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Basel III Norms Extension Provides Short Term Breather to Public Sector Banks

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 Basel III Norms Extension Provides Breather to Public Sector Banks
The Reserve Bank of India (RBI), on March 27, 2014, has extended the transitional period for full implementation of Basel III Regulations in India by one year from March 31,
2018 to March 31, 2019, closer to the internationally agreed date of January 1, 2019. RBI’s move provides short term breather to banks (specifically public sector banks or PSBs)
facing challenge of raising tier I capital to meet Basel III norms. In addition, RBI has also tightened the loss absorption features of non-equity capital instruments which is
expected to strengthen protection provided to depositors /other senior Debt holders, but could reduce investor appetite for these instruments, which in any case is not yet
tested well in Indian markets so far. The key impact of RBI’s revised norms is covered in following bullets:

 Extension of transitional period for full implementation of Basel III regulation in India
RBI has extended the implementation schedule for Capital Conservation Buffer (CCB) by one year from FY2015-FY2018 to FY2016-FY2019 consequently the Basel III Capital
Regulations will be fully implemented as on March 31, 2019, now closer to the internationally agreed date of January 1, 2019, as against earlier timeline of March 31, 2018. The
earlier and revised schedule is as follows:

Chart 1: Minimum Tier I Capital Requirement including CCB Chart 2: Minimum Total Capital Requirement including CCB
14.00% 14.00%

12.00% 12.00%

10.00% 10.00%

8.00% 8.00%

6.00% 6.00%

4.00% 4.00%

2.00% 2.00%

0.00% 0.00%

Mar-14

Mar-15

Mar-16

Mar-17

Mar-18

Mar-19
Mar-14

Mar-15

Mar-16

Mar-18

Mar-19
Mar-17

Earlier Revised Earlier Revised

Source: RBI, ICRA Research Source: RBI, ICRA Research

In ICRA’s estimate, as on December 31, 2013, PSBs had reported Basel III CRAR of 11.1% and Tier I capital of 8.1%, the corresponding figures for private banks were 15.1% and
11.3%, indicating banks may be able to meet the norms quite easily in the short term. However, Tier I for most PSBs is lower than 9.5% required at the end of transition period.
Further, significant differences do exist between PSBs with minimum Tier I for a public sector bank at 5.6% as on December 2013, indicating some of the banks may need to
mobilize significant capital in the short term as well even to meet the relaxed norms. Further, as PSBs current capitalization levels and internal capital generation have been
significantly lower than their private counterparts, the capital requirement remains bigger challenge for PSBs as compared to private banks.

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 Chart 3: Year-wise Tier I Capital Requirement of PSBs (in Rs billion)
1,400.00

1,200.00

1,000.00

800.00

600.00

400.00

200.00

-
FY15 FY16 FY17 FY18 FY19

Earlier Revised

Source: Results Release/Investor Presentation of Banks, ICRA Research

In ICRA’s estimate PSBs tier I capital requirement to meet growth and to meet Basel III norms would increase from Rs 3.3-3.6 trillion to Rs 3.9-4.2 trillion due to longer
transition period; while during FY2015-FY2018, the requirement would reduce from Rs 3.3-3.6 trillion to Rs 2.8-3 trillion.

PSBs needed CET11 capital of Rs. 2-2.2 trillion2 and AT1 capital of Rs. 1.3-1.4 trillion during FY2015-FY2018 (as per earlier norms), as per revised schedule PSBs CET1 & AT1
capital requirement would be marginally higher at Rs 2.5-2.7 trillion and Rs 1.4-1.5 trillion respectively during FY2015-FY2019. However the extension of CCB implementation
provides short-term breather whereby PSBs tier I capital requirement for FY2015 reduces to less than Rs 150 billion as against earlier requirement of Rs 200-450 billion,
against which Government of India (GoI) has budgeted Rs 110 billion.

Notwithstanding, the short term breather, RBI has emphasized that banks need to improve and strengthen their capital planning processes, Board of banks should actively
engage in the capital planning process and oversee its implementation to avoid last minute rush for capital raising. In ICRA’s views, banks could opt to mobilize capital larger
than minimum required as per Basel III Regulations in initial years of implementation, as minimum capital requirement in later years is much higher however same would also
depend on investor appetite and capital market conditions.

1
Core Tier I or common equity
2
Assuming 14% growth in risk weighted assets and internal capital generation of 7.2%, capital buffer of 1% and excluding capital surcharge for Domestic Systemic Important Bank (D-SIBs)

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  Pre-specified trigger for principal loss absorption relaxed during the transition period
RBI has now prescribed two pre-specified triggers for Basel III compliant Additional Tier I (AT1) instruments issued before March 31, 2019; a lower pre-specified trigger at CET of
5.5% of Risk Weighted Assets (RWAs) will apply and remain effective before March 31, 2019, after which this trigger would be raised to CET of 6.125%. AT1 instruments issued
on or after March 31, 2019 will, however, have pre-specified trigger at CET1 of 6.125% of RWAs only. The relaxation on the pre-specified trigger levels till March 31, 2019 could
increase investor appetite for AT1 capital instruments.

 Strengthening of loss absorption features of non-equity capital instruments

Under the earlier norms, in addition to conversion feature, both the temporary and permanent write-down features were permitted at the pre-specified trigger point for AT1
capital instruments. Under revised norms RBI has removed option of temporary write-down feature and accordingly banks are allowed to issue non-equity capital instruments
with conversion/ permanent write-down feature. The change is expected to strengthen protection to depositors/other senior Debt holders, however could reduce investor
appetite for these instruments. In ICRA’s opinion investor appetite for permanent write-down feature could be low, this could result in fresh issuances of non-equity tier I
capital instruments only with conversion feature.

 Restrictions on Dividend/ coupon on capital instruments

As per earlier norms, RBI prescribed that coupons/dividends on non-equity tier I capital instruments must be paid out of distributable items; now RBI has clarified that dividend
on common shares and perpetual non-cumulative preference shares will be paid out of current year’s profit only. Also, coupon payment on perpetual debt instrument (PDI)
would be paid to the extent of available profit in the current year; thus banks would not be able to use distributable reserves pertaining to previous years to make
coupons/dividends payment on non-equity tier I capital instruments in years of net losses. These restriction are likely to have a positive impact on capital conservation,
however restrictions on coupon on ATI instruments, could reduce the investor appetite, as probability of missed coupon goes up and any missed coupon is a permanent loss to
the investors, as the coupon is non cumulative in nature.

Overall, although RBI has given a short term breather to PSBs, it has clearly asked the banks to be proactive in capital management to avoid last minute rush. As there is no
relief on overall capital requirement on full implementation of Basel III norms, capital would remain a big challenge for PSBs; PSBs Tier I capital requirement for Basel III and for
growth during FY15-FY19 remains relatively large at 120-135% of their current market capitalization. Thus, the improvement in investor sentiment as well as development of
Additional Tier 1 capital instruments market would be critical for meeting the huge capital requirement. As private sector banks are better capitalized, have better internal
capital generation and enjoy better valuations, Tier I capital requirement looks less daunting at 25-30% of their current market capitalization. As for other changes, lowering of
pre-specified trigger may lower probability of default in the transition period; while other restrictions could lead to better capital conservation in the event of stress.

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 Table 1: Minimum Capital Ratios under Basel III Norms
Minimum Capital Ratios Earlier Norms Revised Norms
Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19
Minimum Common Equity Tier 1 (CET1) 5.0% 5.5% 5.5% 5.5% 5.5% 5.0% 5.5% 5.5% 5.5% 5.5% 5.5%
Capital conservation buffer (CCB) 0.0% 0.625% 1.25% 1.875% 2.5% 0.0% 0.0% 0.625% 1.25% 1.875% 2.5%
Minimum CET1 + CCB 5.0% 6.125% 6.75% 7.375% 8.0% 5.0% 5.5% 6.125% 6.75% 7.375% 8.0%
Minimum Tier I Capital + CCB 6.5% 7.625% 8.25% 8.875% 9.5% 6.5% 7.0% 7.625% 8.25% 8.875% 9.5%
Minimum Total Capital + CCB 9.0% 9.625% 10.25% 10.875% 11.5% 9.0% 9.0% 9.625% 10.25% 10.875% 11.5%
Source: RBI, ICRA Research

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