Chapter 2 Impact of the BASEL Norms on the Banks Although there was no binding imposition on the compliance to the Basel Norms neither for the member G10 countries nor for any other country, more than hundred countries adhered to it with India starting its implementation from 1993 (Bannerjee, 2012). These norms had engineered a shift in the portfolio composition, lending behaviour and performance of the banks. 2.1 Impact of Basel Norms on the Portfolio Composition of Banks Adherence to the Basel accords fostered by a timely catalysts of change for the necessity to balance the profitability and stability of the banks brought about significant shift in the portfolio composition of the banks. Haubrich & Watchel (1993) and Hall (1993) had found a significant change in the portfolio of the US banks following the introduction of risk based capital standards as per the Basel Norms with a significant shift in holding government securities and moving away from bank lending. It had shifted the primary focus of the banks to maintain the minimum capital requirements rather than making profitable business transactions (Hall, 1993). In contrast to these findings, Jackson (1999) and Jablecki (2009) observed that there was only an apparent increase in the capital with the help of capital arbitrage mainly through the process of securitization 12 in the US. However Jackson (1999) also found that there was an increase in the risk weighted capital ratio of all the G10 countries following the Basel Accord with the average Capital Adequacy Ratio(CAR) or the Capital Risk Adjusted Ratio (CRAR) rising from 9.3% in 1988 to 11.2% in 1996. Ediz et al (1998) studied the impact of the regulatory norms on the UK banks. The capital requirements of the 12 Securitization is the process of pooling different loans and debts of the bank and selling the pooled debt as securities to the investors e.g. CDS 15
banks in UK vary from bank to bank as per the requirements set by the central bank. Irrespective of the different levels of capital requirements, it was found that these capital adequacy norms pose a serious challenge to the bank's management. Any improvement in capital ratios are brought in by issuing more capital rather than shifting away from corporate loans which are termed as risky assets as per the Basel Accords. This finding clearly contradicts the findings in the US banking sector. In the US, the banks tried to maintain their capital ratios by decreasing the corporate loans and advances whereas in UK the capital ratios were maintained by an increase in the overall capital and not affecting the corporate lending. 2.2 Impact of Basel Norms on the Lending Behaviour of Banks The Capital adequacy norms have synergistically architected the bank's investments into less risky investments through an increased investments in government securities. Furfine (2000) accounts for the decline in the loans and advances of the banks owing to the increased importance of the riskiness of assets in a bank's portfolio. Chami and Cosimano (2001) and Van den Heuvel (2002) emphasised the relationship between monetary policy and bank capital by tracing the impact of changes in monetary policy on bank capital and lending via the altering of bank profitability. Their findings resonate the practices of the banks as documented by Furfine (2000) wherein it is said that binding regulatory capital requirement limits the ability of capital constrained banks (banks with lower CAR) to increase lending in response to an expansionary monetary policy, thereby, to an extent, reducing the potency of monetary policy. Similar are the findings of Rime (2003) for Swiss banks, Ayuso et al. (2003) for Spanish banks, and Lindquist (2004) for Norwegian banks. The proactively evolved and coordinated imperatives of the Basel norms empowered minimizing the risky assets in the bank's portfolio and was speculated to have a negative effect on the profitability of the banks since it reduced the bank lendings (Hancock, Laing & Wilcox, 1995; Wall & Peterson, 1995 and Peek & Rosengren, 1995). 16
2.3 Analysis of the Impact of Basel Norms in the Indian Banking Sector The Indian banking sector moved towards a gradual compliance with the Basel Accords after the process of liberalization. However the effects in the Indian banking sector did not vary much from that of the global scenario. It witnessed a change in the capital structure and portfolio composition with an increased investments in the government securities. There are different views about aptness of India adapting to the Basel Accords in the time of development. Nachane et al (2000) analyzed the impact of the capital requirements on the behaviour of the commercial banks in India. In their study they criticized that the regulations simply aimed at reducing the risk associated with a systematic problem and so any cosmetic changes to the capital to meet the regulatory constraints would hardly materialize the primary aim of making the banking sector stable. They also found that the banks meet the regulatory requirements of the capital by adjusting their asset side of the balance sheet by substituting risky loans with government securities or by raising funds from market by issuing securities and increasing the level of retained earnings which implicitly suggests adoption of the US practice as well the UK practice, as described earlier. Nag and Das (2004) documented that the adoption of stricter risk management practice in respect of bank lending in the post reform period and its interplay with minimum capital requirements (regulatory pressure) have had a dampening effect on the overall credit supply in the Indian banking sector. Nachane et al. (2006) analyzed the impact of the capital requirements of the banks by segregating the banks as capital constrained or not capital constrained 13. Their recommendations revealed that in the scenario where the banks are supposed to provide credit for the development of the economy, the Basel II norms would 13 Capital Constrained banks were those who had to reduce their lending in order to meet up with the capital adequacy norms 17
pose challenges for formulation of the monetary policy since the requirements would decrease the bank lending of the capital constrained banks. They also stated that the effectiveness of the monetary policy also depends on the credit quality of the bank loans, securities and liquidity of the banks' balance sheet. Thus it suggests that the supervisory pillar along with the capital requirement pillar could together help in the formulation of an efficient monetary policy. Although Nitsure (2005) and Sen and Ghosh (2005) stressed upon the importance and the need for implementation of Basel II in India, they also anticipated the excessive importance of risk appetite in a bank's portfolio will affect the lending to the SMEs and would thus have an impact on the priority sector lending. We have analyzed the impact of the Basel norms on the Indian banking sector, divided across the different ownerships: Nationalised Banks, SBI and its Associates, Private Sector banks and the Foreign Banks across the three different eras pre-basel, Basel I and Basel II. 2.3.1 Data The sample comprises of the data of all the scheduled commercial banks that operated during this period and were listed in the RBI database 14. The sample comprises of 120 banks listed in the RBI database divided across four ownership structures Nationalised banks (20), SBI and its Associates (8), Domestic Private Sector Banks (35) and Foreign Banks (57). However owing to different mergers and opening of new banks, the sample is not a balanced panel. The banks included in our sample are detailed in Appendix 1(a-d). 2.3.2. Time Period The time period of our study begins from 1999 to account for the policies laid down by the Banking sector reforms report of 1998 which were reflected on the balance sheet of the banks 14 RBI Database http://dbie.rbi.org.in/dbie/dbie.rbi?site=statistics 18
from the following year. We have divided our studies into three eras: pre-basel (1999-2002), Basel I(2003-2008) and Basel II( 2009-2012) era. Although there has not been full implementation of Basel I in the Indian Banking sector and some of the norms were implemented from 2000, the market risk amendment was brought in the year 2002 which marks the end of the Pre -Basel era. Therefore, we consider 2003 as the beginning of the Basel I era in the Indian banking sector. The Basel II guidelines were issued by RBI to be implemented from 2008 and marks the end of the Basel I era. Thus 2009 marks the inception of Basel II era in the Indian banking sector. The literature discussed earlier documents a change in the asset composition of the Indian banks following the adoption of the norms laid down by the Banking sector reforms of 1998. In this section we try to get an idea about the change in the asset composition of the banks and the increased investments and advances in the government securities. We base our analysis on the calculation of the following ratios of the three eras across the different ownership. i. Ratio of investment in government securities to total investments(gsti) ii. iii. iv. Ratio of advances to government undertakings to total advances(agta) Ratio of advances secured by tangible assets to total advances(astta) Ratio of unsecured advances to total advances(uata) v. Ratio of priority sector advances to total advances(psata) The ratio of priority sector advances to total assets has been analysed in order to account for the social perspective of a bank. The summary of the analysis are expressed in Table 2.1 a, b, c, d below. The detailed data are documented in Appendix 1(a-d). 19
Table 2.1 a - Shift in asset composition of SBI and its Associates Era GSTI AGTA ASTTA UATA PSATA Pre basel 0.80 0.08 0.86 0.07 0.37 Basel I 0.90 0.05 0.80 0.15 0.38 Basel II 0.89 0.04 0.82 0.14 0.34 Table 2.1 b - Shift in asset composition of Nationalised Banks GSTI AGTA ASTTA UATA PSATA Era Pre basel 0.70 0.10 0.80 0.11 0.33 Basel I 0.80 0.07 0.78 0.16 0.36 Basel II 0.83 0.06 0.75 0.20 0.31 Table 2.1 c - Shift in asset composition of Private sector Banks Era GSTI AGTA ASTTA UATA PSATA Pre basel 0.64 0.09 0.82 0.10 0.29 Basel I 0.78 0.06 0.82 0.12 0.32 Basel II 0.74 0.03 0.83 0.14 0.34 Table 2.1 d - Shift in asset composition of Foreign banks Era GSTI AGTA ASTTA UATA PSATA Pre basel 0.62 0.11 0.66 0.23 0.24 Basel I 0.78 0.12 0.55 0.33 0.28 Basel II 0.81 0.11 0.42 0.47 0.37 20
2.4. Observations: Impact of Basel Norms in the Indian banking Sector 2.4.1. Investment in Government Securities It was widely speculated that the inclusion of the risk factor in the capital base of the banks would bring about an increase in the investments in government securities since these were considered to the least risky. However we find contrasting results across the different ownerships. There was a significant increase in the investment in government securities in case of all the banks from the pre Basel era to Basel I era. In the next phase, there was a marginal increase in GSTI for the nationalised banks and foreign banks but there was marginal decline in GSTI for the private sector banks and SBI group. It is also observed that government securities were the most invested assets by all the banks across the three eras. 2.4.2 Advances to Government Undertakings It also expected that the advances to the government undertakings would increase with the inclusion of the risk factor in the capital base. However, we observe contradictions to our expectation. Although there was marginal variation in AGTA across all the ownerships, we observe that it had mainly decreased across all the banks. This was probably due to the reason that the government undertakings issued securities for generating funds rather than directly taking loans from the banks. 2.4.3. Unsecured Advances and Advances secured by Tangible Assets The Basel norms fostered the idea of credit on the basis of a borrower's credit worthiness. Thus the concept of the collateral gave in way for issue of loans on the basis of the borrower's credit rating scores. This very fact illustrates the reason for the decrease in the ratio of advances secured by tangible assets to total advances and an increase in the ratio unsecured advances to total advances across the three eras. Although we observe only marginal decrease 21
in ASTTA for the nationalised banks, private sector banks and the SBI group, we observe a significant decrease in ASTTA for the foreign banks. Similarly, we observe significant increase in UATA for the foreign banks over the three eras. The nationalised banks had also increased their UATA across the three eras while the SBI group had increased it from the pre Basel era to Basel era and showed minimal signs of variation thereafter. The private sector banks however showed marginal increase in UATA over the three eras. 2.4.4. Priority Sector Advances The concept of developing the economy through priority sector advances was introduced in 1972 on the basis of the recommendations of the National Credit Council. Although the definition of the sectors has been redefined on the basis of Narasimham committee's recommendation, this regulation continues to be prevalent even in today's banking environment. There are different norms prevalent for meeting the priority sector lending targets for the domestic commercial banks and the foreign banks. Although the capital adequacy norms had no recommendations for meeting up with this prevalent regulation of the Indian banking sector, we observe an increase in the priority sector lending for the foreign banks and private sector banks over the three eras. However in case of the other banks, we observe only a marginal variation. We shall take a detailed look on this measure in the following chapter. 2.5 Conclusion The capital structure of the banks had changed following the implementation of the Basel norms across all the four ownerships. The inception of the concept of risk in the instruments underlying the capital base of a bank brought in incentives for the banks to invest in the government securities which were considered to be risk free. This brought in the framework to balance profitability and stability of the banks. However, a more detailed look needs to be 22
taken on the performance of the banks before coming to a conclusion about the impact of these capital accords on the performance. 23