Executive Summary

A good and strong banking infrastructure plays a vital role in supporting economic activity and meeting the financial needs of all sections of the society and thus contributing in the overall growth of the country. For the smooth flow of credit in an economy and to meet various other requirements of the country, it is essential that banks should be financially sound. Capital adequacy ratio (CAR) is one of the measures which ensures financial robustness of banks in absorbing a reasonable amount of loss. 

Important terms related to Capital Adequacy:

BASEL III

It is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector. The Basel Committee on Banking Supervision published the first version of Basel III in late 2009, giving banks approximately three years to satisfy all requirements. Largely in response to the credit crisis, banks are required to maintain proper leverage ratios and meet certain minimum capital requirements.

Basel III is part of the continuous effort to enhance the banking regulatory framework. It builds on the Basel I and Basel II documents, and seeks to improve the banking sector’s ability to deal with financial stress, improve risk management, and strengthen banks’ transparency.

Minimum Capital Requirement

Basel III introduced tighter capital requirements in comparison to Basel I and Basel II. Banks’ regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity, and their dividends can be cancelled at any time. Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.

Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Risk-weighted assets represent a bank’s assets weighted by coefficients of risk set forth by Basel III. The higher the credit risk of an asset, the higher is its risk weight. Basel III uses credit ratings of certain assets to establish their risk coefficients.

In comparison to Basel II, Basel III strengthened regulatory capital ratios which are computed as a percent of risk-weighted assets are called CRAR.

CRAR is a ratio that determines the bank’s capacity to meet the time liabilities and other risks carried by the assets of the banks. In simple words CRAR explains the capital requirement for potential losses and protects the bank’s depositors and other lenders. It has two components, one is Capital which is the numerator and the other is Risk Weighted assets which is the denominator, both the components are discussed in detail below.

Significance of CRAR

  • The ratio is helpful in determining financial soundness of banks in absorbing a reasonable amount of loss.
  • Bank may trigger the PCA (Prompt corrective action) framework if it breaches the limit as fixed by the regulator.

How to calculate CRAR

Tier1 Capital+ Tier2 Capital

Risk weighted Assets

Threshold Prescribed by the Reserve Bank of India (RBI) for minimum capital ratio:

Minimum Capital Ratios As % to RWA as on June 30, 2020
Minimum Common Equity Tier 1 (CET 1) 5.5
Capital conservation buffer (CCB)* 1.875 (2.5 as on 30.09.2020)
Minimum CET 1+ CCB

Additional Tier 1

8

1.5

Minimum Tier 1 Capital (additional Tier 1 Capital + CET 1) 7
Minimum Tier 2 Capital 2
Minimum total Capital** 9
Minimum total Capital+CCB 10.875 (11.5 as on 30.09.2020)

*Capital conservation buffer was introduced during the year 2017 to maintain upto 0.625% with the condition to increase the same annually by 0.625% maximum upto 2.5%. As on 31.03.2020 it should be maintained at 2.5% but due to Covid-19 pandemic RBI has given relaxation to maintain the same till 30.09.2020.

**The difference between the minimum total capital requirement of 9% and the Tier 1 requirement can be met with Tier 2 and higher form of Capital.

CAPITAL :

Capital has two component Tier 1 and Tier 2 capital as already explained in the above paragraphs.

TIER 1 Capital :  It is the core capital of the bank and majorly consist of paid up capital, statutory reserves and other disclosed free reserves as reduced by equity investments in subsidiary, intangible assets, current & brought-forward losses. Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity and their dividends can be cancelled at any time.

TIER 2 Capital :  It is supplementary capital of the bank and it includes undisclosed Reserves, General Loss reserves ,hybrid debt capital instruments and subordinated debts with an original maturity of at least five years.

RISK WEIGHT ASSETS :

Risk Weight assets are of three types:

  • Credit Risk RWA
  • Market Risk RWA
  • Operational Risk RWA

Credit Risk RWA:

Credit risk is defined as the possibility of losses associated with reduction of credit quality of borrowers or counterparties. In a bank’s portfolio, losses arise from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading settlements, or any other financial transaction. Alternatively, losses occur from reduction in portfolio value due to deterioration in credit quality.

Market Risk RWA:

Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are:

1. The risks pertaining to interest rate related instruments and equities in the trading book; and

2. Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

The issues involved in computing capital charges for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and other precious metals) in both trading and banking books. Trading book for the purpose of capital adequacy will include:

1. Securities included under the Held for Trading category

2. Securities included under the Available for Sale category

3. Open gold position limits

4. Open foreign exchange position limits

5. Trading positions in derivatives, and

6. Derivatives entered into for hedging trading book exposures.

Operational Risk RWA:

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk but excludes strategic and reputational risk. Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.

Author Bio

Qualification: CA in Practice
Company: S.Vaish & Co.
Location: Kanpur, Uttar Pradesh, IN
Member Since: 20 Jul 2020 | Total Posts: 1

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