In India a high percentage of borrowers have the best rating, which means that under new Basel norms a significant amount of bank capital could be freed, says Soumya Kanti Ghosh
INDIAN banks did not have much to cheer about of late. First, there was the prospect of loan waiver scheme announced in the Union budget making a possible dent on the banks’ portfolio and second, the global economic meltdown bringing further bad news for the already beleaguered Indian banks. However, with the Indian banks currently in the process of implementing best risk management practices in alignment with Basel II norms, they will have much to cheer about in the current financial year.
First a word on Basel I approach. The Basel I approach was just a onesize-fit-all approach for capital regulation in particular, with all corporate borrowers carrying the risk weight of 100%. Also, it gave rise to significant gaps between the measurement of regulatory capital and the actual economic risk experienced by banks. To overcome this approach, the Basel II norms were recommended to cover a comprehensive range of risk (credit, market and operational). In India, the RBI also targets a smooth implementation of Basel II which is expected to lay down a sophisticated and risk-conscious banking system in the country. In fact, in the recently announced credit policy, the RBI has also proposed criteria for the applicability of Basel norms to state/district cooperative banks/regional rural banks (apart from the scheduled commercial banks).
One of the key drivers of the Basel reforms is to better align regulatory capital with risk. To this end, capital requirements for higher-rated borrowers will fall significantly. An immediate corollary of this, capital needs for lower-rated borrowers will also rise significantly. Clearly, developing economies contain a disproportionate number of lower-rated borrowers, and hence on average regulatory capital requirements for developing country borrowers may increase significantly post-Basel II.
It is here that this study begs to differ. If we look at the data on credit ratings on corporate debt securities in India, we find that a significant chunk of the borrowers have been rated in the highest security bracket. One of the important reasons for this is that lower ratings are typically not accepted by issuers as there is no market for the same. Another important reason for almost no interest in bonds (rated below “A”) is the fact that there is very little recourse for recovery in case of any default in such bonds, thanks to a long drawn out judicial process in India. Interestingly, although the new securitisation act (SARFAESI Act) has been introduced in the country, so far the number of deals has been insignificant under that route, possibly because of higher transaction costs.
To substantiate our point, we looked at the rating distribution of rated papers on the NSE debt market segment and found that a significantly large chunk of the papers (more than 86%) were in the AAA till AA- segment, with AAA papers dominating the trading. There was virtually no market below A- category.
For our analysis, we made a basic assumption that the bank’s asset portfolio mimics the market portfolio of these outstanding debts for calculating the new capital requirement under the standardised approach. We call this the optimistic rating distribution/Scenario 1. For estimating the new capital requirement we took the incremental non-food credit growth in FY2008-09 at 22%-25% (this is a reasonable assumption, given that credit growth is expected to slowdown in FY2008-09). The capital plunge was then calculated by taking the difference in risk weighted assets by assuming a status quo of Basel I (applying 100% risk weight). Our estimates reveal that as much as Rs 38,000 crore of extra capital will be available to the banks in the current fiscal only, which is more than the investment requirement for airports in the country over 2008-2012.
WE REPLICATED the same process in Scenario 2, but this time we stressed the portfolio of the banks, by making it heavy towards lower-rated papers. In this scenario, the total capital freed could still be as much as Rs 22,500 crore.
Let me discuss a couple of points which came out in the course of analysis. First, this exercise is a rather simplistic approach and critics might argue that the extra capital freed up will be outstripped by the increased requirement by way of operational and market risk. To this we can say that, assuming a spread of at least 3.5% (given the fact that the RBI earlier used to give this rate of interest on idle CRR balances), the incremental income generated could be as much as Rs 1,300 crore on this additional capital, thus partly neutralising the possibility of increased capital requirement, if any.
What the RBI could do in this regard? On an average, credit rating agencies have similar risk assessments, and hence will lead to similar lending on the part of the Indian banks in Basel II. This is further amplified by the observation that “because credit rating agencies do not like to change their ratings frequently, they tend to lag market measures of risk. Ratings rise as markets become optimistic and fall as markets become pessimistic. This possibly increases the propensity of financial crises in the financial system”. In this regard, the advanced (IRB) approach is superior to the standardised approach in which it allows large banks to use their internal risk rating models. Subsequently, the RBI must actively encourage the Indian banks to use the advanced (IRB) approach. Banks could then become specialised rating agencies in areas where they have much lending experience and proprietary knowledge.
Finally, my problem with Basle II, particularly in the light of the subprime crisis, is whether ratings provided by rating agencies can be used to solely determine the amount of capital required in the first place! To this, I must say the idea in this exercise is to only reveal the possibility of incremental capital benefit in lieu of a safer banking system visà-vis Basel II and nothing else.
(The author is a director with a leading MNC. Views are personal )
