Capital Adequacy Ratio : Introduction Capital Adequacy Ratio : Meaning Types of Capital Concepts of Risk-Weighted Assets Implications of not Meeting Capital Adequacy Norms Suggestions to Improve Capital Adequacy Ratio Basel Il Norms Impact of Basel I Norms Capital Adequacy-indian Context Status of Basel Ill Capital Adequacy Norms Q90a0q0g00000Q0QqQ CAPITAL ADEQUACY RATIO : INTRODUCTION Capital adequacy is basically a measure of banks capital. It is expressed as a percentage of bank’s risk weighted credit exposure. This ratio protects depositors interests. It promotes the stability and efficiency of the banking system. The authorities should ensure that banks have sufficient capital to keep them out of difficulty. Scanned with OKEN Scanner20.2 PASEL ig In any organisation capital is considered as an a of is Stent Whenever . concemed with banking sector capital is very important because it rind Confidence 5° ae depositors regulations and also act as a cushion against losses arising due to Rormal yh activities. In pre-liberalisation era, public sector banks in India ic, Bevernment owned by wig sulffcient reason to instill public confidence and therefore there was no need to maintain gt "364 capital funds. But after liberalisation and delegulation of financial sector, most of the counts Wale world are facing the problem of poor quality of bank loans and high leverage ratio, Because ohne problems now it is very essential to follow capital standard norms. Capital adequacy is the ratio of capital funds in relation to deposits or assets of val university accepted measure of strength of bank. Capital adequacy approach came into Promina is July 1998. ‘ The Committee on Banking Regulations and supervising Practices (popularly know Committee or Cookes Committe) released the framework on international convergence of measure and capital standards The committee examined the issue of capital adequacy : ype capital and what are the risks that capital should cover ? Since capital is seen as a cushion ag ® unforseen losses, capital is the measure of banks intemal strength to absorb credit risks, wig? Tesult is losses on account of bad debts. CAPITAL ADEQUACY RATIO : MEANING Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio ratio of a bank’s capital to its risk. National regulators track a bank’s CAR to ensure that a reasonable amount of loss and are complying with their statutory Capital requirements, (CRAR) is 2 it can abso, The capital required by a bank also depends on risk associated with its assets. Therefore te amount of capital required by a bank should be measured in relation to various assets in its balance sheet. This will show to what extent the banks capital funds can meet unexpected losses without effecting the existence of bank. Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed asa percentage of its risk weighted credit exposures. The Basel Committee adopted weighted risk approach. It is a ratio of capital fund to risk weighted assets (CRAR). Itis expressed in percentage terms. Capital Funds Risk Weighted Assets Capital adequacy ratio measures the financial strength of a bank by using its capital and assets. It is used to protect depositors and promote the stability and efficiency of financial systems around te world. *100 USE OF CAR 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, ete. In the most simple @ Scanned with OKEN Scannerulation, a bank's capital is the “cushi + Shion" f i orother lenders. Banking Tegulators in most countess, whi gereby maintaining confidence in the banki 'es define and mo, fem, : 20.3 Protect the bank’s deposi h lepositors nitor CAR to protect depositors, equity leverage formulations althouey eee fFMUlaion, it ses are by definition o Uses equity over qual to d, i. r ieverage, however, CAR recowns et Plus i |. Capital adequacy ratio orted as a percentage of ‘ : Measures the avail i r “ lable capital of bank report ge of * The purpose is to establish that amount of losses, before being at - Capital is broken down as Tier Tier-2, supplemental capital he * A bank with high CAR is considered to be above the minimum requirements. required to suggest solvency. The higher CAR of a bank, the more likely it is to be able to withstand a financial downturn or other unforeseen losses. IVPES OF CAPITAL ‘The Basel rules recognize that different types of equity are more important than others. To ‘ecognize this different adjustments are made : igh capital on resery insolvent, 1, core capital such as e Id as part of e to handle a certain 2 tisk for becoming quity and disclosed reserves, and Tequired reserves of a bank. s 1, Tier I Capital : Actual contributed equity plus retained earnings. 2. Tier Il Capital : Preferred shares plus 50% of subordinated debt, Different minimum CAR ratios are applied : minimum Ti ier I equity to risk-weighted assets may e4%, while minimum CAR including Tier Il capital may be 8% 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. The committee distinguished between two types of capital—Tier I Capital/Core Capital and Tier UCapital/Supplementary Capital. 1. Tier 1 Capital—Core Capital 1. Paid up Capital 2. Statutory Reserves 3. Disclosed free Reserves laa 4. Capital Reserves representing surplus arising out of sale proceeds of assets 5. Equity investments in subsidiaries Scanned with OKEN Scanner6. Losses in current period and those brought forward from previous years and 7. Intangible Assets Tier I Capital should at no point of time be less than 50% of the total capital. This implies Latta Tcannot be more than 50% of the total capital. 2. Tier Il Capital Consists of . 1. Undisclosed Reserves and cumulative perpetual preference Shares. 2. Revaluation Reserves. : 3. General provisions and loss reserves upto a maximum of 1.25% of weighted risk assets, 4. Investment fluctuation reserves not subject to 1.25% restriction. 5. Hybrid debt capital instruments (Bonds). 6. Subordinate debt (Long term unsecured loans). It is very important to know about certain on balance sheet items and off balance sheet items and also risk attached to these on and off balance sheet items. (a) On Balance Sheet Items : These items are those assets which appear in balance sheet of a bank. These assets are asignag the weighted risk it degree of risk as expressed as a percentage of denoted weights. Such as ca Joans, investments and other assets. The RBI has given different percentage weights to various type, of assets appearing in the balance sheet. (b) Off Batance Sheet Items : Items which are not apparent on the face of a balance sheet of a bank are called off balance sheet items e.g. guarantees, letter of credit forward Contracts etc. These items are firstly converted intp credit items by applying the credit conversion factor given by RBI. Then the appropriate weighted risk is assigned and the asset is thus converted into weighted risk asset. Finally both on and of balance sheet items are combined for the purpose of calculating capital adequacy ratio of any bank. CONCEPTS OF RISK-WEIGHTED ASSETS (RWA) a For purpose of calculating capital adequacy, risk weights have to be assigned to different category assets—the so-called RWA measure. Four-weight category have been suggested. I. Category | (weight 0 percent) : It includes (a) cash (b) gold bullion (c) claims on central government and central bank (domestic or foreign) denominated in national currency, (d) claims on OECD central Government and cent banks and (e) claims guaranteed by OECD center governments. Il. Category I! (weight 20 percent) : It includes (i) Claims on multilateral. develop ment banks or claims guaran ais collateralized by securities issu nn need by ee ed by such banks (multilateral development banks indulé Scanned with OKEN Scannerr sano . ee "the World Bank, Asian Develo Investment Bank etc.) 20.5 pment Bank, African Development Bank, European (i) Claims on banks incorporated in the OECD and loans guaranteed by such banks. | ii) Claims on banks outside OECD and loans guaranteed by such banks, provided the claims and loans have a residual maturity of less than 1 year. Gv) Claims on non-domestic OECD public sector entities (PSEs are defined to include state governments, local authorities such as municipalities but not public sector enterprise engaged in commercial operations) : (v) Cash receivables |. Category Ill (weight 50 percent): Loans fully secured by mortgage on residential property. v. Category IV. (weight 100 percent) : It includes : (i) Claims on the private sector and public sector commercial companies. (ii) Claims on non-OECD banks of residual maturity exceeding 1 year. (iii) Claims on non-OECD central governments, which are not denominated in national currency. (iv) Office premises, plant and equipment, and other fixed machinery. (v) Real estate and other investments (excluding residential premises) (vi) Capital instruments issued by other banks. (vii) All other assets. The Accord also seeks to incorporate the Off-Balance Sheet activities within the risk accounting ramework. This is does via a system of conversion factors. Each OFBS transaction is assigned a onversion factor, and after multiplication by the conversion factor, the OFBS transaction is treated as Fit were an on-balance sheet item and multiplied by the weight corresponding to that category, epending on the status of the counterparty. Risk Weights for Important Assets Cash, balance with RBI 0% Balance with other banks i 20% Govt. Approved Securites : : 25% Secured loans to Staff Members 20% Housing Finance loans to individuals secured by Mortgage : 75% Mortgage based securitization of assets 775% Forex and gold open position 100% ~Central/State Govt. guaranteed advances 0% | ~Loans to PSUs 100% | ~ Other loans : ee i ~Loans guaranteed by DICGC/ECGC sige SO. Scanned with OKEN Scanner20.6 BASEL Non = SSI advances up to CGF guarantee . O . ~ Advances against term deposits, LIC policy, NSCs with adequate margin ™ — Consumer credit/credit cards 125%, — Exposure to capital market 125% — Commercial real estate 150%, = Venture capital part of Capital market exposure 150% Defects of the Basel | Base I was criticised on a number counts. Still some defects persisted. They are: ( The Accord was criticized for assigning different weights to OECD and non-gcy exposures of banks. (ii) It made emphasis on credit neglecting others. (iii) The accord did not distinguish between sound and weak banks using a “one hat fit alr approach. (iv) Finally, there are objections to CRAR as a method of regulation IMPLICATIONS OF NOT MEETING CAPITAL ADEQUACY NORMS 1. Credibility of Banks will be Adversely Affected : With the globalisation, Indian banks wi be rated according to international standards including capital adequacy norms thereby the defaulting banks will lose their credibility and acceptability both in India as well as abroad, 2. Restrict the Flexibility and Expansion : Ministry of finance government of Indian has taken CAN as an basis to grant autonomy and flexibility in some operational areas. Moreover meeting CAN is also required for banks to be eligible for opening new branches. 3. Fall in Deposits : The public sector Enterprises prefer to park their surplus funds only with bank abiding CAN. The individual depositors may also show the same preference and in that case the deposit Mobilisation of defaulting banks will fall. 4. Fall in Profitability : Those banks who are not meeting CAN and thereby having problem of capital funds will have to reduce their asset size. This will force them to reduce their commercial lending. Moreover banks may depending more on zero-risk securities which will offer lower profitability compared to commercial lending. 5. Decline in Economic Growth : Low Profitability will also lead to decline in loans to trade and industry which ultimately adversely affect economic growth of country. 6. No Satisfactory response from Capital Market : To most of the public banks government provide funds in case of urgency, but due to limited budget it cannot provide further funds to enhance bank's capital base, then they have to go for public issue to increase their capital base, but it may not secure a good response if capital adequacy norms are not being followed. tl Scanned with OKEN ScannerFr age NORMS 20.7 2. Better Assets Management : To Improve the profitability, which will lead to improvement in CAR, A bank can reduce its size of assets-composition by including assets carrying lower ornil risk weights. 3. Improved Recovery Methods : By improving recovery techniques of NPA’s banks can improve CAR. After reforms a no. of measures were suggested to speed up the recovery of NPA’sie. banks can undertake compromise proposals or sale of NPA’s at discount. Mergers Batter Assets Management Improved Recovery Methods Sree aa) oearkerGy Recapitalisation by Government Equity Participation by Employees Raising Funds through Capital Market 4. Recapitalisation by Government : Government has undertakes the responsibility to influence capital base of needy and weak banks from time to time and for this purpose bail out packages are also being announce for banks to enhance their capital base. In March 1997 govt. gave 13,346 crore to banks. 5, Equity Participation by Employees : When employees will participate in ownership they will be motivated and there will be improvement in productivity, which will lead to increase in profits. Which will certainly improve CAR. 6. Raising Funds Through Capital Market : Bank can approach capital market to raise funds in order to enchance their capital base. But the banks approaching the market should have higher profit not only to encourage investors response as well as to sustain higher dividend pay out. BASEL Il NORMS : INTRODUCTION at Efforts were made to rectify the defects. Consequently a revised version emerged. Basel Accord IT Was finalised on June 26, 2004. The Basel Committee clubbed various risk situations into three categories : | (i) Credit Risk (il) Market Risk yore mente (iii) Operational Risk Scanned with OKEN Scannert i F 20.8 Non , ital adequacy. The strength of pillar of ab E It adopted three pillar approach to capital adequi vnenalener ti, determines its safety and strength. Same is the case with risk manag % The committee identified three pillars for risk management. () Pillar —Minimum Capital Requirement (i) Pillar 1—Supervisory Review Process (ii) Pillar 11—Market discipline The prescription of minimum capital requirement is already there. The siniman a otherwise known as regulatory capital acts as a sort of insurance for the interests o epositors, @ Pillar I : Minimum. Capital Requirement—the New Accord proposes. signs improvement in assessment of credit risk and additional charge for operationa, However, there is no change in definition of capital and capital change for market tisk, Gi) Pillar II: Supervisiory Review—In order to ensure that banks have adequate Capital a also to encourage banks to adopt better risk management techniques. Gi) Pillar TH. Market discipline—envisages effective use of mandatory disclosure of management practices resulting in higher transparency. Tsk, IMPACT OF BASEL Il ACCORD NORMS _ The new accord this requirement. U; CAPITAL ADEQUACY—INDIAN CONTEXT - The Narasimham Committee I recommended the adoption of BIS norms on capital adequacy fo banks which was accepted by the RBI. The RBI introduced in April 1992 a tisk-weighted asset ratio system for all banks (including branches of foreign banks) in India as a capital adequacy measure. Under the proposed system, the balance sheet assets, non-funded items and other off-balance sheet* exposures will be assigned weights according to the Prescribed risk as a method of measuring capital The fundamental objectives of stipulating capital adequacy based on tisk-weighted assets were to: 1. To ensure the strength, soundness and Stability of the banking system, and 2. Ensure a fair and high degree of consistenc (i) Indian banks which have branches abroad are directed to achieve the BIS norm of 8 Percent of the risk weighted assets ag early as possible and in any case before Maret 31, 1994, y in its application, Scanned with OKEN Scannerwore 20.9 @y orien banks operating in India will have to achieve this norm by March 31, 1993. ga other banks will have to achieve norm of 4 percent by March 31, 1993 (Tier 1 or core capital having been set at not less than 50 percent of total capital) and the 8 percent corm by March 31, 1996. The total Tier 2 elements will be limited to a maximum of 100 cent of Tier 1 elements for the purpose of compliance of these-norms. Banks were advised to review the existing level of capital funds VIS-a-VIS prescribed level and Jan to increase the capital in a phased manner to achieve the prescribed ratio by the Fd of the stipulated period. ed on the recommendations of the Committee on Banking Sector Reforms, 1998, the minimum ens mised to9 percent, effective from March 31, 2000. 4 The other mea @an additional risk weight of 20 percent for investment in Government guaranteed securities by PSUS; (ii) 20 percent risk weight on state government guaranteed advances which remain jut a5 on March D1, 2000 and 100 percent weight in case of continued default as on March 31, nde “weight of 2.5 percent on account for market risk for government and approved securities; sures introduced on the basis of the recommendations of the Committee include: wi 100 percent weighton the foreign exchange open position limit. Table : Capital Adequacy Ratio-Bank Group-wise (As at end-March) Percent Bank Group “oP ao00 | anon | 20027 [200s [200 | 2005_| 2006 ‘cas 13 111 4 12.0 127 129 128 123 (PSBs 13 10.7 112 118 12.6 13.2 129 122 (i) Nationalised Banks 106 10.1 10.2 10.9 122 13.1 132, 123 \(i) SBI Group 123 116 12.7 13.3 13.4 13.4 124 ng lod Pvt. Sector Banks 1 so | sats aeazsnele se | etazss | 125 [TET |New Pvt. Sector Banks 118 134 1s 123 113 10.2 121 126 foreign Banks 108 ng | 120 | 129 | 152 15.0 148 13.0 Conclusion : It may be noted that while capital acts as a cushion against unforeseen losses, the capital adequacy ratio does not capture the quality of assets. It thus reflects unadequately the intrinstic stength of banks. Meeting capital adequacy qs not enough when NPAs are high and large provisions fe to be made but as a part of overall strategy. _ STATUS OF BASEL III CAPITAL ADEQUACY NORMS eel Tis a consultative document entitled ‘Strengthening the Resilience of the Banking Sector’. thee ineee by the Basel Committee on Banking Supervision at the Bank for International Apa (BIS) in Basel, Switzerland on December 17, 2009. This document was an expanded and ajay oyeion ofan earlier document ‘entitled, Enhancement of the Basel II Framework published ly 2009. The main aim of these two documents was to specify how td’itprove the ability of 8 Sector to absork frrancal and. economic shocks arising from stresses. The central part of the & Scanned with OKEN Sc ‘anner™” 20.10 \ i “BASEL Ny Basel III regulatory reform package is to establish the minimum regulatory capital and jg, requirements that banks must hold to absorb unexpected losses, NEW DEFINITION OF CAPITAL it ittee determined that Tier 1 capital mus Basel III redefines regulatory capital. The committee e 1 MUS con predominantly of common equity and retained earnings to raise the quality, consistency a transparency of regulatory capital. ; Under current standards, there are two types of capital counted in meeting the capital adequacy rules under Basel I: (Core Capital : Core Capital is Tier 1. It is made up of mainly common shareholder's equity (issued and fully paid) (i) Supplementary Capital : Supplementary Capital is Tier 2. It consists of subordinate ety, limited-life preferred stocks and loan loss reserves and goodwill. Banks can hold 2% of common equity to risk-weighted assets. Consequently, banks can display strong Tier 1 capital containing a limited amount of tangible common equity. The financial cig, demonstrated that the resources to cushion against credit losses and write-downs came out retained earning, which is a part of a tangible equity base of a bank. Under Basel III framework Tier ‘pital is adjusted to narrow it as close as possible to bank tangible common shares. Goodwill ang preferred stock, as well as other assets, would not be included in the Tier 1 capital. The Central bank governors approved a capital requirement policy that would increase the minimum common equity that banks must hold as capital from the current 2% to 4.5% by 2015. The central bank governors added mortgage servicing rights (MSRs) deferred tax assets (DTAs) and holdings in other financial institutions (HIOFIs) to be part of Tier 1 capital instead of just tangible ‘common equity. The banks argued that MSRs, which are contractual agreements in which the rights to service existing mortgages can be sold easily to offset unexpected losses, should be considered Tier 1 Capital, Deferred Tax Assets, assets that are used to reduce the amount of taxes that a company will pay in later tax period, were also added to Tier 1 capital. Bankers argued that DTAs are very liquid assets that can be used to offset unexpected losses. Holdings in other financial institutions (HIOFIs) were considered by bankers as equivalent to the bank’s own common equities and could be easily sold to offset losses. The share of these three added assets should not exceed in aggregate more than 15% of a bank’s Tier 1 capital, which limits dilution of the amount of common tangible equity in Tier 1 capital. A. Capital Conservation Buffer : ‘The committee established a capital conservation buffer that banks must maintain to ensure that banks build up capital buffers outside periods of financial stress that can be drawn down when losses Scanned with OKEN Scannere \ “asEL NORMS 20.11 h Countercyclical Capital Buffer ; : , procyclicality means that banks are able to disproportionately expand lending when economic xévty is expanding and disproportionately contract lending when economic activity is contracting economic expansions, lending is less risky and the Bael framework would recommend less peed for capital. c.New Liquidity Requirement : Banks experienced liquidity difficulties during the financial crisis, despite meeting their regulatory risk-weighted assets capital requirements. Basel Ill introduced a new global liquidity gandard to be internationally harmonized. The committee developed two minimum standards for junding liquidity. @) There is a 30 days liquidity coverage ratio, consisting mostly of government securities and cash, which would promote short term resilience to potential liquidity disruptions. (ii) The second is a long-term structural ratio to address liquidity mismatches. It provides incentives for banks to use stable sources to fund their operations. QUESTIONS Ea | Explain the meaning of capital adequacy. State its adoption in India. 2. Describe the detailed provisions ‘of Base Il Accord ? What are its defect of Risk Weighted Assets Ratio System. What are the advantages of adoption of . Give the meani this system ? 4, Describe the provisions of Basel Il Accord. State the importance of the Accord. Sire aad a (PU 2017 Nov.) (Marks 5) |. Capital Adequacy Ratio. .. Risk Weighted Approach . Define Capital Conservation Buffer. |. What is Countercyclical Capital Buffer ? . Define Core Capital. 3. What is CAR ? cil ”. Basell || Norms. (PU 2017 Nov.) (Marks 5) Neowraene 000 Scanned with OKEN Scanner