Vinay Dutta

Senior Professor in Finance

FORE School of Management, New Delhi
 Banking Regulations

Banking is the most heavily regulated industry, because

financial institutions touch the life of every individual and
every business in our society. Therefore, a comprehensive
understanding and appreciation of banking regulation is
essential to the success of every financial institution

Jonathan L Levine, Member of Financial Industry Group providing legal counsel to

banks, thrifts and other financial services providers .
 Discussion Issues
?
• Bank regulation and Bank supervision: Are they
same or inter-related?
• The goals of bank regulation and supervision, or
why regulate and supervise banks?
 Bank regulation and Bank supervision:
Are they same or inter-related?

Bank regulation refers to the rules that regulate the

establishment and operations of banks.
Bank supervision refers to the implementation of
those rules and regulations.
Bank regulation and bank supervision are
intertwined as regulation focuses on setting rules
and guidelines and supervision on examining and
evaluating the implementation of rules and
regulations.
 The goals of bank Regulation and supervision or
why regulate and supervise banks?

The goals of bank regulation and supervision are to

provide for the stability of the overall financial
system, protect consumers and investors, and
ensure adequate competition in the provision of
banking services.
The goals of bank Regulation and supervision or
why regulate and supervise banks?

• Power to create money

• Protection of depositors interest
• High leverage
• Financial / Monetary stability
• Efficient and competitive financial system
• Limit excessive risk taking
Changing Banking Regulations
 Changing Banking Regulations

• Macro( policy) level and Micro (transaction) level to

Macro (policy) level

• Prescription based to Prudential guidelines

• Compliance based, Rule based, Check list based to

Risk management based, Best practices based
 Discussion
?
Safe, stable and stronger bank versus High-profit
making risky bank

The Case of Global Trust Bank or Yes Bank

 Banking Regulations

Regulation

Monetary Prudential

Preventive Protective Supportive

Limitation of risk- Support to Support to banks

taking activities of depositors
Lender of the last
banks
Deposit insurance resort
Exposure norms scheme
Types of banking regulations
Monetary control
Safety and sound regulation
 Discussion Issue
?
Deposit Insurance

Consider the issue whether or not the government should

provide a system of deposit insurance.

What should policymakers reasonably expect deposit insurance

to accomplish? Should it be wholly or partly subsidized by the
tax payers? What portion of the cost should be borne by banks?
By the depositors?

Should riskier banks pay higher deposit insurance premiums?

Explain how would you determine exactly how big an insurance

premium each bank should pay each year?

Do you think that high levels of insurance coverage increases the

likelihood of banking crisis?
 Capital Adequacy (Capital Adequacy )

Basel Accords

Basel Committee on Banking Supervision (BCBS)

 Basel Accords
• 1988 First accord : Basel-I

• 1996 Market risk amendment allowing usage of internal models

• 1999 First consultative package on new accord : Basel-I

• January 2001- 2nd consultative package. May 2001-Deadline for comments

• End 2001 Publication of new accord

• 2004 Implementation of the Basel II accord originally planned (*Actually

implemented in March 2008). India: Banks adopted standardized
approach for credit risk and basic indicator approach for operational risk
with effect from March 31, 2009

• Basel III-Capital Regulations implemented in India with effect from April 1,

2013 in a phased manner. Transition period for full implementation was
extended by RBI up to March 31, 2019 as against internationally agreed
date: January 1, 2019.
• RBI again notified extension of the transition period for implementing the
last tranche of 0.625 per cent of risk-weighted assets (RWAs) under the
Capital Conservation Buffer (CCB) by one year to March 31, 2020.
 Basel II Accord

Key Objective: To align regulatory capital to underlying

risk and to induce banks to strengthen their risk
management capabilities

Three Pillars of Basel II Accord

Pillar I Minimum capital requirements

Pillar II Supervisory review process
Pillar III Market discipline
 Evolution of Basel II to Basel III

Basel - II Basel - III

Pillar I Pillar II Pillar III

Pillar I Pillar II Pillar III
Enhanced Enhanced Enhanced
Minimum Supervisory Disclosure Minimum Capital Supervisory Risk
Capital Review & Market &, Liquidity Review Disclosure
Requirements Process Discipline Requirements Process for & Market
Firm-wide Risk Discipline
Management
and Capital
Planning
 Capital Requirements Under Basel II and Basel III

As a percentage of risk-weighted assets

Basel II Basel III (as on

January 1, 2019)
A = (B + D) Minimum Total Capital 8.0 8.0

B Minimum Tier 1 Capital 4.0 6.0

of which: Minimum Common Equity
C
Tier 1 Capital 2.0 4.5
Maximum Tier 2 Capital
D 4.0 2.0
(within Total Capital)

E - 2.5
Capital Conservation Buffer (CCB) +
Minimum Common Equity
F=C+E 2.0 7.0
Tier 1 Capital + CCB
G=A+E Minimum Total Capital + CCB 8.0 10.5

Issue: Why banks are required to hold buffers in the capital

structure and what are its implications?
Issue: Why banks are required to hold buffers in the capital
structure and what are its implications?

Banks have to hold buffers in the capital structure to bear

losses.

All borrowers to some extent have to (indirectly) shoulder

the “carry cost” of distressed assets and, increasingly,
frauds, through higher margins on their loans
Banks need to maintain Capital Adequacy Ratio (CAR)

If Advances = 100

And CAR = 9%

Then Capital has to be = 9

If NIM = 3%

Then Profit = 3

Profit 3
So, ROCE = = = 33.33%
Capital 9
 Suppose this bank wants to triple its profits

Triple Advances = 300

And CAR = 9%

Then Capital has to be = 27

If NIM = 3%

Then Profit = 9 Double!

Profit 9
So, ROCE = = = 33.33%
Capital 27

Profits are tripled but shareholders/ management is

not happy because ROCE is static
 If profits were tripled but capital is not

Triple Advances = 300

And Profit = 9

And Capital kept at = 9

Capital 9
Then CAR = = = 3%
Advances 300

This would be a violation of regulatory capital norms.

Issue: What shall bank do to increase ROCE, without

violating the regulatory capital norms.
One of the ways to increase ROCE is to generate fee Income

Profit 3
ROCE = = = 33.33%
Capital 9

Profit from Capital + Profit from Capital

consuming sources non-consuming sources
ROCE =
Capital

Profit from Lending + Profit from fees from

Third party sales
ROCE =
Capital

3 + 1.5
ROCE = = 50% Increase in profits
9 Increases the ROCE

Can you think of another way to increase ROCE?

 Limits on Bank Lending (Large Exposure Framework)

Single Counterparty Group Exposure

• Normally the sum of all the • The sum of all the exposure
exposure values of a bank to a values of a bank to a group of
single counterparty must not connected counterparties
be higher than 20 percent of must not be higher than 25
the bank’s available eligible percent of the bank’s
capital base at all times. available eligible capital base
at all times.

• In exceptional cases, Board of • Covid effect: On 23.05.20,

banks may allow an additional RBI raised a bank’s exposure
5 percent exposure of the to a group of connected
bank’s available eligible counterparties from 25% to
capital base. 30% of the eligible capital
base of the bank up to June
30, 2021.
Eligible capital base: Tier 1 capital as per the last audited balance sheet.
Market structure and competition
Consumer protection regulation
Credit Allocation
 NPA Impact

Why is banking a risky business?

Number of car loans 100000
Size of car loan (Rs. in lakh) 5
Car loan portfolio (Rs in lakh) 500000
Return on Assets 2.00%
Total expected earnings (Rs in lakh) 10000

• What percentage of car loans will go bad to burn total expected earnings?
• What action bank should take while pricing car loans?
• What are the implications of non-recovery/delay in resolution of bad loans?
 NPA Impact

The uncertainty and lags around the

resolution/liquidation process has meant that a
(recovery) risk premium is added to the borrowing
margin of all borrowers, including those who are
diligently servicing their debt.
Key Shortcomings in the Legal Framework for Resolution of NPAs

• Absence of hard-coded, time-bound period for resolution; and

• Agency and co-ordination failures at banks and Joint Lender’s

Forums in pushing through viable restructuring plans or, failing
that, initiating liquidation
 Key Initiative for Resolution of NPAs

• The Insolvency and Bankruptcy Code (IBC): IBC was enacted in

May 2016 to strengthen India’s financial architecture;

• IBC is a modern code which empowers creditors to take

necessary action upon failure to pay. Default even by a day, of
at least Rs. 100,000, allows a creditor, financial or operational
to file a reference in the National Company Law Tribunal
(NCLT);

• IBC provides for a single-window, time bound route for

resolution of an asset with an explicit emphasis on promotion
of entrepreneurship (not preservation of entrenched
defaulter elite), maximization of value of assets, and
balancing the interest of all stakeholders;
 Key Initiative for Resolution of NPAs

• The most significant cost to a sponsor under IBC may be the

possibility of losing the firm to potential bidders.
Impact
May incentivize firms to avoid defaults and not over-borrow or
incentivize to borrow sensibly and dutifully service debt.

• For a creditor, as asset in most cases, is more valuable when it

is a going concern and generating cash flow, as compared to
an asset under liquidation.
• IBC puts a time limit of 180 days (extendable by a further
ninety days) within which the adjudicating authority under
the law will pass a liquidation order on the insolvent company.
Impact
Threat of liquidation, could potentially result in larger losses
for creditors, and expected to be sufficient incentive for them
to co-ordinate during the resolution period and quickly arrive
at a decision.
Calculation of Risk Weighted Assets (RWAs) and Capital
Adequacy Ratio (CAR)
Rs in Cr.
Portfolio of Bank One Rs in Cr. Risk weight RWA's
Investment in G-Sec 60000 0% 0
Investment in equity shares 6000 125% 7500
MSME loans (Govt Guaranteed) 45000 0% 0
Working capital loans to A rated
corporates 150000 50% 75000
Consurmer loans 6000 100% 6000
Cash in vaults/ATMs etc. 15000 0% 0
Balance with banks 3000 20% 600
Other assets 18000 100% 18000
Solution:
Risk weighted loan portfolio 81000
Risk weighted investment portfolio 7500
Total RWAs 107100
CAR @ of 9% 9% 9639
Minimum required CET I at 5.50% 5.50% 5890.5
CAR if paid up capital is Rs.15000 15000 14.01%

Bank One capacity to create RWA with Capital of Rs 15000 166667