CAR and Basel Norms I, II & III

Prof. Divya Gupta

What is BIS?

The BIS, set up in 1930, in Swiss city Basel, the oldest international financial institution. It is increasingly recognized as the principal center for international central bank cooperation.

What is BCBS (Basel Committee on Banking Supervision)

This is a committee appointed by BIS to look into the adequacy of capital of banks with international presence. And the most far reaching of these initiatives was the laying down of minimum capital standards in 1988, known as Basel Capital accord.

Capital adequacy ratio (CAR)

It is the ratio of the banks capital to its risk weighted assets. To assess the capital adequacy of banks based on this ratio it is essential to understand three aspects: Composition of Capital Composition of Risk weighted assets Assigning Risk Weights

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It is the most important measure of banks soundness. It acts as a buffer. Adequacy is expressed as a minimum numerical ratio which the banks are expected to maintain. CAR= Capital / RWAs Capital = Tier I + Tier II

Risk Adjusted Assets & off B/S items:

Risk adjusted assets would mean weighted aggregate of funded and non-funded items. Degrees of credit risk expressed as percentage weightings have been assigned to B/S assets & conversion factors to off-balance sheet items. For ex. Banks investments in all securities should be assigned a risk weight of 2.5 % for market risk. (addition to credit risk)

Risk weight on different items of Assets & Off B/S items

s.n 1 2 Item of assets
Cash bal with RBI, other banks Investment in govt, central or state govt securities Investments in bonds issued by banks Loans granted to PSU or others Housing loans against mortgage Premises, furniture & fixtures Guarantee issued by bank Forward asset purchase & forward

Risk weight (in%)

0 2.5

3 4 5 6 7 8

22.5 100 50 100 20 100

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Advances against LIC, FD, NSC and Kisan Vikas Patra where adequate margin is available would carry Zero weight. Loans to staff would also carry Zero weight.

Capital Funds

Basel committee has defined capital in two tiers: Tier I Tier I capital is the core capital, which provides the most permanent and readily available support against unexpected losses
Tier II Tier II capital will consist of elements that are not permanent in nature or are not readily available

Tier - I

1. 2. 3. 4.

Tier I capital in the case of Indian Banks consist of: (Core capital) Paid up capital Statutory reserves Disclosed free reserves Capital reserves representing surplus arising out of sale proceeds of assets. Accumulated losses will be deducted from Tier I Capital. Equity investment in subsidiaries and intangible assets will also be deducted from Tier I capital.

Tier II Capital

Tier II capital in the case of Indian Banks consist of: (Supplementary capital)

* Undisclosed reserves * Asset revaluation reserves * General provisions and loss reserves * Hybrid Capital instruments * Cumulative perpetual preference shares

Limits and Restrictions:

The total of Tier II (supplementary) elements will be limited to a maximum of Tier 1 elements. Subordinated debt will be limited to a maximum of 50% of Tier 1 elements. General provisions is eligible for inclusion in Tier II will be limited to a maximum of 1.25% of risk weighted assets. Asset revaluation reserve which has taken the form of latent gains will be subject to a discount of 55%

Subordinated Debts:

These debts in Tier 2 capital are subject to the following discounts.

Remaining maturity of instruments
Less than 1 year
1 year and more but less than 2 years 2 year and more but less than 3 years 3 year and more but less than 4 years 4 year and more but less than 5 years Rate of discount

100%
80% 60% 40% 20%

Reporting

Maintenance of CAR 9%

Reporting: Banks should furnish annual return after every year ending indicating: Capital funds Conversion of Off balance sheet assets Calculation of risk weighted assets Calculation of capital funds ratio

What is the original accord or Basel I accord?

The Basel Committee came out with its first document on International Convergence of Capital measurements and Capital Standards in 1988 as a harbinger to tone up the safety and stability of commercial banking in world over. It requires internationally active banks to hold capital equal to at least 8% of basket of assets measured in different ways according to their riskiness .
CAR = Capital / Credit Risk = 8%

What are the shortcomings of Basel I accord?

1. This is a straight forward one-size-fits-all approach 2. It doesnt distinguish between risk profile and risk management standards across banks 3. All advances carried equal risk weights of 100% , irrespective it is a blue chip company or itinerant trader 4. It does not account past payment record, a favorable credit history in respect of the activity or the region where the borrower operated, availability of good collateral while assigning risk weights. 5. Basel-I concentrated only on credit risk and eschewed any effort to address other significant banking risks such as market risk, and operational risk

What are the risks banks/FIs usually face and their respective intensities?
Out of so many risks the Basel Committee clubbed various risks situation in three categories
Credit risks-emanates owing to default of the counter parties in respect of fund and non-fund exposure. It constitutes 95% Market risk-arises on change of market variable in the form of liquidity constraints, prices and exchange rates. It constitutes 4% Operational risks-results from inadequate or failed internal process, people and systems or external events. It constitutes 1% The above percentage is only indicative and may widely vary in different banking environment and again bank to bank position

Tier 3 capital

The capital required as defined in the Basel Market Risk Amendment dated 25th Nov, 2005. It consists of short term subordinated debt for the sole purpose of meeting a proportion of the capital requirements for market risks. Tier 3 capital will be limited to 250% of a banks Tier 1 capital that is required to support for market risks. This means that minimum of 28.5% of market risks needs to be supported by Tier 1 capital.

What is Basel-II?
To make the system more compliance to changing environment Basel- I has been revised to new accord Basel - II. Primarily it calls for distinguishing among various risk and more importantly quantifying them. CAR=Capital/Credit Risk + Market, Risk + Operational Risk
It rests on a set of three mutually reinforcing pillars namely 1. 2. 3. Minimum Capital Requirement Supervisory review Market Discipline

What is Pillar - 1?
Pillar - 1 is the minimum capital requirement
Minimum Capital Requirements

Credit Risk

Market Risk

Operational Risk Basic Indicator Approach

Standardized Approach

Standardized Approach
Foundation IRB

IRB

Standardized Approach Advanced Measurement Approach

Modern Approach Advanced IRB

What is Pillar 2?

It is Supervisory Review. It is based on four principles

Banks should have a process for assessing their overall capital adequacy in relation to their risk profile. Supervisors should review and evaluate banks internal capital adequacy assessments and strategies also their ability to monitor and ensure their compliance with regulatory capital ratios Supervisors expect banks to operate the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of minimum An early intervention to prevent capital falling from minimum level.

What is the Pillar 3?

Third pillar is about Market Discipline. This tells about self disclosure regarding Financial Position Risk Management Strategies and Practices Risk Exposures Accounting Policies Information relating to basic business Management and corporate governance practices

What are the challenges it faces while implementing it?

As it is mandated by the regulator, RBI, to implement the accord from first fiscal of 2007, but it faces some difficulties. These are
More capital requirements

Impact on profitability due to huge implementation costs, particularly for smaller banks
As the level of rating penetration is very low, the rating of borrowers in all cases an uphill task and sometimes it feared of biasing

Given the paucity of supervisory resources, there is a need to reorient the resource deployment strategy

Basel III
Under Basel III the total capital a bank is required to hold is 8.0% of its risk-weighted assets. Total capital is divided into two broad categories: Tier I capital and Tier II capital. Tier I capital is capital that is available to absorb losses on a "goingconcern" basis, or capital that can be depleted without placing the bank into insolvency, administration or liquidation. Tier II capital is capital that can absorb losses on a "gone-concern" basis, or capital that absorbs losses in insolvency prior to depositors losing any money.

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The required ratio of Common Equity Tier 1 capital to risk-weighted assets will go up from 2% to 4.5% under Basel III. This percentage will also be more difficult to meet as Basel III have introduced stricter regulatory adjustments. These new capital requirements will be progressively phased in between 1 January 2013 and 1 January 2015
In addition, the minimum total Tier I capital requirement will increase from 4% to 6% under Basel III

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Capital conservation buffer

Basel III has also introduced a capital conservation buffer which requires an additional 2.5% of Common Equity Tier I capital to be held over and above the absolute minimum requirements. This buffer is intended to be available to be drawn down during periods of stress.

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Counter-cyclic capital buffer

A separate counter-cyclical buffer has also been introduced to ensure that the banking sector's capital requirements take account of the macroeconomic environment in which banks operate. This buffer will range between 0 to 2.5% of a bank's riskweighted assets and will be determined by the relevant regulator in each jurisdiction.

Definition of 'Liquidity Coverage Ratio - LCR

'

Highly liquid assets held by financial institutions in order to meet short-term obligations. The Liquidity coverage ratio is designed to ensure that financial institutions have the necessary assets on hand to ride out short-term liquidity disruptions. Banks are required to hold an amount of highly-liquid assets, such as cash or Treasury bonds, equal to or greater than their net cash over a 30 day period (having at least 100% coverage). The liquidity coverage ratio started to be regulated and measured in 2011, but the full 100% minimum won't be enforced until 2015. '

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The liquidity coverage ratio is an important part of the Basel Accords, as they define how much liquid assets have to be held by financial institutions. Because banks are required to hold a certain level of highly-liquid assets, they are less able to lend out short-term debt.

The Net Stable Funding Ratio (NSFR)

The net stable funding (NSF) ratio measures the amount of longer-term, stable sources of funding employed by an institution relative to the liquidity profiles of the assets funded and the potential for contingent calls on funding liquidity arising from off-balance sheet commitments and obligations. The standard requires a minimum amount of funding that is expected to be stable over a one year time horizon based on liquidity risk factors assigned to assets and off-balance sheet liquidity exposures. The NSF ratio is intended to promote longer-term structural funding of banks balance sheets, off-balance sheet exposures and capital markets activities.

Thank You!!!