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Balancing growth and capital requirements - EY - India

Balancing growth and capital requirements

Assessing the impact of BASEL III on the Indian banking sector

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The role of the banking sector in the credit intermediation is critical for sustainable economic growth.

The BASEL III framework is focused on a sustained increase in capital, particularly equity capital, to absorb the potential impact of market, credit and operational risks

With BASEL III to be introduced in 2013, this report helps assess the need for capital in the banking sector in India.

Since the availability of credit is vital to sustain overall economic growth, the failure of the banking system can lead to a freeze in credit markets and a severe degradation in growth potential.

The global financial crisis of 2008 found its roots in the sustained under-estimation of risk, coupled with deteriorating levels of equity capital. Based on the lessons drawn from this crisis, the Basel Committee on Banking Supervision (BCBS) has drafted the BASEL III regulatory framework.

  • This framework is focused on a sustained increase in capital, particularly equity capital, to absorb the potential impact of market, credit and operational risks.
  • BASEL III also focuses on requiring banks to keep a sufficient stock of high-quality liquid assets to manage short-term financial stress. With the introduction of the new framework, the need for capital is expected to rise.

The Indian banking system is at an important crossroad — the balance between growth and the need for additional capital.

Where credit off-take is sustained at current levels, along with a similar profitability and asset profile, the Indian banking sector, as a whole, is likely to require significant capital infusion by 2015. Individual banks may require capital infusion as early as 2013.

The Indian banking sector’s ability to balance growth and capital requirements is dependent on the following factors:

Optimization of capital composition

With the exception of private banks, Indian banks have an underutilized base of Tier-II capital. The ability to fully fund growth through tier-I and tier-II capital will be critical to managing return on equity.

Sustaining and enhancing net profit margins:

The focus on enhancing balance sheet size as the cost of net margins is likely to impact growth, as BASEL III stresses on the need for common equity i.e., paid-up share capital and free reserves.

Retention of profits

Retaining earnings through a cautious approach towards dividend payouts is crucial to meet the needs of common equity under BASEL III.

Quicker transition to the evidence-based estimation of risk as opposed to formula-based approaches

Lack of appropriate risk quantification has led to the overestimation of capital requirements for credit and operational risk. The ability to allocate capital in line with evidence-based risk quantification, as opposed to formula-based allocation, is important for the accurate estimation of capital requirements. In general, the delay in transition to advanced approaches has potentially led to an over-estimation of regulatory capital requirements.

Restructuring risk-return expectations from the market risk portfolio

Unlike credit and operational risk, a transition to advanced approaches for market risk is likely to increase the requirement of regulatory capital. The need for additional capital stems from volatility being a key measure for determining risk and a sustained increase in this volatility across financial markets, especially equity markets.

Additional capital requirements for stress conditions and credit risk in trading portfolios are likely to further enhance the need for regulatory capital.

This report analyzes various alternatives for banks to manage capital requirements, through rationalizing the capital mix, improving internal risk-management practices, and modifying balance sheet-management policies. Download our report for details.

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