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Understanding Banking System Basel Norms

and Banking Stability


Introduction
Banking system is the backbone of any nations economy. For an economy to
remain healthy and going, it is important that the banking system grows fast
and yet be stable.
This catches the biggest dilemma of policymakers. How to achieve both the
objectives simultaneously?
Over a period of time, several indicators have been developed which gauge
the depth and stability of the banking system. Examples can be Nonperforming assets, Capital adequacy ratio (CAR) etc.
Similarly, mechanisms to ensure their stability have also been developed.
Some of the examples can be CRR; SLR; Basel conventions; regular
directions of the RBI; Financial Stability and Development Council etc.
In this section, we will talk about some of these indicators and mechanisms.
They have also been in news for quite some time Basel III norms and NonPerforming assets (NPAs).
We will try to first clarify the related concepts; then understand the
seriousness of the issue; gauge their impact on the Indian economy and then
offer some possible solutions as well as look into some of the committees
reports which have examined the matter.
In this article (Part-1 of a two part series), we will only deal with Basel norms.
NPAs will be dealt with comprehensively in the next article.

About Basel norms


Basel is a city in Switzerland which is also the headquarters of Bureau of
International Settlement (BIS). BIS fosters co-operation among central banks
with a common goal of financial stability and common standards of banking
regulations. Currently there are 27 member nations in the committee.

Basel guidelines refer to broad supervisory standards formulated by this


group of central banks- called the Basel Committee on Banking Supervision
(BCBS). The set of agreement by the BCBS, which mainly focuses on risks to
banks and the financial system are called Basel accord.
The purpose of the accord is to ensure that financial institutions have enough
capital on account to meet obligations and absorb unexpected losses. India
has accepted Basel accords for the banking system.
So, if the Basel norms are banking standards, then who has the authority to make them? Are
they mandatory for every country?

As said earlier, the Basel Committee makes these norms. The Committees
decisions have no legal force. Rather, the Committee formulates supervisory
standards and guidelines and recommends statements of best practice in the
expectation that individual national authorities will implement them. In this
way, the Committee encourages convergence towards common standards
and monitors their implementation, but without attempting detailed
harmonisation of member countries supervisory approaches.
So, India can either accept them or reject them depending on the kind of
financial system it wants. So far, we have implemented or wished to
implement all Basel norms.

Basel I
In 1988, BCBS introduced capital measurement system called Basel capital
accord, also called as Basel 1. It focused almost entirely on credit risk. It
defined capital and structure of risk weights for banks. Naturally if the capital
with the banks is adequate to cover the risks ( e.g. a power plant) they have
invested in, then the bank is safe.
The minimum capital requirement was fixed at 8% of risk weighted assets
(RWA). RWA means assets with different risk profiles. For example, an asset
backed by collateral would carry lesser risks as compared to personal loans,
which have no collateral. India adopted Basel 1 guidelines in 1999. The Basel
norms are set up by the Basel committee on Banking supervision.
It is important to understand that the Basel accords have been the result of
cooperation by the countries over the years.

But why cooperate between member countries when banks


operate within national boundaries?
It is because these banks lend not only to its country men but also other
nations. Also, private investors and sovereign nations take loans from banks
across other nations. Further, the financial system of the world is so
interconnected that one incident of a banking collapse has its repercussions
all over the world. There can be no better example that the 2008 Global
recession.
Therefore, global cooperation on banking matters is a absolute necessity in
todays world. And, not only cooperation but also adoption of some uniform
standards is also important.

Again, Why uniform standards?


Bankers and investors invest over the world preferably in markets where
they get best returns. The markets will give returns only when the economy
is stable. And, economy will be stable only when the banking system is
stable. Hence, it is important for investors and agencies to measure the
stability of the banking system. If all the nations adopt different standards,
then calculating stability figures will be a big headache for investors.
Also, suppose some nations run banks on better standards i.e. better risk
management, better returns, lower exposure to volatile markets etc., then
they have a better chance of getting foreign investment.
But, if all nations adopt uniform standards, then at least the investors can be
attracted by only the strength of the economy.
Hence, it is important to have uniform standards especially when it comes to
the banking system which is so complex and vast.
The Basel norms try to achieve exactly the same. Till date three different
Basel accords ( or norms) have come each with a better safeguard than the
next one.

Basel II
In 2004, Basel II guidelines were published by BCBS, which were
considered to be the refined and reformed versions of Basel I

accord. The guidelines were based on three parameters.

1. Banks should maintain a minimum capital adequacy requirement of 8% of


risk assets,
In India, such a practice is equivalent to maintaining a Capital Adequacy ratio
(CAR).
2. Banks were needed to develop and use better risk management
techniques in monitoring and managing all the three types of risks that is
credit and increased disclosure requirements.
Increased disclosure requirements raise the confidence of investors
and depositors in the bank. The more transparent a bank is, the more
stable it is deemed to be.
3. Banks need to mandatorily disclose their risk exposure, etc to the central
bank.
This is important so that the central bank (RBI in India) is aware of the
risks that the banking system is going through.
There is a practice in India to publish bi-annual Financial Stability reports by
the RBI. The latest report published recently is of June 2014.
Basel II norms in India and overseas are yet to be fully implemented.
You will find some technical words like risk exposure etc. in the text. We do
not need to go into details. We only need to know their general meaning.

Basel III
In 2010, Basel III guidelines were released. These guidelines were introduced in response to the
financial crisis of 2008.

A need was felt to further strengthen the system as banks in the developed
economies were under-capitalized, over-leveraged and had a greater reliance
on short-term funding. Too much short-term funding makes the banks prone
to risks. Banks generally rely on short-term funding because it is profitable.

Also the quantity and quality of capital under Basel II were deemed
insufficient to contain any further risk. This was because the banking system
was growing. The world economy was growing too. Hence, what is sufficient
earlier was not sufficient now.
Basel III norms aim at making most banking activities such as their trading
book activities more capital-intensive. The guidelines aim to promote a more
resilient banking system by focusing on four vital banking parameters viz.
capital, leverage, funding and liquidity.
Again we need not go in technicalities, just the broad picture.
This is how it was broadly done.

Capital
The capital requirement (as weighed for risky assets) for Banks was more
than doubled. ( e.g. 4.5% from 2% in Basel-II accord for common equity)

Leverage
Leverage basically means buying assets with borrowed money to multiply
the gain. The underlying belief is that the asset will return the investor more
than the interest he has to pay on the loan.
Obviously doing so is risky business. Thus the Basel III puts a limit on the
banks for doing this. The numbers are not important here. Getting the
concept is important.

Funding and liquidity


Banks can be subjected to a lot of risk if all depositors come and ask all their
money at the same time. This is a hypothetical situation but it has happened
in real with Lehman Brothers the bank whose collapse gave us the 2008
recession.
So, Basel III puts a requirement for the banks to maintain some liquid assets
all the time. Liquid assets are those which can be easily converted to cash.
In India, this practice can be correlated with that of maintaining CRR and
SLR.

Implementation of Basel III norms in India


The RBI has postponed the implementation of these norms to 2019.
It is important to note that it is not easy to implement these norms as it
requires several changes in the present banking system.
There are several challenges in the successful implementation of Basel III
norms.
1. Higher capital requirement for banks The private banks have
the autonomy to raise capital from the markets. But the Public sector
banks have to rely on the government mostly. The government has
recently decided to infuse 12000 Cr. rupees in the PSBs. In the coming
years even more will be required.
2. More technology deployment Implementing the norms would
require much more sophisticated technology and management styles
that the Indian banks are presently using. Upgrading both will impose
huge cost on the banks and hurt their profitability in the coming years.
3.Liquidity crunch Banks would need to invest more on liquid
assets. These assets do not give handsome returns usually which
would reduce the banks operating profit margin. Further higher
deployment of more funds in liquid assets may crowd out good private
sector investments and also affect economic growth.

The way ahead for the banks


To address these issues and to protect their profitability margins, banks need
to look beyond regulatory compliance and take proactive actions.
In this regard the following strategies need to be adopted:

1. Change in Business Mix They will need to lend more to


profitable yet safe sectors. For e.g. corporate loans. But even corporate
loans in India have been under a lot of stress. Banks are facing
increasing NPAs (we will talk about it in the next article). Still they are
safer and more profitable than retail loans. Priority Sector lending (PSL)

however limits their options.


2. Low-Cost Funding One of the most important factors to meet the
new regulations is to have a stable low-cost deposit base. For this,
banks need to focus more on having business
correspondents/facilitators to reach customers as adding branches will
increase costs and have an impact on the profit margin.
The RBI is thinking of introducing UID based mobile wallets to increase
the reach of the financial system. Perhaps the banks can tie up with
wallet operators based on some innovative business model. There are
many opportunities.
3. Improvement in systems and procedures - Refining the
systems and procedures may help banks economise their risk-weighted
assets, which will help reduce capital requirements to some extent. It is
possible that they would impose cost in the short-run, but they would
yield great returns in the future.

Conclusion
It is clear that the banking system in the coming times will have to go
through a lot of rough weather. Increasing operational complexities, global
interconnectedness and high economic growth worldwide will present several
challenges for the banks. While strategies like Basel III will of course address
these challenges, what is even more important is their proper
implementation. More than this, the banks will need to have a wider outlook.
They must anticipate changes in the Indian economic system and react
accordingly. Indian banking regulations are one of the most stringent and
consequently one of the safest in the world. Let us evolve each time better
and stronger.