Inside RBI’s Basel III Credit Risk Overhaul

The Reserve Bank of India has put forth a draft circular for overhauling its Basel-III alignment on credit risk. Let’s take a 360-degree view of the circular in terms of Basel’s Pillar-I, Pillar-II and Pillar-III. 

Basel Pillar-I: Total Alignment with the Standardised Approach
For a start, capital charge for banks can be explained as the amount of shareholder money banks are expected to put on table alongside depositors’ money when lending. RBI’s set of norms for statutory capital on credit risk is already based on the Basel-III’s Standardised Approach and aligned with Basel norms to the extent of 80-90%. This draft proposes to align the balance 10-20%.

The proposed changes principally result in about two benefits each for the wholesale and retail loan portfolios. Capital requirements for lending to large businesses and non-banking finance companies that are rated BBB are down by 25%—from 100% risk weight to 75%—at the level of Basel’s international standard. 

Can this have a significant impact on the lending activity? The answer should be affirmative. One in four, among the rated companies and NBFCs in India lies in the BBB grade. The second alignment in relation to wholesale obligors is about those that furnish real estate assets as collateral. Banks’ capital requirement for lending to this group is proposed to be sharply reduced, ranging in cuts up to 80%. 

When the underlying assets are residential with low loan-to-property value ratio, then reduction is high, while on the other end, if the underlying assets are commercial property with high loan-to-property-value ratio, then there is little or no reduction.

On the retail side, banks’ capital requirement for home loans is being brought down by about 20%. Capital requirement for credit card debt outstandings in general has been brought down by 12.5%, along with corresponding reduction of 50% for credit card transactor outstandings. Transactor outstandings for a given credit facility are those where the obligor has not made drawdowns resulting in debt in preceding 12 months. All of these changes are adoption of Basel-III norms.

On retail lending, small exposures are said to be part of a ‘Regulatory Retail Portfolio’. They attract low capital burden to, say, vehicle and personal finance loans. Yet, the ‘Regulatory Retail’ seems to be defined more by exclusions than inclusions. Inclusions should be established by detailed regulatory wording, not through market practices. The latter will leave room for interpretation, making audits, reviews, and enforcements difficult. This should be addressed.

Proposed regulations seek to reduce capital burden of banks for MSME lending. This is to be achieved by bringing down related risk-weight to 85%, from say, 125% that currently corresponds to unsecured retail loans.

The proposed changes are expected to free up around 1.65% of banks' capital, at current composition of their portfolios. Half of this benefit would come from proposed measures on MSME segment. Should this encourage banks to undertake more MSME assets, the commercial opportunity could expand further.

Pillar-II: A Step Forward to Empirical Risk-based Capital Assessment
While the amount of capital release is significant, it is not a game changer at systemic level, as is generally made out to be. Looked at strategically, its main benefit can be derived from steps taken on management of credit risk on MSME.

Back-of-the-envelope calculations suggest that existing capital requirement is based on assumptions of high portfolio losses. Therefore, one would like to assume that the proposed reduction is based on delinquency data suggesting lower loss experiences.

The new mechanism will effectively have MSME assets placed above BB-rated entities, and just below BBB. Interestingly, one in every two Indian businesses falls in the rating range of BBB and BB. The proposal is accompanied by supervisory process retaining the discretion to induce higher capital requirements for MSME loans of bank(s).

This sounds appropriate yet puts the onus on RBI’s supervisory review process. That would entail high degree of responsibility, should the reviews end up being reactive in nature. To minimise that risk, banks would have to monitor these portfolios not just on the basis of default experience, but with set of credit models that are proactive in nature. That in turn can be attained by banks investing in the right kind of knowledgeability, models and processes. It needs to be then complemented with the SREP reviewing and validating bank models and their outcomes with regularity.

This could be turned into an opportunity, by viewing it as a dress rehearsal for adoption of advanced methods for capital estimation under the IRB. In my previous column “Why Indian Banks Need Risk-based Capital Charge Mechanism”, I had argued that IRB method would be significantly more efficient for estimation of capital requirements because it uses advanced risk-based approaches.

Pillar-III: Work to Do
Basel Pillar-III is about disclosures. It sets out minimum expectations for disclosures, to reduce information asymmetry, promote comparability of banks, and enable market participants to access key information on risk exposures to build confidence about adequacy of capital.

Disclosure requirements for countries or banks that follow the Basel’s Standardised Approach, is significantly lighter to the ones that follow its Advanced Approach. Indian banks, followers of the Standardised Approach, routinely make public breakdown of their loan exposures to various industries and delinquencies therein. This is accompanied by gradation of risk at a minimal level, for bank-wide exposures as whole. This leaves the intended audience gasping for information. Some of the disclosures expected for complete alignment with Pillar-III norms, include breakdown of each portfolio into risk gradations along a number of categories. This sort of information would provide deeper picture.

While banks are mandated to make granular disclosures about their industry exposures, the retail business exposure gets clubbed together. There is something amiss about this. Lack of breakdown of retail portfolios would not have been more than a hiccup until retail exposures of banks were small. Today they are not. For several banks, retail exposures are well over a third of the total, and some are assumed to be heading northwards of halfway mark.

The longer we wait, the asking run rate goes up, requiring more to be achieved in a shorter time. If it were to be addressed, this would be a good time because banks are in good health.