1 Sep 2014

Domestic Systematically Important Banks:An analysis of long -term benefits (PART I)

Taking lessons from the global credit meltdown, Reserve Bank of India came up with “Frame work for dealing with Domestic Systemically Important Banks (D-SIBs)” on July 22 2014 and soon it became a common topic of discussion among Indian Bankers.

This declaration by India’s central bank immediately raised many questions among public and investors, such as,  “Are private banks going to benefit from this move?”, “Will Public Sector Banks need fresh capital infusion?”, “If yes, how does the government plan to meet this requirement- via capital infusion through budgetary allocations or disinvestments?”, “Will the cost of borrowing increase for banks?”, “How will performance of banks be affected?” and many others.

What are D-SIBs?

D-SIBs are banks of national economic importance whose failure can severely strain the entire banking system. These banks would be subjected to differentiated supervisory requirements and higher intensity of supervision, based on the risks they pose to the financial system.

These measures are part of Basel III norms on Risk Supervision, to be implemented in phases, during 2016-2019. The ultimate aim of this categorization is to minimize the possibility of financial crisis and instill financial discipline among top Indian banks. In 2008 crisis, it was observed that when a handful of large, highly interconnected banks, were subjected to financial distress,  there was a system-wide collapse and public money was required to rescue the financial system.

Image Source: http://www.quora.com/What-are-domestic-systemically-important-banks-D-SIBs-What-is-RBIs-framework-to-identify-them

How may a bank fail ?

The main sources of funds for any bank are equity and deposits. As a bank expands and grows, its deposits also grow, but share capital remains the same, resulting in abnormal equity to deposit ratio. Depositors start playing a dual role of fund supplier as well as risk taker. In case of any loss of confidence, it may lead to a situation of Bank Run, and the bank is unable to cope up with the demands made by depositors as advances made to customers can’t be reclaimed in such a small time. These series of events lead to busting of the bank and engulfing the whole economy, if it is large and interconnected with financial system of that country. 

Image Source: http://www.rbi.org.in/

The present frame work asks for additional common equity tier (CET 1) requirement ranging from 0.2% to 0.8% of risk weighted assets (RWA).Selection of such banks would be done in a 2 stage screening process. Firstly, Indian and foreign banks having assets beyond 2% of Indian GDP would be taken as sample. Secondly, based on following parameters and associated weightage, their systematic importance shall be calculated:-
  • Size-40%,
  • Interconnectedness- 20%,
  • Availability of Substitute -20%,
  • Complexity- 20%

Accordingly, a level 1 to 4, systematically lower to higher systematic importance will be created and applicable norms will be implemented.

Apart from capital adequacy, norms like liquidity surcharges, tighter large exposure restrictions, will also be incorporated in the frame work.

The first list of such banks is expected to be declared by RBI in August, 2015 and the frame work will be implemented and monitored in a phased manner, starting in April, 2016. It would be an annual calculation exercise, done on basis of annual financial statements of selected banks.

From recent banking developments, we know, Indian public sector banks are sound in terms of capitalization, but need capital injection from government to meet additional capital requirement. But, they are poorly capitalised, when compared to banks of other emerging economies. Analysts believe 9% would be comfortable level for any Indian bank. But, India’ largest lender SBI and 2nd largest public lender Bank of Baroda, just touch this magical numbers, with 9.5% and 10.1% respectively. On the other hand private banks enjoy a better position, as their range is 12-14%.

This Article is written by Anshu Kumar (PGDM 2014-16)

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