Basel III – Capital requirement norms

Life follows the path of a rollercoaster. None is a consistent winner nor looser. YES bank is a quintessence for it. From a leading private sector bank in the economy, the bank’s going concern underwent a shadow of doubt in the recent past. Banks with shallow financial indicators i.e. breaching threshold capital requirement norms, asset quality (NPA ratio – Non performing asset ratio) and profitability (-ve return on assets) fall under the prompt corrective action (PCP) of the reserve bank. The classification happens from low-level risk (1) to high-level risk (3) before getting placed under PCP.  The yard stick of a bank’s ability to bear the brunt of losses is indicated by CAR (Capital Adequacy ratio). Risk weighted assets occupy the numerator & capital of the bank in the denominator. Capital is further demarcated into Tier – 1 & Tier – 2. Tier one capital is generally capable of absorbing the losses of the bank, without a necessity to cease operations. Tier two capital gets utilized to absorb phenomenal losses in the case of winding up of banks. The norms for capital adequacy are set by “Basel committee for Bank Supervision” (BCBS) – which is a consortium of monetary authorities from 27 countries. BCBS is headquartered with “Bank for international settlements” based on Switzerland. Incumbent, Basel III norms are in practice. The ratios / norms set by the Basel committee are subject to tweaks by the monetary regulator of the respective jurisdiction. There have been instances of Gov. owned @ public sector banks slipping into PCP. PCP lays restriction on certain operations of a bank, for instance branch expansions / managerial remuneration / lending to parties with weak credit ratings. To shore up the capital base, GoI (Govt of India) pumps in capital quid pro quo shares in the banks. The infusion was so titanic in the past 5 years, which had resulted in government’s stake exceeding 90% in select banks, making it difficult to infuse further capital in such banks.

The liquidity crunch in banks aggravated the financial crisis of 2007-2008. Liquidity stress arises because of cash flow mismatches, to a dominant extent. For instance, a term loan for 5 years is sanctioned on the basis of a deposit receipt for 2 years; the amounts can be presumed to be equal. The cash outflow for the deposit was due in 2 years’ time, whereas the cash inflow was due in 5 years’ time. The matter would be insignificant if the amount in question was INR 1 crore, but what if it’s INR 1000 crore?? Such was the scenario with global banks, then. The bank would fail to repay the depositors on time, shackling investor’s confidence in the the bank and system. A contemporary instance was the case of YES bank, where a timely intervention by RBI maintained the confidence in the system. The banks’ deposit base eroded within days of moratorium lifting; a special liquidity window to fund the widespread withdrawal by RBI came in hand for the YES bank to manage the circumstance. Basel III norms incorporated two additional liquidity requirements to circumvent liquidity stress in the sector. These were –

Net stable funding ratio: Emphasis is placed to avoid funding long term assets through short term liabilities. From a bank’s perspective, long term loans should not be funded by deposits with a duration lesser than that of a loan.  Numerically it’s a division of ‘Available stable funding’ by ‘required stable funding’. Available stable funding is a weighted sum of a bank’s capital & liabilities (i.e. deposits). Share capital, unencumbered (not earmarked / having burden) reserves shall be assigned the maximum weight of 100, while deposits are assigned a weight based on their duration. Required stable funding encapsulates assets (i.e. loans) of the bank; weights assigned in direct proportion with duration. For instance, a working capital loan may be assigned 20%, whereas term loans might fetch 70% +. In brief, it estimates how much of the bank’s loans, require a long-term stable funding.  The ratio should exceed / equate 100%.

Liquidity Coverage ratio: The ratio stipulate banks to maintain an amount equaling, forthcoming 30 days net cash flows, in the form of liquid assets. Numerically it’s the ratio of “high quality liquid assets” & “net cash flows expected in upcoming 30 days”. High quality liquid assets are cashable anytime with / without insignificant loss. Net cash flow is arrived by estimating total cash inflows & outflows for forthcoming 30 days period.

To culminate with, Basel III emphasis 100% Liquidity coverage ratio, however countries have the leeway fix the threshold at their volition, based on the needs in the domestic territory. Given the situation in India, ratio have been deeply diluted to flush in excess liquidity in the economy. Banks in India, have reported profits during Q1 – 2020. The profits are based on the minimum provision requirements, as insisted by RBI for covid linked losses. The veracity of loans / advances shall come to light only when the moratorium gets lifted. As moratorium is in place, banks need not recognize NPA during the period. IBC (insolvency and bankruptcy code) abeyance, is another feather on the cap for beleaguered companies, but not banks. The avalanche of NPA is still in progress; the day for them to hit the treasuries is not so far!!!

Published by adithyaarunachalam

I'm a millennial, from Chennai, India. Passionate about building up a career in finance, I follow and stay abreast on news feeds. I'm a novice blogger, So feel free to pass on your conjecture to me @adithyaarunachalam@Gmail.com

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