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Baba’s Explainer – Dhanalaxmi Bank: Need for closer monitoring

  • IASbaba
  • October 28, 2022
  • 0
Economics, Governance
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Syllabus

  • GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development
  • GS-3: Monetary Policy 

Context: On October 20, Kerala-based Dhanlaxmi Bank informed  the stock exchanges that some shareholders have requested to hold an Extra-ordinary General Meeting (EGM) with two key items on agenda.

  • First, to curb the powers of CEO as a section of shareholders are unhappy with his performace. Once the powers to use capital is suspended, the CEO of a bank is an inconsequential role.
    • In other words, the indirect message for the bank chief is to quit the position. But, in this case, the CEO—Shivan JK, a former State Bank officer—is unlikely to quit.
    • This situation opens up room for an open confrontation between a section of influential shareholders and the top executive at the bank. That doesn’t augur well for the well-running of the bank.
  • Second, to empower one of the key shareholders to negotiate a settlement with some warring former directors.
Why is the internal issue of a private bank a matter of concern?
  • Former CEO Sunil Gurbaxani was ousted by shareholders in September 2020 in a high drama-filled event. If such a scenario happens yet again, that will once again raise serious questions about the larger governance issues at the bank.
  • Dhanlaxmi Bank has a long history of premature top level exits that include former CEOs and board members—often without citing any specific reason.
  • The chaos at the top is bound to impact confidence of depositors, shareholders and investors in the bank.
  • A bank is a guardian of public money and is different from other companies in that sense. This is why banks are regulated strictly by the Reserve Bank of India (RBI) to avoid institutional failures.
  • The RBI—being the guardian and regulator of the country’s banking institutions—must step in to bring back order in the bank and ensure organizational stability.
  • The final powers to appoint private bank CEOs (or remove them) rests with the central bank. Any such changes can happen only with the regulator’s prior approval.
  • The RBI has nominee directors on the board of the bank. But, whether these directors have shown ability to fulfil their duties as the situation demands is matter of debate looking at the past developments
How did Dhanlaxmi Bank get to this situation?
  • Dhanlaxmi Bank’s capital to risk weighted assets ratio (CRAR) dropped to around 13% at the end of March this year from 14.5% a year ago, prompting the RBI to take stock of the financial health of the bank.
  • Under Basel-III norms, which were adopted by financial regulators across the globe banks are supposed to maintain their CRAR at 9% or above.
  • The RBI’s move to increase its oversight on Dhanlaxmi Bank is seen as a response to the deterioration in the bank’s capital adequacy.
  • It should be noted that Dhanlaxmi Bank’s capital adequacy has dropped below the stipulated standards in the past and it has even been placed under the prompt corrective action framework (PCA) by the RBI to deal with serious deteriorations in its financial position.
    • Under the PCA, the RBI places restrictions on lending by troubled banks and keeps a close eye on them until their financial position improves sufficiently.
  • Also, Dhanlaxmi Bank has been accused by its minority shareholders of mismanagement like expansion of the bank to new geographies amid an unexpected rise in expenses. The management has also been accused of inadequate disclosure of information to explain the rise in costs.
What are Basel norms?
  • Basel norms or Basel accords are the international banking regulations issued by the Basel Committee on Banking Supervision.
    • The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters for the central banks of different countries.
    • BCBS was established by the Central Bank governors of the Group of Ten countries in 1974.
    • The committee expanded its membership in 2009 and then again in 2014. The BCBS now has 45 members from 28 Jurisdictions, consisting of Central Banks and authorities with responsibility of banking regulation.
  • The Basel norms is an effort to coordinate banking regulations across the globe, with the goal of strengthening the international banking system.
  • The measures suggested by Basel committee aim to strengthen the regulation, supervision and risk management of banks.
  • Basel standards are minimum requirements which apply to internationally active banks. It is a regulatory framework followed on a voluntary basis on a global scale.
How has Basel norms evolved over the years?

The Basel Committee has issued three sets of regulations which are known as Basel-I, II, and III.

Basel-I

  • It was introduced in 1988.
  • It focused almost entirely on credit risk.
  • Credit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest.
  • It defined capital and structure of risk weights for banks.
  • The minimum capital requirement was fixed at 8% of risk weighted assets (RWA).
  • RWA means assets with different risk profiles.
  • For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral.
  • India adopted Basel-I guidelines in 1999.

Basel-II

  • In 2004, Basel II guidelines were published by BCBS.
  • These were the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which the committee calls it as pillars.
  • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets
  • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
  • Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank.

Basel-III

  • Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09.
  • A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
  • It was also felt that the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk
  • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters capital, leverage, funding and liquidity.
  • Capital: The capital adequacy ratio is to be maintained at 12.9%. The minimum Tier 1 capital ratio and the minimum Tier 2 capital ratio have to be maintained at 10.5% and 2% of risk-weighted assets respectively.
    • In addition, banks have to maintain a capital conservation buffer of 2.5%. Counter-cyclical buffer is also to be maintained at 0-2.5%.
    • Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to accurately calculate and more difficult to liquidate.
  • Leverage: The leverage rate is the ratio of a bank’s tier-1 capital to average total consolidated assets. The leverage rate has to be at least 3 %.
  • Funding and Liquidity: Basel-III created two liquidity ratios: LCR and NSFR.
    • The liquidity coverage ratio (LCR) will require banks to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. This is to prevent situations like Bank Run”. The goal is to ensure that banks have enough liquidity for a 30-days stress scenario if it were to happen.
    • The Net Stable Funds Rate (NSFR) requires banks to maintain a stable funding profile in relation to their off-balance-sheet assets and activities. NSFR requires banks to fund their activities with stable sources of finance (reliable over the one-year horizon).
    • The minimum NSFR requirement is 100%. Therefore, LCR measures short-term (30 days) resilience, and NSFR measures medium-term (1 year) resilience.
  • The deadline for the implementation of Basel-III was March 2019 in India.
    • It was postponed to March 2020. In light of the coronavirus pandemic, the RBI decided to defer the implementation of Basel norms by further 6 months.
    • Extending more time under Basel III means lower capital burden on the banks in terms of provisioning requirements, including the NPAs.
Why is capital adequacy important for a bank?
  • Banks lend to different types of borrowers and each carries its own risk. This exposes the bank to a variety of risks of default and as a result they fall at times. Therefore, Banks have to keep aside a certain percentage of capital as security against the risk of non-recovery.
  • Capital Adequacy Ratio or capital to risk weighted assets ratio (CRAR) is the ratio of a bank’s capital to its risk-weighted assets and current liabilities.
  • The CRAR, which is a ratio that compares the value of a bank’s capital (or net worth) against the value of its various assets weighted according to how risky each asset is, is used to gauge the risk of insolvency faced by a bank. (insolvency is inability to pay back creditors, in this case the depositors of bank)
    • The riskier a type of asset held in a bank’s balance sheet, the higher the weightage given to the value of the asset while calculating the bank’s capital adequacy ratio. This causes the capital adequacy ratio of the bank to drop, thus signalling a higher risk of insolvency during crises.
  • The capital position of a bank should not be confused with cash held by a bank in its vaults to make good on its commitment to depositors.
  • In other words, the CRAR tries to gauge the risk posed to the bank by the quality or riskiness of the assets on the bank’s balance sheet.
  • It is an indicator of the ability of a bank to survive as a going business entity in case it suffers significant losses on its loan book.
  • A bank cannot continue to operate if the total value of its assets drops below the total value of its liabilities as it would wipe out its capital (or net worth) and render the bank insolvent.
  • So, banking regulations such as the Basel-III norms try to closely monitor changes in the capital adequacy of banks in order to prevent major bank failures which could have a severe impact on the wider economy.
  • This ratio is utilized to secure depositors and boost the efficiency and stability of financial systems all over the world.
What happens next with Dhanalaxmi Bank?
  • Dhanlaxmi Bank has been trying to issue additional shares in the open market through a rights issue in order to deal with its capital adequacy woes.
  • Through a rights issue, the bank will be able to raise more equity capital from existing shareholders.
  • This is in contrast to an initial public offering where shares are issued to new shareholders.
  • The additional capital could help in raising the bank’s capital adequacy ratio which is necessary to comply with regulations and serve as a buffer that absorbs any losses incurred by the bank on its loan book in the case of any crisis in the future.
  • The rights issue, however, has been delayed by the ongoing court battle with minority shareholders regarding the composition and strength of the management board. This delay could compromise the bank’s ability to meet the RBI’s stipulated norms on capital adequacy anytime soon.
  • The RBI is likely to keep a close eye on Dhanlaxmi Bank over the next few months and may even decide to intervene in case the delay of the rights issue threatens the bank’s ability to comfortably meet the capital adequacy norms.
  • In fact, Dhanlaxmi Bank could even become an acquisition target in case its management is unable to raise the required capital. In such a case, an investor with the capital required to immediately boost the bank’s capital adequacy may well find favour with the RBI.

Main Practice Question: What are Basel Norms and why is it important for the banking system?  

Note: Write answer his question in the comment section.


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