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Diluting capital adequacy norms in banks imprudent

The Union government will reportedly hold discussions with the Reserve Bank of India (RBI) in an attempt to have the regulator dilute the capital requirements for Indian banks. The hope is that the RBI will reduce the common equity tier — I (or CET-I) ratio for Indian banks. This is the ratio of common stock and reserves divided by its risk-weighted assets; as a percentage, Indian banks are currently required to keep at least 5.5 per cent of such capital in reserve. However, the international Basel-III standards are less stringent, requiring banks to keep 4.5 per cent in hand. The government — the owner of 70 per cent of the banking sector — is faced with a fiscal crunch at precisely the time that bad loans are ballooning, thereby increasing banks’ capital adequacy needs. According to CRISIL, six public sector banks are dangerously close to breaching the RBI’s capital adequacy recommendations — 5.5 per cent for CET-I and an additional 2.5 per cent for the capital conservation buffer. This set includes Punjab National Bank — which is the country’s second-largest public sector lender. The government would normally be required to pay to further capitalise these banks — but, if it instead reduces the requirements, then it can “save” that money.

This would be an imprudent course to pursue. It betrays either a lack of knowledge of the Indian banking sector or a lack of care. There is a very good reason why Indian capital adequacy ratios are higher than those recommended by the international Basel-III norms. This is because the health of the banking sector in India requires greater attention, given the problems of regulation. In the words of former RBI governor Duvvuri Subbarao, explaining why the RBI felt it necessary to set higher ratios than those negotiated at Basel: “The higher prescription is intended to address any judgemental error in capital adequacy viz. wrong application of standardised risk weights, misclassification of asset quality, etc.” While the government argues that the end of regulatory forbearance for “extend and pretend” means that this argument no longer applies, there will be few takers for this self-serving claim. Trust in Indian banks has simply not reached a level at which the international norms are relevant; India still requires norms that take into account what Mr Subbarao had called “judgemental errors”.

This is natural for developing countries; in fact, many of India’s peers have set even higher capital adequacy ratios. It is worth noting that the basic logic of the Basel-III requirements is for greater capital to be built up at times of growth and is run down at times of weakness. It is not for the regulations themselves to be altered at precisely the time when they are needed to preserve the health of the banking sector. The government’s bank recapitalisation plan to secure the health of the Indian banking system cannot be secured on the cheap. Just because that package is falling short in terms of size does not mean that other essential regulatory requirements should be diluted to make the finance ministry’s job easier. The RBI would do well to stand firm and stick to its existing expectations from banks.