Capital: Is it a punishment?

I have started with a question on capital: Why? Well, there has been much discussion in the media about the level of capital banks need to hold — should the capital adequacy ratio (ratio of capital to risk-weighted assets) — CAR — be 9 per cent as per Reserve Bank of India (RBI) norms? Or why not 8 per cent as per Basel norms? Should government-owned banks need to hold the same level of capital as other banks?

To discuss this, we first need to appreciate and distinguish between the roles of provisions and of capital. In a sentence, provisions are meant to cover the expected losses whereas capital is meant to capture unexpected losses, beyond the expected losses, at a certain level of confidence.

Is the RBI being unfair in asking banks to hold 9 per cent CAR and higher risk weights than what Basel prescribes for some credit ratings? Let me put this in perspective.

The Basel capital adequacy norms, under the standardised approach for credit risk capital which India follows, are calibrated according to the observed default rates and losses given default, based on global sample data. These assign risk weights calibrated on the international external credit ratings (ECRs) of banks’ exposures. However, the Basel norms require the risk weights to be recalibrated if the observed loss rates in a jurisdiction corresponding to an ECR are higher. The default rates and the percentage of loss given default in India are much higher in comparison to the rates on which the Basel norms are calibrated. Our calculations show that if we recalibrate the risk weights accordingly, while keeping the capital adequacy ratio at 8 per cent, the amount of additional capital that banks would reply would be roughly around Rs 2 trillion.

Looking at it another way, given the low recovery rates observed in India, the provision coverage ratio (PCR) that is, the ratio of loan loss provisions to non-performing assets (NPAs) needs to be much higher than its current level of 50 per cent at system level.

Low PCR is a contingent charge on capital because when the NPA ultimately results in losses being booked, the provisions held for that exposure may not be enough to absorb the losses, the shortfall being a net loss, which erodes capital. I might add that India is among the countries having relatively high level of unprovided NPAs in relation to capital. So, the way forward would be to either boost the PCR or compensate with more capital. How much more should we provide? We could consider targeting a net NPA ratio (NPAs net of provisions to loans net of provisions) of, say, 3 per cent, considering most G20 countries, including emerging economies, have gross non-performing asset ratio (GNPA ratio) below 3 per cent.

Basel has three pillars, of which two are linked to capital requirements. What is not often talked about in India is the second pillar -- the Supervisory Review and Evaluation Process (SREP). Our supervision teams, as part of their annual supervisory process for assessment of risk and capital (SPARC), compute Pillar 2 capital for each commercial bank but do not enforce this as a requirement. If enforced, the resultant additional capital requirement at system level would be over Rs. 2 trillion. I might also add that the SPARC model is a best in class model that has been independently validated.

The media has also been talking about the capital conservation buffer (CCB). Yes, the CCB is a macroprudential tool to enable banks to lend during an economic downturn. However, internationally, the CCB sits on a plump cushion, above the Pillar 1 and the Pillar 2 capital. Hence, if the cushion exists, supervisors will not be worried if the CCB is drawn down during an economic downturn. However, in India, there is no such cushion, for many banks. The CCB is the only capital that is available above the bare bones minimum capital requirement. Hence when a bank in India breaches CCB, it becomes a supervisory concern.

What really mystifies me is why the debate on bank capital focuses on 8 per cent vs 9 per cent — that is, the minimum capital requirement.

  • Do we want our PSBs to live hand-to-mouth at the poverty line of minimum capital?
  • Research studies have suggested minimum core capital ratio ranging from 9 per cent to 53 per cent with a median of 13 per cent.
  • Banks which choose to operate at the poverty line where capital is concerned, are condemned to stay poor.
  • Internationally, banks in 8 per cent minimum CAR jurisdictions operate at levels of 14 per cent or higher.
  • So the more meaningful approach would be to debate what should be the optimal level of capital for banks in India, given the ground realities. And not on whether the poverty line should be 8 per cent or 9 per cent. Because that’s not where we want our banks to be.

It has been argued that since public sector banks (PSBs) have the comfort of an implicit government guarantee, they need not meet the minimum regulatory capital requirements. This argument does not hold water for a number of reasons, including moral hazard, losing market credibility, a non-level playing field etc. Let me offer just one other reason: typically, a downturn in the business cycle is accompanied by stress not only in the financial system but also in the fisc. In such a situation, the government would face constraints in generously recapitalising banks, leading to a situation where government owned banks get driblets of capital which are just enough to meet minimum regulatory capital, and inadequate for growth.

In closing, let us also not forget that business cycles and financial crises are old companions that walk hand in hand and are here to stay. When the going gets tough, it’s the banks with capital that can get going. Banks with inadequate capital will be punished by their ecosystem.

May I therefore take the liberty of suggesting that we should spend some time discussing what we need to do, in terms of capital, competencies and good governance, to be better prepared for the next crisis when it comes. And come it will.

Excerpts from RBI Executive Director Sudarshan Sen’s keynote address at the BS Annual Banking Forum held in Mumbai on December 6

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