Reducing the risk of meltdown

The Basel Committee on Banking Supervision, a group of regulators from 27 countries including the United States, reached an agreement on September 12 on a new set of norms — Basel III. Under it, banks will be required to significantly raise their capital adequacy levels thereby reducing the risk of another financial meltdown. The agreement more than doubles the amount of equity capital that banks must hold in relation to their assets. Apart from enhancing the requirement to 4.5 per cent of their assets from 2.5 per cent, it calls for the creation of a “conservation buffer” of 2.5 per cent that can be used in an emergency. However, in such an eventuality they will be forced to conserve capital by, for instance, halting dividends. There is also a third, optional rule — a counter-cyclical buffer that regulators can impose when credit is flowing freely. On top of all this, banks have to hold 1.5 per cent of capital, which may or may not be in the form of equity, as an additional margin of protection, should the first line of defence — the core equity reserves — be breached. Basel III has been welcomed around the world as a substantial improvement over Basel II. Particularly, its recognition of the role of counter-cyclical measures in times of both boom and bust is a valuable lesson learnt from the latest crisis.
However, there are weaknesses which banks are likely to exploit for reducing the levels of capital they have to set aside. There are no clear guidelines on how liquid assets are to be valued. The new rules are risk-weighted: the more speculative their investment the more the capital banks must set aside. The risk will be evaluated by the rating agencies whose track record was not at all impressive during the crisis. The new rules are to be brought into force in phases starting 2013 and so they will not be fully in place until 2018. Banks in India are sufficiently capitalised and are unlikely to need additional capital as they migrate to Basel III. However, their profitability might be curtailed as the implementation of the new norms would result in a lower leverage. Also, the dominant public sector banks that rely on perpetual debt instruments to shore up their Tier-I capital will have the challenging task of maintaining a minimum common equity of 7 per cent. Even without the new norms, a few leading government banks feel constrained in their efforts to raise resources through capital market equity offerings. The government's shareholding in them cannot fall below 51 per cent.