 12.4 11.9 12.3 13.2 12.7 12.5 12.25 13.70 15.5 14.8 13.7 11.9 11.5 11.3 11.2 11.1 New Private Sector Banks 11.9 12.5 12.8 13.7 12.5 11.7 12.1 14.1 14.3 15.2 16.86 16.66 Old Private Sector Banks 11.5 12.3 11.3 10.2 12.1 12.6 12.0 14.4 15.1 14.2 14.55 14.12 12.6 12.9 15.2 15.0 14.0 13.0 12.4 13.1 15.1 15.6 16.97 16.64 11.4 12.0 12.7 12.9 12.8 12.3 12.3 13.0 13.2 13.6 14.2 14.2 Foreign Banks All Banks

Source: Report on Trend and progress in India, RBI 201 Table 1: CRAR level of Indian Banking Groups
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The overall Capital Adequacy Ratio of all the banks has increased from 11.4 to 14.2 % from 2000 to 2012. Also the Capital Adequacy Ratio (CAR) has remained stable at 14.2 % in the recent years of all the commercial banks on India which is much higher than the stipulated limit of 9%. Group-wise the Old public sector banks are the only group whose CAR declined. In 2004-05 the CAR of Other public sector banks was 15.5 and it declined to 11.1% on 2012, a drop of 4.4%. This was due to the rise in the risk weighted assets relative to the capital. The increase in the risk weighted assets was due to the rise in the loan portfolio especially increased in housing and retail loans over the years. Each group has shown a decline in CAR from 2010-11 to 2011-12 worth the sole exception of State Bank Group. Among the public sector banks that need more common stock or core equity to meet capital requirement norms have five fiscal years to adhere to the new norms. The option of additional instruments such as perpetual non-cumulative preference shares, or perpetual debt instruments, that can be included take in tier I capital can a hit due to the loss absorption features. The new norms could further make these instruments costlier.

The private sector banks are in a better position to raise capital from the market as they are well capitalized whereas for public sector banks, government have to shell out money. Already looming under high fiscal deficit government will have a tough time in raising capital after making the policy of owning majority stake in these banks. And to top it all that Moody’s Investors Service Inc. downgraded State Bank of India not because of the quality of assets but due to the inability government to infuse capital into the bank. Out of the Rs 15,000 odd crore the government has promised to infuse this year will be just adequate to maintain 8% tier I capital ratio. This means that banks will need additional capital to fund their growth. This will be hard especially on mid-cap public sector banks. In addition of this public sector banks have high non-performing assets than the private banks which mean that it will be charge on the capital and cause them to raise more capital. But the problem arises when we look at the bank‘s capital on a risk adjusted basis. "Indian banks' risk-based capital is only moderate and that is a weakness for the majority of the Indian banks that we rate," (S&P report on Indian banks). Though the banks meet the capital requirements but when it comes to risk adjusted capital, it is lower for Indian banks than their Asian counterparts. S&P‘ risk adjusted capital considers the differences between bank‘s loan book and their exposure to risk which vary from industry to industry.

Also there may be some negative consequences arising out of shift from Basel II to III. These
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are related to deductions that are made while calculating capital adequacy ratio. The guidelines state that deductions should be made only if they exceed 15% of the core capital at aggregate level and 10% at individual level. This still doesn‘t hurt banks but the guideline to deduct 100% from core capital which is way harsher than RBI guideline of 50% deduction from tier I & 50% from tier II is likely to be strict for them.

Though RBI is conservative in its approach, implementation of Basel III norms requires increase in capital in public sector banks. Further out of capital proportion of expensive core capital i.e. Common equity is likely to increase. According to proposed norms, the Common equity requirements are set to be raised by 4.5%. Along with the conservation and counter cyclical buffer, the total capital requirements would be increase to between 10.5-13%. While the core capital in most of the private and foreign banks exceeds 9% but there are some public sector banks which fall short of the target. Out of these, banks having 70% government holding can easily raise capital by diluting government stake. But banks with less than 70% government stake are constrained to raise capital since government has a policy of maintaining 51% stake in all public sector banks. Presently there are only six banks that has a higher than 70% government stake.

Other Public Sector Banks
Banks Allahabad Bank Bank of India Dena Bank IDBI Banks Ltd. Oriental Bank of Commerce Syndicate Bank of India Union Bank of India GOI Holding 55.2% 62.7% 55.2% 70.5% 58% 66.2% 54.4% CAR 12.83% 11.95% 11.51% 14.58% 12.69% 12.24% 11.85%

Source: Report on Trend and progress in India, RBI 2012 Table 2: CAR level & Government holdings of Indian public sector banks

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Leverage Ratios of Indian Banks From Indian Banks‘ point of view, RBI already had Statuary Liquidity Ratio (SLR), as a regulatory mandate. The statutory liquidity portfolio of Indian banks is constituted only for moderate risk i.e. Market Risk and it is excluded from leverage ratio. The tier I capital of many Indian banks is comfortable (more than 8%) and their derivatives activities are not very large. So leverage ratio cannot be a binding constraint for Indian Banks. Reducing the Pro-Cyclicality of Financial Sector Regulation The pro-cyclicality reforms of Indian banks came into existence during the financial crisis. Banks found difficulty during the financial crisis in lending. Along with a rise in risk weighted assets and disqualification of non-common tier I and tier II capital instruments for inclusion under framework would further increase the requirement of capital. According to report prepared by ICRA(2010), if the risk weighted assets were to grow by 20%, the requirement of additional capital by banking sector excluding foreign banks would be about Rs. 6000 billion over the next nine years. Out of this public sector will require 75-80% of the additional capital. The idea behind making the countercyclical provision and establishing capital buffers is that banks should build up higher capital during the good economic condition and run in economic contraction with safety and soundness. The foremost challenge arises in this reforms of Basel III is identifying the good and bad economic condition. Also the size of the capital buffer, which is varying with the economic cycle, will be a difficult task for banks. The capital buffer should have capability of absorbing the losses in stressed condition as well as keeping lending. Basel committee is working for identifying the criteria of good and stressed economic condition as well as the size of the capital buffer.

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Profitability
The average Return on Equity (ROE) of the Indian banking system for the last three years has been approximately 15 per cent. Implementation of Basel III is expected to result in a decline in Indian banks‘ ROE in the short-term. However, the expected benefits arising out of a more stable and stronger banking system will largely offset the negative impact of a lower ROE in the medium to long term. It is also fair to assume that investors will perceive the benefits of having less risky and more stable banks, and will therefore be willing to trade in higher returns for lower risks. Now the debate is whether banks will bear the increased cost of capital themselves or pass it to their depositors and borrowers. This trade off has to be assessed in the context of the relatively higher level of net interest margins (NIMs) of Indian banks, of approximately 3 per cent. This higher NIM suggests that there is scope for banks to improve their efficiency, bring down the cost of intermediation and ensure that returns are not overly compromised even as the cost of capital may increase. This has a likely impact on the lending rates of banks. Suppose, a typical Indian bank has ROE of 15 per cent and interest paid on non equity elements of capital is 10 per cent. Further, suppose that the equity to RWAs ratio of the bank is 6 per cent. Now if the bank is required to maintain an additional 1 per cent equity, the weighted average cost of funds would rise by 5 basis points only. If the equity capital required rises by 2 per cent, the increase in lending rate to pass on the full increase in cost of capital to borrowers would be 10 basis points. There is likely to be some increase in cost of non-equity capital as well. But, all this is unlikely to push the cost of lending significantly. And, Indian banks should keep in mind that their net interest margins (NIMs) are very high as compared with their counterparts in many other countries. This only indicates the need for improving efficiency and considerable scope for bringing down the cost of intermediation. The fact that while many large international banks are required to increase their equity capital by more than 100 per cent over the existing levels, many Indian banks would certainly not be required to increase their equity levels by that order is appreciable. Therefore, the impact on their ROE is likely to be much less than 3 to 4 percentage points as observed in the case of European banks.

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Benefits of Effective Implementation of Basel III
Effective implementation of Basel III will demonstrate to regulators, customers, and shareholders that the banking system is recovering well from the global financial crisis of 2008 and has been developing the resilience to future shocks. A smooth implementation will also contribute to a bank‘s competitiveness by delivering better management insight into the business, allowing it to take advantage of future opportunities. At the same time, the challenges in implementation of Basel III should not be underestimated. For every bank, working out the most cost-effective model for implementing Basel III will be a critical issue. The comfortable capital adequacy levels at present for the Indian banking system do provide some comfort. However, as the economy grows, so will the credit demand requiring banks to expand their balance sheets, and in order to be able to do so, they will have to augment their capital; more specifically the equity capital. While implementation of Basel III would undoubtedly imply some costs, this should not be the criterion to determine whether Basel III would add value to the financial system. The correct measure should be whether or not Basel III would deliver a much safer financial system with reduced probability of banking crises at affordable costs. The impact of costs is minimized through long phase-in. At times a debate is raised whether it is appropriate for the countries which neither contributed to the crisis nor have exposure to the toxic assets need to implement Basel III. The reason is that in the present-day globalised world it is difficult for any local financial and economic system to completely insulate itself from the global economic shocks. The indirect effects of events happening in any part of the world can very well be transmitted throughout the world through various channels. In addition, many provisions of Basel III address the weaknesses in the measurement of risk under Basel II framework revealed during the crisis. Thus, Basel III would strengthen the financial system of both developing and developed countries. It needs to be appreciated that if the implementation of Basel III is not consistent across jurisdictions there would be a race to the bottom to make use of arbitrage opportunities, which nobody wins! However Indian banks should minimize costs by retaining maximum amount of earnings in the initial years of implementation, even though they might meet the capital requirements at that point in time with smaller retentions. This would avoid costs involved in fresh issuances.
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Indian banks are also comfortably placed in terms of liquidity requirements as they have a large reservoir of liquid Government securities to meet the SLR stipulation. RBI is considering how much of it can be allowed to be reckoned towards compliance with the LCR. It is also expected that as the proportion of equity in the capital structure of banks rises, it would reduce the incremental costs of raising further equity as well as non-common equity capital.

Challenges with the Indian Banking Industry
The feature of additional capital requirements, will pose a challenge for the Indian banks though, the overall capital level of the banks will see an increase. Another challenge is restructuring the assets of some of the banks would be a tedious process, since most of the banks have poor asset quality leading to significant proportion of NPA. This also may lead to Mergers & Acquisitions, which itself would be loss of capital to entire system. The new norms seem to favour the large banks that have better risk management and measurement expertise, who also have better capital adequacy ratios and geographically diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. Thus, banks will have to re-structure themselves if they are to survive in the new environment. Improved risk management and measurement aim to give momentum to the use of internal rating system by the international banks. Since the Indian financial markets are not subject to similar stress level as financial markets in advanced countries therefore implementation of countercyclical buffer is going to be tough. Also at the same time Indian banks follow retail business which means that they are less dependent on short-term or overnight funding. Further Indian banks have large amount of liquid assets that will enable them to meet new standards.

RBI regulates Indian banks to maintain Statutory Liquidity Ratio (SLR) i.e. a fixed portion of government securities. The issue is whether these should be included in estimation of liquidity ratio. Since SLR is to be maintained on regular basis therefore it should be considered in calculating liquidity ratio. Public Sector As it is, raising money from the markets is easier for private sector banks, most of which are well-capitalized. For state-owned banks, it is the government that has to spend the money and

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its finances are in a mess. With the fiscal deficit being where it is, the government has been uncertain in capitalizing public sector banks after having made a policy decision to continue owning majority stake in these lenders. Moody‘s Investors Service Inc. downgraded State Bank of India in October, not so much for its balance-sheet weakness, but because of the questions regarding the government‘s infusion of capital into the bank. Secondly, for public sector banks, even the Rs 15,000-odd crore the government has promised to pump in this year will be just about adequate for maintaining an 8% tier I capital ratio. That means banks will need additional capital for funding credit growth. That will hit mid-cap state-run banks hard, especially those with middling return on assets of 0.5-0.6%, say brokerage firms. If they can‘t raise additional capital, earnings will be hit, putting these stocks under further pressure. Thirdly, in general, there have been more additions to non-performing assets (NPAs) for public sector banks in recent years than for private sector ones. A higher level of NPAs is ultimately a charge on the capital of banks, and this would necessitate still more capital raising for these lenders. Fourthly, public sector banks will have to reduce unamortized expenditure on pension liabilities from common equity tier I capital from January 2013. To be sure, they have to do that by 2015, so the impact will be short-term in nature. Still, Kotak estimates that this could have an impact of up to 30 basis points in the capital adequacy ratio of these banks in the March quarter. Goldman Sachs calculates that this could also affect their net worth by 2-5%. Since the beginning of 2004-05, 16 of 19 public sector banks have underperformed the Bankex. That trend is likely to be reinforced with the introduction of Basel III.

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Basel III norms & its Impact on European Bank
The new norms are set to make the banking system safer by solving many of the flaws that came up during the 2008 crisis. In order to improve risk management capabilities the focus should be given to improving quality and depth of capital and renewing the concept of liquidity management. The underlying principle is that if the banks will be able to fully understand the risk they are facing then this will be good for not only their business but also for investors and the government. The impacts of these regulations are considerable. The estimated impact of these regulations on European Banking sectors is Euro 1.1 trillion (Mckinsey & Co.) of capital shortfalls and Euro 1.3 (Mckinsey & Co.) trillion short term liquidity shortfalls. The 1.1 trillion capital shortfalls are approximately around 60% of the European tier I core capital. Further they will also face a Euro 2.3 (Mckinsey & Co.) trillion shortfalls in long term funding. Considering the fact that all measures of Basel III norms are implemented by 2019, the pre tax ROE of Euro banks would decrease by 3.7 to 4.3%. The lower bound is calculated excluding the net stable funding ratio while upper bound includes Net stable funding ratio (NSFR). There are two implications of the regulations, Capital impact and Funding Impact.

Capital Impact
The impact of the regulatory norms have been calculated considering the core tier I ratio of 4.5%, Tier I ratio of 6% and Capital conservation buffer of 2.5%of tier I. The extra shield of 2.5% of capital conservation buffer accounts for 55% of the estimated shortfall. This estimate may not be accurate considering the fact that banks on average tend to hold a minimum of 4% more than the earlier minimum of 4% Tier I capital. This will decrease with the new Basel III norms but banks will still hold 1% as a cushion. Taking all these assumptions, the total capital deficit of European Banks is estimated to be €1.1 trillion and €2.3 trillion shortfalls in long term funding.

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Funding Impact
The total shortfall in short term funding due to the liquidity coverage ratio (LCR) is around €1.3 trillion. This is around 40% of the average liquidity buffer held by banks at present. The shortfall arising out of Net stable funding ratio (NSFR) is about €2.3 trillion which is equal to 10 to 15% of current available funding. The twin effects above rebuild the long term funding. After discussing the Capital and Funding Impact, it is also worthwhile to consider the impact of Basel III norms on different banking segment i.e. retail, corporate and investment. To find out the impact on different segments, the changes in capital cost, liquidity cost and long term funding cost is considered and it‘s corresponding increase in cost of banking products. In the ranges provided below, the long-term funding requirement—the net stable funding ratio (NSFR)—as written today drives the upper limit of the range; as noted, implementation as currently written seems unlikely. This is particularly important in the following discussion, as the long-term funding ratio is a key cost driver for some products, especially corporate products, cash trading activities, and low-rated and financial institution bonds. The estimates below represent the additional cost for banks and do not consider any possible remedies. For all three segments—retail, corporate, and investment banking—some rational responses are already under way. Banks can of course mitigate some of the impact through costreduction programs, capital-efficiency measures, de-risking, and price adjustments. Our experience suggests that in some markets and business segments, notably some corporate lending markets, prices will probably increase, while in others, such as many retail banking markets in Europe, any pricing adjustments will be subject to the competitive environment and therefore limited. As banks review the rise in costs outlined below, a key consideration will be the implications for their margins. This should be the starting point for an assessment of the impact on their different businesses, as they seek to manage profitability and adjust to the new regulatory environment.

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Retail banking The retail banking business is affected mainly by those parts of Basel III that affect the entire bank, in particular higher capital and liquidity requirements. New capital ratios will affect retail banks especially, as most have operated in recent years with lower capital ratios than wholesale banks. Some retail institutions will also be particularly affected by capital quality measures, such as the deduction of silent participations in Germany. Liquidity requirements will also be a factor, even after being lowered in the July 2010. The effect of Basel III‘s new product-specific requirements is less relevant. The new marketrisk framework does not apply to the retail segment, and the new funding requirements pose no particular challenge after the amendments in the July 2010 Annex, which established that deposits are now largely accepted as long-term funding and significantly reduced long-term funding requirements for mortgages. Residential mortgages require only 65 percent long-term funding, whereas earlier versions of the rules called for 100 percent. Short-term retail loans will see an increase in costs of up to 70 basis points. This effect is driven mainly by the increase in target ratios for a segment with relatively high risk weights; higher liquidity and long-term-funding needs will also contribute to higher costs. As discussed above, banks may in some cases be able to pass these on to customers, given the relatively high margin on these products. For certain consumer finance segments, repricing may be difficult. Corporate banking Like retail banking, corporate banking will also be affected primarily by the corporate effect of increased capital target ratios. The new ratios will also affect many standard corporate banking products. Long-term corporate loans and long-term asset-based finance businesses (commercial real estate, project finance) will face an increased funding cost of about 10 basis points. Uncommitted credit lines to financial institutions and uncommitted liquidity lines to both financial institutions and corporates will see a cost increase of 60 basis points just for higher liquidity requirements, plus some 15 to 25 basis points for higher capital requirements. Given the price sensitivity of some corporate lending markets, banks may not be able to fully pass on these cost increases. If they cannot, the higher costs will lead to a reduction in profitability and eventually less capital being allocated to these businesses.

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Other products will also be affected, especially those with relatively high risk weights such as structured finance or unsecured loans, which will be especially hard hit. Indeed, specialized lending (including structured finance and trade finance, among other businesses) is among the most affected, with an estimated increase of about 60 basis points, mainly due to the new target ratios. The trade finance business is worth a special note, as it is touched by several elements of the new framework. First, Basel III increases the risk weight for financial institutions by some 20 percent to 30 percent. Lending between financial institutions is an essential element of trade finance, with banks often representing their clients, typically through letters of credit. Second, trade finance commitments fall afoul of the new leverage ratio; they now count in full against that threshold, a fivefold increase over today‘s capital ratio requirements. Finally, as mentioned above, the new liquidity rules are designed to set reserves against off-balancesheet liquidity lines such as letters of credit and trade guarantees. Investment banking Of the three segments, investment banking and, in particular, capital markets bear the most product-specific changes—and of course are also affected by the higher target ratios. The biggest effects to products come from the new market-risk and securitization framework, the changed liquidity of securities through the introduction of the LCR, and significant amendments to the OTC derivative business. Overall, trading businesses will see the most significant impact and the greatest need for review. As specific examples, consider three activities: OTC derivatives, cash trading, and securitizations: OTC derivatives: These activities will be affected in two main ways. First, the stressed value at risk, the incremental risk charge (IRC), and the comprehensive risk measure (CRM) for correlation trading under the European Union‘s Capital Requirements Directive III (CRD III) will require banks to hold more capital for market risk. Second, the newly introduced credit valuation adjustments (CVAs) under CRD IV will require banks to hold more capital for counterparty credit risk. The CVA requirements remain high despite their mitigation in the July 2010 Annex. Our current estimate is that CVAs will increase RWAs by a factor of 3— on top of the effects of changes in the market-risk framework. Along with increased liquidity costs and reduced liquidity benefits, this might raise costs by up to 85 basis points on the market value of unnetted, uncollateralized positions on average—a significant increase. Most affected would be trades with lower-rated counterparties and trades with counterparties with
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limited netting ability; sales of risk-management products to corporates come to mind. For banks to maintain profitability, these costs would have to be compensated through some combination of improved collateral and netting arrangements, more effective central counterparty management, and moving some businesses and products to central counterparty clearing platforms outside the bank. Cash trading: Profitability of cash trading will be driven down by the higher cost of holding inventories, particularly the matched funding requirements on lower-rated assets. These will rise by between 20 and 40 basis points. If we assume that at a big ―flow‖ house, inventory turnover is between 4 and 50 times annually, these higher costs would amount to a widening of bid-ask spreads by between 1 and 10 basis points. In addition, cash trading will see higher hedge costs from OTC derivatives, as described above. Inasmuch as these costs cannot be passed on, one result might be that some market-making would be abandoned and market depth and liquidity would be reduced, further increasing bid-ask spreads, and may drive some trading activity toward exchanges. Securitizations: The securitization business is worth a special note. All three amendments to the Basel Capital framework—CRD II, CRD III, and CRD IV—affect securitizations. Overall, these changes could increase capital requirements by a factor of up to ten. CRD II (which anticipates part of Basel III and is to be implemented by the end of 2010) forces investors to ensure that, before they can buy a piece of a new securitization they must ensure that the originator has complied with the ―skin in the game‖ rule—which requires banks to hold at least 5 percent of the securitizations they create at all times. Banks can opt to keep either a first-loss piece or a ―vertical‖ slice across the tranches of the securitization. The impact on capital requirements could be up to 500 percent, in the case of the first-loss piece, and about 50 percent if they choose to take a vertical slice.

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Profitability
Studies have suggested that internationally, Basel III requirements will have a substantial impact on profitability. One such study conducted by McKinsey & Company suggest that all other things being equal, Basel III would reduce return on equity (ROE) for the average bank by about 4 percentage points in Europe. The retail, corporate, and investment banking segments will be affected in different ways. Retail banks will be affected least, though institutions with very low capital ratios may find themselves under significant pressure. Corporate banks will be affected primarily in specialized lending and trade finance. Investment banks will find several core businesses profoundly affected, particularly trading and securitization businesses. Banks are already seeking to manage ROE in the new environment by balance-sheet restructuring and business model adjustments. The study suggests that the balance sheet restructuring and businessmodel adjustments could potentially mitigate up to 40 percent of Basel III‘s ROE impact, on an average.

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Implication of Basel III norms on Indian & European banks
The banking system in India has been robust because it is isolated, largely serving the domestic requirements only. Therefore, only the domestic pressure and pulls impact both the performance and the capital of the Indian banking. Overall in the next five years, the Indian banking will require about $60 billion of funds or capital to really meet the Basel-III requirements as now laid out by the RBI. Out of this, about $38 to about $39 billion will be required by public sector banking. Now when it comes to preparedness, both the private as well as the public sector banking will have to start preparing to mobilise that kind of capital (Economic Times).

Capital Requirements
The capital requirement will have to be raised through common equity which is tier-1 capital. Therefore, to that extent both the dividend policy as well as the mobilisation of further capital will be under pressure. But looking at the financial performance of the Indian banking, the sector should be capable of doing that. The government of course will have to work out some way in which it will put this required $38 to $39 billion of capital if it has to hold that 51% of the threshold investment in the public sector banking.

Basel III

Draft Basel III guidelines
FY13 FY14 FY15 FY16

Proposed Basel III norms by RBI
FY17 FY13 FY14 FY15 FY16 FY17 FY18

Common Equity Additional tier I capital Tier I Capital Tier II Capital

3.6 2.4 6.0 3.0

4.5 1.5 6.5 3.0

4.5 1.5 7.0 2.5

5.0 1.5 7.0 2.0

5.0 1.5 7.0 2.0

4.5 1.5 6.0 3.0

5.0 1.5 6.5 2.5

5.5 1.5 7.0 2.0

5.5 1.5 7.0 2.0

5.5 1.5 7.0 2.0

5.5 1.5 7.0 2.0

5.5 1.5 7.0 2.0

Source: RBI website Table 3: Proposed Guidelines for Basel III norms

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Tier I capital
Common Equity

Out of the nine banks taken for analysis each one of them meet the Common equity and Tier I capital requirement till 2018. Some of the banks are just meeting the minimum requirement. Central bank of India and Dhanlaxmi Bank with Tier I capital ratio of 7.79% and 7.73% respectively are among the lowest tier I capital ratio. While the public sector backs have low Tier I ratio, European banks have a strong tier I ratio.

18,00 16,00 14,00 12,00 10,00 8,00 6,00 4,00 2,00 0,00

Common Equity(%) Tier I capital(%)

Figure 1: Common Equity and tier I ratio’s of different banks

Additional Tier Capital

Basel III norms suggest that innovative instruments such as perpetual debt instrument should not be more than 15% of the Tier I capital. Among the nine banks except Central Bank of India all Innovative instruments have less than 15% of Innovative instruments. Central bank of India has 20% of innovative perpetual debt out of their Tier I capital.

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Additional Tier %
30,00% 25,00% 20,00% 15,00% 10,00% 5,00% 0,00%

Adittional Tier

Figure 2: Additional tier ratio of banks Therefore, either Central bank of India needs to raise their core equity or reduce their innovative debt to meet the Basel III requirement. Central bank of India has innovative perpetual debt of Rs. 2200 crores with a tier I capital of Rs.10978.41 crores therefore to meet the Basel III requirement Central bank need to raise Rs. 3688 crores of common equity.

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Tier II Capital
―According to Basel III norms excess Additional Tier 1 capital above the 1.5% of RWAs can be reckoned by the bank further to the extent of 27.27% (1.5/5.5) of Common Equity Tier 1 capital in excess of 8% RWAs. Similarly, excess Tier 2 capital above 2% of RWAs can be reckoned by the bank further to the extent of 36.36% (2/5.5) of Common Equity Tier 1 capital in excess of 8% RWAs.‖ (BCBS Report)

5 4,5 4 3,5 3 2,5 2 1,5 1 0,5 0

Tier II capital

Figure 3: Tier II ratio of banks

All the banks have excess of 2% of Tier II capital except for European banks Citi and Duetsche bank having 0.89 % and 0.85% respectively. Therefore Citi bank and Duetsche bank need to raise Rs. 9720 crores and Rs. 7798 crores through preference shares or other reserves.

Capital conservation buffer
Apart from maintaining capital requirement, Basel III norms ensure banks to build capital buffers outside the period of stress. Outside of periods of stress, banks should hold buffers of capital above the regulatory minimum. When buffers have been drawn down, one way banks should look to rebuild them is through reducing distributions of earnings. This could include reducing dividend payments, share-backs and staff bonus payments.

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Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital. Basel III proposes a capital conservation buffer of 2.5% of Common equity tier I above the minimum capital requirement.

Capital conservation buffer %
12,00 10,00 8,00 6,00 4,00 2,00 0,00

Figure 4: Capital conservation buffer All the nine banks have enough conservation buffer out of Common equity to meet the requirement. This means that Indian as well as European banks have enough buffer to meet the period of stress.

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Status of Capital Adequacy Standards

To ascertain the extent of difference in CRAR across various categories of banks (Nationalized Banks, SBI Group, Old Private Sector Banks, New Private Sector Banks, and Foreign Banks) regarding CAR, ANOVA Test has been applied to test the following null hypothesis:

H0: There is no significance difference in CAR of Nationalized Banks, SBI Group, Old Private Sector Banks, New Private Sector Banks and Foreign Banks.

H1: There is a significance difference in CAR of Nationalized Banks, SBI Group, Old Private Sector Banks, New Private Sector Banks and Foreign Banks.

CRAR Level of Indian Banking Group Year Nationalized State Bank Bank Group Other Public Sector Banks 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 13.2 12.3 12.4 12.1 12.1 12.5 13.47 13.03 12.4 11.9 12.3 13.2 12.7 12.5 12.25 13.70 15.5 14.8 13.7 11.9 11.5 11.3 11.2 11.1 New Private Sector Banks 12.5 11.7 12.1 14.1 14.3 15.2 16.86 16.66 Old Private Sector Banks 12.1 12.6 12.0 14.4 15.1 14.2 14.55 14.12 14.0 13.0 12.4 13.1 15.1 15.6 16.97 16.64 12.8 12.3 12.3 13.0 13.2 13.6 14.2 14.2 Foreign Banks All Banks

Table 4: CAR ratio of Indian banking groups 2004-05 to 2011-12

It is observed from Table 5, given below that the calculated F-value is more than the table value, resulting in the rejection of null hypothesis. So, it may be concluded that there is a significant difference in CAR of Nationalized Banks, SBI Group, Old Private Sector Banks, New Private Sector Banks, and Foreign Banks.

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ANOVA Source of Variation Between Groups Within Groups Total

SS 31.36905 89.25066 120.6197

df

MS F P-value F crit 6 5.228175 2.870349 0.017785 2.290432 49 1.821442 55

Table 5: Anova results for Indian Banking groups This shows that different banking groups will be impacted differently due to implementation of Basel III norms.

Comparison of Indian & European Banks
Basel III norms have impacted both Indian Banks as well as Indian Banks also. However the level of impact differs as both have different level of capital. While European banks seek to deleverage their books to meet new capital adequacy norms in the midst of the euro zone sovereign debt crisis, Indian banks are taking this as a business opportunity and acquiring quality assets at attractive prices. Indian Banks Common Equity Indian Banks have an average European Banks European Banks have common equity

common equity of 8.35% which is of 11.22% higher than their Indian much higher than the 4.5% required. Additional Equity (Tier I capital) Additional tier ratio is 7.23% with huge variation between banks such as Central bank with 20% and Dhanlaxmi bank with 0%. Tier I Capital Indian banks have average tier I capital ratio of 8.9% much higher than the Basel III requirement. Only Central Bank has common equity deficit of Rs. 3688 crore to meet requirement. European banks have additional tier ratio of 12.43% with Duetsche bank having 25% invested in noncumulative preference securities. European banks have a healthy ratio of 12.7 % with around 88% invested in tier I capital out of Total capital. counterparts.

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Indian banks have a tier II capital of 3.9%. Basel III says the tier II Tier II Capital capital should be only 2%, excess of which can be added to common equity.

European banks have a very low tier II capital of just 1.6% with Citi and Duetsche bank at 0.89% and 0.85%. They are therefore required to maintain 2% ratio with issue of preference share or other instruments.

ROE

Return on Equity of Indian Banks is likely to go down by less than 3-4% and will vary from bank to bank.

ROE of European banks will decline by 4%.

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Conclusion
The net effect that Basel III will have on Indian Banks is that these banks will have to find additional sources of capital. This is not going to be easy even though banks have been told to ensure compliance in a phased manner commencing January 2013 and ending January 2018. The government‘s unwillingness to reduce its stake in public sector banks (PSBs) means the additional capital for PSBs will have to come from public funds. Given the opportunity cost of this additional capital, especially when government finances are very constrained, it is far from certain whether cost-benefit trade-off justify such infusion. The government must therefore be prepared to dilute its stake down to 51% in state owned banks, and churn other assets. Sell holdings in other public enterprises and slash subsidies, use the proceeds to infuse fresh capital in the bank can be some of the options with the RBI. In case of European banks, they have enough tier I capital but when it comes to tier II capital they are still far behind. Also when it comes to Return on Equity (ROE) they are likely to be hurt more and have to restructure their balance sheet. Therefore, while banks have no choice in complying with Basel III, how they choose to implement it can offer scope for competitive advantage. Those banks that implement Basel III with a view to improving their business processes as well as their regulatory processes stand to reap further rewards compared to those banks that see Basel III compliance as an end in it. This way the Basel III regulations may work as a revolution for the banking sector.

The return on equity from the banking system by and large on account of the larger capital requirement will come down. In this capital requirement will have to be in common equity which is tier-1 capital. Therefore, to that extent both the dividend policy as well as the mobilisation of further capital will be under pressure. But looking at the financial performance of the Indian banking, the sector should be capable of doing that. The government of course will have to work out some way in which it will put this required capital if it has to hold that 51% of the threshold investment in the public sector banking.

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References
1. Alexander Lehmann, Micol Levi and Peter Tabak. ―Basel III and regional financial integration in emerging Europe.‖ JEL Classification Number: G21.(June, 2011) 2. Neelam Dhanda and Shalu Ran.i ―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) 3. Gambhir N Santosh (2007), ―Basel II: Are Indian Banks Going to Gain?‖ Jamanala Bajaj Institute of Management Studies, Mumbai. 4. Reserve Bank of India (2006), Annual Report 2011-12, available at www.rbi.org.in 5. Basel Committee on Banking Supervision. 2010. ―Working Paper on the Regulatory Treatment of Operational Risk‖ (September). 6. Reserve Bank of India (2009), ―Revised Draft Guidelines for Implementation of the New Capital Adequacy Framework‖, RBI Circular DBOD No. BP 7. Reserve Bank of India, Report on Trend and progress of Banking in India (various years). 8. Annual Report of SBI Bank, HDFC, Citi banks (2010-11, 2011-12). 9. Basel Committee on Banking Supervision (2010), ―Guidance for national authorities operating the countercyclical capital buffer‖, www.bis.org/publ/bcbs187.htm. 10. Bank of International Settlements (2010), ―Group of Governors and Heads of Supervision announces higher global minimum capital standards‖, www.bis.org/press/p100912.pdf 11. Committee on the Global Financial System (2010), ―Funding patterns and liquidity management of internationally active banks‖, CGFS Papers no. 39, Basel: BIS. 12. Institute of International Finance (2010), ―IIF Views on the Basel Committee Consultative Document ‗Countercyclical Capital Buffer Proposal‘‖, September, available on the web.

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