2. Balance Sheet
Assets or Usage of funds
• Cash & bank balances
• Investments
• Advances
Liabilities or Sources of
funds
• Capital & Reserves
(No due-date, no fixed rate of
return & to be paid last in case of
winding up).
• Borrowed funds
(Have due-date, fixed rate of
return & are paid before share-
holders in case of winding-up.)
3. Principles
• Liabilities- Taken at book value
• Assets - The lower of book value or market value
• Minimum capital should be adequate to absorb the
maximum loss that is likely to occur.
It means, others money is treated as more sacrosanct.
Thus, capital in a business is regarded as a surrogate for
the financial strength of the business.
What then is minimum capital? To know that, one
needs to assess the loss that is likely to occur.
This leads us to the concept of risk weights.
4. Basel-1
Addressed mainly credit risk and
• defined components of capital
• assigned risk weights to different types
of assets
• assigned credit conversion factors to off-balance
sheet items and
• bench marked minimum ratio of
capital to risk weighted assets
Risk weight norms under Basel –1 were of a straightjacket
nature. The Basel- II accord addresses this
shortcoming by emphasizing on the credit rating
methodologies.
5. The Basel - II Accord
• 1st Pillar- Minimum capital requirements
Replaces existing ’one-size-fits-all’ frame work with several
options for banks.
• 2nd Pillar- Supervisory review process
Provides guidelines for supervisors for effective implementation.
• 3rd Pillar- Market discipline
Clamps disclosure norms about risk management practices.
The revised accord provides incentives to banks to improve
their risk management systems.
6. Components of Capital
Regulatory capital would consist of
Tier-I or core capital (paid up capital, free reserves & unallocated
surpluses, less specified deductions.)
Tier-Il or supplemental capital (subordinated debt > 5yrs., loan loss
reserves, revaluation reserves, investment fluctuation reserves, and
limited life preference shares ) and
Tier- III capital (short term subordinated debt >2yrs & < 5yrs solely for
meeting a proportion of market risk.)
Tier II capital restricted to 100% of Tier-I capital
Long term subordinated debt to be < 50 % of tier-I capital
Tier III to be less than 250 %of Tier-I capital assigned to market risk,
i.e., a minimum of 28.5 % of market risk must be covered by tier-I
7. Pillar-1 Minimum Capital Requirements
The total capital ratio must not be lower than 8%
• The scope of risk weighted assets is expanded to include certain additional
aspects of market risk and also operational risk.
– For the first time, operational risk is brought under the ambit of risk-
weighted assets
Thus, total risk-weighted assets = Risk weighted assets for credit risk
+ 12.5* Capital for market risk
+ 12.5 Capital for operational risk
Minimum capital requirement is calculated in three steps:
Capital for credit risk
Capital for market risk and
Capital for operational risk
8. Pillar- I MCR : CAPITA L FOR CREDIT RISK
a Standard approach
Based on ratings of External Credit Assessment Institutions ( ECAI ),
satisfying seven requisite criteria and to be approved by national
supervisors. A simplified standard approach (SSA) is also put in place.
Internal rating based ( IRB) approaches
Based on the bank’s internal assessment of key risk parameters such as,
probability of default ( PD), loss given at default ( LGD ),
exposure at default ( ED), and effective maturity ( M ) etc.
b Foundation approach and
c Advanced approach
Banks, however, cannot determine all the above four parameters. .In
foundation approach, banks estimate PD and supervisors decide the other
parameters.In the Advanced approach, banks have more say on all the
parameters as well.
9. Pillar- I MCR : CAPITA L FOR MARKET RISK
The risk of losses in on-balance sheet and off-balance
sheet positions arising from movements in market
prices.
Following Market risk positions require capital charge:
Interest rate related instruments in trading book
Equities in trading book and
Forex open positions
10. Pillar- I MCR : CAPITA L FOR MATKET RISK
The minimum capital required comprises two components:
• Specific charge for each security and
• General market risk charge towards
interest rate risk in the portfolio
Capital charge for interest rate related instruments
Banks have to follow specific capital charges prescribed by
RBI for interest rate related instruments as given on page nos.315 & 316
of the text book. These charges range from 0 % to 9 % for different
instruments and for different maturities.
As regards general market risk, RBI has prescribed ‘duration ’ method
to arrive at the capital charge for market risk ( modified duration ).
11. Pillar- I MCR : CAPITA L FOR OPERATIONAL RISK
There is a general perception that the operational
risks are on the rising path
The downfall of Barings Bank is mainly attributed to
operational risk. Operational risk would vary with the
volume and nature of business. It may be measured
as a proportion of gross income.
Operational risk is the risk of loss resulting from
inadequate or failed internal processes, people and
systems or from external events.
Contd.
12. Pillar- I MCR : CAPITA L FOR OPERATIONAL RISK
(Contd.)
Capital charges for operational risks
Basic Indicator Approach
Average over the three years of a fixed percentage (denoted v by Alfa,
presently 15% ) of positive annual gross income.
Standardised Approach
Here, bank’s activities are divided into eight business lines such as
corporate finance, retail banking, asset management etc. Each
business line is assigned a factor say, Beta, which determines the
capital requirement for that business line. Average for three years
gives capital for operational risks.
Advanced Management Approach
Here, bank’s internal risk measurement system is used after due
vetting by the supervisor. As a minimum five year observation period
of internal loss data is required this method may evolve over a
period of time.
13. Prevention and control of operational risks
• Personnel :Ensure employee integrity, domain knowledge and
efficiency through effective selection, training and promotion.
• Work Culture :A value based ethical business approach
• Organisational structure: Effective chain of command,
compliances and redressal mechanism
• Audit and Internal Control: Effective audits, mix of continuity
and surprise checks.
• System Reviews and Revision: Periodical reviews in the
light of changing environment, legal frame work, experience etc.
are essential.
14. Pillar- II : Supervisory Review Process
Transparency and objectivity : Hall marks of the process
Two objectives :
Ensuring adequate capital of banks
Encouraging banks to develop and implement
better risk management practices
(ICAAP- Internal Capital Adequacy Assessment
Process ).
The supervisory duties are guided by four principles
15. Supervisory Review Process :Four Principles
• 1. Banks should have rigorous processes to ensure
adequate capital
• 2 Supervisors should review and evaluate risk
management systems and strategies and take
appropriate action whenever warranted.
• 3 Supervisors should expect banks to operate above
the minimum regulatory capital levels to cover the
uncertainties related to the system and bank specific
uncertainties.
• 4 Supervisors should intervene and take immediate
remedial action whenever a bank’s capital is sliding
below the minimum regulatory capital.
.
16. Pillar- II : Supervisory Review Process
• The supervisory review process would invariably involve
some amount of discretionary elements. Supervisors,
must therefore take care to carryout their obligations in a
transparent and accountable manner.
17. Pillar- III : Market Discipline
• Disclosure norms to enable the market to assess a
bank’s position
• Market discipline contributes to a safe and sound
banking environment.
• Disclosures under pillar-III have been ensured not to
conflict with those required under accounting standards
• Information given under pillar-III to be consistent with
that given in the audited statements.
• Banks to give all information in one place
• Disclosures to be on a semi-annual basis. However,
critical information needs to be published on a quarterly
basis.
Contd.
18. Pillar- III : Market Discipline (Contd.)
• Proprietary and confidential information need not be
disclosed
• However, the bank must draw attention to the
information that it has not disclosed and must state the
reasons for the non-disclosure. The bank must, however,
part with more general information on that subject
matter.
Banks should have a formal disclosure policy approved
by the board
Pillar-III prescribes qualitative and quantitative
disclosures in this regard.
19. Asset Classification and Provisioning norms
• An account is considered non-performing when interest
/ instalments remain unpaid for 90 days.
• Income recognition of non-performing assets to be on
receipt basis and not on accrual basis.
• Assets to be classified as:
- Standard assets
-Substandard assets
-Doubtful assets and
-Loss assets
• First stage of NPA is sub-standard category. Progressive
deterioration drags it through the next classifications.
20. Provisioning Norms
• NPA causes two fold impact on profitability. Firstly, asset
ceases to earn interest, and secondly, provisions are to
be created against the NPA based upon the asset
classification and value of security if any.
• Depending on the age of the NPA, the classification
changes. With the passage of time, recovery probability
diminishes and provisioning requirement goes up.
• A non-performing asset backed with no security moves
from sub-standard category to loss category.
• Provisioning requirements for Doubtful-III category and
for loss category are the same i.e. at 100%.
21. Profit Planning
Profitability is a function of six variables, viz.
1 Interest income 4 Interest expenses
2 Fee based income 5 Staff expenses
3 Trading income 6 Other operating expenses
Maximising the first three and
minimising the others would boost profitability.
Contd.
22. Profit Planning (Contd.)
• Banks have to optimise the allocation of funds amongst
securities
credit portfolios
forex / bullion positions
to achieve best possible results in terms of profitability and
capital adeqacy.
Fee-based income areas may have to be reworked with the
introduction of new products and phasing out of out
dated ones.
23. GUIDELINES FOR IMPLEMENTATION OF THE
NEW CAPITAL ADEQUACY FRAMEWORK
APRIL, 2007. BASEL II FINAL GUIDELINES
• All commercial banks ( excluding local area banks and RRBs )shall
adopt
Standardised approach for credit risk and
Basic Indicator Approach for operational risk.
Banks shall continue to apply standardised duration approach for
market risk.
24. GUIDELINES FOR IMPLEMENTATION OF THE
NEW CAPITAL ADEQUACY FRAMEWORK
APRIL, 2007. BASEL II FINAL GUIDELINES
Effective dates for migration
Foreign banks in India and Indian banks with operational
presence outside India to migrate to above selected
approaches w.e.f. 31st March, 2008.
All other commercial banks are encouraged to migrate to
these approaches not later than 31st March, 2009.
