Arunav Nayak

What is CAR?
 Capital adequacy provides regulators with a means of
establishing whether banks and other financial
institutions have sufficient capital to keep them out of
difficulty. Regulators use a Capital Adequacy Ratio
(CAR), a ratio of a bank’s capital to its assets, to assess
risk.
 CAR = (Bank’s Capital)/(Risk Weighted Assets)
= (Tier I Capital + Tier II Capital)/(Risk Weighted
Assets)
Concepts of Capital Adequacy
Norms
 Tier I Capital

 Tier II Capital

 Risk Weighted Assets

 Subordinated Debts
Risks Involved
 Credit Risk

 Market Risk
a) Interest Rate Risk
b) Foreign Exchange Risk
c) Commodity Price Risk etc.

 Operational Risk
Basel – I Norms
In 1988, the Basel I Capital Accord was created. The
general purpose was to:

1. Strengthen the stability of international banking

system.

2. Set up a fair and a consistent international banking

system in order to decrease competitive inequality
among international banks.
Basis of Capital in Basel - I
 Tier I (Core Capital): Tier I capital includes stock issues
(or share holders equity) and declared reserves, such as
loan loss reserves set aside to cushion future losses or for
smoothing out income variations.

 Tier II (Supplementary Capital): Tier II capital includes all

other capital such as gains on investment assets, long-term
debt with maturity greater than five years and hidden
reserves (i.e. excess allowance for losses on loans and
leases). However, short-term unsecured debts (or debts
without guarantees), are not included in the definition of
capital.
Risk Categorization
According to Basel I, the total capital should represent
at least 8% of the bank’s credit risk.
Risks can be:
 The on-balance sheet risk (like risks associated with
cash & gold held with bank, government bonds,
corporate bonds etc.)
 Market risk including interest rates, foreign
exchange, equity derivatives & commodities.
 Non Trading off-balance sheet risks like forward
purchase of assets or transaction related debt assets
Limitations of Basel – I Norms
 Limited differentiation of credit risk

 Static measure of default risk

 No recognition of term-structure of credit risk

 Simplified calculation of potential future counterparty

risk

 Lack of recognition of portfolio diversification effects

Basel – II Norms
Basel – II norms are based on 3 pillars:
 Minimum Capital – Banks must hold capital against
8% of their assets, after adjusting their assets for risk

 Supervisory Review – It is the process whereby

national regulators ensure their home country banks
are following the rules.

 Market Discipline – It is based on enhanced

disclosure of risk
Risk Categorization
In the Basel – II accord, Credit Risk, Market Risk and
Operational Risks were recognized.
Under Basel – II, Credit Risk has three approaches
namely, standardized, foundation internal ratings-
based (IRB), and advanced IRB
Operational Risk has measurement approaches like
the Basic Indicator approach, Standardized approach
and the Advanced Measurement approach.
Impact on Banking Sector
 Capital Requirement

 Wider Market

 Products

 Customers
Advantages of Basel II over I
 The discrepancy between economic capital and
regulatory capital is reduced significantly, due to that
the regulatory requirements will rely on banks’ own
risk methods.

 More Risk sensitive

 Wider recognition of credit risk mitigation.

Pitfalls of Basel – II norms
 Too much regulatory compliance

 Over Focusing on Credit Risk

 The new Accord is complex and therefore demanding

for supervisors, and unsophisticated banks

 Strong risk differentiation in the new Accord can

adversely affect the borrowing position of risky
borrowers
Basel – III Norms
Basel – III norms aim to:

 Improving the banking sector's ability to absorb

shocks arising from financial and economic stress

 Improve risk management and governance

 Strengthen banks' transparency and disclosures

Structure of Basel – III Accord
 Minimum Regulatory Capital Requirements based on
Risk Weighted Assets (RWAs) : Maintaining capital
calculated through credit, market and operational risk
areas.
 Supervisory Review Process : Regulating tools and
frameworks for dealing with peripheral risks that
banks face
 Market Discipline : Increasing the disclosures that
banks must provide to increase the transparency of
banks
Major changes in Basel - III
 Better Capital Quality
 Capital Conservation Buffer
 Counter cyclical Buffer
 Minimum Common Equity and Tier I Capital
requirements
 Leverage Ratios
 Liquidity Ratios
 Systematically Important Financial Institutions
Basel III and its impact
 On Banks

 On Financial Stability

 On Investors
References
 Bank For International Settlements, “Basel Committee
on Banking Supervisions”,
http://www.bis.org/bcbs/index.htm
 Investopedia,
http://www.investopedia.com/articles/economics/10/
understanding-basel-3-
regulations.asp#axzz26w2DIKab
 Bank Credit Management by G.Vijayaraghavan,
Chapter – 14, pp- 170 - 171
Thank You