By Priyanka Venkat
The Reserve Bank of India (RBI) on 4th September 2017 announced the addition of HDFC bank to the list of Domestic Systemically Important Banks (D-SIBs) in the country. This addition comes two years after State Bank of India (SBI) and ICICI bank were declared as D-SIBS.
What are D-SIBs and how are they classified?
D-SIBs are those banks that fall in a category similar to that of the too big to fail list of banks, a term coined after the 2008 financial crisis. The downfall of such banks would have disastrous effects on the economy, mainly due to their size and their interconnectivity with other financial institutions. Post the 2008 crisis, the Basel Committee on Banking Supervision issued guidelines for member countries to form a framework that regulates D-SIBs. The RBI is required to announce the banks deemed as D-SIBs every year in August.
The selection criterion involves two steps. Firstly, a sample is created to evaluate the systemic importance of banks. This sample would mostly exclude smaller banks that are less likely to have a massive impact on the economy in case of failure. The banks that are included in the sample are the ones whose size as a percentage of GDP exceeds 2%. The sample isnt restricted to only domestic banks and includes large foreign banks too. This is owing to the fact that while the balance sheet of foreign banks operating in India is smaller in size, they are generally active in the derivatives market and provide services that are hard to replace.
Sampling followed by evaluation
In addition to size, factors such as complexity, interconnectivity and lack of easily available substitutes also play a role in choosing banks for the sample. However, the RBI gives size the highest priority, as it believes that the failure of a bank that has a large share of financial activities is more likely to drastically affect the real economy, thereby resulting in a domino effect. Once the sample is created, the next step is to evaluate the systemic importance of banks. A composite score is assigned to each of the banks, and those with scores crossing a specified threshold are called D-SIBs. The banks are then classified into different buckets based on their scores.
Bucketing of banks
There are currently four buckets. Banks in the fourth bucket have to maintain an additional 0.8% of risk weighted assets as Common Equity Tier 1 (CET1). Banks in bucket three need to maintain an additional 0.45% of additional tier I capital, which will increase to 0.6% from April 2019. Bucket two entails a requirement of 0.4% and banks in bucket one (HDFC and ICICI) need to maintain an additional 0.15% of the same from 2018, increasing to 0.2% from 2019. ICICI and HDFC bank are placed in the first bucket, while SBI is placed in the third bucket. A higher bucket number indicates that bank is more lucrative or systemically important. Based on the bucket number, banks will be exposed to a higher or lower capital surcharge. Therefore, a higher capital surcharge will be imposed on SBI as opposed to ICICI or HDFC bank.
Implications for HDFC and the banking sector
HDFC has shown a rapid growth of 33% in terms of balance sheet size in a period of one year (30th June 2016 to 30th June 2017), surpassing that of ICICI bank. D-SIBs in general, face more regulation than their peers in the banking system and are required to meet the standards set by the RBI. This includes maintaining reserves, being conservative while providing loans to reduce the risk of bad loans, and tightening their approach towards assessing risk. Being designated as a D-SIB is more likely to be welcomed by HDFC and work in its favour. It is likely that theyll see an increase in investor interest and funding, considering the perception of security that this designation creates. Moreover, the regulations are less likely to affect customers or hinder the banks growth as HDFC has an adequate capital base to fulfill the capital requirements.
Dangers, however, exist if the RBI decides to pursue a more stringent regulatory policy in the future that extends to other crucial areas. Establishing a cap on the number of branches a bank can have, inhibiting its risk appetite or imposing heavier capital requirements are just some of the ways in which banks can be hindered in the bid to evade a financial crisis. While imposing regulations on such banks could possibly prevent the need for a bailout, worse outcomes are also realized if such banks declare bankruptcy or are unable to add to economic development and growth.
The aspiration to be big is likely to dwindle when the costs of being a successful start to weigh down on growth. While saving the taxpayers money is a priority, it is imperative that it does not blind us to take steps that forego the most crucial of all objectiveseconomic progress.
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