Prudential regulation of banks

The Basel Committee on Banking Supervision (BCBS) is the primary global

standard setter for the prudential regulation of banks and provides a forum for
regular cooperation on banking supervisory matters for the central banks of different
countries. It was established by the Central Bank governors of the Group of Ten countries in 1974.
The committee expanded its membership in 2009 and then again in 2014. The BCBS now
has 45 members from 28 Jurisdictions, consisting of Central Banks and authorities
with responsibility of banking regulation. It provides a forum for regular cooperation on banking
supervisory matters. Its objective is to enhance understanding of key supervisory issues and
improve the quality of banking supervision worldwide. Banks lend to different
types of borrowers and each carries its own risk. They lend the deposits of the public
as well as money raised from the market i.e, equity and debt. This exposes the bank to a
variety of risks of default and as a result they fall at times. Therefore, Banks have to keep
aside a certain percentage of capital as security against the risk of non – recovery. The Basel
committee has produced norms called Basel Norms for Banking to tackle this risk.
Prudential Norms
The Basel Committee has issued three sets of regulations which are known as Basel-I, II,
and III.

Basel-I
It was introduced in 1988.
It focused almost entirely on credit risk.
Credit risk is the possibility of a loss resulting from a borrower's failure to repay
a loan or meet contractual obligations. Traditionally, it refers to the risk that a
lender may not receive the owed principal and interest.
It defined capital and structure of risk weights for banks.
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-I guidelines in 1999.
Basel-II
In 2004, Basel II guidelines were published by BCBS.
These were the refined and reformed versions of Basel I accord.
The guidelines were based on three parameters, which the committee
calls it as pillars.
Capital Adequacy Requirements: Banks should maintain a minimum
capital adequacy requirement of 8% of risk assets
Supervisory Review: According to this, banks were needed to develop
and use better risk management techniques in monitoring and managing
all the three types of risks that a bank faces, viz. credit, market and
 operational risks.
Market Discipline: This needs increased disclosure requirements.
Banks need to mandatorily disclose their CAR, risk exposure, etc to the
central bank.
Basel II norms in India and overseas are yet to be fully implemented
though India follows these norms.
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.
It was also felt that the quantity and quality of capital under Basel II were
deemed insufficient to contain any further risk.
The guidelines aim to promote a more resilient banking system by focusing on four
vital banking parameters viz. capital, leverage, funding and liquidity.
Capital: The capital adequacy ratio is to be maintained at 12.9%. The
minimum Tier 1 capital ratio and the minimum Tier 2 capital ratio have to be
maintained at 10.5% and 2% of risk-weighted assets respectively.
In addition, banks have to maintain a capital conservation buffer of 2.5%.
Counter-cyclical buffer is also to be maintained at 0-2.5%.
Leverage: The leverage rate has to be at least 3 %. The leverage rate is the ratio
of a bank’s tier-1 capital to average total consolidated assets.
Funding and Liquidity: Basel-III created two liquidity ratios: LCR and
NSFR.
The liquidity coverage ratio (LCR) will require banks to hold a buffer
of high-quality liquid assets sufficient to deal with the cash outflows
encountered in an acute short term stress scenario as specified by
supervisors.
This is to prevent situations like “Bank Run”. The goal is to ensure
that banks have enough liquidity for a 30-days stress scenario if it
were to happen.
The Net Stable Funds Rate (NSFR) requires banks to maintain a
stable funding profile in relation to their off-balance-sheet assets and
activities. NSFR requires banks to fund their activities with stable sources
of finance (reliable over the one-year horizon).
The minimum NSFR requirement is 100%. Therefore, LCR
measures short-term (30 days) resilience, and NSFR measures
medium-term (1 year) resilience.

The deadline for the implementation of Basel-III was March 2019 in India. It
was postponed to March 2020. In light of the coronavirus pandemic, the RBI
 decided to defer the implementation of Basel norms by further 6 months.
Extending more time under Basel III means lower capital burden on the banks
in terms of provisioning requirements, including the NPAs.
This extension would impact the perception of Indian Banks and central banks
in the eyes of the global players.

Tier 1 Capital vs. Tier 2 Capital

Banks have two main silos of capital that are qualitatively different from one
another.
Tier 1: It refers to a bank's core capital, equity, and the disclosed reserves that
appear on the bank's financial statements.
In the event that a bank experiences significant losses, Tier 1 capital
provides a cushion that allows it to weather stress and maintain a
continuity of operations.
Tier 2: It refers to a bank's supplementary capital, such as undisclosed
reserves and unsecured subordinated debt instruments that must have an
original maturity of at least five years.
Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult
to accurately calculate and more difficult to liquidate.
INTRODUCTION: FDI in BANKING SECTOR
FDI is basically a cross - border investment. Foreign Direct Investor generally acquires
Shares or Bonds of the Investment enterprise that give voting power or control over the
company. FDI generally includes Mergers & Acquisitions, Building new Facilities, etc.

FDIs can be achieved by one of two strategies:

 The first strategy is for the company to set up new factories and plants from the
scratch. This method is called as a „Greenfield Investment‟. Companies like
McDonald's and Starbucks tend to use the Greenfield approach when expanding
overseas.
 The second FDI strategy is through cross-border mergers and acquisitions that
involve acquiring an existing foreign enterprise in the country of interest. This
method is called a „Brownfield Investment‟. An example of a brownfield
investment occurred in 2008, when the Indian truck company Tata Motors
acquired Land Rover and Jaguar from Ford. Tata Motors didn't have to build those
factories from scratch.
FDIs can also be classified into horizontal and vertical forms. A company investing in the
same business abroad that it operates domestically is a case of a horizontal FDI. On the
other hand, vertical FDI occurs if a company invests in a business that plays the role of a
supplier or a distributor.

FDIs help less-developed and developing nations to overcome their Saving - Investment
gap, which limits the level of domestic investment. FDIs fill such gaps by bringing
foreign investment into the country. They also help in bridging gaps in management,
technology, entrepreneurshipand skills.

Growth of FDI IN Banking Sector:

The banking industry in India has shown remarkable progress in financial health and
offering employment since the last few years. The banking sector continues to remain a
highly dominant sector in India in spite of financial slowdown. Because of globalization,
many Indian banks are competing at global level on the virtue of their innovative
products and sound financial status.

Foreign Direct Investment plays an important role for the economy of the host country as
it not only provides opportunities to enhance economic development but also opens
several doors to optimize national earnings by employing all the resources effectively. FDI
has contributed a lot in enhancing efficiency of the Indian banking sector, creating
innovative financial products and improving capitalization of banks by making them
adaptable to changing market conditions.

Since the year 1990, the banking sector in India has undergone many drastic changes.
Initially, Indian government has contributed to the equity of a large number of public
 sector banks in order to enhance their capital adequacy levels. After that, the Government
has tried to improve the structure of the Indian banking sector by offering licenses to
latest generation of private sector banks. This step was highly successful, as most of the
banks introduced modern technology to excel in the competition by opening branches
and ATMs across the India in order to acquire customers from their competitors. In
recent times, the Indian government has taken an important step by allowing foreign
banks to take over Indian private sector banks.

The Indian Government always encourages foreign banks to strengthen their presence in
the Indian banking sector. Recently, the RBI has announced important policy
changes with regard to Foreign Direct Investment (FDI) in Indian banking
sector. Here are these important guidelines –
 Foreign Direct Investment (FDI) of up to 49% from different sources will be allowed in
private sectors banks of India on the automatic route.
 According to the government guidelines, fresh shares issue under automatic route will not
be available to foreign investors who have technical or financial collaboration in the allied
or similar field. Such category of foreign investors will have to take approval from Foreign
Investment Promotion Board (FIPB).
 Foreign bank which has branch in India is eligible for FDI in private sector banks, after
taking approval from the RBI, subject to the limit of 49% mentioned above.
 The RBI has allowed foreign investors to set up new branches in rural India and weak
banks with an investment of up to 74 percent.
 The 74 percent limit will include all the investment done under Portfolio Investment
Scheme (PIS) by NRIs and FIIs along with the all the shares acquired by OCBs. It also
includes Private placements, IPOs and GDR/ADRs along with acquisition of shares from
current shareholders.
 The aggregate foreign holding in private bank from different sources will be permitted up
to 74% of entire paid up capital of the private bank. Apart from this, at least 26% of the
entire paid up capital should be held by residents.

Benefits of FDI in Indian Banking Sector:

 Transfer of technology from overseas countries to the domestic market

 Ensure better and improved risk management in the banking sector
 Assures better capitalization
 Offers financial stability in the banking sector in India

Problems faced by Indian Banking Sector:

FDI in Indian banking sector resolves the following problems often faced by various
banks in the country:

 Instability in financial matters

 Innovativeness in financial products or schemes
  Technical developments happening across various foreign markets
 Non-performing areas or properties
 Poor marketing strategies
 Inefficiency in management
 Changing financial market conditions

Impact of FDI in Indian Banking Sector:

In 2011, the number of projects in the Indian financial services sector increased by
21%, whereas the value of FDI projects increased by 75%. Despite a high growth
potential, FDI in the industry remains low compared with other rapidly developing
economies, due to capital account convertibility, capital lock-ins and numerous
regulations. About 22% of the financial services companies surveyed said that capital
convertibility is the main concern faced by investors and 21% believed that capital
lock-ins are a key challenge in the sector. However, the demand for a wide array of
financial services products, ranging from credit to insurance, is growing. Currently,
only 47% of the Indian population has access to banking facilities, while only 15% of
the total insurable populations have life insurance coverage. This is a tiny portion of
the giant Indian market, underlining the domestic growth potential in the sector.
Industry experts anticipate India will become the world‟s third-largest banking
market by 2025 and the third-largest life insurance market by 2015. India‟s vast
potential in financial services, and particularly in insurance, will increasingly attract
investors as the GOI relaxes restrictions on investment. According to our survey, 38%
of financial services companies believe that relaxing Insurance Regulatory and
Development Authority (IRDA) caps on marketing commissions will attract more
foreign participation in the sector, while 26% feel that it will be made more attractive
by relaxing FDI caps.
BANKS AS INTERMEDIARIES:

Banks are a critical intermediary in what is called the payment system, which helps an
economy exchange goods and services for money or other financial assets. Also, those with
extra money that they would like to save can store their money in a bank rather than look for
an individual that is willing to borrow it from them and then repay them at a later date. Those
who want to borrow money can go directly to a bank rather than trying to find someone to
lend them cash Transaction costs are the costs associated with finding a lender or a
borrower for this money. Thus, banks lower transactions costs and act as financial
intermediaries—they bring savers and borrowers together. Along with making transactions
much safer and easier, banks also play a key role in the creation of money.

BANKS AS FINANCIAL INTERMEDIARIES

An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—
that is, an institution that operates between a saver who deposits money in a bank and a borrower who
receives a loan from that bank. Financial intermediaries include other institutions in the financial market
such as insurance companies and pension funds, but they will not be included in this discussion because
they are not considered to be depository institutions, which are institutions that accept
money deposits and then use these to make loans. All the funds deposited are mingled in one big pool,
which is then loaned out. Figure 1 illustrates the position of banks as financial intermediaries, with
deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the
banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the
loans, not to firms that are suffering losses and may be unable to repay.

Fig
ure 1. Banks as Financial Intermediaries. Banks act as financial intermediaries because
they stand between savers and borrowers. Savers place deposits with banks, and then
receive interest payments and withdraw money. Borrowers receive loans from banks
and repay the loans with interest. In turn, banks return money to savers in the form of
withdrawals, which also include interest payments from banks to savers.