Restrictive regulatory regime

Rather than inject fresh capital only into banks that transgressed most, and punish all equally with draconian restrictions for transgressions of few, a judicious lowering of CARs will help all banks

The lead editorial in Business Standard on Friday, August 10, 2018, titled “Don’t ignore risks” opines that bringing the Reserve Bank of India’s (RBI) capital adequacy requirements to Basel III standards “would be an imprudent course to pursue” and that the effort to do so “betrays either a lack of good knowledge of the Indian banking sector or a lack of care.” The edit does not take cognisance of Indian economy’s present structure or growth imperatives.

For several reasons, it is strange for the RBI to insist on 22 per cent higher CET-1 norms for Indian banks than stipulated by Basel III (5.5 per cent compared to 4.5 per cent under Basel III). This 100 bps differential is maintained at all levels strapping Indian banks with higher capital adequacy norms than peers in advanced or emerging economies. 

With a sovereign guarantee for all deposits held by public sector banks (PSBs) and practically the entire banking sector (as demonstrated when ICICI was protected in the wake of 2008 financial crisis), there is no reason for the RBI to mandate higher than Basel III capital adequacy ratios (CARs) for Indian banks. Higher CARs are required principally for safeguarding depositors’ interests. These interests are more than assured with the sovereign guarantee implicit in the predominantly public sector ownership of the Indian banking sector.

“Bank Capital Regulations around the World,” by the Federal Reserve Board, Washington DC, in 2016, and several other publications by multilateral agencies highlight that countries with higher GDP growth rates and higher returns generally choose a lower minimum regulatory capital threshold than those with lower growth and returns. 

Research also indicates that countries with higher government ownership of banks generally choose lower minimum regulatory capital thresholds. India, with high economic growth and high government ownership of the banking sector, should have lower minimum regulatory capital thresholds. India, surely should not have CARs higher than Basel III.

Second, there has been a sharp rise in recognition of non-performing assets (NPAs) and deceleration in credit provided by scheduled commercial banks these past few years. This indicates that in terms of the cycle for which regulators have designed a capital cushion, we are closer to the bottoming of metrics with lower expected reserves rather than just ending the good times with the greatest expected reserves. There is every sign that the economic cycle in India is in its early stages of acceleration after significant structural changes, with credit growth only recently accelerating after decelerating for the past several years.

The main goals of macroeconomic policy at this stage should be: 1) to ensure that the nascent recovery is supported by banks; and 2) precious and scarce financial resources of a country with per capita GDP less than 20 per cent of global average are not unnecessarily dormant and should rather be put to productive use for expanding capacity and generating a supply response to rising demand levels. This will help avoid perking up of inflationary pressures and expectations in the economy.

The potential benefits to the economy of a credit expansion are more than an order of magnitude greater than the capital required to maintain current RBI capital adequacy thresholds at the most stressed banks. A lower CAR, in line with Basel III, frees up unproductive dormant capital across the banking sector and not just in stressed banks. Every scheduled commercial bank, especially those that have been judicious in their advances with very high underwriting standards, will also have materially more potential capital to disburse and given the greater cushion to regulatory thresholds will feel comfortable disbursing more. This will support sustained acceleration of the economy and help overall credit quality in the economy improve with rising sales, better coverage ratios, and assets appreciating, resulting in the strengthening of a multi-year virtuous cycle.

As a result of RBI’s own well recognised efforts in recent years, including the 360 degree recognition of stressed assets and NPAs, the Indian banking system poses less systemic risk than at any time in recent history. This is due to: 1) the bulk of bad loans already recognised; 2) higher underwriting standards put in place for recent advances; 3) greater reluctance to take risk at scheduled commercial banks; 4) more objective and earlier recognition of changes in risk in the system; and finally 5) establishing of a time bound process for resolution of NPAs through the IBC. 

With greatly reduced systemic risk of the banking system in the country, excessive regulatory thresholds above slower growth countries with substantially higher total debt is unnecessarily preventing the productive deployment of dormant assets in a country with precious and scarce financial resources. 

It is also fairer to banks that were better managed and more judicious. Rather than inject fresh capital only into those banks that transgressed the most, and punish all equally with draconian restrictions for the transgressions of a few players, a judicious lowering of CARs will help all banks. While the shift to Basel III norms will provide all banks greater flexibility in advancing credit, the banks with the healthiest balance sheets and largest capital cushions above regulatory thresholds, will clearly be the ones that could grow and benefit the most. This is surely desirable. 

Providing further runway for all banks to serve the needs of the growing economy will serve to strengthen our economy and help our per capita GDP progress faster towards global averages. A glance at China’s debt growth (Table II), especially since the 2008 world financial crisis, shows India’s relatively conservative leverage and the potential to expand the credit to GDP ratio.

It would be a tragedy for our regulator to throttle down our economy from its rightful pace due to our regulator’s low confidence in its own abilities to monitor the banks, as insinuated in the edit, based on a former governor’s extraordinary admission of regulatory weakness. Abnormally conservative CARs imposed by the RBI punish well-run banks as much as those that have been irresponsible. It also slows down the path to prosperity for a nation where per capita GDP is still less than 20 per cent of the global average.

Kumar is vice-chairman, NITI Aayog; Pai is senior consultant, NITI Aayog