In order to make the Indian financial system safer from the impact of any potential global financial crisis, the Reserve Bank of India (RBI) released draft regulations of Basel-III for Indian banking sector on December 30, 2011.

The global financial system witnessed collapse and severe stress in several major financial conglomerates in the crisis that started with the collapse of Bear Sterns in 2008, and Indian regulators are trying to ensure that our financial system does not catch a cold when the world sneezes.

Hence, the move towards Basel-III framework that identifies systemic risk as an important risk factor and improves the ability of banks to withstand crisis by prescribing more stringent capital norms with higher quality capital, and more robust liquidity requirements.RBI's draft guidelines suggest a minimum Tier-I capital of 7 per cent of Risk Weighted Assets (RWAs) on an ongoing basis, with common equity ratio of at least 5.5 per cent, and a minimum total capital of at least 9 per cent of RWAs on an ongoing basis. Additional capital conservation buffer (CCB) is in the form of common equity will be phased in, culminating in an additional 2.5 per cent. Hence, the total capital requirements would be 11.5 per cent of Risk Weighted Assets. Currently, banks in India have to maintain a CAR of 9 per cent with minimum Tier-I of 6 per cent.

Implementation of Basel-III in India is proposed to begin on January 1, 2013 and it is proposed to be fully implemented by March 31, 2017, compared to the January 1, 2019 deadline proposed by the Basel Committee. Every year beginning from January 1, 2013, CCB has to be increased by 0.625 per cent.

CAPITAL ADEQUACY RATIO

The Indian banking sector is already under stringent supervision as compared to banks in most international jurisdictions. The total capital adequacy ratio for the banks currently stands at 9 per cent, as compared to 8 per cent prescribed in Basel-II.

While most of the private and foreign banks have core capital above 9 per cent and should not face many challenges in complying with the additional capital requirements under Basel III, several of the public sector banks (that constitute 70 per cent of the Indian banking sector) would require additional capital under Basel-III norms – which may be a constraint give the current fiscal deficit and the mandate for the government to continue owning a minimum of 51 per cent stake in the PSU banks.

Preliminary estimates suggest that the Indian banking sector requires Rs 1.1 billion of capital to comply with the Basel-III norms. While the objective of the Basel-III norms is to ensure the reduction of loss in adverse times and improve the quality of capital, the moot question for the Indian banking sector (more so for the public sector banks) is the concern of raising the additional capital.

Will the government be able to pump in the capital required for growth and simultaneously hold onto their stake while not increasing the fiscal account deficit? Maintaining a high level of core capital would also negatively impact the return on equity, and ROA of the banking sector.

LIQUIDITY RATIO

In the Basel-III draft guidelines that were issued last week, the Reserve Bank of India mentions the liquidity ratio which will be introduced in a phased manner. The minimum standard for liquidity ratios are expected between 2014 and 2018.

Currently, with the SLR at 24 per cent and CRR at 6 per cent, 30 per cent of each banks' balance-sheet is not available for lending. How these reserve requirements are factored in during the liquidity calculations will need to be assessed.

On the whole, Basel-III norms seek to build a strong banking system with adequate capital, sufficient liquidity in times of stress, and reduced systemic risk in the long run, but these norms are bound to put pressure on the banks to raise capital in uncertain macro-economic conditions, particularly in a period when the government's finances and ability to meet the incremental capital needs are already stressed.