Basel III norms may dull banks in the short run

Implementation of Basel III norms in India would result in erosion of banks' profitability (return on equity), said experts.

“Basel III adoption would decrease Return On Equity and in the short run bank stocks would be less attractive to investors,” said Prof T T Rammohan, of IIM Ahmedabad, speaking at FICCI-IBA conference in Mumbai.

The norms are to be implemented over a six year horizon starting January 1, 2013. Full implementation is expected to be achieved by January 1, 2019.

“Risk would also reduce simultaneously due to enhanced safety and re-rating of banking stocks would eventually occur.”

The norms entail increasing the percentage of capital to be set aside by banks to counter contingencies and improve the banking sector's ability to absorb shocks arising from financial and economic stress.

To implement Basel III, the Indian Banking system requires a capital of Rs 6-8 lakh crore by 2019.

On the one hand, RBI has been advocating a cap on banks' net interest margins and on the other, also asking banks to pursue financial inclusion – a concept which by default in high margin in nature, said experts.

“If the market environment (competition) restricts net interest margins to 2.5 per cent, return on assets can be increased only if banks shore up their fee income or decrease their operating expenses,” said Mr R K Bakshi, ED Bank of Baroda.

“For this, pricing of fee-based products should be appropriately done and PSU banks should also concentrate on increase their front end sales force to up volume.”

Adoption of Basel III norms is expected to reduce the risk of spill over of shocks from the financial economy to the real economy. For instance, during the credit crisis of 2008, liquidity across the world dried up sharply and availability of credit to businesses became scarce.

In their assessment of the macroeconomic impact of the transition to the new bank capital and liquidity standards, the Financial Stability Board and Basel Committee of Banking Supervision ascertained that “each one percentage point increase in bank's actual ratio of tangible common equity to risk-weighted assets will lead to a decline in the level of GDP relative to its baseline path by about 0.20 per cent after implementation is completed.”

The period of implementation was assumed to be four years in this case.

Risk coverage

Basel III norms advocate raising the quality of capital to absorb shocks, consistency in the global definition of what constitutes capital, and adequate disclosure on capital quality to enhance comparability between two financial institutions. The model also envisages enhancement of risk coverage to constrain leverage by banks and introduce additional safeguards against risk of models going awry.

Buffers

The norms specify two additional buffers, the first a capital conservation buffer of 2.5 per cent (to build buffers during periods of boom so that they may be utilised during periods of stress). The other is a countercyclical buffer of 2.5 per cent for ensuring the macro economic factors are taken into account when capital requirements are assayed.

The second buffer has been mooted to ensure that losses incurred in a downturn after a period of excessive credit growth do not spark a vicious cycle and spill over as a downturn in the real economy, squeezing liquidity which then is again transmitted back to the banking sector.

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