John Kenneth Galbraith, famous Harvard Economist and the US Ambassador to India during J.F. Kennedy's Administration wrote. 'All Financial Crises are the result of Debt that, in one fashion or another, has become Dangero

CS Professional · Banking - Law and Practice · PYQS · June 2021
John Kenneth Galbraith, famous Harvard Economist and the US Ambassador to India during J.F. Kennedy's Administration wrote. 'All Financial Crises are the result of Debt that, in one fashion or another, has become Dangerously out of Scale'. This was clearly demonstrated in the Financial Crisis which took place in the US in 2008. Aggressive lending characterized by Sub-prime Housing Loans and excessive leverage in major Banks and Financial Institutions led to the most serious financial challenge since the Great Depression of 1930s. The Sub Prime Crisis had reportedly led to a total write off of 1.18 trillion Dollars. One has to understand the causes of the Financial Crisis and take appropriate measures to avoid its recurrence. In order to withstand such a shock in future, the Basel Committee on Banking Supervision (BCBS) has announced on 13th September, 2010, New Capital Rules as agreed by the global regulators. The new requirement, known as Basel-III, demands a substantial strengthening of existing capital requirements. This involves higher global Minimum Capital Standards for Banks. As cited above, Basel-III reforms are the response of BCBS to improve the Banking Sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the Risk of Spill over from the financial sector to the real economy. During the Pittsburgh Summit in September 2009, the G-20 leaders committed to strengthen the regulatory system for Banks and other Financial Firms and also act together to raise Capital Standards, to implement strong International Compensation Standards aimed at ending practices that lead to excessive risk-taking, to improve the Over-The-Counter Derivatives Market and to create more powerful tools to hold large global firms to account for the risks they take. For all these reforms, the leaders set for themselves strict and precise timetables. Consequently, the BCBS released comprehensive reform package entitled "Basel-III: A global regulatory framework for more resilient Banks and Banking Systems" (known as Basel III capital regulations) in December 2010. Basel-III reforms strengthen the Bank-level i.e. Micro prudential regulation, with the intention to raise the resilience of individual Banking Institutions in periods of stress. Besides, the reforms have a Macro prudential focus also, addressing system wide risks, which can build up across, the Banking Sector, as well as the pro-cyclical amplification of these risks over time. These new Global Regulatory and Supervisory Standards mainly seek to raise the Quality and level of Capital to ensure Banks are better able to absorb losses on both a going concern and a gone concern basis, increase the Risk coverage of the Capital framework, introduce Leverage Ratio to serve as a backdrop to the Risk-based Capital measure, raise the Standards for the Supervisory Review Process (Pillar-2) and Public Disclosures (Pillar-3) etc. The Macro prudential aspects of Basel-III are largely enshrined in the Capital Buffers. Both the Buffers i.e. the Capital Conservation Buffer and the Countercyclical Buffer are intended to protect the Banking Sector from periods of excess Credit Growth. Reserve Bank of India (RBI) issued Guidelines based on the Basel-III reforms on Capital Regulation on 2nd May, 2012, to the extent applicable to Banks Operating in India. Banks have started implementing the Guidelines from 1st April, 2013 in India in a phased manner. Banks are advised by RBI to report the CRAR as per Basel-II and Basel-III simultaneously in all their disclosures to the stakeholders. In this backdrop, you are required to give answers in the context of prevailing Banking Practices and various RBI Compliances to the following: What are the potential challenges in implementing the Countercyclical Capital Buffer?

Answer & Explanation:

A critical component of the Basel-III package is a countercyclical capital buffer which mandates banks to build up a higher level of capital in good times that could be runned down in times of economic contraction, consistent with safety and soundness considerations. This is conceptually neat, but is challenging in operational terms, as indeed evidenced by Spain's recent experience. The foremost challenge is identifying the inflexion point in an economic cycle which should trigger the release of the buffer. It is quite evident that both tightening too early or too late can be costly in macroeconomic terms. The identification of the inflexion point therefore needs to be based on objective and observable criteria. It also needs long series data on economic cycles. The countercyclical capital buffer as prescribed in Basel-III was initially based on the credit / GDP metric. A study undertaken by the Reserve Bank shows that the Credit to GDP ratio has not historically been a Good indicator of buildup of systemic risk in our Banking system. Furthermore, some economic sectors such as Real Estate, Housing, Micro Finance and Consumer Credit are relatively new in India, and Banks have only recently begun financing them in a big way. The risk builds up in such sectors cannot accurately be captured by the aggregate credit to GDP Ratio. The Reserve Bank has so far calibrated countercyclical policies at the sectoral level. The Basel Committee also has now recognized that no single variable can fully capture the dynamics of the economic cycle. Appropriate calibration of the buffer requires country specific judgement backed by a broad range of other simple indicators used in financial stability assessments.

Topics: Risk Management in Banks

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