Banking System – Basel Norms and Banking Stability
Introduction
Banking system is the backbone of any nation’s economy. For an economy to remain healthy and going, it is important that the banking system grows fast and yet be stable.
This catches the biggest dilemma of policymakers. How to achieve both the objectives simultaneously?
Over a period of time, several indicators have been developed which gauge the
depth and stability of the banking system. Examples can be Non-performing
assets, Capital adequacy ratio (CAR) etc.
In this section, we will talk about some of these indicators and mechanisms.
They have also been in news for quite some time – Basel III norms and Non-
Performing assets (NPAs).
We will try to first clarify the related concepts; then understand the seriousness of the issue; gauge their impact on the Indian economy and then offer some possible solutions as well as look into some of the committee’s reports which have examined the matter.
In this article (Part-1 of a two part series), we will only deal with Basel norms.
NPAs will be dealt with comprehensively in the next article.
About Basel Norms
Basel is a city in Switzerland which is also the headquarters of Bureau of
International Settlement (BIS). BIS fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations. Currently there are 27 member nations in the committee.
Basel guidelines refer to broad supervisory standards formulated by this group
of central banks- called the Basel Committee on Banking Supervision (BCBS). The set of agreement by the BCBS, which mainly focuses on risks to banks and
the financial system are called Basel accord.
The purpose of the accord is to ensure that financial institutions have enough
capital on account to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system.
So, if the Basel norms are banking standards, then who has the authority to
make them? Are they mandatory for every country?
As said earlier, the Basel Committee makes these norms. The Committee’s
decisions have no legal force. Rather, the Committee formulates supervisory standards and guidelines and recommends statements of best practice in the expectation that individual national authorities will implement them. In this way, the Committee encourages convergence towards common standards and monitors their implementation, but without attempting detailed harmonisation of member countries’ supervisory approaches.
So, India can either accept them or reject them depending on the kind of
financial system it wants. So far, we have implemented or wished to implement
all Basel norms.
Basel I
In 1988, BCBS introduced capital measurement system called Basel capital
accord, also called as Basel 1. It focused almost entirely on credit risk. It defined
capital and structure of risk weights for banks. Naturally if the capital with the
banks is adequate to cover the risks ( e.g. a power plant) they have invested in,
then the bank is safe.
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 1 guidelines in 1999. The Basel norms are set up by the Basel committee on Banking supervision.
It is important to understand that the Basel accords have been the result of cooperation by the countries over the years.
But why cooperate between member countries when banks operate within national boundaries?
It is because these banks lend not only to its country men but also other
nations. Also, private investors and sovereign nations take loans from banks across other nations. Further, the financial system of the world is so
interconnected that one incident of a banking collapse has its repercussions all over the world. There can be no better example that the 2008 Global recession.
Therefore, global cooperation on banking matters is a absolute necessity in today’s world. And, not only cooperation but also adoption of some uniform standards is also important.
Again, Why uniform standards?
Bankers and investors invest over the world preferably in markets where they get best returns. The markets will give returns only when the economy is stable.
And, economy will be stable only when the banking system is stable. Hence, it is important for investors and agencies to measure the stability of the banking
system. If all the nations adopt different standards, then calculating stability figures will be a big headache for investors.
Also, suppose some nations run banks on better standards i.e. better risk
management, better returns, lower exposure to volatile markets etc., then they have a better chance of getting foreign investment.
But, if all nations adopt uniform standards, then at least the investors can be
attracted by only the strength of the economy.
Hence, it is important to have uniform standards especially when it comes to the banking system which is so complex and vast.
The Basel norms try to achieve exactly the same. Till date three different Basel accords ( or norms) have come – each with a better safeguard than the next one.
Basel II
In 2004, Basel II guidelines were published by BCBS, which were considered
to be the refined and reformed versions of Basel I accord. The guidelines
were based on three parameters.
1. Banks should maintain a minimum capital adequacy requirement of 8% of
risk assets,
In India, such a practice is equivalent to maintaining a Capital Adequacy ratio
(CAR).
2. Banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that is credit and
increased disclosure requirements.
Increased disclosure requirements raise the confidence of investors and
depositors in the bank. The more transparent a bank is, the more stable it
is deemed to be.
3. Banks need to mandatorily disclose their risk exposure, etc to the central
bank.
This is important so that the central bank (RBI in India) is aware of the
risks that the banking system is going through.
There is a practice in India to publish bi-annual Financial Stability reports by the RBI. The latest report published recently is of June 2014.
Basel II norms in India and overseas are yet to be fully implemented.
You will find some technical words like risk exposure etc. in the text. We do not
need to go into details. We only need to know their general meaning.
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. Too much short-term funding makes the banks prone to risks. Banks generally rely on short-term funding because it is profitable.
Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. This was because the banking system was growing.
The world economy was growing too. Hence, what is sufficient earlier was not
sufficient now.
Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive. The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
Again we need not go in technicalities, just the broad picture.
This is how it was broadly done.
Capital
The capital requirement (as weighed for risky assets) for Banks was more than
doubled. ( e.g. 4.5% from 2% in Basel-II accord for common equity)
Leverage
Leverage basically means buying assets with borrowed money to multiply the
gain. The underlying belief is that the asset will return the investor more than
the interest he has to pay on the loan.
Obviously doing so is risky business. Thus the Basel III puts a limit on the banks
for doing this. The numbers are not important here. Getting the concept is
important.
Funding and liquidity
Banks can be subjected to a lot of risk if all depositors come and ask all their
money at the same time. This is a hypothetical situation but it has happened in real with Lehman Brothers – the bank whose collapse gave us the 2008
recession.
So, Basel III puts a requirement for the banks to maintain some liquid assets all
the time. Liquid assets are those which can be easily converted to cash.
In India, this practice can be correlated with that of maintaining CRR and SLR.
Implementation of Basel III norms in India
The RBI has postponed the implementation of these norms to 2019.
It is important to note that it is not easy to implement these norms as it requires
several changes in the present banking system.
There are several challenges in the successful implementation of Basel III norms.
- Higher capital requirement for banks – The private banks have the
autonomy to raise capital from the markets. But the Public sector banks
have to rely on the government mostly. The government has recently
decided to infuse 12000 Cr. rupees in the PSBs. In the coming years even
more will be required. - More technology deployment – Implementing the norms would
require much more sophisticated technology and management styles that
the Indian banks are presently using. Upgrading both will impose huge
cost on the banks and hurt their profitability in the coming years. - Liquidity crunch – Banks would need to invest more on liquid assets.
These assets do not give handsome returns usually which would reduce
the bank’s operating profit margin. Further higher deployment of more
funds in liquid assets may crowd out good private sector investments and
also affect economic growth.
The way ahead for the banks
To address these issues and to protect their profitability margins, banks need to look beyond regulatory compliance and take proactive actions.
In this regard the following strategies need to be adopted:
- Change in Business Mix – They will need to lend more to profitable yet
safe sectors. For e.g. corporate loans. But even corporate loans in India
have been under a lot of stress. Banks are facing increasing NPAs (we will
talk about it in the next article). Still they are safer and more profitable
than retail loans. Priority Sector lending (PSL) however limits their options. - 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. The RBI is thinking of introducing UID based mobile wallets to increase
the reach of the financial system. Perhaps the banks can tie up with wallet
operators based on some innovative business model. There are many
opportunities. - Improvement in systems and procedures – Refining the systems and
procedures may help banks economise their risk-weighted assets, which
will help reduce capital requirements to some extent. It is possible that
they would impose cost in the short-run, but they would yield great
returns in the future.
Conclusion
It is clear that the banking system in the coming times will have to go through a lot of rough weather. Increasing operational complexities, global interconnectedness and high economic growth worldwide will present several
challenges for the banks. While strategies like Basel III will of course address
these challenges, what is even more important is their proper implementation.
More than this, the banks will need to have a wider outlook. They must
anticipate changes in the Indian economic system and react accordingly. Indian banking regulations are one of the most stringent and consequently one of the safest in the world. Let us evolve each time better and stronger.
These notes are provided by ‘Dnyanjyoti Free Learning University’ to help students to learn and prepare for their Government exams.
