Dodgy way of shoring up bank finances

On March 1, the RBI made a bland announcement that, on a review of the existing capital adequacy guidelines, it had made some amendments to the treatment of certain balance sheet items for the purposes of determining banks' regulatory capital.

This took the markets by storm and bank stocks zoomed. The press release stated that the review was carried out with a view to further aligning the definition of regulatory capital with the internationally adopted Basel III capital standards, issued by the Basel Committee on Banking Supervision (BCBS).

The short point of the amendments is that banks will now be able to reckon unrealised gains from revaluation as part of Tier I capital or what is now known as Common Equity Tier 1 (CET1). Till now, this was something the regulators in India — always considered to be very conservative — had never conceded. Accumulated “other comprehensive income” as unrealised gains are euphemistically called is reckoned as part of capital in many countries.

The three amendments made on March 1 are as follows. First, revaluation reserves arising from change in the carrying amount of a bank’s property consequent upon its revaluation would be considered as common equity tier 1 capital (CET1) instead of Tier 2 capital as hitherto. These would continue to be reckoned at a discount of 55 per cent. Second, foreign currency translation reserves arising due to translation of financial statements of a bank’s foreign operations to the reporting currency may be considered as CET1 capital. These will be reckoned at a discount of 25 per cent.

Deferred tax assets arising due to timing differences may be recognised as CET1 capital up to 10 per cent of a bank’s CET1 capital. The media reports suggest that these amendments would provide the Indian public sector banking system with Rs 35,000 crore of additional Tier 1 capital thereby providing their balance sheets with the much needed room for Additional Tier 1 and Tier 2 capital to ensure adequate capital.

To a large extent this announcement made up for the market’s disappointment in the Union Budget of the announcement of only Rs 25,000 crore for recapitalisation of banks -- with no mention of where the balance would come from.

Tier 1 capital is intended to ensure the solvency of a bank as a going concern. Hence, it is important that the quality of the capital reckoned as Tier 1 capital is such that it can be depended upon to absorb losses. For example, although foreign exchange translation gains have been recognised by accountants as part of reserves, in India there has always been a difference in the accounting treatment and the regulatory treatment of foreign exchange translation.

Foreign exchange fluctuations are unpredictable. While Indian banks with overseas branches would gain from the translation difference of the overseas branches being reckoned as capital, the question is whether this is prudent if we apply the test of going concern. It is not until the overseas branch is closed that the translation gains can be actually used for capital to support the bank.

Similarly is the case of revaluation of property –no doubt the RBI circular stipulates conditions like readily saleable, based on two valuation reports etc.; but given the stickiness and illiquid nature of property markets, it is difficult to see how revaluation gains can be called upon to be truly loss absorbing. In fact, it is quite interesting that when Basle 2 allowed this only in Tier 2, Basle 3 that claims to have ensured better quality capital has provided a window for jurisdictions to include this under CET1.

Let’s look at the Basle bible.

The current Basle 3 document (Para 52 of the June 2011 revision) includes in Common Equity Tier 1 the following items:

•Common shares and stock surplus (share premium)

•Retained earnings

•Accumulated other comprehensive income and other disclosed reserves;

•Common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital.

Certain regulatory adjustments are applied in the calculation of Common Equity Tier 1

Accumulated other comprehensive income (bullet three above) refers to various unrealised losses and gains – for example a major part of it could be the marked to market losses or gains on the (available for sale) AFS category of securities held by banks. A footnote to the third bullet in the Basle document states, “There is no adjustment applied to remove from Common Equity Tier 1 unrealised gains or losses recognised on the balance sheet. Unrealised losses are subject to the transitional arrangements set out in paragraph 94 (c) and (d). The Committee will continue to review the appropriate treatment of unrealised gains, taking into account the evolution of the accounting framework.”

What this means is that the Committee has not yet given its final verdict on taking the benefit of the unrealised gains. In aligning itself with the international accounting and maybe even regulatory practice, has the RBI given up its conservative and prudent stance on regulatory capital?

The writer is a former Deputy Governor, RBI

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