KHALSA COLLEGE FOR WOMEN

BANK MANAGEMENT
ASSIGNMENT
TOPIC- CAPITAL ADEQUACY

SUBMITTED TO: SUBMITTED BY:

MRS PARAMJEET KAUR PALAK BANSAL
MCOM- SEM 3
5804
What Is Capital Adequacy Ratio – CAR?
The capital adequacy ratio (CAR) is a measurement of a bank's available capital expressed as
a percentage of a bank's risk-weighted credit exposures. The capital adequacy ratio, also
known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and
promote the stability and efficiency of financial systems around the world. Two types of
capital are measured: tier -1 capital, which can absorb losses without a bank being required
to cease trading, and tier- 2 capital, which can absorb losses in the event of a winding-up
and so provides a lesser degree of protection to depositors.

Calculating CAR
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-
weighted assets. The capital used to calculate the capital adequacy ratio is divided
into two tiers.

CAR = Tier 1 capital+ Tier 2 capital / Risk Weighted Assets

Tier-1 Capital
Tier-1 Capital, or core capital, consists of equity capital, ordinary share capital,
intangible assets and audited revenue reserves. Tier-1 capital is used to absorb losses
and does not require a bank to cease operations. Tier-1 capital is the capital that is
permanently and easily available to cushion losses suffered by a bank without it
being required to stop operating. A good example of a bank’s tier one capital is its
ordinary share capital.

Tier-2 Capital

Tier-2 capital comprises unaudited retained earnings, unaudited reserves and general loss
reserves. This capital absorbs losses in the event of a company winding up or liquidating.
Tier-2 capital is the one that cushions losses in case the bank is winding up, so it provides a
lesser degree of protection to depositors and creditors. It is used to absorb losses if a bank
loses all its Tier-1 capital.
The two capital tiers are added together and divided by risk-weighted assets to calculate a
bank's capital adequacy ratio. Risk- weighted assets are calculated by looking at a bank's
loans, evaluating the risk and then assigning a weight. When measuring credit exposures,
adjustments are made to the value of assets listed on a lender’s balance sheet.

All of the loans the bank has issued are weighted based on their degree of credit risk. For
example, loans issued to the government are weighted at 0.0%, while those given to
individuals are assigned a weighted score of 100.0%.

Risk-Weighted Assets
Risk-Weighted Assets are used to determine the minimum amount of capital that must be
held by banks and other institutions to reduce the risk of insolvency. The capital
requirement is based on a risk assessment for each type of bank asset. For example, a loan
that is secured by a letter of credit is considered to be riskier and requires more capital than
a mortgage loan that is secured with collateral.

WHAT IS MEANT BY BASEL NORMS OR BASEL ACCORDS?

 Basel norms are international banking regulations issued by the Basel Committee on

Banking Supervision (BCBS).
 The Basel norms is an effort to coordinate banking regulations across the globe,
with the goal of strengthening the international banking system.
 The Basel Committee on Banking Supervision (BCBS) consists of representatives from
central banks and regulatory authorities of 27 countries (including India).
 Its secretariat (administrative office) is located at the Bank of International
Settlements (BIS) headquartered in the city of Basel in Switzerland. Hence, the
name Basel norms.
 The Basel Committee has issued three sets of regulations as of 2018 known as Basel-
I, II, and III.

BASEL-I
Basel-1 was introduced in the year 1988. It focussed primarily on credit (default) risk faced
by the banks.

As per Basel-1, all banks were required to maintain a capital adequacy ratio of 8 %.

The capital adequacy ratio is the minimum capital requirement of a bank and is defined
as the ratio of capital to risk-weighted assets.

The capital was classified into Tier 1 and Tier 2 capital.

 Tier 1 capital is the core capital of a bank that is permanent and reliable. It includes
equity capital and disclosed reserves.
 Tier 2 capital is the supplementary capital. It includes undisclosed reserves, general
provisions, provisions against Non-Performing Assets, cumulative non-redeemable
preference shares, etc.

The risk-weighted asset is the bank’s assets weighted according to risks.

The assets of the bank were classified into 5 risk categories of 0 % or 0, 10 % or 0.1, 20 % or
0.2, 50 % or 0.5 and 100 % or 1. Example- cash into 0 % risk category, home mortgage into
20 % risk category and corporate debt into 100 % risk category.

Let’s say- a bank has Rs.100 as cash reserves, Rs.200 as home mortgage and Rs.300 as loans
given out to companies. The risk-weighted assets= (Rs.100 * 0) + (Rs.200 * o.2) + (Rs.300 *
1) = 0 + 40 + 300 = Rs340

Therefore, this bank has to maintain 8 % of Rs.340 as minimum capitals. (at least 4 % in tier-
1 capital)

India adopted Basel-1 in 1999.

BASEL-II
Basel-II was issued in 2004.
This framework is based on three parameters.

 Minimum capital requirements: Banks should continue to maintain a minimum

capital adequacy requirement of 8% of risk-weighted assets. However, the definition
of capital adequacy ratio was refined. Also, Basel-II divides the capital into 3 tiers.
Tier-3 capital includes short-term subordinated loans. (subordinated loans means
lower in the ranking. It is repaid after other debts in case of bank liquidation.)
 Regulatory supervision: According to this, banks were required to develop and
use better risk management techniques in monitoring and managing all the three
types of risks that a bank faces, viz. credit, market, and operational risks
 Market Discipline: It increased disclosure requirements. Banks need to mandatorily
disclose their CAR, risk exposure, etc. to the central bank.

Presently India follows Basel-II norms.

BASEL-III

The financial crisis of 2007-08 revealed shortcomings in the Basel norms. Therefore, the
previous accords were strengthened.

Basel-III was first issued in late 2009. The guidelines aim to promote a more resilient
banking system.

 Capital: The capital adequacy ratio is to be maintained at 12.9%. The minimum Tier 1

capital ratio and the minimum Tier 2 capital ratio have to be maintained at 10.5 %
and 2 % of risk-weighted assets respectively.
 In addition, banks have to maintain a capital conservation buffer of 2.5%.
 Counter-cyclical buffer is also to be maintained at 0-2.5%.
 The leverage rate has to be at least 3 %. The leverage rate is the ratio of a bank’s
tier-1 capital to average total consolidated assets.
 Liquidity: Basel-III created two liquidity ratios: LCR and NSFR. The liquidity coverage
ratio(LCR) will require banks to hold a buffer of high-quality liquid assets sufficient
to deal with the cash outflows encountered in an acute short term stress scenario
as specified by supervisors. The minimum LCR requirement will be to reach 100% on
 1 January 2019. This is to prevent situations like “Bank Run”. The goal is to ensure
that banks have enough liquidity for a 30-days stress scenario if it were to happen.
On the other hand, the Net Stable Funds Rate (NSFR) requires banks to maintain
a stable funding profile in relation to their off-balance-sheet assets and activities.
NSFR requires banks to fund their activities with stable sources of finance (reliable
over the one-year horizon). The minimum NSFR requirement is 100 %. Therefore,
LCR measures short-term (30 days) resilience, and NSFR measures medium-term (1
year) resilience.

The deadline for the implementation of Basel-III was March 2019 in India. It was postponed
to March 2020.

Update: In light of the coronavirus pandemic, the RBI decided to defer the implementation
of Basel norms by further 6 months.