BASEL III in India and Impact With the implementation of RBI capital regulation norms on Basel-III from January

1, 2013, there is a pressure on banks to have more equity capital. According to Basel Committee on Banking Supervision "Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector". Thus, we can say that Basel 3 is only a continuation of effort initiated by the Basel Committee on Banking Supervision to enhance the banking regulatory framework under Basel I and Basel II. This latest Accord now seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency. Basel III measures aim to: Improve the banking sector's ability to absorb shocks arising from financial and economic stress Improve risk management and governance Strengthen banks' transparency and disclosures. In gist, Basel III guidelines are aimed to improve the ability of banks to withstand economic and financial stress as the new guidelines are more stringent than the earlier requirements for capital and liquidity in the banking sector. Basel III has been designed to address the weaknesses that become too obvious during the 2008 financial crisis. The intent of the Basel Committee seems to prepare the banking industry for any future economic downturns. The framework enhances bank-specific measures and includes macro-prudential regulations to help create a more stable banking sector. With the introduction of Basel III in India, banks will have to Maintain a minimum 5.5% in common equity (as against the current 3.6%) by March 31, 2015. Create a capital conservation buffer (consisting of common equity) of 2.5% by March 31, 2018. Maintain a minimum overall capital adequacy of 11.5% (against the current 9%) by March 31, 2018. Increase the loss absorption capacity of banks Additional Tier I capital and not to issue additional Tier I capital to retail investors.

Risk-based capital ratios to be supplemented with a leverage ratio of 4.5% during parallel run. Banks allowed adding interim profits (subject to conditions) for computation of core capital adequacy. Deduct the entire amount of unamortised pension and gratuity liability from common equity Tier I capital for the purpose of capital adequacy ratios from January 1, 2013 Impact on Banks Incremental equity requirements appear achievable as long as banks can find investors for the riskier Additional Tier I capital. However, Indian banks would need as much as Rs.3.95 trillion capital over the next six years, out of which the requirements for common equity would be Rs.1.3-2.0 trillion, for Additional Tier I Rs. 1.9 trillion, and for Tier II Rs. 1 trillion. A sizeable part (around 80%) of the common equity requirement relates to Public Sector Banks (PSBs). Of the PSBs total equity requirement, the Government of Indias (GOIs) share would be Rs. 0.3 to 0.8 trillion (going by the Union Finance Ministrys current stance of maintaining 58% shareholding in PSBs). The incremental equity requirement appears manageable, considering past trends in capital mobilisation. Indian banks raised over Rs. 1 trillion in equity during the period 200708 to 2011-12, of which around 54% was mobilised by PSBs and 46% by private banks. However, if one were to exclude 2007-08, when some large banks took advantage of the buoyancy in the capital markets to raise around Rs. 0.5 trillion, the equity raised by Indian banks over the four years from 2008-09 to 2001-12 was around Rs. 0.5 trillion; of this, around 60% was infused by the Government of India (GOI) and Life Insurance Corporation. While the equity target may appear easy at first glance, it may not prove to be so eventually, given that the RBI has also introduced loss-absorption features in Additional Tier I capital instruments. These features could well limit investor appetite for these instruments as it would be difficult to assess the probability of their conversion into equity or of a principal write-down in a stress scenario (and the extent of the resultant loss). In case banks are unable to mobilise the required Additional Tier I and the gap is bridged by raising common equity, the incremental equity requirement may go up to as high as Rs. 3.24 trillion over the next six years where the GoIs share could be a staggering Rs. 1.2-1.7 trillion. Increase of 25-30 bps (basis points) in lending yields may help most banks protect their return on equity. As of December 31, 2011, around 15 PSBs have less than 8% core Tier I capital and of these eight have less than 7%. When banks with low core Tier I shore up their capital to around 9% (required 8% + 1% cushion), their return

on equity (ROE) could drop by 1-4%, which they could seek to compensate by raising their lending yields (as long as competitive forces allow them to do so), increasing fee income, or rationalizing costs. In ICRAs view, since the largest bank would also need to shore up its capital and may therefore raise its lending yields to compensate for the ROE loss, the smaller banks may also have an opportunity to do the same. However, banks with relatively low core capital (less than 7%) would have to take a knock on their ROE. As for private banks, most of them being well capitalised already, the transition to Basel III may not impact their earnings significantly. In fact, their competitive position could improve when the PSBs raise their lending yields. However, at the same time, the upside potential for private banks could be limited by the higher minimum core capital requirement. Further, as the countercyclical buffer has to be set annually, when activated (in times of stress), the buffer requirement could introduce an element of variation in lending rates and/or the ROE of banks. So, it can be concluded that with the advent of Basel III, high risk- high return lending strategy without proper appraisal, may become tough. Moreover, Indian economy is likely to face some tough times ahead due to compilation of these norms which is spread over years. However, these norms are likely to build an additional cushion to make Indian financial structure less prone to the future financial crisis.