Capital Adequacy Compliance Capital adequacy norms for banks have been introduced with a view to improve financial soundness and stability, to provide stable resources to absorb losses and to enhance loss absorption capacity to meet business risks. The division of capital fund held by banks has been classified on the basis of the characteristics of the instrument, quality of the instrument and the supervisory requirements. Capital funds are hence kept in Tier I and Tier II forms. Supervisory requirements as per Basel committee norms states the elements of Tier I capital to include paid up capital, statutory reserves, free reserves, capital reserves, perpetual non cumulative preference shares, innovative perpetual debt instruments and capital reserves representing surplus arising out of sale proceeds of assets. Tier II capital includes undisclosed reserves, revaluation reserves, general provisions, loss reserves, hybrid capital instruments, subordinated debt and investment reserve account. Tier I capital for foreign banks consists of interest free funds from head office kept in a separate account in India, innovative instruments eligible for inclusion, statutory reserves kept in India and remittable surplus retained in India which the bank cannot repatriate. Tier II capital of foreign banks consists of those items applicable to Indian banks and head office borrowings raised in foreign currency. Foreign banks are required to furnish an undertaking to Reserve Bank of India that funds included under Tier I capital will be retained in India as long as the bank functions in India. Besides this an auditor certificate to the effect that funds representing surplus remittable to head office including provision towards tax or for any contingencies be furnished to Reserve Bank of India. Foreign banks are permitted to hedge entire Tier I capital subject to certain conditions. Equity and non-equity investment in subsidiaries are to be deducted at 50% from Tier I and Tier II capital of the parent bank while assessing capital adequacy. In case of securitization of standard assets the first loss credit enhancement provided by the originator of securitized transaction can be deducted at 50% from Tier I and Tier II capitals of the bank. In case of second loss credit enhancement the deduction is 50% from Tier I and Tier II capital. Securities issued by special purpose vehicles held by banks in excess of 10% of the original amount of issue shall be deducted at 50% from Tier I and Tier II capital. Tier II capital is limited to a maximum of 100% of total Tier I capital for compliance purposes. Capital adequacy ratio is computed with reference to risk weighted assets. These requirements specify that 9% of risk weighted assets is the capital requirement for existing banks. This is 10% in case of new private sector banks. If the bank is carrying on insurance business, the capital adequacy is stated as 10%. For local area banks the capital adequacy ratio has been specified as 15%. Tier I capital should at any point of time be less than 50% of total capital.

Basel Framework for Capital Adequacy Basel committee norms for capital adequacy are comprehensive covering requirements for several capital transactions. For each of the risk prone assets several computation procedures have been suggested. Credit adequacy computation with reference to each type of risk such as credit risk, operational risk and market risk are also indicated by the Basel committee. Stages of Computation •

Step 1 –

•

Notional principal amount of each instrument is multiplied by the percentages Maturity

Conversion Factor

One year & less

0.5%

1 year > 5 years

1.10%

Over five years

3.05%

Step 2 –

Adjusted value thus obtained is to be multiplied by the risk weight allotted to the relevant counterparty Computation of Position of Interest Rate Derivatives

Instrument

Specific risk change

General market risk charges

Exchange traded futures • Government debt security • Corporate debt security • Index on interest rate

No Yes No

Yes Yes Yes

OTC forwards • Government debt securities • Corporate debt securities • Index on interest rate

No Yes No

Yes Yes Yes

Forward rate agreements and swaps

No

Yes

Forward foreign exchange

No

Yes

Options • Government debt securities • Corporate debt securities • Index on interest rate • Forward rate agreements, and swaps

No Yes No No

Computation of Capital for Market Risk

(Amount

Risk

Capital charge

Interest Rate

General market Risk

)

XXX

Net position (parallel shift) Horizontal disallowance Vertical disallowance (basics) Options Specific market risk

XXX

General market risk

XXX

Specific risk

XXX

Foreign exchange & gold

XXX

Total capital

XXXX

Computation of Capital for Market Risk

(Amount in value)

Capital Funds

XXX

Tier I capital

XX

Tier II capital

XX

Risk Weighed assets

XXX

Risk weighted assets for credit risk

XX

Risk weighted assets for market risk

XX

Total CRAR

XX

Minimum capital required to support credit risk (Risk weighted assets for credit risk x 9%)

XX

Tier I (4.5% x Risk weighted assets for credit risk)

XX

Tier II (4.5% x Risk weighted assets for credit risk)

XX

Capital applicable to support market risk (Capital fund – Minimum capital required to support credit risk)

XX

Tier-I (Tier I capital –Tier I capital requirement to support credit risk)

XX

Tier-II (Tier II capital –Tier II capital requirement to support credit risk)

XX

Risk Weights for Computation of Capital Charge for Credit Risk Sr. No. I Balances

Item of asset or liability

Risk Weight%

1.

Cash, balances with RBI

0

2.

i. Balances in current account with other banks

20

ii. Claims on Bank

20

II

Investments (Applicable to securities held in HTM)

1.

Investments in Government Securities

0

2.

Investments in other approved securities guaranteed by Central/

0

State Government. If the repayment of principal / interest in respect of State Government Guaranteed securities included in item2, 4 and 6 has remained in default, for a period of more than 90 days banks should assign100% risk weight. However the banks need to assign 100% risk weight only on those State Government guaranteed securities issued by the defaulting entities and not on all the securities issued or guaranteed by that State Government.

3.

0

Investments in other securities where payment of interest and repayment of principal are guaranteed by Central Government. (Investments in Indira Kisan Vikas Patra (IVP/KVP) and investments In bonds and debentures where payment of interest and principal is guaranteed by Central Government.)

4.

0

I Investments in other securities where payment of interest and repayment of principal are guaranteed by State Governments.

5.

20

Investments in other approved securities where payment of interest and repayment of principal are not guaranteed by Central/State Govt.

6.

Investments in Government guaranteed securities of Government undertakings which do not form part of the approved market borrowing program.

20

7.

Claims on commercial banks

20

8.

Investments in bonds issued by other banks

20

9.

Investments in securities which are guaranteed by banks as to payment of interest and repayment of principal.

20

10.

Investments in subordinated debt instruments and bonds issued by other banks or public financial institutions for their Tier II capital.

20

11

Deposits placed with SIDBI/NABARD in lieu of shortfall in lending to priority sector.

100

12

Investment in mortgage backed securities (MBS) of residential assets of housing finance companies (HFCs) which are recognized and supervised by National Housing Bank

50

13

Investment in mortgage backed securities (MBS) which are backed by housing loan qualifying for 50% risk weight.

50

14

Investment in securitized paper pertaining to an Infrastructure facility.

50

15

Investments in debentures/ bonds/ security receipts/ Pass through certificates issued by securitization company / SPVs/ reconstruction company and held by banks as investment

100

16

All other investments including investments in securities issued by

100

private financial institutions. 17

Direct investment in equity shares, convertible bonds, debentures and units of equity oriented mutual funds

125

18

Investment in mortgaged backed securities and other securitized exposures to commercial real estate

150

19

Investments in venture capital funds

150

20

Investments in securities issued by SPVs underwritten on originator banks during the stipulated period of three months

100

21

Investments in securities issued by SPVs in respect of securitization of standard asset underwritten on bank as third party service provider during the stipulated period of three months

100

22 NPA Investment purchased from other banks

100

23 Investments in instruments issued by non banking finance companies ND-SI

125

III Loans & Advances including bills purchased and discounted and other credit facilities 1

Loans guaranteed by Government of India

0

2

Loans guaranteed by State Governments.

0

3

Loans granted to public sector undertakings of Government of India.

100

4

Loans granted to public sector undertakings of State Governments.

100

5

For the purpose of credit exposure,

20

i)

Bills purchased /discounted/negotiated under letter of credit (LC) is treated as an exposure on the LC issuing bank and assigned risk weight as is normally applicable to inter-bank exposures.

ii)

Bills negotiated under LCs, bills Purchased /discounted/negotiated without LCs,

6

(i) Govt

0

(ii) Banks

20

(iii) Others

100

Others including PFIs

100

7

Leased assets

100

8

Advances covered by DICGC(Deposit insurance and credit guarantee)/ECGC

50

9

Small scale industry advances guaranteed by Credit Guarantee Fund Trust for Small Industries (CGTSI) up to the guaranteed portion.

0

10 Insurance cover under business credit shield

50

12 Loans and advances granted to staff of banks which are fully covered by superannuation benefits and mortgage of flat/house.

20

13 Housing loans above Rs. 30 lakh sanctioned to Individuals against the mortgage of residential housing properties having LTV(Loan to values) ratio equal to or less than 75%

75

14 Housing loans upto Rs. 30 lakhs sanctioned to Individuals against the mortgage of residential housing properties having LTV(Loan to values) ratio equal to or less than 75%.

50

15 Housing loans of Rs. 75 lakh and above sanctioned to individuals (irrespective of LTV(Loan to values) ratio)

125

16 Consumer credit including personal loans and

125

i)

credit cards Educational Loans

17 Loans up to Rs. 1 lakh against gold and silver ornaments

50

18 Takeout Finance

20

(i) Unconditional takeover (in the books of lending institution)

20

(a) Where full credit risk is assumed by the taking over institution

100

(b) Where only partial credit risk is assumed by taking over institution i) the amount to be taken over ii) the amount not to be taken over 18 (ii) Conditional take-over (in the books of lending and Taking over institution)

100

19 Advances against shares to individuals for investment in equity shares (including IPOs/ESOPs), bonds and debentures, units of equity oriented mutual funds, etc.

125

20 Secured and unsecured advances to stock brokers

125

21 Fund based exposures commercial real estate

150

22 NPA purchased from other banks

100

23 Loans & Advances NBFC-ND-SI

125

IV Other Assets 1

Premises, furniture and fixtures

100

2

Income tax deducted at source (net of provision)

0

Advance tax paid (net of provision)

0

Interest due on Government securities

0

Accrued interest on CRR balances and claims on

0

RBI on account of Government transactions (net of claims of Government/RBI on banks on account of such transactions) All other assets

100

Capital Adequacy of Banks in India The Narasimham committee appointed for framing new economic policy in 1991 endorsed the Basel committee norms for adoption by India banks. Accordingly Reserve Bank of India issued directions for adoption of Basel I norms in 1992. Later Basel II norms have been adapted from March 2008. At present there is a three track approach for compiling with Basel norms. Initially all commercial banks should comply with Basel I norms regarding credit and market risk. Urban cooperative banks should maintain capital for credit risk as per Basel I norms and for market risk through surrogate charges. Rural banks follow capital adequacy norms but these are not on par with Basel norms. Accordingly capital adequacy standards for commercial banks have been determined and implemented. Reserve Bank of India announced in May 2004 that banks in India should examine the options available under Basel II norms for revised capital adequacy framework and latter issued draft guidelines for implementation. These were to be adopted by March 2008. Although all commercial banks are preparing for adoption of revised capital adequacy norms as per Basel II recommendations the complexity and intense data requirements for implementation has brought out several challenges. Some of the challenges are linking of credit rating with regulatory capital standards, unfavorable effect on credit flows due to inequality in the sovereign ratings of developing and emerging countries compared to developed and industrialized countries. Differential weights adopted by Reserve Bank of India for non-scheduled banks and financial institutions, extensive data requirements, advanced computational procedure and cost of implementation are the other challenges faced by banks in the implementation of Basel II norms for capital adequacy. Disclosure of capital adequacy Banks are required to disclose their capital adequacy compliance in a detailed manner indicating compliance for Tier I and Tier II capitals, adjustments made, assumptions of the method adopted and details of capital adequacy for each type of risk coverage namely market risk, operational risk and credit risk. An illustration of capital adequacy compliance is provided below. Equity Capital •

Bank has authorized share capital of XX crores comprising XXXX equity shares of 10/- each.

•

Bank has issued, subscribed and paid-up equity capital of XX crores, constituting XXXX number of shares of 10/- each.

•

Bank’s shares are listed on the National Stock Exchange and the Bombay Stock Exchange.

•

GDRs issued by the bank are listed on the London Stock Exchange (LSE).

•

During the year, the Bank has also allotted equity shares to employees under its Employee Stock Option Plan.

Debt Instruments •

Bank has raised capital through –

Innovative Perpetual Debt Instrument (IPDI) eligible as Tier 1 Capital

–

Tier 2 capital in the form of Upper Tier 2

–

Subordinated bonds (unsecured redeemable non-convertible debentures)

•

Perpetual Debt Instrument

•

The Bank has raised Perpetual Debt Instruments eligible as Tier 1 Capital

Tier I Capital Date of Allotment

Rate of Interest

Period

Amount

30 September 2006

10.05%

Perpetuity

XXX Cores

15 November 2006

7.167%

Perpetuity

USD XX million INR (XXX Cores)

Total

XXX Cores

Conversion Rates XX / USD (as on 31/3/2011)

Tier II Capital Date of Allotments

Rate of Redemption

Rate of Interest

Amount

11 August 2006

10 August 2021

7.25%

USD XX million INR (XXX crore)

24 November 2006

23 November 2021

9.35%

XX Crore

6 February 2007

6 February 2022

9.5%

XX Crore

28 June 2007

28 June 2022

7.125%

USD XX million INR (XXX) Crore

Total

Subordinated Debt

XXX Crore

Date of Allotment

Date of Redemption

Rate of Interest

Amount

20 Sep 2002

20 June 2012

9.3%

XX

21 Dec 2002

21 Sep 2012

8.95%

XX

26 July 2003

26 April 2011

6.70%

XX

26 July 2003

24 April 2013

7.00%

XX

15 June 2004

15 Oct 2013

6.5%

XX

25 July 2005

25 July 2012

Average 1 year benchmark + 65 basis

XX

22 March 2006

22 July 2013

8.5%

XX

22 March 2006

22 Jun 2013

8.32%

XX

22 March 2006

22 March 2016

8.75%

XX

22 March 2006

22 March 2016

8.56%

XX

28 June 2006

28 Sep 2013

8.95%

XX

30 March 2007

30 March 2017

9.1%

XX

7 Nov 2008

7 Nov 2018

11.75%

XX

28 March 2009

28 March 2019

9.95%

XX

16 June 2009

16 June 2019

9.15%

XX

Total

XXX

Capital Fund Capital A Tier 1 Capital •

Paid-up Share Capital

• Reserves and surplus (Excluding Foreign Currency Translation Reserve) •

Innovative Perpetual Debt Instruments

•

Amount deducted from Tier 1 capital

•

Investments in subsidiaries

•

Deferred Tax Assets

XXX XX XX XX

XX XX

B Tier 2 Capital (net of deductions) (B.1+B.2+B.3-B.4) B.1 Debt Capital Instruments eligible for inclusion as Upper •

XX Tier 2 Capital

Total amount outstanding

XX

•

Of which amount raised during the current year

XX

•

Amount eligible as capital funds

XX

B.2 Subordinated debt eligible for inclusion in Lower Tier Capital •

Total amount outstanding

XX

•

Of which amount raised during the current year

XX

•

Amount eligible as capital funds

XX

B.3 Other Tier 2 Capital - General provisions and loss reserves

XX

B.4 Deductions from Tier 2 Capital •

Investments in Subsidiaries

C Total Eligible Capital

XX XX

Capital Adequacy Banks are subject to the capital adequacy guidelines stipulated by RBI, which are based on the framework of the Basel Committee on Banking Supervision. As per the capital adequacy guidelines under Basel I, the bank is required to maintain a minimum ratio of total capital to risk weighted assets (CRAR) of 9.0%, at least half of which is required to be Tier 1 capital. As per Basel II guidelines, banks are required to maintain a minimum CRAR of 9.0%, with minimum Tier 1 capital ratio of 6.0%. In terms of RBI guidelines for implementation of Basel II, capital charge for credit and market risk the banks are required to maintain at the higher levels implied by Basel II or 80% of the minimum capital requirement computed as per the Basel I framework. An assessment of the capital requirement of the banks are carried out through a comprehensive projection of future businesses that takes cognizance of strategic intent of the banks, profitability of particular businesses and opportunity for growth. Mapping of credit, operational and market risks to this projected business growth enables assignment of capital that not only adequately covers the minimum regulatory capital requirement but also provides for growth. Calibration of risk to business is enabled by a strong risk culture in the banks aided by effective, technology based risk management systems. Capital Requirements for various Risks

Credit Risk

Capital

Capital requirements for Credit Risk •

Portfolios subject to standardized approach

XX

•

Securitization exposures

XX

Market Risk Capital requirements for Market Risk •

Standardized duration approach

XX

•

Interest rate risk

XX

•

Foreign exchange risk (including gold)

XX

•

Equity risk

XX

Capital requirements for Operational risk •

Basic indicator approach

XX

Capital Adequacy Ratio of the Bank

(X%)

Tier 1 CRAR

(X%)

Tier II CRAR

(X%)

Questions 1. Discuss Basel Committee recommendations for capital adequacy. 2. What are the initiatives taken by RBI to comply with capital adequacy norms of Basel committee? 3. What is Three Track Approach of RBI for the implementation of capital adequacy? 4. Explain the steps in the computation of capital adequacy of commercial banks. 5. What are the guidelines for capital adequacy of foreign banks in India? 6. Explain the procedure for credit risk compliance for capital adequacy. 7. Explain how market risk compliance of capital adequacy is achieved. 8. Explain the computation of capital adequacy requirement for operational risk compliance. 9. What are the disclosure norms for commercial banks regarding capital adequacy. 10. What are the challenges faced by commercial bank in the implementation of Basel II norms of capital adequacy.

Key Words Capital adequacy, undisclosed reserves, revaluation reserves, general provisions, loss reserves, hybrid capital instruments, subordinate debt, investment reserves, floating reserves, perpetual

cumulative preference shares, redeemable non cumulative preference shares, redeemable cumulative preference shares, available for sale securities, held for trading securities, capital adequacy ratio, capital charge.