Capital Adequacy Ratio and Basel Accords

Capital Adequacy Ratio and Basel Accords: At first glance, a bank is a company or industry that operates in the service sector of any economy. However, the failure of a bank could have a far greater economic impact than any other type of business or commercial activity. In general, modern economies are more reliant on banks than in the past—banks are now referred to as the backbone of economies.

Today, banks must function properly in order for an economy to function properly. Because bank credit creation (i.e. loan disbursals) is a high-risk business, depositors’ money is dependent on the banks’ lending quality. More importantly, banks are at the heart of the entire payment system, both public and private. The failure of a bank has the potential to destabilize an economy. This is why governments around the world pay close attention to banking regulations.

How banks should maximize credit creation while minimizing risk and continuing to operate permanently?

Every bank regulatory provision aims to achieve a simple equation, namely, “how banks should maximize credit creation while minimizing risk and continuing to operate permanently.” As any loan forwarded to any individual or firm (irrespective of their credit-worthiness) has the risk of becoming a bad debt (i.e., NPA in India) with a probability of 50%, risks in the banking business are always present and cannot be made ‘zero.’ However, banks must function in order for economies to function.

Finally, the world’s central banks began devising tools to reduce banking risks on the one hand, while also providing cushions (shock-absorbers) to banks on the other, so that banks do not go bankrupt (i.e., shut down after becoming bankrupt).

  1. The provision of keeping a cash ratio of total deposits mobilized by the banks (known as the CRR in India);
  2. the provision of maintaining some assets of the deposits mobilized by the banks with the banks themselves in non-cash form (known as the SLR in India); and
  3. The provision of the capital adequacy ratio (CAR) norm.

The capital adequacy ratio (CAR) standard is the most recent provision in the area of regulating banks so that they can withstand the likely risks and uncertainties of lending. The CAR—also known as the Basel Accord—was agreed upon by the central banking bodies of the developed economies in 1988 at a meeting of the Bank for International Settlements in Basel, Switzerland (BIS).

Basel-I capital adequacy ratio

The Basel-I capital adequacy ratio norms were agreed upon at this time, requiring banks to maintain a certain amount of free capital (i.e., ratio) to their assets (i.e., loans and investments made by the banks) as a cushion against possible losses in investments and loans. This capital ratio capital was set at 8% in 1988. It means that if a bank’s total investments and loans forwarded total Rs.100, the bank must maintain a free capital of 8 at any given time. The capital adequacy ratio is calculated as the proportion of total capital to total risk-weighted assets.

CAR, or capital adequacy ratio, is calculated as a percentage of a bank’s risk-weighted credit exposures:

CAR= Total of the Tier 1 & Tier 2 capitals = Risk-Weighted Assets

This ratio, also known as the ‘Capital to Risk-Weighted Assets Ratio (CRAR),’ is used to protect depositors and promote financial system stability and efficiency around the world. According to Basel II standards, there are two types of capital: Tier 1 capital, which can absorb losses without forcing a bank to stop trading, and Tier 2 capital, which can absorb losses in the event of a winding-up but offers less protection to depositors. The new Basel III norms have created a third category of capital, known as Tier 3 capital.

As part of the financial sector reforms, the RBI implemented the capital-to-risk weighted assets ratio (CRAR) system for banks operating in India in 1992, in accordance with BIS standards.

The Basel norms were later extended

The Basel norms were later extended to term-lending institutions, primary dealers, and non-banking financial companies (NBFCs) in the following years. Meanwhile, the BIS developed a new set of CAR standards known as Basel-II. The following are the RBI guidelines for CAR regulations in India:

  • Basel-I norm of the CAR was to be achieved by the Indian banks by March 1997.
  • CAR norm was raised to 9 percent with effect from March 31, 2000 (Narasimham Committee-II had recommended raising it to 10 percent in 1998).

(iii) Foreign banks and Indian banks with a foreign presence must comply with Basel-II norms as of March 31, 2008, while other scheduled commercial banks must comply by March 31, 2009. The CAR must meet the Basel-II standard of 12%.

Why Maintain CAR?

The basic question which comes to mind is why do the banks need to hold capital in the form of CAR norms? Two reasons have been generally forwarded for the same:

  1. Bank capital helps to prevent bank failure, which occurs when a bank’s obligations to pay depositors and other creditors are not met. After the loss in its business, the low capital bank has a negative net worth. In other words, it converts to insolvent capital and thus serves as a buffer to reduce the risk of the bank becoming insolvent.
  2. The amount of capital affects returns for the owners (equity holders) of the bank.

Basel Accords

The Basel Accords (Basel I, II, and now III) are a set of agreements established by the Basel Committee on Bank Supervision (BCBS), which makes recommendations on banking regulations in the areas of capital risk, market risk, and operational risk. The accords’ goal is to ensure that financial institutions have sufficient capital on hand to meet obligations and absorb unexpected losses. They are critical to the banking industry and are currently being implemented in over 100 countries around the world. The BIS Accords were the result of a long-term effort to achieve greater international consistency in prudential capital standards for banks’ credit risk. The accords’ goals can be summarised as follows:

(i) to strengthen the international banking system;

 (ii)          to promote convergence of national capital standards; and

(iii)          to iron out competitive inequalities among banks across countries of the world.

The Basel Capital Adequacy Risk-related Ratio Agreement (Basel I) of 1988 was not a legal document. It was created for internationally active banks that are members of the BIS’s Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland. However, the implementation details were left to national discretion. This is why Basel I appeared to be G10-focused.

First Basel Accord

The first Basel Accord, known as Basel I, focuses on financial institutions’ capital adequacy. The capital adequacy risk (the risk a financial institution faces as a result of an unanticipated loss) divides a financial institution’s assets into five risk categories (0 percent, 10 percent, 20 percent, 50 percent, and 100 percent). Internationally operating banks are required to have a risk weight of 8% or less.

Basel II, the second Basel Accord, is set to be fully implemented by 2015. It focuses on three main areas known as the three pillars: minimum capital requirements, supervisory review, and market discipline. The goal of this agreement is to strengthen international banking requirements while also overseeing and enforcing them.

The Basel III Accord, also known as Basel III, is a comprehensive set of reform measures aimed at strengthening banking sector regulation, supervision, and risk management. These measures are intended to:

  • improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source be;
  • improve risk management and governance; and
  • strengthen banks’ transparency and disclosures.

The capital of the banks has been classified into three tiers as given below:

Tier 1 Capital

A term used to describe a bank’s capital adequacy, or its ability to absorb losses without having to stop trading. From a regulator’s perspective, this is the most important indicator of a bank’s financial strength (this is the most reliable form of capital). It consists of the most reliable and liquid forms of financial capital, primarily stockholders’ equity and the bank’s disclosed reserves—equity capital cannot be redeemed at the holder’s discretion and disclosed reserves are the bank’s liquid assets.

Tier 2 Capital

A term used to describe a bank’s capital adequacy—it can absorb losses in the event of a winding-up and thus provides depositors with less protection. Secondary bank capital is referred to as Tier II capital (the second most reliable form of capital). This has to do with Tier 1 Capital. From the perspective of a regulator, this capital is a measure of a bank’s financial strength. It includes retained earnings after taxes, revaluation reserves for fixed assets and long-term equity securities, general loan-loss reserves, hybrid (debt/equity) capital instruments, subordinated debt, and undisclosed reserves.

Tier 3 Capital

A term used to describe a bank’s capital adequacy; it refers to the bank’s tertiary capital, which is used to meet/support market risk, commodity risk, and foreign currency risk. Other than Tier 1 and Tier 2 capitals, it includes a wide range of debt. In comparison to Tier 2 capital debts, Tier 3 capital debts may have a higher number of subordinated issues, undisclosed reserves, and general loss reserves. Assets must be limited to 250 percent of a bank’s Tier 1 capital, unsecured, subordinated, and have a minimum maturity of two years to qualify as Tier 3 capital.

The total liquid cash and SLR assets of the banks that can be used at any time are known as disclosed reserves. They become part of the company’s core capital in this way (Tier 1). Undisclosed Reserves are a financial institution’s unpublished or hidden reserves that may not appear on publicly available documents like a balance sheet but are nonetheless real assets that are accepted as such by most banking institutions but cannot be used at will. That is why they are included in the company’s secondary capital (Tier 2).

Basel III Provisions

The Basel III provisions have defined bank capital in a variety of ways. They treat common equity and retained earnings as the most important components of capital (as they have in the past), but they limit the inclusion of items like deferred tax assets, mortgage-servicing rights, and financial institution investments to no more than 15% of the common equity component. The goal of these rules is to increase the quantity and quality of capital.

While the key capital ratio has been increased to 7% of risky assets, Tier-I capital, which includes common equity and perpetual preferred stock, will be increased from 2% to 4.5 percent in phases beginning in January 2013 and ending in January 2015. Banks will also be required to set aside an additional 2.5 percent as a contingency for future stress. Banks that fall short of the buffer will be unable to pay dividends, but will not be forced to raise capital.

The new standards are based on central bankers’ renewed focus on macro-prudential stability.’ This shift in strategy was prompted by the global financial crisis that followed the subprime mortgage crisis in the United States. Basel II was a previous set of guidelines that focused on macro-prudential regulation.’ In other words, instead of microregulating individual banks, global regulators are now focusing on the system’s overall financial stability.

Banks in the West, which are generally market leaders, are facing low growth, capital erosion due to sovereign debt exposures, and increased regulation. They will have to accept a permanent decrease in their returns on equity as a result of the new capital requirements. Indian banks, on the other hand, as well as those in other emerging markets like China and Brazil, are well-positioned to maintain their returns on capital as a result of Basel III.

Financial experts believe that Basel III will alter the economic landscape by shifting banking power to emerging markets.

BASEL III compliance of the PSBs & RRBs

The capital to risk-weighted assets ratio (CRAR) of India’s scheduled commercial banks was 13.02 percent in March 2014 (Basel-III), but it dropped to 12.75 percent in September 2014. For 2015, the regulatory requirement for CRAR is 9%. The decline in aggregate capital positions, on the other hand, was due to deterioration in PSB capital positions. While the CRAR of scheduled commercial banks (SCB) was satisfactory in September 2014, the banking sector, particularly PSBs, will require substantial capital in the future to meet regulatory requirements for additional capital buffers.

Since 2011-12, the government has been following a recapitalization program for PSBs and RRBs in order to bring them into compliance with Basel III norms57. The government has also established a High-Level Committee on the subject, which has proposed the creation of a “non-operating holding company” (HoldCo) under a special Act of Parliament (action is yet to come regarding this).

Up until March 2015, the government injected three tranches of capital into banks (infused funds go to the RRBs through the PSBs under which they fall).:

(i)            Rs.12,000 crore infused during 2012-13 in seven PSBs.

(ii)           Rs.12,517 crore infused in 2013-14 in 8 PSBs.

(iii)          In 2014-15, the PSBs have recapitalized with Rs.6,990 crore. This capital infusion was based on some new criteria— asset quality, efficiency, and strength of the banks.

(iv)         During 2015-16, the government released Rs.19,950 crore to 13 PSBs (Economic Survey 2015-16).

(v)          For the year 2016-17, the government has announced a sum of Rs.25,000 crore for the purpose of recapitalizing the PSBs (Union Budget 2016-17).

(vi)         The Indradhanush scheme was launched (in 2015-16) by the Government under which the PSBs are to be infused with 70,000 crores by March 2019 to enable them to meet the ‘global risk norms’ (i.e., Basel III norms).

(vii)        The ongoing recapitalization of PSBs received a major boost when the government announced a massive sum of 2.11 lakh crores in February 2018. Up until October 2019, a portion of the money injected into PSBs will be mobilized through Recapitalisation Bonds, while the rest will be raised by banks through the market (disinvestment process) and budgetary support. This procedure will also assist banks in achieving their capital adequacy goals. 

According to the Economic Survey 2019-20, the capital to risk-weighted asset ratio (CRAR) of scheduled commercial banks (SCBs) was 12.8 percent in September (it was 13.9 percent in March 2018), owing to an improvement among PSBs (private sector banks). 

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