Demystifying Basel III – Part 1

Part 1 – Why Basel III?

‘Basel’ is a word which makes many bankers alert even in any casual conversation! Why Basel III? What improvements Basel III has brought in over Basel II? These are the questions which are asked pretty frequently whenever a banker (or a central banker, for that matter) meets a person who is interested in banking regulation. So let us keep ourselves well prepared to respond to such eager questions and  have a look as to what really has improved in Basel III!

Before we look into what improvements Basel III has brought over Basel II in banking regulation, let us first see what improvements did Basel II brought over Basel I. What can be termed as paradigm shift in Basel II over Basel I was that Basel II introduced ‘risk sensitive’ capital regulation while Basel I had ‘one-size-fits-all’ approach. But aftermath of collapse of Lehman Brothers (it is now over four years since this happened), Basel II regulations required a re-look, mainly for the following reasons:

  1. The main charge against Basel II was that the ‘risk sensitive’ capital requirements made it pretty pro-cyclical. Let me explain: In good times, when banks are doing well, and the market is willing to invest capital in them, Basel II does not impose any additional capital requirements on banks (i.e., when the market is willing to invest in banks, banks may not need the capital!). On the other hand, in stressed times, when banks require additional capital and markets are reluctant to supply that capital, Basel II requires banks to bring in more capital!
  2. This was one of the reasons for the increased stress during the time of crisis – As we saw during the crisis, it was the failure to bring in capital when under pressure that forced major international banks into a vicious cycle of deleveraging, thereby hurting global financial markets.
  3. Another charge against Basel II was that even as it made capital regulation more risk sensitive, it did not bring in corresponding changes in the definition and composition of regulatory capital to reflect the changing market dynamics. Let me explain a bit further – Under Basel II, the market risk models failed to factor-in the risk from complex derivative products that were coming on to the market in a big way! These models demanded less capital against trading book exposures on the assumption that trading book exposures could be easily sold and exposures unwound! This gave an incentive to banks to park many exposures in their trading book rather than in banking book to optimize capital! As we know now, much of these assets (now termed as toxic assets) and their securitized derivatives were the epicenter of the crisis.
  4. The next charge against Basel II concerns leverage. Note that Basel II did not have any explicit regulation covering leverage! It assumed that its risk based capital requirement would automatically mitigate the risk of excessive leverage! This assumption, as it turned out, was flawed as excessive leverage of banks was one of the prime causes of the crisis.
  5. Besides, Basel II did not adequately cover liquidity risk. Since liquidity risk, if left unaddressed, could cascade into a solvency risk, liquidity proved to be the undoing of virtually every bank that came under stress in the depth of the crisis.
  6. Further, Basel II exclusively focused on individual financial institutions, ignoring the systemic risk arising from the inter-connectedness across the institutions which aggravated the crisis.   

The enhancements in Basel III over those of Basel II are given in the Part 2.

(This blog is based on various publications of BIS)

The CRR Story!

A subject as dull as “CRR” shot into prominence on 28th August 2012, thanks to two representatives of stalwart institutions of India (Note that I am refraining from using the word ‘stalwart’ to the individuals concerned – as these individual’s claim to fame is due the institutions they represent).

As per media reports, Mr Pratip Chaudhuri, Chairman, State Bank of India (SBI) wants the Reserve Bank of India to abolish CRR as these funds will then be available for lending and will help country’s economic growth. Mr Chaudhuri apparently said why should banks be subjected to CRR and why not insurers and mutual funds subjected to CRR, who also deal with public money?

While responding to a question on this issue by a student of Great Lakes Institute of Management near Kancheepuram, during its third annual financial conference “Systemic Risk”  Mr K.C. Chakrabarty, Deputy Governor, Reserve Bank of India (RBI)  reported to have said the SBI boss will have to work within the existing regulatory framework and if he cannot do so, he has to find some other place!

This news item really made the day for many keyboard happy bankers (both in-service and retired) to contribute their views on various forums and groups. Overnight, CRR became an interesting topic. I am sure Google statistics will show record number of hits for this word since 28th of August 2012!

In this context, let us have a look at the following questions:

  1. What is CRR
  2. Why CRR
  3. Is CRR an effective monetary tool?
  4. Why CRR is not applicable to Insurance Companies and Mutual Funds?

 

1. What is CRR?

CRR is Cash Reserve Ratio. We all know that banks accept deposits for the purposes of lending or investment. CRR refers to keeping a portion such bank deposits (technically known as net demand and time liabilities – NDTL) with the central banks or in their vaults!. CRR is a central bank regulatory requirement.

The following are the demand liabilities of banks (Banks should pay these liabilities on demand which may come at any time): Current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, overdue cash certificates and overdue cumulative/recurring deposits,  Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand (Point to be noted here is that on most of these deposits, banks do not pay any interest to depositors)

Time Liabilities are those which are payable otherwise than on demand; they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, deposits held as securities for advances which are not payable on demand and Gold Deposits.

2. Why CRR?

The CRR is used as a tool in monetary policy, influencing the country’s borrowing and interest rates by changing the amount of funds available for banks to lend.

Central bank fixes this percentage of NDTL which is required to be deposited. Central bank can change this percentage as a monetary measure to control the availability of funds in the economy i.e. to inject liquidity or to suck liquidity.

When a central bank increases CRR, the banks need to deposit higher amount of funds which will reduce the availability of funds for lending. This will ultimately result in reduction of liquidity in the economy. The reverse happens when a central bank reduces CRR.

3. Is CRR an effective monetary tool?

CRR is a traditional tool which central banks have at their disposal and this tool, perhaps, originated along with the origin of the concept of central banks.

The main objective of CRR is to control liquidity in the market. However, central banks do have other tools which can also do the job of controlling liquidity pretty efficiently. One such tool, which is being widely used by central banks is open market operations i.e., buying or selling government issued bonds which carry nil or low risk weightages. Credit ceilings, margin requirements and collateral requirements are some other tools which can also be used by central banks for any specific or surgical remedies, including liquidity management.

One demerit of CRR is that it does not distinguish between banks having higher liquidity and those having lower liquidity. Generally, uniform ratio is applied to all the banks. But open market operations will facilitate banks to decide as to how much of their liquidity can be surrendered or augmented and thereby offers much more freedom.

Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves. They generally prefer to use open market operations to implement their monetary policy. The People’s Bank of China uses changes in reserve requirements as an inflation-fighting tool, and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits and zero on time deposits and all other deposits.

4. Why CRR is not applicable to Insurance Companies and Mutual Funds?

The business model of Insurance Companies and Mutual Funds differ significantly from that of commercial banks.

Insurance companies and mutual funds do not accept demand deposits (i.e., deposits payable on demand – through ATMs, by cheque etc.) and neither do they lend funds like banks do.

As they cannot lend like banks, their capability to create money or impact money supply in the economy is severely limited.

One can argue that there are mutual funds which have characteristics of demand deposits. But it is to be noted that such mutual funds will not be in the business of lending funds, like banks do. Their deployment of funds is largely confined to investments in bonds, equities and wholesale debt.

CRR is not made applicable to insurance companies and mutual funds mainly because their capability to create money is severely impaired by the nature of their business.

Conclusion:

While CRR has its utility as a monetary tool, any suggestions to phase-out CRR requires considered thought and well researched approach, rather than any publicity seeking statements. There are proper forums to raise these issues and it is prudent to raise them and discuss them in such forums rather than giving media statements.

On the other hand, one cannot lay the blame on the CRR for lack of liquidity available for lending as we find that commercial banks in India have placed more than the required amount of funds in SLR securities.

If the issue is that CRR balances do not earn interest, then perhaps, the issue raised should be on payment of interest on CRR rather than demanding abolition CRR!