Introduction In the later part of the last decade the financial world witnessed severe turmoil due to the

contagion effect of the US subprime crisis and many banks in US and Europe either went bankrupt or were on the verge of bankruptcy. Several big banks had to be rescued by providing high bailout packages by the Government. The burden of the bailout package was borne by the common man as the money came from the tax payers. The crisis in the banking sector happened despite banks in US and Europe proclaimed adherence to Basel II norms. In fact just five days before the bankruptcy of Lehman Brothers in September 2008, it had boasted Tier 1 capital of 11%, three times more than the regulatory minimum. This raised questions about the efficiency of Basel II norms. Short Comings of Basel II Capital requirement ratio of 4% proved to be inadequate to withstand huge losses. The capital requirement was pro cyclical i.e. if the global economy expands and assets prices rise the country and the counter party risk associated with the borrower tend to decrease and thus capital requirement is lowered; however in the event of recession, the reverse

is also true thus raising capital requirement. Securitisation, a way of financing a

pool of assets which involves transferring them to a third party conduit, was incentivised by Basel 2. This enabled banks to reduce their capital requirement, take on growing risks and increase their leverage.

These short comings called for more stringent regulatory process. As a result Basel Committee on Banking Supervision (BCBS) addressed these problems by introduction of new enhanced regulatory framework known as Basel 3. Basel 3: Overview The key elements of the proposed Basel III guidelines include the following: Definition of capital made more stringent, capital buffers introduced and Loss absorptive capacity of Tier 1 and Tier 2 capital. Forward looking provisioning prescribed. Modifications made in counterparty credit risk weights. New parameter of leverage ratio introduced. Global liquidity standard prescribed.

Capital requirements of Basel 3 1 Minimum Capital requirement

Basel 3 introduces 2.5% capital conservation buffer to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. Counter Cyclical capital buffer Basel 3 introduces counter cyclical capital buffer ranging from 0 to 2.5% of banks risk weighted assets to take care of the risks that are built up in the banking system due to excessive credit growth. Leverage Ratio The leverage ratio is the ratio of a bank's

Under Basel 3 the total capital bank is required to hold is 8% of its risk weighted assets. Total capital includes

equity to the unweighted sum of its total assets Leverage Ratio= Tier I Capital/Exposure Leverage Ratio should be at least 3%.It is designed to put a cap on buildup of leverage as well as to introduce additional safeguards against financial risks Numerator includes Tier 1 capital i.e. Common equity tier 1 and additional Tier 1 Capital. Denominator is exposure which includes on balance sheet exposures, no netting of collateral, no netting of loans and funds etc.

Tier 1 Capital Tier I capital is core capital; this includes equity capital and disclosed reserves. It is used to absorb losses on going concern basis. Basel 3 norms require the ratio of capital to risk weighted assets to increase from 2% to 4.5%. Tier 2 Capital Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt, and more.

Capital Conservation Buffer

Impact of Basel 3 Common equity capital being the highest quality capital with banks increase in it would ensure that banks remains solvent even during time of financial crisis. Also the new proposals are to be implemented gradually over a period of 6 years beginning from 2013 extending to 2019 so that the banking sector can move to higher capital and liquidity standards while supporting lending to the economy.

Introduction of capital conservation buffer and counter cyclical buffer will drive firms away from sourcing short term funding there by impacting price and profit margins.

If different countries implement Basel 3 norms according to their own respective ways with respect to international regulatory it may lead to arbitrage opportunities that can disrupt the stability of entire financial systems.

However increase in the capital ratios by reducing lending results into less access to credit and thereby increasing the borrowing costs. These norms are more likely to impact small and medium sized firms. These norms would reduce return on equity (RoE) for banks in the range of 35%. The strong improvement in transparency and the emphasis placed on market discipline is one of the positives of the Basel III proposals. The Basel committee arguments about the disclosures provided by the banks and states that they have been deficient till date. And applying market discipline will require a published To increase capital bases banks would have to reduce the issuance of dividends, share buybacks and discretionary bonuses and reduce spending costs. This would reduce the investor appetite for bank debt or equity. reconciliation of regulatory capital measures to the financial statements, the separate disclosure of all regulatory adjustments, the identification of all limits applied, and the description of the main features of hybrid capital instruments. It also requires rigorous computation of Stringent capital requirements might eliminate weaker banks and can lead us to earlier years of less competition and financial instruments; not good from the consumers point of view. leverage ratios to facilitate comparison of various financial metrics between different jurisdictions like GAAP and IFRS.

Impact of Basel 3 on Indian Banks Capital Requirements The proposed Basel 3 guidelines would improve the quality of Tier 1 capital, introduce capital conversation buffer and counter cyclical buffer which would be built during times of excessive growth and would be depleted during times of recession thereby acting as cushion during financial crisis.

The major concern comes with the introduction of two other liquidity ratios. This would call for additional capital to be created by banks which is approximately Rs 600,000 crore by Indian Banks by March 2019.

As regard to leverage ratio, Indian banks have comfortable Tier I capital of about 10%. Also liquidity ratio of most the Indian banks dont rely on short term or

Parameters

Basel Basel II III

India*

wholesale overnight funding. All of them more or less still follow the retail banking

Tier I capital

Tier I

4%

6%

6%

model. Also as per extant RBI stipulation, a good portion of resource mobilized is

Core 2% Tire I Tier I + Tier 2 Conservation buffer Counter Cyclical buffer Total capital requirements 8% NA NA 8%

4.5%

placed in SLR bonds, which would provide adequate liquidity during times of distress.

8%

9% Conclusion The lesson learnt from 2008-09 crisis have led to further refinement Basel 2 norms.

2.5% NA

02.5%

NA

As with Basel 2 norms, Basel 3 norms implies risk based capital regime. The new norms proposed by no means suggest the

10.5- 9% 13%

end of the story, still some of the refinement is needed which includes Identifying and treatment of systematically important financial instruments. Eligibility of non-common equity Tier 1 and Tier 2 instruments.

*-indicates rates currently prevailing in Indian banking system From the above table we can say that indian banks have enough tier 1 and tier 2 capital to meet Basel 3 requirements.

Basel 3 may not provide solution to all the problems faced by banking sector but however its a continuous effort on part of Basel Committee to enhance banking regulatory framework.