A study on

BASEL Committee II & BASEL Committee III and Its Implication on

India
A Project Report-International Economic Organization

SUBMITTED BY:
SHILPA SHARMA (17H78)
SHUBHAM RAVAL (17F80)
SIDDHARTH VYAS (17F81)
SWAPNIL MACWAN(17M82)

SEMESTER IV

UNDER THE GUIDANCE AND SUPERVISION OF:

Dr. Yogesh C. Joshi & Dr. Mitesh Jayswal

G.H. PATEL POSTGRADUATE INSTITUTE OF BUSINESS

MANAGEMENT
MBA PROGRAMME (2018-2019)
SARDAR PATEL UNIVERSITY, VALLABH VIDHYANAGAR
 INDEX

CHAPTER 1

INTRODUCTION

1.1 OBJECTIVES OF THE STUDY

1.2 INTRODUCTION

1.3 RESEARCH METHODOLOGY

1.4 DATA COLLECTION METHOD

1.5 LITERATURE REVIEW

CHAPTER-2

NEED FOR BASEL II

2.1 NEED FOR BASEL II

2.1.1 The Purpose of Basel I
2.1.2 Pitfalls of BASEL I

CHAPTER 3

INTRODUCTION TO BASEL II & ITS IMPLICATION ON INDIA

3.1 INTRODUCTION TO BASEL II

3.1.1 The First Pillar: Minimum Capital Requirement:
3.1.2 The Second Pillar: Supervisory Review Process:
3.1.3 The Third Pillar: Market Discipline:

3.2 Introduction of Basel Norms in Indian Banking System

3.3 Impact of Basel II Norms on Banking System

3.4 Positive Impact of Basel II on Banks in India

3.5 Negative Impact of Basel II on Banks in India

CHAPTER 4

NEED FOR BASEL III

4.1 Pitfalls of BASEL II

CHAPTER 5

INTRODUCTION TO BASEL III & ITS IMPLICATION ON INDIA

5.1 INTRODUCTION TO BASEL III

5.1.1 December 2017 - Finalization of the Basel III post-crisis regulatory reforms

5.2 Credit risk

5.3 The CVA framework

5.4 Operational risk

5.5 The leverage ratio

5.6 ADVENT OF BASEL III IN INDIA

5.6.1 Objectives of Adoption of Basel III for Indian Banking Industry
 5.6.2 Benefits and Challenges posed by Basel III for Indian PSBs

5.7 MACRO-ECONOMIC EFFECT

5.8 EFFECT ON CAPITAL REQUIREMENTS

CHAPTER 6

CONCLUSIONS
6.1 CONCLUSIONS

REFERENCE
 PREFACE

Theories are important for understanding any subject or fields. But learning of various
aspects is much more effective to understanding any subject as a whole. The basic aim of the
project report is to help the students for developing their analytical abilities and different
thoughts at different angles of the situation. The Management Research Project is being very
helpful to the students of MBA for enhancing themes managerial capabilities and skills.

The basic motive behind of this project is to acquire knowledge about various aspects of the
industry that can aid the student in their future career. With our interest, we have selected
BASEL Committee II & BASEL Committee III and Its Impact on India
. This report helps us to develop our skill & confidence to do better in all respect in
management fields.

In our analysis we have gone for analyzing by the our objectives. Future outlook of the BIS is
concluded that will help us in our future career.

We have tried our best and have applied all our efforts, knowledge and sources available, in
this project.
 ACKNOWLEDGEMENT

With immense please we are presenting “BASEL Committee II & BASEL Committee
III and Its Impact on India” Project report as part of the curriculum of ‘PGDM’. We wish
to thank all the people who gave us unending support.

I express my profound thanks to Prof. Dr. Yogesh C Joshi, and Prof. Dr. Mitesh
Jayswal. project guide and all those who have indirectly guided and helped us in preparation
of this project.

I also like to extend our gratitude to all staff and our colleagues of College of
Management, who provided moral support, a conductive work environment and the much-
needed inspiration to conclude the project in time and a special thanks to my friends who are
integral part of the project.

Thanking you.

Prof. Dr. Yogesh C. Joshi

 CHAPTER 1

INTRODUCTION
1.1 OBJECTIVES OF THE STUDY
1. To know what is the need for BASEL committee II.
2. To understand what is BASEL II and its impact on India.
3. To know what is the need for BASEL committee III.
4. To understand what is BASEL III and its impact on India.

1.2 INTRODUCTION

Basel II is an international business standard that requires financial institutions to

maintain enough cash reserves to cover risks incurred by operations. The Basel accords are a
series of recommendations on banking laws and regulations issued by the Basel Committee
on Banking Supervision (BSBS). The name for the accords is derived from Basel,
Switzerland, where the committee that maintains the accords meets. Basel II improved on
Basel I, first enacted in the 1980s, by offering more complex models for calculating
regulatory capital. Essentially, the accord mandates that banks holding riskier assets should
be required to have more capital on hand than those maintaining safer portfolios. Basel II also
requires companies to publish both the details of risky investments and risk management
practices. The full title of the accord is Basel II: The International Convergence of Capital
Measurement and Capital Standards - A Revised Framework.

The three essential requirements of Basel II are:

1. Mandating that capital allocations by institutional managers are more risk sensitive.
2. Separating credit risks from operational risks and quantifying both.
3. Reducing the scope or possibility of regulatory arbitrage by attempting to align the
real or economic risk precisely with regulatory assessment.

Basel II has resulted in the evolution of a number of strategies to allow banks to make risky
investments, such as the subprime mortgage market. Higher risks assets are moved to
unregulated parts of holding companies. Alternatively, the risk can be transferred directly to
investors by securitization, the process of taking a non-liquid asset or groups of assets and
transforming them into a security that can be traded on open markets.
Basel III is an extension of the existing Basel II Framework, and introduces new capital and
liquidity standards to strengthen the regulation, supervision, and risk management of the
whole of the banking and finance sector.

It was agreed upon by the members of the Basel Committee on Banking Supervision in
2010–2011, and was scheduled to be introduced from 2013 until 2015. However, changes
made from April 2013 extended implementation until March 31, 2018. The Basel III
requirements were in response to the deficiencies in financial regulation that is revealed by
the 2000’s financial crisis. Basel III was intended to strengthen bank capital requirements by
increasing bank liquidity and decreasing bank leverage.
The global capital framework and new capital buffers require financial institutions to hold
more capital and higher quality of capital than under current Basel II rules. The new leverage
ratio introduces a non risk-based measure to supplement the risk-based minimum capital
requirements. The new liquidity ratios ensure that adequate funding is maintained in case
there are other severe banking crises.

1.3 RESEARCH METHODOLOGY

As per the research design, exploratory research as being used as the main purpose is to gain
insight and an understanding of the economic international organization named BIS.
1.4 DATA COLLECTION METHOD
Data has been collected from secondary resources such as websites, journals, research papers
reference books, official site of BIS, etc.
1.5 LITERATURE REVIEW
1. Integration of regulatory capital and liquidity instruments, March 2016
This working paper aims at reviewing the literature assessment of recent reforms. It
consists of “three essays” on capital (Section 2), on liquidity and its interaction with capital
(Section 3) and on other supervisory requirements (Section 4). Although there are many
studies on the effects of capital requirements, there are relatively few on the effects of
liquidity requirements and other supervisory tools. In part, this is because capital
requirements have been in place for a considerable time and over more than one business
cycle, while liquidity requirements and other supervisory tools, such as buffers,
macroprudential policies and stress tests, have only been implemented since the recent
financial crisis.

1. The Bank of International Settlements as a think tank for financial policy-making

Carola Westermeier 2018, Vol. 37, no. 2, 1 –187.
The Bank of International Settlements (BIS) is known to be the ‘bank of central banks
‘and a congenital place where central bankers meet to discuss policies. However, this
contribution shows that it is also far more. Economic research and policy-making are closely
connected within the BIS. Researchers and analysts provide knowledge for financial
regulation and introduce new approaches to policy-makers who meet within the BIS-hosted
bodies, such as the Basel Committee of Banking Supervision. The Monetary and Economic
Department of the BIS operates like a think tank in the end of nancial policy-making. This is
exampled by the introduction of macro prudential regulation, a new approach that originated
within the BIS. By combining post-structural discourse theory with the concept of discourse
coalition, this paper shows how macro prudential regulation became a frame of reference
promising to maintain nancial stability and how the BIS benefits from this.
 CHAPTER-2
NEED FOR BASEL II
2.1 NEED FOR BASEL II
From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United
States. Bank failures were particularly prominent during the 1980s, an era that is often
referred to as the "savings and loan crisis." Banks throughout the world were lending
extensively, while countries' external indebtedness was growing at an unsustainable rate. As a
result, the potential for the bankruptcy of the major international banks because grew as a
result of low security. In order to prevent this risk, the Basel Committee on Banking
Supervision, comprised of central banks and supervisory authorities of 10 countries, met in
1987 in Basel, Switzerland.
The committee drafted a first document to set up an international "minimum amount" of
capital that banks should hold. This minimum is a percentage of the total capital of a bank,
which is also called the minimum risk-based capital adequacy. In 1988, the Basel I Capital
Accord was created. The Basel II Capital Accord follows as an extension of the former, and
was implemented in 2007. In this article, we'll take a look at Basel I and how it impacted the
banking industry.

2.1.1 The Purpose of Basel I

In 1988, the Basel I Capital Accord was created. The general purpose was to:
● Strengthen the stability of international banking system.
● Set up a fair and a consistent international banking system in order to decrease
competitive inequality among international banks.

The basic achievement of Basel I has been to define bank capital and the so-called bank
capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks
and governments in the world, a general definition of capital was required. Indeed, before this
international agreement, there was no single definition of bank capital. The first step of the
agreement was thus to define it.

The Basel I agreement defines capital based on two tiers

● Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholder equity) and
declared reserves, such as loan loss reserves set aside to cushion future losses or for
smoothing out income variations.
● Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains
on investment assets, long-term debt with maturity greater than five years and hidden
reserves (i.e., excess allowance for losses on loans and leases). However, short-term
unsecured debts (or debts without guarantees), are not included in the definition of
capital.

Credit risk is defined as the risk weighted asset, or RWA, of the bank, which are a bank's
assets weighted in relation to their relative credit risk levels. According to Basel I, the total
capital should represent at least 8% of the bank's credit risk (RWA).

In addition, the Basel agreement identifies three types of credit risks

● The on-balance-sheet risk (see Figure 1)
 ● The trading off-balance-sheet risk: These are derivatives, namely interest rates,
foreign exchange, equity derivatives and commodities.
● The non-trading off-balance-sheet risk: These include general guarantees, such as
forward purchase of assets or transaction-related debt assets.

Let's take a look at some calculations related to RWA and capital requirement. Figure 1
displays predefined categories of on-balance-sheet exposures, such as vulnerability to loss
from an unexpected event, weighted according to four relative risk categories.

Figure 1: Basel's Classification of risk weights of on-balance-sheet assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires a

risk weight of 100%. The RWA is therefore calculated as RWA = $1,000 × 100% = $1,000.
By using Formula 2, a minimum 8% capital requirement gives 8% × RWA = 8% × $1,000 =
$80. In other words, the total capital holding of the firm must be $80 related to the unsecured
loan of $1,000. Calculation under different risk weights for different types of assets are also
presented in Table 2.

Figure 2: Calculation of RWA and capital requirement on-balance-sheet assets

Market risk includes general market risk and specific risk. The general market risk
refers to changes in the market values due to large market movements. Specific risk refers to
changes in the value of an individual asset due to factors related to the issuer of the security.
There are four types of economic variables that generate market risk. These are interest rates,
foreign exchanges, equities and commodities. The market risk can be calculated in two
different manners: either with the standardized Basel model or with internal value at risk
(VaR) models of the banks. These internal models can only be used by the largest banks that
satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover, the
1996 revision also adds the possibility of a third tier for the total capital, which includes
short-term unsecured debts. This is at the discretion of the central banks. (See also: Get To
Know the Central Banks and What Are Central Banks?)
2.1.2 Pitfalls of BASEL I

The Basel I Capital Accord has been criticized on several grounds. The main criticisms
include the following:

● Limited differentiation of credit risk: There are four broad risk weightings (0%, 20%,
50% and 100%), as shown in Figure 1, based on an 8% minimum capital ratio.
● Static measure of default risk: The assumption that a minimum 8% capital ratio is
sufficient to protect banks from failure does not take into account the changing nature
of default risk.
● No recognition of term-structure of credit risk: The capital charges are set at the same
level regardless of the maturity of a credit exposure.
● Simplified calculation of potential future counterparty risk: The current capital
requirements ignore the different level of risks associated with different currencies
and macroeconomic risk. In other words, it assumes a common market to all actors,
which is not true in reality.
● Lack of recognition of portfolio diversification effects: In reality, the sum of individual
risk exposures is not the same as the risk reduction through portfolio diversification.
Therefore, summing all risks might provide an incorrect judgment of risk. A remedy
would be to create an internal credit risk model—for example, one similar to the
model as developed by the bank to calculate market risk. This remark is also valid for
all other weaknesses.

These listed criticisms have led to the creation of a new Basel Capital Accord, known as
Basel II, which added operational risk and also defined new calculations of credit risk.
Operational risk is the risk of loss arising from human error or management failure. The
Basel II Capital Accord was implemented in 2007.

The Basel I Accord, issued in 1988, has succeeded in raising the total level of equity capital
in the system. Like many regulations, it also pushed unintended consequences; because it
does not differentiate risks very well, it perversely encouraged risk seeking. It also promoted
the loan securitization that led to the unwinding in the subprime market.
 CHAPTER 3

INTRODUCTION TO BASEL II & ITS IMPLICATION ON

INDIA
3.1 INTRODUCTION TO BASEL II

The principal reason for adopting Basel II norms was that, it considers both credit and
operational risks apart from market risk as the major sources of risks. Basel II norms direct
banks to allocate adequate amounts of capital for these types of risks unlike Basel I. The
revised framework i.e. Basel II norms presents an array of options for determining the capital
requirements for credit risk and operational risk. This facilitates banks and supervisors to
identify and implement approaches which are most suitable for their banking operations.

Basel II also requires companies to publish both the details of risky investments and risk
management practices. The full title of the accord is Basel II: The International Convergence
of Capital Measurement and Capital Standards - A Revised Framework.

The three essential requirements of Basel II are:

4. Mandating that capital allocations by institutional managers are more risk sensitive.
5. Separating credit risks from operational risks and quantifying both.
6. Reducing the scope or possibility of regulatory arbitrage by attempting to align the
real or economic risk precisely with regulatory assessment.

The main structure of Basel II depends on 3 Pillars concept:

1. Minimum Capital Requirements
2. Supervisory Review of Capital Adequacy
3. Market Discipline

3.1.1 The First Pillar: Minimum Capital Requirement:

The first pillar measures the minimum regulatory capital that needs to be maintained by
banks after considering three risks namely credit risk, operational risk and market risk.

3.1.2 The Second Pillar: Supervisory Review Process:

The second pillar deals with management of various risks faced by banks such as systematic
risk, risks related to strategy, reputation, liquidity and legal issues. It provides banks to check
and reconsider their Risk Management System by developing their own risk management
techniques to administer and manage their risks. Supervisors are assigned the task of
evaluating and reviewing the capital requirement of banks with respect to various risks faced
by them.

3.1.3 The Third Pillar: Market Discipline:

The third pillar focuses on disclosure of various important information of banks which
facilitates market participants to consider aspects like risk exposure, techniques of risk
assessment and capital adequacy maintained by banks. Market discipline aims to share this
vital information of banks which is used to assess bank performance by market participants
like investors, customers, financial experts and analysts, other banks and rating agencies.
In a nutshell, all the three pillars of Basel II norms focuses on to provide greater stability in
the financial system by ensuring adequate capital to manage risks faced by banks, reviewing
the risk management by Supervisors and sharing the significant information by way of
market disclosure. The same is described in the figure below.
3.2 Introduction of Basel Norms in Indian Banking System

In response to the Basel I Accord of 1988, Reserve Bank of India issued required guidelines
and instructions to all the Indian Banks for implementing the norms as per best international
banking practices. RBI issued broad guidelines and directives in an attempt to execute,
supervise prudential norms of credit like practices of supervision, licensing, liquidity, risk
management and techniques of banking supervision on a regular basis .
In India, Basel I framework was put into practice from 1992-93 which was extended for three
years. Banks with branches abroad were required to conform completely by March 31, 1994
and other banks were required to abide by the rules by March 31, 1996. In response to the
1996 amendment of Basel I framework, India accepted and made necessary changes for the
banks to maintain capital for market risk component, by imposing various reserves and
capital charges in the beginning, for these risks between 2000 and 2002. Later on, these were
replaced with capital charges as stipulated by Basel I framework in June 2004, which came
into existence completely from March 2005. The Indian Banking System has shown
considerable improvement on several factors due to the successful implementation of banking
sector reforms since 1991. And hence the Indian Banking System is competent enough to
shift to Basel II norms efficiently.
Commercial banks in India began implementing Basel II framework from March 31, 2007.
RBI gave instructions in October 2006 that foreign banks operating in India and Indian banks
located abroad would adopt the Standardised Approach for measuring credit risk and the
Basic Indicator Approach for calculating operational risk component under Basel II norms,
applicable from March 31, 2008 whereas all other scheduled commercial banks are required
to move to Basel II framework by March 31, 2009.

3.3 Impact of Basel II Norms on Banking System

Basel II framework will increase the volatility of the capital requirements of any developing
country. This is because the credit rating process and access is less in a developing country
compared to a developed country, where it is very easily put into practice. The same is the
case with India where credit rating is less penetrated, so majority of the proportion of bank
assets in its balance sheets are unrated claims. As per Basel II norms, less credit rating
requires more capital adequacy to mitigate the risk which might arise from the assets. This
also means that the operational risk requirement may increase and hence the overall capital
requirement of the bank will be more. This may act as a hurdle to implement Basel II norms
in some countries. Many countries across the world implemented Basel I Accord, but they
had maintained a slightly higher capital than the minimum requirement of 8%. As per second
pillar of review process, supervisors with their agency focus on improving the internal risk
management of banks so that they can switch to IRB Approach, rather than implementing
standard approach of measuring risk, like other competitor banks. Moreover, the supervisors
who are in-charge of audit and review of Basel II Norms in banks should aim to check the
capital adequacy, size, domestic capital markets, availability and disclosure of information,
degree of measuring and monitoring the provision of loans and losses.
Many countries will most likely decide to implement simpler and easier approaches of
Basel II like Simplified Standardized Approach and Standardized Approach because the
former uses only the ratings of official export credit guarantee agencies for sovereign risk
assessment whereas the latter will use the credit ratings from private agencies. Still the
developing countries faced problem in implementing alternative approaches for measuring
capital as per Basel II, i.e. there are two versions of Standardized and IRB Approaches, but it
does not highlight appropriate reasons or benefits to use the most risk-sensitive approach,
thereby developing arbitrage possibilities. Moreover, in countries with less developed capital
market and financial system, reliable credit ratings are not available for most of the assets in
the bank’s credit portfolio. In such cases, the Standardized Approach will assist very little to
relate risk with capital requirement and hence it would be a poor replacement of Basel I
framework. Hence the capital requirement in developing countries will increase which they
are not prepared for. Moreover, the regulatory and supervisory bodies in those countries are
not all set to meet the challenge of second pillar of Basel II norms, due to lack
of developed infrastructure, insufficient human capital etc.
The implementation of Basel II framework on the Japanese Banking industry resulted in
decrease of share prices and reduction of loan provisions for banks that had low capital ratios.
This is because second pillar of Basel II norms enforces a large burden on minimum capital
requirement to be maintained by banks. Moreover, the second pillar also increases the
regulatory capital requirement of banks. Thus, in order to relate the existing literature about
the implementation of Basel II in a developing country, the researcher analyzes the impact of
Basel II Norms on the Indian Banking sector as India itself is a developing country and has
adopted Basel II Norms in its banking system.

3.4 Positive Impact of Basel II on Banks in India

Basel II Norms will have a positive impact on the Indian Banking System in the following
ways:
Firstly, the implementation of Basel II norms results in reduction of regulatory capital
by reducing the credit risk weights, this can be done by suitably altering the bank’s portfolios.
The Internal Ratings Based (IRB) Approach would provide autonomy to the individual banks
to evaluate their own risk and determine the requirement of economic capital.
The Standardised and Internal Ratings Based (IRB) Approaches are advanced approaches for
calculating credit and operational risk component respectively as per Basel II norms. These
methods will help consider most of the risks faced by banks and hence are required to
maintain lower capital which will result in lower costs following these approaches.
Basel II framework considers economic risk in line with regulatory risk faced by
banks. This will result in easy disbursement of loans to corporate, increase in retail loans and
mortgage loans with higher margins. It will also transform the way credit risk is managed by
banks because it will make sure that banks have sufficient capital to face operational risk. The
other benefit to banks is the development of better risk assessments system, leading to an
edge over other banks, by focusing on only those target segments, markets and customers
who have high risk and high return ratio. The other advantage to banks for implementing
Basel II norms is superior understanding of risk return trade-off for estimating risks for
capital supporting specific business, corporate, customers, products, services and various
processes.
The other benefits that the banks would receive by adopting Basel II framework
would be the robust risk estimation, measurement and management process, which will result
in serving the customers better including small and medium sized businesses. It will lead to
liquidity for those small businesses and help them for their growth and expansion needs .
The second pillar of Basel II Accord considers the very important Supervisory Review
Process. It brings in the concept of Economic Capital which will assist the banks to decide a
minimum capital adequacy requirement based on the level of risk resulted from the
transaction. It benefits the bank to achieve an improved relationship between risk and
minimum capital required to be maintained by respective banks.
Basel II norms will also offer banks with business benefits like improving corporate
governance and allocation of capital. The risk-based pricing will help to improve the
bank’s competitiveness. Capital will be saved and better decision making will allow counter
parties to deal in a better way and increasing the value of stakeholders .
Basel II offers the banks with several alternatives, from which they can select appropriate risk
measurement approaches applicable to them. For example, large banks are expected by the
market and supervisors to implement advanced risk management techniques whereas small
banks with relatively easy operations may use a simple and less expensive risk management
system. This is because Basel II framework is drafted flexibly to integrate any changes which
may occur in future, the same principles can be included without making changes in the basic
arrangement. Banks will have the autonomy in its operations but has some constraints to
ensure a basic minimum capital adequacy requirement .
Other additional advantages of Basel II norms are adopting a more active portfolio
management system and advanced, progressive risk measurement system. The portfolio of
banks is managed by taking into consideration high risk and high return assets, this is
possible because banks has access to better, reliable, timelier and higher quality risk
information and capital requirement in advance. The pricing of products will be more risk
sensitive and proactive which results in overall improvement in the performance management
of banks.

3.5 Negative Impact of Basel II on Banks in India

After implementing Basel II norms, Banks in India might face certain negative aspects, which
are mentioned as follows:
The first disadvantage with Basel II framework is with reference to higher capital
requirement by banks. The Basic Indicator Approach states that banks should maintain capital
charge for operational risk component which should be equivalent to the average of the 15%
of annual positive gross income of last three years, excluding any year when the gross income
was negative. It also indicates that capital required by the banks would depend on the level of
Non- Performing Assets (NPAs) of banks.
The second disadvantage of implementing Basel II norms deals with investment and
expenditure pattern of banks. The banks in order to be risk aversive, give priority to
investment in government securities rather than giving loans to small businesses. This has
resulted in negatively affecting the credit disbursed to agriculture and small-scale industries .
The third and the fourth negative aspect is role of rating agencies and regulatory bodies in
India. As per the directives of Basel II Accord, banks are required to gather new information
and the same is supposed to be disclosed to the general public as a part of Market Discipline,
to make sure its transparency. There are only four rating agencies in India, initially they had
common rules which will be updated to incorporate new Basel II framework. Regulatory
bodies too will encounter challenge as they have to provide same level playing field in terms
of jurisdiction at international level, as Basel II norms are adopted in various countries.
Moreover, they have to make sure that their auditors and supervisors are sufficiently trained
to evaluate banks’ compliance as per new capital rules
 CHAPTER 4

NEED FOR BASEL III

4.1 Pitfalls of BASEL II
The first cause was “pro-cyclical process” due to this if there is economic boom in the
country then banks require less capital for recovering the risk but in case of down of economy
then banks require more capital for recovering the risk. The Basel Accord II has “pro-
cyclical process” due to this if there is economic boom in the country then banks require less
capital for recovering the risk but in case of down of economy then banks require more
capital for recovering the risk.
The second cause of failure was the lot of use the rating provided by external sources.
In many organizations has no credit assessment department so they relays on credit rating
provided institutions. So the external credit rating provided institutions became more
important. This create the problems like the external institutions mispriced the risk due to this
the conflicts were arises and that’s why we need to revise the Basel Accord.

The U.S. bank’s supervisors most of the time claims that the two approaches like Advance
Internal Rating Based (AIRB) and Advanced Measurement Approach (AMA) for credit and
operational risk respectively are very complex so these are implemented by only large banks
in U. S. So, the financial institution having $250 Billion consolidated assets are requiring that
they implement the advance approaches.
The Basel II impact on capital requirements is being influenced by both the utilised approach
and bank’s risk profile. At a quick glance it becomes clear that the banks utilising
standardised approach are at disadvantage compared to the ones employing IRB or A-IRB
approaches.
Considering the risk profile, the local retail banks, especially those registering large mortgage
exposures, can benefit from important reductions of capital requirements while at the
opposite the investment and emerging markets banks are going to be subject to additional
capital requirements.
On long term, Basel II should trigger a reduction of the cost for the banks (reduced capital
requirements for several lines of business); however most probably we will witness negative
impacts for a while due to implementation costs and/or the efforts of smaller banks to raise
additional capital.

Basel II has definitely added value to the prudential rules and regulations, answering in many
instances to the need to promote increased safety of the financial sector. The new
requirements improved the prudential framework by adding minimum capital requirements
for market and operational risks, improved assessment of risk sensitivity (more classes of
assets and types of exposures) and introduction of internal models for credit risk.
Nevertheless real life implementation proved several negative impacts and limitations of
Basel II, especially in the light of the current financial crisis.
One of the main negative impacts is represented by significant reductions of capital
requirements for banks utilising internal models not correlated with their ability to withstand
systemic crises – an overestimation of their capacity to properly assess risks by using internal
models.
The “model risk”, generated by the lack of macro variables and improper internal
mechanisms for risk measurement, triggered an imbalance between exposures and capital
(unjustly amplifying the leverage and volatility of capital requirements) (Georgescu, 2012).
Too much emphasis on the external ratings is another negative side of Basel II: rating
agencies have been too optimistic in setting the ratings (basically no rules in force in this
respect) and Europe (especially Eastern Europe) has benefited much later (1990s) from the
presence of external ratings and rating agencies compared to US.
Basel II provisions also generated an underestimation of capital requirements in relation to
the banks’ trading books by employing untested and unrealistic VAR models (Atik, 2009).
Securitisation transactions have also contributed to the contagion effect and triggered
systemic risks, which are not fully addressed by the current rules.
One other limitation worth mentioning is represented by the fact that liquidity risk is
improperly addressed by the Basel II framework on both financing side and individual asset
liquidity (Georgescu, 2012).
One last remark refers to the fact that Basel II generated competitive advantage for the large
banks owning infrastructure and resources to implement its requirements and also for non-
banking financial institutions not subject to Basel II requirements.

The seven pitfalls are:

● Waiting for the regulators to provide detailed guidance and lay out an implementation
road map.
● Failing to understand the overlap among regulatory initiatives, or dealing with them in
a siloed manner.
● Failing to make the link between information, technology, risk management, and the
business.
● Attempting to build Basel II infrastructure without data and technical architecture
road maps.
● Failing to generate the internal support needed for a smooth implementation.
● Underestimating the magnitude of cultural change that Basel II requires.
● Not correctly factoring Basel II into the institution's merger and acquisition strategy.
 CHAPTER 5
INTRODUCTION TO BASEL III & ITS
IMPLICATION ON INDIA
5.1 INTRODUCTION TO BASEL III

Basel III is a comprehensive set of reform measures, developed by the Basel

Committee on Banking Supervision, to strengthen the regulation, supervision and risk of the
banking sector.
The Basel Committee is the primary global standard-setter for the prudential regulation of
banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to
strengthen the regulation, supervision and practices of banks worldwide with the purpose of
enhancing financial stability.

The Committee reports to the Group of Governors and Heads of Supervision (GHOS).
The Committee seeks the endorsement of GHOS for its major decisions and its work
programme. The Committee's members come from Argentina, Australia, Belgium, Brazil,
Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy,
Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South
Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
From 1993 to 2008 the total assets of a sample of what we call global systemically important
banks saw a twelve-fold increase (increasing from $2.6 trillion to just over $30 trillion). But
the capital funding these assets only increased seven-fold, (from $125 billion to $890 billion).
Put differently, the average risk weight declined from 70% to below 40%.

The problem was that this reduction did not represent a genuine reduction in risk in the
banking system. One of the main reasons the economic and financial crisis became so severe
was that the banking sectors of many countries had built up excessive on and off-balance
sheet leverage.
This was accompanied by a gradual erosion of the level and quality of the capital base. At the
same time, many banks were holding insufficient liquidity buffers. The banking system
therefore was not able to absorb the resulting systemic trading and credit losses nor could it
cope with the reintermediation of large off-balance sheet exposures that had built up in the
shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by the
interconnectedness of systemic institutions through an array of complex transactions. During
the most severe episode of the crisis, the market lost confidence in the solvency and liquidity
of many banking institutions. The weaknesses in the banking sector were rapidly transmitted
to the rest of the financial system and the real economy, resulting in a massive contraction of
liquidity and credit availability. Ultimately the public sector had to step in with
unprecedented injections of liquidity, capital support and guarantees, exposing taxpayers to
large losses. The effect on banks, financial systems and economies at the epicentre of the
crisis was immediate.
However, the crisis also spread to a wider circle of countries around the globe. For these
countries the transmission channels were less direct, resulting from a severe contraction in
global liquidity, cross-border credit availability and demand for exports. Given the scope and
speed with which the recent and previous crises have been transmitted around the globe as
well as the unpredictable nature of future crises, it is critical that all countries raise the
resilience of their banking sectors to both internal and external shocks. The G20 Leaders at
the Seoul Summit endorsed the Basel III framework and the Financial Stability Board’s
(FSB) policy framework for reducing the moral hazard of systemically important financial
institutions (SIFIs), including the work processes and timelines set out in the report submitted
to the Summit. SIFIs are financial institutions whose disorderly failure, because of their size,
complexity and systemic interconnectedness, would cause significant disruption to the wider
financial system and economic activity.

We read in the final G20 Communique: "We endorsed the landmark agreement reached by
the Basel Committee on the new bank capital and liquidity framework, which increases the
resilience of the global banking system by raising the quality, quantity and international
consistency of bank capital and liquidity, constrains the build-up of leverage and maturity
mismatches, and introduces capital buffers above the minimum requirements that can be
drawn upon in bad times.

The framework includes an internationally harmonized leverage ratio to serve as a backstop

to the risk-based capital measures. With this, we have achieved far-reaching reform of the
global banking system. The new standards will markedly reduce banks' incentive to take
excessive risks, lower the likelihood and severity of future crises, and enable banks to
withstand - without extraordinary government support - stresses of a magnitude associated
with the recent financial crisis.

This will result in a banking system that can better support stable economic growth. We are
committed to adopt and implement fully these standards within the agreed timeframe that is
consistent with economic recovery and financial stability.
The new framework will be translated into our national laws and regulations, and will be
implemented starting on January 1, 2013 and fully phased in by January 1, 2019."
To ensure visibility of the implementation of reforms, the Basel Committee has been
regularly publishing information about members’ adoption of Basel III to keep all
stakeholders and the markets informed, and to maintain peer pressure where necessary. It is
especially important that jurisdictions that are home to global systemically important banks
(G-SIBs) make every effort to issue final regulations at the earliest possible opportunity. But
simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for: full,
timely and consistent implementation of Basel III.
In response to this call, in 2012 the Committee initiated what has become known as the
Regulatory Consistency Assessment Programme (RCAP). The regular progress reports are
simply one part of this programme, which assesses domestic regulations’ compliance with the
Basel standards, and examines the outcomes at individual banks. The RCAP process will be
fundamental to ensuring confidence in regulatory ratios and promoting a level playing field
for internationally-operating banks. It is inevitable that, as the Committee begins to review
aspects of the regulatory framework in far more detail than it (or anyone else) has ever done
in the past, there will be aspects of implementation that do not meet the G20’s aspiration: full,
timely and consistent.

The financial crisis identified that, like the standards themselves, implementation of global
standards was not as robust as it should have been. This could be classed as a failure by
global standard setters. To some extent, the criticism can be justified – not enough has been
done in the past to ensure global agreements have been truly implemented by national
authorities. However, just as the Committee has been determined to revise the Basel
framework to fix the problems that emerged from the lessons of the crisis, the RCAP should
be seen as demonstrating the Committee’s determination to also find implementation
problems and fix them.

5.1.1 December 2017 - Finalization of the Basel III post-crisis regulatory reforms

The Basel III reforms complement the initial phase of the Basel III reforms announced in
2010.
The 2017 reforms seek to restore credibility in the calculation of risk weighted assets (RWAs)
and improve the comparability of banks’ capital ratios.
RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank
must maintain to deal with unexpected losses. A prudent and credible calculation of RWAs is
an integral element of the risk-based capital framework.
The revisions seek to restore credibility in the calculation of risk-weighted assets (RWAs) and
improve the comparability of banks’ capital ratios by:

● enhancing the robustness and risk sensitivity of the standardised approaches for credit
risk, credit valuation adjustment (CVA) risk and operational risk;
● constraining the use of the internal model approaches, by placing limits on certain
inputs used to calculate capital requirements under the internal ratings-based (IRB)
approach for credit risk and by removing the use of the internal model approaches for
CVA risk and for operational risk;
● introducing a leverage ratio buffer to further limit the leverage of global systemically
important banks (G-SIBs); and
● replacing the existing Basel II output floor with a more robust risk-sensitive floor
based on the Committee’s revised Basel III standardised approaches.
5.2 Credit risk
Credit risk accounts for the bulk of most banks’ risk-taking activities and hence their
regulatory capital requirements. The standardised approach is used by the majority of banks
around the world, including in non-Basel Committee jurisdictions. The Committee’s revisions
to the standardised approach for credit risk enhance the regulatory framework by:
● improving its granularity and risk sensitivity. For example, the Basel II standardised
 approach assigns a flat risk weight to all residential mortgages. In the revised
standardised approach mortgage risk weights depend on the loan-to-value (LTV) ratio
of the mortgage;
● reducing mechanistic reliance on credit ratings, by requiring banks to conduct
sufficient due diligence, and by developing a sufficiently granular non-ratings-based
approach for jurisdictions that cannot or do not wish to rely on external credit ratings;
and
● As a result, providing the foundation for a revised output floor to internally modelled
capital requirements (to replace the existing Basel I floor) and related disclosure to
enhance comparability across banks and restore a level playing field.
In summary, the key revisions are as follows:
● A more granular approach has been developed for unrated exposures to banks and
corporates, and for rated exposures in jurisdictions where the use of credit ratings is
permitted.
● For exposures to banks, some of the risk weights for rated exposures have been
recalibrated. In addition, the risk-weighted treatment for unrated exposures is more
granular than the existing flat risk weight. A standalone treatment for covered bonds
has also been introduced.
● For exposures to corporates, a more granular look-up table has been developed. A
specific risk weight applies to exposures to small and medium-sized enterprises
(SMEs). In addition, the revised standardised approach includes a standalone
treatment for exposures to project finance, object finance and commodities finance.
● For residential real estate exposures, more risk-sensitive approaches have been
developed, whereby risk weights vary based on the LTV ratio of the mortgage (instead
of the existing single risk weight) and in ways that better reflect differences in market
structures.
● For retail exposures, a more granular treatment applies, which distinguishes between
different types of retail exposures. For example, the regulatory retail portfolio
distinguishes between revolving facilities (where credit is typically drawn upon) and
transactors (where the facility is used to facilitate transactions rather than a source of
credit).
● For commercial real estate exposures, approaches have been developed that are more
risk sensitive than the flat risk weight which generally applies.
● For subordinated debt and equity exposures, a more granular risk weight treatment
applies (relative to the current flat risk weight).
● For off-balance sheet items, the credit conversion factors (CCFs), which are used to
determine the amount of an exposure to be risk-weighted, have been made more risk-
sensitive, including the introduction of positive CCFs for unconditionally cancellable
commitments (UCCs).
5.3 The CVA framework
The initial phase of Basel III reforms introduced a capital charge for potential mark-to-market
losses of derivative instruments as a result of the deterioration in the creditworthiness of a
counterparty.
This risk – known as CVA risk – was a major source of losses for banks during the global
financial crisis, exceeding losses arising from outright defaults in some instances. The
Committee has agreed to revise the CVA framework to:
● enhance its risk sensitivity: the current CVA framework does not cover an important
driver of CVA risk, namely the exposure component of CVA. This component is
 directly related to the price of the transactions that are within the scope of application
of the CVA risk capital charge.
As these prices are sensitive to variability in underlying market risk factors, the CVA also
materially depends on those factors. The revised CVA framework takes into account the
exposure component of CVA risk along with its associated hedges;
● strengthen its robustness: CVA is a complex risk, and is often more complex than the
majority of the positions in banks’ trading books. Accordingly, the Committee is of
the view that such a risk cannot be modelled by banks in a robust and prudent manner.

The revised framework removes the use of an internally modelled approach, and consists of:
(i) a standardised approach; and
(ii) a basic approach. In addition, a bank with an aggregate notional amount of non-centrally
cleared derivatives less than or equal to €100 billion may calculate their CVA capital charge
as a simple multiplier of its counterparty credit risk charge.

● improve its consistency: CVA risk is a form of market risk as it is realised through a
change in the mark-to-market value of a bank’s exposures to its derivative
counterparties.
As such, the standardised and basic approaches of the revised CVA framework have been
designed and calibrated to be consistent with the approaches used in the revised market risk
framework. In particular, the standardised CVA approach, like the market risk approaches, is
based on fair value sensitivities to market risk factors and the basic approach is benchmarked
to the standardised approach.

5.4 Operational risk

The financial crisis highlighted two main shortcomings with the existing operational
risk framework.
First, capital requirements for operational risk proved insufficient to cover operational
risk losses incurred by some banks.
Second, the nature of these losses – covering events such as misconduct, and
inadequate systems and controls – highlighted the difficulty associated with using internal
models to estimate capital requirements for operational risk. The Committee has streamlined
the operational risk framework. The advanced measurement approaches (AMA) for
calculating operational risk capital requirements (which are based on banks’ internal models)
and the existing three standardised approaches are replaced with a single risk-sensitive
standardised approach to be used by all banks.

The new standardised approach for operational risk determines a bank’s operational risk
capital requirements based on two components:
(i) a measure of a bank’s income; and
(ii) a measure of a bank’s historical losses.
Conceptually, it assumes:
(i) that operational risk increases at an increasing rate with a bank’s income; and
(ii) banks which have experienced greater operational risk losses historically are assumed to
be more likely to experience operational risk losses in the future.
The leverage ratio complements the risk-weighted capital requirements by providing a
safeguard against unsustainable levels of leverage and by mitigating gaming and model risk
across both internal models and standardised risk measurement approaches.

5.5 The leverage ratio

To maintain the relative incentives provided by both capital constraints, the finalised
Basel III reforms introduce a leverage ratio buffer for G-SIBs. Such an approach is consistent
with the risk-weighted G-SIB buffer, which seeks to mitigate the externalities created by G-
SIBs. The leverage ratio G-SIB buffer must be met with Tier 1 capital and is set at 50% of a
G-SIB’s risk weighted higher-loss absorbency requirements. For example, a G-SIB subject to
a 2% risk-weighted higher-loss absorbency requirement would be subject to a 1% leverage
ratio buffer requirement. The leverage ratio buffer takes the form of a capital buffer akin to
the capital buffers in the risk weighted framework. As such, the leverage ratio buffer will be
divided into five ranges.

As is the case with the risk-weighted framework, capital distribution constraints will be
imposed on a G-SIB that does not meet its leverage ratio buffer requirement. The distribution
constraints imposed on a G-SIB will depend on its CET1 risk-weighted ratio and Tier 1
leverage ratio.

A G-SIB that meets:

(i) its CET1 risk-weighted requirements (defined as a 4.5% minimum requirement, a 2.5%
capital conservation buffer and the G-SIB higher loss-absorbency requirement) and;
(ii) its Tier 1 leverage ratio requirement (defined as a 3% leverage ratio minimum
requirement and the G-SIB leverage ratio buffer) will not be subject to distribution
constraints.

A G-SIB that does not meet one of these requirements will be subject to the associated
minimum capital conservation requirement (expressed as a percentage of earnings). A G-SIB
that does not meet both requirements will be subject to the higher of the two associated
conservation requirements.
The finalisation of Basel III in December 2017 represents an important milestone for
the Basel Committee’s response to the global financial crisis. The full set of Basel III reforms
will help enhance the resilience of the banking system. The Basel Committee will continue to
exercise its mandate to strengthen the regulation, supervision and practices of banks
worldwide. The agenda changes, but the purpose is constant – to safeguard and enhance
financial stability
The Basel Committee has agreed that jurisdictions may exercise national discretion in periods
of exceptional macroeconomic circumstances to exempt central bank reserves from the
leverage ratio exposure measure on a temporary basis.
Jurisdictions that exercise this discretion would be required to recalibrate the minimum
leverage ratio requirement commensurately to offset the impact of excluding central bank
reserves, and require their banks to disclose the impact of this exemption on their leverage
ratios.
The Committee continues to monitor the impact of the Basel III leverage ratio’s treatment of
client-cleared derivative transactions. It will review the impact of the leverage ratio on banks’
provision of clearing services and any consequent impact on the resilience of central
counterparty clearing.
The Basel III framework consisting of the three Pillars namely minimum capital requirement,
supervisory review process and market discipline along with the liquidity measures and
SIFI‟s are depicted as per the figure below:
5.6 ADVENT OF BASEL III IN INDIA

In the ambit of the Basel III Accord the Reserve Bank of India (RBI), the regulatory authority
of the Indian banking industry, issued guideline on implementation of Basel III in May 2012,
which are applicable to all commercial banks operating in India. The Basel III capital
regulation has been implemented from April 1, 2013 in India in phases and it will be fully
implemented as on March 31, 2019. Further, on a review in May 2013, the parallel run and
prudential floor for implementation of Basel II vis-à-vis Basel I have been discontinued.
Banks have to comply with the regulatory limits and minima as prescribed under Basel III
capital regulations, on an ongoing basis. To ensure smooth transition to Basel III, appropriate
transitional arrangements have been provided for meeting the minimum Basel III capital
ratios, full regulatory adjustments to the components of capital etc.
(RBI, 2015) The Basel III Capital Regulations guidelines issued by RBI are bifurcated into
six parts: Part A: Minimum Capital Requirement (Pillar 1), Part B: Supervisory Review and
Evaluation Process (Pillar 2), Part C: Market Discipline (Pillar 3), Part D: Capital
Conservation Buffer Framework, Part E: Leverage Ratio Framework, Part F: Countercyclical
Capital Buffer Framework.
Further, the guidelines on „Liquidity Risk Management by Banks‟ were issued by RBI vide
circularDBOD.BP.No.56/21.04.098/2012-13 dated November 7, 2012. Two minimum
standards viz. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) for
funding liquidity were prescribed by the Basel Committee for achieving two separate but
complementary objectives. In addition, a set of five monitoring tools to be used for
monitoring the liquidity risk exposures of banks was also prescribed in the said document.
As evident from the comparative ratio‟s stated above, it can be inferred that RBI has always
been conservative in stipulating the Basel norms as compared to the norms suggested by the
Basel Committee.

5.6.1 Objectives of Adoption of Basel III for Indian Banking Industry

The adoption of Basel III norms are intended to reduce the probability and severity of crisis
in the banking industry and to enhance the financial stability of the country. India is the
world‟s fastest growing major economy, coupled with this fact and the various initiatives like
Make in India, the banking industry should be strong enough to provide a firm and durable
foundation for economic growth. Moreover the compliance with the global standard
regulations will enable the Indian banks to avoid any disadvantages in the global competition.
The features of Basel-III such as higher risk coverage, thrust on loss-absorbing capital in
periods of stress, improving liquidity standards, creation of capital buffers in good times and
prevention of excess buildup of debt during boom times would help create a resilient banking
system.
(RBI, 2015) Basel III reforms strengthen the bank-level i.e. micro prudential regulation, with
the intention to raise the resilience of individual banking institutions in periods of stress.
Besides, the reforms have a macro prudential focus also, addressing system wide risks, which
can build up across the banking sector, as well as the procyclical amplification of these risks
over time.

5.6.2 Benefits and Challenges posed by Basel III for Indian PSBs

Public Sector Banks (PSBs) include the banks where the Government of India is holding a
majority stake of more than 50% by way of the nationalization process. PSBs work for social,
economic and at times political cause also. They are bestowed with the burden of controlling
and guiding the economy at the most critical times of inflation and deflation and cannot shy
away from their duties which private and foreign sector banks may deem to be unprofitable.
PSBs control nearly 72 percent of the market amongst the
Any new regulation is associated with various costs and benefits. Banks face the daunting
task of meeting stakeholder, regulator and customer expectations while complying with
stringent new regulatory requirements that are gradually taking place because of Basel III
framework. The various benefits derived and the challenges faced by Indian banks through
the implementation of Basel III are as enumerated below.

5.7 MACRO-ECONOMIC EFFECT

(Mahapatra, 2012) The increase in equity capital requirement is likely to increase the
weighted average cost of capital. Banks would partly pass on the increase cost of capital to
the borrowers as higher lending rates. Thus, the equilibrium lending rates are likely to be
marginally higher and as a consequence, credit growth could be a little lower than in the last
few years. (BIS, 2010) The Macroeconomic Assessment Group (MAG) established in
February 2010 by Financial Stability Board and BCBS to coordinate an assessment of the
macro economic implications of the Basel Committee‟s proposed reforms,estimates that
bringing the global common equity capital ratio to a level that would meet the agreed
minimum requirement and the capital conservation buffer would result in a maximum decline
in GDP, relative to baseline forecasts, of 0.22%, which would occur after 35 quarters. In
terms of growth rates, annual growth would be 0.03 percentage points (or 3 basis points)
below its baseline level during this time.
This is then followed by a recovery in GDP towards the baseline. Banks can also
respond to the higher capital requirements by reducing costs or becoming more efficient. In
fact a less stable financial system could have more deleterious consequences. The extent to
which the great recession put global economic growth back is proof enough of this (BIS,
2010) Historical experience suggests that, in any given country, banking crises occur on
average once every 20 to 25 years, i.e. the average annual probability of a crisis is of the
order of 4 to 5%. The evidence indicates that banking crises are associated with large losses
in output relative to trend and that these costs extend well beyond the year in which the crisis
erupts. The cumulative (discounted) output losses range from a minimum of 20% to well in
excess of 100% of pre-crisis output, depending primarily on how long-lasting the effects are
estimated to be. It is inferred that each 1 percentage point reduction in the annual probability
of a crisis yields an expected benefit per year equal to 0.6% of output when banking crises are
allowed to have a permanent effect on real activity. When crises are seen to have only a
temporary effect each 1 percentage point reduction in the annual probability of a crisis yields
an expected benefit per year equal to 0.2% of output. Mapping tighter capital and liquidity
requirements into reductions in the probability of crises is particularly difficult. Although
there is considerable uncertainty about the exact magnitude of the effect, the evidence
suggests that higher capital and liquidity requirements can significantly reduce the probability
of banking crises. As one would expect, the incremental benefits decline at the margin. Thus,
they are relatively larger when increasing bank capital ratios from lower levels and they
decline as standards are progressively tightened.
More stringent capital regulation can result in a positive long-run effect on GDP growth,
since the benefits of decline in the expected cost of avoiding banking crises outweigh the
costs of complying with the stringent capital requirements, such as higher lending spreads
and reduction in lending.

5.8 EFFECT ON CAPITAL REQUIREMENTS

The overall capital adequacy ratio proposed by RBI is at 11.50 % as against the 9.00% at
present. Moreover, the additional leverage ratio has been introduced at 4.50 %. (Subbarao,
2012) Subbarao D., RBI Governor, stated in his speech in Oct 2012 that the Reserve Bank‟s
estimates projectan additional capital requirement of Rs 5 trillion (i.e. Rs 5,00,000 Cr), of
which non-equity capital will be of the order of Rs 3.25 trillion (i.e. Rs 3,25,000 Cr) while
equity capital will be of the order of Rs 1.75 trillion (i.e. Rs 1,75,000 Cr). Majority of this
requirement was to made good by the Govt of India as the PSBs are Govt Undertakings. In
this endeavour, the Government of India has infused total Rs 82422 Cr in the PSB‟s since
Oct 2012 till Nov 2016. The year wise break up is as follows:
The Govt. of India launched the „Indradhanush‟, a seven point plan to revamp the PSB‟s in
Aug 2015. In the reforms note it was stated that the PSBs are adequately capitalized and
meeting all the Basel III and RBI norms. However, the Government of India wants to
adequately capitalize all the banks to keep a safe buffer over and above the minimum norms
of Basel III. The Govt. of India estimated that extra capital required for the FY 2016 to FY
2019 is likely to be about Rs 1,80,000 Crore, excluding the internal profit generation which is
going to be available to PSBs (based on the estimates of average profit of last three years i.e.
FY 2013 to FY 2015). Out of the total requirement, the Government of India proposed to
make available Rs.70,000 Crores out of budgetary allocations for four years, Rs 25,000 Cr in
FY 2015-16, Rs 25,000 Cr in FY 2016-17, Rs 10,000 Cr in FY 2017-18 and Rs 10,000 Cr in
FY 2018-19. The residual requirement of Rs 1,10,000 Cr is proposed to be raised from
market. Unfortunately the things didn‟t turn up as expected by the Govt. of India and the
PSBs posted considerable losses for the FY 2015-16. (FitchRatings, 2016) Fitch Ratings, vide
its press release dt 11.09.2016, stated that the progressive increase in minimum capital
requirements under Basel III is likely to put nearly half of Indian banks in danger of
breaching capital triggers. State banks are the most at risk, given their poor existing capital
buffers and weak prospects for raising capital through market channels.(ICRA, 2016)
InICRA‟s estimate, Aug 2016, PSBs will need to raise Tier 1 capital of Rs 1.7-2.1 trillion (Rs
1,72,000 – Rs 2,10,000 Crore) during FY 2017-FY 2019 to meet the higher regulatory
minimum capital requirements as well as to fund growth. Of this requirement, around 40%
can be made through raising of AT1 instruments; however, given the elevated risk for existing
instruments and the weak investor appetite, it is unlikely that PSBs will be able to raise the
required AT1 capital. Hence, their dependence on equity raising to meet
minimum Tier 1 capital requirements remains very high. The present position of PSBs has
discouraged the investors from investing in their shares or debt. More capital will be needed
from the Govt., over and above the proposed under
Indradhanush reform, to restore market confidence. Though, considering the fiscal concerns,
it is difficult for Govt of India to keep on infusing capital in the banks. The Union Budget
2017-18 has kept the budgetary allocation for capital infusion in PSBs unaltered at Rs 10000
Cr. The capital crunch may lead to contraction of credit by the PSBs in general or to a
specific sector carrying high risk weight like real estate, personal loans, corporate having
external rating in on investment grade i.e. below BBB etc.

EFFECT OF PROFITABILITY

The increase in capital requirements will have a negative effect on ROE. Due to this it is
believed that Basel III will adversely effect the shareholders of banks. However, some
authors believe that a decrease in ROE due to increase in capital does not lead to reduction in
the value as the shareholders expect lower return by way of improved downside protection.
Basel III also introduces a Leverage ratio of 3 % as the ratio of Tier 1 Capital to total
exposure, the new leverage ratio maylimit banks‟ scope of action.
Basel III introduced the new liquidity requirements in form of LCR and NSFR. The banks
need to hold significantly more liquid low-yielding assets to comply with the LCR, which
will have adverse impact on the profitability. Though, in case of PSBs the existing SLR
requirements runs parallel to the LCR, which poses additional burden on banks. Considering
this, RBI has reduced the SLR to 20.75 % as on Oct 2016 from 23.00 % as on April 2013, i.e.
since the implementation of Basel III. A portion i.e. 7% of LCR is also available for LCR.
The NSFR will necessitate the banks to change their funding preference towards long-term
funding, which will also lead to higher funding cost.

EFFECT ON OPERATIONAL ISSUES

The PSBs need urgently to improve their systems of risk management and supervision to
achieve Basel III norms. This may also necessitate the skill development of the officials at all
levels to ensure capital conservation. The PSBs along with Govt and RBI need to undertake
reforms related to governance-related problems in their organizations. The PSBs are
consistently losing their market share to their private sector peers due to being less efficient in
delivering services, low cost efficiencies and comparatively higher delinquencies. The
improved efficiencies and competitiveness of PSBs will also enhance their valuations, which
will enable them to raise equity capital from markets. Basel III provides for improved risk
management systems in banks. It is important that Indian banks have the cushion afforded by
these risk management systems to withstand
shocks from external systems, especially as they deepen their links with the global financial
system going forward. In process of complying with the Basel III guidelines, banks will be
encouraged to take more calculated and strategic approach towards business decision making,
asset choices and growth while allocating capital charge towards opportunities thatsuite the
banks actual risk and return profile, which will lead to better asset quality.
In order to meet the Basel III compliance banks have to ensure that the risk and finance teams
have quick access to centralised, clean and consistent data as the data management
requirement of Basel III are significant for calculating capital adequacy, leverage and
liquidity effectively and accurately. It is imperative for the efficient collection, consolidation
and submission of requisite reports. Better data management will also enable the banks to
manage the customers in a better way and will strengthen the AML framework.
 CHAPTER 6
CONCLUSIONS
 6.1 CONCLUSIONS

Basel II considers both credit and operational risks apart from market risk as the major
sources of risks. Basel II norms direct banks to allocate adequate amounts of capital for these
types of risks unlike Basel I

Implementation of Basel II framework by banks in India has resulted in better performance of

banks, benefitting all its stakeholders. Basel II norms results in reduction of regulatory capital
by reducing the credit risk weights, this can be done by suitably altering the bank’s portfolios.

The global financial crisis of 2007-08 has paved the way for Basel-III norms with emphasis
on the quality of capital in the Bank balance sheet by introducing buffers to withstand
situation arising out financial distress .In spite of Basel –I and Basel-II guidelines, the
financial world saw the worst crisis in early 2008 and whole financial markets tambled. One
of the major debacle was the fall of Lehman Brothers.

The Basel III which is to be implemented by banks in India as per the guidelines issued by
RBI from time to time will be challenging task not only for the banks but also for
Government of India. It is estimated that Indian banks will be required to raise Rs 6, 00,000
crores in external capital in next nine years or so i.e. by 2020

The present study describes the understanding of Basel II norms and its impact on the Indian
Banking System. The focus on the positive and negative impact of adopting Basel Accord on
the banks in India. It outlines that even though there are a few loopholes in the Basel II
framework which has some demerits, but it has far longer list of benefits which outweighs all
the disadvantages. Hence, implementation of Basel II framework by banks in India has
resulted in better performance of banks, benefitting all its stakeholders.

According to Basel III monitoring report (2017) released by BCBS, which covers 210 banks
(consisting of 100 internationally active banks categorised as group-1 and 110 banks
categorised as group-2), all banks meet the risk based minimum capital requirements. Further
98% of the banks in group -1 and 96% of the banks in group-2 had NSFR of more than 90%
(which is to be achieved to 100%). Additionally, 88 % of group-1 banks and 94% of group-2
banks had LCR of more than 100%. Thus, we can infer that there is overall good progress
towards full implementation of Basel III accord internationally.

However, higher capital and minimum liquidity requirements are likely to cause an adverse
impact on return on equity, although coupled with LCR and NSFR, more liquidity is expected
to remain in the system and growth in short tenure assets can be expected. In conclusion, it
can be stated that the guidelines issued under Basel III Accord are effective in theory to
protect the banking system from financial adversities; however, the real effectiveness of
Basel III implementation can be analysed only after its actual implementation. Additionally,
inconsistency in implementation of Basel III across nations would impact the flow of capital
adversely.
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