7 things to know about BASEL III norms

Originally set in 1974, the most recent set of norms, called BASEL III, is likely to be implemented in India from 2019. This affects a lot of banks. If you are an investor, you may need to know about the BASEL III norms.

Why Are BASEL Norms Necessary?

It is not for nothing that banks are considered important for an economy, especially if it is a developing country like India. Go back to 2008, the crisis in the US banking sector wreaked havoc throughout the world. The US is still trying to limp back to economic growth. A banking collapse is one of the worst crises a country can face. The BASEL norms have three aims:

• Make the banking sector strong enough to withstand economic and financial stress
• reduce risk in the system
• improve transparency in banks.

BASEL III Rules

After the 2008 financial crisis, there was a need to update the BASEL norms to reduce the risk in the banking system further. Until BASEL III, the norms had only considered some of the risks related to credit, the market, and operations. To meet these risks, banks were asked to maintain a certain minimum level of capital and not lend all the money they receive from deposits. This acts as a buffer during hard times. The BASEL III norms also consider liquidity risks.

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Capital needs

When you are exposed to more risk, you need a larger safety buffer. The BASEL III norms account for more risk in the system than earlier. As a result, it increases banks’ minimum capital requirements. Tier 1 capital – the main portion of the banks’ capital, usually in the form of equity shares – should amount to 7% of the banks’ risks. So, if the bank has risky assets worth Rs 100, it needs to have Tier 1 capital worth Rs 7. This capital can be easily used to raise funds in times of troubles. Plus, banks also have to hold an additional buffer of 2.5% of risky assets.

Leverage risk

Banks can also pile on debt like other companies. This increases the risk in the system. The Basel III norms limit the amount of debt a bank can owe even further. This is called the Leverage Ratio. This is especially applicable for banks that trade in high-risk assets like derivatives.

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Liquidity

Capital is money that is invested in assets like equity or government bonds. This money, therefore, is not readily available for day-to-day activities. Moreover, during a crisis, the value of investments can fall suddenly like the 2008 financial crisis. This means, the capital a bank holds can fall during times of need. This is why the BASEL III norms ask banks to hold liquid money. This is measured by the Liquidity Coverage Ratio (LCR), a ratio of the liquid money to total assets. This should equal the banks’ net outflows during a 30-day stress period.

Implementation in India

The Reserve Bank of India (RBI) introduced the norms in India in 2003. It now aims to get all commercial banks BASEL III-compliant by March 2019. So far, India’s banks are compliant with the capital needs. On average, India’s banks have around 8% capital adequacy. This is lower than the capital needs of 10.5% (after taking into account the additional 2.5% buffer). In fact, the BASEL committee credited the RBI for its efforts.

Challenges for Indian banks

Complying with BASEL III norms is not an easy task for India’s banks, which have to increase capital, liquidity and also reduce leverage. This could affect profit margins for Indian banks. Plus, when banks keep aside more money as capital or liquidity, it reduces their capacity to lend money. Loans are the biggest source of profits from banks. Plus, India banks have to meet both LCR as well as the RBI’s Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) norms. This means more money would have to be set aside, further stressing balance sheets.

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