The New Capital Adequacy Framework (Basel II) incorporates a capital charge for operations risk. My estimate of the operation risk capital as on March 31, 2006, is approximately Rs 20,000 crore (Rs 200 billion). If banks continue to grow at 25-30 per cent per annum, by March 2010, the capital for operations risk itself may amount to an extra Rs 50,000 crore (Rs 500 billion).
Again, the assumption that the risk-weighted assets will grow linearly with bank credit, may not turn out to be correct, given the explosive growth, in recent years, of off balance sheet transactions like derivatives. Additional capital would be needed for this as well.
While the NCAF gives relief for credit exposures to highly rated companies, it also increases risk weights for lower rated risks. There is also the question to what extent the external agencies ratings will parallel the internal rating systems, particularly of the public sector banks.
The revised accounting norms for calculation of pension liabilities would also dent banks' capital and profitability.
Overall, it is obvious that the problem of additional capital for the banking industry is large; to be sure, a part of the needs would be fulfilled by a ploughback of profits and raising debt capital through tier-II bonds.
Ploughback of profits net of taxes and dividends, may be of the order of Rs 75,000 crore (Rs 750 billion) over three years, but the domestic market has little appetite for tier-II bonds of the banks.
This would mean that the banking system may need to raise anywhere up to Rs 150,000 crore (Rs 1500 billion) by way of fresh equity. Banks too seem to have realised this and the announced plans, including of ICICI and SBI, are around Rs 40,000 crore (Rs 400 billion) (equity issues in the Indian market last fiscal year aggregated barely 75 per cent of this amount). The government also seems conscious of the dimension of the problem, and seems to be toying with the idea of introducing non-voting shares for public sector banks: this would enable capital to be raised without dilution of the governments voting power.
If the supply side of banking capital seems to present daunting problems, what about the demand side? In other words, are the banks, in particular those from the public sector, doing enough to make optimum use of the capital they already have? While there is little quantitative data on the subject, qualitatively one gets an impression that not much attention is being paid by public sector bank managements to the issue.
In fact, the concept of risk-adjusted return on capital in the different segments, and pricing to achieve the desired returns, do seem to be somewhat neglected issues. In theory, segmental reporting exists but neither statutory auditors nor the bank regulator seem to be very much concerned about how the data is collated and presented, and what comparisons and conclusions, if any, can be drawn therefrom. Segmental reporting seems to have become just one more form to be filled.
As for derivatives, there are capital charges for both market and credit risks, and the latter is presently calculated on a gross basis. In his last monetary policy statement, the Governor has advised CCIL "to start a trade reporting platform for rupee interest rate swaps," by August 31.
While this is to be welcomed as far as it goes, we also need an electronic trading platform for the swap market. CCIL is already developing a settlement system for INR derivatives. Ideally, this should be integrated with a trading platform providing straight-through processing of deals.
From a capital adequacy perspective, once CCIL takes over the settlement function, in effect, it steps in between the two parties to a derivatives contract, guaranteeing the obligations of each.
In that case, the regulator should review whether capital charge for the credit risk on outstanding derivatives contract is really needed.
While on the subject, one other issue is worth mentioning - namely the securitisation of banking assets. Securitisation has been in existence in the Indian market for about 15 years and the system has worked quite well. Recently, the legal impediments to listing and trading of securitised paper on stock exchanges have been removed.
Securitisation of assets can be an important source of managing capital (assuming that we develop a deep and liquid corporate bond market, which is needed even otherwise), and this will be facilitated by some changes in the regulatory framework.