Capital adequacy norms

Swayam Siddhi College of Mgt & Research
SSCMR Presentor : Prof. Rahul Shah
CAPITAL ADEQUACY NORMS

Importance of Capital for Banks
Capital is a key ingredient for safe and sound banks and
here is why. Banks take on risks and may suffer losses if the
risks materialize. To stay safe and protect people’s deposits,
banks have to be able to absorb such losses and keep going
in good times and bad. That’s what bank capital is used for.

How Much Capital Bank Should Hold????
The answer lies in the risks it takes. The bigger the risks,
the more capital it needs. That’s why it’s essential that
banks continuously assess the risks they are exposed to
and the losses they may incur. Their assessments are
checked and challenged by banking supervisors.
Supervisors are responsible for monitoring banks’
financial health, and checking their capital levels is an
important part of this.

What is Capital ?
Put simply, capital is the money that a bank has obtained from its
shareholders and other investors and any profit that it has made
and not paid out. Consequently, if a bank wants to expand its
capital base, it can do so for example by issuing more shares or
retaining profits, rather than paying them out as dividends to
shareholders.
Overall, every bank has two sources of funds: capital and debt.
Debt is the money that it has borrowed from its lenders and will
have to pay back. Debt includes among other things deposits
from customers, debt securities issued and loans taken out by
the bank.
Funds from these two sources are employed by the bank in a
number of ways, for example to give loans to customers or to
make other investments. These loans and other investments are
the bank’s assets, along with funds that are held as cash.

A bank’s Balance Sheet:

How does Capital keep Banks Safe?
Capital acts like a financial cushion against losses. When, for
example, many borrowers are suddenly unable to pay back
their loans, or some of the bank’s investments fall in value, the
bank will make a loss and without a capital cushion might
even go bankrupt. However, if it has a solid capital base, it will
use it to absorb the loss and continue to operate and serve its
customers.

Banks uses Capital to absorb losses

Banks in the process of financial intermediation are
confronted with various kinds of financial and non-
financial risks viz.:
CreditRisk
LiquidityRisk
MarketRisk
OperationalRisk
Risk Exposure

Loans and advances given by the banks to
its customers is are an Asset to the bank.
A loan (an asset for the bank) turns as NPA when the EMI,
principal or interest component for the loan is not paid
within 90 days from the due date.
Thus a Bad Loan is an asset that ceases to generate any
income for the bank
Non Performing Assets

• The Basel Committee on Banking Supervision was
established in 1974, by the Bank of International
Settlements (BIS). In order to help the banks to
recognize the different kinds of risks and to take adequate
steps
• An international organization founded in Basel,
Switzerland in 1930 to serve as a Bank for Central
banks.
Risk Management Through Basel Committee

• As per Basel Committee guidelines issued capital
adequacy was considered panacea for risk management.
• All banks were advised to have Capital Adequacy Ratio
(CAR) at least 8%. CAR is the ratio of capital to risk weighted
assets and it provides the cushion to the depositors in case of
bankruptcy.
• Committee consisting of members from each of the G10
countries. It is represented by central bank governors of
each of the G10 countries.
• Thirteen industrialized Nations that meet on an annual
basis to consult each other on international financial matters.

The member countries are: France,
Germany, Belgium, Italy, Japan, the
Netherlands, Sweden, the United Kingdom, the United
States and Canada, with Switzerland, Luxembourg, Spain
It meets regularly 4 times a year.

The basic approach of capital adequacy
framework is that a bank should have sufficient capital to
provide a stable resource to absorb any
losses arising from the risks in its business.
For supervisory purposes capital is split into two
categories:
Tier I and Tier II. These categories represent different
instruments’ quality as capital:
Capital Adequacy Framework

Tier I Capital consists:
Equity Capital (Shareholders' Funds)
DisclosedReserves:
◦ Premium over shares,
◦ Retained earnings,
◦ Legal reserve
It is a bank’s highest quality capital because it is fully
available to cover losses.

Legal reserves are the only assets that
are permitted by government regulations.
Divided into The two asset categories:
Required Reserve (Vault cash & Reserve
deposits )
Excess Reserve (Reserve for loan purposes)
Legal Reserve:

Vault Cash (Required Reserve)
Paper bills and metal coins kept on the bank premises,
both the vault and teller drawers.
To satisfy currency withdrawal demands of depositors.
Vault cash is not part of the official M1 money supply.
M1 includes only the paper bills and metal coins that is in
circulation and held by the nonbank public.

Reserve deposits are the one that regulators require.
These are deposits that banks keep with the Reserve Bank
Of India System.
Required reserves are specified as a fraction of
outstanding deposits--usually about 3 percent -15 percent
Reserve Deposits (Required Reserve)
Excess Reserve
Any legal (or total) reserves over and above those required
by regulators are excess reserves.
These excess reserves are used for loans, which makes
them exceedingly important to the banking industry.

Tier II capitalConsists:
Undisclosed reserves
Revaluation reserves
General provisions
Subordinated debt
Hybrid Instruments.
This capital is less permanent in nature.
The loss absorption capacity of Tier II capital is lower
than that of Tier I capital.

Undisclosed reserves are not common.
They are accepted by some regulators where a bank has
made a profit but this has not appeared in normal retained
profits or in general reserves of the bank.
Many countries do not accept this as an accounting
concept or a legitimate form of capital
Undisclosed Reserve

Revaluation reserve is created when a bank has an asset
revalued and an increase in value is brought to account.
Example: A bank owns the land and building of its head-
offices and bought them for $100 a century ago.
A current revaluation is very likely to show a large
increase in value. The increase would be added to a
revaluation reserve.
Revaluation Reserve

Adequate care must be taken to ensure that sufficient
provisions have been made to meet all known losses and
foreseeable potential losses before considering as part of
Tier II Capital.
General Provisions and Loss Reserve

DEBT and
Have some characteristics of both
EQUITY.
These are close to equity in nature, in that they are able to
take losses on the face value without triggering a
liquidation of the bank, they may be counted as capital.
Example: Preferred stock usually carries no voting rights
but may carry a dividend and may have priority over
common stock in the payment of dividends and upon
liquidation.
Hybrid Instruments

Such debt is referred to as subordinate, because the debt
providers (the lenders) have subordinate status in
relationship to the Normal debt.
A typical example for this would be when a promoter of a
company invests money in the form of debt, rather than in
the form of stock.
Subordinated debt has a lower priority than other bonds
of the issuer in case of liquidation during bankruptcy. It has
minimum maturity period is 5 years.
Subordinated Term Debt

The first accord was the Basel I. It was issued in 1988 and
focused mainly on credit risk.
Banks with international presence are required to hold
capital equal to 8 % of the risk-weighted assets.
Carrying risk weights of zero (for gilts bond ), ten, twenty,
fifty, and up to one hundred percent ( Corporate debt).
It standardizes risk-based capital requirements for banks
across countries as per following measurement:
Basel I Norm

CAR = Tier I + Tier II
Risk Weighted Assets
A measure of a bank's capital. It is expressed as a
percentage of a bank's risk weighted credit exposures.
Basel I Norm
Capital to Risk Weighted Assets Ratio

•
•
It can be arrived simply by multiplying it with
factor that reflects its risk.
•
Low risk assets are multiplied by a low number, high risk
assets by 100% (i.e. 1).
Risk weighted assets is a measure of the amount of a
banks assets, adjusted for risk.
Basel I Norm

Basel I Norm
The main use of risk weighted assets is to calculate Tier1
and Tier 2 capital adequacy ratios.
If its capital is 10% of its assets, then it can lose 10% of
its assets without becoming Insolvent.
Insolvency is simply being unable to pay liabilities;
Liabilities > Assets

Basel II Norm
Basel II is the second set of international banking
regulations defined by the Basel Committee on Bank
Supervision (BCBS). It is an extension of the regulations for
minimum capital requirements as defined under Basel I. The
Basel II framework operates under three pillars:
•Capital adequacy requirements
•Supervisory review
•Market discipline

Pillar 1 includes 3 risks now, operational risk + credit
risk + market risk to meet international standards.
Commercial banks in India adopt Standardized
Approach(SA) for credit risk.
Standardized Approach , the rating assigned by the
eligible external credit rating agencies, largely supports
the measure of credit risk.
Basel II Norm

Basel II Norm
Banks rely upon the ratings assigned by the external credit
rating agencies chosen by the RBI for assigning risk weights
for capital adequacy purposes. As:
a) Credit Analysis and Research Ltd.
b) CRISIL Ltd.
c) FITCH Ltd. and
d) ICRA Ltd.
International credit rating agencies :
a) Fitch;
b) Moody's; and
c) Standard & Poor's.

Banks must disclose the names of the credit rating
agencies that they use for the risk weighting of their
assets.
The risk weights associated with the particular rating
grades as determined by RBI for each eligible credit
rating agency as well as the aggregated risk weighted
assets.
Basel II Norm


Pillar 2: Supervisory Review Process (SRP) — The
establishment of suitable risk management systems in banks
and their review by the supervisory authority (RBI).
As in terms of the Pillar 2 requirements of the New Capital
Adequacy Framework, banks are expected to operate at a
level well above the minimum requirement
Basel II Norm

Pillar 3: Market Discipline — seeks to achieve increased
transparency through expanded disclosure requirements
tor banks.
For such comprehensive disclosure, IT structure must be
in place for supporting data collection and generating MIS
which is compatible with Pillar 3 requirements
Basel II Norm

Computation of CRAR under BASEL II
Basel II Tier I CRAR = Tier I capital / (Credit Risk RWA +
Operational Risk RWA + Market Risk RWA)
Basel II Total CRAR = Total capital / (Credit Risk RWA +
Operational Risk RWA + Market Risk RWA)
RWA - risk weighted assets
Basel II Norm

Basel II Mandates
Capital to Risk Weighted Assets Ratio (CRAR) of 8% and
Tier I capital of 6%.
The RBI has stated that Indian banks must have a CRAR of
minimum 9%, effective March 31, 2009.
The Government of India has stated that public sector
banks must have a capital cushion with a CRAR of at least
12%, higher than the threshold of 9% prescribed by the
RBI.
Basel II Norm

Failure to adhere to Basel II can attract RBI action
including restricting lending and investment activities.
However, private sector banks as well as public sector
banks are likely to comply with Basel II norms since March
31, 2009
Basel II Norm

What is "Basel III"
A global regulatory standardon
 bank capital adequacy
 stress testing and
 market liquidity risk
With a set of reform measures to improve
 Regulation
 supervision and
 risk management
Basel III Norm

 Reducing profitability of small banks and threat of takeover
 Lack of comprehensive approach to address risks
 Self-regulation in area of asset securitization
 Lack of safety
 Inability to strengthen the stability of financial system
 Failure to achieve large capital reductions
Why Basel III Norm

 To minimize the probability of recurrence of crises to
greater extent
 To improve the banking sector's ability to absorb shocks
arising from financial and economic stress.
 Toimprove risk management and governance
 Tostrengthen banks' transparency and disclosures.
Aim Of Basel III

 Bank-level, or micro prudential, regulation, which will
help raise the resilience of individual banking
institutions to periods of stress.
 Macro prudential, system wide risks that can build up
across the banking sector as well as the procyclical
amplification of these risks over time.
Target of Basel III

Micro- prudential elements
• Tominimize the risk contained with individual
institutions
The elements are:
 Definition of capital
 Enhancing risk coverage of capital
 leverage ratio
 International liquidity framework
Basel III Norm

Macro- prudential elements
 Totake care of the issues relating to the systemic risk
The elements are:
 Leverage ratio
 Capital conservation buffer
 Countercyclical capital buffer
 Addressing the procyclicality of provisioning requirements
 Addressing interconnectedness
 Addressing the too- big to- fail problems
 Addressing reliance on external credit rating agencies.
Basel III Norm

Pillar 1- Minimum Capital Requirements
• Calculate Required Capital based on
 Market risk
 Credit risk
 Operational risk
• Used to monitor funding concentration
Basel III Norm

Pillar 2- Supervisory Review Process
 Bank should have strong internal process
 Adequacy of capital based on risk evaluation
Basel III Norm
Pillar 3 – Enhanced Disclosure
 Provide market discipline
 Intends to provide information about banks exposure to
risk

The relationship among the three pillars:
 Second pillar – supervisory review process to ensure the first
pillar
- intended to ensure that the banks have adequate capital
 Third pillar – compliments first and second pillar
- a discipline followed by the bank such as disclosing
capital structure, tier-i and tier-ii capital and approaches to
assess the capital adequacy
i.e. assessment of the first pillar.
 Model of commercial banks interpret first pillar as a closure
threshold rather than bank’s asset allocation
Basel III Norm

•The new and stricter regulations of the basel3 like higher
capital requirements, the new liquidity standard, the
increased risk coverage, the new leverage ratio or a
combination of the different requirements will be difficult to
adopt by the banks
•Banks have to take a number of actions to meet the various
new regulatory ratios, restoring of data
•Banks must be able to calculate and report the new ratios.
Which requires the huge implementation effort.
Basel III Norm
Challenges of Basel III Implementation:

Banks usually have 3 types of challenges
1. Functional challenges
2. Technical challenges
3. Organizational challenges
Basel III Norm
Challenges of Basel III Implementation:

•Developing specifications for the new regulatory
requirements, such as the mapping of positions (assets and
liabilities) to the new liquidity and funding categories in the
LCR and NSFR calculations.
•the specification of the new requirements for trading book
positions and within the CCR framework (e.g. CVA) as well as
adjustments of the limit systems with regard to the new
capital and liquidity ratios.
•Crucial is the integration of new regulatory requirements into
existing capital and risk management as some measures to
improve new ratios (e.g. liquidity ratios) might have a negative
effect on existing figures.
Basel III Norm
Functional Challenges

•The technical challenges includes the availability of data, data
completeness, and data quality and data consistency to
calculate the new ratios.
•The financial reporting system with regard to the new ratios
and the creation of effective interfaces with the existing risk
management systems.
Basel III Norm
Technical Challenges

•The operational challenges includes stricter capital
definition lowers banks’ available capital. At the same
time the risk weighted
(RWA) for
assets securitizations,
trading book positions and certain
counterparty credit risk exposures are significantly
increased.
•The stricter capital requirements, the introduction of the
LCR and NSFR will force banks to rethink their liquidity
position, and potentially require banks to increase their
stock of high-quality liquid assets and to use more stable
sources of funding.
Basel III Norm
Operational Challenges

•Basel III also introduces a non-risk based leverage ratio of 3
percent. Group1 banks are failed in maintaining the this
leverage ratio
•The banks will experience increased pressure on their
Return on Equity (RoE) due to increased capital and liquidity
costs, which along with increased RWAs will put pressure on
margins across all segments
Basel III Norm

Capital…
 Indian banks need to raise Rs 1.5 lakh crore to Rs 1.75
lakh crore as capital to meet the BASEL- III
requirements.
 Can PSU banks mobilize this sort of capital?
- Probably
government is
NO, The alternate to the
either to reduce shareholding
below 50% or slowdown PSU growth
 Can private banks raise this sort of money?
- They probably can, because Rs 500 billion was
raised in last 5 years
Basel III Norm
Indian Scenario

Problems for PSUs
 Capital adequacy ratio
- has been stipulated at 9%, unchanged from what
the regulator requires in India currently, banks here will
need to raise more money than under the current Basel
II norms because several capital instruments cannot be
included under the new definition.
Ex: Perpetual Bond
 Maintaining an 8% tier I capital ratio
 More additions to non-performing assets
 Unamortized expenditure on pension liabilities
Basel III Norm
Indian Scenario

The Indian economy is also expected to grow at an
annual growth rate of 8-9% for next 10 years or so. This
would undoubtedly necessitate a considerable growth
in bank capital.
Basel III Norm
Indian Scenario

Issues relating to SLR and LCR
 India, banks are statutorily required to hold minimum reserves of
high-quality liquid assets at 24% of net demand and time liabilities.
 The proportion of liquid assets in total assets of
banks will increase substantially, if the SLR
reserves are not reckoned towards the LCR
(Liquidity coverage ratio) and banks are to meet
the entire LCR with
assets, thereby lowering
additional
their
liquid
income
significantly.
 RBI is examining to what extent the SLR
requirements could be reckoned towards the
liquidity requirement under Basel III.
Basel III Norm
Indian Scenario

 Retail banks will be affected least, though institutions with
very low capital ratios may find themselves under
significant pressure.
 Corporate banks will be affected primarily in specialized
lending and trade finance.
 Investment banks will find several core businesses
profoundly affected, particularly trading and securitization
businesses.
 Balance sheet restructuring and business-model
adjustments could potentially mitigate up to 40 percent of
Basel III’s RoE impact, on an average.
 Government banks may have to sacrifice growth
Basel III Norm
Profitability

 The impact of credit requirements on the profitability of
banks would depend upon sensitivity of lending rates to
capital structure of banks and sensitivity of the credit
growth to the lending rates.
 When banks with low core Tier I shore up their capital to
around 9% required, their return on equity (RoE) could
drop by 1-4%.
 Basel III will force banks to plough back a larger chunk of
their profit into the balance sheet.
 Banks might have to rationalize dividend policies so that
more profit could be retained and used as capital,
indicating a lower dividend for the government.
Basel III Norm
Profitability

 Demonstrate that the banking system is recovering well from the
global financial crisis of 2008 and has been developing the resilience to
future shocks.
 Contribute to a bank’s competitiveness by delivering better
management insight into the business, allowing it to take advantage of
future opportunities.
 Strengthen the financial system of both developing and developed
countries by addressing the weaknesses in the measurement of risk
under Basel II framework.
 Delivers a much safer financial system with reduced probability of
banking crises at affordable costs. The impact of costs is minimized
through long phase-in.
 It is expected that as the proportion of equity in the capital structure of
banks rises, it would reduce the incremental costs of raising further
equity as well as non-common equity capital.
Basel III Norm
Benefits Of Implementation

The Reserve Bank’s approach has been to adopt Basel III
capital and liquidity guidelines with more conservatism and
at a quicker pace. The impact of these rules is not going to be
onerous and there will be considerable advantage in adopting
Basel III by our banks.
Basel III Norm
RBI’s Approach

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Capital adequacy norms

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