FE Column : India?s Basel III problem

In order to comply with the Basel III guidelines, aimed at strengthening the global banking sector in the aftermath of the economic crisis of 2008-09, the Reserve Bank of India (RBI) recently announced its draft guidelines for Indian banks. RBI?s guidelines are more stringent than the ones laid down in the Basel III framework. The guidelines lay down strict capital adequacy norms and propose to enhance the quality of the banks? capital by increasing the equity component therein. These guidelines also propose to augment the loss absorption capacity of the non-equity tier-1 capital and subordinated debt. Indian banks will have to reach the proposed capital adequacy requirements in a phased manner by March 2017, earlier than the 2019 timeframe laid down in the original Basel III framework (see table).

The guidelines propose an enhancement in the minimum tier-1 capital adequacy ratio to 7% of a bank?s risk weighted assets (RWA), while retaining the total capital (including both tier-1 and tier-2 capital) adequacy ratio at 9%. However, banks would be required to maintain a capital conservation buffer (CCB) of 2.5%, comprising only common equity capital, to be dipped into in times of economic stress. With the stipulation of the CCB, the total capital requirement of banks has been raised to 11.5% of their RWA.

Indian banks have historically maintained capital adequacy levels at 4-5 percentage points higher than the regulatory requirement. As of March 2011, the capital adequacy ratios of Indian banks stood at 13.1% and 16.5% for public sector banks and private sector banks, respectively. While Indian banks are comfortably placed to meet the proposed capital adequacy norms in the near-term, CRISIL Research estimates that banks, especially public sector banks, would be required to raise huge capital by March 2017 to meet the suggested norms (and have a small buffer over and above the regulatory requirement) without compromising on growth.

Assuming a credit growth of 17-18% (CAGR) over the next five years, and an average capital adequacy of 12% for public banks and 12.5% for private banks by March 2017, we expect an additional capital requirement of R4.2 trillion over the next five years. Of this, the tier-1 capital requirement would be R2.7 trillion, to be raised through a mix of equity and non-equity instruments.

The guidelines also lay down a ?write-off? clause according to which non-equity capital instruments such as perpetual non-cumulative preference shares (PNCPS), innovative perpetual debt (IPD), and upper and lower tier-2 bonds can be written off or converted into common equity upon the occurrence of a trigger event that puts the viability of a bank under threat. This clause is intended to ensure that investors holding these instruments would be treated on par with equity shareholders in case the viability of a bank is under threat.

CRISIL Research believes that the ?write-off? clause would increase the risk perception of these instruments. Consequently, the cost of capital would go up as the returns on these instruments have to be commensurate with the enhanced risk. As of March 2011, nearly 35% of the total capital of public sector banks and 27% of the total capital of private sector banks is in the form of non-equity instruments.

Of the R2.7 trillion of additional tier-1 capital required, approximately 90% will have to be raised by the public sector banks. These banks are the dominant players in the Indian banking sector, but have lower capital adequacy ratios as compared to their private counterparts. We believe that raising such a huge amount of capital would be a challenge for the public sector banks, who have together raised only R0.5 trillion of equity capital in the last seven years up to March 2011. We therefore estimate that the stipulated norms can be met only with the support of the government of India through capital infusion.

On the other hand, private sector banks, with their high capital adequacy ratios and high proportion of common equity, are well placed to comply with the new guidelines.

CRISIL Research believes that the expansion of equity capital and the expected increase in the cost of non-equity capital following the inclusion of the ?write-off? clause would affect the returns generated by the public sector banks over the longer term. As a major portion of the additional tier-1 capital will be raised by the public sector banks in the form of equity, their average return on equity (RoE) is expected to fall by 300-400 bps over the next five years.

The author heads CRISIL Research