ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Contacts: Vibha Batra

vibha@icraindia.com

+91-124-4545302 Karthik Srinivasan,

karthiks@icraindia.com

+91-22-30470028 Puneet Maheshwari

puneetm@icraindia.com

The proposed Basel III guidelines seek to improve the ability of banks to withstand periods of economic and financial stress by prescribing more stringent capital and liquidity requirements for them. ICRA views the suggested capital requirement as a positive for banks as it raises the minimum core capital stipulation, introduces counter-cyclical measures, and enhances banks ability to conserve core capital in the event of stress through a conservation capital buffer. The prescribed liquidity requirements, on the other hand, are aimed at bringing in uniformity in the liquidity standards followed by banks globally. This requirement, in ICRAs opinion, would help banks better manage pressures on liquidity in a stress scenario. The capital requirement as suggested by the proposed Basel III guidelines would necessitate Indian banks1 raising Rs. 600000 crore in external capital over next nine years, besides lowering their leveraging capacity. It is the public sector banks that would require most of this capital, given that they dominate the Indian banking sector. Further, a higher level of core capital could dilute the return on equity for banks. Nevertheless, Indian banks may still find it easier to make the transition to a stricter capital requirement regime than some of their international counterparts since the regulatory norms on capital adequacy in India are already more stringent, and also because most Indian banks have historically maintained their core and overall capital well in excess of the regulatory minimum. As for the liquidity requirement, the liquidity coverage ratio as suggested under the proposed Basel III guidelines does not allow for any mismatches while also introducing a uniform liquidity definition. Comparable current regulatory norms prescribed by the Reserve Bank of India (RBI), on the other hand, permit some mismatches, within the outer limit of 28 days.

+91-124-4545348 Sumeet Gambhir

sumeetg@icraindia.com

+91-124-4545329 Manushree Saggar

manushrees@icraindia.com

September 2010

+91-124-4545316

Except foreign banks

ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Introduction The key elements of the proposed Basel III guidelines include the following: 1. Definition of capital made more stringent, capital buffers introduced and Loss absorptive capacity of Tier 1 and Tier 2 Capital instrument of Internationally active banks proposed to be enhanced 2. Forward looking provisioning prescribed 3. Modifications made in counterparty credit risk weights 4. New parameter of leverage ratio introduced 5. Global liquidity standard prescribed The Basel committee is expected to finalise the Basel III guidelines by December 2010, following which a sixyear phase-in period beginning 2013 is likely to be prescribed. This note seeks to assess the impact of the proposed Basel III guidelines on Indian banks capitalisation profile and their liquidity position till 2018. The impact of the suggested norms relating to forward looking provisioning and counterparty risk weights are not captured in this note, since for that more granular data would be required and these are not available currently in the public domain. The norms on leverage ratio and net stable funding ratio are also not discussed in this note as they are likely to be implemented not before 2019. Capital requirement: The new elements and their impact on Indian banks The proposed Basel III guidelines seek to enhance the minimum core capital (after stringent deductions), introduce a capital conservation buffer (with defined triggers), and prescribe a countercyclical buffer (to be built up in times of excessive credit growth at the national level). Changes in standard deductions The proposed Basel III guidelines suggest changes in the deductions made for the computation of the capital adequacy percentages. The key changes for Indian banks include the following: Table 1: Deductions from CapitalProposed vs. Existing RBI Norms Proposed Basel III Existing RBI Norm Guideline Limit on deductions Deductions to be made All deductibles to be deducted only if deductibles exceed 15% of core capital at an aggregate level, or 10% at the individual item level Deductions2 from Tier I All deductions from core 50% of the deductions from Tier I or Tier II capital and 50% from Tier II (except DTA and intangible assets wherein 100% deduction is done from Tier I capital ) Treatment of significant Any investment exceeding For investments up to: investments in common 10% of issued share capital (i) 30%: 125% risk weight or risk shares of unconsolidated to be counted as significant weight as warranted by external rating financial institutions and therefore deducted (ii)30-50%: 50% deduction from Tier I and 50% from Tier II

Impact Positive

Negative

Negative

These typically include intangible assets and losses, Deferred Tax assets (DTA), Any gain on sale recognized upfront on securitization of assets, Securitization exposure, Investment in financial subsidiaries and associates etc.

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ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

While the proposal to make deductions only if such deductibles exceed 15% of core capital would provide some relief to Indian banks (since all such deductibles are currently reduced from the core capital), the stricter definition of significant interest and the suggested 100% deduction from the core capital (instead of 50% from Tier I and 50% from Tier II) could have a negative impact on the core capital of some banks. Capital conservation buffer The Basel committee suggests that a new buffer of 2.5% of risk weighted assets (over the minimum core capital requirement of 4.5%) be created by banks. Although the committee does not view the capital conservation buffer as a new minimum standard, considering the restrictions imposed on banks and also because of reputation issues, 7% is likely to become the new minimum capital requirement. The main purpose of the proposed capital buffer is two-fold: 1. It can be dipped into in times of stress to meet the minimum regulatory requirement on core capital. 2. Once accessed, certain triggers would get activated, conserving the internally generated capital. This would happen as in this scenario, the bank would be restrained in using its earnings to make discretionary payouts (dividends, share buyback, and discretionary bonus, for instance). The final contours of the norm on conservation of capital would be known by December 2010. However, the Basel committee may allow some distribution of earnings by the banks, which are in breach of the proposed capital conservation buffer. If a bank wants to make payments in excess of the amount that the norm on capital conservation allows, it would have the option of raising capital for such excess amount. This issue would be discussed with the banks supervisor as part of the capital planning process. Table 2: Illustration on distributable Earnings in Various Scenarios Actual conservation capital as Maximum Permissible earnings percentage of required that can be distributed in the conservation capital subsequent financial year < 25% 0% 25% - 50% 20% 50% - 75% 40% 75% - 100% 60% >100% 100% Countercyclical buffer The Basel committee has suggested that the countercyclical buffer, constituting of equity or fully loss absorbing capital, could be fixed by the national authorities concerned once a year and that the buffer could range from 0% to 2.5% of risk weighted assets, depending on changes in the credit-to-GDP ratio. The primary objective of having a countercyclical buffer is to protect the banking sector from system-wide risks arising out of excessive aggregate credit growth. This could be achieved through a pro-cyclical build up of the buffer in good times. Typically, excessive credit growth would lead to the requirement for building up higher countercyclical buffer; however, the requirement could reduce during periods of stress, thereby releasing capital for the absorption of losses or for protection of banks against the impact of potential problems. The key features of the buffer include the following: Credit-GDP gap could be used as a reference point Buffer to be set at the national level every year Buffer to be calculated at the same frequency as the normal capital requirement Banks could be given one year to comply with the additional capital requirement Reduction in buffer could take effect immediately Banks not meeting the norm could be restrained from distributing the earnings (in the same manner as in the case of the capital conservation buffer)

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ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Enhancement in Loss Absorption capacity of capital of internationally active banks The Basel committee issued a consultative document in August 2010 to introduce a write off clause in all non-common Tier I and Tier II instruments issued by internationally active banks. The main features include the following: Capital instruments to be written off on the occurrence of trigger event In the event of write off, instrument holders could be compensated immediately in the form of common stock The trigger event is the earlier of: o The decision to make a public injection of fund or support, without which the bank would become non-viable ( as determined by National authority) o A decision that write-off is necessary to prevent the bank from becoming non-viable (as determined by the National Authority) The main purpose of the proposed contingent capital clause is to: Ensure that holders of capital bear the loss in a stress scenario before public money is infused and are not its (public funds) beneficiaries; and Reduce the possibility of public support for a bank under stress, as the banks core capital base would get strengthened at the expense of non-core capital (Tier I and Tier II) holders. Capital instruments with this clause are likely to increase the downside risk for potential investors; therefore the risk premium could go up. However, price discovery may not be easy as it could be difficult to assess the probability of conversion to equity or a principal write-down and the extent of loss after the event. Further considering the riskier nature of these instruments, there may be a wider notching in the credit rating of such instruments as compared to existing capital instruments. Additionally in case this loss absorption clause is adopted, a large number of instruments would get disqualified for inclusion under Tier I and Tier II capital. Therefore, Indian banks would need to mobilize capital for replacing this as well; the quantum of capital to be replaced could be large as total non common Tier 1 and Tier 2 capital of Indian bank is close to Rs. 200000 crore as on March 31, 2010 and large part of it is issued by internationally active banks. However, transition may be not be abrupt as these instruments would be phased out over 10 years starting 2013; their recognition would be capped at 90% in the first year and the percentage would drop by 10% each subsequent year. Comparison on Capital Requirement Overall, with the Basel III being implemented, the regulatory capital requirement for Indian banks could go up substantially in the long run (refer Table 3). Additionally within in capital, the proportion of the more expensive core capital could also increase. Moreover, capital requirements could undergo a change in various scenarios, thereby putting restriction on banks ability to distribute earnings. Please refer to Annexure 2 for an Illustration on the same. Table 3: Regulatory Capital Adequacy LevelsProposed vs. Existing RBI Norm Proposed Basel Existing RBI III Norm Norm Common equity (after deductions) 4.5% 3.6% (9.2%) Conservation buffer 2.5% Nil Countercyclical buffer 0-2.5% Nil Common equity + Conservation buffer + Countercyclical buffer 7-9.5% 3.6% (9.2%) Tier I(including the buffer) 8.5-11% 6% (10%) Total capital (including the buffers) 10.5-13% 9% (14.5%) Source: Basel committee documents, RBI, Basel II disclosure of various banks; Figures in parenthesis pertain to aggregated capital adequacy of banks covering over 95% of the total banking assets as on March 31, 2010. Please refer Annexure 1 for details. Indian banks are subjected to more stringent capital adequacy requirements than their international counterparts. For instance, the common equity requirement for Indian banks is 3.6% , as against the 2%
Innovative perpetual debt and perpetual non-cumulative preference share cannot exceed 40% of the 6% Tier I, thereby minimum core capital works out to be 60% of 6%, which is 3.6%

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ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

mentioned in the Basel document. At the same time, the total capital adequacy requirement for Indian banks is 9%, as against the 8% recommended under Basel II. Moreover, on an aggregate basis, the capital adequacy position of Indian banks is comfortable, and being so, they may not need substantial capital to meet the new norms. However, differences do exist among various banks. While most of the private sector banks and foreign banks have core capital in excess of 9%, that is not the case with some of the public sector banks, as Chart 13 brings out.

Once Basel III comes into force, some public sector banks are likely to fall short of the revised core capital adequacy requirement and would therefore depend on Government support to augment their core capital. In recent times, Government of India (GOI) support has come via non-core Tier I, but this form of support may change in favour of equity capital, especially for banks falling short on core capital. The expected growth in the risk weighted assets along with the requirement of more stringent capital adequacy norms would also require banks to mobilise additional capital. In a scenario of 20% annualised growth in riskweighted assets and in internal capital generation, the volume of additional capital that would be required by the banking sector (excluding foreign banks) as a whole over the next nine years ending March 31, 2019 works out to be Rs. 600000 crore (over internal capital generation). Of this, the public sector banks would require 7580% and private banks 20-25%. However, any variation in the assumed growth rate may lead to a change in the volume of capital required. Further, in case some non-common Tier I and Tier II capital instruments get disqualified for inclusion under regulatory capital, the requirement would go up. It could be a challenge to find the investors, with higher risk appetite, to subscribe to the capital requirement of Indian banks.

* IDBIs Common equity% increased to 6.1% from 4.4% as on March 31, 2010 after factoring in the RS 3119 crore equity infusion by the GOI in August-2010

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ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Impact on return on equity

Chart 3: Return on Core Tier 1

at various levels of Core Tier 1
20.00% 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 6.0% 7.0% 8.0% Core Tier 1 Capital
As discussed, the minimum core Tier I capital requirement may increase to 7-9.5% (9.5% including countercyclical buffer at the maximum level) and the overall Tier I capital to 8.5-11% (depending on the countercyclical capital buffer level). This would impact the leveraging capital of banks and therefore their return on equity (ROE). For instance, a bank generating 18% ROE on a core capital of 6% would generate around 15% ROE (3 percentage points lower) in case it were to raise its core capital to 8%. As most private sector banks and foreign banks in India are very well capitalised, transition to Basel III may not impact their earnings much, but the upside potential associated with higher leveraging would decline. As for public sector banks, those with Core Tier I less than 7% would be negatively impacted. Further, as the countercyclical buffer has to be set annually by the RBI, this could introduce an element of variation in lending rates and/or the ROE of banks. Liquidity Table 4: Liquidity RatioProposed vs. Existing RBI Norm Proposed Basel III Existing RBI Norm Liquidity Ratios Liquidity Coverage Ratio = Number of 1 2-7 8-14 Stock of high quality liquid days assets/Net cash outflows Maximum 5% 10% 15% over a 30-day time period >= Permissible 100% gap (as % of outflows) Net Stable Funding Ratio No such norm (NSFR) = Available amount of stable funding/Required amount of stable funding > =100%

Return on Core Tier 1

9.0%

9.5%

1528 20%

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ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

The net stable funding ratio (NSFR) is likely to be implemented from 2019. But implementation of the liquidity coverage ratio (LCR) from 2015 may necessitate banks to maintain additional liquidity since the LCR requirement is more stringent; also some assumptions on the rollover rates and the required liquidity for committed lines may be more stringent. However, considering the period of one month and the fact that most Indian banks have upgraded their technology platforms, the transition to LCR may not be a very difficult one.

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ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Annexure 1: Capitalization Profile of Top Indian Banks as on March 31, 2010 Public Sector Banks (Amount in Rs. crore) Core Tier-1 (net of deductions) 5,876 4,221 13,157 12,230 2,069 12,030 4,341 5,724 2,202 7,952 6,603 6,095 7,297 15,207 2,127 75,295 2,343 3,748 1,965 3,505 2,658 5,206 3,482 8,657 2,871 2,478 205,119 Core Tier-1 (net of deductions) % 7.72% 7.81% 8.43% 7.51% 5.61% 7.99% 4.71% 8.19% 7.33% 4.37% 10.50% 7.68% 8.63% 8.04% 7.14% 8.60% 7.70% 7.07% 6.70% 7.52% 8.31% 7.17% 4.90% 7.06% 6.85% 6.40% 7.66% Tier-1 (net of deductions) % 8.12% 8.18% 9.20% 8.57% 6.41% 8.54% 6.83% 9.25% 8.16% 6.35% 11.13% 8.67% 9.28% 9.11% 7.68% 9.28% 8.35% 8.64% 7.59% 8.16% 9.24% 8.24% 7.06% 7.91% 8.16% 7.69% 8.60% Tier-2 (net of deductions) % 5.51% 5.75% 5.16% 4.43% 6.37% 4.89% 5.40% 6.12% 4.61% 5.13% 1.58% 6.11% 3.25% 5.04% 5.41% 4.21% 4.95% 6.26% 4.84% 5.10% 4.50% 4.46% 6.16% 4.60% 4.64% 4.81% 4.75% CRAR % GOI shareholding % 55.23% 51.55% 53.81% 64.47% 76.77% 73.17% 80.20% 57.17% 51.19% 52.67% 80.00% 61.23% 51.09% 57.80% 100.0% 59.41%

Allahabad Bank Andhra Bank Bank of Baroda Bank of India (Consolidated) Bank of Maharashtra Canara Bank Central Bank of India Corporation Bank Dena Bank IDBI Bank Indian Bank Indian Overseas Bank Oriental Bank of Commerce Punjab National bank Punjab & Sind Bank State Bank of India - Group State Bank of Bikaner & Jaipur State Bank of Hyderabad State Bank of Mysore State Bank of Patiala State Bank of Travancore Syndicate Bank UCO Bank Union Bank United Bank Vijaya Bank Total - Public Sector Banks

13.62% 13.93% 14.36% 13.0% 12.78% 13.43% 12.23% 15.37% 12.77% 11.48% 12.71% 14.78% 12.54% 14.16% 13.10% 13.49% 13.30% 14.90% 12.42% 13.26% 13.74% 12.70% 13.21% 12.51% 12.80% 12.50% 13.36%

66.47% 63.59% 55.43% 84.20% 53.87%

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Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Private Sector Banks (Amount in Rs. crore)

Core Tier-1 (net of deductions) 15,369 4,680 20,484 43,106 2,140 1,972 2,986 7,490 1,412 3,020 102,659

Core Tier-1 (net of deductions) % 10.89% 16.92% 13.13% 12.12% 9.65% 9.62% 12.79% 17.31% 12.42% 11.84% 12.42%

Tier-1 (net of deductions) % 11.18% 16.92% 13.26% 12.92% 9.65% 10.11% 12.79% 17.31% 12.42% 12.85% 12.88%

Tier-2 (net of deductions) % 4.62% 1.44% 4.20% 6.23% 5.68% 4.79% 3.10% 1.97% 2.97% 7.76% 5.05%

CRAR %

Axis Bank Federal Bank HDFC Bank ICICI Group Indusind ING Vysya Bank Jammu & Kashmir Bank Kotak Group South Indian Bank Yes Bank Total - Private Sector Banks Foreign Banks (Amount in Rs. crore)

15.80% 18.36% 17.44% 19.15% 15.33% 14.91% 15.89% 19.28% 15.39% 20.61% 17.93%

Core Tier-1 (net of deductions) 4,665 15,607 4,171 9,144 1,722 8,037 43,346 Core Tier-1 (net of deductions) 351,124

Core Tier-1 (net of deductions) % 16.62% 17.29% 16.50% 16.63% 6.72% 8.94% 13.80% Core Tier-1 (net of deductions) % 9.19%

Tier-1 (net of deductions) % 16.62% 17.29% 16.50% 16.63% 7.94% 8.94% 13.90% Tier-1 (net of deductions) % 9.97%

Tier-2 (net of deductions) % 0.46% 0.57% 0.71% 1.40% 4.56% 3.47% 1.87% Tier-2 (net of deductions) % 4.58%

CRAR %

Barclays Bank4 Citibank - Group Deutsche Bank HSBC Bank RBS Standard Chartered Bank Total - Foreign Banks All SCBs (Amount in Rs. crore)
5

17.07% 17.86% 17.21% 18.03% 12.50% 12.41% 15.77% CRAR %

14.55%

4
5

Figures as on March 31, 2009

Figures as on December 31, 2009. Also, Core Tier-I and Tier-I are assumed to be same due to non-availability of data

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Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Annexure 2: An illustration on movement of capital requirement and triggers under various scenarios Regulatory Capital = Core Capital + Capital Conservation Buffer + Countercyclical buffer (if any)

Actual Regulatory Core Capital 8%

Capital Conservation Buffer 2.5%

Core Capital 4.5%

Complete release of countercycli cal buffer Restriction on earning distribution continue (although restrictions are lower)

Actual Regulatory Core Capital 6.5%

Capital Conservation Buffer 2.5%

Countercylical Buffer 1%
Normal Scenario

Actual Regulatory Core Capital 8%

Capital Conservation Buffer 2.5%

Core Capital 4.5%

Core Capital 4.5%

Introduction of countercyclical buffer No restriction on earning distribution

Stress situation, normal credit growth

High credit growth scenario

Actual Regulatory Core Capital 5.5%

Countercyclical Buffer 1.5%

Capital

Countercyclical Buffer 2.5%

Actual Regulatory Core Capital 8.5%

Conservation Buffer 2.5%

Capital Conservation Buffer 2.5%

Core Capital 4.5%

Core Capital 4.5%

Stress situation , high credit growth continues

Higher credit growth scenario

Part release of countercyclical buffer Restriction on earning distribution become higher

Higher level of countercyclical buffer Restriction on earning distribution kicks in

Note: Figures in circles represent the minimum regulatory requirement

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Proposed Basel III Guidelines: A Credit Positive for Indian Banks

Annexure3: Time lines (shading indicates transition periods) (All dates are as of 1 January)
2011 Leverage Ratio 2012 2013 2014 2015 2016 2017 2018 Migration to Pillar 1 4.5% 1.25% 5.75% 4.5% 1.875% 6.375% 4.5% 2.50% 7.0% As of 1 January2019

Supervisory monitoring

Minimum Common Equity Capital Ratio Capital Conservation Buffer Minimum common equity plus capital conservation buffer Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials) Minimum Tier 1 Capital Minimum Total Capital Minimum Total Capital plus conservation buffer Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital Liquidity coverage ratio Observ ation period begins Net stable funding ratio Obser vation period begins

Parallel run 1 Jan 2013-I Jan 2015 Disclosure Starts 1 Jan 2015 3.5% 4.0% 4.5% 4.5% 0.625 % 5.125 % 60.0 %

3.5%

4.0%

4.5%

20.0%

40.0%

80.0%

100.0%

100.0%

4.5% 8.0% 8.0%

5.5% 8.0% 8.0%

6.0% 8.0% 8.0%

6.0% 8.0%

6.0% 8.0%

6.0% 8.0%

6.0% 8.0% 10.5%

8.625 9.25% 9.875% % Phased out over 10 year horizon beginning 2013

Introduce minimum standard

Introduce minimum standard

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ICRA Comment

Proposed Basel III Guidelines: A Credit Positive for Indian Banks

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