The Finance Ministry’s unequivocal missive to 10 state-owned lenders to submit time-bound turnaround plans, or forsake any further capital infusion from the government, is a small yet timely step in the right direction.
Why was this step essential?
As the Reserve Bank of India had flagged in Financial Stability Report, risks to the banking sector remain worryingly “high”.
The continuous deterioration in asset quality, especially at the public sector banks (PSBs), has led to low profitability and substantial value erosion to the principal shareholder — the government.
PSBs saw the proportion of their gross non-performing assets to total advances almost double in the 12 months through September 2016 to 11.8%.
Why has the Centre included the employees?
Staff, who have been a key element in the growth and development of the sector, have a vested interest in the health of PSBs; the risk of continued failure is closure and job losses.
The stipulation of a three-year time limit for the implementation of the turnaround is also significant as Indian lenders have to meet Basel III capital regulations by March 31, 2019.
What is 'Basel III'?
Basel III (Capital adequacy norms) is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector.
Minimum Capital Requirements
Basel III introduced tighter capital requirements in comparison to Basel I and Basel II. Banks' regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity, and their dividends can be cancelled at any time. Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.
Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Risk-weighted assets represent a bank's assets weighted by coefficients of risk set forth by Basel III. The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of certain assets to establish their risk coefficients.
In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at 8%.