COMMENTARY

Economic & Political Weekly EPW august 31, 2013 vol xlviii no 35
17
Cost of Implementing Basel III
Subhasish Roy
The views expressed here are personal and not
those of the bank.
Subhasish Roy (s.roy@idbi.co.in) is Deputy
General Manager, Risk Department, IDBI Bank.
Implementing Basel III will
increase government borrowing
which may worsen the countrys
scal situation, and could curtail
bank credit. But Basel III is
expected to provide a more stable
banking system and help Indian
banks compete globally through
improved risk-management
systems. This article proposes a
strategy to minimise the pain
of implementing the framework
in India.
T
he Basel Committee on Banking
Supervision (BCBS) that was set
up in 1974 by a group of central
bank governors has been setting stand-
ards since 1988 when the Basel I accord
was signed. It emphasised the importance
of adequate capital by categorising it
into two tier I (core capital) and tier II
(supplementary capital). The accord re-
quired banks to hold a capital equivalent
to 8% of risk-weighted value of assets.
Though Basel I was adopted by many
countries, it had a number of aws. For
instance, it was risk insensitive, it did
not differentiate between credit risk and
other types of risk, and it could easily be
circumvented by regulatory arbitrage.
1 Origin of Basel II
To address these limitations, the BCBS
formalised Basel II in 1999 in a consulta-
tive paper, and a nal version of the new
capital adequacy framework was released
in 2004. The important features of Basel II
were the following:
It aimed to align banks capital with their
basic risk proles and give impetus to the
development of sound risk management.
The capital framework was built on
three naturally reinforcing pillars. The
rst covered regulatory capital for credit
risk, market risk and operational risk. The
second addressed the need of an effective
supervisory review by allowing supervisors
to evaluate a banks assessment of its
own risk to determine whether it was
reasonable. It thus provided implicit
incentives to banks to develop their own
internal models for risk evaluation. The
third provided effective market discipline
through greater disclosure by banks.
It addressed the issues emerging
from the divergence of regulatory capital
requirements and accurate economic
capital calculations.
1.1 Cost of Basel II
Compared to Basel I, Basel II was highly
complex, more risk sensitive, and com-
prehensive. So, effective implementation
of Basel II depended on the availability of
reliable, accurate and timely data, which
implied more cost. In Basel II, the capital
calculation was to be based on credit risk,
market risk and operational risk. Due to
the different calculation, the capital re-
quirement in credit risk alone was higher
compared to Basel I. Taking together all
three risks credit, market and operational
the total capital charge for Basel II was
much higher than Basel I. Apart from the
cost of higher capital, the compliance
cost in Basel II was very high on account
of the data, modelling, and compliance
burden. The Centre for the Study of Fi-
nancial Innovation (CSFI) mentioned in
one of its reports that the cost of Basel II
implementation in Europe was estimated
to exceed $15 million. In India, to the best
of my knowledge, no exclusive study has
been made on the cost of compliance,
but according to Reserve Bank of India
(RBI) estimates, the cost of equity capital
requirements was Rs 670-725 billion.
1.2 Origin of Basel III
Some of the major causes of the 2008
global nancial crisis were excess li-
quidity, too much leverage, too little
capital, and inadequate liquidity buffers.
In addition, there were shortcomings in
risk management, corporate governance,
market transparency, and quality of
supervision. This pointed to systemic loop-
holes in the Basel II framework, which
was considered to have a more risk-
sensitive approach compared to Basel Is
one-size-ts-all approach.
The main shortcoming of Basel II was
that in good times, when banks were
performing well and the market was
willing to invest capital in them, there
were no signicant additional capital re-
quirements. But, in difcult times, when
banks needed more capital, the market
was averse to investing capital in them.
This affected many international banks,
and the vicious cycle inuenced the global
nancial market, ultimately leading to
the failure of many banks. The Basel
Committee introduced a comprehensive
reforms package through the Basel III
framework to address both rm-specic
and broader systemic risk. Learning
lessons from the crisis, its aim was to
minimise the probability of such a crisis
COMMENTARY
august 31, 2013 vol xlviii no 35 EPW Economic & Political Weekly
18
recurring. The objectives improve the
shock-absorbing capacity of each bank
as the rst line of defence. Interestingly,
Basel III does not replace Basel II, but is
an enhancement of it. The enhancements
of Basel III are mainly in four broad
areas (i) an increase in the level and
quality of capital; (ii) an introduction of
liqui dity standards; (iii) modications
in provisioning norms; and (iv) better
and more transparent comprehensive
disclosures. The details of the proposed
Basel III norms as prescribed by the RBI
are in Table 1.
Though Basel III has a superior approach
to Basel II in terms of both systemic and
bank-specic risk, its cost of implemen-
tation will be much higher. Apart from
the additional cost of net equity capital
(difference between capital requirements
under Basel III and Basel II) of around
Rs 930 to Rs 1,025 billion, as estimated
by the RBI, there will be some other costs
to the economy.
2 Cost to the Economy
2.1 Higher Fiscal Decit
In India now, the common equity ratio of
most banks falls in the range of 6% to
10%. In my opinion, banks may be able to
comply with the higher capital require-
ment as per Basel III norms at least until
nancial year (FY) 2015 without infusing
fresh equity, even taking into account the
marginal increase in capital requirement
due to pressure on return on equity (ROE).
However, with increasing minimum
capital ratios and loan growth outpacing
internal capital generation in most public
sector banks (PSBs), the shortfall of capital
will mount between 2015-16 and 2017-18,
mainly due to introduction of a capital
conservation buffer (CCB). Some PSBs are
likely to fall short of the revised core capital
adequacy requirement and will depend
on government support to augment it.
As around 70% of the banks in India are
in the public sector, capital requirements
will be more from PSBs. The additional
equity capital requirement in PSBs under
Basel III norms in the next ve years
works out to around Rs 1,400-1,500 bil-
lion (Table 2). The government being
the major shareholder in PSBs, the main
burden will be on it. The degree of the
governments nancial burden will de-
pend on the degree of recapitalisation by
the government to these banks. If the
government maintains the existing share-
holding pattern, its recapitalisation bur-
den will be around Rs 900-1,000 billion.
Based on the estimated gures in
Table 2, if one assumes the government
continues with the existing shareholding,
its total nancial burden will be around
Rs 910 billion (1.10% of gross domestic
product; GDP) in the next ve years. This
is expected to increase government bor-
rowing requirements per year to around
Rs 182 billion.
As shown in Figure 1, during the period
FY 2005 to FY 2012 there was a strong
positive correlation (value of R has been
worked out at 0.93) between government
borrowing and scal decit (FD). Con-
sidering this trend, it is expected that
higher government borrowing will push
up the countrys FD in the future as well.
2.1.1 Estimation of Fiscal Decit
Considering GDP at a factor cost of
Rs 82,326.52 billion in FY 2012 and a per
year government borrowing requirement
of Rs 182 billion (mainly due to Basel III
implementation), Indias FD is expected
to increase by 22 bps each year. While
calculating this gure, the following as-
sumptions have been made.
(i) The governments other borrowing
requirements will not increase signicantly
in the next ve years even after the Kelkar
Committees tax/GDP ratio, growth of dis-
investment receipts, and subsidies.
(ii) As per the Kelkar Committee report
and the latest budget estimates, Indias
Table 1: Proposed BASEL III Norms for Banks as Per RBI (%)
13 April 14 March 15 March 16 March 17 March 18 March
(a) Minimum common equity 4.50 5.0 5.5 5.5 5.5 5.5
(b) Capital conservation buffer (CCB) 0 0 0.6 1.3 1.9 2.5
(c) Minimum core equity (a + b) 4.5 5.0 6.1 6.8 7.4 8.0
(d) Additional Tier 1 capital 1.5 1.5 1.5 1.5 1.5 1.5
(e) Min Tier 1 capital (a + d) 6.0 6.5 7.0 7.0 7.0 7.0
(f) Tier 2 capital 3.0 2.5 2 2 2 2
(g) Minimum total capital (e + f) 9.0 9.0 9.0 9.0 9.0 9.0
(h) Minimum total capital (g+b) including CCB 9.0 9.0 9.6 10.3 10.9 11.5
(i) Counter cyclical buffer * NA NA NA NA NA NA
(J) Minimum total capital (h+i) 9.0 9.0 9.6 10.3 10.9 11.5
* Operational guidelines will be issued separately.
Source: RBI.
Table 2: Estimated Equity Capital Requirements for Indian Banks under Basel III (Rs billion)
Public Private Total
Sector Banks Sector Banks
(A) Additional equity capital requirements under Basel III 1,400-1,500 200-250 1,600-1,750
(B) Additional equity capital requirements under Basel II 650-700 20-25 670-725
(C) Net equity capital requirements under Basel III (A-B) 750-800 180-225 930-1,025
(D) Of additional equity capital requirements under Basel III
for public sector banks (A)
Government share (if present shareholding pattern is maintained) 880-910
Government share (if shareholding is brought down to 51%) 660-690
Market share (if the governments shareholding pattern is
maintained at present level) 520-590
Assumes risk-weighted asset growth of 20% per annum, and that internal accruals will be around 1% of risk-weighted assets.
Source: RBI.
3.9
4
3.3
6
6.5
4.9
5.9
2.5
9.3
4.8
6.5
8.4
8.4
6.7
7
9.5 9.6
5.15
6.71
3.16
3.28
4.71
4.01
6.51
Figure 1: Government Borrowing and Fiscal Deficit (2005-12)
7
6
5
4
3
2
1
0
Source: RBI and CMIE.
- 12
- 10
- 8
- 6
- 4
- 2
- 0 | | | | | | | | | |
Fiscal deficit
GDP
Government borrowing
2005 2006 2007 2008 2009 2010 2011 2012
COMMENTARY
Economic & Political Weekly EPW august 31, 2013 vol xlviii no 35
19
FD is estimated at 5.3% in FY 2013, 4.8%
in FY 2014, and 3.9% in FY 2015. It is esti-
mated to be 3% by FY 2017.
(iii) Indias GDP will grow around 5.5%
to 8% per annum in the next ve years,
considering the current estimates of
the RBI and targeted growth of 8%
by 2015.
Based on the above assumptions and
taking into account the 22 bps increase
in FD per annum, it is predicted that
Indias FD in FY 2017 will be above the
governments medium-term target of 3%
(Table 3). It may be mentioned that if
there is a delay in recovery of the world
growth rate and actual growth of tax
revenue and disinvestment receipts are
lower than the projected gure, Indias
FD will be much higher than 3.22% by
2017. In addition, if banks provisions in-
crease and protability falls in the next
ve years, it will increase the requirement
of capital, which will further increase
the countrys FD.
According to the data for the period
2005 to 2012, FD had a negative correla-
tion (value of R has been worked out at
-0.62) with GDP growth (Figure 1). Based
on the past trend, it may be said that a
higher FD could dampen future savings,
investments, and GDP growth.
In the neoclassical and Keynesian
views, higher FD pushes up interest rates,
and this is seen in India during the
period FY 2008 to FY 2013 (estimated),
where FD has exhibited a positive corre-
lation with long-term deposit rates (LTDR)
(with a one-year lag) (Figure 2). Consid-
ering this, it can be said that due to rising
LTDR, banks average lending rates will
also show an upward movement with
some lag effect, which may also affect
Indias credit growth and thereby the
growth of the economy.
2.2 Lower Credit Offtake
To meet the new norms, a signicant
number of public and private sector
banks will have to raise capital from
Table 3: Estimates of Fiscal Deficit (2013 to 2017)
FY 2013 FY 2014 FY 2015 FY 2017
FD (%) projected
by the government 5.3 4.80 3.90 3.0
Estimated FD after full
recapitalisation of
PSBs due to Basel III 5.3 5.02 4.12 3.22
Source: RBI
the market, which will
further push up the
interest rate. This will
mean higher cost of capi-
tal and lower return on
equity. According to a
CARE study, return on
equity is expected to fall
by around 80-100 bps for every 1% in-
crease in common equity ratio. Consid-
ering this, banks whose core equity ra-
tios are low are expected to have pres-
sure on return on equity in the range of
100 bps to 200 bps (Table 4).
Pressure on return on equity will be
more on PSBs, whose core equity ratio in
general is much lower than private
sector banks. Given that about 70% of
the banks are in the public sector, the ef-
fect on prot of the banking sector could
be signicant. To compensate for the re-
turn on equity loss, banks may increase
their lending rates. Further, with rising
effective cost of capital, the relative immo-
bility displayed by Indian banks on raising
fresh capital is also likely to directly affect
credit offtake in the long run. In addition,
on account of the introduction of a li-
quidity coverage ratio (LCR) in Basel III,
banks need to keep more funds in liquid
assets (mostly government securities),
which may crowd out private sector in-
vestments and thereby affect the countrys
growth. The credit offtake, which has
declined in FY 2012 compared to FY 2011,
may come down further. Thus consider-
ing the positive correlation between GDP
growth and credit offtake (Figure 3), it
may be said that GDP growth (Q2 of FY
2013), which is lower at 5.3, is expected
to come down further in the future.
From the above, it is evident that
implementing Basel III will increase gov-
ernment borrowing, which may worsen
Table 4: Core Equity Ratio and Capital Adequacy
Ratio (as on 31 March 2012)
Core Equity Capital Adequacy
Ratio Ratio
Total public sector banks (%) 7.8 13.36
Total private sector banks (%) 11.5 14.82
Source : CARE and IBA.
Figure 2: Fiscal Deficit and Long-Term Deposit Rates (2008 to 2013)
Source: RBI and CMIE.
2.5
6
6.5
4.9
5.9
6.15
8.5
9
8.5
7.75
8.75
9.25
Fiscal deficit LTDR (1 year lag)
2008 2009 2010 2011 2012 2013
10
8
6
4
2
0
Figure 3: GDP Growth and Credit Offtake
Source: RBI and CMIE.
45
35
25
15
5
0
6.5
26.7
39.6
6.7
9.3 9.6 9.5
7
8.4 8.4
28.5
23
17.8 17.1
21.3
16.8
1 2 3 4 5 6 7 8
Credit Offtake
GDP
Corrigendum
AB Bank Limited
Balance Sheet and Schedule to Balance Sheet as on 31st March, 2013 for
AB Bank Limited published in the edition of June 29-July 6, 2013, Vol XLVIII,
Nos 26 & 27.
In the Balance Sheet as on 31st March 2013, page 368
(1) Contingent Liability - Schedule 12, the amount of Rs 217,634,498 may
be read as Rs 329,902,748.
In the Schedules Forming Part of Balance Sheet, page 370
(1) Schedule 12: Contingent Liabilities: (IV) Other items for which the Bank is
contingently liable Rs 1,421,681,439 may be read as: (IV) Other items for
which the Bank is contingently liable Forward Contracts Rs 112,268,250
(2) Amount appearing in TOTAL Rs 1,639,315,937 may be read as
Rs 329,902,748.
Kelkar committee on fiscal consolidation
COMMENTARY
august 31, 2013 vol xlviii no 35 EPW Economic & Political Weekly
20
the countrys scal situation. In addition,
due to higher lending rates and crowding
out of private investments, Indias growth
may be severely affected as it needs more
credit to achieve a higher growth path at
this crucial juncture. More credit is re-
quired to (i) shift the Indian economy
from services to manufacture where the
credit intensity is higher per unit of GDP
than that for services; (ii) to double its
investments in infrastructure; and (iii) to
implement the governments and RBIs
goal of nancial inclusion.
3 Proposed Strategy
Considering the high cost of implement-
ing Basel III and its probable impact
on the Indian economy and nances of
the government, the following steps
may be adopted.
(1) The date of implementing a minimum
common equity for PSBs could be post-
poned by at least two or even three years.
This is because minimum tier I capital is
already much higher in private and foreign
banks compared to PSBs. In the case of
PSBs, the principal owner and shareholder
is the government, and these banks are
much more controlled. Further, in India,
the playing eld of private banks and
PSBs is not the same. Apart from normal
banking business, PSBs have to comply
with government directives on waiver
schemes for farmers, nancial inclusion,
directed lending, and so on. These are not
so stringent for private players. Hence
this move will soften the governments
burden of allocating additional amounts
for capital in the immediate future, and
also give some relief to PSBs to protect their
prot margin by not having any addi-
tional pressure on return on equity.
(2) As per Basel norms, the requirement of
capital is linked to the risk-weighted assets
growth of a bank. In the case of private
sector banks, the capability of raising
capital in Basel III is to be met by their
shareholders on the basis of the perform-
ance of each banks share price, which
reects the banks protability. In the
equity market, investors will put money on
more protable banks to maximise their
earnings. However, in the case of PSBs,
there are no specic criteria for allocat-
ing capital to them. In the current set-up,
a major portion of capital is allocated by
the government to PSBs based on its
shareholding pattern. In this, all the banks,
whether their asset books are growing at
a desired rate or not and whether their
return on equity is high or not, are equally
eligible for capital from the government.
To recapitalise PSBs, the government has
to raise around Rs 910 billion in the next
few years. As capital is scarce, and the
government has to borrow at a market
rate without getting a proportionate
return, it is important that there be
specic criteria to allocate capital to these
banks. In my opinion, allocation of capital
needs to be based on two factors asset
growth, and the risk prole of banks.
The risk prole is to be calculated taking
into account the various categories of
risk such as credit risk, market risk,
liquidity risk, compliance risk, opera-
tional risk, and earning at risk. To quan-
tify the risk in each area, suitable risk
parameters need to be xed. Based on
this, the government needs to monitor
the combined risk prole of banks.
Banks that grow at the target growth
rate (xed by the government) and
whose risk prole is below a predeter-
mined trigger level will be eligible for
getting the full amount of their capital.
The others will get proportionately less
capital. This mechanism will incenti-
vise banks to grow at a desired level
with a lower risk prole, and penalise
those that do not. With higher growth
and a lower risk prole, the nancial
performance of PSBs will improve,
which in turn will improve their return
on equity and share price. The govern-
ment being the major shareholder, this
will increase its earning.
4 Conclusion
Basel III implementation has some cost
to the Indian economy in the short run.
Though Indian banks remained sound
through the nancial crisis, India is a part
of the global economy and cannot fully
deviate from Basel III norms. As Basel III
is expected to provide a stronger and more
stable banking system, it will in the long
run help Indian banks compete globally
through improved risk-management sys-
tems. If one compares the cost of bank
failure without the new framework to the
cost of implementing it, it would be wise to
implement Basel III in India after incorpo-
rating the two measures suggested above.
References
Basel Committee on Banking Supervision (2010):
Basel Committees Response to the Financial
Crisis: Report to the G20, Bank for International
Settlements, Basel.
Ministry of Finance (2012): Report of the Commit-
tee on Roadmap for Fiscal Consolidation (Kelkar
Committee), Available at http://nmin.nic.in/
reports/Kelkar_ Committee_ Report.pdf
Rangarajan, C and D K Srivastava (2004): Fiscal
Decits and Government Debt: Implication for
Growth and Stabilisation, Economic & Political
Weekly, Vol 40, No 27.
Reserve Bank of India (2011 and 2012): Report on
Trend and Progress of Banking in India, 2010-11
and 2011-12, RBI, Mumbai.
Roy, Subhasish (2012): Tweak Those Basel III
Norms, Financial Express, 10 October.
Subbarao, D (2012): Basel III in International and
Indian Contexts: Ten Questions We Should Know
the Answers For, Inaugural Address at the An-
nual FICCI-IBA Banking Conference, Mumbai, 4
September, available at http://www. bis.org/
review/r120904b.pdf
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