GS Notes

6. Economics Notes 39

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Elaborate Notes

BASEL-III NORMS

The Basel Accords are a set of international banking regulations issued by the Basel Committee on Banking Supervision (BCBS). They set out the minimum capital requirements for banks.

  • Historical Context and Genesis: The need for Basel-III norms arose directly from the deficiencies in financial regulation exposed by the global financial crisis of 2008. The crisis, triggered by the collapse of Lehman Brothers, revealed that many banks, despite being technically compliant with the existing Basel-II framework, were over-leveraged and held insufficient liquidity buffers. The BCBS, an international committee of banking supervisory authorities established by the G10 central bank governors in 1974, concluded that the existing framework was inadequate to handle a systemic crisis. As noted by scholars like Ben Bernanke (former Chairman of the US Federal Reserve), the crisis was a “classic financial panic” but of a global scale, where a lack of high-quality capital and liquidity exacerbated systemic risk. Consequently, in 2010, the BCBS published the first version of the Basel-III guidelines.

  • Objective - A More Resilient Banking System: The primary goal of Basel-III is to enhance the banking sector’s ability to absorb shocks arising from financial and economic stress, thereby reducing the risk of spillover from the financial sector to the real economy. It aims to achieve this by strengthening bank-level (microprudential) regulation and addressing system-wide risks (macroprudential). The guidelines focus on four key parameters: capital, leverage, funding, and liquidity.

  • Pillar 1: Capital Quality and Quantity:

    • Better Capital Quality: Basel-III places a strong emphasis on the quality of capital, specifically on Common Equity Tier 1 (CET1), which is the highest quality of regulatory capital as it can absorb losses immediately as they occur. This includes common shares and retained earnings. The minimum CET1 ratio was increased to 4.5% of risk-weighted assets (RWAs).
    • Capital Conservation Buffer (CCoB): This is a mandatory buffer of 2.5% of RWAs, to be built up with CET1 capital outside periods of stress. Its purpose is to ensure that banks maintain a cushion of capital that can be drawn down to absorb losses during stressed periods. If a bank’s CCoB falls, it faces restrictions on discretionary payments like dividends and staff bonuses, thus conserving capital. This measure forces banks to build resilience during good economic times.
    • Counter-Cyclical Capital Buffer (CCyB): This is a macroprudential tool. The CCyB is a variable buffer ranging from 0% to 2.5% of RWAs, implemented by national regulators. It is designed to be increased when credit growth is judged to be excessive (an economic “overheating” phase), which slows down lending and prevents the build-up of systemic risk. Conversely, during a downturn or crisis, the buffer can be released to encourage banks to continue lending, thereby preventing a credit crunch. This concept aligns with the economic theories of Hyman Minsky, who argued about the inherent instability of credit cycles.

  • Pillar 2: Leverage Ratio:

    • The crisis revealed that banks could build up excessive leverage while appearing to have strong risk-based capital ratios. The leverage ratio was introduced as a non-risk-based backstop measure. It is defined as the ratio of Tier 1 capital to the bank’s total consolidated assets (including off-balance sheet exposures). Basel-III introduced a minimum leverage ratio requirement (initially set at 3%) to constrain the build-up of leverage in the banking sector and reinforce the risk-based requirements with a simple, transparent measure.

  • Pillar 3: Funding and Liquidity:

    • A key lesson from the 2008 crisis was that capital adequacy alone is not sufficient; liquidity is equally critical. Many banks faced a liquidity crisis even when they were solvent. Basel-III introduced two new liquidity ratios:
    • Liquidity Coverage Ratio (LCR): This ratio addresses short-term liquidity risk. It requires banks to hold a stock of High-Quality Liquid Assets (HQLA) – such as central bank reserves and high-rated government bonds – sufficient to cover their total net cash outflows over a 30-day stress scenario. The formula is Stock of HQLA / Total net cash outflows over the next 30 calendar days ≥ 100%. This ensures that banks have enough cash-like assets to survive an acute, short-term liquidity disruption.
    • Net Stable Funding Ratio (NSFR): This ratio addresses long-term structural liquidity mismatches. It requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. It mandates a minimum amount of stable funding (like customer deposits and long-term wholesale funding) over a one-year horizon. The formula is Available amount of stable funding / Required amount of stable funding ≥ 100%. While LCR ensures resilience over 30 days, NSFR promotes resilience over a longer period, discouraging excessive reliance on short-term wholesale funding to finance long-term assets.

Insolvency and Bankruptcy Code (IBC)

  • Pre-IBC Framework and Need for Reform: Before the enactment of the Insolvency and Bankruptcy Code (IBC) in 2016, India’s insolvency resolution framework was fragmented, inefficient, and time-consuming. It was governed by multiple laws, including the Sick Industrial Companies Act (SICA), 1985, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, and the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act, 1993. This led to overlapping jurisdictions, inordinate delays, and very low recovery rates for creditors. The Bankruptcy Law Reforms Committee (BLRC), chaired by T.K. Viswanathan, was set up in 2014 to address these issues. Its 2015 report provided the foundational architecture for the IBC, recommending a consolidated, time-bound legal framework.
  • A Unified, One-Stop Solution: The IBC, 2016 is a comprehensive law that consolidates and amends the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms, and individuals in a time-bound manner. Its primary objectives are to maximise the value of assets, promote entrepreneurship, ensure the availability of credit, and balance the interests of all stakeholders, including small investors.
  • Insolvency vs. Bankruptcy: The Code clearly distinguishes between the two terms. Insolvency is a financial state where an individual or organisation is unable to meet their debt obligations as they become due. Bankruptcy is the legal outcome of insolvency; it is a court order that formally declares a person or entity bankrupt, thereby initiating a legal process for resolving the debts.
  • Institutional Framework: The IBC establishes a robust institutional infrastructure to manage the resolution process efficiently:
    • Adjudicating Authority (AA): The National Company Law Tribunal (NCLT) is the AA for corporate insolvency (companies and LLPs), while the Debt Recovery Tribunal (DRT) is the AA for individuals and partnership firms. The AA is responsible for initiating the process, appointing professionals, and approving the final resolution plan.
    • Insolvency Professionals (IPs): These are licensed professionals who manage the entire insolvency process. Upon initiation, an IP takes control of the debtor’s assets and management, collates claims, forms the Committee of Creditors (CoC), and helps them in decision-making.
    • Insolvency Professional Agencies (IPAs): These agencies (e.g., the Indian Institute of Insolvency Professionals of ICAI) are responsible for admitting IPs as members and developing a code of conduct and professional standards for them.
    • Information Utilities (IUs): These are centralised repositories of financial information that store data about debts and defaults. This helps to establish the facts of a case unambiguously and efficiently, reducing information asymmetry and delays. National E-Governance Services Ltd. (NeSL) is India’s first IU.
    • Insolvency and Bankruptcy Board of India (IBBI): This is the apex regulatory body that oversees the functioning of IPs, IPAs, and IUs. It is responsible for framing and enforcing rules and regulations for the insolvency resolution process.
  • Time-Bound Resolution Process: A key feature of the IBC is its strict timelines. The Corporate Insolvency Resolution Process (CIRP) must be completed within 180 days, which can be extended by a one-time extension of 90 days. Including litigation time, the overall outer limit has been set to 330 days by a 2019 amendment. For startups and small companies, the process is faster, with a limit of 90 days, extendable by 45 days. This time-bound nature creates pressure on debtors to negotiate and prevents them from using legal loopholes to delay proceedings, a common issue in the pre-IBC era.

BENEFITS AND CHALLENGES OF IBC

  • Benefits of IBC:

    • Addressing NPA Problem: The IBC has been a critical tool for banks in resolving their Non-Performing Assets (NPAs). By providing a clear and time-bound mechanism for recovery or resolution, it has changed the credit culture from a ‘debtor in possession’ to a ‘creditor in control’ model.
    • Faster Resolution: Compared to the previous regime where resolution could take years, the IBC offers a significantly faster mechanism. As of recent data from the IBBI, a significant amount of debt has been resolved through the code. The figure cited, Rs 2.5 lakh crore brought back, reflects the direct impact on bank balance sheets.
    • Preventing Job Losses: By prioritising resolution over liquidation, the IBC aims to keep viable businesses operational. A successful resolution plan often involves a new management taking over and continuing the business, thereby saving jobs that would have been lost in liquidation.
    • Ensuring Credit Discipline: The fear of losing control of their company under the IBC has instilled greater financial discipline among corporate promoters. They are now more proactive in repaying debts to avoid being dragged into insolvency proceedings. This has improved the overall credit culture in the economy.

  • Challenges of IBC:

    • Delays in Resolution: Despite the statutory timelines, judicial delays and overburdened NCLT benches have led to significant backlogs. The IBBI data often shows that the average time taken for resolution exceeds the 330-day limit, especially for large cases. For instance, the resolution of Essar Steel took over 800 days.
    • Large “Haircuts”: A ‘haircut’ refers to the portion of the debt that creditors (lenders) have to forgo as part of the resolution plan. While some haircut is inevitable in insolvency, there have been cases with extremely high haircuts (over 90%), raising concerns among lenders about the effectiveness of the recovery process. This has led to debates on whether the objective of value maximisation is being met.
    • Low Approval and High Liquidation Rate: A significant percentage of cases admitted under IBC have ended in liquidation rather than resolution. According to IBBI reports, the number of companies sent for liquidation is considerably higher than those successfully resolved. This indicates that many companies enter the CIRP too late, when their assets have already eroded, making revival unviable. The low approval rate of 15% (as cited for 2016-2020) highlights this challenge.
    • Lack of Digitalization: The insolvency ecosystem is yet to be fully digitized. Manual processes for filing claims, sharing information, and conducting meetings can contribute to delays and inefficiencies, undermining the goal of a swift resolution.

MONEY

  • The Barter System and its Problems:

    • Historical Context: Before the invention of money, economies operated on a system of barter, which involves the direct exchange of goods and services for other goods and services. Archaeological evidence from ancient societies across Mesopotamia, Egypt, and the Indus Valley suggests the prevalence of non-monetary exchange systems. However, as economies grew more complex, the limitations of barter became apparent.
    • Double Coincidence of Wants: This is the most significant hurdle of the barter system. A successful transaction requires that two individuals each have a good the other wants. As the economist William Stanley Jevons noted in his work Money and the Mechanism of Exchange (1875), this mutual desire is a rare coincidence and makes trade highly inefficient.
    • Absence of a Common Measure of Value (Unit of Account): In a barter economy, there is no standard unit to measure the value of goods. Exchange ratios must be established for every pair of goods (e.g., how many kilograms of wheat for one meter of cloth, how many apples for one pot). This makes accounting and price comparison extremely complex.
    • Difficulty in Storing Value: Many commodities, especially agricultural produce, are perishable and cannot be stored for long periods. Therefore, using them to store wealth is impractical. One cannot save ‘purchasing power’ for the future effectively.
    • Indivisibility of Certain Goods: It is difficult to exchange goods that cannot be easily divided. For example, if a horse is worth ten sacks of wheat, a person who only needs five sacks of wheat cannot simply offer half a horse in exchange.
    • Problem of Deferred Payments: It is difficult to make contracts involving future payments (deferred payments) in a barter system due to disagreements over the quality and value of the goods to be repaid in the future.

  • Money and its Functions:

    • Money evolved to overcome the inefficiencies of barter. Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context.
    • Medium of Exchange: This is the primary function of money. It acts as an intermediary in transactions, eliminating the need for a double coincidence of wants and facilitating trade.
    • Common Measure of Value (Unit of Account): Money provides a common denominator to measure the value of all goods and services. Prices are expressed in monetary units, which simplifies economic calculations and allows for meaningful comparison of value.
    • Standard for Deferred Payment: Money serves as a standard for future payments. Debts and future obligations can be created and settled in monetary terms, which facilitates lending, borrowing, and the creation of credit markets.
    • Store of Value: Money allows individuals to transfer purchasing power from the present to the future. Unlike perishable commodities, modern money is durable and can be held over time to be used for future consumption.

  • Types of Money:

    • Full-bodied Money: This is money where the intrinsic value of the commodity from which it is made is equal to its face value (its value as money). For example, a gold or silver coin whose metal content is worth its face value. Historically, most coinage systems were based on full-bodied money.
    • Token Money (or Fiat Money): This is money whose face value is significantly higher than its commodity value (intrinsic value). Modern coins and paper currency are examples of token money. A ₹100 note costs very little to produce, but its value as money is ₹100 because it is declared as legal tender by the government.
    • Paper Money:
      • Representative Full-bodied Money (Convertible Paper Money): This form of paper money is fully backed by a metallic reserve, typically gold or silver. The issuing authority guarantees to convert this paper money into a pre-specified amount of the precious metal on demand. The Gold Standard of the 19th and early 20th centuries operated on this principle.
      • Inconvertible Paper Money (Fiat Money): This is paper money that is not convertible into any commodity like gold or silver by the issuing authority. Its value derives from the “fiat” or order of the government, which declares it as legal tender. The public accepts it as a medium of exchange based on their trust in the stability and authority of the issuing central bank and government. All modern currencies, including the Indian Rupee, are inconvertible or fiat money. The Reserve Bank of India (RBI) is not obligated to convert rupee notes into an equivalent amount of gold or silver.

Prelims Pointers

  • Basel Committee on Banking Supervision (BCBS): An international committee of banking supervisory authorities, headquartered at the Bank for International Settlements (BIS) in Basel, Switzerland.
  • Basel-III Norms: International regulatory framework for banks, developed in response to the 2008 financial crisis.
  • Key Parameters of Basel-III: Capital, Leverage, Funding, and Liquidity.
  • Capital Conservation Buffer (CCoB): A mandatory capital buffer of 2.5% of risk-weighted assets (RWAs).
  • Counter-Cyclical Capital Buffer (CCyB): A variable capital buffer ranging from 0% to 2.5% of RWAs, set by national regulators.
  • Leverage Ratio: A non-risk-based measure defined as Tier 1 Capital divided by total consolidated assets. Basel-III proposes a minimum of 3%.
  • Liquidity Coverage Ratio (LCR): Requires banks to hold High-Quality Liquid Assets (HQLA) to cover net cash outflows over a 30-day stress period.
  • Net Stable Funding Ratio (NSFR): Requires banks to maintain stable funding for their assets over a one-year horizon.
  • Insolvency and Bankruptcy Code (IBC), 2016: A unified law for insolvency resolution in India.
  • Adjudicating Authority for Corporates: National Company Law Tribunal (NCLT).
  • Adjudicating Authority for Individuals/Partnerships: Debt Recovery Tribunal (DRT).
  • Regulator for IBC: Insolvency and Bankruptcy Board of India (IBBI).
  • CIRP Timeline: 180 days, extendable by 90 days. The maximum timeline, including litigation, is 330 days.
  • CIRP Timeline for Startups: 90 days, extendable by 45 days.
  • Information Utility (IU): A centralized repository of financial data to verify debts and defaults.
  • Barter System: A system of exchange where goods are directly traded for other goods.
  • Double Coincidence of Wants: A key problem of the barter system where two parties must each have a good that the other wants.
  • Functions of Money:
    1. Medium of Exchange
    2. Measure of Value (Unit of Account)
    3. Store of Value
    4. Standard of Deferred Payment
  • Full-bodied Money: Money whose face value is equal to its intrinsic (commodity) value.
  • Token Money: Money whose face value is greater than its intrinsic value.
  • Fiat Money: Inconvertible paper money made legal tender by a government decree. The Indian Rupee is a fiat currency.

Mains Insights

BASEL-III NORMS

  • Cause and Effect: The 2008 Global Financial Crisis was the primary cause for the formulation of Basel-III. The effect was a paradigm shift in banking regulation from focusing merely on capital adequacy (Basel II) to a more holistic approach encompassing liquidity, leverage, and macroprudential stability. This reflects a deeper understanding that financial stability depends on multiple reinforcing factors, not just capital ratios.
  • Debate: Growth vs. Stability: A major debate surrounding Basel-III implementation, especially in developing economies like India, is the trade-off between financial stability and economic growth.
    • Arguments for Stability: Proponents argue that the higher capital and liquidity requirements make banks more resilient, preventing costly bailouts and systemic crises which severely hamper long-term growth.
    • Arguments against (on Growth): Critics argue that forcing banks to hold more capital and liquid assets reduces their lending capacity, increases the cost of credit, and can stifle economic growth, particularly for credit-starved sectors like MSMEs. Indian banks have argued that the stringent norms could impact their profitability and ability to fund infrastructure projects.
  • Implementation Challenges in India: India has been largely compliant with Basel-III norms. However, the implementation has posed challenges, particularly for Public Sector Banks (PSBs) which have historically struggled with high NPAs and low profitability, making it difficult for them to raise the required capital from the market. This has necessitated repeated capital infusions by the government.

Insolvency and Bankruptcy Code (IBC)

  • Shift in Credit Culture: The IBC marks a significant behavioural shift in the debtor-creditor relationship in India. Previously, the system was heavily tilted in favour of the debtor (promoter), who could delay legal proceedings for years. The IBC’s time-bound process and the threat of losing control have empowered creditors and instilled credit discipline among borrowers. This is a crucial reform for improving the ‘Ease of Doing Business’ ranking.
  • Resolution vs. Liquidation - A Critical Analysis: While the primary objective of IBC is resolution (reviving the company), a large number of cases have ended in liquidation.
    • Causes: This can be attributed to the late admission of cases (when the company is beyond saving), lack of viable resolution plans, and procedural delays that lead to value erosion.
    • Consequences: High liquidation rates mean loss of employment, destruction of organisational capital, and often lower recovery for creditors compared to a successful resolution. This challenges the core philosophy of the Code.
  • Historiographical Viewpoint: The IBC can be viewed as the culmination of decades of staggered and often ineffective legal reforms in the insolvency space. It represents a move away from a piecemeal approach (SICA, SARFAESI) towards a consolidated, modern, and market-driven framework. Its success or failure will be a key determinant of India’s long-term corporate health and credit market depth.
  • Way Forward: Challenges like judicial delays, low recovery rates (high haircuts), and the need for more IPs can be addressed through:
    1. Increasing the number of NCLT benches and leveraging technology for faster processing.
    2. Introducing a pre-packaged insolvency resolution process (already done for MSMEs) to speed up resolutions.
    3. Developing a more mature market for distressed assets to ensure better price discovery and viable resolution plans.

MONEY

  • Evolutionary Perspective: The evolution from barter to commodity money, then to metallic money, paper money, and now to digital/electronic money reflects the increasing complexity of human economies. Each stage was an innovation that reduced transaction costs and facilitated greater economic activity.
  • Sovereignty and Fiat Currency: The shift from commodity-backed money (like the Gold Standard) to fiat money represents a significant increase in the economic sovereignty of a nation-state. It gives the central bank control over the money supply (monetary policy), allowing it to manage inflation, employment, and economic growth. However, this power comes with the responsibility to maintain the public’s trust in the currency’s value. Mismanagement can lead to hyperinflation, as seen in countries like Zimbabwe or Venezuela.
  • Contemporary Challenges: Cryptocurrencies: The rise of cryptocurrencies like Bitcoin presents a fundamental challenge to the traditional concept of money and the monopoly of the state over its issuance.
    • Debate: Proponents see it as a decentralized, trustless medium of exchange free from government manipulation. Critics point to its extreme volatility, lack of intrinsic value, use in illicit activities, and inability to function effectively as a unit of account or store of value, making it more of a speculative asset than money.
    • Policy Implications: This has forced central banks globally, including the RBI, to explore Central Bank Digital Currencies (CBDCs), which would combine the technological benefits of digital currency with the stability and backing of a central authority. This is a key area of policy debate relevant to GS-III.

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