capital adequecy ratio

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CAR and Basel Norms I, II & III

Prof. Divya Gupta


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What is BIS?

The BIS, set up in 1930, in Swiss city Basel,

the oldest international financial institution. It

is increasingly recognized as the principalcenter for international central bank

cooperation.


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What is BCBS (Basel Committee onBanking Supervision)

This is a committee appointed by BIS to look

into the adequacy of capital of banks with

international presence. And the most farreaching of these initiatives was the laying

down of minimum capital standards in 1988,

known as Basel Capital accord.


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Capital adequacy ratio (CAR)

It is the ratio of the banks capital to itsrisk weighted assets. To assess the capital

adequacy of banks based on this ratio itis essential to understand three aspects:

Composition of Capital

Composition of Risk weighted assets

Assigning Risk Weights


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It is the most important measure of banks

soundness. It acts as a buffer.

Adequacy is expressed as a minimumnumerical ratio which the banks are expected

to maintain.

CAR= Capital / RWAsCapital = Tier I + Tier II


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Risk Adjusted Assets & off B/S

items: Risk adjusted assets would mean weighted

aggregate of funded and non-funded items.

Degrees of credit risk expressed as percentageweightings have been assigned to B/S assets &conversion factors to off-balance sheet items.

For ex. Banks investments in all securities shouldbe assigned a risk weight of 2.5 % for marketrisk. (addition to credit risk)


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Risk weight on different items of Assets &Off B/S items

s.n Item of assets Risk weight

(in%)

1 Cash bal with RBI, other banks 0

2 Investment in govt, central or state govtsecurities

2.5

3 Investments in bonds issued by banks 22.5

4 Loans granted to PSU or others 100

5 Housing loans against mortgage 50

6 Premises, furniture & fixtures 100

7 Guarantee issued by bank 20

8 Forward asset purchase & forward 100


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Advances against LIC, FD, NSC and Kisan

Vikas Patra where adequate margin isavailable would carry Zero weight.

Loans to staff would also carry Zeroweight.


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Capital Funds

Basel committee has defined capital in two tiers:

Tier I Tier I capital is the core capital, which

provides the most permanent and readilyavailable support against unexpected losses

Tier II Tier II capital will consist of elementsthat are not permanent in nature or are notreadily available


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Tier - I

Tier I capital in the case of Indian Banks consist of:(Core capital)

1. Paid up capital

2. Statutory reserves3. Disclosed free reserves4. Capital reserves representing surplus arising out of sale

proceeds of assets. Accumulated losses will be deducted from Tier I

Capital. Equity investment in subsidiaries and intangible assets

will also be deducted from Tier I capital.


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Tier II Capital

Tier II capital in the case of Indian Banksconsist of: (Supplementary capital)

* Undisclosed reserves

* Asset revaluation reserves

* General provisions and loss reserves

* Hybrid Capital instruments

* Cumulative perpetual preference shares


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Limits and Restrictions:

The total of Tier II (supplementary) elementswill be limited to a maximum of Tier 1 elements.

Subordinated debt will be limited to a maximum

of 50% of Tier 1 elements. General provisions is eligible for inclusion in Tier

II will be limited to a maximum of 1.25% of riskweighted assets.

Asset revaluation reserve which has taken theform of latent gains will be subject to a discountof 55%


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Subordinated Debts:

These debts in Tier 2 capital are subject to the followingdiscounts.

Remaining maturity of

instruments

Rate of discount

Less than 1 year 100%

1 year and more but less than 2years

80%

2 year and more but less than 3years 60%

3 year and more but less than 4years

40%

4 year and more but less than 5

years20%


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Reporting

Maintenance of CAR 9%

Reporting: Banks should furnish annual return after every

year ending indicating:Capital funds

Conversion of Off balance sheet assetsCalculation of risk weighted assetsCalculation of capital funds ratio


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What is the original accord or

Basel I accord?The Basel Committee came out with its first document on

International Convergence of Capital measurements and

Capital Standards in 1988 as a harbinger to tone up the

safety and stability of commercial banking in world over.

It requires internationally active banks to hold capital

equal to at least 8% of basket of assets measured in

different ways according to their riskiness .

CAR = Capital / Credit Risk = 8%


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What are the shortcomings of

Basel I accord?1. This is a straight forward one-size-fits-all approach

2. It doesnt distinguish between risk profile and riskmanagement standards across banks

3. All advances carried equal risk weights of 100% ,irrespective it is a blue chip company or itinerant trader

4. It does not account past payment record, a favorable credithistory in respect of the activity or the region where theborrower operated, availability of good collateral whileassigning risk weights.

5. Basel-I concentrated only on credit risk and eschewedany effort to address other significant banking risks such as

market risk, and operational risk


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What are the risks banks/FIsusually face and their respective

intensities?Out of so many risks the Basel Committee clubbed various risks situation

in three categories

Credit risks-emanates owing to default of the counter parties in respect of

fund and non-fund exposure. It constitutes 95%

Market risk-arises on change of market variable in the form of liquidityconstraints, prices and exchange rates. It constitutes 4%

Operational risks-results from inadequate or failed internal process,

people and systems or external events. It constitutes 1%

The above percentage is only indicative and may widely vary in differentbanking environment and again bank to bank position


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Tier 3 capital

The capital required as defined in the BaselMarket Risk Amendment dated 25th Nov, 2005.

It consists of short term subordinated debt for

the sole purpose of meeting a proportion of thecapital requirements for market risks.

Tier 3 capital will be limited to 250% of a banksTier 1 capital that is required to support for

market risks. This means that minimum of 28.5% of market

risks needs to be supported by Tier 1 capital.


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What is Basel-II?

To make the system more compliance to changing

environment Basel- I has been revised to new accord

Basel - II. Primarily it calls for distinguishing among various

risk and more importantly quantifying them.CAR=Capital/Credit Risk + Market, Risk + Operational Risk

It rests on a set of three mutually reinforcing pillars

namely

1. Minimum Capital Requirement

2. Supervisory review

3. Market Discipline


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What is Pillar - 1?

Pillar - 1 is the minimum capital requirement

Minimum Capital Requirements

Market RiskCredit Risk

Standardized

Approach

IRB StandardizedApproach

Modern

Approach

Foundation IRB

Advanced IRB

Operational Risk

Basic Indicator

Approach

Standardized

Approach

Advanced

Measurement

Approach


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What is Pillar 2?

It is Supervisory Review. It is based on four principles

Banks should have a process for assessing their overall capital

adequacy in relation to their risk profile.

Supervisors should review and evaluate banks internal capital

adequacy assessments and strategies also their ability to monitor and

ensure their compliance with regulatory capital ratios

Supervisors expect banks to operate the minimum regulatory capital

ratios and should have the ability to require banks to hold capital inexcess of minimum

An early intervention to prevent capital falling from minimum level.


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What is the Pillar 3?

Third pillar is about Market Discipline. This tellsabout self disclosure regarding

Financial Position

Risk Management Strategies and Practices

Risk Exposures

Accounting Policies

Information relating to basic business Management and corporate governance

practices


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What are the challenges it

faces while implementing it?As it is mandated by the regulator, RBI, to implement the accord from

first fiscal of 2007, but it faces some difficulties. These are

More capital requirements

Impact on profitability due to huge implementation costs, particularlyfor smaller banks

As the level of rating penetration is very low, the rating of borrowersin all cases an uphill task and sometimes it feared of biasing

Given the paucity of supervisory resources, there is a need to reorientthe resource deployment strategy


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The required ratio of Common Equity Tier 1 capital torisk-weighted assets will go up from 2% to 4.5% underBasel III. This percentage will also be more difficult to

meet as Basel III have introduced stricter regulatoryadjustments. These new capital requirements will beprogressively phased in between 1 January 2013 and 1January 2015

In addition, the minimum total Tier I capital requirementwill increase from 4% to 6% under Basel III


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Capital conservation bufferBasel III has also introduced a capital conservation

buffer which requires an additional 2.5% of CommonEquity Tier I capital to be held over and above theabsolute minimum requirements. This buffer isintended to be available to be drawn down duringperiods of stress.


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Definition of 'Liquidity Coverage Ratio - LCR'

Highly liquid assets held by financial institutions in orderto meet short-term obligations. The Liquidity coverageratio is designed to ensure that financial institutions have

the necessary assets on hand to ride out short-termliquidity disruptions. Banks are required to hold anamount of highly-liquid assets, such as cash or Treasurybonds, equal to or greater than their net cash over a 30

day period (having at least 100% coverage). Theliquidity coverage ratio started to be regulated andmeasured in 2011, but the full 100% minimum won't beenforced until 2015. '


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The liquidity coverage ratio is animportant part of the Basel Accords, as

they define how much liquid assets haveto be held by financial institutions.Because banks are required to hold a

certain level of highly-liquid assets, theyare less able to lend out short-term debt.


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The Net Stable Funding

Ratio (NSFR)

The net stable funding (NSF) ratio measures the amount oflonger-term, stable sources of funding employed by aninstitution relative to the liquidity profiles of the assetsfunded and the potential for contingent calls on fundingliquidity arising from off-balance sheet commitments andobligations. The standard requires a minimum amount offunding that is expected to be stable over a one year timehorizon based on liquidity risk factors assigned to assets

and off-balance sheet liquidity exposures. The NSF ratio isintended to promote longer-term structural funding ofbanks balance sheets, off-balance sheet exposures andcapital markets activities.


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capital adequecy ratio

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