Will bankers ever learn? – On proposed changes to Basel-III norms

Source: The post is based on the article “Will bankers ever learn?” published in Business Standard on 13^th October 2023.

Syllabus: GS 3 – Indian Economy – Money & Banking

Relevance: About proposed changes to Basel-III norms.

News: US regulators are proposing some changes to capital requirements under Basel-III norms.

What are the proposed changes?

Banks with assets over $100 billion must use standardized models for credit and operational risk capital instead of internal models.

For market risk, these banks must calculate risk-weighted assets using both standardized and model-based methods, opting for the higher figure.

Additionally, they would have to account for unrealized gains or losses on available-for-sale securities.

These changes are expected to boost bank capital, which is viewed as a positive development.

How is this new change different from the previous one?

Previously: Under Basel-II norms, banks could use internal risk-based (IRB) models to capture their specific risks. Banks that effectively managed risk could have lower capital requirements using IRB models than the standardized models.

However, regulators are reconsidering the use of IRB models due to issues during the Global Financial Crisis (GFC) and decided to reduce reliance on IRB models in Basel-III norms.

Current Proposal: American regulators are preferring standardized models for credit and operational risk while keeping internal models for market risk. Standardized models assess risk based on average risk experience.

This shift may also prompt the Reserve Bank of India (RBI) to reconsider its move towards using internal models for credit loss estimation.

The new US proposals are centered on the idea that more equity capital for banks is safer. However, this idea is being opposed by some of the experts.

What are the arguments against the proposal?

First, critics argue that increasing capital requirements for banks would make it more expensive for banks to lend money, which would lead to higher interest rates for borrowers.

However, this is not necessarily the case, because banks are currently able to borrow money at lower rates than they should be. Hence, the concerns for lending money at higher rates won’t arise.

Second, critics argue that increasing capital requirements for banks will lead to lower returns on equity and make bank stocks less attractive to investors.

However, this is not true, because a bank’s stock price is determined by its price/earnings ratio (P/E) and earnings per share (EPS).

Further, when equity requirements rise, EPS tends to decline, but banks with higher equity are seen as safer by investors.

Moreover, worldwide, banks hold capital well above regulatory requirements. In the US, the average capital adequacy exceeds 16% against an 11% requirement, and Indian private banks maintain a 19% capital adequacy versus 12%.

Hence, banks with higher capital also tend to enjoy higher valuations.

What can be the way ahead?

Bankers resist higher regulations due to their bonuses being linked to return on equity (ROE).

Hence, to address this concern, boards could shift the performance metric from ROE to return on risk-adjusted capital, as relying on excessive debt for higher ROE is not sustainable.