CAPITAL ADEQUACY & PLANNING

CAPITAL ADEQUACY & PLANNING

INTRODUCTION
 Capital is one of a number of factors considered when assessing the safety
and soundness of each financial institution.
 The efficient functioning of markets requires participants to have confidence
in each other's stability and ability to transact business.
 Capital rules help foster this confidence because they require each member
of the financial community to have, among other things, adequate capital.
 This capital must be sufficient to protect a financial organisation's
depositors and counterparties from the risks of the institution's on- and off-
balance sheet risks.
 Top of the list are credit and market risks; not surprisingly, banks are
required to set aside capital to cover these two main risks.
 Capital standards should be designed to allow a firm to absorb its losses,

and in the worst case, to allow a firm to wind down its business without loss
to customers, counterparties and without disrupting the orderly functioning
of financial markets.
 An adequate capital base acts as a safety net for the variety of risks that an
institution is exposed to in the conduct of its business.
 It is available as a cushion to absorb possible losses and provides a basis
for confidence in the institution by depositors, creditors and others.
 The regulation of capital is commonly viewed as the most important tool
available to financial institution regulators. It is the measure by which an
institution’s solvency is assessed.

SAMRITI GOEL

MBA LECTURER
 CAPITAL ADEQUACY & PLANNING

MEANING OF CAPITAL

 Capital is the investment in, or contribution to, the business of an institution

that ranks behind depositors and other creditors as to entitlement to
repayment or return on investment.
 Capital provides a stable resource to absorb any losses and thus provide a
measure of protection to depositors and other creditors in the event of
liquidation.
 The net worth of a business; that is, the amount by which its assets exceed
its liabilities.
 The money, property, and other valuables which collectively represent the
wealth of an individual or business.
 The basic funds and assets used by people, governments and businesses to
sustain and equip their income-earning activity.
 The accounting concept of capital refers to issued capital and retained
earnings of the company, representing the owners' or shareholders' initial
contribution to the business and the wealth that generates.

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MBA LECTURER
 CAPITAL ADEQUACY & PLANNING

CAPITAL ADEQUACY

 Percentage ratio of a financial institution's primary capital to its assets

(loans and investments), used as a measure of its financial strength and
stability.
 According to the Capital Adequacy Standard set by Bank for International
Settlements (BIS), banks must have a primary capital base equal to at least
eight percent of their assets.
 Amount of capital relative to a financial institution's loans and other assets.
 Almost all banking regulators require that banks hold a certain minimum of
equity capital against their risk weighted assets.
 The Basel Committee on Bank Supervision, a coordinating body within the
Bank for International Settlements, supervises the administration of capital
reserves for central bankers around the world.
 A ratio that can indicate a bank’s ability to maintain equity capital sufficient
to pay depositors whenever they demand their money and still have enough
funds to increase the bank’s assets through additional lending.
 Banks list their capital adequacy ratios in their financial reports.
 It is stated in terms of equity capital as a percent of assets.
 Capital adequacy management is that the manager must decide the amount
of capital that bank should maintain and then acquire the needed capital.
 An amount of money which a bank has to have in the form of stockholders'
capital, shown as a percentage of its assets.

Capital Adequacy Ratio (CAR)

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MBA LECTURER
 CAPITAL ADEQUACY & PLANNING

 Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets

Ratio (CRAR), is a ratio of a bank's capital to its risk.

 This ratio is used to protect depositors and promote the stability and
efficiency of financial systems around the world.
 Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."

 National regulators track a bank's CAR to ensure that it can absorb a

reasonable amount of loss and are complying with their statutory Capital
requirements.
 Capital adequacy ratios ("CAR") are a measure of the amount of a bank's

capital expressed as a percentage of its risk weighted credit exposures.

 Capital adequacy ratio is defined as

 where Risk can either be weighted assets ( ), or the respective national

regulator's minimum total capital requirement. If using risk weighted assets,

≥ 10%.

 The percent threshold (10% in this case, a common requirement for

regulators conforming to the Basel Accords) is set by the national banking

regulator.

Two types of capital are measured:

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MBA LECTURER
 CAPITAL ADEQUACY & PLANNING

 Tier one capital, which can absorb losses without a bank being required to

cease trading, and

 Tier two capital, which can absorb losses in the event of a winding-up and

so provides a lesser degree of protection to depositors.

USES OF CAR

1) Capital adequacy ratio is the ratio which determines the capacity of the

bank in terms of meeting the time liabilities and other risk such as credit
risk, operational risk, etc.
2) In the most simple formulation, a bank's capital is the "cushion" for
potential losses, which protect the bank's depositors or other lenders.
3) Banking regulators in most countries define and monitor CAR to protect
depositors, thereby maintaining confidence in the banking system.
4) CAR is similar to leverage; in the most basic formulation, it is comparable

to the inverse of debt-to-equity leverage formulations.

5) Unlike traditional leverage, however, CAR recognizes that assets can have

different levels of risk.

Capital Adequacy of Financial Intermediaries (FI)

What is a Financial Intermediary (FI)

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MBA LECTURER
 CAPITAL ADEQUACY & PLANNING

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.

Need for Capital:

 Financial Intermediaries need capital for two reasons:

1) To run operations of their business.

2) To safeguard against the losses, that may arise.

 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 the good performance of FIs the regulatory authority (RBI) has
specified the minimum capital for the FI.
 This requirement is called Capital Adequacy, and it is specified for Banks
and Non Banking Financial Corporations (NBFCs).

Computation of capital adequacy ratio (CAR) of banks:

For computation of CAR, we need to calculate:

• Tier I capital
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 CAPITAL ADEQUACY & PLANNING

• 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:

1. Paid up equity capital

2. Statutory reserves
3. Capital reserves
4. Other disclosed free reserves

Less:

1. Equity investments in subsidiaries

2. Intangible assets
3. Current and Accumulated Losses, if any

Step 2: Compute Risk Weighted Assets

Step 3: Compute tier II capital

These are not permanent in nature or, are not readily available.

Tier II capital consists of-

a. Undisclosed reserves and cumulative perpetual preference shares

b. Revaluation Reserves (RR)

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 CAPITAL ADEQUACY & PLANNING

c. General Provisions and Loss Reserves (GPLR)

d. Hybrid Debt Capital Instruments
e. Subordinated Debts

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 10%.

CAPITALPLANNING OR MANAGEMENT

 Managing capital is the ongoing process of determining and maintaining

the quantity and quality of capital appropriate for an institution.

 Managing capital adequacy requires a clear understanding of an

institution’s capital requirements and capital position related thereto.

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MBA LECTURER
 CAPITAL ADEQUACY & PLANNING

 Capital management is an important component in the safe and sound

management and the strategic planning of all institutions.

 The objective of capital management is to ensure that, on the one hand,

capital is, and will continue to be, adequate to maintain confidence in the
safety and stability of the institution and that, on the other hand, the return
on capital is sufficient to satisfy the expectations of investors.

 Although the particulars of capital adequacy and capital management will

differ among institutions, a comprehensive capital management programme
requires:
a. establishing and implementing sound and prudent policies governing
the quantity and quality of capital required to support the institution;
and
b. developing and implementing appropriate and effective procedures to
monitor, on an ongoing basis, the institution’s capital requirements
and capital position to ensure that the institution meets its capital
requirements and will continue to meet its future capital
requirements.

Capital Management Procedures

Each licensee needs to develop and implement appropriate and effective
procedures to manage its capital position. Such capital management procedures
need to include, at a minimum:

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 CAPITAL ADEQUACY & PLANNING

a. ongoing monitoring procedures to ensure that the institution’s capital

position meets its minimum capital requirements; and
b. a process of capital planning to ensure that the institution will
continue to meet its future requirements.
 When measuring capital adequacy it is not sufficient to consider only the
current capital position.
 The conditions on which any such judgement is based will change over time.

Therefore, each licensee needs to have in place a capital planning process

in order to be prepared for changing conditions.
 At a minimum, each institution should develop, at least annually, a plan for
maintaining adequate capital.

A capital plan needs to :

 see section for adjustments;
 identify the underlying assumptions supporting the projection;
 identify the quantity, quality and sources of additional capital required, if
any; assess the availability of any external sources identified;
 and estimate the financial impact of raising additional capital.

SAMRITI GOEL

MBA LECTURER