Basel III Guidelines—Will our banks prove equal to the challenge posed by the RBI?

In the face of stringent Basel III guidelines, banks have to take effective steps to meet these challenges and a series of strategies are required to be planned and executed by all the stakeholders to reach the goalpost in good time without any hiccup

The draft guidelines on Basel III capital requirements released by Reserve Bank of India (RBI) last month are more stringent than those proposed by Basel Committee on Banking Supervision (BCBS), in terms of higher requirement of common equity capital, stricter leverage ratios, and shorter time span for implementation, and the banks may need to raise about Rs2.7 trillion equity capital by March 2017, according to a report issued by CRISIL on 3rd January 2011.  

If we take the Crisil report at face value, the magnitude of the problem can be realized, when we compare the fresh capital required to be raised with the present net worth of all the commercial banks. The net worth of all the commercial banks covering capital and reserves as on 31st March, 2011 was Rs 5,09,891 crore and the additional  capital required during the next five years is estimated by Crisil at Rs2,70,000 crore, which is more than 52% of the present net worth of all the banks put together. Though a part of it can be raised through Tier II capital and a part of it through plough back of profits, this will be the biggest challenge for the banking sector of our country for the next five years. 

While it is not known what prompted the RBI to take a ‘holier than thou’ attitude in stipulating stricter norms a and shorter time-frame than those prescribed under the Basel III guidelines, more so when our country’s economy is in a state of flux, it will, no doubt, result in developing a strong and stable banking system in India, that can stand the test of times and the country can feel proud, if what is stipulated by RBI is achieved without any mid-term course correction. As nearly 70% of the banking business in our country is in the public sector, this requires concerted efforts on the part of the banks, RBI and the government to source this large capital requirement of the banks and the regulatory authorities should provide the necessary wherewithal for the banks to comply with these requirements in good time, without any hiccups. 

Though the finance minister has been promising adequate injection of capital to the public sector banks during the current fiscal, banks are yet to get a clear picture of capital infusion, and this only shows how vulnerable is the position of a large number of public sector banks in our country. The largest public sector bank of our country had to recently face the ignominy of being downgraded by a credit rating agency for not being able to comply with the existing minimum regulatory capital requirements, but this had little impact on the government which is still grappling with the budget deficit to make any firm commitment to the bank concerned. Against this background, it is rather ironic that the RBI has proposed stringent norms than mandatorily required, though these norms are yet to be formalized for implementation. 

Whether RBI will modify these norms or not on the basis of feedback to be received from the banks and other stakeholders, the fact remains that banks have a mammoth task before them to ensure that they prove equal to the challenge posed before them by the regulator. 

It is, therefore, worthwhile to identify in advance the steps required to be taken by all the stakeholders in the interest of the smooth implementation of the Basel III norms as and when finalized. A series of steps required to be initiated by the banks; the govt. and the RBI can be summarized as under. 

What the banks will have to do:

First and foremost, the profitability ratios of the banks need to be strengthened by improving income and reducing expenditure with a view to plough back as much profits as possible into reserves. The PSU banks have been feeling the pinch of low valuation of their shares in the bourses which makes their job of raising capital from the public difficult. While the price earning multiples (PE) of all public sector banks, barring SBI, are in the region of low single digits, the new generation banks still enjoy  double digit PE multiples, which is indicative of the aversion of investors towards PSU banks. This is due to, among other things, the lower profitability of PSU banks and the high incidence of non-performing assets (NPAs) in their portfolio. Against this background, the following are the important tasks cut out for the banks to improve their profitability and bring down NPAs in their books without hurting their customers. 

  • Primarily banks should initiate steps to conserve capital by introducing risk mitigation measures, which will not only bring down the impact of loans turning bad, but also help in reducing the burden of NPAs. This is an ongoing exercise and any laxity in this regard will only result in creating a demand for more capital. 
  • The banks have to improve their risk assessment tools and be wary of adverse selection, when they are flushed with funds, more so when the demand for credit is low and competition is tough in the market place.
  • In the case of priority sector lending, PSU banks in their anxiety to reach targets are tempted to relax their lending norms, which may result in accumulating NPAs, causing considerable damage to their loan portfolio. The banks have to guard against such temptations and ensure that the sanction of loans is based purely on merits and only after meeting all the required criteria, without being influenced by external factors. 
  • There is an urgent need to bring down the expenditure by improving efficiency at all levels in all the banks in our country.  One way to improve efficiency is to encourage customers to go for Internet banking and increased use of ATMs which will not only serve to bring down the pressure on banks’ counters, but will also result in saving considerable time for the staff, who otherwise get bogged down by routine transactions, which can efficiently be done though the online system now provided via the core banking solution up and running in all the commercial banks in the country. 

Banks today charge a fee for use of ATMs beyond a certain number of transactions per month. Banks should consider not only abolishing completely these charges, but also provide incentives for customers using the ATMs and also Internet banking at least for a couple of years till the customers develop a habit of dealing with the banks more through automated systems than through the physical visits to the branches. This can create a metamorphosis in the way in which customers deal with the banks, bringing down operating costs substantially in the long run. The banks should, however, ensure that their technology is robust and prevent any mishaps like hacking, etc and fully protect the interest of the customer. 

What the regulator can do:

The RBI as a regulator, in its own enlightened self interest, must also play a role no less than any other stakeholder in supporting the banks to meet these challenges, and following are a few strategies for their consideration. 

  1. All banks are required to deposit with RBI a good portion of their cash for meeting cash reserve requirements (CRR) stipulated by RBI, and this does not yield any return for the banks. Holding 6% of their total liabilities in non-yielding assets compelled a leading banker to say that the biggest NPAs of banks today is the cash held for meeting the CRR, causing considerable dent on their earnings. The government in their wisdom had withdrawn the payment of interest on these cash balances kept with RBI by amending the RBI Act a few years back, putting the banks in a bind of having to forego a sizeable part of their income for no fault of theirs. The RBI should now consider compensating the banks for this loss of income, and this can best be achieved, if not by amending the Act, by progressively reducing the CRR to a level of at least 3%, if not lower, within the next three years, which will go a long way to improve the profitability of banks. If this results in excess liquidity in the system, the RBI can use alternate methods to siphon off liquidity like open market operations or raising SLR, but bringing down CRR to a reasonable limit should be their priority in the interest of giving a push to the profitability of banks. 
  2. There is a need to improve corporate governance in public sector banks to create trust and confidence of the investors. While the RBI has now introduced separation of the post of chairman and managing director in all private sector banks, it is yet to do so in PSU banks. While the system of having a non-executive chairman and a separate whole-time managing director-cum-CEO has been working well in private banks, the time has come to implement this separation of posts even in public sector banks, to enhance the level of competence of management of banks. In fact the report of the Consultative Group of Directors of Banks and Financial Institutions headed by AS Ganguly, constituted by the RBI had recommended separation of the posts of chairman and the managing director as early as in April 2002, but this is yet to be implemented in PSU banks. While the MD & CEO will be the driving force, the non-executive chairman will serve as a conscience keeper for the bank. The RBI should, however, ensure that the non-executive chairman is a thorough banking professional who can serve as a friend, philosopher and guide to the CEO and add considerable value to the position he heads without any fear or favour.  
  3. At present, it is generally observed that the CEOs of banks are appointed for short tenures, without giving an opportunity for the person appointed to complete the job taken on hand. In PSU banks, CEOs are appointed for periods as low as 12 to24 months, which is not in the interest of the banks concerned.  Even in private sector banks, the present policy of RBI is to approve appointments of CEOs for a period not exceeding three years, even in cases where the board of the bank recommends a longer tenure and the age of the candidate is also within the guidelines. This again is not in tune with the recommendations of the aforesaid AS Ganguly Committee, which has specifically stated that the CEOs should have sufficiently long tenure to enable them to leave a mark of their leadership and business acumen on the bank’s performance.  But the RBI, in its wisdom restricts the tenure to three years at a time to the CEOs of private banks, which not only causes uncertainty, but veritably affects the performance of the banks. The RBI and the government should uniformly appoint all future CEOs for a minimum period of four to five years, thereby helping the banks to perform better. 

What the central government can do:

The central government as the majority shareholder of a number of banks has a great responsibility to support the banks’ efforts in meeting the obligations under the Basel III guidelines, and a few of the initiatives required are detailed below. 

  1. The primary responsibility of the government is to meet the capital requirements of all the public sector banks, keeping in view not only the Basel III guidelines, but also the increased role to be played by the banking sector in the accelerated GDP (gross domestic product) growth envisaged during the 12th Plan period, which  targets a growth rate of 9%. Therefore, prudence calls for a proper and systematic allocation of resources by the government on year-to-year basis to the banking sector in the interest of smooth compliance of Basel III guidelines. Alternatively, the government should consider diluting its stake to 40%, retaining management control through amendment to the appropriate laws, so that banks can raise capital from the market. 
  2. The government is keen that the banks should play their rightful role in financing infrastructure, but the RBI is concerned about lending short-term resources for long-term uses, causing maturity mismatch, which is felt to be a risky proposition for banks. The only sensible solution for this predicament is to allow banks to raise long-term resources like infrastructure bonds with tax benefits permitted for some of the non-banking finance companies recently. But it is really a mystery that the banks have been kept out of this long-term resource raising programme for unknown reasons, more so when the banks would have been able to raise substantial resources through this medium, thereby serving the cause of infrastructure admirably. The government should immediately consider allowing banks to raise resources through this medium without any further delay, so that a few large banks can quickly raise resources before the end of this financial year. 
  3. The government has permitted performance-based cash incentives to the CMDs and executive directors of public sector banks for the last couple of years, but has kept lakhs of other employees out of this incentive scheme without any rhyme or reason. In order to galvanize the entire rank and file for better performance, it is necessary to offer the incentive scheme to all permanent employees of the public sector banks as well, making them equally responsible by rewarding for their performance. The government can even consider offering employee stock options (ESOPs) to create a feeling of ownership among the employees, which will go a long way in improving overall performance as well as customer service in banks. 
  4. As stated earlier, there is a need to get better valuation for the shares of PSU banks on the bourses by making it freely available to the potential investors. The government has imposed a limit of 20% for investment by foreign institutional investors (FIIs) in each of the public sector banks, which restricts the availability of shares. With the government holding more than 51% of the shares and fully in control, and with the stipulation that no single individual or institutions can hold more than 5% of equity of any bank without prior clearance from the RBI presently in force, there is no need to be wary about FIIs cornering the shares of these banks. It is in the interest of the banks to gradually relax this cap for FIIs to invest up to 35% to 40%, which will help the banks to raise equity quickly either through the qualified institutional placement (QIP) route or through follow-on public offers, whenever required without much hassle. 

The need of the hour is no doubt, to make the banks of our country strong and robust to meet any eventuality of another meltdown in the wake of the impending European crisis and all the steps suggested above are in this direction of giving a strong foundation for an uncertain future. 

(The author is a banking & financial consultant. He writes for Moneylife under the pen-name ‘Gurpur’)


Free Helpline
Legal Credit