Understanding Banking System – Basel Norms and Banking Stability

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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.

Similarly, mechanisms to ensure their stability have also been developed. Some of the examples can be CRR; SLR; Basel conventions; regular directions of the RBI; Financial Stability and Development Council 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.

1. 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.

2. 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.

3.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:

1. 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.

2. 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.

3. 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.

 

Model questions

Prelims

1. Consider the following statements:

    1. Basel norms are mandatory for every member nation.

    2. India has not implemented Basel III norms till date.

Which of these is/are correct?

a) Only 1

b) Only 2

c) Both

d) None

 

Solution: b)

 

2. Consider the following statements key focus areas in the banking system:

    1. Merger of banks

    2. Regular disclosure of information to the Central bank

    3. Investment in risky assets

Which of these areas are dealt with by the Basel III norms?

a) 1 and 2

b) 2 and 3

c) 1 and 3

d) All of the above

 

Solution: b)

 

Mains

1. “The Indian banking system has been exposed to a lot of vulnerabilities in past few years due to the global economic climate.” Critically examine some of the important mechanisms available to address these vulnerabilities in India. (300 words)

2. The Basel III norms present a much safer regulation of the banking system than Basel II, yet it has not been implemented in India. Examine the key issues and challenges in their implementation and offer some solutions to address the same. (300 words)

  • alteracc34

    gr8 article, thanks Insights team… pls continue to post such articles on key issues…

  • dfgdgdfg

    quality article. Thanks a lot to the writer and insights.

  • Tahir Ahmed Majid

    Sir, kindly provide the link for PDF of the article also. That’ll be really helpful.

    • Shashwat Tiwary

      Use ‘Pocket’ app…you can save articles in it in a readable format. Its available for both android and windows ( laptops and phones)

  • Vivek B

    Although a nice article with focus on concepts, it has left some important concepts and has created a little confusion regarding some.

    Basel 2 norms rests on 3 main pillars- capital risk, market risk, supervisory risk. Market risk could also have been discussed and with better clarity on them.
    Basel 3 has CAMELS as its main concepts, it would have been great if this could have been linked to the article above. Also a little more focus could have been given to Basel 3 and concepts like free capital.

    The challenges and solutions are insightful.
    Thanks

    • roe

      Hi vivek,

      I think it does justice with the needs of the GS paper. More details could have made it better, but then there is always the chance that you are crossing the boundary of GS and entering that of the economics optional subject. Even in that so much detail is not required. Thats my view. One can surely disagree.

  • Rohit Kothari

    The article mentions 27 but there are 60 member banks in BIS.

    • Rohit Kothari

      sorry.. its correct 27 members in committee n 60 as member banks..

  • Chandu RedE

    A master piece 🙂

  • Thank u INSIGHT…..Good Piece Of Information……

  • Shalu

    great work insights..!! appreciate ur efforts 🙂

  • priya

    nice article..also a window into where to draw the line in gs 🙂

  • Is CAR additional to SLR,CRR? If so then ~26%+8% of money=34% not available for lending ,again added to that priority sector lending ~35-40% …then is it like only 25-30% of money with banks available for private sector/infra lending?

    @all, clarify my doubt

  • Vishwas Anand

    grt

  • suraj

    thanks ,informative.

  • Sanks

    Good Article will be helpful for my PO interview