Chapter 1. Introduction. The Basel Committee was formed in the year 1974 in Basel, Switzerland to serve as a forum

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1 Chapter 1 Introduction The Basel Committee was formed in the year 1974 in Basel, Switzerland to serve as a forum for international banking supervision for regular cooperation on banking supervisory matters. Initially the membership was limited to the G 10 countries 1, represented by the governor of the central banks of these countries. However in 2009, the membership was expanded to twenty seven countries 2 (BCBS 2009). The main functions of the committee involves formulating the Core Principles for effective banking supervision and the concordat on crossborder banking supervision and encourages convergence to common global banking standards. The committee is further divided into specific task forces comprising of the Standards Implementation Group, the Policy Development Group, the Accounting Task Force, the Basel Consultative Group. The Basel committee underwent a series of steps before its successful and a structured evolution as it is today. The committee is today known for issuing the international guidelines for risk management and recommending a sound framework for banking supervision worldwide via the Basel Norms. Although these norms are not binding on the member countries as well as the non member countries, these norms have been well accepted by all the countries and the local banking rules are proposed by keeping these norms as a benchmark The Rationale for Setting up the BASEL Committee The deterioration in the quality of the banks when they were trying to balance the profitability and stability renewed the interest in banking regulation. The Basel committee was set up following the serious disturbances in the international currency and banking 1 G 10 Countries: Belgium, Canada, France, Italy, Japan, Netherlands, UK, USA, Germany and Sweden 2 Present Members of Basel committee: G10 countries, Argentina, Australia, Brazil, China, Hong Kong SAR, India, Indonesia, Korea, Luxembourg, Mexico, Russia, Saudi Arabia, Singapore, South Africa, Spain, Switzerland, Turkey 1

2 markets in the 1970s and failure of a major German Bank Bankhaus Herstatt on June Since 1980, about 130 countries, which comprised of about three quarters of the members of the IMF were facing significant banking distress (Banerjee, 2012). The growth of international business had opened up an international loan market. In order to provide a level playing ground for capturing the international loan market, the banks needed to follow a set of similar norms. Further there was a need to improve the flow of information between the banking supervisors of the different countries. Thus in a nutshell, the Basel norms aimed at serving as a platform for exchanging information on national supervisory arrangements by improving the techniques for supervising international banking business by framing guidelines for risk management by maintaining a minimum capital standards and supervisory standards. 1.2 Evolution of the BASEL Norms The Basel Accords of 1988 or commonly referred to as BASEL I was formed on the basis of the report of the consultative group report of The BASEL I issued in 1988 by the governors of the central banks of the G 10 countries. The initial focus was on the management of credit risk but soon it was felt the need to incorporate market risk and was introduced via the market risk amendment of BASEL I in 1997(BCBS, 1996). The committee felt the need to address the risks in a better way following the turmoil in the international markets in the late 1990s and it was proposed to strengthen the BASEL I norms through a formulation of a new set of norms via BASEL II in After minor rectification in the existing norms, the committee came up with a new structure of the norms in the BASEL II which was based on the three pillars namely, minimum regulatory capital, supervisory review and market discipline. The concept of operational risk was introduced by BASEL II and the guidelines for the measurement of credit risk, market risk and operational risk with the help of various advanced techniques were issued in The Financial crisis of shook 2

3 the whole economy across the globe and questions started to be raised about the effectiveness of BASEL II (Danila 2012). In order to address the issues which brought about the financial crisis, it was extremely necessary to introduce guidelines on off balance sheet exposures of the banks and securitization of the banks via credit default swaps (CDS) and credit debt obligations (CDO) 3 by further strengthening of the BASEL II norms in However to build a stable banking environment which will be able to handle shocks and stress, BASEL III guidelines were introduced in 2010 with the introduction of capital conversion buffers and counter cyclical capital buffers and liquidity risk management Brief Overview of the BASEL Norms Basel I The Basel Norms aimed at creating a portfolio of banks to counter the risks arising from credit risks. It proposed a framework for calculating the capital to risk weighted assets ratio (CRAR), also referred to as CAR (Capital Adequacy Ratio) by grouping the assets into four categories depending on their credit risk. The minimum stipulated CRAR was 8% of the Risk weighted Assets(RWA). It identified three types of credit risk: the on balance sheet risk; off balance sheet risks comprising of derivatives, foreign exchange, commodities and non trading off balance sheet risks comprising of forward purchase of assets or transaction related debt. assets. The calculation of RWA as documented by on the basis of Basel I framework (BCBS, 1988) is as follows : RWA = 0*(bucket1) + 0.2*(bucket2) + 0.5*(bucket3) + 1.0*(bucket4) 3 CDS and CDOs are structured asset backed security instruments by which banks used to remove risky assets and loans of high probability of default outside its assets books to reflect a healthy balance sheet. CDS is a financial swap agreement that the seller of the CDS will compensate the bank in the case of a loan default or other credit event. A CDO is a structured financial product that pools together cash flow generating assets and repackages this asset pool into discrete tranches that can be sold to investors. 3

4 where Bucket 1 consists of assets with zero default risk (e.g. cash, government bonds/ securities), bucket 2 consists of assets with a low rate of default (e.g. loans to OECD banks), bucket 3 consists of medium-risk assets (essentially residential mortgage loans), and bucket 4 consists of the remaining assets (in particular loans to nonbanks). The Basel I also decomposed the capital into Tier I capital- comprising of Equity Capital and Disclosed Reserves and Tier II capital- comprising of undisclosed reserves, general provisions, hybrid debt capital instruments 4 and subordinate debt 5. Through an amendment of Basel I in 1996, the market risk was introduced in the framework along with two methods for calculating the market risk namely Standardized Approach and In House Approach based on Value at Risk (VaR) Basel II The Basel I norms were soon realised to be insensitive to risk and led to the foundation of Basel II. The Basel II norms are based on the three pillars: i. Minimum Regulatory Capital: The Basel II laid the foundation of a new set of norms for the minimum regulatory capital on the basis of the credit risks assigned to each and every component of the portfolio of the banks by incorporating credit risk, market risk and operational risk rather than by simply categorizing assets into buckets as per the Basel I guidelines. 4 Hybrid debt capital instruments are securities which combines two or more debt and capital instruments e.g. a convertible bond. 5 Subordinate debt is a debt instrument that ranks below other debts with regard to its claim on assets and earnings. 6 VAR method is a statistical approach to the evaluation of market risks. The aim of the VaR model is to calculate consistently the loss, with a specified probability, over a specified holding period of time, which a bank might experience on its portfolio from an adverse market movement 4

5 ii. Supervisory Review: The Basel II guidelines laid down the key principles for supervision, management guidance and supervisory transparency and accountability. iii. Market Discipline: The Basel II encouraged market discipline by instilling a set of disclosure requirements for assessment of risk exposure and capital adequacy of the bank by market participants. The Basel II also laid down new guidelines for measurement of credit risk and the operational risk while retaining the measurement of market risk as per the amendment of Basel I. The credit risk is measured by two approaches: (i) Standardized Approach- which was similar to that of Basel I but incorporated the credit rating scores by rating agencies for assessing the risk of a particular asset in a banks' portfolio and (ii) Internal rating Based Approach which laid the emphasis of assessing the credit risk of a asset internally by a bank by estimation of the parameters like probability of default, exposure at default, etc. However the adoption of the latter approach required supervisory approval of the central bank. The measurement of operational risk i.e. the risk arising from direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events could be measured by three approaches: (i) Basic Indicator Approach (BIA) - which involved averaging over a fixed percentage of positive annual gross income of the bank over the previous three years; (ii) Standardized Approach (SA)- which involved dividing the Bank s business activities into different business lines 7 and calculating a capital charge by multiplying the gross income of the business line by a factor for three years, where overall capital is the three year average of the simple summation of charges across business lines in 7 Business lines of Bank's business activities: Corporate Finance, Trading and sales, Retail Banking, Commercial Banking, Payments and settlements, Retail Brokerage, Asset Management 5

6 each year; (iii) Advanced Measurement Approach (AMA) wherein the banks were allowed to determine its own mechanism for determining capital requirements of operational Risk under prior approval of supervisory authorities (BCBS,2001) BASEL III The financial crisis of posed serious questions for the Basel II framework and thus to prevent the banking failures, the Basel Committee further strengthened the norms of Basel II. The Basel III framework laid down more strict requirements for the Capital by increasing the level of equity in the capital base of the banks and by raising the Tier I capital to a minimum of 6% from 4% of the total risk weighted assets by The common equity 8 requirements has been raised from 2% to 4.5%. The framework also introduces capital conversion buffer 9 of 2.5% to withstand future periods of stress and a countercyclical buffer capital 10 ranging from 0.5%-2.5% to link the capital requirement of a bank with the macroeconomic determinants of the economy. Apart from these the Basel III also introduces Leverage ratio measured as the ratio of Tier I Capital to Total Assets at a minimum level of 3% by The Basel III also introduced the concept of better liquidity risk management designed to ensure that a bank maintains an adequate level of unencumbered, high-quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors. The standard requires that the ratio be no 8 Common Equity comprises of the common shares (or comparable instruments) and retained earnings 9 The capital conservation buffer, which comprises of 2.5% of Risk Weighted Assets in the form of Common Equity Tier 1 capital is intended to ensure that institutions are able to absorb losses in stress periods lasting for a number of years. 10 The countercyclical capital buffer is introduced to achieve the broader macro-prudential goal of protecting the banking sector and the real economy from the system-wide risks stemming from the boom-bust evolution in aggregate credit growth and more generally from any other structural variables and from the exposure of the banking sector to any other risk factors related to risks to financial stability. - European Commission (2011) 6

7 lower than 100% by Through the introduction of Net Stable Funding Ratio (NFSR) 11, the accord ensures that investment banking inventories, off-balance sheet exposures, securitization pipelines and other assets and activities are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles Implementation of Basel Norms in India With the liberalization of the Indian economy in 1991 and the banking sector reforms of 1998, the Indian banking sector witnessed an implementation of credible paradigm shift (Das, 2010) with the authoritative assertiveness of the RBI engineered towards compliance to the Basel Accords. These regulations aimed at deregulation of the interest rates, easing directed credit restrictions under the priority sector lending arrangements, reduction of statutory preemptions and fostering prudential norms. The blueprints of the reforms were the Narasimham Committee I report which was published in 1991 followed by the Narasimham Committee II report commonly known as the banking sector reforms of Despite the period of liberalization coinciding with the implementation of the Basel norms elsewhere on the globe, it was not possible for the Indian Banking sector to embrace these norms after the decades of financial repression. The Narasimham Committee reports paved the way for gradual implementation of Basel Norms in India (Das, 2010). The recommendations of the Narasimham committee (1991) as documented in RBI and planning commission reports are as follows: Statutory Pre-emtions: The degree of financial repression in the Indian banking sector was significantly reduced with the lowering of the Cash Reserve ratio (CRR) and Statutory Liquidity ratio (SLR), which were regarded as one of the main causes of the low profitability 11 The Net Stable Funding Ratio (NSFR) requires institutions to maintain a sound funding structure over one year in an extended firm-specific stress scenario. Assets currently funded and any contingent obligations to fund must be matched to a certain extent by sources of stable funding. 7

8 and high interest rate spreads in the banking system. The committee recommended that the SLR should be reduced to 25% within a period of five years and a progressive reduction of the CRR to 3-5%. The reduction of the CRR and SLR resulted in increased flexibility for banks in determining both the volume and terms of lending. Redefining the Priority Sectors: Prior to the liberalization, agriculture and small scale industries were considered to be the priority sectors and concessional interests rates were given to these sectors. The Narasimham Committee recommended a reduction from 40% to 10% for the priority sector lending. However, this recommendation has not been implemented and the targets of 40% of net bank credit for domestic banks and 32% for foreign banks have remained the same. However on the basis of its recommendation the definition of priority sector was broadened with sectors like Information Technology, education, trade, etc. Liberalization of the Interest Rates: The deregulation of interest rates was a major component of the banking sector reforms that aimed at promoting financial savings and growth of the organized financial system. The most important step that was taken by the committee was the abolition of the administered lending rates for loans exceeding Rs 200,000. Typically these loans accounted for 90% of the total loans in the bank s portfolio. However the banks were required to announce their prime lending rate (PLR) based on the cost of the funds and transaction costs.. Uniform accounting practices: The committee recommended uniform accounting practices in regard to income recognition, asset classification and provisioning against bad and doubtful debts. Weakening the Entry Barriers: As discussed earlier the imposed entry barriers affected the performance and the efficiency of the banks. The removal of the strict entry barriers brought 8

9 in a significant rise in the competition and paved the way for seven new private banks between 1994 and Apart from this, over 20 foreign banks started their operations from This brought in sophisticated technology, skilled work force, better portfolio diversification and better risk managements in the banks. Prudential Norms: The Naramsimham committee report also fostered the strengthening of the prudential norms and the supervisory structure. The revised and improved prudential norms paved the way from a micro regulation of the banking sector to the strategy for the macro segment of the economy. New guidelines were set up for income recognition of the banks where in the practice of treating a putative income was changed. This was a very mature step for the development of the economy and marked a significant improvement but it was still to catch up with the strict Non Performing Asset (NPA) recognition of the developed nations where a loan is considered as non-performing after one quarter period of outstanding interest payments compared to that of two quarters in India. The committee stipulated a minimum Capital Adequacy Ratio of 8% by 1996 for the Indian Banks and that of the foreign banks by To complete the process of banking reforms, the government appointed yet another committee under the chairmanship of Mr. Narsimham in Banking Sector Committee. The committee focused on various areas such as capital adequacy, bank mergers, bank legislation, etc. The recommendations of the Banking Sector committee also referred to as Narasimham Committee II report are detailed below. Strengthening Banks in India: In order to make the banks capable of handling the issues related to domestic liquidity and exchange rate management, the committee considered the 9

10 concept of Current account convertibility. For this reason the committee recommended mergers of large banks which would bring in a multiplier effect in the industry. Narrow Banking : Many banks faced huge problems owing to the high volume of nonperforming assets in their portfolio. Some of the banks had more than 20% of NPAs in their portfolio. In order to help the banks come out of this situation, the committee suggested that the weak banks should be allowed to place their funds only in short term and risk free assets. Capital Adequacy Ratio: The committee recommended the government to increase the CAR in order to strengthen the banking system and maintain the absorption capacity. Bank ownership and review of Banking laws: It had already been seen that the government regulations and the professional banking strategies don t go hand in hand. So it was decided that the functions of the board needed to be reviewed and fostered towards a professional corporate culture. For this purpose they recommended a review of the banking laws. Adoption of Technology and upgradation of Staffs: The committee recommended the implementation of computerized banking and upgradation of the existing technology. The committee also recommended compulsory training programs for the bank employees in order to make them in line with the upgraded technology. In this era of holistic convergence towards Basel norms, the weakening of the entry barriers brought in the inception of competition in the sector along with technological advancements and challenged the adaptive potential of the existing banks. Compliance to these norms and in the run for its existence in the competitive environment, the banks objectively incubated diverging portfolio of products and services leading to a change in the capital allocation and business operations of the banks. 10

11 It was stipulated that foreign banks operating in India should achieve a CRAR of 8% by March 1993, while Indian banks with branches abroad should comply with the norm by March All other banks were to achieve a capital adequacy norm of 4% by March 1993 and the 8% norm by March In its midterm review of monetary and credit policy in October 1998 (RBI, 1998), the RBI raised the minimum regulatory CRAR requirement to 9%, and banks were advised to attain this level by 31March The RBI responded to the market risk amendment of Basel I in 1996 by initially prescribing various surrogate capital charges, such as an investment fluctuation reserve of 5% of the bank s portfolio and a 2.5% risk-weight on the entire portfolio for these risks between 2000 and These were later replaced with Value at Risk (VaR)-based capital charges, as required by the market risk amendments, which became effective from March India went a step ahead of Basel I in that banks in India were required to maintain capital charges for market risk on their available for sale portfolios as well as on their held for trading portfolios from March 2006 while Basel I required market risk charges for trading portfolios only. In May 2004, RBI announced that banks in India should examine the options available under Basel II for a revised capital adequacy framework. In February 2005, RBI issued the first draft guidelines on Basel II implementations (RBI, 2005) in which an initial target date for Basel II compliance was set for March 2007 for all commercial banks, excluding Local Area Banks like cooperative banks and Regional Rural Banks. This deadline was, however, postponed to March 2008 for internationally active banks and March 2009 for domestic commercial banks in RBI s mid-year policy announcement of 30 October 2006 (RBI master Circular, 2008). 11

12 Table 1.1- Comparison of RBI guidelines with that of Basel III Guideline Basel II Norm Draft Basel III Guideline Proposed Basel III Norms as per RBI FY Min Common Equity Capital Conversi on Buffer (CCB) Min Core Equity Addition al Tier I Capital Min Tier I Capital Tier II Capital Min Total Capital Min Total Capital +CCB Source: Composition as per the Final guidelines on Basel III issued by RBI and BIS (2011) The final guidelines for implementation of Basel III were introduced on 12th May 2010 and was initially scheduled to be implemented from January 2013 (RBI,2012). However the implementation has been postponed to May The RBI extended the timeline for compliance with Basel III requirements from 2017 to In addition, RBI reduced the leverage ratio from 5% to 4.5%. However, on comparison to Bank for International Settlements (BIS), RBI continued to target a stricter minimum common equity requirement (5.5% vs 4.5%), faster implementation (31st Mar, 2018 vs 1st Jan, 2019) and higher leverage ratio (4.5% vs 3%). 12

13 1.5 Objective of the Study The main objective of this study is to analyse the following research questions. i. What is the impact of the Basel norms on the asset and investment composition of the Indian banking sector? ii. What is the impact of capital adequacy ratio on the performance of the Indian banking sector? iii. How is the Indian banking sector adopting the capital adequacy norms of Basel III? In Chapter 2, we have analysed the impact of the Basel norms on the Indian banking sector. The Basel norms has fostered the idea of maintenance of capital adequacy ratio in order to balance the profitability and stability of the banks. However, in order to maintain the capital standards as per the Basel requirements, the banks had to re-engineer their asset and investment composition. The focus of this study is on these changes in the asset and investment composition of the banks in the different regulatory regimes ( pre-basel, Basel I and Basel II) of the Indian banking sector. The changes in the asset and investment composition are likely to have an impact on the banks' performances. We measured the performance of the Indian banking sector in terms of profitability, productivity, asset quality [Chapter 3] and technical efficiency [Chapter 4]. Although the performance of the banks has been measured in terms of efficiency, profitability and productivity in the prior studies, there exists very limited number of studies which have analysed the performance of the Indian banking sector across the different regulatory regimes. Since the Basel norms aimed at improving the quality of advances made by the banks via proper monitoring, it is likely to bring in a decrease in the bad debts and non performing assets in a banks' portfolio. We therefore include the measure of asset quality in our study. Data on profitability, productivity and asset quality was collected from the RBI 13

14 database. We have measured the technical efficiency of the banks by using Data Envelopment Analysis. Banks are required to maintain minimum CAR of 9% as per the RBI guideline. An analysis of the trends of various performance indicators may highlight various changes in these indicators in the three regulatory regimes. However it was essential to analyse the cause of these changes. In this study, we have analysed the impact of Capital Adequacy Ratio (CAR) on the performance of the Indian Banking sector using panel data analysis. The financial recession of which was mainly due to the banking failures had exposed various loopholes in the Basel II framework and raised criticisms about its efficacy. The Basel III norms thus fostered the idea of the quality of capital for enhancing the stability of the banks and to introduce mechanisms for operation during the time of financial turmoil. As a result, Basel III norms has brought in significant changes in the set of financial instruments which formed the capital base of the banks with more focus on equity capital. The RBI issued guidelines for the implementation of Basel III norms in the Indian banking sector in 2010 with a directive to implement it from We have analysed the preparedness of the Indian banking sector to adopt the Basel III norms on the basis of the changes in the capital structure of the banks in Chapter 6. 14