Capital Adequacy

Norms
Submitted to : Mrs. Ramneek Kaur

Submitted by : Radhika 5805

Kanishka 5806
 Capital Adequacy Ratio
Introduction
• Capital adequacy ratio is defined as:
CAR= Tier I + Tier II + Tier III capital (capital
funds) Risk Weighted Assets (RWA)

CAR

Tier 1 Tier 2 Tier 3

Tier-I Capital consists of:-
 Paid-Up Capital.
 Statutory Reserves.
 Other Disclosed Free Reserves: Reserves which are not kept side for
meeting any specific liability.
 Capital Reserves : Surplus generated from sale of Capital Assets

Tier-II Capital consists of :-

 Undisclosed Reserves and Paid-Up Capital Perpetual Preference Shares.
 Revaluation Reserves (at discount of 55%).
 Hybrid (Debt / Equity) Capital.
 Subordinated Debt.
 General Provisions and Loss Reserves.

There is an important condition that Tier II Capital cannot exceed 50% of Tier-I
Capital for arriving at the prescribed Capital Adequacy Ratio.
Tier 3 :can be used to meet a proportion of the capital requirements of market
risk . Consist of subordinated debt with some limitations. It came into existence
after Basel II norms.
 Types of Risks
• This is the risk of non recovery of loan or the risk of
Credit risk reduction in the value of asset

Interest rate risk • this risk arises due to fluctuations in the interest rates

Liquidity risk • Liquidity is the ability to meet commitments

Foreign exchange risk • it involves currency rate risk, transaction rates

Regulatory risks • risk associated with the impact on profitability and financial
position of a bank due to changes in the regulatory conditions

Technology risks • This risk is associated with computers and the

communication technology

Market risk • This is the risk of losses in off and on balance sheet

Strategic risk • This is the risk arising out of strategic decisions taken by
the banks
 Components of risk management
system

Risk
management
system

Risk Risk
Risk control
identification measurement
 Risk weighted assets

1st Lowest risk category: (no default risk) 0% risk weightage

e.g.( Gov. .bonds)

2nd Lowest risk category: (low defaulted risk) 20% risk weightage
e.g.,( interbank deposits. Full backed mortgage bonds)

3th Risk category (Low to moderate default risk) 50%Risk weightage

e.g.. (municipal bonds, residential mortgage)

4th Risk category (moderate to high default risk) 100% risk weightage risk)
e.g.. ( all other loans, commercial; property etc.
 Basel Committee
• Established by central bank governors of G-10 countries.
• It has 27 members currently.
• Objective was to enhance understanding of key supervisory
issues and improve the quality of banking supervision
worldwide.
• Meets at BIS, Basel, Switzerland.
• First major result was 1988 accord.
 27 members
Algeria Cana Greece Latvia Romania
Argentina Chile Hong Kong Lithuania Russia
Australia China Hungary Malaysia Saudi Arabia
Austria Croatia Iceland Mexico Singapore
Belgium Denmark India Netherlands South Africa
Bosnia and Estonia Israel New Zealand Spain
Herzegovina Finland Italy Norway Switzerland
Brazil France Japan Poland Thailand
Bulgaria Germany Korea Portugal united kingdom
The European Bank
 Basel accords

There are 3 set of basel accords:

 Defects of Basel I
• 1) The Accord was criticized for assigning
weights to OECD and NON OECD exposures of
banks.
• 2) It made emphasis on credit neglecting
others.
• 3) The accord did not distinguish between
sound and weak banks.
• 4) Finally, There are objections to CRAR as a
method of regulation
 Implications for not meeting capital
adequacy norms
• Credibility of banks will adversely affect.
• Restrict the flexibility and expansion
• Fall in deposits
• Fall in profitability
• Decline in economic growth
 Suggestions to improve capital
adequacy Ratio
• Mergers
• Better Asset management
• Improve recovery methods
• Recapitalization by government
• Equity participation by employees
Basel II
Pillar I

CREDIT RISK

OPERATING RISK

MARKET RISK
 CREDIT RISK MEASUREMENT APPROACHES
Criteria
Rating
Risk weight
Probability of default i.e.
the likelihood that a
borrower will default
over a given time period
Exposure of default: for
loans, the amount of the
facility that is likely to be
drawn if a default occurs
Loss given default (LGD):
The proportion of the
exposure that will be lost
if a default occurs
Standardized approach
External
Calibrated on the basis
external ratings by the basel
committee
Implicity provided by the
basel committee tied to risk
weights based on external
ratings
Implicity provided by the
Basel Committee, tied to
risk weights based on
external ratings
Implicity provided by the
Basel Committee, tied to
risk weights based on
external ratings
Internal ratings based(IRB) Approach
Foundation approach Advanced approach
Internal Internal
Function povided by the Function provided by the
basel committee basel committee
Provided by bank based Provided by bank based
on own estimates on own estimates
Supervisory values set Provided by bank based
by the Basel on own estimates;
Commmittee extensive process and
internal control
requirement
Supervisory values set Provided by bank based
by the Basel Committee on own estimates;
extensive process and
internal control
requirement
Maturity i.e. the Implicity recognition Supervisory values set Provided by bank based
remaining economic by the Basel Committee on own estimates (with an
maturity of the exposure or allowance to exclude
At rational discretion, certain exposures)
provided by bank based
on own estimates (with
an allowance to exclude

Data requirements  Provision dates  Rating data Same as IRB

 Default events  Default events foundation plus:
 Exposure data  Historical data to  Historical loss data to
 Customer segmentation estimate PD’s (5 estimate LGD (7 years)
 Data collateral years)  Historical exposue
segmentation  Collateral data data to estmate EAD(7
 External ratings years)
 Collateral data

Credit risk mitigation Defined by the supervisory All collaterals from All types of collaterals, if
techniques (CRMT) regulator; including standardised approach; bank can prove a CRMT by
finanacial collateral, receivables from goods internal estimation
gaurantees, credit and services; other
derivatives. “netting” (on physical securities if
and off the balance sheet) certain criteria are met
and real estates.
Maturity : the remaining  Minimum requirements Same as Standardized Same as IRB foundation,
economic maturity of the for collateral approach; plus plus minimum
exposure management minimum requirements requirements to ensure
(administration/ to ensure quality of quality of estimation of
evaluation) internal ratings and PD all parameters
 Provisioning process estimate on and their
use in the risk
management process
 OPERATIONAL RISK MEASUREMENT APPROACHES
Calculation of capital charge Basic indicator approach Standardized approach
Calculation of capital charge  Average of gross  Gross income per
Qualifying criteria income over three regulatory business
years as indicator. lines as indicator.
 Capital charge equals  Depending on business
15% of that indicator line, 12%, 15% or 18%
of that indicator as
capital charge
 Total capital charge
equals sum of charge
per business line
 No specific criteria  Active involement of
 Companies with the board of directors and
basel committee’s senior management
“sound practices for the  Existence of operational
management and risk managemet
supervision of function
operational risk”  Sound operational risk
recommended management system
 Systematic tracking of
loss data
Advanced measurement
approach (AMA)
 Capital charge equals
internally generated
measure based on
a)internal loss data; b)
external loss data c)
scenario analysis d)
business environment
and internal control
factors
 Recognition of risk
mitigation (up to 20%
possible)
 Market discipline
reinforces efforts to
promote safety and
soundness in banks.
 Core disclosures (basic
information) and
supplementary
disclosures to make
market discipline more
effective.
 Market risk
 Market risk is simply the risk of loss as a result
of movements in the market prices of assets.
 In this regard, Basel II makes two clear
distinctions –
 one in respect of asset categories,
 and the other regarding types of principal
risks..
 Pillar II Supervisory Review
• Principle 1: Banks should have a process for assessing their overall capital
adequacy in relation to their risk profile and a strategy for maintaining their capital
levels.

• Principle 2: Supervisors should review and evaluate banks’ internal capital

adequacy assessments and strategies, as well as their ability to monitor and
ensure their compliance with regulatory capital ratios. Supervisors should take
appropriate supervisory action if they are not satisfied with the result of this
process.

• Principle 3: Supervisors should expect banks to operate above the minimum

regulatory capital ratios and should have the ability to require banks to hold capital
in excess of the minimum.

• Principle 4: Supervisors should seek to intervene at an early stage to prevent

capital from falling below the minimum levels required to support the risk
characteristics of a particular bank and should require rapid remedial action if
capital is not maintained or restored.
 Pillar III Market discipline
• Banks, including consolidated banks, should provide all
Scope and frequency pillars 3 disclosures, both qualitative and quantitative, as at
end-march each year along with annual financial statements
of disclosure

• The disclosure should be subjected to adequate

Validation validation.

• Information should be regarded as material i.e.

Materiality without omission

General disclosure • what disclosure it will make, the internal control over the
process, process for assessing the appropriateness of their
principle disclosures, validation and frequency
 CHALLENGES IN BASEL II IMPLEMENTATION

Constitute Challenges
Banks  Interpret new regulations and understand effects on business
 Secure and maintain board and senior management sponsorship
 Face new expectations from regulators, rating agencies and customers
 Need to consider whether to target certain customers / products or
eliminate others
Customers  Face new costs resulting from need to provide lenders with new, timely
information
 Use key performance indicator to monitor performance
 Face request for better collateralization
 Manage rating process
Regulators  Need well trained, educated professionals to fill roles
 Create regulation that reflects the linkage among risks
 Provide incentives for banks to evaluate risks through stress testing and
scenario analysis
Rating agencies  Seek to improve reputation (national agencies)
 Maintain high quality of ratings
Financial institutions  Interpret new regulations and understand effects on business and risk
out of basel II scope management
 Demonstrate quality as Basel II emerges as a best practice standard
 Basel III Pillars

Pillar 1 : Minimum Regulatory Capital Requirements based

on Risk Weighted Assets (RWAs) : Maintaining capital
calculated through credit, market and operational risk areas.

Pillar 2 : Supervisory Review Process : Regulating tools and

frameworks for dealing with peripheral risks that banks face.

Pillar 3: Market Discipline : Increasing the disclosures that

banks must provide to increase the transparency of banks
 Features of basel III
(b) Capital
(a) Better Capital (c) Countercyclical
Conservation
Quality : Buffer
Buffer

(d) Minimum
Common Equity
(e) Leverage Ratio (f) Liquidity Ratios
and Tier 1 Capital
Requirements

(g) Systemically
Important
Financial
Institutions (SIFI)
 Comparison of Capital Requirements under Basel II and Basel III

Requirements Under Basel II Under Basel III

Minimum Ratio of Total Capital To
8% 10.50%
RWAs
Minimum Ratio of Common Equity to
2% 4.50% to 7.00%
RWAs
Tier I capital to RWAs 4% 6.00%
Core Tier I capital to RWAs 2% 5.00%

Capital Conservation Buffers to RWAs None 2.50%

Leverage Ratio None 3.00%
Countercyclical Buffer None 0% to 2.50%
Minimum Liquidity Coverage Ratio None TBD (2015)

Minimum Net Stable Funding Ratio None TBD (2018)

Systemically important Financial

None TBD (2011)
Institutions Charge
Summary