Basel III Accord

Conceptual Framework of Basel III Accord

Basel III is the third installment in the regulatory framework designed by the BCBS to
strengthen the banking sector. The continuous efforts to reduce the risks associated
with the financial sector are further developed from the Basel I and II framework.
Hence, the regulatory measures aim is to improve the ability to absorb shocks from
the financial and economic stress. This will be accomplished through improving the
risk management and governance, as well as by strengthening the banks‘ transparency
and disclosures.

The regulatory framework is complex and consists of the same three pillars as Basel II
with a few additional requirements and enhancements. Pillar I consists of minimum
capital requirements and liquidity requirements, and will again be the focus as they
demonstrate the capital strength of the bank. Through these requirements, the Basel
III regulation aims to strengthen the banking sector by raising both the quality and
quantity of the regulatory capital base, as well as by raising additional adequate
capital buffers.

Basel Accords in the Banking Industry

Bank executives are in a difficult position. On the one hand their shareholders require
an attractive return on their investment. On the other hand, banking supervisors
require these entities to hold a substantial amount of expensive capital. As a result,
banks need capital efficient business models to prosper. Banking regulators and
supervisors are in a difficult position as well. Excessively conservative capital
requirements may lessen banks' appetite for lending, endangering economic growth.
Excessively light capital requirements may weaken the resilience of the banking
sector and cause deep economic crises.

Objectives of Basel III Accord

Basel III is a set of international banking regulations developed by the Bank for
International Settlements in order to promote stability in the international financial
system. The purpose of Basel III is to reduce the ability of banks to damage the
economy by taking on excess risk. With that in mind, banks must hold more capital

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against their assets, thereby decreasing the size of their balance sheets and their ability
to leverage themselves. While these regulations were under discussion prior to the
financial crisis, their necessity is magnified as more recent events occur.

Relevance of Basel III Accord for the Banking Industry

The necessity of the Basel III in enhancing soundness and stability in the banking
sector cannot be over-emphasized. Nout Wellink, Chairman of the Basel Committee
on Banking Supervision has indicated that the proposed amendments reflected under
Basel III would ensure that certain risks relating to trading activities, securitizations
and exposure to off-balance sheet vehicles are better reflected in minimum capital
requirements, risk management practices and disclosures to the public (Bank for
International Settlement, 2010).

Basel III has no doubt, been a great improvement on the previous Accord and its
relevance in ensuring prudent risk management cannot be underestimated. The
increase in common equity requirement to 4.5% and Tier 1 Capital (going concern) to
6% will further boost the banks‘ resilience to stress. The introduction of Capital
Conservation and Counter Cyclical buffers of 2.5% of Common Equity Tier 1 and
between 0 to 2.5% of Risk Weighted Assets respectively could go a long way to cover
excessive risk taking such as sub-prime lending, securitization and other off-balance
sheet items. Besides, the inclusion of trading and off-balance sheet transactions and
attachment of more weight to securitization and derivatives have the potential to
check excessive risk taking and provide better buffer for banks. In addition to these,
risk management practices would also be improved through the calculation of Credit
Valuation Adjustment Capital Charge to cover mark-to-market losses on counterparty
risk to over-the counter Derivatives and stress testing. One of the major feature
associated with the global financial crises was huge debt associated with top banks in
the United States such as Lehman Brothers Bear Stearns, Morgan Stanley and Merrill
Lynch. In responding to this, Basel Committee on Banking Supervision introduced
Leverage Ratio of not less than 3% to avoid excessive borrowings by international
banks. The introduction of Liquidity Coverage Ratio under Basel III is a plus and
clearly shows how concern the Basel Committee on Banking Supervision is with
regards to liquidity risk. The Net Stable Funding Ratio which was initially proposed
in 2010 was re-proposed in January 2014. The Committee issued its final Net Funding

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Ratio in October 2014. The Liquidity Coverage Ratio and Net Stable Funding Ratio
would enable that Banks would to meets their obligations when they fall due and to
avoid mismatch between assets and liability. Disclosure requirement under Basel II
are also enhanced under Basel III. New disclosure requirements such as full
reconciliation of all regulatory capital items to the balance sheet, separate disclosure
of all regulatory amendments, description of key characteristic of capital instruments,
disclosure of all limits of capital and minima, disclosure of Tier 1 Capital and other
capital ratios would boost public access to company information and aid in investor
decision makings. Last but not least, the more stringent risk management practices
and public disclosure are likely to improve investor confidence and protection.

In spite of the improvements detected under Basel III, some writers hold the view that
though it is necessary to improve the soundness and stability of banking system, the
Accord is not sufficient in ensuring total prudent risk management. According to
Laurens (2012), the dependence on national supervisors and authorities to implement
the Basel III as pertained during the Basel II is likely to slow down the
implementation process and meeting of timeline as evidenced in Basel II. Lauren
(2012) assertion was based on the premise that one needs to take into consideration
varied national policies, cultures, regulatory framework and so on. Even though, this
may be true, it is important to accommodate these diverse factors to make the Accord
easily adaptable to prevailing conditions within the host nation. Where the Basel
Committee on Banking Supervision deems it fit to revise the implementation
timetable it can do so within a reasonable period. The Committee has already
extended the completion period twice - from 2015 to March 31, 2018 and further
extended to March 31, 2019 (Bank for International Resettlements, n.d.). Byres
(2012) also believes that Basel III is not sufficient because the full set of policy
reforms needed to address a future occurrence of financial crisis has not been
completed. Byres (2012) indicates the need for robust implementation by putting in
place compelling measures to ensure that the requirements within the Basel III are
fully implemented by national authorities and within time limits, and upgrade
supervisory capacity is very critical.

Undoubtedly, Basel III like any regulatory or supervisory framework could have not
been without limitations since predictions of future conditions cannot always be
accurate. In fact, the proponents of this Accord would recognize that Basel III is a

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means of enhancing prudent risk management and not an end in itself. Besides,
prudent risk management is a process and not an event. Thus there is the need to
periodically review the existing framework and to improve on them based on
prevailing conditions. Whether Basel III would lead to prudent risk management in
banking depends on certain factors and a continuous assessment of it. Like the Basel
II, national regulators or supervisors are being depended on to ensure compliance by
banks under their jurisdiction. How well Basel III enhances prudent risk management
in the banking system would depend on:

1. How equipped these national supervisors are in terms of understanding the

rudiments of the Accord itself and how they are applied,

2. Adequate logistics and human resource with requisite experiences and

qualifications amongst others.

3. Regular training of these supervisors by Basel Committee on Banking Supervision

is therefore very significant.

In addition, the role of auditors in successful implementation of Basel III is critical.

The role of auditors have not been clearly stated under Basel III. Incorporation of the
role of auditors through training and collaboration will go a long way to enhance
compliance of Basel III‘s requirements. Furthermore, the Basel Committee would still
rely on the banks to calculate various capital and capital buffer requirements. In the
past, unethical behavior on the part of some banks‘ officials brought doomed to the
whole financial system. However, there are not clear sanctions under Basel III like the
previous ones to deter such behaviors. Inclusion of stringent sanctions in future
framework are therefore recommended if the Accords would enhance prudent risk
management in the banking system.

Basel III in the Indian Banking Industry

Introduction to Basel III Capital Norms for Indian Banking

The reform package concerning to capital regulation, together with the enhancements
to Basel II framework and amendments to market risk framework is aimed at
improving the quality, consistency, and transparency of the capital base. With the
disclosure of all the elements of capital required to be disclosed along with a detailed
reconciliation to the published accounts, it is expected that the transparency of capital

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base would be improved. This would in turn also improve the market discipline under
Pillar 3 of the Basel II framework.

Measures are initiated towards enhancing risk coverage. Currently, the counterparty
credit risk in the trading book covers only the risk of the counterparty default. The
Basel III norm include an additional capital charge for ‗credit value adjustment‘
(CVA) risk which captures risk of mark-to-mark losses due to deterioration in the
credit worthiness of the counterparty. The risk of interconnectedness among ‗larger
financial firms‘ will be better captured through a prescription of 25% adjustment to
the to the ‗asset value correlation‘ (AVC) under IRB approaches to credit risk. In
addition, the guidelines on counterparty credit risk management with regard to
collateral, margin period of risk management requirements have been strengthened.

The capital conservation buffer (CCB) has been proposed in order to ensure that
banks build up capital buffers during normal times which can be drawn down as
losses are incurred during stressed period. These capital conservation rules are
designed to avoid breaches of minimum capital requirement during the times of crisis.
As a result, besides the minimum total capital (MTC) of 8 %, banks will be required
to hold a capital conservation buffer of 2.5 % of RWAs in the form of common equity
to withstand future periods of stress bringing the total capital to RWAs to 10.5%. The
capital conservation buffer in the form of common equity will be phased-in over a
period of four years in a uniform manner of 0.625% per year, commencing from
January 1, 2016.

In addition to CCB, a countercyclical capital buffer within a range of 0 – 2.5% of

common equity or other fully loss absorbing capital would be put into effect
according to domestic circumstances. The aim of countercyclical capital buffer is to
achieve the broader macro-prudential goal of protecting the banking sector from
periods of excessive aggregate credit growth. This countercyclical capital buffer will
only be in effect whenever there is excess credit growth that results in a system-wide
build-up of risk and would be an extension of the capital conservation buffer range.

Further, measures are initiated supplementing the risk-based capital requirement with
a Leverage Ratio. A simple, transparent, non-risk based regulatory leverage ratio has
been introduced under Basel III. Accordingly, the capital requirements will be
supplemented by a non-risk based leverage ratio, which is proposed to be calibrated

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with a Tier 1 leverage ratio of 3%. The ratio will be captured with all assets and off-
balance sheet (OBS) items at their credit conversion factors and derivatives with
Basel II netting rules and a simple measure of potential future exposure ensuring that
all derivatives are converted in a consistent manner to a ―loan equivalent‖
amount. The ratio will be calculated as an average over the quarter.

Basel III Accord Capital Adequacy Requirements

As a response to the aftermath of global financial crisis (GFC), with a view to

improving the quality and quantity of regulatory capital, RBI has stated that the
predominant form of Tier I capital must be common equity; as it is critical that banks‘
risk exposures are backed by high quality capital base. As a result, under Basel III
guidelines, total regulatory capital will consist of the sum of the following categories:

1. Tier 1 Capital (going-concern capital)

a. Common Equity Tier 1

b. Additional Tier 1

2. Tier 2 Capital (gone-concern capital)

Furthermore, in addition to the minimum Common Equity Tier I capital of 5.5%

of RWAs, banks are also required to maintain a capital conservation buffer
(CCB) of 2.5% of RWAs in the form of common equity Tier I capital.
Consequently, with full implementation of capital ratios 62 and CCB the capital
requirements are summarised in table-2.1 here below:

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 TABLE - 2.1
Regulatory Capital requirements in India as per Basel III

Sl. As % to
Regulatory Capital
No. RWAs
(i) Minimum common equity Tier I ratio 5.5
(ii) Capital conservation buffer (comprised of common equity) 2.5
Minimum common equity Tier I ratio plus capital
(iii) 8.0
conservation buffer [(i)+(ii)]
(iv) Additional Tier 1 capital 1.5
(v) Minimum Tier 1 capital ratio [(i) +(iv)] 7.0
(vi) Tier 2 capital 2.0
(vii) Minimum total capital ratio (MTC) [(v)+(vi)] 9.0
Minimum total capital ratio plus capital conservation buffer
(viii) 11.5
[(vii)+(ii)]
Source: Basel III guideline issued by RBI

Components of the Common Equity Tier 1(CET) Capital

Elements of Common Equity Tier 1 capital will remain the same under Basel III.
Accordingly, the Common Equity component of Tier 1 capital will comprise the
following:

(i) Common shares (paid-up equity capital) issued by the bank which meet the
criteria for classification as common shares for regulatory purposes;
(ii) Stock surplus (share premium) resulting from the issue of common shares;
(iii) Statutory reserves;
(iv) Capital reserves representing surplus arising out of sale proceeds of assets;
(v) Other disclosed free reserves, if any;
(vi) Balance in Profit & Loss Account at the end of the previous financial year;
(vii) Banks may reckon the profits in current financial year for CRAR
calculation on a quarterly basis provided the incremental provisions made
for non-performing assets at the end of any of the four quarters of the
previous financial year have not deviated more than 25% from the average

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 of the four quarters. The amount which can be reckoned would be arrived at
by using the following formula:
EPt= {NPt – 0.25*D*t}

Where;
EPt = Eligible profit up to the quarter‗t‘ of the current financial year; t
varies from 1 to 4
NPt = Net profit up to the quarter‗t‘
D= average annual dividend paid during last three years
(viii) While calculating capital adequacy at the consolidated level, common
shares issued by consolidated subsidiaries of the bank and held by third
parties (i.e. minority interest) which meet the criteria for inclusion in
Common Equity Tier 1 capital (please see paragraph 3.4 of Section B); and
(ix) Less: Regulatory adjustments / deductions applied in the calculation of
Common Equity Tier 1 capital [i.e. to be deducted from the sum of items (i)
to (viii)].

Components of Additional Tier 1 Capital

Elements of Additional Tier 1 capital will remain the same. Additional Tier 1 capital
consists of the sum of the following elements:

(i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with

the regulatory requirements
(ii) Stock surplus (share premium) resulting from the issue of instruments
included in Additional Tier 1 capital;
(iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital,
which comply with the regulatory requirements;
(iv) Any other type of instrument generally notified by the Reserve Bank from
time to time for inclusion in Additional Tier 1 capital;
(v) While calculating capital adequacy at the consolidated level, Additional
Tier 1 instruments issued by consolidated subsidiaries of the bank and held
by third parties which meet the criteria for inclusion in Additional Tier 1
capital and

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 (vi) Less: Regulatory adjustments / deductions applied in the calculation of
Additional Tier 1 capital [i.e. to be deducted from the sum of items (i) to
(v)].

Components of Tier 2 or Supplementary Capital

Elements of Tier 2 capital will largely remain the same under existing guidelines
except that there will be no separate Tier 2 debt capital instruments in the form of
Upper Tier 2 and subordinated debt. Instead, there will be a single set of criteria
governing all Tier 2 debt capital instruments.

(i) General Provisions and Loss Reserves

a. Provisions or loan-loss reserves held against future, presently unidentified
losses, which are freely available to meet losses which subsequently
materialize, will qualify for inclusion within Tier 2 capital. Accordingly,
General Provisions on Standard Assets, Floating Provisions7, Provisions
held for Country Exposures, Investment Reserve Account, excess provisions
which arise on account of sale of NPAs and ‗countercyclical provisioning
buffer8‘ will qualify for inclusion in Tier 2 capital. However, these items
together will be admitted as Tier 2 capital up to a maximum of 1.25% of the
total credit risk-weighted assets under the standardized approach. Under
Internal Ratings Based (IRB) approach, where the total expected loss
amount is less than total eligible provisions, banks may recognise the
difference as Tier 2 capital up to a maximum of 0.6% of credit-risk weighted
assets calculated under the IRB approach.
b. Provisions ascribed to identified deterioration of particular assets or loan
liabilities, whether individual or grouped should be excluded. Accordingly,
for instance, specific provisions on NPAs, both at individual account or at
portfolio level, provisions in lieu of diminution in the fair value of assets in
the case of restructured advances, provisions against depreciation in the
value of investments will be excluded.
(ii) Debt Capital Instruments issued by the banks;
(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference
Shares (PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) /
Redeemable Cumulative Preference Shares (RCPS)] issued by the banks;

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(iv) Stock surplus (share premium) resulting from the issue of instruments
included in Tier 2 capital;
(v) While calculating capital adequacy at the consolidated level, Tier 2 capital
instruments issued by consolidated subsidiaries of the bank and held by third
parties which meet the criteria for inclusion in Tier 2 capital
(vii) Revaluation reserves at a discount of 55% ;
(viii) Any other type of instrument generally notified by the Reserve Bank from
time to time for inclusion in Tier 2 capital; and
(ix) Less: Regulatory adjustments / deductions applied in the calculation of Tier 2
capital [i.e. to be deducted from the sum of items (i) to (vii)].

TABLE-2.2
Regulatory Capital Ratios in the year 2018

(i) Common Equity Tier 1 7.5% of RWAs

(ii) Capital conservation buffer 2.5% of RWAs
(iii) Total CET 1 10% of RWAs
(iv) PNCPSa/PDIb 3.0% of RWAs
2.05% of RWAs
(v) PNCPS/PDI eligible for Tier 1 capital {(1.5/5.5) ×
7.5% of CET 1}
0.95% of
(vi) PNCPS/PDI not eligible for Tier 1 capital
RWAs(3-2.05)
(vii) Eligible Total Tier 1 capital 9.55% of RWAs
(viii) Tier 2 issued by the bank 2.5% of RWAs
2.73% of RWAs
(viii) Tier 2 capital eligible for CRAR {(2/5.5) × 7.5 %
of CET 1}
0.23% of RWAs
(ix) PNCPS/PDI eligible for Tier 2 capital
(2.73 – 0.23)
0.72% of RWAs
(x) PNCPS/PDI not eligible for Tier 2 capital
(0.95 – 0.23)
(xi) Total available capital 15.50%
4.78% (12.28%
+ 2.5%)(CET1–
(xii) Total capital 10% + AT1–
2.05% + Tier 2–
2.73)
Perpetual Non-Cumulative Preference Shares (PNCPS)
a
b
Perpetual Debt Instruments (PDI)
Source: RBI guidelines on Basel III

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Regulatory Adjustments/ Deductions

The existing guidelines stipulate the banks to make regulatory adjustments/deductions

from either Tier 1 capital or 50% from Tier 1 and 50% from Tier 2 capital. Therefore,
it has been possible for some banks under the current standards to display strong Tier
1 ratios with limited tangible common equity. On the other hand, the crisis has
revealed that credit losses and write-downs were absorbed by common equity.
Therefore, it is the common equity base which best absorbs losses on a going concern
basis. Consequently, under Basel III, most of the deductions are required to be applied
to common equity both at solo and consolidated level.

The regulatory adjustments/deductions would include;

(i) Goodwill and all Other Intangible Assets

(ii) Deferred Tax Assets (DTAs)

(iii) Cash Flow Hedge Reserve

(iv) Shortfall of the Stock of Provisions to Expected Losses

(v) Gain-on-Sale Related to Securitisation Transactions

(vi) Cumulative Gains and Losses due to Changes in Own Credit Risk on Fair
Valued Financial Liabilities

(vii) Defined Benefit Pension Fund Assets and Liabilities

(viii) Investments in Own Shares (Treasury Stock) and

(ix) Investments in the Capital of Banking, Financial and Insurance Entities.

Disclosure Requirements

In order to ensure adequate disclosure of details of the components of capital which

aims at improving transparency of regulatory capital reporting as well as improving
market discipline, banks are required to disclose the following:

(i) A full reconciliation of all regulatory capital elements back to the balance
sheet in the audited financial statements;

(ii) Separate disclosure of all regulatory adjustments and the items not deducted
from Common Equity Tier 1

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 (iii) A description of all limits and minima, identifying the positive and negative
elements of capital to which the limits and minima apply;

(iv) A description of the main features of capital instruments issued; and

(v) Banks which disclose ratios involving components of regulatory capital (e.g.
―Equity Tier 1‖, ―Core Tier 1‖ or ―Tangible Common Equity‖ ratios) must
accompany such disclosures with a comprehensive explanation of how these
ratios are calculated.

Banks are also required to make available on their websites the full terms and
conditions of all instruments included in regulatory capital. The Basel Committee will
issue more detailed Pillar 3 disclosure shortly, based on which appropriate disclosure
norms under Pillar 3 will be issued by RBI.

During the transition phase banks are required to disclose the specific components of
capital, including capital instruments and regulatory adjustments which are benefiting
from the transitional provisions.

Transitional Arrangement

S. Capital ratios and deductions from common equity will be fully phased-in and
implemented as on March 31, 2017. The phase-in arrangements for banks operating in
India are indicated in the following Table-2.3

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 TABLE - 2.3
Basel III: Transitional Arrangements - Scheduled Commercial Banks in India
(Excluding LABs and RRBs)
(% of
RWAs)
Minimum capital ratios March March March March March March
2013 2014 2015 2016 2017 2018
Minimum Common Equity
4.5 5.0 5.5 5.5 5.5 5.5
Tier 1(CET1)
Capital conservation buffer
0.625 1.25 1.875 2.5
(CCB)
Minimum capital ratios March March March March March March
2013 2014 2015 2016 2017 2018
Minimum CET1+ CCB 4.5 5.0 6.125 6.75 7.375 8.0
Minimum Tier 1 capital 6.0 6.5 7.0 7.0 7.0 7.0
Minimum Total Capital* 9.0 9.0 9.0 9.0 9.0 9.0
Minimum Total Capital +CCB 9.0 9.0 9.625 10.25 10.875 11.5
Phase-in of all deductions
20 40 60 80 100 100
fromCET1 (in %)
The difference between the minimum total capital requirement of 9% and the Tier 1 requirement can be met with Tier 2 and
higher forms of capital.
Source: RBI Basel III Guidelines

It is clarified that capital instruments, which no longer qualify as non-common equity,

Tier I capital or Tier II capital (e.g. Tier 2 debt instruments with step-ups) will be
phased out beginning January 1, 2013. Fixing the base at the nominal amount of such
instruments outstanding on January 1, 2013, their recognition will be capped at 90%
from January 1, 2013, with the cap reducing by 10 % points in each subsequent year.
This cap is applicable to Additional Tier 1 and Tier 2 instruments separately and
refers to the total amount of instruments outstanding, which no longer meet the
relevant entry criteria. To the extent, an instrument is redeemed, or its recognition in
capital is amortised, after January 1, 2013, the nominal amount serving as the base is
not reduced. The minimum capital conservation ratios a bank must meet at various
levels of the common equity Tier I capital ratios.

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 TABLE - 2.4
Minimum capital conservation standards for individual bank

Common Equity Minimum Capital Conservation Ratios

Tier I Ratio (expressed as a percentage of earnings)
5.5% - 6.125% 100%
>6.125% - 6.75% 80%
>6.75% - 7.375% 60%
>7.375% - 8.0% 40%
>8.0% 0%

The countercyclical capital buffer is aimed at ensuring that banking sector capital
requirements take account of the macro-financial environment in which banks
operate. The buffer will be implemented through an extension of the CCB and vary
between zero and 2.5% of RWAs, depending on the extent of the build-up of system-
wide risks.

Leverage ratio

The Basel Committee will test a minimum tier 1 leverage ratio of 3% during the
parallel run period from 1 January 2013 to 1 January 2017. During the period of
parallel run, banks should strive to maintain their existing level of leverage ratio but,
in no case the leverage ratio should fall below 4.5% as per RBI guidelines. Final
leverage ratio requirement would be prescribed by RBI after the parallel run taking
into account the prescriptions given by the Basel Committee.

Liquidity risk measurement

Basel 3 has introduced two new liquidity standards to improve the resilience of banks
to liquidity shocks. In the short-term, banks will be required to maintain a buffer of
highly liquid securities measured by the LCR. The standard requires that the ratio be
no lower than 100%. The objective of the NSFR is to promote resilience over a longer
time horizon by creating additional incentives for banks to fund their activities with
more stable sources of funding on an ongoing basis. The standard requires that the
ratio be no lower than 100%.

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Transition phase for the liquidity standards under Basel 3

LCR, including any revisions, will be introduced as on 1 January 2015 in phased

manner (starting at 60%) and the NSFR, including any revisions, will move to a
minimum standard by 1 January 2018. The LCR and NSFR will thus become binding
for the banks from 1 January 2015 and 2018, respectively i.e. banks will have to
ensure that they maintain the required LCR and NSFR at all times starting from
January 2015 and January 2018, respectively.

RBI Guidelines: For Indian Banks on Basel III

Reserve Bank of India in response to the comprehensive reform package entitled

―Basel III: A global regulatory framework for more resilient banks and
banking systems‖ of the Basel Committee on Banking Supervision (BCBS) issued
guideline for Indian Banks in December 2010.

The major highlights of the draft guidelines are:

Minimum Capital Requirements

 Common Equity Tier 1 (CET1) capital must be at least 5.5% of risk-weighted

assets (RWAs);

 Tier 1 capital must be at least 7% of RWAs; and

 Total capital must be at least 9% of RWAs.

Capital Conservation Buffer

 The capital conservation buffer in the form of Common Equity of 2.5% of

RWAs.

Transitional Arrangements

 It is proposed that the implementation period of minimum capital requirements

and deductions from Common Equity will begin from January 1, 2013 and be
fully implemented as on March 31, 2019.

 Capital conservation buffer requirement is proposed to be implemented

between March 31, 2014 and March 31, 2019.

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 The implementation schedule indicated above will be finalized taking into
account the feedback received on these guidelines.

 Instruments which no longer qualify as regulatory capital instruments will be

phased-out during the period beginning from January 1, 2013 to March 31,
2022.

Enhancing Risk Coverage

 For OTC derivatives, in addition to the capital charge for counterparty default
risk under Current Exposure Method, banks will be required to compute an
additional credit value adjustments (CVA) risk capital charge.

Leverage Ratio

 The parallel run for the leverage ratio will be from January 1, 2013 to January
1, 2017, during which banks would be expected to strive to operate at a
minimum Tier 1 leverage ratio of 5%. The leverage ratio requirement will be
finalized taking into account the final proposal of the Basel Committee.

Issues and Challenges of Basel III for Indian Public and Private Sector Bank

The new Basel III will definitely pose some impact on Indian Banks. These are:

Higher Capital Requirement: Presently, in India, most banks' common equity ratio
falls in the range of about 6-10 per cent. According to the norms laid down by RBI,
Indian lenders have to maintain a minimum common equity ratio of 8% and total
capital ratio of 11.5% by 2019. As of March 2017, state-run banks maintain an
average common equity ratio of 8.5%. Some public sector banks (PSBs) are however
struggling and already four lenders are under the prompt corrective action plan of the
regulator. This, without infusing any fresh equity, even while taking into account the
marginal increase in capital requirement. According to RBI estimates, state-run banks
would require Rs 1 lakh crore while the entire banking sector would require an
additional capital requirement of Rs 5 lakh crore to meet the norms by 2019. Banks
may not be able to raise the required capital, which would curtail their ability to lend.

Pressure on Return on Equity: To meet the new norms, apart from government
support a significant number of banks have to raise capital from the market. This will
push the interest rate up, and in turn, cost of capital will rise while return on equity

16
(RoE) will come down. To compensate the RoE loss, banks may increase their
lending rates. However, this will adversely affect the effective demand for loan and,
thereby, interest income. Further, with effective cost of capital rising, the relative
immobility displayed by Indian banks with respect to raising fresh capital is also
likely to directly affect credit offtake in the long run. All these affect the profitability
of banks.

Pressure on Yield on Assets: On account of higher deployment of funds in liquid

assets that give comparatively lower returns, banks' yield on assets, and thereby their
profit margins, may be under pressure. Further higher deployment of more funds in
liquid assets may crowd out good private sector investments and also affect economic
growth.

Action Required from Banks

To address these issues and to protect their profitability margins, banks need to look
beyond regulatory compliance and take proactive actions - assessing their lines of
business, level of risk profiles, economizing capital and drawing up funding
strategies.

In this regard the following strategies need to be adopted:

Change in Business Mix: Since retail banking has a comparatively lower risk weight
compared to corporate banking (except in the case of clients who are A rated and
above), the impact on higher allocation of capital will be less on retail banking.
Further, in corporate banking, as chances of a default in short-term loans is less, on an
average, compared to chances of a default in long-term loans, banks need to shift
towards short-term/retail loans. And to take a granular approach to protect their
margins under the new Basel III norms.

Change in Customer Mix: Banks need to review their capital allocation to each
client segment and price it in line with the profile to ensure that capital is allocated to
segments that generate higher risk-adjusted returns.

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.

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Improvement in systems and procedures: Refining the rating model/data cleaning/
modernization of systems and procedures may help banks economies their risk-
weighted assets, which will help reduce capital requirements to some extent.

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References

1. Basel III – Implementation. (2020). Retrieved from https://www.fsb.org/work-

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