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India's Basel III leniency comes at a cost

Reserve Bank India 230px
By Isabella Zhong
08 Apr 2014

India's cash-strapped state-owned banks breathed a sigh of relief last month when the country's central bank pushed back its rollout of Basel III by a year. But the move fails to reward the better functioning private sector banks and takes India a step further away from a more efficient financial system.

In late March the Reserve Bank of India (RBI) delayed implementing the Basel III capital conservation buffer for banks by one year, to March 2016. The move offered some precious relief: word has it that the country's public sector undertaking (PSU) banks would simply not have been able to cope without the extra time.

ICRA, a domestic credit ratings agency, reckons that PSU banks would have needed anywhere between Rs200bn and Rs450bn ($3.33bn-$7.5bn) of new tier one equity capital to be compliant. The moratorium sees that requirement fall to about Rs150bn to keep within existing capital adequacy levels as loans grow, and Rs110bn of that has already been pledged by the Indian government.

Unlike their privately owned counterparts, India's PSU banks have long struggled with raising equity. State Bank of India fell short of its $1.5bn target in a capital raising in January, getting only $1.2bn even after pricing at the bottom of its range.

The problem for PSU banks is that investors tend to be put off by their weak — and worsening — credit fundamentals. In 2013 the average non performing asset (NPA) ratio of PSU banks was 2%, four times greater than the 0.5% of the private banks. The ratio for private banks had held steady from 2012, while PSU banks had deteriorated from 1.5%.

And at 0.78%, PSU banks also recorded a much lower average return on assets compared to their private sector peers, which generated 1.63%.

This performance gap, which analysts expect will continue to widen, is something the RBI wants to tackle. Last November RBI governor Raghuram Rajan pledged to revamp Indian banking by introducing greater competition. On April 2 the central bank kicked its private sector bank licensing system back into life after a 20 year break, with the approval of two new licences.

The hope is that increased private sector participation will improve the efficiency of the Indian banking sector through increasing private sector participation.

Better solution

Against that backdrop, the RBI's move to extend the Basel III deadline looks somewhat hypocritical.

For one, the move creates an uneven playing field that doesn't reward the private sector firms — who would have easily been able to meet the original schedule — for being better run. Instead, it looks like an attempt to indulge the needs of poorly run PSU banks.

That is not conducive to private sector participation, which has already been discouraged by red tape. Conglomerates Tata Sons and Mahindra last year withdrew applications for banking licences, citing onerous regulatory requirements by the RBI.

Moreover, the move will not encourage PSU banks to clean up their act. In China, a country where state owned banks have come to expect regulators to accommodate their needs, NPAs have become a crippling problem, and one that authorities are now grappling with.

A better approach would have been for the RBI to stick to its guns with the implementation schedule, but take measures to make PSU banks more attractive to investors.

Tougher lending guidelines and heightened governance and disclosure requirements would see PSU banks reduce their exposure to NPAs. Stricter screening of loan applications would be a good start — research firm Finacle reckons that the main cause of NPAs is misappropriation of funds by borrowers.

As the credit fundamentals of PSU banks improve, investors will no longer be so wary of them — and the banks would be in a better position to meet higher capital requirements.

Regulators could also usefully make progress in structural and policy reform efforts, such as keeping India's current account deficit in check. Doing so would help build investor confidence in the macroeconomic backdrop.

The systemic importance of PSU banks means that the Indian government will need to allocate additional capital support to help them through the next year. That's understandable. But making it easier for the banks to shirk capital requirements is nothing more than a short-term fix to a long-term problem.

By Isabella Zhong
08 Apr 2014