RBI introduces Basel-III capital framework for All India Financial Institutions

  • September 22, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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RBI introduces Basel-III capital framework for All India Financial Institutions

Subject: Economy

Section: Monetary Policy

Context: The RBI has introduced norms on the Basel III capital framework, fund raising, exposure guidelines, and norms on classification and valuation of investment portfolios for All India Financial Institutions (AIFIs), which will come into effect from April 2024.

What are All India Financial Institutions (AIFIs)?

India has five AIFIs regulated by the central bank, namely the Export-Import Bank of India (EXIM Bank), the National Bank for Agriculture and Rural Development (Nabard), the National Bank for Financing Infrastructure and Development (NaBFID), the National Housing Bank (NHB), and the Small Industries Development Bank of India (SIDBI).

Why there is need for Basel-III capital framework?

As the Indian economy grows, AIFIs are increasingly being seen as key institutions to promote the flow of direct or indirect credit to the economic sectors they cater to. It has been decided, therefore, to extend the Basel III Capital framework to the AIFIs

Capital adequacy

  • AIFIs will be required to maintain a minimum total capital of 9 per cent by April 2024, wherein minimum tier-I capital will need to be at 7 per cent and common equity tier-I (CET-1) capital at 5.5 per cent. For NHB, the implementation date will be July 2024, given that its accounting year is July–June.
  • All financial subsidiaries, except those engaged in insurance and non-financial activities (both regulated and unregulated), will need to be fully consolidated for the purpose of capital adequacy, the RBI said, adding that this will ensure an assessment of capital adequacy at the group level, taking into account the risk profile of assets and liabilities of the subsidiaries.
  • The central bank has capped AIFIs’ investments in capital instruments of banking, financial, and insurance entities at 10 per cent of their capital funds. AIFIs will not be allowed to acquire a fresh stake in a bank’s or AIFI’s equity shares if the acquisition leads to its holding exceeding 5 per cent of the investee’s equity capital.
  • Further, AIFIs’ equity investment in a single entity cannot exceed 49 per cent of the equity of the investee. While AIFIs can hold this entire 49 per cent stake as a pledgee, if the acquisition is against AIFI’s claims, the stake will need to be brought below 10 per cent within three years.
  • AIFIs need to evaluate their capital adequacy relative to their risks and consider the potential impact on earnings and capital from economic downturns, it said, adding that an AIFI’s capital planning process “should incorporate rigorous, forward-looking stress testing”.

The Basel Committee on Banking Supervision: 

  • It was established by the Central Bank governors of the Group of Ten countries in 1974.
  • The Basel Committee on Banking Supervision is an organization made up of 45 members, comprising central banks and bank supervisors from 28 jurisdictions. 
  • It is the primary global standard setter for the prudential regulation of banks. 
  • Additionally, it provides a forum for regular cooperation on banking supervisory matters.
  • It doesn’t have any formal authority over banks due to their decisions having no legal force, the members work together to achieve the mandate set out by it.
  • The Group of Governors and Heads of Supervision (GHOS) overseeing the Basel Committee . This group sets out the general agenda and approves the committee’s charters.

Basel Norms:

  • The Basel Committee on Banking Supervision (BCBS) issues Basel Norms for international banking regulations.
  • The goal of these norms is to strengthen the international banking system by coordinating banking regulations around the world.
  • The Basel Committee has currently issued three guidelines to achieve its goal: Basel I, II, and III.
  • Basel I
    • It was introduced in 1988.
    • It was almost entirely concerned with credit risk.
    • It established the capital and risk-weighting structure for banks.
    • The required minimum capital was set at 8% of risk-weighted assets (RWA).
      • RWA refers to assets with varying risk profiles. For example, an asset backed by collateral would be less risky than a personal loan with no collateral.
    • Capital is divided into two categories: Tier 1 capital and Tier 2 capital.
      • Tier 1 capital is the bank’s core capital because it is the primary measure of the bank’s financial strength. The majority of core capital is made up of disclosed reserves (also known as retained earnings) and paid-up capital. It also includes non-cumulative and non-redeemable preferred stock.
      • Tier 2 capital – It is used as supplemental funding since it is less reliable than the first tier.It consists of undisclosed reserves, preference shares, and subordinate debt.
    • In 1999, India adopted the Basel 1 guidelines.
  • Basel II
    • In 2004, Basel II guidelines were published by BCBS.
    • These were the refined and reformed versions of Basel I accord.
    • The guidelines were based on three parameters, which the committee calls it as pillars.
      • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets
      • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
      • Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank.
    • Basel II norms in India and overseas are yet to be fully implemented though India follows these norms.
  • Basel III
    • In 2010, Basel III guidelines were released.
    • These guidelines were introduced in response to the financial crisis of 2008.
    • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
      • Capital: The capital adequacy ratio is to be maintained at 12.9%. The minimum Tier 1 capital ratio and the minimum Tier 2 capital ratio have to be maintained at 10.5% and 2% of risk-weighted assets respectively. In addition, banks have to maintain a capital conservation buffer of 2.5%. Counter-cyclical buffer is also to be maintained at 0-2.5%.
      • Leverage: The leverage rate has to be at least 3 %. The leverage rate is the ratio of a bank’s tier-1 capital to average total consolidated assets.
      • Funding and Liquidity: Basel-III created two liquidity ratios: LCR and NSFR.
        • The liquidity coverage ratio (LCR) will require banks to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. The goal is to ensure that banks have enough liquidity for a 30-days stress scenario if it were to happen.
        • The Net Stable Funds Rate (NSFR) requires banks to maintain a stable funding profile in relation to their off-balance-sheet assets and activities. NSFR requires banks to fund their activities with stable sources of finance (reliable over the one-year horizon). The minimum NSFR requirement is 100%.
economy RBI introduces Basel-III capital framework for All India Financial Institutions