Banking Industry in India

A RESEARCH PROJECT ON
BANKING INDUSTRY IN INDIA: IMPACT OF BASEL-II NORMS ON CAPITAL ADEQUACY OF BANKS

Submitted in the partial fulfillment of requirement for the Degree of
MASTER OF BUSINESS ADMINISTRATION

(2005-07)
Supervised by: Dr. Mahesh Garg Reader Department of Business Management
Submitted by: Akanksha Jain Roll No. 0510404 MBA (Finance) Final
G.J.U.S&T Hisar
GURU JAMBHESHWAR UNIVERSITY of Science and Technology, HISAR
DEPARTMENT OF BUSINESS MANAGEMENT
DEPARTMENT OF BUSINESS MANAGEMENT
GURU JAMBHESHWAR UNIVERSITY of Science and Technology, HISAR

Ref Date..
Dr. Mahesh Garg Reader
CERTIFICATE
This is to certify that Akanksha, student of MBA (Finance) final year Roll No. 0510404 has worked under my supervision and guidance on the Research Project entitled- Banking Industry in India: Impact of Basel-II norms
on Capital Adequacy of Banks

The project is completed in the partial fulfillment for the requirement of the degree of MBA. The matter used in the project is original and authentic to the best of my knowledge. I recommend that the project is fit for evaluation. I wish her all success in life and future.
(Dr. Mahesh Garg)
Acknowledgement
First of all , we thank the almighty for giving this precious gift of life so that we can learn and keep learning. A project report is never the sole product of a person whose name appears on the cover. There is always the help, guidance and suggestions of many in preparation of such a report. I feel great pleasure to present this project report on Banking Industry in India: Impact of Basel -II norms on Capital Adequacy of Banks with the hope that it will be up to desire expectations and receive immense approval. So, I have indebted to several people who have helped me in completing my project. I wish to express my sincere thanks to Dr. Mahesh Garg, Reader, Department of Business Management, GJUS&T, Hisar for their co-operation ,motivation, invaluable guidance, sympathetic and encouraging attitude at every stage of preparation of this project His keen interest, timely and constant encouragement and generous cooperation gave me confidence and strength to progress this report. His valuable advice, constructive criticism and suggestion during course of my study really helped me a lot. I also thank him for providing full facilities required in submitting our report within a limited time span. I express my sincere thanks to all those who directly or indirectly helped me in the successful completion of this project. Finally, I am thankful to my parents and God for their blessings and showing me the right way at all moments. (Akanksha Jain)
Preface
The first task of a corporate entity is to proceed to mobilize its capital. The entity can receive public credibility and acceptance only after its capital is adequately subscribed. Since commercial banks mobilize huge savings from the public accumulating demand and short-term liabilities to deploy these funds in a portfolio of investment and credit products, it devolves a huge customer base and thrives on customer support. A commercial bank survives and sustains itself on account of the implicit thrust and confidence reposed by the public in its solvency and credit worthiness. The adequacy of the capital of the institution guaranteeing its assured ability to discharge its payment obligation at any time is the solid edifice on which this confidence and trustworthiness are built. The first Capital Accord of 1988 played a positive role in strengthening the soundness and stability of banks and enhanced the competitive equality among international banks. The Accord provided a framework for a fair and reasonable degree of consistency in the application of capital standards in different countries, on a shared definition of capital. Due to rapid transformation of the financial market since 1988 Accord, situation has arisen where regulatory capital alone may not be a good indicator of financial condition of banks. It is therefore, essential that the capital, which supervisors mandate the institutions to hold, should be adequate to cover the risks to which the institutions are exposed. After the guidelines prescribed in Basel-I Accord, which laid stress on Capital Adequacy norms (prescribed capital adequacy was 8%), an improved version in the form of Basel-II Accord finally arrived laying better and much needed stress on market risk as well. It revised capital adequacy to 9% and also suggested scientific measurement and measurement of various other risks as well which were earlier not considered in Basel-I Capital Accord. The above project throws light on the various risks covered under the Basel-II norms and the impact of these norms on the capital adequacy of banks.
Contents
Chapter 1. 2. 3. Particulars Banking Industry In India Introduction to Capital of Commercial Banks Relevance of Capial Adequacy Basel-1 Accord Introduction Capital Adequacy Ratio-1988 Features of Basel-1988 Accord Computation of CAR Conclusion Basel-11 Accord Introduction Issues specific to new Framework Objectives of the new framework Banks Capital structure and Basel-11 Pillars of Basel-11 Capial Adequacy Ratio Implementation Challenges Impact of Basel-11 Norms Capital Adequacy Ratio of SBI group Reasearch Methodology Need & Objective of the Reasearch Methodology of the Study Analysis and Findings Analysis of CAR Of SBI Group Conclusion Bibliography Page No. 1 4 7 9 10 11 12 20 26 29 30 32 33 35 37 43 45 47 49 56 57 59 61 65 78 85
4.
5. 6. 7. 8.
Chapter-1 Banking Industry In India
Banking Industry In India

Organized banking was active in India since the establishment of the General Bank of India in 1786. After independence, the Reserve Bank of India (RBI) was established as the central bank and in 1955, the Imperial Bank of India, the biggest bank at the time, was taken over by the government to form state-owned State Bank of India (SBI). RBI had undertaken an exercise to merge weak banks to strong banks and the total number of banks thus reduced from 566 in 1951 to 85 in 1969.
With the objective of reaching out to masses and meeting the credit needs of all sections of people, the government nationalized 14 large banks in 1969 followed by another 6 banks in 1980. This period saw enormous growth in the number of branches and the banks branch network became wide enough to reach the weakest sections of the society in a vast country like India. SBIs network of 9033 domestic branches and 48 overseas offices is considered to be one of the largest for any bank in the world.
The economic reforms unleashed by the government in early nineties included banking sector too, to a significant extent. Entry of new private sector banks was permitted under specific guidelines issued by RBI. A number of liberalization and de-regulation measures aimed at consolidation, efficiency, productivity, asset quality, capital adequacy and profitability have been introduced by the RBI to bring Indian banks in line with International best practices. With a view to giving the state-owned banks operational flexibility and functional autonomy, partial privatization has been authorized as a first step enabling them to dilute the stake of the government to 51 per cent. The government further proposed, in the Union Budget for the financial year 2000-01, to reduce its holding in nationalized banks to a minimum of 33 per cent on a case by case basis.
Foreign Banks and New Private Sector Banks
Though the new private sector banks and foreign banks have a lower share in customer deposits (8.2 per cent and 4.9 per cent respectively), they command a higher share of the net profit (9.8 per cent and 10.4 per cent respectively). Due to restrictions on branch expansion, foreign banks traditionally focused their operations on the top 25 cities of the country. However, they differentiated their operations by focusing on premier customers and set superior standards in productivity, customer service and operating efficiencies by using stateof-the-art technology. Global best practices were introduced and practiced. More importantly (as we will discuss later), they built durable competencies by attracting the best manpower, building proprietary technologies and processes and by building strong brand image. The new private sector banks modeled their strategies after the foreign banks. They built much larger branch networks than foreign banks, though small by comparison to public sector banks.
Chapter-2 Introduction To Capital of Commercial Bank
INTRODUCTION
Subsequent to its incorporation and securing a legal status, the first task of a corporate entity is to proceed to mobilize its capital. The entity can receive public credibility and acceptance only after its capital is adequately subscribed. After contribution of promoters' quota and completion of all legal formalities, the offer to the public inviting them to subscribe to the capital of the company is made either through the IPO route or though private placement. Incorporation of the company gives it a legal status. Investing it with adequate capital transforms it as a business entity. Thus the first cash flow into the company is by way of the in-flows on account of capita subscriptions. The capital represents the ownership rights of the company. The Authorized Capital, Issued Capital, Subscribed Capital and Paid-up Capital are all to be disclosed in the company's balance sheet. Capital of the Company consists of different types like Equity Capital, Preference Capital, long-term Loan-Capital or Debt-capital (Debentures or Bonds) and short-term loan capital (Working Capital). The performance of the company is rated on the basis of the return it is able to generate on its capital through the process of its business or service activities. The capital of a corporate body in the strict sense represents only the shareholders equity and retained earnings. This is called the risk capital. The equity share capital contributed by shareholders is not returnable to them. The corporate body is also not bound by law to declare dividends. However as a measure of judicious financial policy corporates always strive towards maximization of equity shareholders wealth. This is accepted as the objective of prudent financial management. Capital of the firm represents the shareholders (owners) stake in the business. It is intended to provide for its stability and continuity and helps to cross over temporary periods of crisis. It also acts as a source of confidence to the other stakeholders of the business and motivates them to come forward and to play their respective roles effectively. From a broader perspective the capital of the firm may include certain other types of longterm liabilities in addition to the shareholders stake. Thus it may include preference share capital, and, debentures, which may be irredeemable, or redeemable over the long term. Though these are repayable, unless the terms of issue specifically term them as irredeemable, their redemption is considered as normally being not met out of the assets of
the company but out of current and future earnings. Where the corporate body is showing adequate profitability, they need not be considered as a direct burden on the assets of the company. These sources may be specified as Tier-II Capital to distinguish them from owners' equity.
Relevance of Capital Adequacy

Capital adequacy is not only relevant in respect of Banks but also of all financial institutions. Capital has a decisive and significant role in the case of all financial intermediaries. The term financial intermediary includes Banks, Investment Companies, Insurance Companies, Development Financial Institutions, Non-Banking Finance Companies, Mutual Funds, etc. All these financial institutions assist in the transfer of savings from economic units/individuals with excess money to those that need capital for investments.
Financial Intermediaries need capital for two reasons: To run operations of their business. To safeguard against the losses, that may arise. Holding adequate capital helps financial intermediaries to survive even during substantial losses. It gives time to re-establish the business and avoid any break in operations. To ensure uninterrupted good performance of Financial Institutions the regulatory authorities have specified the minimum capital for them. This requirement is called Capital Adequacy. RBI has specified it for Banks and Non Banking Financial Corporations (NBFCs). SEBI in turn has prescribed Capital Adequacy for all financial intermediaries under its regulatory authority. IRDA similarly decides the capital requirement of Insurance Companies. But traditionally the concept of capital adequacy linking capital to size and volume of financial operations was not realized. It was only in the 1980s the importance of possessing adequate capital was realized at the level of international banking. Recent developments in the field of international banking are brought in a debate in the Lok Sabha of Indian Parliament.
"Traditionally, deposit taking and lending or the interest payments has been the core business of the banks. But the greater financial deregulation in the world during the Eighties, coupled with revolutionary advances in the communications technology, has changed the very nature of banking. It has unleashed greater competitive pressures. Banks are now deriving an ever-increasing percentage of income from sources other than interest from merchant banking operations such as, trading in securities, brokerage, portfolio management services, underwriting, and providing back up liquidity. "Greater portion of credit and liquidity exposure is being incurred by off balance sheet items and inter bank transactions, leading to reduced transparency. "There is a general agreement that the system needed reforms to better suit the needs of supplier and users of funds. The Bank of International Settlements (BIS) based in Basle, which is a Central Banker's bank, had set a Committee consisting of several
Governors of the Central Banks- "the Committee on Banking Regulations and Supervisory Practice" in 1988. This Committee released a broad framework of standards, which are known as BIS standards. They are followed by all the banks in the world, particularly those operating in international fields."(Extract from a debate in the Lok Sabha dated 19.08.92)
CHAPTER-3 BASEL-I ACCORD
BASEL ACCORD-INTRODUCTION
The interconnectedness of banks and resulting shared riskswere some of the drivers that lead to the creation of original 1988 basel capital accord , which focused on the overall amount of capital that a bank must hold .Sufficient capital is critical for limiting a banks insolvency risk and potential cost for the depositors if the bank fails. This concern over capital stemmed from number of key concerns, namely:Stability of banking system during late 1970s early 1980s. Decline in capital held by banks. Increase of off balance sheet activities. Financial institution have typically sought short term competitive advantage by maintaining low levels of capital and there by reducing the costs or conversely increase their leverage . through banking is general has been regulated by government, the introduction of original accord added the capital requirements, which required internationally active banks to maintain 8% capital to risk weighted assets.The committee on banking regulation and supervisory practices (basel committee on banking supervision) examined the issue of capital adequacy in 1988, which came to be popularly known as basel-1. The objective was to have the common norms for all the banks , which would strengthen the capital resources of international banks in order to improve the stability of international banking system and to reduce the competitive inequalities arising from the differences in capital requirements across nations. This forced the banks of G-10 countries to implement a credit risk framework . For the first time restrictions were placed on on the exposures that a commercial bank could hold in relation to its capital base. It must be noted that the basel committee does not possess any supra-national supervisory authority and its conclusions do not have any legal or binding force. The basel-1 provided for the implementation of credit risk measurement framework with a minimum regulatory capital of 8 percent by the end of 1992.
Capital Adequacy Ratio - Basel Accord 1988
The growing concern of commercial banks regarding international competitiveness and capital ratios led to the Basel Capital Accord 1988. The accord sets down the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries, to be achieved by year-end 1992. The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The document consists of two broad sections, which cover: The definition of capital and The structure of risk weights. The Basel Accord 1988 for the first time brought out the need that the capital of a bank should be directly in proportion not only to its risk-based assets, but also to the risk-weight age (quality) thereof. The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of the G10 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition. Capital is necessary for banks as a cushion against losses and it provides an incentive for the owners of the business to manage it in a prudent manner. The 1988 Accord requires internationally active banks in the G10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their risk-content. The definition of capital is set (broadly) in two tiers, Tier-1 being shareholders' equity and retained earnings and Tier-2 being additional internal and external resources available to the bank. The bank has to hold at least half of its measured capital in Tier-1 form. A portfolio approach is taken to the measure of risk, with assets classified into four buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that some assets (essentially bank holdings of government assets such as Treasury Bills and bonds) have no capital requirement, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claim. However, virtually all claims on the non-bank private sector receive the standard 8% capital requirement. There is also a scale of charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc. This is the only complex section of the 1988 Accord and requires a two-step approach whereby banks convert their off-balance sheet positions
into a credit equivalent amount through a scale of conversion factors, which then are weighted according to the counter partys risk weighting. The 1988 Accord has been supplemented a number of times, with most changes dealing with the treatment of off-balance sheet activities. A significant amendment was enacted in 1996, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument. The two principal purposes of the Accord were to ensure an adequate level of capital in the international banking system and to create a "more level playing field" in competitive terms so that banks could no longer build business volume without adequate capital backing. These two objectives have been achieved. The merits of the Accord were widely recognized and during the 1990s the Accord became an accepted world standard, with well over 100 countries applying the Basel framework to their banking system.
Salient Features of Basel 1988 Accord

Two significant parts of Basel 1988 accord are its 1. The Constituents of capital 2. The risk weights The recommendations of the committee on these core areas are reproduced hereunder: I. The Constituents of Capital - (a) Core Capital (basic Equity) The Committee considers that the key element of capital on which the main emphasis should be placed is equity capital and disclosed reserves. This emphasis on equity capital and disclosed reserves reflects the importance the Committee attaches to securing a progressive enhancement in the quality, as well as the level, of the total capital resources maintained by major banks. The Committee has therefore concluded that capital, for supervisory purposes, should be defined in two tiers in a way which will have the effect of requiring at least 50% of a bank's capital base to consist of a core element comprised of equity capital and published reserves from post-tax retained earnings (tier 1). The other elements of capital (supplementary capital) will be admitted into tier 2 up to an amount equal to that of the core capital. (b) Supplementary Capital (i) Undisclosed Reserves Under this heading are included only reserves which, though unpublished, have been passed through the profit and loss account and which are accepted by the bank's supervisory authorities.
(ii) Revaluation Reserves Some countries, under their national regulatory or accounting arrangements, allow certain assets to be revalued to reflect their current value, or something closer to their current value.
(iii) General provisions/general loan-loss reserves General provisions or general loan-loss reserves are created against the possibility of future losses. Where they are not ascribed to particular assets and do not reflect a reduction in the valuation of particular assets, these reserves qualify for inclusion in capital and it has been agreed that they should be counted within tier 2.
(iv) Hybrid Debt Capital Instruments In this category fall a number of capital instruments which combine certain characteristics of equity and certain characteristics of debt. Each of these has particular features, which can be considered to affect its quality as capital. It has been agreed that, where these instruments have close similarities to equity, in particular when they are able to support losses on an on-going basis without triggering liquidation, they may be included in supplementary capital. (v) Subordinated Term Debt The Committee is agreed that subordinated term debt instruments have significant deficiencies as constituents of capital in view of their fixed maturity and inability to absorb losses except in liquidation. These deficiencies justify an additional restriction on the amount of such debt capital, which is eligible for inclusion within the capital base. Consequently, it has been concluded that subordinated term debt instruments with a minimum original term to maturity of over five years may be included within the supplementary elements of capital, but only to a maximum of 50% of the core capital element and subject to adequate amortization arrangements.
(c) Deductions from Capital

It has been concluded that the following deductions should be made from the capital base for the purpose of calculating the risk-weighted capital ratio. The deductions will consist of: (i) Goodwill, as a deduction from tier-1 capital elements; (ii) Investments in subsidiaries engaged in banking and financial activities, which are not consolidated in national systems. The normal practice will be to consolidate subsidiaries for the purpose of assessing the capital adequacy of banking groups;
Where this is not done, deduction is essential to prevent the multiple use of the same capital resources in different parts of the group. The deduction for such investments will be made against the total capital base; Despite these concerns, however, the Committee as a whole is not presently in favour of a general policy of deducting all holdings of other banks' capital, on the grounds that to do so could impede certain significant and desirable changes taking place in the structure of domestic banking systems; The Committee has nonetheless agreed that: (a) Individual supervisory authorities should be free at their discretion to apply a policy of deduction, either for all holdings of other banks' capital, or for holdings, which exceed material limits in relation to the holding bank's capital or the issuing bank's capital, or on a case-by-case basis; (b) Where no deduction is applied, banks' holdings of other banks capital instruments will bear a weight of 100%; (c) In applying these policies, member countries consider that reciprocal crossholdings of bank capital designed artificially to inflate the capital position of then banks concerned should not be permitted; (d) The Committee will closely monitor the degree of double gearing in the international banking system and does not preclude the possibility of introducing constraints at a later date. For this purpose, supervisory authorities intend to ensure that adequate statistics are made available to enable them and the Committee to monitor the development of banks holdings of other banks equity and debt instruments, which rank as capital under the present agreement.
II. The Risk Weights

The Committee considers that a weighted risk ratio in which capital is related to different categories of asset or off-balance-sheet exposure, weighted according to broad categories of relative riskiness, is the preferred method for assessing the capital adequacy of banks. The Committee believes that a risk ratio has the following advantages over the simpler gearing ratio approach:
1. It provides a fairer basis for making international comparisons between banking systems whose structures may differ; 2. It allows off-balance sheet exposures to be incorporated more easily into the measure; 3. It does not deter banks from holding liquid or other assets, which carry low risk. The framework of weights has been kept as simple as possible and only five weights are used 0, 10, 20, 50 and 100%. The weighting structure is set out in detail in Annexes 2 and 3 (of the report). There are six aspects of the structure to which attention is particularly drawn. (i) Categories of Risk Captured in the Framework There are many different kinds of risks against which banks' managements need, to guard. For most banks the major risk is credit risk, that is to say the risk of counterparty failure, but there are many other kinds of risk - for example investment risk, interest rate risk, exchange rate risk, concentration risk. The central focus of this framework is credit risk and, as a further aspect of credit risk, country transfer risk. (iii) Claims on Non-Central-Government, Public-Sector Entities (PSEs) The Committee concluded that it was not possible to settle on a single common weight that can be applied to all claims on domestic public-sector entities below the level of central government (e.g. states. local authorities, etc.) in view of the special character and varying creditworthiness of these entities in different member countries. (v) Loans Secured on Residential Property The framework recognizes the importance of collateral in reducing credit risk, but only to a limited extent. In view of the varying practices among banks in different countries for taking collateral and different experiences of the stability of physical or financial collateral values, it has not been found possible to develop a basis for recognizing collateral generally in the weighting system. (iv) Collateral and Guarantees Loans fully secured by mortgage on occupied residential property have a very low record of loss in most countries. The framework will recognize this by assigning a 50% weight to loans
fully secured by mortgage on residential property, which is rented or is (or is intended to be) occupied by the borrower. In applying the 50% weight, the supervisory authorities will satisfy themselves, according to their national arrangements for the provision of housing finance, that this concessionary weight is applied restrictively for residential purposes and in accordance with strict prudential criteria. This may mean, for example, that in some member countries the 50% weight will only apply to first mortgages, creating a first charge on the property; and that in other member countries it will only be applied where strict, legally-based, valuation rules ensure a substantial margin of additional security over the amount of the loan. The 50% weight will specifically not be applied to loans to companies engaged in speculative residential building or property development. Other collateral will not be regarded as justifying the reduction of the weightings that would otherwise apply. (vi) Off-Balance Sheet Engagements The Committee believes that it is of great importance that all off-balance sheet activity should be caught within the capital adequacy framework. The approach that has been agreed, which is on the same lines as that described in the Committee's report on the supervisory treatment of off-balance sheet exposures issued to banks in March 1986, is comprehensive in that all categories of off-balance sheet engagements, including recent innovations, will be converted to credit risk equivalents by multiplying the nominal principal amounts by a credit conversion factor, the resulting amounts then being weighted according to the nature of the counter party. The different instruments and techniques are divided into five broad categories (within which member countries will have some limited discretion to allocate particular instruments according to their individual characteristics in national markets): One member country feels strongly that the lower weight should also apply to other loans secured by mortgages on domestic property, provided that the amount of the loan does not exceed 60% of the value of the property as calculated according to strict legal valuation criteria. 1. Those which substitute for loans (e.g. general guarantees of indebtedness, bank acceptance guarantees and standby letters of credit serving as financial guarantees for loans and securities) - these will carry a 100% credit risk conversion factor;
2. Certain transaction-related contingencies (e.g. performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions) - a 50% credit risk conversion factor; 3. Short-term, self-liquidating trade-related contingent liabilities arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipments) - a 20% credit risk conversion factor; 4. Commitments with an original maturity exceeding one year (the longer maturity serving broadly as a proxy for higher risk facilities) and all NIFs and RUFs - a 50% credit risk conversion factor. Shorter-term commitments or commitments which can be unconditionally cancelled at any time, it is agreed, generally carry only low risk and a nil weight for these is considered to be justified on de minims grounds; 5. Interest and exchange rate related items (e.g. swaps, options, futures) - the credit risk equivalent amount for these contracts will be calculated in one of two ways (see below and Annex 3). Special treatment is needed for the items in (e) above because banks are not exposed to credit risk for the full face value of their contracts, but only to the cost of replacing the cash flow if a counter party defaults. Most members of the Committee accept that the correct method of assessing the credit risk on these items is to calculate the current replacement cost by marking to market and to add a factor to represent potential exposure during the remaining life of the contract. Some member countries, however, are concerned about the consistency of this method in relation to the rest of the system which only makes broad distinctions between relative risks for on-balance-sheet items, particularly for banks where these off-balance sheet items currently constitute only a very small part of the total risks. They would prefer to apply an alternative approach consisting of conversion factors based on the nominal principal sum underlying each contract according to its type and maturity. The Committee has concluded that members will be allowed to choose either of the two methods. The details of the two alternative methods are set out in Annex 3 of the report In order to facilitate date collection, during the transitional period up to end-1992, but not beyond, national supervisory authorities will have discretion to apply residual maturity as a basis for measuring commitments."
COMPUTATION OF CAPITAL ADEQUACY RATIO
Computation of Capital Adequacy Ratio as per Guidelines of RBI

Computation of Capital Adequacy Ratio (CAR) of Banks in India When we say Capital in relation to the financial institutions like banks, what we mean is the Capital funds, which are the total Owned Funds available to the Institution for a reasonably long time. The Capital Funds consist of Tier-I, Tier-II and Tier-III Capital, the components of which are explained below. For computation of CAR, we need to calculate: Tier-I capital Tier-II capital Risk Weighted Assets (RWA)
Step 1: Compute Tier-I capital: Tier I capital is the most permanent and readily available support against unexpected losses. It consists of Paid up equity capital Statutory reserves Capital reserves Other disclosed free reserves Less: Equity investments in subsidiaries Intangible assets Current and Accumulated Losses, if any
Step 2: Calculation of Risk Weighted Assets (RWA)
RWA are calculated by multiplying the relevant weights to the value of assets and offbalance sheet items. The weights assigned to each of the items are as follows: Domestic Operations Funded Risk Assets 1. Cash, balances with RBI, balances with other banks, money at call and short notice and investments in Govt. and other trustees securities 2. Claims on commercial banks such as certificates of deposits etc. 3. Other Investments 4. Loans and advances including bills purchased and discounted and other credit facilities A. Loans guaranteed by GOI B. Loans guaranteed by State Govt. C. Loans guaranteed by PSUs of GOI. D. Loans guaranteed by PSUs of State Govt.. E. Others 5. Premises, furniture & fixtures. 6.Other Assets 0 Percentage weights
20 100
2.5 2.5 100 100 100 100 100
Off Balance Sheet Items Off balance sheet items are first multiplied by the corresponding credit conversion factors. Then it is multiplied by the risk weights attributable to the item. Credit Items 1. Direct Credit Substitutes 2. Certain transaction related to contingent items 3. Short term self liquidating trade related contingencies 4. Sale and repurchase agreement and asset sales with recourse, where the credit risk remains with the bank 5. Forward and asset purchases, forward deposits conversion factors 100 50 20
100 100
and partly paid shares and securities 6. Note issuance facilities and underwriting facilities 7. Other commitments with an original maturity of over 1 year 8. Similar commitments with an original maturity of over 1 year, or which can be cancelled at any time. 9. Aggregate outstanding foreign exchange
50 50
contracts of original maturity Of less than 1 year For each additional year or part thereof Note:
2 3
In the Mid-term Statement on Monetary and Credit Policy for 1998-99, a risk weight of 2.5 per cent was introduced for the risk arising out of market price variations for investments in Government and other approved securities, with effect from the year ending March 31, 2000. In view of the growing share of investments in the assets of banks, the risk weight of 2.5 per cent is being extended to cover all investments including securities outside the SLR. This, however, will take effect from the year ending March 31, 2001. Step 3: Compute Tier-II Capital These are not permanent in nature or, are not readily available. Tier-II capital consists of1. Undisclosed reserves and cumulative perpetual preference shares-Cumulative preference shares should be fully paid and should not contain clauses which permit redemption from shareholders. 2. 3. Revaluation Reserves (RR)- 45% of RR is only taken in calculation of tier-II capital General Provisions and Loss Reserves (GPLR)- Actual GPLR or 1.25% of Risk Weighted Assets, whichever is lower, is taken. 4. Hybrid Debt Capital Instruments- These combine characteristics of both equity and debt. As they are more or less similar to equity, they are included in the Tier-II 5. Subordinated Debts- These must be fully paid up, unsecured, subordinated to the claims of other creditors, also there should be no such clause, which permits
redemption. The amount of subordinate debts to be taken as Tier-II capital depends upon the maturity of debt. Subordinate Debt Instruments will be limited to 50% of Tier-I capital.
Remaining term to maturity 1.Where the date of maturity is above 5 years 2.Where the date of maturity is above 4 years but doesn't exceed 5 years 3.Where the date of maturity is above 3 years but doesn't exceed 4 years 4.Where the date of maturity is above 2 years but doesn't exceed 3 years 5.Where the date of maturity is above 1 year but doesn't exceed 2 years 6.Where the date of maturity does not exceed 1 year
Discount Rate (%) 0 20 60 80 80 100
Amount to be taken in % 100</< TR> 80 40 20 20 10
Note: Tier-II capital cannot be more than Tier-I capital. Capital Adequacy Ratio: Capital Adequacy Ratio = (Tier-I capital + Tier-II capital) / RWA According to the present norm, the Capital Adequacy Ratio of bank as defined earlier should be at least 9%.
Conclusion
The criteria to decide the extent and the structure of Capitalization by Indian Banks can be summarized as under: a. Capital of a Bank should relate to its risk-oriented assets; b. RWA or risk-weight age of assets to be calculated as per prescribed norms; c. Capital adequacy or quantum of capital required for the bank is 10% of RWA; d. e. Of this Tier-1 Capital should be minimum 50% and the balance can be Tier-II capital; Tier-I Capital includes Paid up equity capital; Statutory reserves; Capital reserves; Other disclosed free reserves f. Tier-II capital may include- Undisclosed reserves and cumulative perpetual preference shares; 45% of. Revaluation Reserves (RR); General Provisions and Loss Reserves (GPLR)- Actual GPLR or 1.25% of Risk Weighted Assets, whichever is lower; Hybrid Debt Capital Instruments-; and Subordinated Debts. Tier-II Capital not to exceed the amount of Tier-I Capital.
Adoption of CAR Norms by Indian Banks

Before the onset of banking sector reforms the problem of capital adequacy was not felt as a concern by the Indian Banking System. For one it was a captive sector cut off from international effects with directed system of management. Secondly the opaque structure of accounting standards followed, the financial statements published were not reflecting the real weaknesses of the banking units. Prudential norms of asset classification, income recognition and provisioning were not followed. While the assets were continuously depreciating it was recognized, interest income on accrued basis was accounted and transferred to revenue. There was no competition amongst the nationalized banks in the real sense. Many private banks came to adversity, but these were quickly merged with bigger nationalized banks. RBI prescribed capital Adequacy norms based on Basel 1988 accord for adherence by the Indian Banks in 1993. All Indian banks have been following the stipulation since then. But banks do not publish the calculations based on which their respective capital adequacy is calculated. They submit returns to RBI detailing the calculations, based on which published the bank wise capital adequacy particulars in its website. The CAR ratios are thus available on RBI website in respect of all banks commencing from the year 1998-99 up to the year 2002-03. RBI website published the respective balance sheets of all Indian banks. However the latest balance sheet for the year 2002-03 is not yet put up therein. It is therefore possible to know the Tier I, of each bank and its total Assets. Tier-II Capital calculated as per weight age of maturity of subordinate debts (Bonds) is not published. Neither can it be gathered from the published balance sheet. So is the case with regards to RWA. The information on RWA (Risk Weighted Assets) as calculated by the banks and conveyed to RBI is not available for public information. RBI has furnished on its website CAR separately for TierI and Tier-II capital for the banks for the years 2000-01 and 2001-02. We propose to consider the cases of one leading Foreign Bank (with reference to its Indian Business) i.e. Citibank, the first and second biggest amongst domestic banks i.e. SBI and ICICI, (also these represent the biggest amongst public sector banks and private sector banks respectively) and also that of Punjab National Bank, the biggest amongst the Nationalized Banks and one of the oldest banks in India. As the figures of last financial
year ended 31st March 2003, are not available, we will study only the figures relating to the earlier two years i.e. 2000-01, and 2001-02 in terms of balance sheet figures. There is a record in respect of all these banks of having achieved CAR of over 10% throughout. In respect of ICICI the CAR is stable at 11%plus. But in the year 1999-2000 it shoot up to 19.64% on account of then merger of ICICI (Development Financial Institution) with ICICI Bank in that year. The CAR of all the other three banks is not only maintained over 10% throughout, but also exhibits a general tendency to improve. Of the four banks SBI is having the highest Ratio at 13.50% as at 31.03.2003 followed by PNB at 12.02%. In respect of ICICI the CAR in the years has come down to 11.10% in 2002-03 from the previous years record of 11.44 (2001-02) and 11.57 (2000-01).
CHAPTER-4
BASEL-II ACCORD
INTRODUCTION
The first Capital Accord of 1988 played a positive role in strengthening the soundness and stability of banks and enhanced the competitive equality among international banks. The Accord provided a framework for a fair and reasonable degree of consistency in the application of capital standards in different countries, on a shared definition of capital. Due to rapid transformation of the financial market since 1988 Accord, situation has arisen where regulatory capital alone may not be a good indicator of financial condition of banks. It is therefore, essential that the capital, which supervisors mandate the institutions to hold, should be adequate to cover the risks to which the institutions are exposed. Therefore a new Framework with a view to rectifying the shortcomings the 1988 Accord had on the balance sheet strategy and also in addressing the in-built deficiencies in the riskweighting model had been proposed. RBI acknowledges that the three-pillar approach proposed in the new Framework will suitably enhance, in due course of time, the role of supervisors, on the one hand and the market on the other, in ensuring that the regulated entities maintain adequate capital at all times with reference to their risk profile. This approach would also serve to contribute to the international financial architecture. Though it became a universal benchmark for assessing the adequacy of regulatory capital, the 1998 capital accord had certain shortcomings, some of which are listed herein after: 1. As there were only four risk weights such as 0%, 20%, 50%, and 100%, inadequate differentiation of credit risk had inadvertently crept in. 2. In respect of investments, general quantum equivalent to 2.5% risk weight for the entire portfolio was provided for. 3. The risk weights applied to AAA rated browser and that of lower rated borrower are same though the risk profile of the borrowers may vary substantially relatively. There was no relief of capital to the banks holding relatively less risky assets in their books. 4. Capital charge was same irrespective of the maturity structure of credit exposure and the accord ignored the fact that there is greater risk of default in the longer-term exposure than the one maturing shortly.
5. The accord did not recognize the portfolio diversification effect for credit risk, though such a treatment was given in respect of market risk. 6. The availability of certain credit risk mitigation techniques such as cash margin, collateral security etc. was not recognized. 7. There was no capital charge for the operational risk, though it was a very important source of risk and may be at times, more devastating than credit risk. 8. The Basel Committee emphasizes that the objectives of safety and soundness cannot be achieved solely through capital adequacy and hence the Capital Accord II comprise sophisticated approach consisting mainly three approaches. The first is Minimum Capital Requirements; the second being Supervisory Review and the third Market Discipline. The revised accord can be considered as fully implemented only if all the three pillars are put in place, as a whole package.
Issues Specific to Emerging Markets For New Framework

While appreciating the Committees efforts to address the rigidities inherent in the 1988 Accord, RBI was generally in agreement with the approach of the new Framework. However, it is suggested that the issues and problems specific to emerging markets may also be taken into
account in the new Framework. The dependence of these markets on agricultural sector and its seasonality, low competitiveness, vulnerability of the external sector, low technical skills of the market players, etc., ought to be recognised and properly addressed. Some of the proposals contained in the new Framework may therefore, require some modification / flexibility to fully reflect the macro-economic environment, structural rigidities and concerns of the emerging markets.
Scope Of The Application

The Accord should capture the risks in the whole banking group. At the same time, it should address the safety and soundness of individual banks within the group. To these ends, it is proposed that the Accord be extended to include, on a fully consolidated basis, holding companies that are parents of banking groups. Banking groups are groups that engage predominantly in banking activities and, in some countries, a banking group may be registered as a bank. In addition, the Committee is clarifying the Accords application on a fully consolidated basis to all internationally active banks at every tier within a banking group. Further, supervisors should ensure that each of the banks within a group is adequately capitalised individually. Banks have increasingly expanded into other areas of financial activity, especially the securities and insurance industries. The Committee is therefore clarifying capital treatments for banks investments in those areas. The Committee is also clarifying the capital treatment for significant minority-owned entities and is seeking industry views on the appropriate capital treatment for majority-owned investments in commercial entities. With regard to diversified financial groups, the Committee recognises the need to continue working with insurance and securities supervisors to align capital adequacy standards, and supports the application of techniques such as those developed by the Joint Forum on Financial Conglomerates.
Objectives of the new framework

It is clear that the Accord must evolve along with the changes in the market Therefore committee developed a new and comprehensive capital adequacy framework which focuses on the following supervisory objectives: the Accord should continue to promote safety and soundness in the financial system;
the Accord should continue to enhance competitive equality; the Accord should constitute a more comprehensive approach to addressing risks; and the Accord should focus on internationally active banks, although its underlying principles should be suitable for application to banks of varying levels of complexity and sophistication.
The Accord is a cornerstone of the current international financial architecture. Its overriding goal is to promote safety and soundness in the international financial system. The existence of an adequate capital cushion is central to this goal, and the Committee believes that the new framework should at least maintain the overall level of capital currently in the banking system. The Committee believes that in order to achieve its safety and soundness objectives, the new capital adequacy framework must encompass the three pillars . The 1988 Accord sets out minimum capital requirements, which remain a key pillar of the new capital adequacy framework. More recently, the Committee has emphasized the value of market discipline. The Committee is now making an additional advance in the framework by making explicit the supervisory review pillar, which has already been in place explicitly or implicitly in several countries. In respect to the first pillar, the Committee notes that the methods used to determine the capital charges for credit risk in the current Accord are not overly sophisticated, and the rapid rate of financial innovation in markets and the growing complexity of financial transactions have reduced their relevance. As such, the Committee is now setting forward various approaches for making the Accord more sensitive to credit risk. This effort includes proposing a modified and developed set of rules to serve as the standardized approach. Within the same timeframe, the Committee is also seeking to develop an alternative approach for establishing minimum capital requirements at some sophisticated banks, based on the banks internal credit ratings. When the Accord was first established, it was primarily concerned with minimum capital standards to cover credit risk. In so far as these capital charges covered other types of risk, these were effectively assumed to be proportional to credit risk. The Committee now proposes to develop an explicit capital charge for other risks (such as operational risk), and interest rate risk in the banking book for banks where interest rate risks are significantly above average (outliers). Such a framework would formally take account of a wider range of actual and potential exposures. The Committee fully recognises the benefits of competition in the financial sector and remains
committed to the concept of a level playing field for banks operating in international markets. It is aware, however, that differences in national accounting, tax, legal and banking structures will inevitably create differences between national markets and that the use of banking supervisory rules cannot address all these differences. As such, the Committee believes that the second and third pillars will serve as a complement to the minimum capital requirements set forth in the first pillar. With regard to the supervisory review pillar, the Committee notes that supervisors should focus bank managements attention on developing an internal capital assessment process and on setting targets for capital that are commensurate with the banks particular risk profile and control environment. This internal process would then be subject to supervisory review and intervention where appropriate. The Committee also believes that supervisors have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system. Effective market discipline requires reliable and timely information that enables market participants to make well-founded risk assessments. The Committee plans to issue more detailed guidance on the disclosure of capital levels, risk exposures, and capital adequacy later this year.
The Committee recognizes the critical importance of sound accounting and valuation practices as a basis for setting capital requirements, and strongly encourages supervisors to use all possible means at their disposal to promote sound practices. While a number of supervisors have the power to implement accounting and disclosure requirements directly through binding regulations, others may use more indirect approaches, including issuing sound practice recommendations and interacting with the competent authorities. Thus, as part of this effort, the Committee is also developing sound practice guidance on loan valuation, loan loss provisioning and credit risk disclosure.
BANKS CAPITAL STRUCTURE AND BASEL-II

While the 1988 first accord covered only credit risk, the market risk aspect was introduced later in 1996-97. It may now be appropriate to take stock of the broad contents of the Accord, through consultative paper during the intervening one and a half decade period, though the basic objective of strengthening of the international banking system remains same in both the accords.
There is a need to create awareness on the second accord that has been in the thick of discussions among the financial experts for couple of years. Agreed by all the constituents of BASEL Committee and preceded by extensive consultations with supervisors as well as bankers worldwide, the new accord sets out the details of the framework for measuring capital adequacy and minimum standards to be achieved which the national supervisory authorities, represented on the Committee, will propose for adoption in their respective countries. The Central Bank Governors and Heads of Banking Supervision of the Group-10 countries have endorsed the revised framework. Banks in India will have to move forward with appropriate adoption procedures as directed by the Reserve Bank of India. While the thrust of accord was adequate capitalization of banks in relation to predominantly credit coupled with one-size-fits-all approach of measuring it. The second accord recognizes the banks face a number of risks in the form of credit, market and operational risks in broader sense with multidimensional approach for measuring it, besides giving importance to the supervisor through the regulatory mechanism and public disclosure. It is firmly believed that that one-size-fits-all approach for measuring the risk is not feasible and acceptable. The committee intends that the framework is available for implementation by 2006, with one more year for impact study or parallel calculations needed for the most advanced approaches and hence to be available for the total implementation by the end of 2007. There may be further need to review the calibration of the revised Framework, prior its total implementation. However, the national supervisor for banks should examine carefully the benefits of the revised framework to consider adoption at such time as it believes is considered with its broader supervisory priorities, in the context of domestic banking system, when developing a timetable and approach for implementation. There is a need to exercise sound judgment while determining a banks state of readiness, particularly during the implementation process. Basel II accord and built broadly on what is known as three pillars viz., Minimum Capital Requirement (Pillar 1), Supervisory Review (Pillar II) and the Market Discipline (Pillar III) with the latter two serving as a complementary tool to the first
one.The accord requires banks to divide or segregate their exposures into broad categories reflecting similar type of borrowers with identical intrinsic risks. The thrust of the revised Framework is the greater use of assessments of capital calculations. The Minimum Capital Requirements is worked out for the combined effect of credit, market and operational risks, based on a particular approach to be adopted from out of menu of approaches as tabulated herein after.
PILLAR I
The primary objective of Basel-2 is to introducr greater risk sensitivity in to the calculation of amount of capital that a bank needs to hold. The revised accord has retained the current definition of capital i.e. Tier-1, Tier-11, Tier-111 capital.BIS introduced Tier-111 capital in 1996 as a part of the proposals for market risk, but RBI has not yet introduced the same.
Credit risk External rating based Internal rating based Foundation IRB
Market risk Standardized approach Model based approach
Operational risk Basic indicator approach Standardized approach Advanced measurement approach
Advanced IRB
The pillar I deal with adequacy of capital for the banks built up assets carrying credit, market and operational risk. In the calculation of capital adequacy ratio, there exists two components viz Capital, the numerator and Assets, the denominator. By capital what is meant is Capital Funds, consisting of core capital and statutory reserves/profit (Tier-I), Long term subordinated debts, revaluation reserves etc.(Tier-II) and short-term subordinated debts not exceeding 250% of Tier-I capital (Tier-II specifically for market risk only.) Similarly by assets what is meant is risk-weighted asset. Here again, the word risk has a special connotation of mix of credit risk, market risk and operational risk. Special feature of the second accord is the multi various options, available to the banks to choose from, depending on the available sophistication in a bank for measuring the risk and the ability to adopt statistical tools in their calculations.
CREDIT RISK The risk of loss to the bank due to the failure of borrowers and counter parties in meeting their commitments, that is called Credit risk. 1. One based on External Credit Rating Agencies (ECRA), also known as Standardized Approach. 2. Internal Rating Based (IRB). STANDARDISED APPROACH The standardized approach specified under Basel-II is more sensitive, vis--vis Base-I, to the credit risks associated with the obligators. The new approach grades the credit risk of an obligator (both on and off balance sheet items) by assigning different risk weights on the basis of the credit ratings given by external credit assessment institutions (primarily rating agencies). Under Base-I on the other hand, different risk weights were assigned to different types of obligators. To illustrate, under Basel-II, for corporates, the risk weight could vary from as low as 20% for a Aaa rated obligator to as high as 150% for a B1 or lower rated obligator, whereas under Base-I, the risk weight for all corporate borrowers
would be a standard 100%. The key obligators that have been differentiated under Basel-II are sovereign, corporate, banks, securities firms, multilateral development banks, noncentral government public sector enterprises, and retail. Table 1: Risk Weight for Corporate Loans and Bonds (Standardized Approach-Basel-II accord) Ratings Aaa to Aa3 A1 to A3 Baa1 to Ba3 Below Ba3 Unrated Risk Weights 20% 50% 100% 150% 100%
INTERNAL RATINGS BASED APPROACH
In this approach, a bank uses its internal ratings, instead of external ratings as under the standardized Approach, to measure the credit risk of an obligor. The IRB Approach is based on the measurement of unexpected loss (UL) and expected loss (EL) derived from four key variables: probability of default (PD); loss given default (LGD); exposure default (EAD); and effective maturity (M). The banks will have to estimate the potential future loss from the exposure and assign risk weights accordingly. The IRB approach has been further subdivided into Foundation Approach and Advanced Approach. In Foundation Approach, a bank would internally estimate the PD and the other three variables, whereas in Advanced Approach, the bank would be expected to provide the other three variables as well. The implementation of IRB Approach is subject to explicit approval of the regulator who would have the discretion to allow the bank concerned to use its internal credit rating systems of assessing credit risk. Banks would have to satisfy the regulators about the adequacy and robustness of their risk management systems and internal rating process, and of their competency in estimating the key variables. The IRB approach is more risk sensitive as compared with the Standardized Approach and would benefit banks with improved risk management systems, strengthening their risk assessment processes.
The measurement of Credit Risk requires to be disaggregated in to individual components , i.e. probabilities of default , loss given default, exposure at default and correlation of defaults.Basel-11 intends to introduce a shift in the responsibility for measuring risk from regulators to banks.
MARKET RISK
Market risk is the possibility of loss caused by the changes in the market variables. with regard to market risk, banks have option of two approaches to choose from and they are Standardized approach- under it, interest rate risk, equity position risk, foreign exchange risk, commodities risk and the options risk are the distinct sources identified and the accord provides detailed treatment to be adopted by banks depending on the extent of risk to which banks are exposed for each of these sources. Banks are also allowed to use their own internal models to calculate the capital charge for market risk, again subject to models meeting certain standards set by the supervisor. IRB Approach- the stress-testing process becomes an important dimension of the IRB approach, wherein worst possible scenario and simulation approaches are brought into. The input in the Internal model is a VaR model. It provides an appropriate percentile of banks portfolio loss distribution.
OPERATIONAL RISK
It may be termed as the remaining or residual risk, is the risk of arising from various types of technical or human errors or failed internal process, legal hurdles, fraud, failure of people and systems or from external agencies. unlike credit and market risks which are quantifiable based on certain calculations and estimates, quantification of operational risk is a tricky proposition as reasonable prediction of operational risk which is the likely loss on account of internal process, human and systems failure, is rather difficult and no scientific calculation can be put in place for quantification of behavior pattern. Nevertheless, Basel-II has given three options in this regard and they are known as1. Basic indicator approach
2. Standardized approach 3. Measurement approach
Basic Indicator Approach It links the capital charge for operational risk to a single parameter, that is, the banks gross annual revenue. The capital charge is calculated as an average of the pervious three years of a fixed percentage (defined as set at 15% by the Basel committee) of positive gross annual income, ignoring years in which income was either zero or negative. Standardized Approach This approach is a variant of the Basic Indicator Approach. Here, the activities of a bank are divided into eight business lines; namely corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management and retail brokerage. Within each business lines, a fixed percentage multiplier (specified as Beta; varies from 12% for retail brokerage to 18% for corporate finance) is specified by Basel-I. The capital charge for each business line is calculated by multiplying the beta for each business line with its gross annual income. The total capital charge for the bank is the three-year average of the summation of the capital charge across each business line. The negative capital charges for a business line can offset a positive capital charge from another business line in a year, but not across years. Advanced Measurement Approach Under this approach, the capital charge will be the risk measure generated by the banks internal operational risk measurement system that uses both quantitative and qualitative criteria. The bank would need to satisfy the regulator, that its board and senior management has an active oversight on operational risk management framework, the operational risk measurement system are sound and is implemented with integrity, and that it has resources in the use of the approach in the major business lines as well as control and audit functions.
PILLAR II
In the second pillar of the Basel-I, the role of supervisory review process is viewed as a critical component to other two pillars, viz capital requirement and market discipline.
Here, the new accord stress the importance and need for supervisors of banks to take a comprehensive view on how banks have gone about in handling the risk sensitive issues, risk management, capital allocation process, etc. In this regard, the guiding principles for the supervisor are: Banks to hold capital above the minimum capital requirement. Intervention at an early stage to prevent capital from declining to below the benchmark level Reviews of internal capital adequacy assessment and strategy Assessment of overall capital in relation to the Risk Profile.The Pillar II emphasizes the need for banks to assess their capital adequacy provisions in relation to their overall risk profile and for supervisors to review the same.
PILLAR III
It provides a framework for the improvement of banks disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, and the like. The pillar also indicates the remedial measures that regulators can take to keep a check on erring banks and maintain the integrity of the banking system. Further, Pillar III allows the banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts.
CAPITAL ADEQUACY RATIO

The capital adequacy ratio is expressed as a percentage of capital to the risk weighted Asset. In respect of market risk and operational risk, the capital charge calculated using any of the above methods is multiplied by 12.5[for rs 8 capital the RWA is 100 and hence the multiplying factor is 12.5(100/8)] so as to bring it at par with the risk-
weighted asset for credit risk. Thus, the Capital Adequacy ratio, under the Capital Accord II, can be expressed as follows:
CAR
Tier-I+ Tier-II+ Tier-III(capital funds) RWA for Credit Risk+(12.5 x capital charge for Market and Operational risk)
Calculation of Capital Adequacy in relation to economic risk is a necessary condition for the long-term soundness of the financial institutions. As banks carry on the business on a wide area network basis, it is critical that they are able to continuously monitor the exposure across the entire organization and aggregate the risks so that an integrated approach/view is taken. It can be achieved either or in combination of the two aspects detailed below Lowering the denominator (RWA or Exposure) Increasing the numerator (Capital Funds)
A. Lowering the Risk Weighted assets can be achieved through: Reduction in asset size without decline in credit quality Improvement in the asset quality at the existing volume level Ensuring better recovery management and striking compromise proposal and settlement. Composition of asset mix with low or nil risk weight. B. Similarly improvement in the Capital Funds can be achieved through the following measure:
Re-capitalization through Public/Right issue Employee participation in equity Revaluation reserve (45% of the increased valuation) Merger of banks having superior capital adequacy ratio Cross holding within the permissible limits Innovative instruments-hybrid character to be classified as tier-II
IMPLEMENTATION CHALLENGES
The implementation of Basel-I is highly complex and challenging owing to: Complex nature of the accord itself It is dependent on the financial reporting standards and flexibility given to local bank/financial regulators. Thus, many countries need to strengthen their accounting policies, loan classification and provisioning policies, without which the new accord will not meet its stated objective of aligning capital requirements closely with the risk profile.
IMPLEMENTATION ISSUES
First, organizations implementing Basel-II will have to hire and retain people with requisite skills sets. Secondly, institutions need to implemented complex and highly sophisticated models to measure various risks. This requires a high degree of automation, centralization and software support. Further, the experts who would be working with the sophisticated techniques and models will have to explain to senior management in an understandable manner, as to how the models work, the implicit assumptions, the impact of various decisions and how the models comply with the regulatory requirement. Implementation worries exist at supervisory level too. As outlined in Pillar II, the new accord stresses on the supervisory review process. This creates enormous pressure on the regulators in the form of trained manpower, skill sets and resources. RBI in its response to the Basel-II has stated, the minimum requirements stipulated even under the foundation IRB approach, are difficult to be implemented, ex\specially in the emerging markets. Most of the banks do not have robust rating systems and historical data on Probability of Default (PD), nor do the supervisory authorities maintain time series data for estimating Loss Given Default (LGD). Besides banks, supervisors would be required to invest considerable amount in upgrading technology systems and human resources to meet the minimum standards. Banks in emerging markets would, therefore, face serious implementation challenges due to
lack of adequate technical skills, under development of financial markets, structural rigidities and less robust legal system.
Impact of Basel-II Norms
Impact of Basel-II Norms

While there is no second opinion regarding the purpose, necessity and usefulness of the proposed new accord- the techniques and methods suggested in the consultative document would pose considerable challenges for banks in India. Capital Requirement: The new norms will almost invariably increase capital requirement in all banks although capital requirement for credit risk may go down due to adoption of more risk sensitive models-such advantage will be more than offset by additional capital charge for operating and market risk. Profitability: Competition among banks for highly rated corporate needing lower amount of capital may exert pressure on already thinning interest spread. Huge implementation cost may also impact profitability for smaller banks. Risk Management Approaches: It provides for alternative approaches for computation of capital requirement of various risks. However, competitive advantage of IRB may lead to domination of this approach among big banks. Banks adopting IRB will be more sensitive than those adopting standards approach. This may result in higher risk-assets flowing to banks on standardized approach-as they would require lesser capital for these banks on IRB approach. Hence, the system as a whole may maintain lower capital than warranted and become more reliable. Supervisory Framework: Implementation of Basel-II norms will prove a challenging task for the bank supervisors as well. Given the paucity of supervisory resources-there is a need to reorient the resources deployment strategy. Supervisory cadre has to be properly trained for understanding of critical issues for risk profiling of supervised entities and validating and guiding development of complex IRB models. Disadvantage for Smaller Banks: The new framework is very complex and difficult to understand. It calls for revamping the entire management information system and allocation of substantial resources. Therefore, it may be out of reach for many smaller banks.
CHAPTER-5
CAPITAL ADEQUACY RATIO OF SBI GROUP
Calculation of Capital Adequacy of State Bank of India

Particulars Tier I Capital %-age
Tier II Capital Total
2005-06
9.36% 2.52% 11.88%
STATE BANK OF INDIA-TIER-1 CAPITAL FOR THE YEAR 2005-06 Particulars Capital Statutory Reserves Capital Reserves Share Premium Revenue & other Reserves (50%) Balance of Profit Total Less Deductions
(Figures in 000s) 2005-06 5262989 170209236 4181048 35105733 29372232 3393 244134631
Investment in Subsidiaries and/or joint ventures Total of Tier I capital Tier II Capital Total (I + II)
24032531 221102100 (9.36%) 59258257.68 (2.52%) 279360357.60 11.88%
Note: Revenue reserves are taken at 50%.
STATE BANK OF INDIA-Classification of assets for the year 2005-06 Particulars Cash in hand Balances with RBI Balances with Banks in India Money at call & short notice Balances with Banks outside India Investments (less Investment subsidiaries) Advances Premises (including under construction) Other Fixed Assets Other Assets Total Assets less excluded items
Figures 000s 2005-06 20802305 195724734 6025747 80810608 142236617 1601309879 2616415336 9149480 15703501 1976358 4690154565
in
In the absence of information needed the assets could not be worked out as per risk-weightage and RWA calculated to check the CAR of the bank as furnished. But as Capital (Tier I + II) and CAR are given RWA can be calculated on the formulaeRWA = Capital (Tier I + II) / CAR SO RWA=279360357.60/11.88 =23515181.61 thousands
Calculation of Capital Adequacy of State Bank of Indore

2005-06
7.55% 3.85% 11.40%
STATE BANK OF INDORE-TIER-1 CAPITAL FOR THE YEAR 2005-06 Particulars Capital Statutory Reserves Capital Reserves Share Premium Revenue & other Reserves (50%) Balance of Profit Total Less Deductions Investment in Subsidiaries and/or joint ventures Total of Tier I capital Tier II Capital Total (I + II)
(Figures in 000s) 2005-06 175000 5975000 312570 437500 1638550 98 8538718 21929 8516789 (7.55%) 4342998.36 (3.85%) 12859787.36 (11.40%)
STATE BANK OF INDORE-Classification of assets for the year 2005-06 Particulars Cash in hand Balances with RBIL Balances with Banks in India Money at call & short notice Balances with Banks outside India Investments (less Investment subsidiaries) Advances Premises (including under construction) Other Fixed Assets Other Assets Total Assets less excluded items
Figures 000s 2005-06 247294 11218371 3742896 1050000 4230126 51097908 118759705 319931 807659 15612278 207086168
in
RWA = Capital (Tier I + II) / CAR RWA=12859787.36/ 11.40=1128051.52 thousands
Calculation of Capital Adequacy of State Bank of Hyderabad

2005-06
8.95% 3.13% 11.08%
STATE BANK OF INDORE-TIER-1 CAPITAL FOR THE YEAR 2005-06 Particulars Capital Statutory Reserves Capital Reserves
(Figures in 000s) 2005-06 172500 6762844 20808
Share Premium Revenue & other Reserves (50%) Balance of Profit Total Less Deductions Investment in Subsidiaries and/or joint ventures Total of Tier I capital Tier II Capital Total (I + II)
7092023.50 4 14048179.50 63253 13984926.50 (8.95%) 4890817.87 (3.13%) 18875744.37 (11.08%)
STATE BANK OF INDORE-Classification of assets for the year 2005-06 Particulars Cash in hand Balances with RBIL Balances with Banks in India Money at call & short notice Balances with Banks outside India Investments (less Investment subsidiaries) Advances Premises (including under construction)& other fixed assets Other Assets Total Assets less excluded items
Figures 000s 2005-06 650052 21926878 3528282 3500000 448078 142496837 20863094 2234506 22625947 218273674
in
RWA = Capital (Tier I + II) /CAR RWA=18875744.37/11.08=1703587 thousands
Calculation of Capital Adequacy of State Bank of Patiala

2005-06
9.84% 3.83% 13.67%
STATE BANK OF INDORE-TIER-1 CAPITAL FOR THE YEAR 2005-06 Particulars Capital Statutory Reserves Capital Reserves Share Premium Revenue & other Reserves (50%) Balance of Profit Total Less Deductions Investment in Subsidiaries and/or joint ventures Total of Tier I capital Tier II Capital Total (I + II)
(Figures in 000s) 2005-06 247500 9210560 6302879 15760939 3500 15757439 6133230 21890670
STATE BANK OF INDORE-Classification of assets for the year 2005-06 Particulars Cash in hand Balances with RBIL Balances with Banks in India Money at call & short notice Balances with Banks outside India Investments (less Investment subsidiaries) Advances Premises (including under construction)& other fixed assets Other Assets Total Assets less excluded items
Figures 000s 2005-06 429327 14664868 2156601 12436515 2085635 125614306 221800167 2274441 30250786 411712376
in
RWA = Capital (Tier I + II) / CAR RWA=21890670/13.67=1061365.76
Calculation of Capital Adequacy of State Bank of Mysore

Particulars Tier I Capital %-age Tier II Capital Total 2005-06 7.44% 3.93% 11.37%
Calculation of Capital Adequacy of State Bank of Travancore

Calculation of Capital Adequacy of State Bank of Saurashtra

Calculation of Capital Adequacy of State Bank of Bikaner and Jaipur

CHAPTER-6
RESEARCH METHDOLOGY
Need of the research

The research has tremendous ingrained advantage. Capital adequacy is the emerging area of concern in Banking Sector these days. With the stiff competition prevailing in Banking Sector, capital adequacy has become an essence. The new capital accord namely Basel-II new capital accord aims at improving the safety and soundness of financial system by aligning capital adequacy assessment closely with the underlying risks in the banking industry, providing a thorough supervisory review process and enhancing market discipline. It further seeks to maintain the overall level of capital in the system and enhance competitive quality. Basel-II when finalized and adopted will establish the basic capital frameworks for committee member countries as well as non member countries. The need of doing this research was to have a look at the defects of the Basel-I norms and to know what Basel-II has brought in its package.
Objective of the study

The introduction of the prudential norms in India since 1992-93, consequent upon the recommendation of the committee on financial systems, has ushered in a sea change as regards the regulatory framework for the financial sector. Although the regulatory structure has gradually been tightened over the years with the avowed objective of moving towards international best practices, relatively little attention has been paid towards assessing the effectiveness of regulations. It is our belief that the current system of recapitalization followed in India represents an over-reliance on Basle norms and presents several lacunae. In particular one-cap-fits-all theology inherent in the Basle system may introduce an unacceptable amount of inflexibility in Indian context. While it remains that high enough capital adequacy standards may discourage gambling behavior and provide effective cushion in an upswing, they might prove to be inadequate in downturns, as firms find it difficult to service their loans. In the face of such vicissitudes in the operating environment, as each bank attempts to satisfy their capital adequacy standard, the whole system may find itself completely undetermined, eventually resulting in worsening of capital adequacy standards. The widened criticism in respect of the old Accord seems to have led the Basle Committee on banking supervision to propose the new consultative paper on Capital Adequacy Framework in
June 1999 which aims to further strengthen the soundness of financial system. The primary objective of new accord are1. Promotion of safety and soundness of financial system; 2. The enhancement of competitive equality and 3. The constitution of more comprehensive approach to addressing risks. So the primary objective of the present study would be to investigate the relationship between changes in attitudes to risks and the level of capital in banking sector. So, the major contours of the study are Identification of the key variables that impinge upon the capital adequacy of banks Implications of new capital adequacy framework with special emphasis on credit rating.
METHODOLOGY OF THE STUDY

Building upon a review of the received literature and the evolution of the regulatory framework for banks in India since 1992-93, the study would take an exploration of interlinkages between capital and risks for banks with a view to examining the implications on the banking system of changes in the regulatory framework. Towards this end, the study would utilize several periods of cross-section data on commercial banks in a simultaneous equation framework to estimate the effect of capital changes on risk. An important aspect of the methodology would be its recognition of the fact that changes in both capital and risk has endogenous (i.e. discretionary) and exogenous (i.e. Non-discretionary) components. Consequently, the focus would be on determining the effects of discretionary changes in capital (i.e. risk), which are induced by either endogenous or exogenous changes in risk. Finally, with the new capital accord expected to be operational in the near future and given its emphasis on the ratings methodology, to what extent do banks impact the ratings process? As an added exercise an attempt will be made to address the related issue that if the CAR is inadequate as a regulatory framework, to what extent can alternative models of market risk induce banks to move from initial conditions along the leading curve to achieve the desirable levels of capital provisioning for varying levels of risk.
SAMPLE DESIGN
A sample of five banks each from nationalized, private and foreign sector was taken to know the overall level of the Capital Adequacy Ratio being maintained by different banks in various sectors, to comment on the capital adequacy of the banks. Along with that the Capital Adequacy Ratio of SBI GROUP that includes eight banks has been calculated to comment upon the impact of Basel-II norms on the Capital Adequacy Ratio of Indian banking industry.
LIMITATIONS OF THE STUDY
1.
Due to a time constraint, a small selection was taken. So we cannot comment on the capital adequacy of each and every bank.
2. The secondary data has been used, which is not very reliable, so accuracy has not been guaranteed.
CHAPTER-7 ANALYSIS & FINDINGS
A. Capital Adequacy Ratio of Nationalized Banks

Name Of Banks Capital Adequacy Ratio(%) Years
2001-02 State Bank Of India 2002-03 2003-04 2004-05 2005-06
13.35
13.50
13.53
12.45
11.88
Punjab National Bank Bank Of Baroda Canara Bank Dena Bank
10.70 11.32 11.88 7.6
12.02 12.65 12.5 6.0
13.5 13.91 12.7 9.5
14.78 12.62 12.7 11.91
11.95 13.65 11.22 10.62
Analysis of CAR of Nationalized Banks

If we compare the capital adequacy ratio of Nationalized Banks during the last five years period ranging from 2001-02 to 2005-06 than we can group this analysis in to two broad parameters below: Improvement in the Capital Adequacy Ratio Decline In The Capital Adequacy Ratio From the table it may be noted that almost all the banks have maintained the threshold level of 9.00% CAR. But it is also analyzed from the table that out of sample of five banks , CAR four banks has been declined this year as compared to the last year, except Bank of Baroda which CAR has been increased to 13.65% as compared to the last year, which is a good achievement for Bank of Baroda. Apart from this Dena Bank has also increase its CAR above the average level of 9.00 % in the year 2004-05.
B.
Capital Adequacy Ratio Of Private Sector Banks

2001-02 HDFC Bank 2002-03 2003-04 2004-05 2005-06
13.93
11.12
11.66
12.16
11.41
Indusindh Bank UTI Bank Ing Vyasa Bank ICICI Bank
12.5 10.65 11.57 11.44
12.13 10.9 9.81 11.10
12.75 11.21 11.05 10.36
11.62 12.66 9.09 11.78
10.54 11.08 10.67 13.33
Analysis of CAR of Private Sector Banks

If we look at the table it may be analyzed that all Banks are maintaining their CAR level above the average with ICICI having the highest CAR level , the Bank which was quite stable in maintaining the CAR level over the past few years has shown a remarkable growth in its CAR level this year as compared to previous years, which is a healthy sign for the Bank. On the other hand UTI Bank which has shown a consistent level of growth over the past few years has decreased its CAR level this year to 11.08% as compared to the previous years.
C.
Capital Adequacy Ratio of Foreign Banks

2001-02 American Express Citibank ABN Amro Bank NV Bank Of America 2002-03 2003-04 2004-05 2005-06
10.71 11.04 13.18 21.07
10.93 11.30 12.57 21.08
10.74 11.11 13.48 22.92
10.87 10.78 10.55 30.07
10.20 11.33 10.44 23.41
Bank Of Ceylon
30.94
32.29
45.26
49.40
56.37
Analysis of CAR of Foreign Banks

Among all the foreign Banks mentioned above ,Bank of America has shown a decline in the CAR level in the year 2005-06, the decline with a huge percentage not a good sign for Bank of America as compared to the previous year 2004-05 when it has shown a remarkable growth , while the other Banks that were quite stable in maintaining their CAR level during the last few years has decreased their CAR level as compared to the previous year, except Bank of Ceylon which has shown a remarkable growth this year has increased its CAR level to 56.37% from 49.40 % as compared to the previous year with the highest level of CAR this year.
CHAPTER-8 ANALYSIS OF CAR OF SBI GROUP
CAR OF STATE BANK OF INDIA YEAR TIER-1 2000-01 8.65 2001-02 7.68 2002-03 8.81 2003-04 7.36 2004-05 8.04 2005-06 9.36
TIER- II 4.14 5.67 4.69 6.17 4.41 2.52
CAR 12.79 13.35 13.5 13.53 12.45 11.88
ANALYSIS
From the above table it can be said that, in the year 2000-01 CAR level of SBI stood at 12.79, which is much above the average level of 9%. After that, it starts increasing its CRR with the growth percent of nearly 4.5 for a consecutive period of three years. Then it starts declining with a percentage variation of 7.9.This year CAR stood at 11.88 ,which is below the CAR level as compared to previous years CAR level of 12.45%. Apart from the CAR level of State Bank Of India TIER-1 is increasing at an Average of .61 %. As the CAR is Following the pattern of growth for the period 2001-04, But TIER-1 is following the uneven growth & decline. As it can be seen from the above table that the TIER-1 capital has been decreased to 7.68% in the year 2001-02 as compared to the TIER-1 capital of the year 2000-01.In the year 2002-03 it has been increased with a percentage of 0.13% in the year 2003-04 it again decreased to 7.36% with a percentage of 0.08 as compare to the previous years TIER-I capital of 8.81. In the year 2005-06 it increase to 9.36% with a growth percentage of 0.14 as compare to the previous
years TIER-I of 8.04%. TIER-II has been increased to 5.67% in the year 2001-02 as compare to the previous years 4.14% with a growth percentage of 0.23%. In the year 2002-03 it decreased to 4.69% . In the2005-06 it decreased to 2.52% which is the lowest this year
. CAR OF STATE BANK OF BIKANER & JAIPUR
YEAR 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06
TIER-1 8.67 9.45 10.52 7.89 7.95 8.50
TIER- II 3.72 3.97 2.66 5.04 4.65 3.58
CAR 12.39 13.42 13.18 12.93 12.6 12.08
ANALYSIS
From the above table, it can be analysed that, State Bank of Bikaner and Jaipur followed the same pattern of growth and decline in its CAR level as of State Bank of India with a same percentage of growth and decline. As it can be seen in the year 2000-01 CAR was 12.39% and the TIER-1 and TIER-II Capital was 8.67% and 3.72. In the year 2001-02 CAR has been increased and TIER-1 and TIER-II capital has also been increased to 9.45% and 3.97 % respectively.TIER-I was following the same increasing pattern in the year 2002-03 10.52% but the TIER-II capital was decreasing and it was 2.66% in the same year. But in the year 2003-04 TIER-I capital has decreased to 7.89% whereas TIER-II increased to 5.04%. It can be seen that there is a inverse relation in TIER-I and TIER-II capital because it can also be seen from the table that in the year 2005-06 TIER-I increased to 8.50% and TIER-II decreased to 3.58% as compare to previous year.
CAR OF STATE BANK OF HYDERABAD YEAR TIER-1 2000-01 10.02 2001-02 9.99 2002-03 9.84 2003-04 7.41 2004-05 7.58 2005-06 8.95
TIER- II 2.26 4.04 5.07 6.88 4.16 3.13
CAR 12.28 14.03 14.91 14.29 11.74 12.08

Banking Industry in India

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A RESEARCH PROJECT ON

BANKING INDUSTRY IN INDIA: IMPACT OF BASEL-II NORMS ON CAPITAL ADEQUACY OF BANKS

MASTER OF BUSINESS ADMINISTRATION

Supervised by: Dr. Mahesh Garg Reader Department of Business Management

GURU JAMBHESHWAR UNIVERSITY of Science and Technology, HISAR

DEPARTMENT OF BUSINESS MANAGEMENT

DEPARTMENT OF BUSINESS MANAGEMENT

GURU JAMBHESHWAR UNIVERSITY of Science and Technology, HISAR

Dr. Mahesh Garg Reader

on Capital Adequacy of Banks

(Dr. Mahesh Garg)

Chapter-1 Banking Industry In India

Banking Industry In India

Foreign Banks and New Private Sector Banks

Chapter-2 Introduction To Capital of Commercial Bank

Relevance of Capital Adequacy

CHAPTER-3 BASEL-I ACCORD

Capital Adequacy Ratio - Basel Accord 1988

Salient Features of Basel 1988 Accord

(c) Deductions from Capital

II. The Risk Weights

COMPUTATION OF CAPITAL ADEQUACY RATIO

Computation of Capital Adequacy Ratio as per Guidelines of RBI

Step 2: Calculation of Risk Weighted Assets (RWA)

2.5 2.5 100 100 100 100 100

Discount Rate (%) 0 20 60 80 80 100

Amount to be taken in % 100</< TR> 80 40 20 20 10

Adoption of CAR Norms by Indian Banks

Issues Specific to Emerging Markets For New Framework

Scope Of The Application

Objectives of the new framework

BANKS CAPITAL STRUCTURE AND BASEL-II

Market risk Standardized approach Model based approach

INTERNAL RATINGS BASED APPROACH

2. Standardized approach 3. Measurement approach

CAPITAL ADEQUACY RATIO

Impact of Basel-II Norms

Impact of Basel-II Norms

Calculation of Capital Adequacy of State Bank of India

24032531 221102100 (9.36%) 59258257.68 (2.52%) 279360357.60 11.88%

Note: Revenue reserves are taken at 50%.

Calculation of Capital Adequacy of State Bank of Indore

Note: Revenue reserves are taken at 50%.

RWA = Capital (Tier I + II) / CAR RWA=12859787.36/ 11.40=1128051.52 thousands

Calculation of Capital Adequacy of State Bank of Hyderabad

(Figures in 000s) 2005-06 172500 6762844 20808

7092023.50 4 14048179.50 63253 13984926.50 (8.95%) 4890817.87 (3.13%) 18875744.37 (11.08%)

Note: Revenue reserves are taken at 50%.

RWA = Capital (Tier I + II) /CAR RWA=18875744.37/11.08=1703587 thousands

Calculation of Capital Adequacy of State Bank of Patiala

Note: Revenue reserves are taken at 50%.

RWA = Capital (Tier I + II) / CAR RWA=21890670/13.67=1061365.76

Calculation of Capital Adequacy of State Bank of Mysore

Calculation of Capital Adequacy of State Bank of Travancore

Calculation of Capital Adequacy of State Bank of Saurashtra

Calculation of Capital Adequacy of State Bank of Bikaner and Jaipur

Need of the research

Objective of the study

METHODOLOGY OF THE STUDY

LIMITATIONS OF THE STUDY

CHAPTER-7 ANALYSIS & FINDINGS

A. Capital Adequacy Ratio of Nationalized Banks

Punjab National Bank Bank Of Baroda Canara Bank Dena Bank