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Basel recommendations: Are we prepared?

Oct 1, 2004

With India on the path of globalisation, the Indian economy is likely to get affected in almost all areas and the banking sector is no exception. As Indian banks are slowly but surely getting further integrated into global financial markets, there is an increasing need to integrate the regulatory environment of Indian banks to global standards. Here we are referring to the Basel committee recommendations that the RBI has decided to implement in the Indian banking sector. In this article we deal with one of the most crucial aspects of the recommendations, which pertains to the issue of capital adequacy.Capital adequacy is one of the most important parameters that indicates the health of a bank. Since banks deal with large amount of capital, their losses could also be in large quantum. Thus, the importance of adequate capital, as it protects a bank against any such adversity. Further, the level of capital also determines how much business (that is lending) the bank can undertake. Capital also determines how the bank can expand physically i.e. in terms of branches. Due to the significance of capital in the working of a bank, the Basel committee has laid foremost importance to laying uniform norms for banking sector across the globe.

The Basel committee has recommended that the Capital Adequacy Ratio (CAR), which is the measure of the level of capitalization of a bank, should be at a level of not less than 8%. In the Indian context, this may not be a concern at the moment as the RBI has already mandated Indian banks to have a CAR of over 9%. The concern would arise, however, when the Basel recommendations are implemented to their full effect. The Basel norms recommend a change in the way banks assign risk weightages (essential for the calculation of CAR) to the assets they hold. Thus, when these changes are enforced, the CAR levels of Indian banks could drop significantly.

Further, there are practical problems in implementing the recommendations and Indian banks are not well prepared to do so. For one, there are technological problems that need to be first sorted out. Most Indian banks do not have a core baking solution that is essential to adequately monitor the state of assets, which in turn helps in the proper assignment of risk weightages. Lack of technological preparedness would mean that banks would have to spend heavily on implementing core banking solutions and full automation of branches before the Basel recommendations could take effect.

Another aspect that could have profound implications on the CAR structure of Indian banks is regarding the risk weightage for sovereign investments (G-sec investments of banks). Earlier sovereign investments carried a risk weightage of 0%. However, under the new set of recommendations, the risk weightage could vary from 0% to 150% depending upon the country. If implemented, this could have a significant impact on the capital requirements of banks and they may be forced to raise additional capital from the capital markets.

So what does all this mean to investors who are looking to invest in banking sector stocks? The most important implication from the perspective of the investor is that as and when the Basel recommendations are implemented (most likely in a phased manner), we are likely to see a rise in capital requirements for Indian banks. This could force them to tap equity markets for additional capital to maintain their CAR, thus in turn diluting the returns to shareholders. However, this is not a bad thing in itself, as banks do need regular infusion of capital to sustain operations. What is important, however, from the investor perspective is that they need to identify banks with the best systems.

For one, investors need to identify banks that have already implemented or are in the process of implementing a core banking solution. Investors also need to check up on the level of automation of a particular bank. There is a need to focus on the quality of assets of a bank. Implementation of the Basel recommendations may be an eventuality and not all banks would be in the best position to meet the conditions set by the same. Over the long-term a bank’s preparedness to meet the conditions would be a key determinant of its success in the rapidly globalising financial services arena.

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