Reserve Bank of India's Countercyclical Capital Buffers Are Credit Positive for Banks

Alka Anbarasu, Vice President - Senior Analyst, Financial Institutions Group, Moody's Investors Service Singapore 

Last Thursday, the Reserve Bank of India (RBI) issued guidelines on when it will require Indian banks to maintain a countercyclical capital buffer (CCCB), an additional layer of loss-absorbing capital on top of banks' increased minimum capital requirements under Basel III. The RBI guidelines also detail how large the CCCB must be in India under different circumstances, and state that banks will be subject to restrictions on discretionary distributions such as dividend payments, share buybacks and staff bonuses if they do not meet the CCCB requirements. The guidelines are credit positive for Indian banks because they make clear that banks will be required to hold the additional capital amid periods of rapid credit growth. 

Basel III gives regulators in individual jurisdictions the discretion to implement a CCCB of up to 2.5% of risk weighted assets when they see fit, to offset pro-cyclicality by requiring banks to hold more capital at times when the regulator judges that the macro-financial environment could encourage excessive risk-taking. 

According to the RBI's guidelines, the key trigger for activating the CCCB will be when the credit/GDP ratio has risen relative to its long-term trend. The RBI said it will require banks to hold the full 2.5% buffer when the gap between the credit/GDP ratio and the long-term trend exceeds 15 percentage points. The central bank will implement a CCCB of less than 2.5% when the gap is between three and 15 percentage points, with the size of the required CCCB increasing on a graduated scale. Although the credit/GDP ratio will be the key trigger, the RBI said it will maintain its discretion when reducing the CCCB, and will also look at other indicators, including banks' ratios of loans to deposits, nonperforming assets and interest coverage. 

CCCB-activation guidelines from other countries such as Hong Kong, Switzerland and Norway focus not only on the level of credit/GDP, but also on household debt indicators such as banks' mortgage assets and property prices. In contrast, corporate loans, which account for about 80% of Indian banks' loan exposure, have negatively affected banks' asset quality owing to high corporate leverage, while the asset quality of loans to households have been relatively stable. Thus, the RBI has focused its triggers on overall domestic credit and the health of banks and corporates to sustain the increase in credit. In keeping with what the RBI has indicated, we do not expect the CCCB norms to be activated in 2015. As the exhibit below shows, although India's domestic credit/GDP ratio has consistently increased over the years, the level at the end of March 2014 of 80.2% (the most recent data available) remains within the three-percentage-point acceptable range of the five-year average of 78.2%. 

Nevertheless, these guidelines provide the RBI with a tool to compel banks to conserve capital and moderate their balance sheets during periods of fast credit growth, which would benefit the banks' credit quality.