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Capital Adequacy Ratio

Capital Adequacy Ratio

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Published by: Vinit Tulaskar on Nov 02, 2010
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Capital Adequacy Ratio

The Committee on Banking Regulations and Supervisory Practices (Basel Committee) had released the guidelines on capital measures and capital standards in July 1988 which were been accepted by Central Banks in various countries including RBI. In India it has been implemented by RBI w.e.f. 1.4.92 Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR), is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and are complying with their statutory Capital requirements. Capital adequacy is an indicator of the financial health of the banking system. It is measured by the Capital to Risk-weighted Asset Ratio (CRAR), defined as the ratio of a bank s capital to its total risk-weighted assets. Financial regulators generally impose a capital adequacy norm on their banking and financial systems in order to provide for a buffer to absorb unforeseen losses due to risky investments. A well adhered to capital adequacy regime does play an important role in minimizing the cascading effects of banking and financial sector crises. Basel Committee on Banking Supervision (BCBS). initiated Basel I norms in 1988, considered to be the first move towards risk-weighted capital adequacy norms. In 1996 BCBS amended the Basel I norms and in 1999 it initiated a complete revision of the Basel I framework, to be known as Basel II. In pursuance of the Narasimhan Committee recommendations, India adopted Basel I norms for commercial banks in 1992, the market risk amendment of Basel I in 1996 and has committed to implement the revised norms, the Basel II, from March 2008. Capital adequacy standard in India In India, at present, there is a three track approach for Basel compliance the commercial banks are Basel I compliant with respect to credit and market risks; the urban cooperative banks maintain capital for credit risk as per Basel I and market risk through surrogate charges; and the rural banks have capital adequacy norms that are not on par with the Basel norms . The three track approach is justified by the necessity to maintain varying degree of stringency across different types of banks in India reflecting different levels of operational complexity and risk appetite. The three track approach is also justified in order to ensure greater financial inclusion and for an efficient credit delivery mechanism.

The notion of capital adequacy Banks and other financial institutions are, in their basic form, mediators of money accepting deposits from the public on one hand and issuing credit on the other. Banks earn, again very basically, from a financial spread between the interest rate of credit issued to that paid on deposits accepted. As any other corporation the net of a bank's asset and liabilities is the bank's capital. This capital plays a very significant role in assuring the soundness and viability of a bank as it can be perceived as a cushion, of sorts, which absorbs various losses the bank may have due to the risks involved in its operations. Therefore, the capital held by banks is highly regulated by the government. Any company, when bankrupt, may cause heavy losses to its close economic environment. But the companies that were in business with the bankrupt company had, or should have had the ability to manage the risks in doing business with that particular company and were compensated for that risks by profits generated through that business. When a bank goes bankrupt the general public, which had trusted the bank to be conservative enough to keep the deposit side intact, suffers. The public has very little in the way of tools to ensure and manage the risks in their dealings with banks (other than carefully choosing their bank). Capital adequacy in banks is therefore highly important and closely monitored. A bank should have, in essence, adequate capital to cover the risks it incurs in its lending and financing operations. Risks are abundant in banks and include mainly the credit risk incurred in lending activities of not being repaid by the lender but also significant market risks due to the financial nature of the business and significant operational risks due to the complexity of banks' operations. Banks are also exposed to many other risks such as legal risks, liquidity risk, business risk, reputational risk and endless others.

How is capital adequacy regulated? In order to regulate capital adequacy very detailed requirements of how a bank should handle its capital are issued by regulators everywhere. The most famous of

these regulations are the Basel regulations published by the Basel committee of the Bank for International Settlements (BIS) which is an international organization that promotes international cooperation in monetary and financial issues and which central banks turn to for regulatory guidance and insight. The regulation regarding capital adequacy issued by the BIS are known as Basel I and Basel II and contain detailed requirements and guidance on capital adequacy. Essentially, this guidance break down the bank's off and on balance sheet items and translates these items into what are known as Risk Weighted Assets (RWA) where each asset receives a certain weighting dependant on the risk associated with it. For example, a US government bond will receive a negligible risk weight while credit issued to a non-ranked company will be weighted as 100% risky asset. These risk weighted assets are than summed to receive the total risk weighted assets of the bank and are translated into a capital requirement accordingly. The regulation is very detailed and includes requirements both on the risk weighted asset side and the capital side. Banks cannot recognize, for example, any sort of capital as regulatory capital for the purpose of demonstrating capital adequacy. Banks are expected to have capital buffers which are excess capital a bank holds, over the regulatory requirements, to withstand unexpected risks and scenarios. The problem, as we've experienced, begins when banks get involved in business that has not yet received proper regulatory treatment. This issue will always be an open issue as regulators usually react to market developments, thus always lagging behind. For the purpose of calculating capital adequacy a detailed and common segmentation of business is published and regulated by the regulator. When something does not fit the mold it usually receives a treatment that is not necessarily appropriate or no treatment at all. This is how financial crisis spring to life Use Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the simplest formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's depositors or other lenders. Banking regulators in

most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system. CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk. What was Basel I? Basel I was an international accord to set minimum levels of capital for banks, building societies and other deposit taking institutions. It was designed to create a level playing field for lenders from different countries and to ensure that lenders were sufficiently well capitalized to protect depositors and the financial system. Why are the requirements changing? The first Basel Accord is now being replaced by a new accord, Basel II. The new accord is being introduced to keep pace with the increased sophistication of lenders' operations and risk management and overcome some of the distortions caused by the lack of granularity in Basel I. Lenders had been able under Basel I to reduce required capital in ways that did not reflect lower real risk (in what has become known as regulatory capital arbitrage). The intention is that Basel II will align required minimum capital more closely with lenders' real risk profile. What are the main differences between Basel I and Basel II? Basel I required lenders to calculate a minimum level of capital based on a single risk weight for each of a limited number of asset classes, eg, mortgages, consumer lending, corporate loans, exposures to sovereigns. Basel II goes well beyond this, allowing some lenders to use their own risk measurement models to calculate required regulatory capital whilst seeking to ensure that lenders establish a culture with risk management at the heart of the organization up to the highest managerial level.

Formula Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures. Capital adequacy ratio is defined as: CAR = Capital Risk Where Risk can either be weighted assets or the respective national regulator's minimum total capital requirement. If using risk weighted assets, CAR = T1 + T2 10%.

The percent threshold (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator. Two types of capital are measured: tier one capital (T1 above), which can absorb losses without a bank being required to cease trading, and tier two capital (T2 above), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. Risk weighting Since different types of assets have different risk profiles, CAR primarily adjusts for assets that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR calculation vary from country to country, but general approaches tend to be similar for countries that apply the Basel Accords. In the most basic application, government debt is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the CAR. Risk weighting example Local regulations establish that cash and government bonds have a 0% risk weighting, and residential mortgage loans have a 50% risk weighting. All other types of assets (loans to customers) have a 100% risk weighting.

Bank "A" has assets totaling 100 units, consisting of:
y y y y y

Cash: 10 units. Government bonds: 15 units. Mortgage loans: 20 units. Other loans: 50 units. Other assets: 5 units.

Bank "A" has deposits of 95 units, all of which are deposits. By definition, equity is equal to assets minus debt, or 5 units. Bank A's risk-weighted assets are calculated as follows Cash 10 * 0% = 0

Government bonds 15 * 0% = 0 Mortgage loans Other loans Other assets 20 * 50% = 10 50 * 100% = 50 5 * 100% = 5

Total risk Weighted assets Equity 65 5

CAR (Equity/RWA) 7.69% Even though Bank "A" would appear to have a debt-to-equity ratio of 95:5, or equityto-assets of only 5%, its CAR is substantially higher. It is considered less risky because some of its assets are less risky than others.

Regulatory capital In the Basel I accord bank capital was divided into two "tiers", each with some subdivisions. Tier 1 (core) capital Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in profits each year since, paid out no dividends and made no losses, after 10 years the Bank's tier one capital would be $200. Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. These are commonly referred to as upper tier one capital. Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock. Capital in this sense is related to, but different from, the accounting concept of shareholders' equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord. Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems. The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses which are covered by provisions, reserves and current year profits. The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total assets. The Tier 1 risk based capital ratio is the ratio of a bank's core (equity capital) to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's Central bank). Most central banks follow the Bank for International Settlements (BIS) guidelines in setting formulae for asset risk

weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%. A good definition of Tier 1 capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can't be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are held by the bank, and are thus money that no one but the bank can have an influence on. Tier 1 capital is also seen as a metric of a bank's ability to sustain future losses Tier I capital include *paid-up capital *statutory reserves *other disclosed free reserves *capital reserves representing surplus arising out of sale proceeds of assets. Minus *equity investments in subsidiaries, *intangible assets, and *losses in the current period and those brought forward from previous periods to work out the Tier I capital.

Tier 2 (supplementary) capital Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form of financial capital, from a regulator's point of view. The forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord. National regulators of most countries around the world have implemented these standards in local legislation. Tier 1 capital is considered the more reliable form of capital. There are several classifications of tier 2 capital, which is composed of supplementary capital. In the Basel I accord, these are categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

Undisclosed Reserves Undisclosed reserves are not common, but 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. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results. Revaluation reserves A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters 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. General provisions A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital. Hybrid instruments Hybrids are instruments that have some characteristics of both debt and shareholders' equity. Provided 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. Subordinated-term debt Subordinated-term debt is debt that is not redeemable (it cannot be called upon to be repaid) for a set (usually long) term and ranks lower than (it will only be paid out after) ordinary depositors of the bank. Risk weighted assets - Fund Based: Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets. A bank's assets weighted according to credit risk. Some assets, such as debentures, are assigned a higher risk than others, such as cash.

Non-funded (Off-Balance sheet) Items: Obligations that are contingent liabilities of a bank, and thus do not appear on its balance sheet. The credit risk exposure attached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the off-balance sheet items by the credit conversion factor. This will then have to be again multiplied by the relevant weightage. Reporting requirements: Banks are also required to disclose in their balance sheet the quantum of Tier I and Tier II capital fund, under disclosure norms. An annual return has to be submitted by each bank indicating capital funds, conversion of off-balance sheet/non-funded exposures, calculation of risk -weighted assets, and calculations of capital to risk assets ratio,

Computation of capital adequacy ratio (CAR) of banks: For computation of CAR, we need to calculate:
y y y

Tier I capital Tier II capital Risk Weighted Assets (RWA)

Step 1: Compute Tier I capital: Tier I capital is the most permanent and readily available support against unexpected losses. It consists of1. Paid up equity capital 2. Statutory reserves 3. Capital reserves 4. Other disclosed free reserves Less: 1. Equity investments in subsidiaries 2. Intangible assets 3. Current and Accumulated Losses, if any Step 2: Compute Risk Weighted Assets RWA are calculated by multiplying the relevant weights to the value of assets and off-balance sheet items.

Step 3: Compute tier II capital These are not permanent in nature or, are not readily available Capital Adequacy Ratio (CAR) Indian Banks

Private banks ICICI HDFC Axis Citibank Average Nationalised Banks SBI bank Canara Bank

CAR 1 7 .7 % 15.69% 1 6 .5 % 13.23% 1 5 .2 3 % CAR 1 4 .2 5 % 1 4 .1 %

Punjab National Bank Bank of Baroda Average

1 4 .0 3 % 1 4 .0 1 % 1 3 .2 4 %

Comparing India and Rest
y CAR of Indian banks both Private and Public banks have combined average of 14.24 % y JP Morgan, last man standing in crisis has CAR of 11.3 % y UBS(11.8%), BNB Paribas (6.9%), Credit Suisse(11%),Standard Chartered (8.3%),Deutsche bank(8.10%) HSBC(8.5%), Bank of China(13.4%), Can we build a relation between NPA and CAR. y Its treated as edges on opposite side of the sea. y How can we narrow them.

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