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

- ratio of equity capital over loans and investments

• Ratio of Paid up Capital to Reserves• Capital-Deposit Ratio

- used previously in USA & UK

- high C-D ratio implies low risk for depositors

- Extent varies on the quality of assets into which the deposits are converted

Therefore due consideration has to

be given to

the quality of asse

ts, caliber o

f

its management and its

Modus o

perandi

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

So…

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

ParticularsAmount (Rs.

Crore) (1) RW (%)(1) *(2) (rs. Crore)

(3)Cash and Bank Balance with RBI 188.36 0 0Money at call and short notice 212.5 0 0InvestmentsGOI Securities 601.13 2.5 15.03Certificate of deposits 4.65 22.5 1.05Other approved securities 352.16 2.5 8.80others 27.77 102.5 28.46Advancesguaranteed by GOI 359.87 0 0.00Others 918.09 100 918.09Fixed assets 147.94 100 147.94Other assets 81.85 100 81.85Total 1201.22

1. Funded risk assets

CONTINUED…

ParticularsAmount (Rs.

Crore) (1) RW (%)(1) *(2) (rs. Crore)

(3)Guarantees given on behalf of constituents 131.33 100 131.33Forward exchange contracts (2141.45 * .02 + 713.82*.05) 78.52 100 78.52Total 209.85

2. Off-Balance sheet items

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

(Rs. Crore)1 - Discount

rate Amount

considered (Rs. Crores)

undisclosed reserves 36.62 1 36.62Revaluation reserves 34.88 0.45 15.696General provisions and loss reserves

36.29 1 or 1.25% of RWA whichever

is lower

17.64

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

•More emphasis on banks’ internal methodologies, supervisory review & market discipline

•Flexibility, menu of approaches, capital incentives for good risk management

•Increased risk sensitivity

•Focus on a single risk measure

•One size fits all

•Broad brush structure

The Existing Accord The New Accord

BASEL II STRUCTURE

Market Market DisciplineDiscipline

Minimum Capital Minimum Capital RequirementsRequirements

SupervisorySupervisoryReview ProcessReview Process

Pillar 1“Quantitative”

Pillar 2“Qualitative”

Pillar 3“Market Forces”

• Calculation of capital requirements

• Credit risk

• Operational risk

• Advanced Approaches

• Trading book (market risk)

• Process for assessing overall capital adequacy

• Banks are expected to operate above the minimum regulatory capital ratios

• Early intervention by supervisors

• Disclosure requirements

• Capital structure

• Risk exposures

• Capital adequacy

New Basel Capital Accord

RISK COMPONENTS TO CAPITAL ADEQUACY CALCULATION

8%8%Total CapitalCredit Risk + Market Risk + Operational Risk

SignificantlyRefined

New

Unchanged

(Could be set higher under pillar 2)

RelativelyUnchanged

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

• 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.

Credit assessmentAAA to

AA-A+ to A-

BBB+ to BB-

Below BB- Unrated

Risk-weight 20% 50% 100% 150% 100%

INTERNAL RATING BASED APPROACH (IRB)

The IRB calculation of risk-weighted assets for exposure tosovereigns, banks or corporates depends on four quantitativeinputs:• 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 on own estimates.

Provided by banks, based on own estimates.

LGD Supervisory rules set by the committee

Provided by banks, based on own estimates.

EGD Supervisory rules set by the committee

Provided by banks, based on own estimates.

M Supervisory rules set by the committee or at National Discretion, by Banks’ own estimate

Provided by banks, based on own estimates.

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

• 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

Areas to be considered by an organisation while preparing for Basel II

CONCLUSIONBasel 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 aregetting their act together.

THANK YOU…