CAPITAL ADEQUACY INCLUDING RBI & BASEL NORMS

Concept of Capital Adequacy

Capital adequacy measures the adequacy of the capital i.e. how much capital should be adequate to tackle the riskiness of the loans (assets) given by the bank. This ratio is also called capital to risk weighted asset ratio (CRAR).This ratio is basically used to protect the interest of depositors and promote the stability of the financial system.Capital Adequacy ratio is calculated as follows:

CAR = tier 1capital + tier 2 capital Risk Weighted Assets

Tier 1 capital is the capital which provides a cushion to the Banks against losses upto the date of its winding up. For example, company’s equity share capital can be earmarked as tier 1 capital.

Tier 2 capital is the capital which gives a cushion to the banks after the date of winding up of the company. So, this capital is used to absorb losses after the tier 1 capital is fully utilized. Therefore, it provides a lesser degree of protection to depositors and creditors.

Risk Weighted Assets refer to the fund based assets such as Cash, Loans, Investments and other assets. They are the total assets owned by the Banks. However, the value of each asset is assigned a risk weight. For example, if the bank has given loans to the government by investing in government securities like government bonds, it need not keep any capital. The reason is that, in case of loans given to government in the form of government securities, the risk is zero. Therefore the risk weight for government securities is zero. On the other hand, risk weight assigned in case of corporate loan is 100%.

The degree of % weights risk assigned by the Reserve Bank of India.

The following table shows the Risk weights for some important assets assigned by RBI.

As 

set

	Weighted Risk
Cash	0%
Balance with Reserve Bank of India	0%
Central/ state Government Guaranteed advances	0%
SSI advances up to CGF guarantee	0%
Loans against FD (Fixed Deposits), LIC Policy	0%
Government approved Securities	2.50%
Balance with Banks other than RBI which maintain the 9% CRAR	20%
Secured Loan to the Staff Members	20%
Housing Loans	50%
Housing Loans >Rs. 30 Lakhs	75%
Loans against Gold and Jewellery	50%
Retail Lending up to Rs. 5 crore	75%
Loans Guaranteed by DGCGC / ECGC	50%
Loans to Public Sector Undertakings	100%
Foreign Exchange and Gold in Open Position	100%
Claims on unrated corporates	100%
Commercial Real estate	100%
Consumer Credit	125%
Credit Cards	125%
Exposure to Capital Markets	125%
Venture Capital Investment as a part of Capital Market exposure	150%

From the above table, we have some sort of idea about the assets which are in the form of Cash, Government Securities; loans against FDs etc. which are among the safest of all assets with 0% Risk weight assigned to them. On the other hand, the venture Capital Investment as a part of Capital Market exposure has the maximum risk weight of 150% assigned to them.

Explanation of Risk Weighted Assets with the help of an example 

Let’s take an example to explain the concept of Risk Weighted Assets. In case of housing loans, the risk weight is 50%, which means banks have to set aside its own capital of ` 4.5 for every ` 100 loan 

(this means 50 % of 9% of `100). Presently, the CAR as prescribed by RBI is 9%. Similarly, in case of 100% risk weight (such as Loans to Public Sector Undertakings), banks have to keep aside its own 

capital of ` 9 (100 % of 9% of Rs.100) on the loan. 

Benefits of Capital Adequacy Ratio 

Provides cushion against possible future losses. 

 Motivate banks towards greater efficiency and could force the banks to reduce their operating costs. 

 Enable banks to strengthen their fundamentals which in turn motivate them to show their balance sheet in a better way and help them to raise capital at lower cost. 

Basel Norms 

Introduction 

The Basel Banking Accords are norms issued by the Basel Committee on Banking Supervision (BCBS), formed under the auspices of the Bank of International Settlements (BIS), located in Basel, Switzerland. The committee formulates guidelines and makes recommendations on best practices in the banking industry. The Basel Accords, which govern capital adequacy norms of the banking sector, aim to ensure financial stability and thereby increase risk absorbing capability of the banks. 

The first set of Basel Accords, known as Basel I, was issued in 1988, with primary focus on credit risk. It laid the foundation of risk weighting of assets and set objective targets of capital to be maintained. Basel II was issued in 2004 with the objective of being more comprehensive. It aimed at increasing capital adequacy by imposing a buffer for a larger spectrum of risk. With the passage of time, it has been witnessed that the Basel norms failing to restrict two major crisis during its tenure, the South Asian Crisis in 1998 and Sub-prime Mortgage Crisis in 2007, which raises questions about its effectiveness. As the banking world has started complying with Basel III, the effectiveness of the Basel accord has been subject to criticism. 

Basel I: Capital adequacy against credit risk 

Basel I Accord attempts to create a cushion against credit risk. It comprises of four pillars, namely : 

(i) Nature of Capital: It prescribes the nature of capital that is eligible to be treated as reserves i.e. reserves to be set aside to tackle any credit risk in future. As mentioned above capital to be treated as reserve has been classified into Tier I and Tier II Capital. Tier I is the capital that has the high capacity to absorb losses. Tier II capital comes into picture only when the company is wound up. 

(ii) Risk Weighting: Risk Weighting means creating a systematic mechanism to provide weights to different categories of bank’s assets (on balance sheet as well as off balance sheet assets) on the 

basis of their relative riskiness. Risk Weighting has been discussed above under the heading ‘The degree of % weights risk assigned by the Reserve Bank of India’. 

(i) Target Standard Ratio: It provides unification of the first two pillars. It prescribes that Tier I and II capital should cover atleast 8 % of risk weighted assets of a bank, with at least 4% being covered by Tier I capital alone. 

(ii) Transitional & implementing arrangements: It sets different stages of implementation of the Basel I accord in a phased manner. Due to undercapitalization of the banking sector at that time, a phased manner of implementation was agreed upon, wherein a target of 7.25 percent was to be achieved by the end of 1990 and 8 percent by the end of 1992. 

Basel II: Comprehensive framework with buffer for larger spectrum of risks 

Basel II retained the ‘pillar’ framework of Basel I, yet crucially expanded the scope and specifics of Basel I. 

The 4 pillars were amended as follows: 

(i) Minimum Capital Requirements, risks & target adequacy ratio: The first task was to define reserve which is as follows: 

Reserves = 8% * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves The above formula has been defined with the help of an example: 

The term ‘Risk Weighted Assets’ has already been discussed in the preceding paragraphs. Operational Risk relates to breakdown in internal procedures, people and systems. Examples of operational risks include hiring of substandard people at work at lower salary, inappropriate maintenance of equipment and machinery and fraudulent practices employed by people at work. Lastly, market risk is the risk that the company’s investors may suffer loss due to turbulence in the financial market. 

(ii) Regulator-Bank Interaction: This gave power to the regulators in supervision and dissolution of banks, giving them freedom to set buffer capital requirement above the minimum capital requirement as per pillar I. 

(iii) Banking Sector Discipline: It aims to foster discipline by prescribing adequate disclosures about capital and risk profile to the regulators and public. 

Limitations of Basel II norms which lead to the introduction of Basel III norms 

Although Basel II was a comprehensive capital regulations framework, it failed to combat the circumstances which surfaced after the 2007-08 financial crises. The limitations of Basel II norms have been briefed in the following paragraph in order to have a better understanding as to why Basel III norms have been introduced: 

· There was no stipulation for additional buffer capital. Only during stressed situations banks are asked to bring in additional capital. Failure on the part of the banks to bring in additional capital 

when required may lead an economy into a recession. The reason is that industry may not get the required additional capital when required. 

· Most of the assets of the banks were securitized bonds, derivatives products and other toxic assets (such as mortgage backed securities for e.g. collaterised debt obligations) which cannot be liquidated at the time of crises. 

· Banks were high on debt and there was no regulation for limiting the debt. 

· Basel II also failed to address liquidity risk which may ultimately lead to solvency risk. 

· The focus of Basel II was basically on individual financial institutions. It ignored the interconnection among various financial markets. 

Basel III norms 

Basel III is a comprehensive set of reforms which aims to strengthen the regulation, supervision and risk management of the banking sector. 

The Reserve Bank issued Guidelines based on the Basel III reforms on capital regulation on May 2, 2012 which have been implemented from April 1, 2013 in India in phases and it will be fully implemented as on March 31, 2019. 

The basic structure of Basel III remains similar with three pillars which are briefly discussed as below 

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

Maintaining capital calculated through credit, market and operational risk areas. 

Pillar 2: Supervisory Review Process: Regulating tools and frameworks for dealing with peripheral risks that banks face. 

Pillar 3: Market Discipline: Increasing the disclosures that banks must provide to increase the transparency of banks. 

Basel III is an improvement over earlier Accords i.e. Basel I and Basel II which can be clarified by going through the following characteristics of Basel III: 

Major characteristics of Basel III 

(a) Better Capital Quality: One of the major changes made in Basel III is the introduction of stricter definition of capital. Better quality capital leads to higher loss-absorbing capacity. 

(b) Capital Conservation Buffer: Another major change in Basel III is that now banks will be required to hold a capital conservation buffer of 2.5%. The purpose of maintaining conservation buffer is to make sure that banks maintain a balance of capital that can be used to absorb losses during periods of financial and economic stress. 

(c) Countercyclical Buffer: This is also one of the important points of Basel III. The countercyclical buffer has been introduced with the objective to enhance capital requirements in good times and reduce the same in bad times. The buffer will slow banking activity when surplus money is flowing into the

system and will encourage lending when times are tough i.e. in times of credit squeeze (shortage of money). The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss- absorbing capital. 

(a) Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 5.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 7%. Although the minimum total capital requirement will remain at the current 9% level, yet the required total capital will increase to 11.5% when combined with the capital conservation buffer (maximum prescribed limit is 2.5% of RWAs). 

(b) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not risk- weighted). This aims to put a cap on unnecessary increase of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018. 

(c) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively. 

Composition of Capital in the Capital Adequacy Ratio (CAR) under Basel III norms 

Banks are required to maintain a minimum CAR of 9%. Further, the RBI will judge whether the capital held by the bank is commensurate with the risk profile of the bank. So, RBI ensures this by vetting the effectiveness of the bank in identifying, measuring, monitoring and managing various risks. This includes interest rate risk and liquidity risk. Hence, RBI will consider prescribing a higher level of minimum capital ratio for each bank on the basis of their risk profile and risk management systems. 

Capital Adequacy Ratio requirements shall be complied with by a bank at two levels: 

(i) The consolidated Capital Adequacy Ratio Requirements – It measures the capital adequacy of a bank after consolidating the assets and liabilities of its subsidiaries, joint ventures and associates. 

(ii) The standalone Capital Adequacy Ratio Requirements–As the name indicates, it measures the capital adequacy of a bank only on the basis of its sole capital and risk profile. 

Now, computation of ratios under various segregation of regulatory capital in the capital adequacy ratio is as follows: 

Common Equity Tier 1 capital ratio = Common Equity Tier 1 Capital 

Credit Risk RWA + Market Risk RWA + Operational Risk RWA

Equity Tier 1 Capital ratio = Equity Tier 1 Capital 

Credit Risk RWA + Market Risk RWA + Operational Risk RWA 

Total capital ratio (CRAR) = Equity Total Capital 

Credit Risk RWA + Market Risk RWA + Operational Risk RWA 

Here, RWA = Risk Weighted Assets 

CRAR = Capital to Risk Weighted Asset Ratio 

Segregation of Regulatory Capital –Capital in the CAR will consist of the sum of following categories: 

(i) Tier 1 Capital 

(a) Common Equity Tier 1 

(b) Additional Tier 1 

(ii) Tier 2 Capital 

Limits of Segregated Regulatory Capital 

(i) Capital Adequacy Ratio of 9% is prescribed by RBI. 

(ii) Further, Common Equity Tier 1 must be atleast 5.5% of risk weighted assets which includes credit risk, market risk and operational risk. 

(iii) And, additional tier 1 capital must be at the maximum 1.5% of RWA. Therefore, total Tier 1 capital must be atleast 7% (5.5 + 1.5) of RWAs. 

(iv) Lastly, Tier 2 Capital can be admitted maximum upto 2 percent. 

(v) Therefore, total prescribed limit of Tier 1 capital and Tier 2 Capital is 9% (7% tier 1 and 2% tier 2). This leads to a minimum CAR of 9% as mentioned in point (i) above. 

Tier 1 capital is the core measure of a bank's financial strength. It is composed of core capital, which consists primarily of equity share capital and retained earnings. 

Tier 2 capital is the supplementary capital which can be utilized after the winding up of the company. It includes Perpetual Non-Cumulative Preference Shares and debt capital. 

Conclusion 

The basic aim of Basel norms is to create a global banking system that is fairly at the same level. This helps to create a strong financial system worldwide.However, it is not free from some of the limitations. 

In this context, Persaud (2000, 2001) had remarked that a market being large is not sufficient for it to be highly stable and liquid. It must also show a broad range of participants having different objectives as one of the key characteristics. He further expressed that local knowledge is a key competitive advantage to a bank.

The Basel norms tend to overlook national competencies. If we take into account the global scenario there is a vast difference in the extent of development of individual countries. In the present global situation, international banks continue to overshadow the local banks. So, the differences across geographies can be a tricky issue to handle. Therefore, the Basel norms need to include some form of national competencies so as to create level playing field. 

While the Basel norms strive to bring a lot of benefits, they generate high costs for the nations adopting such norms. This is especially true because there is no single set of dates for the implementation of a particular Basel regulation (such as Basel III) worldwide.