MacroScan - Basel II and India's Banking Structure

Globalization and financial innovation have over the last two decades or more multiplied and diversified the risks carried by the banking system. In response, the regulation of banking in the developed industrial countries has increasingly focused on ensuring financial stability, at the expense of regulation geared to realizing growth and equity objectives. The appropriateness of this move is being debated even in the developed countries, which in any case are at a completely different level of development of their economies and of the extent of financial deepening and intermediation as compared to the developing world. Despite this and the fact that in principle the adoption of the core principles for effective banking supervision issued by the Basel Committee on Banking Supervision is voluntary, India like many other emerging market countries adopted the Basel I guidelines and has now decided to implement Basel II.

India had adopted Basel I guidelines in 1999. Subsequently, based on the recommendations of a Steering Committee established in February 2005 for the purpose, the Reserve Bank of India, India's central bank, had issued draft guidelines for implementing a New Capital Adequacy Framework, in line with Basel II. At the centre of these guidelines is an effort to estimate how much of capital assets of specified kinds that banks must hold to absorb losses. This requires some assessment of likely losses that may be incurred and deciding on a proportion of liquid assets that banks must have at hand to meet those losses in case they are incurred. This required regulatory capital is defined in terms ''tiers'' of capital that are characterized by differing degrees of liquidity and capacity to absorb losses. The highest, Tier I, consists principally of the equity and recorded reserves of the bank.

The higher is the risk of loss associated with an investment the more of it that must be covered in this manner, requiring assets to be risk-weighted. A 100 per cent risk loss implies that the whole of an investment can be lost under certain contingencies and a zero per cent risk-weight implies that the asset concerned is riskless. Under Basel I, risk-weights for different kinds of assets were pre-decided by the regulator and the regulatory capital required measured on this basis at 8 per cent of the risk-weighted value of assets. In the transition to Basel II, risk-weights were linked to the external ratings by accredited rating agencies of some of these assets. Finally, banks were to be allowed to develop there own internal ratings of different assets and risk-weight them based on those ratings. This gives greater freedom to individual banks to assess their own economic capital after taking account of risks, resulting in a degree of regulatory forbearance.

This is the first pillar of Basel II. The second pillar is concerned with the supervisory review process by national regulators for ensuring comprehensive assessment of the risks and capital adequacy of their banking institutions. The third pillar provides norms for disclosure by banks of key information regarding their risk exposures and capital positions and aims at improving market discipline.

In India, the RBI had initially specified that the migration to Basel II will be effective March 31, 2007, though it expected banks to adopt only the rudimentary Standardised Approach for the measurement of Credit Risk and the Basic Indicator Approach for the assessment of Operational Risk. The Standardized Approach fixes risk-weights linked to external credit assessments, and then weights them using these fixed weights. The Basic Indicator Approach prescribes a capital charge of 15 per cent of the average gross income for the preceding three years to cover operational risk. Over time, as risk management skills improve, some banks were to be allowed to migrate to the Internal Ratings Based approach for credit risk measurement.

The deadline for implementing Basel II, originally set for March 31, 2007, has now been extended. Foreign banks in India and Indian banks operating abroad are to meet those norms by March 31, 2008, while all other scheduled commercial banks will have to adhere to the guidelines by March 31, 2009. But the decision to implement the guidelines remains unchanged. This is true even though the international exposure of even the major Indian banks is still limited. As far back as 2003, the then chairman of the State Bank of India, India's largest commercial bank had declared that his institution has committed itself to becoming a Basel-II compliant bank, even though the Reserve Bank of India had taken a view that only Indian banks that get 20 per cent of their business from abroad need to follow the Basel-II norms. At that time SBI's international operations contributed just about 6 per cent of its business.

This raises the question as to what effects the implementation would have on the structure of banking in India. It needs to be noted, however, that Basel II allows national regulators to specify risk weights different from the internationally recommended ones for retail exposures. The RBI had, therefore, announced an indicative set of weights for domestic corporate long term loans and bonds subject to different ratings by international rating agencies like Moody's Investor Services which are slightly different from that specified by the Basel Committee (Table 1).

Table 1 >>

Since the loans and advances portfolios of Indian banks largely cover unrated entities that are assigned a risk weight of 100 per cent, the impact of the lower risk weights assigned to higher rated corporates would not be significant. However, given the investments into higher rated corporates in the bonds and debentures portfolio of the banks, the risk weighted corporate assets measured using the standardized approach may be subject to marginally lower risk weights as compared with the 100 percent risk weights assigned under Basel I (ICRA 2005).

In the case of retail exposure, which is the growth segment in the asset structure of most Indian banks post-liberalization, the RBI has gone with the lower 75 percent risk weight prescribed under Basel II norms, as against the currently applicable risk weights of 125 percent and 100 percent for personal/credit card loans and other retail loans respectively. This is likely to accentuate the current tendency to diversify out of productive lending characterizing Indian banks.

The other benefit that Indian banks can exploit is the fact that they have a large short-term portfolio in the form of cash credit, overdraft and working capital demand loans, which are currently unrated, and carry a risk weight of 100 percent. They also have short-term investments in commercial papers in their investment portfolio, which also currently carry a 100 percent risk weight. The RBI's draft capital adequacy guidelines provide for lower risk weights for short tem exposures, if these are rated (Table 2). Thus would allow banks to benefit from their investments in commercial paper (which are typically rated in A1+/A1 category) and give them the potential to exploit the proposed short-term credit risk weights by obtaining short-term ratings for exposures in the form of cash credit, overdraft and working capital loans.

Table 2 >>

The net result is that the implementation of Basel II does provide Indian banks the opportunity to significantly reduce their credit risk weights and reduce their required regulatory capital, if they suitably adjust their portfolio by lending to rated but strong corporates, increase their retail lending and provide mortgage under loans with higher margins. This would, of course, change the proportion of lending in their portfolio and the direction of their lending. But, even if they do not resort to that change, ICRA estimates that the implementation of Basel II would result in marginally lower credit risk weights and a marginal release in regulatory capital needed for credit risk.

However, the same does not hold for operational risk. The Basic Indicator approach specifies that banks should hold capital charge for operational risk equal to the average of the 15 per cent of annual positive gross income over the past three years, excluding any year when the gross income was negative. Gross income is defined as net interest income and non-interest income, grossed for any provisions, unpaid interest and operating expenses (such as fees paid for outsourced services). It should only exclude treasury gains/losses from banking book and other extraordinary and irregular income (such as income from insurance).

Besides this, the exact amount of capital that banks would need would depend on the legacy of bad debt or non-performing assets they carry. Much of the discussion on Basel II is based on the presumption that the problem of bad debt has been substantially dealt with. In the recent past, banks have been able to reduce their provisioning needs by adjusting their non-performing assets. The proportion of total NPAs to total advances declined from 23.2 per cent in March, 1993 to 7.8 per cent in March, 2004.

Among the many routes that were pursued to deal with the accumulating bad debt legacy, there were some that received special attention. The first and most obvious route was to set aside potential profits as provisions for bad assets. Banks have gone part of the way in this direction. The cumulative provisions against loan losses of the public sector banks worked out to 42.5 per cent of the gross NPAs for the year that ended on 31 March 2002 while international norms are as high as 140 per cent. Subsequently, the scheduled commercial banks (SCBs) raised provisions towards NPAs by as much as 40 per cent in 2003-04. By the end of 2003-04, cumulative provisions of SCBs accounted for 56.6 per cent of gross NPAs.

The second was infusion of capital by the government into the public sector banks. It is estimated that the government had injected a massive Rs 20,446 crore towards recapitalization of public sector banks (PSBs) till end-March 1999 to help them fulfil the new capital adequacy norms. Subsequently, the S.P. Talwar and Verma committees set up by the finance ministry had recommended a two-stage capitalization for three weak banks (Indian Bank, United Bank of India and United Commercial Bank) involving infusion of a total of Rs 2,300 crore for shoring up their capital adequacy ratios. Similar infusion arrangements have been underway in the case of financial institutions like the IDBI and IFCI and in bailing out UTI, involving large sums of tax-payers' money.

Finally, there are efforts to retrieve as much of these assets as possible from defaulting clients, either by directly attaching the borrowers' assets and liquidating them to recover dues or by transferring NPAs to specialized asset reconstruction or asset management companies. The government tried to facilitate recovery through the ordinance issued in June 2002, which was subsequently replaced by the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Bill passed in November 2002.

It should be obvious that of the above ways to deal with the legacy of NPAs, the first two are means that involves putting good money in to adjust for bad money, preempting the additional resources that the banks and the government can put into the system. It was only the third, involving a change in the legal framework governing the relations between lenders and borrowers, which involved penalties on the defaulting borrowers. However, it is here that the progress has been slow.

Requirement of additional capital

Thus, there is reason to believe that the improvement in terms of non-performing assets has been largely the result of provisioning or infusion of capital. This meant that if the banks required more capital, as they would to implement Basel II norms, they would have to find capital outside of their own or the government's resources. In ICRA's estimates, Indian banks would need additional capital to the extent of Rs. 120 billion to meet the capital charge requirement for operational risk under Basel II. Most of this capital would be required by the public sector banks (Rs. 90 billion), followed by the new generation private sector banks (Rs. 11 billion), and the old generation private sector banks (Rs. 7.5 billion). In ICRA's view, given the asset growth witnessed in the past and the expected growth trends, the capital charge requirement for operational risk would grow 15-20 percent annually over three years, which implies that the banks would need to raise Rs. 180-200 billion over the medium term.

In practice, to deal with this, a large number of banks have been forced to turn to the capital market to meet their additional regulatory capital requirements. ICICI Bank, for example, has raised around Rs. 35 billion, thus improving its Tier I capital significantly. Many of the public sector banks, namely Punjab National Bank, Bank of India, Bank of Baroda and Dena Bank, besides private sector banks like UTI Bank have either already tapped the market or have announced plans to raise equity capital in order to boost their Tier I capital.

The need to go public and raise capital has begun to challenge the current structure of government policy aimed at restricting concentration of shareownership, maintaining public dominance and limiting foreign influence in the banking sector. One immediate fall-out was that public sector banks are being permitted to dilute the government's stake to 51 per cent, and the pressure to reduce this to 33 per cent is increasing. Secondly, the government has allowed private banks to expand equity by accessing capital from foreign investors.

There have been two consequences of this decision. First, it is putting pressure on the Reserve Bank of India to rethink its policy on the ownership structure of domestic banks. In the past the Reserve Bank has emphasised the risks of concentrated foreign ownership of banking assets in India. Subsequent to the 5th March 2004 notification issued by the Ministry of Commerce and Industry, which had raised the FDI limit in Private Sector Banks to 74 percent under the automatic route, a comprehensive set of policy guidelines on ownership of private banks was issued by the Reserve Bank of India on 2nd July 2004. These guidelines stated among other things that no single entity or group of related entities would be allowed to hold shares or exercise control, directly or indirectly, in any private sector bank in excess of 10 per cent of its paid-up capital. Recognising that the 5th March notification by the Union Government had hiked foreign investment limits in private banking to 74 percent, the guidelines sought to define the ceiling as applicable on aggregate foreign investment in private banks from all sources (FDI, Foreign Institutional Investors, Non-Resident Indians), and in the interest of diversified ownership, the percentage of FDI by a single entity or group of related entities was restricted to 10 per cent. This made the norms with regard to FDI correspond to the 10 per cent cap on voting rights.

The RBI's position was based on its view regarding the advantages of diversified ownership of banks. Despite these strong views the RBI is under pressure to permit appropriate amending legislation to the Banking Regulation Act, 1949, in order to provide that the economic ownership of investors is reflected in the voting rights. On 28th February, 2005, the Reserve Bank released a roadmap for the presence of foreign banks in India. The RBI notification formally adopted the guidelines issued by the Ministry of Commerce and Industry on March 5, 2004 which had raised the FDI limit in Private Sector Banks to 74 per cent under the automatic route, and went on to spell out the steps that would operationalise these guidelines. According to those steps, starting April 2009 the RBI would allow much greater freedom to foreign banks.

Expectations are that if and when this transition occurs there would be a rapid increase in the presence of foreign capital in the banking sector. This is because, using the benefit of an ‘aggregate ownership' ceiling well in excess of 50 per cent in private banks and the relaxation of rules governing foreign institutional investors meant foreign firms have been acquiring substantial stakes in Indian banks. The process of liberalisation keeps alive expectations that the caps on foreign direct investment in different sectors would be relaxed over time, providing the basis for foreign control. Thus, acquisition of shares through the FII route today paves the way for the sale of those shares to foreign players interested in acquiring companies as and when the demand arises and/or FDI norms are relaxed. This creates the ground for speculative forays into the Indian market. Figures relating to end-December 2005 indicate that the shareholding of FIIs varied between 49 per cent in the case of ICICI Bank to as much as 66 per cent in the case of the Housing Development Finance Corporation.

A concomitant of this tendency has been growing pressure to consolidate domestic banks to make them capable of facing international competition. Indian banks are pigmies compared with the global majors. India's biggest bank, the State Bank of India, which accounts for one-fifth of the total banking assets in the country, has an asset base (end-2006) of $84 billion (Bandyopadhyay, Business Standard Banking Annual 2006). It is roughly one-fifth as large as the world's biggest bank - Citigroup - on the basis of Tier I capital. Citigroup's consolidated Tier I capital in 2006 was $79 billion compared to SBI's $7.9 billion. Given this difference, even after consolidation of domestic banks, the threat of foreign takeover remains if FDI policy with respect to the banking sector is relaxed.

Not surprisingly, a number of foreign banks have already evinced an interest in acquiring a stake in Indian banks. Thus, it appears that foreign bank presence and consolidation of banking are inevitable post Basel II. They are, in fact, part and parcel of a two-track approach for ‘further enhancing efficiency and stability to the best global standards.' To quote the RBI:

‘One track is consolidation of the domestic banking system in both public and private sectors. The second track is gradual enhancement of the presence of foreign banks in a synchronised manner'.