Improving banks’ capital efficiency

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SummaryThere is a huge potential to realise capital savings by critically identifying inefficiencies and redesigning the bank processes

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. RBI’s 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 bank’s risk appetite and business strategy determines which segment the bank should grow—herein, 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

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