Capital adequacy

OVERVIEW• Prudential Norms• Basel Committee• BCBS• Basel I• Basel II• Capial Adequacy and its norms• Capital Funds• Basel III• Shortcoming of Basel II• RBI Guidelines regarding Basel III• Regulatory Capital Adequacy Level• International regulatory framework for Banks

PRUDENTIAL NORMS

• The norms which are to be followed while investing funds are called "Prudential Norms." They are formulated to protect the interests of the shareholders and depositors.

• Prudential Norms are generally prescribed and implemented by the central bank of the country. . Commercial Banks have to follow these norms to protect the interests of the customers.

• For international banks, prudential norms were prescribed by the Bank for International Settlements popularly known as BIS.

BASEL COMMITTEE• Basel committee appointed by BIS formulated

rules and regulation for effective supervision of the central banks. For this, it also prescribed international norms to be followed by the central banks. This committee prescribed Capital Adequacy Norms in order to protect the interests of the customers.

Basel Committee on Banking Supervision

• The Basel Committee is a committee of bank supervisors consisting of members from each of the G10 countries.

• The Committee is a forum for discussion on the handling of specific supervisory problems.

• It coordinates the sharing of supervisory responsibilities among national authorities in respect of banks' foreign establishments with the aim of ensuring effective supervision of banks' activities worldwide.

BASEL 1

• In 1988, the Basel Committee(BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks, known as 1988 BaselAccord or Basel 1.

• Primary focus on credit risk• Assets of banks were classified and grouped in

five categories to credit risk weights of zero ‘0’, 10, 20, 50 and up to 100%.

• Assets like cash and coins usually have zero risk weight, while unsecured loans might have a risk weight of 100%.

Pitfalls of Basel ILimited differentiation of credit risk

(0%, 20%, 50% and 100%)Static measure of default risk

The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk.

No recognition of term-structure of credit risk The capital charges are set at the same level regardless of the maturity of a credit exposure.

Simplified calculation of potential future counterparty riskThe current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality.

BASEL II

• Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision

• Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face.

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Basle II. Minimum Capital Requirements-Pillar 1

Sets minimum acceptable capital• Capital arrived by enhanced approach with credit ratings

– External or Public rating– Internal rating

• Explicit treatment to operational risk• Capital Adequacy Framework (NCAF) provides three

distinct options each for computing capital requirement for credit risk and operational risk

• Credit Riska) Standardised Approachb) Foundation Internal Rating Based Approachc) Advanced Internal Rating Based Approach• Operational Riska) Basic Indicator Approachb) Standardised Approachc) Advanced Measurement ApproachAll commercial banks (excluding Local Area Banks and Regional Rural Banks) are required to adopt Standardised Approach for Credit Risk and Basic Indicator Approach for Operational Risk for computing capital to Risk Weighted Assets so as to fall in line with the International standards and reporting to their Boards on quarterly intervals.

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Supervisory Review - Pillar 2

• Banks must attain solvency relative to their risk profile

• Supervisors should review each bank’s own risk assessment & capital strategies

• Banks should maintain excess of minimum capital• Regulators would intervene at an early stage • Possibility of rewarding banks with better risk

management systems.• RBI has already taken steps to conduct supervisory

review

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Market Discipline- Pillar 3• Improved disclosure of – Capital structure– Risk measurement and management practices– Risk profile– Capital adequacyMarket Discipline is termed as development of a set of disclosure requirements so that the market participants would be able to access key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and in turn the capital adequacy of the institution. It is considered as an effective means of informing the market about a bank’s exposure to those risks and provides comparability.

RECENT CHRONOLOGICAL UPDATES

• September 2005 update

• November 2005 update

• July 2006 update

• November 2007 update

• July 16, 2008 update

• January 16, 2009 update

• July 8–9, 2009 update

Basel II

Tier I-Core CapitalPaid up capital ,Free Reserves and unallocated surplusesTier II-Supplementary CapitalSubordinated debt of more than 5 years maturity ,loan

loss reserve, revaluation reserve,investment fluctuation reserve,limited life preference share-restricted to 100% of tier I capital

Tier III Capitalsubordinated debt with shot term maturity [min 2

years] for market risk

CAPITAL ADEQUACY

• A measure of the adequacy of an entity's capital resources in relation to its current liabilities and also in relation to the risks associated with its assets.

• Its net worth is sufficient to absorb adverse changes in the value of its assets without becoming insolvent. For example, under BIS (Bank for International Settlements) rules, banks are required to maintain a certain level of capital against their risk-adjusted assets.

• 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.

INDIA AND CAPITAL ADEQUACY NORMS

• The Government of India (GOI) appointed the Narasimhan Committee in 1991 to suggest reforms in the financial sector.

• In the year 1992-93 the Narasimhan Committee submitted its first report and recommended that all the banks are required to have a minimum capital of 8% to the risk weighted assets of the banks. The ratio is known as Capital to Risk Assets Ratio (CRAR). All the 27 Public Sector Banks in India (except UCO and Indian Bank) had achieved the Capital Adequacy Norm of 8% by March 1997.

• The Second Report of Narasimhan Committee was submitted in the year 1998-99. It recommended that the CRAR to be raised to 10% in a phased manner. It recommended an intermediate minimum target of 9% to be achieved by the year 2000 and 10% by 2002.

CAPITAL ADEQUACY RATIO

• Capital Adequacy Ratio (CAR) is defined as the ratio of bank's capital to its risk assets. Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR).

Formula

• Capital adequacy ratios ("CAR") are a measure of the amount of a bank's core capital expressed as a percentage of its risk-weighted asset.

• Tier 1 capital-which can absorb losses without a bank being required to cease trading, it is calculated as:(paid up capital + statutory reserves + disclosed free reserves) - (equity investments in subsidiary + intangible assets + current & b/f losses)• TIER 2 CAPITAL-which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.A) Undisclosed Reserves, B)General Loss reserves, C) hybrid debt capital instruments and subordinated debts

USE OF CAR

• Capital adequacy ratio is the ratio which determines the bank's capacity to meet the time liabilities and other risks such as credit risk, operational risk etc.

• In the most simple formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other lenders.

• Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.

CAPITAL ADEQUACY NORMS

RISK WEIGHTED ASSET

SUBORDINATED DEBT

• They should be fully paid up instruments.• They should be unsecured debt.• They should be subordinated to the claims of other

creditors. This means that the bank's holder's claims for their money will be paid at last in order of preference as compared with the claims of other creditors of the bank.

• The bonds should not be redeemable at the option of the holders. This means the repayment of bond value will be decided only by the issuing bank.

NEW CAPITAL ADEQUACY FRAMEWORK

New capital adequacy

framework

Capital Funds

Capital Charge

for Credit Risk

External Credit

Assessment

Credit Risk Mitigation

Capital Charge

for Market

Risk

Capital Charge for

Operational Risk

Market Discipline

CAPITAL

• Capital refers to the funds (e.g., money, loans, equity) which are available to carry on a business, make an investment, and generate future revenue.

• Capital is divided into tiers according to the characteristics/qualities of each qualifying instrument. For supervisory purposes capital is split into two categories:

Tier I Tier II.

CAPITAL FUNDS

• Banks are required to maintain a minimum CRAR of 9% on an ongoing basis.

• The RBI will take into account the relevant risk factors and the internal capital adequacy assessments of each bank to ensure the capital held by a bank is commensurate with its overall risk profile.

PRUDENTIAL FLOOR

• Prudential Floor should be highest in following Cases

Minimum capital required to be maintained as per the revised framework.

A specified percent of the minimum capital required to be maintained as per the Basel 1 framework for credit and market risks.

CAPITAL FUNDS FOR INDIAN BANKS

Tier1 capital

Paid-up equity capital, statutory

reserves and other disclosed free

reserves

Capital Reserves Innovative perpetual debt instruments

Other instruments notified by RBI

CAPITAL FUNDS FOR FOREIGN BANKS

Tier1 capital

Interest Free Funds

Statutory Reserves

Capital Reserves Remittances Head Office

Borrowings

TIER2 CAPITAL

Tier2 capital

Revaluation reserves

General provisions and loan-

loss reserves

Hybrid debt capital

instruments

Subordinate debt

Innovative perpetual

debt instruments

Basel III Accord

INTRODUCTION

• Basel III or Basel 3 released in December, 2010 is the third in the series of Basel Accords.

• These accords deal with risk management aspects for the banking sector.

• Global regulatory standard on bank capital adequacy, stress testing and market liquidity risk.

DEFINITION

According to Basel Committee on Banking Supervision "Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector".

FEATURES

(a) Better Capital Quality (b) Capital Conservation Buffer(c) Countercyclical Buffer(d) Minimum Common Equity and Tier 1 Capital

Requirements (e) Leverage Ratio(f) Liquidity Ratios

OBJECTIVES

1. Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source

2. Improve risk management and governance3. Strengthen banks' transparency and

disclosures.

PILLERS

• Pillar 1 : Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs)

• Pillar 2 : Supervisory Review Process• Pillar 3: Market Discipline

SHORTCOMINGS OF BASEL 11

• The capital requirement ratio of 4% was inadequate to withstand the huge losses that

were incurred.• Responsibility for the assessment of

counterparty risk is assigned to the ratings agencies, which proved to be vulnerable to potential conflicts of interest.

• The capital requirement is ‘pro-cyclical.• Basel II incentivizes the process of securitisation.

RBI GUIDELINES REGARDING BASEL III

a) These guidelines would become effective from January 1, 2013 in a phased manner.

b) The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against 8% (international) prescribed by the Basel Committee of Total Risk Weighted assets.

c) Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs, whereas the international norm suggests 4.5%.

d) Under Basel II, Indian banks need to maintain tier I capital of 6%, which rises to 7% under Basel III.

e) banks are also required to maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital.

f) The norm forbids banks from using the consolidated capital of any insurance or non-financial subsidiaries for calculating capital adequacy.

g) Under Basel III, several instruments, including some that have the characteristics of debt, cannot be included for arriving at tier I capital.

h) For the fiscal year ending March 2013, banks will have to disclose capital ratios computed under Basel II and Basel III.

i) RBI has set the leverage ratio at 3% under Basel III.

Regulatory Capital Adequacy LevelsProposed Basel III Norm Existing RBI Norm

Common equity (afterdeductions)

4.5 % 3.6 % (9.2 %)

Conservation buffer 2.5 % Nil

Countercyclical buffer 0-2.5 % Nil

Common equity +Conservation buffer +Countercyclical buffer

7-9.5 % 3.6 % (9.2 %)

Tier I(including the buffer)

8.5 -11 % 6 % ( 10 %)

Total capital(including thebuffers)

10.5 -13 % 9 % (14.5 %)

AFFECT ON INDIAN BANKS

• Indian banks will be required to raise Rs 6,00,000 crores in external capital in next nine years or so i.e. by 2020

• Expansion of capital to this extent will affect the returns on the equity of these banks specially public sector banks.

INTERNATIONAL REGULATORY FRAMEWORK FOR BANKS

• Bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.

• Macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.

News for Basel III

• Indian Government To Push for Basel III Deferral; Plan to Take Up the Issue at G20 Meet

• Basel III to benefit Indian banking system• SBI group requires Rs 1 lakh cr to meet Basel-

III norms

CONCLUSION

Improvement in the quantity and quality of

capital over a period of time that would allow growth and the financing of growth.

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