Basel III blues

Before the 2008 financial crisis, an abundant supply of liquidity with exceptionally low interest rates led banks to expand credit at will, leading to a credit bubble. All through this bubble, banks excessively leveraged their balance sheets, while regulators kept mum because these banks were fully compliant to Basel II norms on their risk weighted assets.

Also, banks were looking for ways to pay excessively high executive compensation. This, for a given NIM (net interest margin) and a given level of borrowing costs, resulted in an ever increasing compression of RoA (return on assets). This, in turn, forced banks to increase leverage to keep shareholders happy by delivering attractive RoE (return on equity). So much so that hedge funds looked like apostles of defensive strategy in comparison.

Soon, regulators got wiser and thought up Basel III norms, which mandate a maximum ratio of assets to capital of, yes, 33 times. Even here, banks need to comply with it only by March 2018.

That said, this is a redeeming feature, because any quicker transition would be counterproductive for the real economy, given the state it is in at present.

To have a sense of what a quicker transition could mean for the real economy, it is insightful to model changes in output/growth through an analogy of ICOR (incremental capital to output ratio) by conceptualising IAOR (incremental assets to output ratio).

Any quicker increase in regulatory capital will, as it already has, result in deleveraging or shrinking of bank balance sheets, hurting output and jobs. Specifically, the IAOR for India is empirically estimated at 2.5, which means for 1 per cent decline in bank assets, output will decline by 0.4 per cent.

This, then, is the powerful way to model the impact on the real economy of any increase in the regulatory capital or leverage ratio for banks, and explains the caution on the part of the regulators in introducing higher regulatory capital and lower leverage ratios in a hurry.

With no further cost cutting and efficiency gains immediately possible in the banking sector, the need to keep return on assets attractive will result in higher borrowing costs for the real economy, the effect of which would be the same as that of involuntary monetary tightening.

It is precisely to mitigate this adverse impact on growth/output/jobs that a calibrated transition to higher regulatory capital/leverage ratio has been envisaged, although the mandated 3 per cent leverage ratio itself is rather low and needs to be higher at around 5 to 7 per cent.

Of course, the upside of longer transition would be improved efficiencies in the banking sector, resulting in reduced borrowing costs for the real economy.

Significantly, Indian banks being already 2.5 times Basel III compliant with a leverage ratio of 7 per cent-plus will need to increase equity capital only to maintain their existing leverage ratio — to remain compliant with themselves, and not at all to comply with Basel III as is widely made out.

The writer is former executive director of the RBI