The central bank is actively engaged in the process of crystallising the Basel III proposals

The Reserve Bank of India on Tuesday suggested to the government for an improvement in executive compensation as well as pay-packets of other employees of public sector banks (PSBs) to improve efficiency in these banks

“The executive compensation in the public sector, as is well known, is lower than that in the private sector... There is perhaps a good reason to revisit this. If public sector banks are required to compete with private banks on a level playing field, there is a good case for compensating them too on a competitive base. There is also the risk that if the public sector bank compensation is not improved, the public sector may lose talent to the private sector,” said RBI Governor D. Subbarao, while inaugurating the FICCI-IBA conference on ‘Global banking: paradigm shift' here.

The remuneration and the incentive structure of public sector bank executives are determined by the government.

Speaking on ‘Post-crisis reforms to banking regulation and supervision — Think global, act local', Dr. Subbarao said: “Reflecting the spirit of the global initiative on compensation structures, we determined that there is need for reform in India too towards aligning compensation structures to FSB (Financial Stability Board) principles.”

The RBI issued draft guidelines to encourage banks to ensure effective governance of compensation, align the compensation with prudent risk taking, improve supervisory oversight of compensation and facilitate constructive engagement by all stakeholders. The guidelines require banks' boards to formulate and adopt a comprehensive compensation policy covering all employees (risk takers and control/compliance staff). “We have advised that variable pay should be risk aligned, but we have not proposed any limit on the variable components.”

As regards foreign banks, Dr. Subbarao said, “we will require them to submit an annual declaration that their compensation structure in India is in conformity with FSB principles and standards.”

As a member of the Basel Committee on Banking Supervision (BCBS), the RBI had been actively engaged in the process of crystallising what has now come to be called Basel III. The Basel III proposals (reforms), broadly, require banks to hold more and better quality capital and to carry more liquid assets, would limit their leverage and mandate them to build up capital buffers in good times that can be drawn down in periods of stress. The Basel III process was not yet complete, he said.

The RBI Governor said Indian banks were not likely to be significantly impacted by the proposed new capital rules. As on June 30, 2010, the aggregate capital to risk weighted assets ratio of the Indian banking system stood at 13.4 per cent of which Tier I capital constituted 9.3 per cent. “Although the Basel III norms are yet to be calibrated, it is unlikely that they will be higher than the above figures. As such, we do not expect our banking system to be significantly stretched in meeting the proposed new capital rules in terms of the overall capital requirement and the quality of capital. Moreover, our banks do not have re-securitisation exposures and their trading books are small.”

However, the proposed changes relating to the counterparty credit risk framework were likely to have capital adequacy implications for some Indian banks having large OTC bilateral derivatives positions. This underscored the importance of enlarging the derivatives transactions coming within the scope of a multilateral settlement mechanism through central counterparties (CCPs), he said.

Dr. Subbarao said, “Basel III reflects the lessons of the crisis (financial), and I believe it is going to be quite game changing. However, as I indicated, not all the reform measures are going to be binding constraints for us. Nevertheless, we should not underestimate the challenge of implementing Basel III. It will demand greater capacity on the part of both banks and the regulators.”

While explaining the impact of Basel III on Indian banks, the RBI Governor noted that India's prudential regulations were ownership neutral. They would be applicable uniformly to public sector banks, private banks and foreign banks. The impact of the measures would of course vary and would depend on the business model and risk profile of the banks and their domestic and overseas balance sheets.

Capital buffers

Dr. Subbarao said in the case of public sector banks, the government, as the owner, would have to contribute to building the capital buffers so as to maintain the floor of 51 per cent in the ownership. This was unlikely to put undue pressure on the government's fiscal position as it would happen during the cyclical upturn when banks' profits and Government's revenues would be buoyant. Consequently, “public sector banks should anticipate no problem in building the buffers contemplated under Basel III.”

The major challenge for banks in India in implementing the liquidity standards was to develop the capability to collect the relevant data accurately and granularly, and to formulate and predict the liquidity stress scenarios with reasonable accuracy and consistent with their own situation. “Since our financial markets have not experienced the levels of stress that advanced country markets have, predicting the appropriate stress scenario is going to be a complex judgement call,” he said.

On the positive side, he said, “most of our banks follow a retail business model and also have a substantial amount of liquid assets which should enable them to meet the new standards.” There was an issue about the extent to which statutory holdings of SLR were counted towards the proposed (Basel III) liquidity ratios. An argument could be made that they should not be counted at all as they are supposed to be maintained on an ongoing basis. However, “it would be reasonable to treat at least a part of the SLR holdings in calculating the liquidity ratio under stressed conditions, particularly as these are government bonds against which the RBI provides liquidity,” he said.

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