List of abbreviations

ABS-Asset Backed Securities

BDC-Business Development companies

BCBS-Basel Committee on Banking Supervision

CAR-capital adequacy ratio

CDO-Collateralized Debt Obligations

DTA-Deferred tax assets

FDIC-Federal Deposit Insurance Corporation

FSB-Financial Stability Board

GAAP-Generally accepted accounting principles

IASB-International accounting standards board

IRB- Internal Rating Based Approach

LCR-Liquidity coverage ratio

MAG-Macroeconomic Assessment Group

MSR-Mortgage Servicing Rights

NSFR-Net stable funding ratio

OTC-Over the counter derivatives

QIS-Quantitative Impact Study

RBI-Reserve Bank of India

REIT-Real Estate Investment Trust

RWA-Risk Weighted Assets

ROE-Return on equity

SLR-Statutory Liquidity Requirement

SME-Small and Medium Enterprise

VAR-Value at risk

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 EXECUTIVE SUMMARY

| After an indepth analysis, I believe that at the aggregate level Indian banks will not have
any problem in adjusting to the new capital rules as required by BASEL III norms, both
in terms of quantum and quality.

| Also, estimates show that the leverage in the Indian banking system is quite moderate.
Indian banks will not have a problem in meeting the leverage ratio requirement. This is
because the Tier 1 capital of many Indian banks is comfortable (more than 9%) and their
derivatives portfolios are also not very large.

| Basel III will have significant impact on the European banking sector. As per initial
estimates, by 2019 the industry will need about ¼1.1 trillion of additional Tier 1 capital,
¼1.3 trillion of short-term liquidity, and about ¼2.3 trillion of longterm funding.

| The impact on the US banking sector will be similar, though the drivers of impact vary. I
believe that the industry will face a Tier 1 capital shortfall at $870 billion (¼600 billion),
the gap in short-term liquidity at $800 billion (¼570 billion), and the gap in long-term
funding at $3.2 trillion (¼2.2 trillion).

| Closing these gaps will have a substantial impact on profitability. All other things being
equal, Basel III would reduce return on equity (ROE) for the average bank by about 4
percentage points in Europe and about 3 percentage points in the United States.

| Despite the long transition period that Basel III provides, compliance with new processes
and reporting must be largely complete before the end of 2012. For an average midsize
bank, I estimate that the technical implementation alone will add about 30 percent to 50
percent to the significant outlay already incurred for Basel II. Implementing the new rules
will require three distinct initiatives: strategic planning for the Basel III world, capital and
risk strategy, and implementation management.

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 INTRODUCTION

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Post crises, the worst since the great depression, the Basel Committee on Banking Supervision
(BCBS) have developed a reform programme to address the lessons of the crisis. BCBS has, with
an intention of strengthening the banking sector has amended the BASEL II norms. The depth
and severity of the financial crisis of 2007-08 were amplified by weaknesses in the banking
sector such as excessive leverage, inadequate and low-quality capital, and insufficient
liquidity buffers. The crisis was exacerbated by a procyclical deleveraging process and the
interconnectedness of systemically important financial institutions.

In response, the committee¶s reforms seek to improve the banking sector¶s ability to absorb
shocks arising from financial and economic stress, whatever the source, thus reducing the risk of
spill over from the financial sector to the real economy.

The reforms strengthen bank-level, or micro prudential, regulation, which will help raise the
resilience of individual banking institutions in periods of stress. The reforms also have a macro
prudential focus, addressing system wide risks, which can build up across the banking sector, as
well as the procyclical amplification of these risks over time. Clearly, these micro and macro
prudential approaches to supervision are interrelated, as greater resilience at the individual bank
level reduces the risk of system wide shocks.

Collectively, the new global standards to address both firm-specific and broader, systemic
risks have been referred to as ³Basel III´.

To understand the importance of the Basel III reforms and where it will lead in terms of capital
regulation, I believe that I have to look back to see where I have come from.

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Basel I, the first internationally agreed capital standard, was issued some 23 years ago in 1988.
Although it only addressed credit risk, it reflected the thinking that experts continue to subscribe
today, namely, that the amount of capital required to protect against losses in an asset should
vary depending upon the riskiness of the asset. At the same time, it set 8% as the minimum level
of capital to be held against the sum of all risk-weighted assets.

Following Basel I, in 1996 market risk was added as an area for which capital was required.
Then, in 2004, Basel II was issued, adding operational risk, as well as a supervisory review
process and disclosure requirements. Basel II also updated and expanded upon the credit risk
weighting scheme introduced in Basel I, not only to capture the risk in instruments and activities
that had developed since 1988, but also to allow banks to use their internal risk rating systems
and approaches to measure credit and operational risk for capital purposes.

What could more broadly be referred to as Basel III began with the issuance of the revised
securitisation and trading book rules in July 2009, and then the consultative document in
December of that year. The trading book rules will be implemented at the end of 2011 and the
new definition of capital and capital requirements in Basel III over a six-year period beginning in
January 2013. This extended implementation period for Basel III is designed to give banks
sufficient time to adjust through earnings retention and capital-raising efforts.

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An exhaustive work of research has already taken place on the new BASEL norms and its
impact on the global banking system by researchers and analysts all over the world.

Brief reviews of the major studies are given below.

Mr. Duvvuri Subbarao, Governor of RBI, in his report on the future of Indian Banking states
that the new BASEL III regulations aimed at better guarding banks against systemic risks of the
type that plunged the world into the crisis. He believes that the Indian banks are comfortably
placed in terms of compliance with the new capital rules. However, he insisted that although a
few individual banks may fall short of the Basel III norms and will have to augment their capital.
But as the phase-in time allowed is long enough, these banks should be able to make a
comfortable adjustment to the enhanced requirement.

Dr. Rupa Rege Nitsure, Chief Economist, Bank of Baroda in her report on BASEL III
believes that the new norms are intended to make the global banking industry safer and protect
economies from financial meltdowns. She points that given that our banks have limited usage of
noncommon equity Tier 1 instruments, most of the Indian banks will be able to meet the
minimum capital requirements ahead of the scheduled time table.

Mr. Hervé Hannoun, Deputy General Manager, Bank for International Settlements states
that Basel III not only enhances the microprudential framework for capital but it also adds a
macroprudential approach that is system-wide and systemic. Since Basel III is BOTH a firm-
specific, risk based framework and a system-wide, systemic risk-based framework.

Mr. Thomas W. Killian, Principal, Sandler O¶Neill, opines that the implications for the U.S.
banking industry of the Basel III requirements in combination with Dodd-Frank Act can be very
decisive. However, he is optimistic that the U.S. banking system and capital markets will

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respond to challenges in an innovative manner as it usually does. He also believes that with
forward planning, banks can be well-positioned to deploy capital to earn attractive returns on the
core business lines and build their franchises.

Mr. Walter W. Eubanks, Specialist in Financial Economics, in his report believes that
extending the deadline for implementing Basel III gives the industry more time to raise
additional capital. However, it also delays putting in place the countermeasures for preventing
the next financial crisis.| According to the new schedule, it will be nine years before Basel III is
fully in place and the probability of a new crisis by then is very high.

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 OBJECTIVES OF THE STUDY

This study is an attempt to analyze the new BASEL accord and its potential impact on the global
banking industry. For the same, I have chosen Indian, European and US banking sector.

The main objectives of the study are as stated below:

š| To understand the newly formed BASEL norms in depth.

š| To analyse the need for the new norms post financial crises.
š| To discuss the impact of BASEL III norms on the global banking industry.

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The report aims at testing the following hypotheses

È| There was no genuine need for the new BASEL III reforms.

È| The bank¶s profitability would not decrease due to the new norms.

È| BASEL III norms are exceedingly conservative which might lead to hindered growth
prospects.

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 V>  ||>|  |

Research Design

For this report the universe of the study taken are banks from India, Europe and the
United States. An indepth analysis is carried out within them on certain parameters as and where
required. The research methodology used is a descriptive one so as brig out the major impact of
the newly formed BASEL norms.

Data Collection

The project requires both qualitative and quantitative analysis and requires much
emphasis on the secondary data than the primary data. The secondary data are collected from the
websites of respective central banks, latest balance sheets of banks etc.

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 Chapter 1

© | Basel II-M





Basel II, formed in 2004, is the capital adequacy framework applicable to the banking sector.
µBasel Capital Accord¶ deals with Capital measurement and Capital Standards for Banks, which
align regulatory capital requirements more closely with underlying risks. The Accord has been
accepted by over 100 countries including India.

The main structure of µBasel II¶ rests on three pillars:

I. Minimum Capital Requirements

II. Supervisory Review Process; and

III. Market Discipline

1. µMinimum Capital Requirements¶, have been prescribed for Credit Risk, Market Risk and
Operational Risk.

Credit Risk:

Under the old Basel I framework, all assets used to get a µone-size-fits-all¶ treatment and were
given a uniform risk weightage of 100% while the stipulated minimum capital adequacy ratio
(CAR) for a Bank was 9%. Under Basel II, while the minimum CAR is unchanged at 9%, the
risk weights assigned to assets would be proportionate to the credit risk associated with these
assets. Within Basel II, various approaches have been prescribed with progressively increasing
risk sensitivity. In the first stage, RBI directed the Indian Banks to adopt µStandardized
approach¶ for Credit risk [followed by Foundation Internal Rating Based (IRB) Approach and
Advanced IRB Approach]. Under the µStandardized Approach¶, credit ratings awarded by
recognized rating agencies would be used to assign risk weights to bank exposures.

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Market Risk:

Banks were directed to apply Standardized Duration Approach for computing capital
requirement of market risks. This is not different from the approach under Basel I.

Operational Risk:

Basel II has also an additional provision for Operational Risk which was absent in Basel I.
Operational risk deals with loss from failed systems and processes, people or as a result of
external events. Various approaches have been prescribed by the Basel Capital Accord for
addressing this risk, viz., Basic Indicator Approach, Standardized Approach and Advanced
Measurement Approach (in the order of increasing complexity and data requirements). To start
with, RBI had prescribed adoption of µBasic Indicator Approach¶ for Indian Banks.

2. The Supervisory Review Process is ³intended not only to ensure that banks have adequate
capital to support all the risks in their business, but also to encourage banks to develop and use
better risk management techniques in monitoring and managing their risks´.

The Committee has identified 



 
 of supervisory review

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation
to their risk profile and a strategy for maintaining their capital levels.

Principle 2: Supervisors should review and evaluate banks¶ internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their compliance with
regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not
satisfied with the result of this process.

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Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital
ratios and should have the ability to require banks to hold capital in excess of the minimum.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling
below the minimum levels required to support the risk characteristics of a particular bank and
should require rapid remedial action if capital is not maintained or restored.

3. Market Discipline refers to disclosure requirements of Banks and to complement both Pillar I
and II. The guiding principle is to allow market participants to be able to assess key parameters
(like CAR) of a Bank using such disclosures.

The Shortcomings of Basel II

The devastating impact of the financial crisis and the ensuing global recession prompted the
authorities to reconsider the international framework regulating the banking system, known as
Basel II. These accords, developed by the Basel Committee on Banking Supervision, deal with
the whole spectrum of regulatory and supervisory issues, including liquidity standards, credit,
operational and market risk management and accounting standards. However, the main feature of
these regulations is that banks have to comply with a minimum Tier 1 capital requirement ratio
to their risk-weighted assets of 4.0%(Tier 1 capital is core capital, consisting of equity, retained
earnings and other instruments); the riskweighting is calculated by using a standardised or
internal-ratings based approach. The goal of this capital requirement is for the bank to be able to
absorb unexpected losses, such as those that occurred during the latest financial crisis.

However, the crisis highlighted a series of shortcomings in the Basel II accords:

‡ The capital requirement ratio of 4% was inadequate to withstand the huge losses that were
incurred.

‡ Responsibility for the assessment of counterparty risk (essential to the risk-weighting of banks¶
assets and therefore in assessing the capital requirement) is assigned to the ratings agencies,
which proved to be vulnerable to potential conflicts of interest.

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‡ The capital requirement is µpro-cyclical:¶ if the global economy expands and asset prices rise,
the country and counterparty risks associated with a borrower tend to decrease and thus the
capital requirement is lower; however, in the event of a recession, the reverse is also true, thus
raising the capital requirement for banks and further restraining lending.

‡ Basel II incentivizes the process of µsecuritization,¶ as financial institutions that repackage their
loans into asset-backed securities are then able to move them off their balance sheets and thus
reduce the assets¶ risk-weighting. As a result, this process enabled many banks to reduce their
capital requirement, take on growing risks and increase their leverage.

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 Chapter 2

Basel III-The hope for a better future

The cornerstone of the Basel Committee¶s reforms is stronger capital and liquidity regulation.
But at the same time, it is critical that these reforms are accompanied by improvements in
supervision, risk management and governance, as well as greater transparency and disclosure.

The fundamental change introduced in the Basel III vis-à-vis Basel II, is that of merging the
microprudential and the macroprudential approaches to supervision. Basel III builds upon the
firm-specific, risk based frameworks of Basel I and Basel II by introducing a system-wide
approach. To its credit, Basel III is BOTH a firm-specific, risk based framework and a system-
wide, systemic risk-based framework.

(Source: www.basel.org.in)

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 | Firm-specific reform measures

1. Capital

The global banking system entered the crisis with an insufficient level of high quality capital.
Banks were forced to rebuild their common equity capital bases in the midst of the crisis at the
point when it was most difficult to do so. The crisis also revealed the inconsistency in the
definition of capital across jurisdictions and the lack of disclosure that would have enabled the
market to fully assess and compare the quality of capital across institutions.

Quality and level of the capital base

The Basel Committee reached agreement on a new definition of capital in July 2010. Higher
quality capital means more loss-absorbing capacity. This in turn means that banks will be
stronger, allowing them to better withstand periods of stress.

A key element of the new definition is the greater focus on common equity, the highest quality
component of a bank¶s capital. Credit losses and write downs come directly out of retained
earnings, which are part of a bank¶s common equity base. The Committee therefore has adopted
a stricter definition of common equity, requiring regulatory capital deductions to be taken from
common equity rather than from Tier 1 or Tier 2 capital as is currently the case. As a result, it
will no longer be possible for banks to display strong Tier 1 capital ratios with limited common
equity net of regulatory deductions.

The Basel Committee is of the view that all regulatory capital instruments must be capable of
absorbing a loss at least in gone concern situations. The Committee has consulted on a proposal
to ensure that all non-common Tier 1 and Tier 2 capital instruments are able to absorb losses in
the event that the issuing bank reaches the point of non-viability.

The concept of Tier 1 that I are familiar with will continue to exist and will include common
equity and other instruments that have a loss-absorbing capacity on a ³going concern´ basis, for

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example certain preference shares. Innovative capital instruments which were permitted in
limited amount as part of Tier 1 capital will no longer be permitted and those currently in
existence will be phased out.

Tier 2 capital will continue to provide loss absorption on a ³gone concern´ basis and will
typically consist of subordinated debt. Tier 3 capital, which was used to cover a portion of a
bank¶s market risk capital charge, will be eliminated and deductions from capital will be
harmonized. With respect to transparency, banks will be required to provide full disclosure and
reconciliation of all capital elements.

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Risk coverage

In addition to raising the quality and level of the capital base, the committee realized the need to
ensure that all material risks are captured in the capital framework. During the crisis, many risks
were not appropriately covered in the risk-based regime. For example, some banks held
significant volumes of complex, illiquid credit products in their trading books without a
commensurate amount of capital to support the risk. Moreover, failure to capture major on- and
off-balance sheet risks, as well as derivative related exposures, was a key factor that amplified
the crisis.

In response, in July 2009 the Committee introduced a set of enhancements to the capital
framework that, among other things, considerably strengthen the minimum capital requirements
for complex securitisations. This includes higher risk weights for resecuritisation exposures (eg
CDOs of ABS) to better reflect the risk inherent in these products, as well as raising the capital
requirements for certain exposures to off-balance sheet vehicles. The Committee also required
that banks conduct more rigorous credit analyses of externally rated securitisation exposures.

Increasing regulatory capital for the trading book has been another crucial element of the
Committee¶s reform programme. In July 2009 the Committee substantially strengthened the rules

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that govern capital requirements for trading book exposures.
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framework, on average, requires banks to hold additional capital of around three to four times the
old capital requirements, thus better aligning regulatory capital requirements with the risks in
banks¶ trading portfolios. These higher capital requirements for trading, derivative and
securitisation activities reinforce the stronger definition of capital and will be introduced at the
end of 2011.

Deterioration in the credit quality of counterparties also was a significant source of credit-related
loss. In response, the Committee has focused on increasing regulatory capital requirements and
improving risk management for counterparty credit risk. This includes the use of stressed inputs
to determine the capital requirement for counterparty credit default risk, as well as new capital
requirements to protect banks against the risk of a decline in the credit quality of a counterparty,
for example, as occurred in the case of the monoline insurers.

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Raising the level of capital

Basel III also introduces higher levels of capital. The minimum requirement for common equity,
the highest form of loss absorbing capital, will be raised from the current 2% level, before the
application of regulatory adjustments, to 4.5% after the application of stricter adjustments. In
addition, factoring in the capital conservation buffer brings the total common equity
requirements to 7%. The higher level of capital is in addition to the stricter definition of common
equity and the increase in capital requirements for trading activities, counterparty credit risk and
other capital markets related activities. Taken together, these measures represent a substantial
increase in the minimum capital requirement to help ensure that banks are able to withstand the
type of stress experienced in the previous crisis. Moreover, as discussed below, supervisors can
require additional capital buffers during periods of excess credit growth and, in the case of
systemically important banks, they can demand additional loss absorbency capacity.

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Containing leverage

Another key element of the Basel III regulatory capital framework is the introduction of a non-
risk-based leverage ratio that will serve as a backstop to the risk-based capital requirement. In the
lead up to the crisis, many banks reported strong Tier 1 risk-based ratios while still being able to
build high levels of on- and off-balance sheet leverage. The use of a supplementary leverage
ratio will help contain the build-up of excessive leverage in the system. It will also serve as an
additional safeguard against attempts to ³game´ the risk-based requirements and will help
address model risk.

The Committee¶s governing body in July 2010 agreed on the design and calibration of the
leverage ratio, which will serve as the basis for testing during a parallel run period. It is
proposing to test a minimum Tier 1 leverage ratio of 3% over this period that begins in 2013.
The leverage ratio will capture both on- and off-balance sheet exposures and derivatives. The
treatment of derivatives will be harmonised across accounting regimes using the regulatory
definition of netting. While there is a strong consensus to base the leverage ratio on the new
definition of Tier 1 capital, the Committee also will track the impact of using total capital and
tangible common equity.

For global banks with significant capital market activities, the 3% calibration is likely to be more
conservative than the traditional measures of leverage that have been in place in some countries.
The main reasons for this are the new definition of capital and the inclusion of off-balance sheet
items in the calculation of the leverage ratio.

2. Liquidity

Strong capital requirements are a necessary condition for banking sector stability but by
themselves are not sufficient. Equally important is the introduction of stronger bank liquidity as
inadequate standards were a source of both firm level and system wide stress.

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Global liquidity standards and supervisory monitoring:

During the crisis, funding suddenly dried up and remained in short supply for a very long period.
In response, the Committee will introduce global minimum liquidity standards to make banks
more resilient to potential short-term disruptions in access to funding and to address longer-term
structural liquidity mismatches in their balance sheets.
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(NSFR), which is a longer-term structural ratio designed to address liquidity mismatches. It
covers the entire balance sheet and provides incentives for banks to use stable sources of
funding.

The framework also includes a common set of monitoring metrics to assist supervisors in
identifying and analysing liquidity risk trends at both the bank and system wide level. To
introduce more consistency, the Committee has developed a set of common metrics that should
be considered as the minimum types of information which supervisors should use in monitoring
the liquidity risk profiles of supervised entities.

3. Risk management and supervision

Stronger capital and liquidity standards must be accompanied by better risk management and
supervision. This is particularly important in an environment of continuously rapid financial
innovation.

In July 2009, the Committee conducted a review of the Pillar 2 supervisory review process to
address several notable weaknesses that were revealed in banks¶ risk management processes
during the financial crisis. The areas addressed include:

¦| firm-wide governance and risk management;

¦| capturing the risk of off-balance sheet exposures and securitisation activities;
¦| managing risk concentrations;
¦| providing incentives for banks to better manage risk and returns over the long term; and

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 ¦| sound compensation practices

In addition to the enhanced Pillar 2 guidance, the Committee strengthened supervisory guidance
in the following key areas:

¦| Liquidity risk management: In September 2008, the Committee issued guidance entitled
Principles for Sound Liquidity Risk Management and Supervision. This guidance, which
is arranged around 17 principles for managing and supervising liquidity risk, takes
account of lessons learned during the crisis and is based on a fundamental review of
sound practices for managing liquidity risk in banking organizations. The guidance for
supervisors has also been augmented substantially. It emphasizes the importance of
supervisors assessing the adequacy of a bank¶s liquidity risk management framework and
its level of liquidity, and suggests steps that supervisors should take if these are deemed
inadequate. The principles also stress the importance of effective cooperation between
supervisors and other key stakeholders, such as central banks, especially in times of
stress.

¦| Valuation practices: In order to enhance the supervisory assessment of banks¶ valuation

practices, the Committee in April 2009 published Supervisory guidance for assessing
banks¶ financial instrument fair value practices. This guidance applies to all positions that
are measured at fair value and at all times, not only during times of stress.

¦| Stress testing: In May 2009, the Committee published Principles for sound stress testing
practices and supervision. The paper sets out a comprehensive set of principles for the
sound governance, design and implementation of stress testing programmes at banks. The
principles address the weaknesses in banks¶ stress tests that were highlighted by the
financial crisis.

¦| Sound compensation practices: In January 2010, the Committee issued Compensation

Principles and Standards Assessment Methodology, which seeks to foster supervisory

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 approaches that are effective in promoting sound compensation practices at banks and
help support a level playing field. The Methodology will help supervisors assess a firm¶s
compliance with the Financial Stability Board (FSB¶s) Principles for Sound
Compensation Practices and related implementation standards. In addition, the
Committee published for consultation in October 2010 a report on the Range of
Methodologies for Risk and Performance Alignment of Remuneration. The report
responds to an FSB recommendation that the Committee should develop a report on the
range of methodologies for risk and performance alignment of compensation schemes
and their effectiveness in light of experience to date.

¦| Corporate governance: Following a public consultation, in October 2010 the Committee

issued a set of principles for enhancing sound corporate governance practices at banking
organisations. The Principles for enhancing corporate governance address fundamental
deficiencies in bank corporate governance that became apparent during the financial
crisis. In line with the Committee¶s principles, and consistent with national laws,
regulations, and codes, supervisors should establish guidance or rules requiring banks to
have robust corporate governance strategies, policies and procedures.

¦| Supervisory colleges: Following a public consultation, the Committee in October 2010

published final guidance on Good Practice Principles on Supervisory Colleges. The
financial crisis underscored the challenges to home and host supervisors in the
consolidated supervision of international banking groups. Besides strengthening
supervisory cooperation and coordination at the micro prudential level, the
implementation of these principles will further foster the increasingly important function
of supervisory colleges in promoting financial stability at the macro prudential level.

4. Market discipline

The crisis revealed that the disclosures provided by many banks about their risk exposures and
regulatory capital bases were deficient and inconsistent.

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In response to these observed weaknesses in public disclosure and after a careful assessment of
leading disclosure practices, the Committee in July 2009 agreed to revise the existing Pillar 3
requirements relating to securitisation exposures and sponsorship of off-balance sheet vehicles,
among others. Banks are expected to comply with the revised requirements by end-2011.

In addition, there was insufficient information about the components of capital, making an
accurate assessment of its quality or a meaningful comparison with other banks difficult.
Furthermore, reconciliation to the reported accounts is often absent. To improve transparency
and market discipline, the Committee is requiring that banks disclose all elements of the
regulatory capital base, the deductions applied and a full reconciliation to the financial accounts.
A bank will need to make available on its website the full terms and conditions of all instruments
included in regulatory capital. The existing requirement for the main features of capital
instruments to be easily understood and publically disclosed will be retained.

The Committee in consultation with the FSB has developed a proposal for Pillar 3 Disclosure
Requirements for Remuneration, which aims to ensure that banks disclose clear, comprehensive
and timely information about their remuneration practices with the overarching goal of
promoting more effective market discipline. Consistency of disclosure requirements should
indeed contribute to a greater convergence of practices and should also promote a level playing
field in the industry. The proposed requirements will allow meaningful assessments by market
participants of banks¶ remuneration practices, while not creating excessive burden or requiring
disclosure of sensitive or confidential information. The Committee expects to issue the proposed
disclosure requirements for public consultation by December 2011.

| A system-wide, systemic risk-based framework

As discussed earlier, Basel III is not only a firm-specific risk-based framework; it is also a
system-wide, systemic risk-based framework. The so-called macroprudential overlay is designed
to address systemic risk and is an entirely new way of thinking about capital.

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This new dimension of the capital framework consists of five elements. The first is a leverage
ratio, a simple measure of capital that supplements the risk-based ratio and which constrains the
build-up of leverage in the system. The second is steps taken to mitigate procyclicality, including
a countercyclical capital buffer. The third element of the macroprudential overlay is steps to
address the externalities generated by systemically important financial institutions through higher
loss-absorbing capacity. The fourth is a framework to address the risk arising from systemically
important markets and infrastructures, in particular, with reference to the OTC derivatives
markets. And finally, the macroprudential overlay aims to better capture systemic risk and tail
events in the banks¶ own risk management framework, including through risk modelling, stress
testing and scenario analysis.

1. Addressing procyclicality

Initiatives like the introduction of the leverage ratio to help contain the build-up of excessive
leverage in the system during periods of credit expansion, as well as the use of stressed inputs for
the calculation of value-at-risk and counterparty credit risk, will help in addressing
procyclicality. In addition, the Committee is reviewing different approaches to address any
excess cyclicality of the minimum capital requirements. It has also developed a concrete
proposal to operationalise an expected loss approach to provisioning as input to the IASB¶s
reform efforts in this area.

Capital buffers

"| | | | | !| 

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| %  | |  | | |
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It was agreed that banks will be required to hold a capital conservation buffer comprising
common equity of 2.5%. This buffer above the minimum could be used to absorb losses during
periods of financial and economic stress. However, as a bank¶s capital level moves closer to the
minimum requirement, the conservation buffer would impose a constraint on the bank¶s
discretionary distributions. Retaining a bigger proportion of earnings during a downturn will help

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ensure that capital remains available to support the bank¶s ongoing business operations during
the period of stress. This framework will reinforce the objective of sound supervision and bank
governance and address the collective action problem that has prevented some banks from
curtailing distributions such as discretionary bonuses and higher dividends, even in the face of
deteriorating capital positions.

In addition, the Committee¶s oversight body agreed on a countercyclical buffer within a range of
0 to 2.5% comprised of common equity or other fully loss absorbing capital, which will be
implemented according to national circumstances.
|%
% | ||
|
|| |
|| | |%
| | |% || | ||% | |/|
|| ! For any given country, this buffer will only be in effect when there is
excess credit growth that is resulting in a system wide build up of risk. The countercyclical
buffer, when in effect, would be imposed as an extension of the conservation buffer range.
Conversely, the buffer would be released when, in the judgment of the authorities, the released
capital would help absorb losses in the banking system that pose a risk to financial stability. This
would help reduce the risk that available credit is constrained by regulatory capital requirements.

Provisioning

In August 2009, the Committee published a set of high level guiding principles to assist the
IASB in addressing issues related to provisioning and fair value measurement. To address
particular concerns about procyclicality, the principles called for valuation adjustments to avoid
misstatement of both initial and subsequent profit and loss recognition when there was
significant valuation uncertainty. Moreover, loan loss provisions should be robust and based on
sound methodologies that reflect expected credit losses in the banks¶ existing loan portfolio over
the life of the portfolio.

The Committee has also developed a concrete proposal to operationalise the expected loss
approach to provisioning proposed by the IASB. The Committee submitted a comment letter to
the IASB in which it spelled out its proposed approach.

2. Systemic risk and interconnectedness

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While procyclicality amplified shocks over the time dimension, excessive interconnectedness
among systemically important banks also transmitted shocks across the financial system and
economy. Systemically important banks should have loss absorbing capacity beyond the
minimum standards. The Basel Committee and the FSB are developing a well integrated
approach to systemically important financial institutions which could include combinations of
capital surcharges, contingent capital and bail-in debt. As part of this effort, the Committee is
developing a proposal on a provisional methodology comprising both quantitative and qualitative
indicators to assess the systemic importance of financial institutions at a global level. The
Committee is also conducting a study of the magnitude of additional loss absorbency that
globally systemic financial institutions should have, along with an assessment of the extent of
going concern loss absorbency which could be provided by the various proposed instruments.
The Committee¶s analysis has also covered further measures to mitigate the risks or externalities
associated with systemic banks, including liquidity surcharges, tighter large exposure
restrictions, and enhanced supervision.

Several of the capital requirements introduced by the Committee to mitigate the risks arising
from firm-level exposures among global financial institutions will also help to address systemic
risk and interconnectedness. These include:

| capital incentives for banks to use central counterparties for over-the-counter derivatives;
| higher capital requirements for trading and derivative activities, as well as complex
securitisations and off-balance sheet exposures (eg structured investment vehicles);
| higher capital requirements for inter-financial sector exposures; and
| the introduction of liquidity requirements that penalise excessive reliance on short term,
interbank funding to support longer dated assets.

Contingent capital

The use of ³gone concern´ contingent capital would increase the contribution of the private
sector to resolving future banking crises and thereby reduce moral hazard. The Committee
recently published a proposal that would require the contractual terms of capital instruments to
include a clause that will allow them ± at the discretion of the relevant authority ± to be written

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off or converted to common shares if the bank is judged to be non-viable by the relevant
authority or if it received a public sector capital injection (or equivalent support) without which it
would have become non-viable.

The Committee also is reviewing the potential role of ³going concern´ contingent capital and
bail-in debt as a further way to strengthen the loss absorbency of systemic banks. The objective
here is to decrease the probability of banks reaching the point of non-viability and, if they do
reach that point, to help ensure that there are additional resources that would be available to
manage the resolution or restructuring of banking institutions.

Cross-border bank resolution

The resolution of a cross-border bank is a complex process, and the financial crisis exposed wide
gaps in intervention techniques and tools needed for an orderly resolution. The orderly resolution
of a cross-border bank is a critical element in addressing systemic risk and the too-big-to-fail
problem. Based on the lessons of the crisis and an analysis of national resolution frameworks, in
March 2010 the Committee issued its Report and Recommendations of the Cross-border Bank
Resolution Group, which set out practical steps to improve cross-border crisis management and
resolutions. The report and recommendations were endorsed by the G20 Leaders and serve as a
basis for further work on this critical issue.

| Implementation of reform measures

An integral component of the Committee¶s standard-setting activities is to take careful

consideration of the potential impact of its proposed standards.

1. Impact assessment

Comprehensive quantitative impact study

The Committee has conducted a comprehensive quantitative impact study (QIS) based on the
December 2009 capital and liquidity proposals to assess the impact of the reform package on
individual banks and on the banking industry. The impact study has helped inform the calibration

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of the requirements and to help ensure an appropriate set of minimum standards across banks,
countries and business models.

Macroeconomic impact assessment

On 18 August 2010, the FSB and the Basel Committee published a joint interim report on the
macroeconomic implications of the proposed higher regulatory standards during the transition to
these new standards, the Macroeconomic Assessment Group (MAG) report. This report was
accompanied by an additional study conducted by the Committee on the long-term economic
impact of the new standards.

The MAG report, which focused on the costs during the transition, concluded that the transition
to stronger capital and liquidity standards is likely to have only a modest impact on economic
growth.
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to the impact of stronger liquidity standards, the MAG study found that these are also likely to
have only mild transitional effects. In all of these estimates, GDP returns to just below its
baseline path in subsequent years.

With regard to the long-term economic impact, the Committee¶s assessment found that there are
clear economic benefits from increasing the capital and liquidity requirements from their current
levels. These benefits accrue immediately and result from reducing the probability of financial
crises and the output losses associated with such crises. The output benefits substantially exceed
the potential output costs for a range of higher capital and liquidity requirements. For example,
with regard to the output benefits associated with reducing the probability of a financial crisis,
the Committee estimates that each 1 percentage point reduction in the annual probability of a
crisis yields an expected benefit per year ranging from 0.2% to 0.6% of output depending on the
assumptions used. The Committee¶s analysis suggests that in terms of the impact on output, there
is considerable room to tighten capital and liquidity requirements while still yielding positive net
benefits.

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2. Transition to the new standards

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their
capital levels. However, preliminary results of the Committee¶s comprehensive QIS show that as
of the end of 2009, large banks will need, in the aggregate, a significant amount of additional
capital to meet these new requirements. Smaller banks, which are particularly important for
lending to the SME sector, for the most part already meet these higher standards.

These new standards will help ensure that the banking sector can meet the higher capital
standards through reasonable earnings retention and capital raising while still supporting lending
to the economy. In recognition of the more stringent regime and to support the ongoing recovery,
the Committee has agreed on appropriate arrangements to help ensure a smooth transition.
During this transition, the Committee will closely monitor the impact and behavior of the new
standards. It will continue to review the implications of the standards and address unintended
consequences as necessary.

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Regarding the leverage ratio, the parallel run period will begin on 1 January 2013, with full
disclosure starting on 1 January 2015. The Committee will monitor the performance of the
leverage ratio over different points of the economic cycle, the impact on different types of
business models, and its behaviour relative to the risk-based requirement. Based on the results of
the parallel run period, any final adjustments would be carried out in the first half of 2017 with a
view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and
calibration.

Criticisms of Basel III and Some Responses

Initially Basel III received harsh criticisms from the banking industry and some regulators. The
criticisms were directed at every proposed requirement that the Basel Committee tried to

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strengthen in response to the 2007-2009 financial crisis. The European banks were most critical
of the proposal, arguing that Basel III favors U.S. banks because U.S. banks historically
maintained a higher level of capital and would more easily meet the quantitative increase in
capital. Moreover, it is much harder to raise capital from the private sector in Europe than in
America. The Institute of International Finance, which represents the world¶s largest commercial
banks, warned in June 2010 that the December 2009 Basel III proposal would require that these
larger banks raise $700 billion in common equity and issue $5.4 trillion in long term debt over
the next five years to meet the standards. The absorption of capital would cause a 3% decline in
the United States¶ GDP compared with what it would be otherwise in five years. JP Morgan
Chase and Morgan Stanley argued that the Basel III proposal would significantly reduce the
availability of credit to the U.S. economy. The American Securities Forum said that Basel III¶s
liquidity coverage ratio ³could have a catastrophic effect on the short-term global capital
markets.´ The main reason is that the liquidity ratio would require banks at all times to hold a
stock of highly liquid assets that equal or exceed their net cash flow calculated over a 30-day
period. This liquidity would significantly reduce short-term funds needed to issue short-term
debt securities, such as money market instruments and corporate and municipal bonds. The
Deutsche Bank¶s comment was that the timetable was too short to increase common equity
because the prospects for future profits, the main source of common equity, are not good in the
short run. The French Bankers Association assessment was that the adjustment to Basel III was
unworkable because it would result in a Tier 1 capital shortage of between $2.7 trillion and $4.7
trillion for the Euro-zone countries alone.

The Basel Committee on Banking Supervision made its own assessment of the Basel III
proposal¶s impact on the global economies. The finding of the Basel Committee¶s assessment
was that higher capital and liquidity requirements can significantly reduce the probability of a
banking crisis. Taking a different approach to assessing the benefits of Basel III, the committee
found that the incremental benefits decline at the margin. Consequently, the benefits are
relatively large when capital ratios are increased from low levels and progressively decline as
standards tighten. For example, the committee found that the decrease in the likelihood of a crisis
is three times larger when capital is increased from 7% to 8% than when capital is raised from

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10% to 11%. The assessment concluded that better capitalization reduces both the likelihood of
crises and the severity of crises when they occur.

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 Chapter 3

Impact of BASEL III on Indian banking

The proposed Basel III guidelines seek to improve the ability of banks to withstand periods of
economic and financial stress by prescribing more stringent capital and liquidity requirements for
them. I believe that the suggested capital requirement is a positive sign for Indian banks as it
raises the minimum core capital stipulation, introduces counter-cyclical measures, and enhances
banks ability to conserve core capital in the event of stress through a conservation capital buffer.
The prescribed liquidity requirements, on the other hand, are aimed at bringing in uniformity in
the liquidity standards followed by banks globally. This requirement, in my opinion, would help
banks better manage pressures on liquidity in a stress scenario.

The capital requirement as suggested by the proposed Basel III guidelines would necessitate
Indian banks raising Rs. 600000 crore in external capital over next nine years, besides lowering
their leveraging capacity. It is the public sector banks that would require most of this capital,
given that they dominate the Indian banking sector. Further, a higher level of core capital could
dilute the return on equity for banks. Nevertheless, Indian banks may still find it easier to make
the transition to a stricter capital requirement regime than some of their international
counterparts since the regulatory norms on capital adequacy in India are already more stringent,
and also because most Indian banks have historically maintained their core and overall capital
well in excess of the regulatory minimum.

As for the liquidity requirement, the liquidity coverage ratio as suggested under the proposed
Basel III guidelines does not allow for any mismatches while also introducing a uniform liquidity
definition. Comparable current regulatory norms prescribed by the Reserve Bank of India (RBI),
on the other hand, permit some mismatches, within the outer limit of 28 days.

Capital requirement: The new elements and their impact on Indian banks

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The proposed Basel III guidelines seek to enhance the minimum core capital (after stringent
deductions), introduce a capital conservation buffer (with defined triggers), and prescribe a
countercyclical buffer (to be built up in times of excessive credit growth at the national level).

Changes in standard deductions

The proposed Basel III guidelines suggest changes in the deductions made for the computation of
the capital adequacy percentages. The key changes for Indian banks include the following:

Table 1: Deductions from Capital²Proposed vs. Existing RBI Norms

Proposed Basel III Existing RBI Norm Impact

Guideline
Limit on deductions Deductions to be All deductibles to be Positive
made deducted

only if deductibles
exceed

15% of core capital at

an

aggregate level, or
10% at the individual
item level
Deductions2 from All deductions from 50% of the deductions Negative
Tier I core from Tier I and 50%
from Tier II (except
or Tier II capital
DTA and intangible
assets wherein 100%
deduction is done from
Tier I capital )

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Treatment of Any investment For investments up to: Negative
significant exceeding 10% of
(i) 30%: 125% risk
issued share capital to
investments in weight or risk weight as
be counted as
common warranted by external
significant

shares of rating
and therefore
unconsolidated
deducted
(ii)30-50%: 50%
financial institutions deduction from Tier I
and 50% from Tier II

(source: www.icra.in)

Capital conservation buffer

The Basel committee suggests that a new buffer of 2.5% of risk weighted assets (over the
minimum core capital requirement of 4.5%) be created by banks. Although the committee does
not view the capital conservation buffer as a new minimum standard, considering the restrictions
imposed on banks and also because of reputation issues, 7% is likely to become the new
minimum capital requirement.

The main purpose of the proposed capital buffer is two-fold:

1. It can be dipped into in times of stress to meet the minimum regulatory requirement on core
capital.

2. Once accessed, certain triggers would get activated, conserving the internally generated
capital. This would happen as in this scenario, the bank would be restrained in using its earnings
to make discretionary payouts (dividends, share buyback, and discretionary bonus, for instance).

The final contours of the norm on conservation of capital would be known by December 2010.
However, the Basel committee may allow some distribution of earnings by the banks, which are
in breach of the proposed capital conservation buffer. If a bank wants to make payments in

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excess of the amount that the norm on capital conservation allows, it would have the option of
raising capital for such excess amount. This issue would be discussed with the bank¶s supervisor
as part of the capital planning process.

Countercyclical buffer

The Basel committee has suggested that the countercyclical buffer, constituting of equity or fully
loss absorbing capital, could be fixed by the national authorities concerned once a year and that
the buffer could range from 0% to 2.5% of risk weighted assets, depending on changes in the
credit-to-GDP ratio. The primary objective of having a countercyclical buffer is to protect the
banking sector from system-wide risks arising out of excessive aggregate credit growth. This
could be achieved through a pro-cyclical build up of the buffer in good times.

Typically, excessive credit growth would lead to the requirement for building up higher
countercyclical buffer; however, the requirement could reduce during periods of stress, thereby
releasing capital for the absorption of losses or for protection of banks against the impact of
potential problems.

The key features of the buffer include the following:

¦| Credit-GDP gap could be used as a reference point

¦| Buffer to be set at the national level every year
¦| Buffer to be calculated at the same frequency as the normal capital requirement
¦| Banks could be given one year to comply with the additional capital requirement
¦| Reduction in buffer could take effect immediately
¦| Banks not meeting the norm could be restrained from distributing the earnings (in the
same manner as in the case of the capital conservation buffer)

Enhancement in Loss Absorption capacity of capital of internationally active banks

The Basel committee issued a consultative document in August 2010 to introduce a ³write off
clause´ in all non-common Tier I and Tier II instruments issued by internationally active banks.
The main features include the following:

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 ¦| Capital instruments to be written off on the occurrence of trigger event
¦| In the event of write off, instrument holders could be compensated immediately in the
form of common stock
¦| The trigger event is the earlier of:
à| The decision to make a public injection of fund or support, without which the
bank would become non-viable ( as determined by National authority)
à| A decision that write-off is necessary to prevent the bank from becoming non-
viable (as determined by the National Authority)

The main purpose of the proposed contingent capital clause is to:

¦| Ensure that holders of capital bear the loss in a stress scenario before public money is
infused and are not its (public funds) beneficiaries; and
¦| Reduce the possibility of public support for a bank under stress, as the bank¶s core capital
base would get strengthened at the expense of non-core capital (Tier I and Tier II)
holders.

Capital instruments with this clause are likely to increase the downside risk for potential
investors; therefore the risk premium could go up. However, price discovery may not be easy as
it could be difficult to assess the probability of conversion to equity or a principal write-down
and the extent of loss after the event. Further considering the riskier nature of these instruments,
there may be a wider notching in the credit rating of such instruments as compared to existing
capital instruments. Additionally in case this ³loss absorption clause is adopted, a large number
of instruments would get disqualified for inclusion under Tier I and Tier II capital. Therefore,
Indian banks would need to mobilize capital for replacing this as well; the quantum of capital to
be replaced could be large as total non common Tier 1 and Tier 2 capital of Indian bank is close
to Rs. 200000 crore as on March 31, 2010 and large part of it is issued by internationally active
banks. However, transition may be not be abrupt as these instruments would be phased out over
10 years starting 2013; their recognition would be capped at 90% in the first year and the
percentage would drop by 10% each subsequent year.

Comparison on Capital Requirement

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Overall, with the Basel III being implemented, the regulatory capital requirement for Indian
banks could go up substantially in the long run. Additionally within in capital, the proportion of
the more expensive core capital could also increase. Moreover, capital requirements could
undergo a change in various scenarios, thereby putting restriction on bank¶s ability to distribute
earnings.

Regulatory Capital Adequacy Levels²Proposed vs. Existing RBI Norm

Proposed BASEL III Existing RBI norms

norms
Common equity (after 4.5% 3.6% (9.2%)
deductions)
Conservation buffer 2.5% nil
Countercyclical buffer 0-2.5% nil
Common equity + Conservation 7-9.5% 3.6% (9.2%)
buffer + Countercyclical buffer
Tier I(including the buffer) 8.5-11% 6% (10%)
Total capital (including the 10.5-13% 9% (14.5%)
buffers)

m

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| 9|8
||
%|pertain to aggregated capital adequacy of banks covering over 95% of the total
banking assets as on March 31, 2010.

Indian banks are subjected to more stringent capital adequacy requirements than their
international counterparts. For instance, the common equity requirement for Indian banks is
3.6%* (Innovative perpetual debt and perpetual non-cumulative preference share cannot exceed
40% of the 6% Tier I, thereby minimum core capital works out to be 60% of 6%, which is 3.6%),
as against the 2% mentioned in the Basel document. At the same time, the total capital adequacy
requirement for Indian banks is 9%, as against the 8% recommended under Basel II. Moreover,
on an aggregate basis, the capital adequacy position of Indian banks is comfortable, and being so,
they may not need substantial capital to meet the new norms. However, differences do exist

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among various banks. While most of the private sector banks and foreign banks have core capital
in excess of 9%, that is not the case with some of the public sector banks.

(source: www.icra.in)

Once Basel III comes into force, some public sector banks are likely to fall short of the revised
core capital adequacy requirement and would therefore depend on Government support to
augment their core capital. In recent times, Government of India (GOI) support has come via
non-core Tier I, but this form of support may change in favour of equity capital, especially for
banks falling short on core capital. The expected growth in the risk weighted assets along with
the requirement of more stringent capital adequacy norms would also require banks to mobilise
additional capital. In a scenario of 20% annualised growth in riskweighted assets and in internal
capital generation, the volume of additional capital that would be required by the banking sector
(excluding foreign banks) as a whole over the next nine years ending March 31, 2019 works out

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to be Rs. 600000 crore (over internal capital generation). Of this, the public sector banks would
require 75-80% and private banks 20-25%. However, any variation in the assumed growth rate
may lead to a change in the volume of capital required. Further, in case some non-common Tier I
and Tier II capital instruments get disqualified for inclusion under regulatory capital, the
requirement would go up. It could be a challenge to find the investors, with higher risk appetite,
to subscribe to the capital requirement of Indian banks.

Impact on return on equity

As discussed, the minimum core Tier I capital requirement may increase to 7-9.5% (9.5%
including countercyclical buffer at the maximum level) and the overall Tier I capital to 8.5-11%
(depending on the countercyclical capital buffer level). This would impact the leveraging capital
of banks and therefore their return on equity (ROE). For instance, a bank generating 18% ROE
on a core capital of 6% would generate around 15% ROE (3 percentage points lower) in case it
were to raise its core capital to 8%.

As most private sector banks and foreign banks in India are very well capitalised, transition to
Basel III may not impact their earnings much, but the upside potential associated with higher
leveraging would decline. As for public sector banks, those with Core Tier I less than 7% would
be negatively impacted. Further, as the countercyclical buffer has to be set annually by the RBI,
this could introduce an element of variation in lending rates and/or the ROE of banks.

Chapter 4

RBI¶s view on the impact of Basel III on Indian banking sector

The building blocks of Basel III are by now quite well known: higher and better quality capital;
an internationally harmonised leverage ratio to constrain excessive risk taking; capital buffers
which would be built up in good times so that they can be drawn down in times of stress;
minimum global liquidity standards; and stronger standards for supervision, public disclosure
and risk management.

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||*
 A quick estimate of
the capital ratios of the banking system after taking into account the regulatory adjustments
under Basel III is indicated in the table below. This estimate, based on the data furnished by
banks in their off-site returns, is approximate. A more accurate picture can be computed when
banks review their Basel III compliance position following the publication of the final Basel III
rules scheduled around the year end.

Parameter Basel III requirement Actual value for Indian banks

as on June 30, 2010
Under Basel Under Basel
II III
Capital to risk weighted 10.5% 14.4% 11.7%
assets ratio (CRAR)
Of which
Tier I capital 8.5% 10% 9%
Common equity 7% 8.5% 7.4%

(source:www.rbi.org.in)

As the numbers in the above table show, Indian banks are comfortably placed in terms of
compliance with the new capital rules. One point to note though is that the comparative position
is at the aggregate level; | !|
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Pro-cyclicality

The Basel III package includes capital buffers to contain the pro-cyclicality of the financial
sector. Building capital buffers will entail additional costs for banks with consequent
implications for investment and hence for overall growth. Apart from the general concern in this
regard, in India there is an additional concern about the variable used to calibrate the

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countercyclical capital buffer. Credit to GDP ratio is put forward as a natural candidate for this
calibration. It is not clear that this will be an appropriate indicator in the Indian context. Unlike
in advanced economies where this ratio is stable, in emerging economies such as India, it will
likely go up for structural reasons - enhanced credit intermediation owing to higher growth as
well as efforts at deepening financial inclusion. However, the proposed framework is flexible
enough to allow national discretion to suit the country situation in a µcomply or explain¶
framework. In India, for instance, sectoral approaches to countercyclical policies have stood the
test in the past and we could continue with such sectoral approaches.

Leverage

Estimates show that the leverage in the Indian banking system is quite moderate.
c !|| |||&(|%   | |
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|
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| | %| | | )|  | |   |  | | ,$ and their
derivatives portfolios are also not very large.

Liquidity

The major challenge for Indian banks in implementing the liquidity standards will be to develop
the capability to collect the relevant data accurately and granularly. Indian banks do not have
much experience to fall back on since our financial markets have not experienced the levels of
stress that advanced country markets have. Predicting the appropriate stress scenario is,
therefore, going to be a complex judgment call. On the positive side, most of our banks follow a
retail business model and their dependence on short term or overnight wholesale funding is
limited. They also have a large amount of liquid assets which should enable them to meet the
new standards.

There is an issue about the extent to which statutory holdings of SLR should be reckoned in the
estimation of the proposed liquidity ratios. An argument could be made that they should not be
counted at all as they are expected to be maintained on an ongoing basis. However, it would be
reasonable to treat at least a part of the SLR holdings in calculating the liquidity ratio under

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stressed conditions, particularly as these are government bonds against which the central bank
provides liquidity.

On the whole, RBI¶s assessment is that Indian banks are well positioned to adjust to the Basel III
norms well within the phase-in period. That does not mean there will be no challenges. There
will be the challenge of upgrading risk management systems and there will be the challenge of
learning to make complex judgement calls. Most importantly, there will be the challenge of
meeting the credit needs of a rapidly growing economy even while adjusting to a more
demanding regulatory regime.

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 Chapter 5

Impact of BASEL III on European Banking sector

Euro Crisis

The acute phase of the global financial crisis was short, lasting from the collapse of Lehman
Brothers on September 15, 2008, to the day the Dow hit a trough on March 9, 2009. But, like a
violent heart attack, the interruption of credit²the economy¶s life blood²lasted long enough to
permanently damage the industrial countries at the center of the crisis. The damage took three
main forms, each of which poses a major risk to the stability of the global economy today: high
and rising public debts, fragile banks, and a huge liquidity overhang that will need to be
eventually withdrawn.

|'
 |D|!| |||| ||! |||  D| | |
! | | | | 
| ;% |  | | | | | | 
|

D|| |'
 %| D|!| |||%| ||. Monetary policy in
the Euro area and in industrialized countries more generally, remains expansionary and, if
anything, the crisis pushes back the time when tightening can occur safely. As a result of the
problems in Europe, the world economy has become even more exposed to the three mega-
vulnerabilities.

The Deeper Causes of the Euro Crisis

While ballooning public debt may be the clearest manifestation of the Euro crisis, its roots go
much deeper²to the secular loss of competitiveness that has been associated with euro adoption
in countries including Greece, Ireland, Italy, Portugal, and Spain (GIIPS).

The sequence of events that led to the secular loss of competitiveness is depressingly similar
among the GIIPS countries:

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‡ The adoption of the euro was accompanied by a large fall in interest rates and a surge in
confidence as institutions and incomes expected to converge to those of Europe¶s northern core
economies.

‡ Domestic demand surged, bidding up the price of non-tradables relative to tradables and of
wages relative to productivity.

‡ Growth accelerated, driven by domestic services, construction, and an expanding government,

while exports stagnated as a share of GDP, and imports and the current account deficit soared
amid abundant foreign capital.

‡ The result was that indebtedness²public, private, or both²surged.

Meanwhile, following reunification, Germany was undergoing a historic transformation to

become the world¶s largest exporter, and all of Europe¶s northern economies reaped the benefits
of the expanded market and decreased competition offered by the GIIPS. But the growth model
in the GIIPS was inherently flawed: eventually, the domestic demand bubble burst. Now,
governments must shrink, and high costs preempt any efforts to resort to export markets for
growth. Countries are stuck in low growth equilibrium²and potential domestic battles over the
limited resources will only accelerate the onset of crisis.

This basic story fits the Euro area periphery, but the details vary within each country. For
example, Italy and Portugal saw growth peak very early on, while Greece, Ireland, and Spain
enjoyed decade-long booms followed by busts during the global crisis. The single monetary
policy of the euro was too loose for the countries who enjoyed the biggest boom and accentuated
their inflation and competitiveness loss, while it was too tight for larger economies like
Germany, depressing domestic demand there and widening its unit labor cost advantage vis-à-vis
the GIIPS.

Effects on Other Countries

A similar and even more virulent strain of the euro disease has already hit countries that are not
part of the Euro area but that pegged their currencies to the euro many years ago, beginning with

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Latvia, Estonia, and Lithuania. Other recent EU joiners, such as Hungary and Romania, retain
flexible exchange rates, but are constrained by large foreign currency debts in their ability to
devalue. As a consequence, they too suffer from the euro disease.

The rest of the world will feel the effects of the Euro crisis via six important channels: first, the
crisis will lower growth in Europe, a market toward which about a quarter of world exports are
destined. Second, it will lead to further euro depreciation, sharply reducing profits from exports
to Europe while also increasing competition from the continent. Third, by keeping policy rates
low in Europe and potentially other industrialized countries as well, the crisis may encourage
capital surges into emerging markets. Fourth, the crisis will add greatly to the volatility of
financial markets and will lead to bouts of risk-aversion. Fifth, and potentially most important,
the crisis could deal a mortal blow to many fragile financial institutions. Sixth, a failure to
contain the crisis will raise the alarm on sovereign debt in other industrial countries and,
inevitably, in any exposed emerging market.

How to save the EURO??

First, task the International Monetary Fund to come up with a recovery plan that is far-reaching
but also provides the time needed for the Greeks to execute it credibly. Just to stabilize its debt
ratio at the current 150 percent of GDP would require Greece to make a huge fiscal adjustment,
equivalent to at least 12 percent of GDP. That implies even larger declines in output. That is why
an agreed rescheduling of Greek debts (extending the maturity of the outstanding debt while
maintaining interest payments), and perhaps ³haircuts´ (creditors taking losses on the principal),
appear inevitable.

Although Euro area leaders are refusing even to discuss a restructuring, the financial markets
have already discounted very large losses on Greek debts. They will not lend to Greece at
reasonable rates until there is clarity about how it will manage its way out of the mess. The
alternative would be for the Euro area to cover Greece¶s financing requirement over the next
three years, some 60 billion euro each year.

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Second, as part of a preemptive program to contain contagion from Greece, other vulnerable
countries should accelerate measures to address their fiscal and competitiveness problems. A
good guideline for them should be to reduce the primary balance²the budget balance excluding
interest payments²by enough to ensure that the debt-to-GDP ratio is firmly on a downward path
within three years. In the case of Spain, for example, this means reducing the primary balance by
some 8 percent over three years, and in Italy by 4 percent. In both cases, that is more than is
currently being contemplated.

The other, equally important reform relates to competitiveness and productivity. A good
guideline is that countries should now aim to recover competitiveness vis-à-vis Germany at the
rate they have lost it. Since unit labor costs in Germany are about flat in nominal terms (nominal
wages rise almost in line with productivity), this means that unit labor costs in the vulnerable
countries need to decline by 5±7 percent over three years. This calls either for modest wage cuts
or²better²for structural reforms to boost productivity (or for both). The main structural
reforms should relate to increasing flexibility and competition in the non-tradable sector,
including a smaller and more efficient government, and reforms of the labor market. Some of
these reforms would take time to bear fruit, but enacting them over the next year would help
reassure markets that the tide was turning.

Third, Germany and the other surplus countries should support a three-year program to expand
demand by about 1 percent of the Euro area¶s GDP in order to offset the deflationary impact of
fiscal adjustments in the vulnerable countries.

Hopefully accompanied by a world trade recovery, the aim of such a program should be to keep
the aggregate European growth rate in the 2 percent+ range, even at the risk of slightly higher
inflation in surplus countries. Reforms favoring consumption and domestic investment in
countries with budget surpluses, a continuation of a policy of low interest rates in the Euro area
and an explicit favoring of a weaker euro would help boost growth. The G20 should support the
program as a means of avoiding a string of sovereign-debt crises endangering the global
recovery.It is high time for the Euro area leaders to move from denial to action²not only in
Greece, but, just as importantly, at home. If all goes well, this episode may be remembered as the
Euro area¶s adolescent crisis.

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 Basel III Impact on the fragile European banks

Assuming full implementation by 2019 of all the measures envisioned in Basel III, and before
any mitigating actions by banks, |<'| |'
 %| |!
|||!|7.||
07| %| % |  | | %| | | =| %. The lower end of the range
excludes the impact of the net stable funding ratio (NSFR), the new rule that governs long-term
funding. The upper end of the range includes the NSFR as defined. It should be noted that the
NSFR consultation is still in progress, and the ratio is widely expected to be less punitive once it
is finalized. The effects will be felt only gradually. On analyzing the various transition periods, I
calculated that the decline in ROE will be 0.3 percentage points by 2013 and 2.1 percentage
points by 2016. The ROE reduction comes as a result mainly of capital and funding impact. On
the capital side of the fully implemented (that is, by 2019) effects, capital quality will account for
0.8 percentage points, increased risk-weighted assets (RWA) for 1.3 percentage points, and
increased capital ratios for 1.3 percentage points (including 0.3 percentage points for new
minimum ratios, 0.8 percentage points for additional cushion, and 0.2 percentage points for
further national discretions). The leverage ratio will decrease ROE by 0.1 percentage points. On
the funding side, 0.2 percentage points will come from the expense of holding more liquid assets
and 0.6 percentage points from the cost of holding more long-term funding.

Capital impact

The extent of the capital shortfall from higher capital ratios is highly sensitive to the assumed
target ratios. I have used the regulatory ratios of 4.5 percent for core Tier 1 and 6 percent for all
Tier 1, together with the required 2.5 percent core Tier 1 conservation buffer. In addition, I
assumed a cushion on top of the regulatory minimum to reach industry target ratios of 9 percent
core Tier 1 and 11 percent Tier 1. This cushion of 2 to 2.5 percentage points accounts for 55
percent of the estimated shortfall. I believe it is an appropriate estimate; historically, banks have
on average held about 4 percentage points more than the regulatory minimum of 4 percent Tier 1
capital.

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Separately, I have factored in national discretions for Switzerland and the United Kingdom. For
the two large Swiss banks, I have assumed a 12 percent core Tier 1 ratio and a 20 percent total
Tier 1 ratio, including contingent capital; this represents a small cushion of 1 percentage point on
top of the minimums proposed recently by the Swiss Expert Commission. For the UK banks, I
have assumed a 12 percent core Tier 1 ratio and a 15 percent Tier 1 ratio in light of statements by
UK regulators that they will likely require more than the Basel III minimum. I did not factor in
any additional requirements for systemically important banks, a topic that was discussed but not
decided upon at the G20 summit in Seoul.

<||
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the leverage ratio embodied in Basel III will not be a major constraint, adding little or nothing to

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the requirements imposed by the risk-based ratios for our sample of top European banks. This
might be different for individual players (for example, specialized public finance lenders), of
course, as well as for banks that plan a focused deleveraging of high-risk assets.

Funding impact

I estimate the total shortfall in short-term funding due to the new liquidity coverage ratio (LCR)
at about ¼1.3 trillion. This represents about 40 percent of the average liquidity buffer held by
banks today. The effects of the NSFR amount to a shortfall of about ¼2.3 trillion in long-term
funding for Europe¶s banks, which is equivalent to about 10 percent to 15 percent of the
currently available funding. The two effects are related; as banks rebuild their long-term funding,
for example, this buildup will also lower their short-term liquidity needs.

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 Chapter 6

BASEL III impact on the US banking

The new Basel Capital Adequacy Accord-Basel III is of concern to the US financial market
mainly because it could put U.S. financial institutions at a competitive disadvantage in world
financial markets. The Basel capital accord is an agreement among countries¶ central banks and
bank supervisory authorities on the amount of capital banks must hold as a cushion against losses
and insolvency. Higher capital requirements constrain bank lending and profitability. The
accords are not treaties. Member countries may modify the agreement to suite their financial
regulatory structures.
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It would increase the amount of common tangible equity held as minimum regulatory capital
because common equity improves loss absorbency. Tangible common equity consists of bank
shares and retained earnings. This increase is a significant change in regulatory capital
requirements because many assets that are being used as regulatory capital would have to be
converted to common tangible equity. By 2015, more than half of the total regulatory capital
would be composed of common tangible equity capital. Common tangible equity will also be
used in a new conservation capital buffer. This capital conservation buffer is to ensure that banks
build up capital outside periods of financial stress that can be drawn down when losses are
incurred. The minimum total capital plus conservation buffer would be 10.5% of risk-weighted
asset in January 1, 2019, which is 2.5% higher than the current minimum requirement. If another
element, the countercyclical capital buffer, is fully added, the minimum total capital requirement
would be 13% of risk weighted assets. This would be a remarkable increase in capital
requirement from current levels. Very few U.S. banks were able to maintain 13% of risk-
weighted assets at the highest level of U.S. bank profitability. At that time, the average total
equity capital ratio was 10.52%.

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Adoption and Implementation of Basel III

The Small Bank/Large Bank Issue

The unfinished business of implementing Basel II complicates the United States¶ implementation
of Basel III. Although U.S. regulators agreed to rules to implement Basel II with modifications to
address the Basel II disadvantages to smaller banks, those modifications were never
implemented due to the onset of the 2007-2009 financial crisis. Large banks were scheduled to
complete their implementation by the first quarter of 2011, but there was never a schedule for
smaller banks to comply with Basel II. The inequity between smaller and larger banks remains
unresolved. At the heart of that issue is that Basel II would have given larger banks an unfair
advantage because they were able to afford to invest in sophisticated management systems that
allowed regulators to permit these large banks to determine the amount of risk-weighted capital
they must hold. Based on the Basel Committee study of these large banks self-assessments of
their risk-weight capital requirement, they would have to reduce their capital requirement by as
much as 29%.

Specific Dodd-Frank Act Issues

In addressing the 2007-2009 financial crisis, the Dodd-Frank Wall Street Report and Consumer
Protection Act has a number of provisions that conflict with Basel III.
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| ||. The U.S. regulatory agencies are in the process
of developing alternatives to rating agencies. There are other conflicts such as the Basel III
clause that bans hybrid bonds as capital. Basel III has a different time frame than Dodd-Frank.

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Dodd- Frank gives larger banks less time to phase out the bonds and smaller banks more time.
Basel III does not make the distinction.

The Basel III trading-book rules may be in conflict with the Volcker rule that prohibits a bank or
institution that owns a bank from (1) engaging in proprietary trading (buying and selling
securities and equities) that is not at the behest of its customers, (2) owning or investing in a
hedge fund or a private equity fund, and (3) limiting the liabilities that the largest banks could
hold. Because other member countries of the Basel Committee have not embraced the Volcker
rule, its implementation in the United States may lower U.S. bank profits domestically. If bank
profits drop at home because of the Volcker rule, U.S. banks may move their proprietary trading
activities to their foreign operations. This transfer could have a negative impact on U.S. trade in
financial services.

Implications of Basel III

As approved by the central bank governors, Basel III has not addressed a major cause of the
financial crisis²which is whether large firms that are heavily intertwined with the global
financial system should be required to set aside more capital because of the broader risks they
pose to the global financial system. The work the committee has done so far on Basel III has not
specifically recognized the role of international counterparty risks, which is a critical part of the
business model international banks continue to use. Consequently, some analysts believe that the
Basel Committee missed a historic opportunity to help level the international banking playing
field. Supporting the status quo, the committee has left the counterparty risk capital requirement
problem to each country¶s regulatory authorities. If that is the case, national bank regulators
could undermine the economic recovery.

Basel III would significantly raise the capital requirement on banks. At the end of the
implementation period, Basel III could require a minimum total requirement of 13% of a bank¶s
risk-weighted assists. This is a level very few large U.S. banks were able to achieve at the height
of their record level of profits in 2006. The complexity of Basel III increases the probability that
it would be unenforceable. As the Basel III framework was presented, it appeared to be as

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complex as Basel II that took six years to negotiate and was never fully implemented before the
greatest financial crisis in 70 years began.

The Basel Committee in Basel III tries to simplify the definition of capital to improve
transparency and enforceability. The industry through its regulators, however, forced the
committee to include other types of assets. By including these assets with common tangible
equity, the committee adds complexity to the process of enforcement because the roles of
mortgage servicing rights and tax deferred assets, for examples, vary widely among countries.
This complexity could undermine the ability to keep the international banking playing field level.
Some analysts attribute the severity of the most recent financial crisis to the lack of regulatory
enforcement. Basel III is complicated not only by the regulations themselves but also by the
implementation schedule.

Basel III adopts a separate global leverage ratio as a part of its regulatory framework. The major
advantage of this regulatory tool is its simplicity. It is an effective constraint of the amount of

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leverage banks are able to create with a given amount of capital. A leverage ratio of 10% limits
the amount of leverage to no more than 10 times the bank¶s capital. However, if the ratio is not
effectively enforced, it will not prevent banks from over-leveraging. For example, although U.S.
regulators had a leverage ratio in place before the financial crisis, it was not able to prevent the
financial crisis. In the United States, the leverage ratio was not enforced as widely as it should
have been and overleveraging was a major cause of the crisis.

Although extending the deadline for implementing Basel III gives the industry more time to raise
additional capital, it also delays putting in place the countermeasures for preventing the next
financial crisis. Analysts have argued that many industrial countries¶ economies are not yet
strong enough to withstand another financial crisis in the near future. The delayed-
implementation schedule undermines the stated purpose of Basel III to prevent the next financial
crisis. According to the new schedule, it will be nine years before Basel III is fully in place.
Some analysts say it is very likely that there will be another crisis before then. On the other hand,
some policymakers are concerned that a shorter transition period may impede the economic
recovery. Because Basel III is implemented by national authorities, they are free to impose
shorter transition periods if deemed necessary.

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Short-Term Implications:

1. Uncertainty until Rules Finalized ± Developing actionable rules to be implemented by U.S.

regulators from the broad outlines of Basel III will likely take at least 6 to 12 months of detailed

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work. During this time, bank managers will have to operate their institutions without certainty on
several critical matters. I expect to see intense debate among the Federal Reserve, other federal
banking agencies and the banking industry as the real world implications of these proposals are
evaluated and practical implementation guidelines developed. This rulemaking activity will
likely focus on four areas ± the required deductions from equity capital, risk weighting
calculations, the level of the ³countercyclical buffer´ required to be set on a national basis, and
the impact of goneconcern capital on non-common Tier 1 and Tier 2 regulatory capital:

(a) Deductions from capital: As we understand the Basel release, the amount of common equity
to be used for capital calculations is not based on a GAAP determination of common equity.
Rather, it is tangible common equity reduced by a myriad of deductions that have largely not
previously impacted U.S. banks. Most significant among these deductions are: (i) deferred tax
assets (net of any associated deferred tax liability); (ii) mortgage servicing rights (³MSRs´); (iii)
equity investment in unconsolidated subsidiaries; (iv) the extent to which reserves do not reflect
forward-looking loan loss provisioning; and (v) investments in other banks, financial institutions
and insurance entities that fall outside the regulatory scope of consolidation. By my calculations,
almost 60 U.S. banks holding approximately $1.5 trillion in assets have MSRs equal to or greater
than 10% of their common equity and 160 banks with $5.2 trillion in assets have deferred tax
assets equal to or greater than 10% of their common equity. For these banks, and others with
higher levels of MSRs or deferred tax assets, the deduction of these assets from the amount of
common equity could significantly reduce their calculated capital ratios. The impact of the
forward-looking loan loss provision requirement is hard to quantify and is inconsistent with
current U.S. GAAP, which requires that loan loss provisions be tied to historical loss experience.
The Basel proposal would also exacerbate the DTA deduction from common equity as an
increase in loan loss provision without an increase in charge-offs will increase the GAAP/tax
differential and inflate the DTA. As such, the deduction from bank equity of a larger DTA
amount will amplify the impact. Hopefully, this ³double-counting´ impact will be evaluated and
addressed through the rulemaking process.

Banks have been active investors in other bank subordinated debt and trust preferred securities
since the time trust preferred securities were first approved as Tier 1 capital by the Fed in 1996.

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Since that time, banks have issued over $325 billion of trust preferred securities and
subordinated debt. While the exact level of participation of banks in this market is not tracked,
U.S. banks may currently own a significant amount of bank and insurance company Tier 1 and
Tier 2 capital securities. Although the Basel language is unclear, such holders could be required
to deduct their excess investments in the capital instruments of unconsolidated financial
institutions using a ³corresponding deduction approach.´ The ³corresponding deduction
approach´ would require the deduction of excess investment from the component of capital of
the investor bank for which the capital would qualify if issued by the investor bank. Thresholds
are specified for common stock investments only, the more relevant of which is aggregate
investment in the common equity of other financial institutions. A similar 10% threshold may
apply to holdings of other non-common capital instruments. When the threshold level of
aggregate investment in noncommon capital instruments is clarified, banks holding excess
investments may decide to sell some of those securities. In addition, the prospect of this capital
deduction may result in the withdrawal of banks as buyers from the market for new issue bank
and insurance company capital securities. If so, there may be an impact on market liquidity and
pricing for such issues. I would expect to see the impact of this deduction evaluated and
addressed in the rulemaking process.

(b) Risk weighting calculations: The framework for risk weighting from Basel III is largely
based on the current Basel II requirements, but with significant refinements to the counterparty
credit risk components largely due to credit valuation adjustments. The Basel Committee also
felt that central counterparties were not widely used, resulting in greater counterparty risk. As a
result, a sophisticated protocol of revised risk weightings is proposed in Basel III that will likely
increase the risk weightings on trading, derivatives and securitization activities. Complicating
this process is the Dodd-Frank requirement that banks no longer rely on published debt ratings
for purposes of determining appropriate risk weightings of investments in debt securities. This
has created a scenario where banks cannot be sure how they will determine the creditworthiness
of securities that will then drive risk weightings. I expect to see rulemaking settle uncertainties
such as whether each bank will have to prepare its own analysis of risks to determine the
appropriate risk weighting or whether banks may rely on a report by a third party other than a
³nationally recognized statistical rating organization,´ or rating agency.

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(c) Countercyclical buffer: Basel III mandates that banks carry a countercyclical buffer of 0% to
2.5% of risk-weighted assets, in common or other ³fully loss absorbing capital´ to protect the
banking sector from periods of excess aggregate credit growth. The level of capital required for
this buffer will be set and implemented according to national circumstances. While it will be left
to the U.S. regulatory authorities to set the level of this countercyclical buffer, at the upper end it
represents a 35% increase in capital over the common equity required. In addition, what
constitutes ³fully loss-absorbing capital´ will be the subject of the rulemaking process.

(d) Gone-concern capital proposal: The Basel Committee has proposed in its August 2010
Consultative Document that all non-common Tier 1 and Tier 2 qualifying regulatory capital be
required to convert into common stock upon a ³triggering event´ as determined by the relevant
regulatory authority. These provisions will require a significant reevaluation of capital structures
and qualifying securities. The impact will be felt not only with respect to new issuances of non-
common capital securities, but could also require banks and investors to amend existing
securities to include this conversion feature. Until rulemaking guidance is provided on these
gone-concern capital issues, the market for non-common Tier 1 and Tier 2 regulatory capital will
likely be dormant for both buyers and sellers.

2. Cautious Capital Management by Banks ± Uncertainty regarding the final rules and
regulations outlined above, and their impact, will likely lead bank managements to take a very
cautious approach to capital management, including dividend policy, stock buybacks and
subordinated debt or trust preferred repurchases and issuances. Once the rulemaking activity is
completed and banks have a clearer view on specific capital requirements for their institutions,
there will likely be a period of active capital management in the next 12 to 18 months as bankers
realign their capital structures for their retained business lines. Of broader concern may be
willingness to lend. It remains to be seen whether prospective and uncertain changes in capital
ratios will lead bankers to become increasingly cautious in making loans for fear of taxing their
capital bases.

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3. Conservative Capital Ratio Determinations by Regulators ± As currently proposed, the
home-country regulator has discretion to impose on domestic banks a countercyclical buffer of
common equity or other fully loss-absorbing capital in a range of 0% to 2.5% of risk-weighted
assets as needed to control excess credit growth within that country resulting in an elevation of
international, system-wide risk. Systemically important banks may have an additional capital
buffer added atop these levels. u||
|%|| |0=$|  |*
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||%||=$| |%|| |#,. These higher effective
levels include the mandatory conservation buffer of common equity in an amount equal to 2.5%
of risk-weighted assets. Dodd-Frank imposes a three-year phase-out of the Tier 1 capital
qualification of trust preferred capital for banks with assets of $15 billion or greater. This is
much more conservative than the 10 year phase-out beginning in 2013 for trust preferred
securities as required under Basel III. The Basel III provision, however, will have an impact on
banks with less than $15 billion of assets, even though the Tier 1 treatment of trust preferred
securities was otherwise permanently grandfathered under Dodd-Frank. These inconsistencies
between Dodd-Frank and Basel III may be resolved in rulemaking rather than legislation.

4. Continued Pressure on Troubled Banks ± Notwithstanding the important rulemaking

process that will take place over the next year, with the passage of Dodd-Frank and the
announcement of the Basel III rules, U.S. regulators can now turn their attention more fully to
the U.S. banks with high levels of asset quality risk and low levels of tangible equity. As of June
30, 2010, it was observed that there were more than 700 banks, holding over $1 trillion in assets,
which either had a Texas ratio greater than 50% or a tangible equity/tangible assets ratio less
than 6%. The FDIC recently announced that there were over 800 banks on its troubled bank list.
These banks will be under intense scrutiny and pressure to find a solution either by raising
capital, de-risking their balance sheets or selling.

Long±Term Implications:

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1. Increased After-Tax Cost of Capital ± Prior to the Basel III requirements, common equity
had to be the ³dominant´ (>50%) component of the Tier 1 capital of U.S. banks. The balance
could consist of qualifying Tier 1 components such as trust preferred securities (up to 25%) and
non-cumulative perpetual preferred stock. By optimally structuring their capital with this
combination of securities, U.S. banks reduced their after-tax cost of capital, improved returns on
common equity and earnings per share and enhanced their franchise values. The new Basel III
requirements will increase the common equity component of Tier 1 capital from at least 51% to
approximately 82% (7% common equity relative to 8.5% Tier 1 capital). Similarly, common
equity will increase as a percentage of total capital from a minimum of 51% to approximately
67% (7% common equity relative to 10.5% total capital). By requiring far greater amounts of
common equity relative to non-dilutive, tax-deductible forms of capital, the cost of capital for
U.S. banks will increase. An example would be the best way to explain this point:

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2. Altered Market for Debt-Like Bank Capital ± The market for bank debt that is treated as
capital may be reduced as a result of (i) the potential limit of 10% of equity for total purchases of
other banks¶ capital securities by banks and (ii) the gone-concern requirement of converting bank
debt into common stock upon a triggering event. While these requirements may be modified in
the rulemaking process, the first of these may reduce the participation of banks in the market as
buyers of these securities, and the second could remove from the market some traditional bank
debt investors, who may be unwilling to risk becoming subordinated/common stock investors
following a triggering event. These changes could therefore lead to less demand, higher cost and
less liquidity in the bank debt capital markets.

3. Pressure on Bank Profitability ± The higher common equity requirements of Basel III could
be expected to reduce bank profitability as expressed by return on common equity, put pressure
on earnings per share and lower growth potential. As a result, I expect to see prudent bankers
consider the following:

(a) Carefully evaluate each business line, loan pricing and investment strategies to determine
whether each is meeting the thresholds required for appropriate returns.

(b) Analyze marginal lending, including non-relationship business and commercial mortgage
lending, which represent high risk-weighted, credit intensive activities with limited cross-sell
potential and lower risk-adjusted returns.

(c) Pursue business line M&A activity either to generate scale-based returns or exit non-core
businesses.

(d) Reduce cost structure and generate non-credit intensive fee income to achieve financial
returns. Cost savings from in-market M&A activity can generate attractive returns with reduced
risk.

4. Opportunities in shadow banking system ± Reduced or substantially re-priced credit

availability from banks could push more lending activity to the ³shadow banking system.´ The

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securitization markets, finance companies, REITs, private equity funds and business
development companies will have the opportunity to pick up the slack in lending activity,
particularly as the economy recovers. Among these, REITs and BDCs have significant tax
advantages, as they can pass through income to investors without paying corporate level taxes.
There are currently 170 publicly-traded REITs with a total market capitalization of $354.0 billion
and there are 24 publicly-traded BDCs with a total market capitalization of $13.7 billion. If and
when the financing markets return for these non-bank lenders, these types of businesses could be
among the biggest beneficiaries of the shift of credit from the banking system to the ³shadow
banking system.´

Chapter 6

Comparing impact in India, Europe and the United States

At the aggregate level Indian banks will not have any problem in adjusting to the new capital
rules as required by BASEL III norms, both in terms of quantum and quality. Also, estimates
show that the leverage in the Indian banking system is quite moderate. Indian banks will not
have a problem in meeting the leverage ratio requirement. This is because the Tier 1 capital of
many Indian banks is comfortable (more than 9%) and their derivatives portfolios are also not
very large.

At first sight, the impact on US banks seems similar, though slightly smaller; of course, the US
banking industry is also smaller than Europe¶s, as measured by assets. Under the same
assumptions, we estimate the shortfall in core Tier 1 capital in the United States at about $700
billion, or ¼500 billion at current exchange rates, and the total Tier 1 capital shortfall at $870
billion, or about ¼600 billion. We estimate the gap in long-term funding for the United States at
$3.2 trillion, or ¼2.2 trillion. These shortfalls would affect profitability; the US banking industry
would see a decrease in ROE of about 3 percentage points. The leverage ratio embodied in Basel
III would not be a major additional constraint, as the United States already has a leverage ratio in
place.

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Looking more closely, a couple of key differences emerge. With respect to capital, the deduction
of mortgage servicing rights plays a more significant role in the United States than it does in
Europe, while minority interests are less relevant. The impact of Basel III¶s RWA-related
measures is not directly comparable between Europe and the United States, due to the very
different starting position of the two industries. Many US banks have not yet implemented Basel
II. Capital ratios in these banks may be more deeply affected by the simultaneous transitions to
both Basel II and III. That said, it is not possible to predict from the outside-in the additional
impact this will have on the capital needs of the US banking sector. With respect to funding, the
most significant factors in the United States include the 40 percent limit in the LCR on debt
issued by public-sector entities, the assumed drawdown rates on corporate and financial credit
and liquidity lines, and the assumed runoff rates of wholesale deposits.

All other things being equal, Basel III would reduce return on equity (ROE) for the average bank
by about 4 percentage points in Europe and about 3 percentage points in the United States.
Despite the long transition period that Basel III provides, compliance with new processes and
reporting must be largely complete before the end of 2012. For an average midsize bank, I
estimate that the technical implementation alone will add about 30 percent to 50 percent to the
significant outlay already incurred for Basel II. Implementing the new rules will require three
distinct initiatives: strategic planning for the Basel III world, capital and risk strategy, and
implementation management.

JJ 
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I strongly believe that the new BASEL III regulations will reduce the probability and severity of
future financial crises and thus promote higher growth over the long term. In this regard, a report
by the Basel Committee estimates that an increase in the banking sector¶s common equity ratio
from 7% to 8% (as required in BASEL III) reduces the probability of a banking crisis by at least
1 percentage point. A 1 percentage point reduction in the probability of a crisis in turn produces

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an expected annual GDP benefit of between 0.2 and 0.6%. These are admittedly rough estimates,
but it is clear that there are substantial benefits associated with a better capitalised banking
sector.

Some noted analysts had pointed out that the delayed-implementation schedule undermines the
stated purpose of Basel III to prevent the next financial crisis. According to the new schedule, it
will be nine years before Basel III is fully in place and they believe that it is very likely that there
will be another crisis before then. I believe that given the fragile economic recovery especially in
developed markets, a shorter transition period may impede growth. However, since BASEL is an
accord and not a treaty, national authorities of respective countries are free to impose shorter
transition periods if deemed necessary.

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À
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| www.rbi.org.in
| www.bis.org.in
| www.crisil.com

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 | Former RBI Governor Mr. Y.V. Reddy¶s book titled ³India and the Global Financial
crises´
| www.mckinsey.com
| www.deloitte.com
| www.icra.co.in
| www.ey.com
| www.pwc.com
| www.citigroup.com

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