CAPITAL ADEQUACY

REQUIREMENTS OF BANKS-
BASEL I & II

PRESENTED BY:
Prerna Garg A65
Megha Jain A68
 NEED FOR CAPITAL
• Servicing its depositors
• Discharging the responsibility of
infrastructural investment
• Acquiring assets
• Establishing branch network
• Entering into fund based activities
• Maintaining net worth requirements
 TRADITIONAL MEASURES OF
CAPITAL ADEQUACY
• Equity Ratio
n to
- ratio of equity capital over loans and investments
i v e
e g
o b
• Ratio of Paid up Capital to Reservesa s t
r of andi
n h i b e er
• Capital-Deposit Ratio eratio ts, cal us op
si d sse od
- used previously incUSA on o& f a UK t s M
u e i ty n d i
- high C-D ratio e dimpliesal low t a risk for depositors
f r
o e q m en u
er e th the equality of assets into which the
- ExtentThvaries on n a g
a
ti s m
deposits are converted
So…
To assess the adequacy of capital based on the
quality of assets, the Capital to Risk Weighted
Assets Ratio (CRAR) or the Capital
Adequacy Ratio (CAR) was introduced in
1988 by the BASEL Capital Adequacy
Accord
 THE BASEL COMMITTEE ON
BANKING SUPERVISION (BCBS)
• BCBS was formed under the auspices of BIS
(Bank for International Settlements- An
international clearing bank for Central banks) in
1974 due to the need for uniform capital
standards.
• The Basel Committee, established by the central-
bank Governors of the G-10 countries.
• The Committee's members come from Belgium,
Canada, France, Germany, Italy, Japan,
Luxembourg, the Netherlands, Spain, Sweden,
Switzerland, United Kingdom and United States.
 BASEL IS CONSTANT WIP

1988 – Basel Accord I

1999 – Consultative paper (Proposal to
replace 1988 accord with Basel II)
2004 – The Final Accord
2006 - Implementation in G10+3 countries
Implementation across EU
Implementation in Emerging Markets
 BASEL ACCORD I (1988)
Principal purposes:
• To ensure an adequate level of capital in the international
banking system
• To create a more level playing field so that banks could no
longer build business volume without adequate capital
backing
The Basel Accord I became a World
standard with well over 100 countries
applying the framework to their banking
system
 BASEL ACCORD I (1988)
• Requires the banks to hold capital equal to at least
8% of its Risk Weighted Assets - CAR
• The definition of capital is broadly into two tiers –
Tier 1 and Tier 2
• Weights are assigned to each asset depending on
its riskiness.
• Assets are classified into four buckets (0%, 20%,
50%, 100%) according to their debtor category.
 CAPITAL ADEQUACY NORMS

To assess the CAR, three aspects are relevant:

• Composition of Capital

• Composition of Risk Weighted Assets

• Assigning Risk Weights

COMPOSITION OF CAPITAL
• Tier 1 Capital
- core capital
- most permanent and readily available support against
unexpected losses

• Tier 2 Capital
- supplementary capital
- not permanent in nature and not readily available
 TIER 1 CAPITAL
Consists of :
• Paid up capital
• Statutory reserves
• Disclosed free reserves
• Capital reserves representing surplus arising out of sale proceeds of
asset

Equity investments in subsidiaries, intangible

assets and losses will be deducted from Tier 1
capital
 TIER 1 CAPITAL FOR FOREIGN
BANKS OPERATING IN INDIA
Consists of :
• Interest free funds from head office kept in a
separate account in the Indian books specifically
for the purpose of meeting the Capital Adequacy
norms
• Statutory reserves kept in Indian books
• Remittable surplus retained in Indian books which
is not repatriable so long as the bank functions in
India
 TIER 2 CAPITAL
Consists of :
• Undisclosed reserves and Cumulative perpetual
preference shares
• Revaluation reserves
• General provisions and loss reserves
• Hybrid debt capital instruments
• Subordinated debt
 COMPONENTS OF TIER 2
• Undisclosed Reserves
- absorb expected losses
- present accumulations of post tax profits
- not encumbered by any known liability

• Cumulative perpetual preference shares

- should be fully paid up
- should not contain clauses which permit redemption by
the holder
 CONTINUED…
• Revaluation Reserves
- Arise from revaluation of assets that are undervalued in the
books, typically premises and marketable securities
- Their reliability depends on the accuracy of estimates of
market value of the assets, the subsequent deterioration in
asset value, or in forced sale, the actual liquidation value
etc.
- Need to be discounted to a minimum of 55% when
including in tier 2 capital
 CONTINUED…
• General Provisions and loss revenues
- Are not attributable to the actual diminution in value or
identifiable potential loss in any specific asset and are
available to meet unexpected losses.
- They are admitted up to a maximum of 1.25 percent of
weighted risk assets.

• Hybrid Debt Capital Instruments

- Combine characteristics of both Debt and Equity
- 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
 CONTINUED…
• Subordinated Debt
- Fully paid up, unsecured, subordinated to the claims of other
creditors, free of restrictive clauses and should not be
redeemable at the initiative of the holder.
- Should have a minimum initial maturity of 5 years.
- Should have a minimum remaining maturity of 1 year.
- Limited to 50 percent of Tier 1 Capital.
- Subjected to progressive discounts as they approach maturity.
 DISCOUNTED RATES FOR
SUBORDINATED DEBT

Remaining Term to Maturity Discount Rate

More than 4 but less than 5 20 percent

More than 3 but less than 4 40 percent

More than 2 but less than 3 60 percent

More than 1 but less than 2 80 percent

Does not exceed 1 year 100 percent

 POINTS TO NOTE

• The sum of Tier 1 and Tier 2 capitals will represent the

capital funds for the computation of CAR.
• The total of Tier 2 elements can be a maximum of 100
percent of the total of Tier 1 elements.
• Investment by banks in the subordinated debt of the other
banks shall be subject to the ceiling of 5 percent of their
investment in shares or corporate bodies.
• A bank’s total investment in the Tier 2 Bonds issued by
other banks and financial institutions shall be permitted to
a maximum of 10 percent of its total capital, the same as
used for computing CAR.
 RISK ADJUSTED ASSETS
• Risk adjusted assets would mean weighted aggregate of
funded and non funded items.
• Degrees of credit risk expressed as a percentage weighting
are assigned to Balance sheet items.
• Conversion factors are assigned to Off-Balance Sheet items.
• Investment in all securities should be assigned a risk weight
of 2.5 percent for market risk in addition to credit risk.
• The value of each asset is multiplied by the relevant weights
to produce risk-adjusted values of assets and off-balance
sheet items.
• The aggregate is taken into account for reckoning the
minimum capital ratio.
 RISK WEIGHTS
• 0%
- Cash
- Claims on Central government and Central Banks
denominated in national currency
- Loans guaranteed by Government of India/ State
Government
- Investment in Government securities
- Investment in other approved securities guaranteed by
Central/State Government
- Investment in securities where payment of interest and
repayment of principal is guaranteed by Central/State
Government. E.g. Indira/ Kisan Vikas Patra
 CONTINUED…
• 20%
- Investment in approved securities where payment of
interest and repayment of principal is not guaranteed by
the Central/State Govt.
- Claims on commercial banks and Public Financial
Institutions
- Investment in securities which are guaranteed by banks
or PFIs
- Investments in bonds issued by other banks or PFIs
- Loans and advances granted to staff of banks which are
fully covered by superannuation benefits and mortgage
of flat or house.
 CONTINUED…
• 50%
- Investment in mortgage backed securities of residential
assets of housing finance companies which are
recognised by National Housing Bank
- Advances covered by ECGC/DICGC
- Housing loans to individuals against the mortgage of
residential property
 CONTINUED…
• 100%
- Claims on private sector
- Investments in subordinated debt instruments and
bonds issued by other banks or public financial
institutions for the Tier 2 capital
- Deposits with SIDBI/NABARD in lieu of the shortfall
in lending to priority sector
- Furniture, fixtures and premises
- Loans granted to public sector undertakings of
government of India
- Loans granted to public sector undertakings of State
governments
 OFF-BALANCE SHEET ITEMS
• The credit risk exposure of such items is calculated by
multiplying the face amount of each of such item by the
credit conversion factor
• This is then multiplied by the risk weight attributed
Examples:
- Certain transaction-related contingent items
- Short term self-liquidating trade-related contingencies
- Forward assert purchases, forward deposits and partly
paid up shares and securities
- Sale and repurchase agreement and asset sales with
recourse, where the credit risk remains with the bank
 EXAMPLE
1. Funded risk assets
Amount (Rs. (1) *(2) (rs. Crore)
Particulars Crore) (1) RW (%) (3)
Cash and Bank Balance with RBI 188.36 0 0
Money at call and short notice 212.5 0 0
Investments
GOI Securities 601.13 2.5 15.03
Certificate of deposits 4.65 22.5 1.05
Other approved securities 352.16 2.5 8.80
others 27.77 102.5 28.46
Advances
guaranteed by GOI 359.87 0 0.00
Others 918.09 100 918.09
Fixed assets 147.94 100 147.94
Other assets 81.85 100 81.85
Total 1201.22
 CONTINUED…
2. Off-Balance sheet items
Amount (Rs. (1) *(2) (rs. Crore)
Particulars Crore) (1) RW (%) (3)
Guarantees given on behalf
of constituents 131.33 100 131.33
Forward exchange contracts
(2141.45 * .02 + 713.82*.05) 78.52 100 78.52
Total 209.85

Total risk Weighted asset = Rs. 1411.07 crores

 CONTINUED…
• Capital
Tier 1 = Equity + statutory reserves + capital reserves – Equity
investments in subsidiaries
= 11.6 + 94.26 + 20.29 – 37.13
= Rs. 89.02 crores
Tier 2
Particulars Amount 1 - Discount Amount
(Rs. Crore) rate considered
(Rs. Crores)
undisclosed reserves 36.62 1 36.62
Revaluation reserves 34.88 0.45 15.696
General provisions and loss 36.29 1 or 1.25% of 17.64
reserves RWA whichever
is lower
total 69.956

Total capital = 89.02 + 69.95 = Rs 158.98 crores

 CONTINUED…
Capital Adequacy ratio
= Capital
Risk Weighted Assets
= 158.98
1411.07
= 11.3 %
Which is more than the stipulated requirement
 EXISTING BASEL CAPITAL ACCORD –
WHY CHANGE?

1988 Capital Accord served the industry well, but

• Insufficiently sensitive to risk
- Very broad categories of risk weights.
- E.g. A loan to Reliance is deemed as risky as a loan
to Haldirams
• Very limited account of risk mitigation
- does not sufficiently recognise credit risk mitigation
techniques, such as collateral and guarantees.
• No incentive structure to improve risk measurement and
risk management practice
 CONTINUED…
• Perverse incentives leading to regulatory arbitrage
- To lend to poorer quality credits
- To securitise better quality assets
- A flat 8 percent charge for claims on the private
sector has given banks an incentive to move high
quality assets off their balance sheet, thus reducing
the average quality of their loan portfolios.
• The regulatory capital requirement has been in conflict
with increasingly sophisticated internal measures of
economic capital.

Therefore, the Basel Committee decided to propose a

more risk-sensitive framework in June 1999.
BASEL II: A MAJOR PARADIGM SHIFT

The Existing Accord The New Accord

• Focus on a single risk • More emphasis on banks’

measure internal methodologies,
supervisory review &
market discipline

• One size fits all • Flexibility, menu of

approaches, capital
incentives for good risk
management

• Broad brush structure • Increased risk sensitivity

 BASEL II STRUCTURE
New Basel Capital Accord

Pillar 1 Pillar 2 Pillar 3

“Quantitative” “Qualitative” “Market Forces”

Minimum Capital Supervisory

Market
Requirements Review Process
Discipline

• Calculation of capital
requirements • Process for assessing
overall capital adequacy • Disclosure
• Credit risk requirements
• Banks are expected to
• Operational risk operate above the • Capital structure
minimum regulatory
• Advanced • Risk exposures
capital ratios
Approaches
• Early intervention by • Capital adequacy
• Trading book supervisors
(market risk)
 RISK COMPONENTS TO CAPITAL
ADEQUACY CALCULATION

Unchanged

Total Capital  8%
Credit Risk + Market Risk + Operational Risk

Significantly Relatively New (Could be set higher

Refined Unchanged under pillar 2)
 CAPITAL ADEQUACY UNDER BASEL II
PILLAR I
• Market risk
– As per Basel Accord I
• Credit risk
– (a) Standardised approach – more granular version of Basel I
– (b) Foundation Internal Rating Based Approach (IRB) – uses
banks’ own credit ratings
– (c) Advanced IRB – other inputs also determined by bank
• Operational risk
– (a) Basic indicator approach - % of revenue
– (b) Standard indicator approach - % of revenue/assets, by line
of business
– (c) Advanced Measurement Approach – internal models etc
 PILLAR 1 – CREDIT RISK
• Standardised approach
– Risk weights (largely) a function of external ratings
AAA to BBB+ to
Credit assessment A+ to A- Below BB- Unrated
AA- BB-
Risk-weight 20% 50% 100% 150% 100%

• IRB approaches (Foundation and Advanced)

– Risk weights a function of internal credit ratings
– Theoretically unlimited number of grades (minimum 7 for
performing loans)
– Does not allow banks themselves to determine all the
elements needed to calculate their own capital requirements.
– Determined through a combination of the quantitative inputs
provided by banks and the formulae specified by the
Committee.
INTERNAL RATING BASED APPROACH (IRB)

The IRB calculation of risk-weighted assets for exposure to

sovereigns, banks or corporates depends on four quantitative
inputs:
• Probability of Default (PD), which measures the likelihood
that the borrower will default over a given time-horizon
• Loss Given Default (LGD), which measures the proportion
of the exposure that will be lost if a default occurs
• Exposure at Default (EAD) which, for loan commitments,
measures the amount of the facility that is likely to be
drawn if a default occurs
• Maturity (M), which measures the remaining economic
maturity of the exposure
 FOUNDATION AND ADVANCED IRB
APPROACH - A COMPARISON

Foundation IRB Advanced IRB

PD Provided by banks, based Provided by banks, based
on own estimates. on own estimates.
LGD Supervisory rules set by Provided by banks, based
the committee on own estimates.
EGD Supervisory rules set by Provided by banks, based
the committee on own estimates.
M Supervisory rules set by Provided by banks, based
the committee or at on own estimates.
National Discretion, by
Banks’ own estimate
 PILLAR 1 – OPERATIONAL RISK
In the Basel II framework, operational risk is defined as the
risk of “losses resulting from inadequate or failed internal
processes, people and systems, or external events.”

• In the near term operational risk is not likely to attain the

precision with which market and credit risk can be
quantified.
• This has posed obvious challenges to the incorporation of
the New Accord.
• Approaches to operational risk are continuing to evolve
rapidly.
 PILLAR II: SUPERVISORY
REVIEW PROCESS

• Inclusion of a supervisory element

• Requires Bank Management
- developing an internal capital assessment process
- Setting targets for capital commensurate with bank’s
particular risk profile
• The process subject to supervisory review and
intervention
 PILLAR III: MARKET
DISCIPLINE
• Enhanced disclosure by banks
- Areas covered are calculation of capital adequacy and
risk assessment methods
- Detailed requirements on internal methodologies for
credit risk, credit risk mitigation techniques and asset
securitization

These norms are set up basically to ensure that

market participants can understand the risk profiles
and adequacy of capital
 MAINTENANCE OF CRAR
• The initial Capital to Risk-weighted Ratio
(CRAR) was initially set at 8 %
• However, to meet the international standards,this
has been raised to 9% with effect from March 31,
2000.
• At the end of March 2002, there were 25 PSBs
with a CRAR exceeding the stipulated 9%
• The implementation of Basel New Accord has
been estimated to be completed by end-2006
 THRUST AREAS
Areas to be considered by an organisation
while preparing for Basel II
• Reviewing existing frameworks
• Deciding the approach for risk measurement and
management
• Building flexible and scalable system
• Developing reliable, efficient disclosure reporting
• Communicating the approach
• Finding the right IT partner for the compliance
 CONCLUSION
Basel II
• Offers a variety of options in addition to the standard
approach to measuring risk.
• Paves the way for financial institutions to proactively control
risk in their own interest and keep capital requirement low.
But..
• Requires strategising risk management for the entire
enterprise, building huge data warehouses, crunching
numbers and performing complex calculations.
• Poses great challenges of compliance for banks and financial
institutions.
Increasingly, banks and securities firms world over are
getting their act together.
THANK YOU…