Making banks safer

Capital adequacy and tighter regulation are just one step forward

The global thinking on bank regulation after the financial crisis of 2008 has converged on to one simple principle. Banks should have more capital in order to support a given volume of lending business. Further, bigger banks - which are deemed to be systemically important, in the sense that their failure could cascade through other institutions - need to have even more capital. Following its mandate of a five-year time frame for Indian banks to achieve compliance with the Basel-III prudential norms, the Reserve Bank of India (RBI) has now announced a stricter capital requirement for banks that it deems to be domestic systemically important banks (D-SIBs), or banks "too big to fail". This categorisation is based on both the size and the intensity of linkages between them and the rest of the financial system. If analysts are to be believed, six banks may be categorised as D-SIBs - two of them could be local branches of foreign banks; two could be domestic private banks; and two could be public sector banks. They will each have to provide additional capital to the tune of 0.2 to 0.8 per cent of their risk-weighted asset base. Other banks will be monitored based on benchmarks emerging from these six for possible classification as D-SIBs.

While this is a measure consistent with the global pattern, the increment being proposed is smaller than that enforced on global systemically important banks (G-SIBS), which is around two per cent. Of course, the context for the two categories is quite different, with failure of the G-SIBs posing a threat to the world's financial system. But, that apart, it must be accepted that the analytical foundations for both the basic capital adequacy norms and the premiums for D-SIBs and G-SIBs are tenuous. Their effectiveness can only be gauged when the system is under stress; if found wanting, they are made more stiff and, once again, only the next crisis will demonstrate the validity of the new norms. Similarly, whether a 0.8 per cent premium will be enough of a deterrent against large banks taking on system-threatening exposures only the next shock can indicate. What is far more important is the extent of scrutiny that these banks are subject to, and the expertise and diligence with which it is done. The RBI's supervisory capabilities are going to be tested by the entry of new banks, both conventional ones and the new formats - payment banks and small banks. The more stringent scrutiny of the D-SIBS will add another level of responsibility. The basic judgment that it must base its supervisory strategy on is that while prudential norms are important, foolproof supervision is perhaps even more so. Strengthening both its methodologies and its human capital is imperative.

It faces another challenge by way of government ownership of banks. Apart from the recently classified D-SIBs, a few more public sector banks will also eventually find themselves in this category. Government control has regularly been associated with mandates to lend that are not quite consistent with prudence. Further, additional capital to support such lending may have to come from an already stretched budget. How these contradictions are going to be reconciled is an important question. The bottom line is that merely imposing higher capital requirements should not lull regulators into a misplaced complacency. They are only one component of a broader regulatory approach to systemic risk.