The Corporate & Commercial Law Society Blog, HNLU

Tag: economy

  • India’s Basel III Paradox: Failure of Mechanics Not Morals

    India’s Basel III Paradox: Failure of Mechanics Not Morals

    BY SMARAK SAMAL, LL.M STUDENT AT NLSIU, BANGALORE

    INTRODUCTION

    It is significant to write down a paradox that openly and dauntingly exists in the Indian banking system, and it should not be reduced to a conflict between strict regulations and lax implementation. There have been multiple occurrences in the Indian system, where white-collar actors have been able to get around the procedural flaws in banking regulations without having to go for deceptive techniques because these safety nets work well as a tool. Yes Bank, Infrastructure Leasing & Financial Services (‘IL&FS’), and Punjab National Bank’s (‘PNB’) crises are indications that they were not just typical governance failures but rather savage attacks on particular systemic underpinnings. The article’s main focus is the willful breach of Basel III regulations, which clarifies topics outside the typical crisis history and improves comprehension of system convergence. To give certain clarity, Basel III relies on 3 core Pillars. Pillar 1 ensures that banks have sufficient capital to absorb market, credit and management risks and hence sets up minimum capital requirements. Whereas supervisory guidance compelling regulators to measure bank’s internal risk control mechanisms and inducing concrete steps when defaults are recognized are acknowledged in Pillar 2. Lastly, Pillar 3 integrates market discipline by warranting public disclosures, permitting market participants and investors to judge a bank’s risk portfolio.

    PNB: THE CIRCUMVENTION OF PILLAR 1 OPERATIONAL RISK CAPITAL

    To start with the PNB scam, which was made possible by Letters of Undertaking (‘LoUs’), was both dramatic and a prime example of the inherent flaws in the Basel III methodology. The Basic Indicator Approach (‘BIA’) is being used by Indian banks to model operational risk in capitalisation. According to the BIA, banks must have capital that is equivalent to 15% of their average gross earnings over the previous three years.The true deception of the scheme lay in avoiding this exact calculation.

    Basically, the fabricated LoUs were exchanged through the Society for Worldwide Interbank Financial Telecommunication (‘SWIFT’) mechanism but never really entered into PNB’s Core Banking Solutions (‘CBS’). Since the official books of the bank were never made aware of these transactions, they never fed into the gross-income figure upon which the BIA is calculated.Thus, PNB’s reported operational-risk capital appeared adequate on paper but was derived from data that unobtrusively sidestepped multi-billion-dollar exposure. Theoretically, there was nothing technically wrong with the BIA formula except that its inputs were corrupted, rendering the compliance meaningless.

    This indicates that Pillar 1’s strict capital ratios come into play only when the bank’s data generation processes are maintained rigorously. The collapse of Pillar 2 calls for Supervisory and Evaluation Process (‘SREP’), which is marked at this juncture. Since 2016, the Reserve Bank of India has issued warnings regarding the dangers of handling SWIFT outside of the CBS.These cautions went unheeded and hence, PNB’s non-compliant “compliance reports” were approved during inspections.  This further suggests that, Pillar 2 supervision can’t be a mere ministerial exercise. It requires digging into the technical details of the Bank’s system since even one missing integration can render the entire Pillar 1 capital framework useless.

    IL&FS: SUBVERTING PILLAR 1 CREDIT RISK VIA A CORRUPTED PILLAR 3

    On the other side, the crisis of IL&FS highlights how  failure in market discipline can directly poison the foundation of Pillar-1’s credit risk calculation. The failure in market discipline can be attributed to violation Pillar 3. Referring to the Basel III Standardised Approach, rating a corporate borrower according to its external credit rating enables Indian banks to establish the corresponding risk weight. For instance, a borrower with a credit rating of “AAA” only attracts a risk weight of 20 percent, and thus, a bank is only required to set aside a tiny amount of capital to cover such an exposure. With an unmanageable debt load exceeding ₹91,000 crore in origin, IL&FS maintained the highly sought-after “AAA” rating from the establishment of Indian rating agencies till a few weeks prior to its default. In fact, the agencies damaged all banks holding IL&FS assets since they failed to raise an alarm in their purported Pillar 3 role of market discipline. The Standardised Approach forced lenders to classify what was effectively a ticking time bomb as a low-risk asset, making their reported capital adequacy levels misleading and needless.

    The distinctive lesson is that the credibility of credit rating organisations closely correlates with the effectiveness of a standardised methodology. In addition to the active supervision of rating agencies and knowledge of conflicts of interest inherent in the issuer-pays model, the self-correcting nature of market forces is a myth. In the absence of trustworthy ratings, Pillar 1’s capital calculations will be a wasteful exercise that will give the financial system a false sense of security.

    YES BANK: GAMING CREDIT RISK NORMS THROUGH ASSET MISCLASSIFICATION

    The bedrock of credit risk management’s honest asset classification was hit hard by the Yes Bank debacle. Evergreening, or lending to problematic borrowers to pay off the interest on past-due obligations, was the fundamental strategy used by the bank. According to the RBI’s Prudential Norms on Income Recognition, Asset Classification, and Provisioning (‘IRAC’), any loan that is past due by more than ninety days must be recorded as a non-performing asset (‘NPA’).

    The connection to Basel III is rather straightforward. The classification of a loan determines the risk weight that is allocated to it under Pillar 1. The risk weight of a corporate loan is typically 100%. However, the risk weight rises to 150 percent and the provision requirements dramatically increase resulting in poor NPA levels. Yes Bank overstated its capital adequacy ratio and negated the need for the Pillar 1 framework by concealing problematic loans under a “standard” classification, understating both its provisioning and its Risk-Weighted Assets (‘RWAs’).

    This only adds to the troubles past this case because under the regulator’s Pillar 2 supervision, the bank showed massive NPA divergences, meaning banks’ reported bad loans and practically a margin higher by regulators. In FY19, as per RBI’s report the gross NPA stood at Rs.11,159 Crore against the declared Rs.7,882 Crore, revealing glaring disparity of 41%. However, strong action from the central bank was delayed, allowing CEO Rana Kapoor’s evergreening to become systemic. Hence, after the RBI finally stepped in, it forced his resignation and arranged the rescue.

    The takeaway is straightforward, though details concerning the classification of assets create credit risk and capital rules. The supervisors who willfully ignore the innocent misreporting don’t simply look the other way; they knowingly participate in the manipulation of Basel requirements, pushing systemic risk under the cover of compliance.

    THE INEFFECTIVE LEGAL BACKSTOP

    When regulation and supervision collapse, the legal system is supposed to provide the last remedy, but in Indian banking the legal backstop has not been able to fulfil this role effectively. The Insolvency and Bankruptcy Code, 2016 was designed to give time-bound resolution and has indeed changed promoter behaviour, but in practice most cases have crossed statutory deadlines, and by the time resolution occurs, the asset value is already diminished. The haircut problem therefore reflects not the defect of IBC alone but the failure of governance and supervision before insolvency. Nevertheless, law as a mechanism of providing remedy, loses its efficacy when procedural timelines are disregarded and asset value is diminished.

    The legal backstop that would have been the ultimate means of holding to account has turned out to be the weakest link. Instead of introducing speed of action, it introduces filters of postponement and ambiguity. Systematic risks continue to be exist even with Basel III plus in action due to lack of effective deterrence which results in further intensifying the paradox and calling for effective solutions.

    These financial crises highlight the necessity to strengthen the Basel Pillars through structural, technological and supervisory reforms. To prevent breakdown of Pillar 1 operational risk safeguards, regulators shall make any manipulation technologically undoable by compulsory, forensic system-integration audits under the RBI’s Pillar 2 ‘SREP’. It will further enable Straight Through Processing (‘STP’) between SWIFT and CBS, supported by verifiable automated reconciliation and alerts for accurate entries. Failure of Pillar 3 market discipline and disputes in Credit Rating System (‘CRA’) was exposed in IL&FS crisis and situations like this could be avoided if RBI adopts a supervisory veto by imposing higher risk weights when external ratings hide stress. Further, by enforcing penalties on auditors and CRA’s for negligence to secure integrity and accountability implementation.

    CONCLUSION: FORGING A CULTURE OF CONSEQUENCE

    The study is also looking at the main bank frauds from the Basel III perspective, within the framework of an analytical grouping with a goal at its limits. In the end, they show that the primary flaw in the Indian banking system is not laws or regulations that take on complicated shapes, but rather how they are applied. This seems to be a recurring theme: the supervisory review in Pillar 2, as covered in more detail in this section, has not adequately evaluated the procedural integrity of Pillar 1 and Pillar 3 processes. Capital ratios are regarded as final measures since they focus entirely on quality of inputs such as credit ratings, asset classification and transactional data acting as key quantitative benchmarks and headline indicators.

    India’s Basel paradox therefore is not about rules but about accountability. It is only when consequence is enforced swiftly and firmly that Basel norms can function as real protection rather than a symbolic framework. Cultivating this culture of consequence is essential if the integrity of the financial system is to be preserved.

    In the long run, this involves more than just anticipating when the banks will file their compliance reports. Supervisory oversight must shift to real time analytics from retrospective assessment, alerting instant identification of evergreening and misclassification through integrated monitoring mechanism .

    The integrity of the systems themselves as well as the integrity of the gatekeepers engaged need to be examined more thoroughly. Bank audits with a technological bent, credit rating agencies’ accountability, and the heightened examination of the misclassified asset class. Systemic integrity will be a regulatory fantasy but not an institutional reality unless India adopts the mechanical foundations of the Basel framework.

  • Evaluating the Impact of the RBI’s Draft Prudential Framework on Project Financing

    Evaluating the Impact of the RBI’s Draft Prudential Framework on Project Financing

    BY ARYAN SHARMA, THIRD-YEAR STUDENT AT MAHARASHTRA NATIONAL LAW UNIVERSITY, MUMBAI

    INTRODUCTION

    Project financing serves as a cornerstone for infrastructure development, by facilitating the construction of essential assets such as roads, power plants, and urban facilities. In May 2024, the Reserve Bank of India released the draft ‘Prudential Framework for Income Recognition, Asset Classification, and Provisioning pertaining to Advances—Projects Under Implementation, Directions 2024’. The draft was aimed at strengthening the regulatory environment that governs project finance. This circular created quite a stir in the financial sector.

    This article aims to examine the implications of these regulatory changes for lenders, borrowers, and the broader infrastructure sector. It explores whether the RBI’s cautious approach strikes the right balance between financial prudence and India’s ambitious infrastructure goals, and it analyzes potential market reactions and policy adjustments that may emerge in response to these new norms.

    UNDERSTANDING PROJECT FINANCE

    A discourse on the implications of the draft prudential norms requires an insight into project financing. Project finance refers to the method of financing infrastructure and other long-gestating capital-intensive projects like power plants, ports, and roads involving huge financial outlays. The typical project involves a high-risk profile, long gestation periods, and uncertain cash flows, all of which characterize the infrastructure sector.

    Unlike a regular loan sanction, which would depend on the character, capital, and capacity of the borrower, the loan structure of project financing predominantly depends on the project’s cash flow for repayment. The project’s assets, rights, and interests form part of the collateral. Additionally, the lender assesses the project sponsors and their experience in handling and commissioning the project. Project funding could be through a consortium of several lending institutions or include loan syndication. It could have any sort of funding proposition. A project has three distinct phases: design, construction, and operation.

    Banks and lending institutions primarily become involved during the construction and operational phases, where money is lent, and out standings appear in the books of accounts. After this, the extant prudential framework of income recognition, asset classification, and provisioning comes into effect.

    The draft prudential framework recently released by the RBI pertains to loans and advances for projects. The regulator has proposed stricter regulations for project financing, which makes it more expensive for lenders to provide loans for infrastructure and industrial projects like roads, ports, and power. The main question is: what has changed and why?

    WHY HAVE THESE CHANGES BEEN PROPOSED?

    During the infrastructure lending boom of 2008 to 2015, banks whitewashed their books of bad loans and defaults, which forced RBI to launch an asset quality review. This led to the unearthing of thousands of crores of hidden bad loans, causing investors to lose money. NPAs in banks shot up to an all-time high of ₹6.11 lakh crores, and the government had to invest more than ₹3 lakh crores in capital to bring banks back into shape.

    Furthermore, facts show that most project loans have been categorized as standard assets, even though there were some projects delayed beyond the planned schedule and were not yielding cash flows. This gave rise to the necessity for more stringent lending standards with extra provisions, which were directed towards avoidance of accounting shocks that might adversely affect the balance sheets of such entities. These actions are cautious from a risk management point of view, based on the regulator’s experience in the last credit cycle. Experience, after all, is a good teacher.

    WHAT ARE THESE NEW REGULATIONS?

    Under the new norms, there will be a broad provisioning of 5% of the funded outstanding on all existing and new exposures at a portfolio level. The new norms also demand a 1% provision even post-completion of the project, well over double the current requirement.

    The central bank has created a provisioning timeline of: “2% by March 31, 2025 (spread over four quarters of 2024-25); 3.50% by March 31, 2026 (spread over four quarters of 2025-26); 5.00% by March 31, 2027 (spread over four quarters of 2026-27)”

    Further, the allowable deferment periods for date of commencement of commercial operations (“DCCO”) are: “Up to 1 year for exogenous risks (including CRE projects); Up to 2 years for infrastructure projects with endogenous risks; Up to 1 year for non-infrastructure projects with endogenous risks; Up to 1 year for litigation cases”.

    Perhaps the RBI’s proposal to impose a 5% provision requirement on project loans has been triggered by the Expected Credit Loss (“ECL”) norms, which require banks to make provisions based on past default experiences.

    The ECL approach provides for the recognition of losses on loans as soon as they are anticipated, even if the borrower has not defaulted. These are prudential standards in accordance with international best practices. Every time the ECL norms are notified, banks will be required to reserve provisions for defaults accordingly.

    HOW WILL THIS IMPACT LENDERS?

    These new norms will significantly increase the provisioning requirements for banks and NBFCs, particularly those involved in large-scale infrastructure lending. Since the 5% provisioning mandate applies uniformly across all infrastructure projects, regardless of their inherent risk profiles, it may create a deterrent effect for lower-risk projects. Lenders could become more cautious in financing even relatively safer infrastructure ventures, as the increased provisioning costs may reduce the overall attractiveness of such exposures. This one-size-fits-all approach could inadvertently constrain credit flow to viable projects.

    The higher provisioning during the construction phase will directly impact the profitability of lenders, as a substantial portion of their capital will be locked in provisions rather than being available for lending.

    For lenders heavily engaged in project financing, such as PFC, REC, and IIFCL, this could mean a reduction in their lending appetite, thereby slowing down infrastructure development in the country.

    IMPACT ON BORROWERS AND PROJECT DEVELOPERS

    Project developers, especially in sectors like power, roads, ports, and renewable energy, will face tighter credit conditions. The cost of borrowing is likely to increase as banks and NBFCs factor in the higher provisioning costs into their lending rates. This could lead to:

    • Higher interest rates on project loans
    • More stringent lending criteria, making it harder for some projects to secure funding
    • Potential project delays, as financing becomes more expensive and risk-averse

    While these measures may enhance financial stability and prevent a repeat of the bad loan crisis of the past decade, they could also create bottlenecks in infrastructure development.

    POSSIBLE MARKET REACTIONS AND POLICY ADJUSTMENTS

    The sharp decline in banking and financial sector stocks following the release of this draft indicates that the market anticipates lower profitability and slower loan growth in the sector. Industry feedback is likely to request risk-weighted provisioning (lower rates for low-risk projects), extended implementation timelines, and carve-outs for strategic sectors like renewables. Developers may also seek clearer DCCO extension guidelines for projects delayed by regulatory hurdles.

    Objections from banks, NBFCs, and infrastructure developers may include requests for tiered provisioning rates based on project risk (e.g., sectors with historically low defaults). There may also be appeals to adjust quarterly provisioning targets to ease short-term liquidity pressures. Additionally, there could be demands for exemptions in renewable energy or other priority sectors to align with national development goals.

    However, the RBI may recalibrate its stance after engaging with industry stakeholders. Potential adjustments could include phased implementation of the 5% norm, reduced rates for priority infrastructure projects, or dynamic provisioning linked to project milestones. Maintaining financial stability remains paramount, but such refinements could ease credit flow to viable projects and mitigate short-term market shocks.

    Given India’s ambitious infrastructure goals under initiatives like Gati Shakti and the National Infrastructure Pipeline, a balance must be struck between financial prudence and the need to maintain momentum in project execution.

    CONCLUSION

    The RBI’s draft prudential framework is definitely a step in the right direction to strengthen financial stability and prevent systemic risks in project financing. However, it also raises concerns about credit availability, borrowing costs, and infrastructure development. It is true that the primary focus remains on the increased provisioning requirements, but the norms also raise broader concerns about their potential impact on credit availability and infrastructure growth, which may have cascading effects. By necessitating higher capital buffers, the norms risk reducing credit availability and increasing borrowing costs, which are unintended consequences that could slow infrastructure development despite their prudential benefits. If implemented as proposed, these norms will fundamentally alter the project financing landscape, making lending more conservative and expensive.    

    Albeit the proposed norms will likely make lending more conservative and expensive, they also offer important benefits, such as improved risk management, better asset quality for lenders, and long-term sustainability of infrastructure financing. The framework could potentially reduce NPAs in the banking system.

    Looking ahead, if implemented as proposed, we may see a short-term slowdown in infrastructure lending followed by more sustainable, risk-adjusted growth. A phased implementation approach could help mitigate transitional challenges, which would allow lenders and developers time to adapt. The framework could be complemented with sector-specific risk weights and credit enhancement mechanisms for priority infrastructure projects.

    The final framework, once confirmed, will be crucial in determining the future trajectory of infrastructure lending in India. Whether the market’s initial reaction is justified or premature remains to be seen, but one thing is clear, i.e., the era of easy project finance is over, and a more cautious, risk-averse approach is here to stay.