Improving banks capital efficiency

Written by pratik | Pratik Shah | Updated: Feb 27 2014, 08:24am hrs
Capital has never been such a precious resource as it is today for Indian banks. The recent regulatory reforms, spearheaded by Basel III, have increased the capital requirements in terms of both the quantity and quality of regulatory capital. On the other hand, deteriorating asset quality witnessed in the recent past has resulted in significant erosion of earnings and decrease in capital formation. RBIs Financial Stability Report (FSR) highlights the fact that profitability of banks as measured by return on assets (RoA) and return on equity (RoE) has significantly declined with a negative growth in profit after tax (PAT), while the risks to the banking sector have further increased with asset quality being a major concern. This has clearly impacted the capital adequacy of banks, of which the worst impacted are the public sector banks (PSBs) that have reported a significant decline in capital to risk-weighted assets ratio (CRAR) to 11.2%. With the stress on Indian economy, the government, which is the primary shareholder, would find it difficult to improve the capitalisation of PSBs. To deal with this, banks need to have a two-pronged approach: improve capital efficiency and asset quality. While much has been talked about asset quality, not much has been done by banks to improve the capital efficiency, which is within the control of the banks.

There is immense potential for improving the capital efficiency of Indian banks through a series of structured initiatives, both strategically and operationally. From a strategic perspective, banks have to review the components that drive the regulatory capital requirements. A banks risk appetite and business strategy determines which segment the bank should growherein, adoption of measures like risk-adjusted return on capital can help the senior management determine where they can have the best return from deploying scarce capital; for instance, lending to venture capital funds vis-a-vis an A-rated corporate may earn a higher interest income but the increase in capital requirement is three-fold. Management should be able to derive insights such as the minimum fee income, and the off-balance sheet portfolio must earn so as to breakeven the cost of associated capital. The other key aspect is to revisit the product design and structure it to be more capital-efficient. In this regard, a thorough cost-benefit analysis of existing products taking into consideration not just the profitability and operational costs but also the relative capital costs shall drive the capital deployment decisions of the bank.

The operational interventions aim to improve the credit and risk processes as well as data and information technology infrastructure to plug the leakages in capital usage which emanate from improper interpretation of the guidelines, poor data quality and IT systems. While strategic initiatives are relatively complex to implement, immediate savings in capital can be realised through a series of guided initiatives at an operational level. Taking the position of Indian banks as of March 2013, advances to the MSME sector stood at R5,62,300 crore, resulting in capital requirements to the extent of R37,955 crore; however, a simple process of getting these exposures covered by the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) would result in net capital savings of about R32,000 crore. Further, advances covered by bank/government guarantees stood at R3,96,343 crore (source: RBI Bulletin).

Assuming half of these guarantees to be government guarantees, capital savings to the extent of R14,268 crore can be realised by recalibrating the capital computation process to correctly recognise and map these guarantees to the underlying exposures. There are various data quality/process related inefficiencies/opportunities in most of the Indian banks, resulting in overestimation of capital requirements, and the major areas of inefficiency include non-recognition of eligible collateral and guarantees, misclassification of exposures, unrated exposures, non-recognition of expired facilities such as letters of credit, bank guarantees and inactive/blocked credit cards, double counting of exposures, use of fall-back values for missing data, etc. In addition to inefficiencies, there are several process-related risks in the entire capital computation process which, if not managed efficiently, would result in overestimation of capital requirements.

There is huge potential to realise capital savings by critically identifying inefficiencies and redesigning the bank processes. For sustainable benefits, capital optimisation thinking should be embedded into the risk culture of a bank across all levels. Business leaders and product groups should be incentivised based on their risk-adjusted performance on the capital deployed, while at an operational level compliance with respect to the capital optimisation framework shall be one of the factors determining the branch performance metrics.

Clearly, that capital is now a precious resource, critical to the survival and growth of banks in India, and that performance measures are changing from net interest margin (NIM) to risk-adjusted return on capital (RAROC), banks must focus on implementing a capital optimisation strategy to manage the regulatory capital demand and protect shareholder value.

(This article is co-authored by Ajay Sirikonda, senior manager, financial services, EY India)

The author is partner, financial services, EY India. Views are personal