India Equity Research | Banking and Financial Services Sector Update

BFSI
Basel III: Tightens norms; generous timelines

Recently, the Basel Committee on Banking Supervision approved Basel III norms September 14, 2010
which focus on higher core Tier I (not including innovative/ preference instruments)
requirements for the banking system. Though the norms on common equity ratio of
7% (including 2.5% of conservation buffer) seem to be stringent, the timeframe Nilesh Parikh
granted to banks (by January 1, 2019) is a relief and reduces the near-term dilution +91-22- 4063 5470
risk. Near-term risks are tempered as most banks maintain core Tier I ratio above 7%. nilesh.parikh@edelcap.com
However, from a long-term perspective it will curtail the excessive leverage enjoyed
by state owned banks which make good use of innovative debt instruments. Private Kunal Shah
banks remain unaffected by the move, given the higher cushion they carry. +91-22-4040 7579
kunal.shah@edelcap.com
„ A brief on guidelines
A substantial strengthening of capital requirements with the objective to equip Vivek Verma
banks to withstand periods of economic and financial stress, thereby supporting +91-22-4040 7576
financial growth. Core tier I capital has been raised from 2% to 4.5% by January vivek.verma@edelcap.com
2015, Tier I capital to be raised from 4% to 6% by January 2015, Capital
conservation buffer to be set to 2.5% by January 2019 and countercyclical buffer
to be set in range 0-2.5% as per different national regulators.

„ No near-term risk; could impact excessive leveraging

Currently, most domestic banks are above the threshold set on common equity by
Basel III. Impact of the new norms will be restricted to a few state-owned banks
like Central Bank of India, Syndicate Bank, UCO Bank, Union Bank, among others.
Timeframe given by the committee allows a breathing space and reduces dilution
risk. Private banks remain unaffected by the move as they carry adequate buffer
(on an average 400-500 bps).

Structurally, the requirement of higher core capital (common equity) will curtail
state-owned banks’ ability to leverage and deliver healthy RoE. Currently, these
banks operate on high leverage (some of them as high as 35 times), utilising the
benefit arising from innovative instruments like IPDI and preference shares
(forming ~10% of Tier I ratio against ~5% for private banks). As the new Basel
norms focus on common equity capital, going forward we believe these
instruments will lose their importance.

„ Other highlights:
The new norms for deductions pertaining to DTA, goodwill, and investments in
subsidiaries will not impact domestic banks as they are already deducted to arrive
at Tier I.

Edelweiss Research is also available on www.edelresearch.com,, Bloomberg EDEL <GO>, Thomson First Call, Reuters and Factset. Edelweiss Securities Limited
 
BFSI

Table 1: Strengthen core capital

B. Capital C. Counter- D. Total regulatory
conservation cyclical capital capital requirement
A. Tier I capital (%) buffer (%) Risk capital (A+B) (%) buffer (%) (A+B+C) (%)
Tier I Core Total Tier I capital Core tier I
capital tier I capital + buffer + buffer
BASEL II 4.0 2.0 8.0 NA 4.0 2.0 NA 8.0
BASEL III 6.0 4.5 8.0 2.5 8.5 7.0 0-2.5 10.5 - 13
Source: BIS, Edelweiss research

„ Capital requirements
• Common equity ratio (Core Tier I capital): It is the highest form of loss
absorbing capital and is obtained after deducting the capital raised through
innovative instruments from Tier I capital. According to the new norms, it has to be
raised from the current 2% to 4.5% till January 1, 2015. Core Tier I ratio will have
to be raised in phases from the current 2% to 3.5% (by January 1, 2013), 4%
(January 1, 2014), and finally to 4.5% by January 1, 2015.
• Tier I capital ratio: It includes common equity and other qualifying financial
instruments. It will also have to be increased in a phased manner from current 4% to
4.5% (January 1, 2013), 5.5% (January 1, 2014), and a final 6% by January 1, 2015.
• Capital conservation buffer: Banks will have to hold a capital conservation buffer
of 2.5% to withstand future periods of stress, bringing the total common equity
requirements to 7%. Capital conservation buffer of 2.5% on top of Tier 1 capital will
be met with common equity after the application of deductions. Its purpose is to
ensure that banks maintain a buffer capital that can be utilised to absorb losses
during periods of financial and economic stress. It will be phased in between January
1, 2016 and year end 2018. Banks with less than 2.5% capital ratio will face
restrictions on payouts of dividends, share buybacks, and bonuses.
• Countercyclical buffer: It will range from 0-2.5% of common equity and the onus
of its selection will be on national regulators. It will come in force when credit
growth in the economy is faster than economic growth so as to reduce system wide
build up of risk. Also, banks will have to set aside higher capital in good times and
the buffer will vary based on nations policy.
• Capital for systemically important banks: The committee also proposes capital
charge on systemically important banks which could be a combination of capital
surcharges, contingent capital, and bail-in-debt.

Chart 1: High leverage

40

32

24
(x)

16

0
CBOI UCO SNDB Dena IOB ALBK ANDB CRPBK OBC
Leverage (Average assets/Equity)
Source: Company, Edelweiss research

2 Edelweiss Securities Limited

  
Table 2: Core Tier I
PSU banks
SBI Corp.
Tier I (INR bn) BOB BOI Canara PNB Union Andhra ALBK CBOI Dena Indian IOB OBC SNDB UCO
(Cons.) Bank
Paid up capital 3.7 5.3 4.1 3.2 6.4 5.1 4.9 4.5 1.4 4.0 2.9 4.3 5.4 2.5 5.2 5.5
Reserves 134.2 119.7 119.7 158.1 809.8 83.0 39.3 54.5 56.2 39.5 21.1 61.7 57.2 70.7 47.0 29.3
Innovative instruments 12.0 17.2 8.4 20.2 59.7 10.4 2.0 3.0 7.4 19.5 2.5 - 7.8 5.5 7.7 3.8
Other capital instruments - - - - - - - - - - - 4.0 - - - 11.5
Amt deducted from tier I cap. 6.3 2.7 3.5 9.2 63.2 1.5 1.9 0.2 0.4 0.1 1.9 - 1.7 0.2 0.2 -
Total tier I capital 144 140 129 172 813 97 44 62 65 63 25 70 69 78 60 50

Core tier I (excl. innovative instru.) 132 122 120 152 753 87 42 59 57 43 22 70 61 73 52 46
Tier I ratio (%) 9.2 8.5 8.5 9.7 9.3 7.9 8.2 8.1 9.3 6.8 8.2 11.1 8.4 9.3 7.3 7.1
Risk weighted assets (RWA) 1,561 1,645 1,507 1,780 8,757 1,226 540 761 699 921 300 629 822 846 824 711

Core tier I ratio (%) 8.4 7.4 8.0 8.5 8.6 7.1 7.8 7.7 8.2 4.7 7.3 11.1 7.4 8.6 6.3 6.5
Difference (%) 0.8 1.0 0.6 1.1 0.7 0.8 0.4 0.4 1.1 2.1 0.8 0.0 0.9 0.7 0.9 0.5

Private banks

Axis HDFC ICICI

Tier I Yes
(cons.) Bank (Cons.)
Paid up capital 4.1 4.6 12.7 3.4
Reserves 156.3 211.1 501.4 27.5
Innovative instruments 4.2 2.0 28.2 2.6
Other capital instruments - - 0.4 -
Amt deducted from tier I cap. 6.7 10.8 83.0 0.7
Total tier I capital 157.9 206.8 459.7 32.8

Core tier I (excl. innovative instru.) 154 205 431 30

Tier I ratio (%) 11.2 13.3 14.0 12.9
Risk weighted assets (RWA) 1,412 1,555 3,293 254

Core tier I ratio (%) 10.9 13.2 13.1 11.9

Difference (%) 0.3 0.1 0.9 1.0
Source: Company, Edelweiss research

Edelweiss Securities Limited

BFSI

3
 
BFSI

Table 3: New capital norms

Common
(%) equity Tier I capital Total Capital

Minimum Capital 4.5 6.0 8.0

Conservation buffer 2.5 2.5 2.5
Minimum + Conservation buffer 7.0 8.5 10.5
Countercyclical buffer 0 - 2.5
Source: BIS

Table 4: Roadmap (%)

As on 1st January 2011 2012 2013 2014 2015 2016 2017 2018 2019
Parallel run 1 Jan 2013 - 1 Jan 2017 Migration to
Leverage ratio Supervisory monitoring
Dislosure starts 1 Jan 2015 Pillar 1
Minimum common equity capital ratio 3.5 4.0 4.5 4.5 4.5 4.5 4.5
Capital conservation buffer 0.625 1.250 1.875 2.5
Minimum common equity plus capital
3.5 4.0 4.5 5.1 5.8 6.4 7.0
conservation buffer
Phase-in deductions from CET1 (including
amounts exceeding the limit for DTAs, MSRs 20.0 40.0 60.0 80.0 100.0 100.0
and financials)
Minimum tier 1 Capital 4.5 5.5 6.0 6.0 6.0 6.0 6.0
Minimum Total capital 8.0 8.0 8.0 8.0 8.0 8.0 8.0
Minimum total capital plus conservation buffer 8.0 8.0 8.0 8.625 9.250 9.875 10.5
Capital instruments that no longer qualify as
Phased out over 10 year horizon beginning 2013
non-core Tier1 capital or Tier 2 capital

Introduce
Observation
Liquidity coverage ratio minimum
period begins
standard

Introduce
Observation
Net stable funding ratio minimum
period begins
standard

Source: BIS
(Shading represents transition periods)

4 Edelweiss Securities Limited

 
BFSI

Edelweiss Securities Limited, 14th Floor, Express Towers, Nariman Point, Mumbai – 400 021,
Board: (91-22) 2286 4400, Email: research@edelcap.com

Vikas Khemani Head Institutional Equities vikas.khemani@edelcap.com +91 22 2286 4206

Nischal Maheshwari Head Research nischal.maheshwari@edelcap.com +91 22 6623 3411

Coverage group(s) of stocks by primary analyst(s): Banking

Allahabad Bank, Axis Bank, Centurion Bank of Punjab, Federal Bank, HDFC Bank, ICICI Bank, IOB, Karnataka Bank, Kotak Mahindra Bank,
OBC, SBI, Yes Bank, IDFC, HDFC, LIC Housing Finance, PNB, Power Finance Corporation, Reliance Capital, SREI Infrastructure Finance,
Shriram City Union, Syndicate Bank and Union Bank.

EW Indices Recent Research

1,600
Date Company Title Price (INR) Recos

1,400 13-Sep-10 Union Asset quality concerns to 370 Buy

Bank recede; Visit Note
1,200 12-Aug-10 State Bank Strong core operating 2,784 Buy
of India performance; Result Update
1,000 11-Aug-10 Banking RBI issues discussion paper
for new private banking
800 licenses; Sector Update

11-Sep-09 11-Mar-10 11-Sep-10 09-Aug-10 Reliance Lower capital gain and 770 Hold
Capital general insurance loss
EW Banks and Financial Services Index Nifty dragged profitability;
Result Update

Distribution of Ratings / Market Cap

Rating Interpretation
Edelweiss Research Coverage Universe
Buy Hold Reduce Total Rating Expected to

Buy appreciate more than 15% over a 12-month period

Rating Distribution* 109 52 12 177
* 4 stocks under review Hold appreciate up to 15% over a 12-month period
> 50bn Between 10bn and 50 bn < 10bn
Reduce depreciate more than 5% over a 12-month period
Market Cap (INR) 108 54 15

Access the entire repository of Edelweiss Research on www.edelresearch.com

This document has been prepared by Edelweiss Securities Limited (Edelweiss). Edelweiss, its holding company and associate companies are a full service, integrated
investment banking, portfolio management and brokerage group. Our research analysts and sales persons provide important input into our investment banking
activities. This document does not constitute an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any
transaction. The information contained herein is from publicly available data or other sources believed to be reliable, but we do not represent that it is accurate or
complete and it should not be relied on as such. Edelweiss or any of its affiliates/ group companies shall not be in any way responsible for any loss or damage that
may arise to any person from any inadvertent error in the information contained in this report. This document is provided for assistance only and is not intended to
be and must not alone be taken as the basis for an investment decision. The user assumes the entire risk of any use made of this information. Each recipient of this
document should make such investigation as it deems necessary to arrive at an independent evaluation of an investment in the securities of companies referred to in
this document (including the merits and risks involved), and should consult his own advisors to determine the merits and risks of such investment. The investment
discussed or views expressed may not be suitable for all investors. We and our affiliates, group companies, officers, directors, and employees may: (a) from time to
time, have long or short positions in, and buy or sell the securities thereof, of company (ies) mentioned herein or (b) be engaged in any other transaction involving
such securities and earn brokerage or other compensation or act as advisor or lender/borrower to such company (ies) or have other potential conflict of interest with
respect to any recommendation and related information and opinions. This information is strictly confidential and is being furnished to you solely for your
information. This information should not be reproduced or redistributed or passed on directly or indirectly in any form to any other person or published, copied, in
whole or in part, for any purpose. This report is not directed or intended for distribution to, or use by, any person or entity who is a citizen or resident of or located in
any locality, state, country or other jurisdiction, where such distribution, publication, availability or use would be contrary to law, regulation or which would subject
Edelweiss and affiliates/ group companies to any registration or licensing requirements within such jurisdiction. The distribution of this document in certain
jurisdictions may be restricted by law, and persons in whose possession this document comes, should inform themselves about and observe, any such restrictions.
The information given in this document is as of the date of this report and there can be no assurance that future results or events will be consistent with this
information. This information is subject to change without any prior notice. Edelweiss reserves the right to make modifications and alterations to this statement as
may be required from time to time. However, Edelweiss is under no obligation to update or keep the information current. Nevertheless, Edelweiss is committed to
providing independent and transparent recommendation to its client and would be happy to provide any information in response to specific client queries. Neither
Edelweiss nor any of its affiliates, group companies, directors, employees, agents or representatives shall be liable for any damages whether direct, indirect, special
or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information. Past performance is not necessarily a
guide to future performance. The disclosures of interest statements incorporated in this document are provided solely to enhance the transparency and should not be
treated as endorsement of the views expressed in the report. Edelweiss Securities Limited generally prohibits its analysts, persons reporting to analysts and their
family members from maintaining a financial interest in the securities or derivatives of any companies that the analysts cover. The analyst for this report certifies
that all of the views expressed in this report accurately reflect his or her personal views about the subject company or companies and its or their securities, and no
part of his or her compensation was, is or will be, directly or indirectly related to specific recommendations or views expressed in this report.

Copyright 2009 Edelweiss Research (Edelweiss Securities Ltd). All rights reserved

Edelweiss Research is also available on www.edelresearch.com ,Bloomberg EDEL <GO>, Thomson First Call, Reuters and Factset. EdelweissEdelweiss
SecuritiesSecurities
Limited Limited
5