Description
The report about what is capital adequacy? How it is calculated? What are the capital requirements, what is basel 1 and basel 2 framework.
Capital Adequacy & Basel Norms: Focus on Credit Risk
Why is Capital Adequacy important? The answer lies in this simple question itself. For any business to survive and grow, it should have ”adequate” or enough capital such that it can absorb any shocks or deal with any unforeseen events as and when they occur. Indian banks have functioned in an insulated environment, where the RBI and the Government policies have influence their functioning. However as the global boundaries for cross border trade and exchange of money seem to become more seamless, the need for Indian banks to be able to compete on a global platform becomes greater. The government along with the RBI is slowly unpeeling the closed kernel of rigid rules and regulations within which banks have been forced to operate so far, it wants to ensure that there is a gradual effort to build up on the Indian banks preparedness and capital availability to withstand global competition. The need for adequate capitalization is also because banks deal in depositor’s money which represents the savings of the masses. These funds rejuvenate businesses across the country. If banks are not well capitalized then a minor shock can send the fates of millions crashing. Hence a sound risk management strategy and processes are very important for a bank to prevent and increase their ability to minimize any major debacle. Capital Adequacy is important because: ? ? Bank’s deal in the depositors money A sound capital base coupled with proper risk management and monitoring systems helps the bank pre-empt, avoid and absorb losses if they occur.
The Basle Committee for Banking Supervision (BCBS) was formed by the Bank for International Supervision in 1974. It has its headquarters in Basle, Switzerland and hence the accord is popularly known as the Basel Accord. Its members are the central banks of the G-10 nations. The backdrop for the Capital Accord was the anxiety on the increase in the number of bank failures particularly in the 1980’s and these countries came together under the aegis of the Bank for International Settlements (BIS) in Basle. The committee was headed by Mr. Peter Cooke and released a document called “The agreed framework on international convergence of capital measures and capital standards”. This accord was meant for the G-10 countries and the committee hoped that the banks having international operations would also comply with the same by 1992. Over 140 accepted the recommendations of the accord including India. The objectives of the capital accord were as follows: 1. Strengthen the soundness of the banks by boosting capital positions 2. Promote the stability of the global banking system 3. Create a level playing field for banks to compete by removing competitive inequality in the form of differing national capital adequacy standards. The accord sought to: 1. Make the regulatory capital more sensitive to differences in the risk profiles among banks
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Capital Adequacy & Basel Norms: Focus on Credit Risk
2. Take into account the off-balance sheet exposures in determining capital adequacy. 3. Lower the disincentives to hold liquid and low risk assets. The RBI issued capital adequacy guidelines in April 1992. As per the guidelines, all scheduled commercial banks (except RRB’s) were required to maintain a minimum Capital to Risk –weighted assets ratio (CRAR) of 8% on an ongoing basis up to the year ending 31 March 1999. With effect from the year ending 31 March 2000, banks are required to maintain a minimum CRAR of 9%. The Capital Accord or the Basel I norms were accepted and implemented in India in 1992. Basel 2 overcame some of the shortcomings of the maiden version viz Basel 1. These were: ? ? There was no capital charge for Operational Risk in Basel 1. There was a “broad bush” approach that was used wherein all the sovereigns had a risk weight of 0% while all the corporates had a risk weight of 100%. Hence there was no distinction made between the different companies as all were clubbed in the same category. The factor that capital requirement of a bank also depends upon the effectiveness of managing risks was not considered Capital charge for Market risk was absent in the original Basel I document. This wase introduced subsequently through amendment in 1996.
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Main Banking Risks Credit /Operational /Market /Forex Liquidity /Credit
Can generate Expected Losses
Can generate Unexpected Losses
Can be covered by: Provisions
Can be covered by: Capital
Basel II aims at stronger and more stable banking systems and fine tuning the computational standards of minimum regulatory capital. The three pillars of Basel II are:
Commercial Banking November 2009 Page 2
Capital Adequacy & Basel Norms: Focus on Credit Risk
Pillar 1: Minimum Capital Requirement: ? The calculation of minimum capital has been re-defined, for a more extensive coverage of all banking risks and their economic substance
Pillar 2: Supervisory Review. ? Focus on a reinforcement role by national (local) regulators
Pillar 3: Market Discipline ? Increased financial disclosure requirements on Bank’s risk profile & level of capitalization
Explanation of the Basle Pillars:
Pillar 1: Minimum Capital Requirement: Under the Basel II accord, the banks capital is divided into two components: ? ? Tier 1 Capital ( banks core capital) Tier 2 Capital (other sources of funds that are long term in nature) Pillar 1 Banks Capital
Tier 1 ? ? Core Capital Tangible net worth ? ?
Tier 2 Various other sources of funds Hybrid Debt ?
Tier 3 Not currently used in India
Commercial Banking November 2009 Page 3
Capital Adequacy & Basel Norms: Focus on Credit Risk
Capital Adequacy calculation =
Eligible total Capital funds (Credit Risk RWA + Market Risk RWA + Op Risk RWA) Composition of Tier 1 Capital “
? ? ? Paid-up equity capital, statutory reserves, and other disclosed free reserves. Capital reserves representing surplus arising out of sale of proceeds of assets. Innovative perpetual debt instruments (IPDI) eligible for inclusion in Tier 1 capital in compliance with regulatory requirements (limited to 15% of total Tier 1 capital as on March 31 of the previous financial year). Perpetual Non-Cumulative Preference Shares (PNCPS) in compliance with regulatory requirements (not exceeding 40% of total Tier 1 capital at any point of time). Any other type of instrument generally notified by RBI from time to time for inclusion in Tier 1 capital. IPDI / PNCPS in excess of the limit shall be eligible for inclusion under Tier 2, subject to limits prescribed for Tier 2 capital. Explanation of terms used: ? IPDI: Also known as Innovative Perpetual Debt Instruments. These can be issued as bonds or debentures by banks for raising Tier I capital. The minimum tenor is 15 years. Hence its borrowed money but it has the characteristics of equity since it can remain with the bank for a long time. The amount issued under such instruments cannot exceed 15% of the total Tier 1 eligible capital These instruments will be issued in Indian Rupees.RBI approval is required for foreign currency instruments. These instruments can have fixed rate or a floating rate linked to a rupee benchmark interest rate. A put option is not allowed, however a call option is allowed after 10 years. The issuing bank cannot pay interest on such instruments if their CRAR falls below the limit prescribed by the RBI. Other banks can invest in such instruments, however the risk weight age assigned will be 100 %. ( Note: Put option absent – means that the buyer cannot ask for redemption. A call option for the issuer means that the issuing bank can redeem the debt instrument after RBI approval) PNCPS: Also known as Perpetual Non-Cumulative Preference shares. In simple terms if this has to be explained is as follows:
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Capital Adequacy & Basel Norms: Focus on Credit Risk
If a bank has not paid dividends in Year 1, then incase it has a stellar Year 2, it can pay a dividend for Year 2 however it cannot pay the dividend for Year 1 in Year 2. Hence the terminology non cumulative is used to describe such instruments. The outstanding amount of these shares along with innovative Tier 1 instruments cannot exceed 40% of Tier 1 capital at any time. The amount in excess of 40% can be included in Upper Tier 2 capital. The amount and maturity of such PNCPs have to be decided by the Board of Directors of the banks subject to certain restrictions. PNCPS cannot be issued with a “put option”. Banks can have a call option after 10 years which can be exercised with the approval of the RBI.PNCPS is shown as capital in the Schedule-1 of the Balance Sheet. PNCPS should be fully paid-up, unsecured and free of any restrictive clauses. No advance can be taken against the security of such instruments. NRI’s and FII’s are allowed subject to certain limits (Investments by FII’s and NRI’s have to be within the overall limit of 49% and 24% of the issue respectively. Investment by a single FII cannot exceed 10% of the issue and investment by a single NRI cannot exceed 5% of the issue). Advances against the security of these instruments, is not allowed. An investment in PNCPS issued by other banks attracts 100% risk weight for CRAR purposes and has to be within the overall ceiling of 10% of the investing banks capital funds. Redeemable Preference Shares (both cumulative and non cumulative) are subject to a progressive “discount” for CRAR purposes as they approach maturity. Hence Tier II capital needs to be replenished.
Composition of Tier 2 Capital:
? ? Revaluation Reserves Denoting revaluation of fixed assets (at a discount of 55%) General Provisions and Loss reserves – general provisions on Standard assets, Floating Provisions, Provisions for Country Exposures, Investment Reserve Account and excess provisions which arise on account of sale of NPAs) – should not exceed 1.25% of total risk weighted assets Hybrid debt capital instruments – Upper Tier 2 capital – Perpetual Cumulative Preference Shares (PCPS), Redeemable Non-cumulative Preference Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS) Subordinated debt – For inclusion in Tier 2 capital, the instrument should be 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 or without the consent of RBI. Subordinated debt instruments with an initial maturity of less than 5 years or having a remaining maturity of one year are not included as part of Tier II capital. They are limited to 50% of Tier I capital. Banks re required to indicate the amount of subordinated debt raised as Tier II by way of explanatory notes in the Balance Sheet as well as under Schedule 5 under “Other Liabilities &Provisions”These instruments carry a fixed maturity and as they approach maturity they are subject to progressive discount for inclusion in Tier 2 capital at the rates given below:
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Remaining maturity of the Instruments Less than 1 year More than 1 year and less than 2 years More than 2 years and less than 3 years More than 3 years and less than 4 years More than 4 years and less than 5 years
Rate of Discount 100% 80% 60% 40% 20%
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IPDI in excess of 15% of Tier 1 capital PNCPS in excess of overall ceiling of 40% Explanation of terms used: ? Perpetual Cumulative Preference Shares (PCPS)/Redeemable Non-Cumulative Preference Shares (RNCPS)/Redeemable Cumulative Preference Shares (RCPS). These instruments can be either cumulative perpetual PCPS or dated RNCPS and RCPS non-perpetual instruments with a fixed maturity of minimum 15 years. The amounts raised are dependant on the Board of Directors of Banks and have to conform to the norm that the outstanding amounts of these instruments along with other components of Tier 2 capital shall not exceed 100% of the Tier 1 capital at any point .These instruments shall not be issued with a “put” option. Banks can retain the call option permissible provided the instrument has run for 10 years which can be exercised with the prior approval of the RBI. Such funds will be classified as borrowings under Schedule 4. Redemptions of such instruments have to be made with the prior approval of the RBI. The bank can exercise a step-up option once in conjunction with the call option after the lapse of 10 years from the date of issue. The step-up shall not be more than 100 bps. (Note: The relationship between percentage changes and basis points can be summarized as follows: 1% change = 100 basis points, and 0.01% = 1 basis point. So, a bond whose yield increases from 5% to 5.5% is said to increase by 50 basis points; or interest rates that have risen 1% are said to have increased by 100 basis points.).The coupon payable to investors can be at a fixed or floating rate. Redemption at maturity shall be with the prior approval of the RBI. Investments by FII’s and NRI’s have to be within the overall limit of 49% and 24% of the issue respectively. Investment by a single FII cannot exceed 10% of the issue and investment by a single NRI cannot exceed 5% of the issue. An advance against the security of these instruments is not allowed.
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Capital Adequacy & Basel Norms: Focus on Credit Risk
Limits on Tier II Capital
Upper Tier 2 instruments along with other components of Tier 2 capital should not exceed 100% of Tier 1 capital. The above limit will be based on the amount of Tier 1 capital after deduction of Goodwill, DTA and other intangible asset but before deduction of investments.
Deductions from Capital:
? Intangible assets and losses in the current period and those brought forward from previous period to be deducted from Tier 1 capital. Deferred Tax Assets to be deducted from Tier 1 capital. Any gain on sale arising at the time of securitization of standard assets, if recognized, should be deducted entirely from Tier 1 capital. Deduction of Securitization exposure 50% from Tier 1 and 50% from Tier 2 capital. Investments in financial subsidiaries and associates – The entire investments in the paid-up equity of the financial entities (including insurance entities), which are not consolidated for capital purposes with the bank, where such investment exceed 30% of the paid up equity of such financial entities and entire investments in other instruments eligible for regulatory capital status of those entities, shall be deducted, at 50% from Tier 1 and 50% from Tier 2 capital. Explanation of terms used: ? Intangible Assets : Eg : Goodwill need to be deducted from the shareholders equity while arriving at the capital adequacy ratio o Deferred Tax Asset: Commonly arise due to difference in Company Laws and Tax Laws. For eg: A windmill project normally has a life of 10 years. The Companies Act permits depreciation of 10% but Income Tax laws permit 80%.Because of this, t he entire tax on the income will be saved. If normal depreciation would have been charged every year, tax would be paid. Thus the saved tax actually pertains to the future years. To provide a correct picture to the shareholders, the taxes which pertain to the future years need to be separated and shown in the balance sheet. The extra tax paid which pertains to the future years is shown as deferred tax asset. The deferred tax asset every year gets reduced to the extent it pertains to that year and becomes part of general reserve. Thus it gets depleted completely
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Securitization: Involves turning traditional non-marketed balance sheet assets (eg: loans) into marketable securities and moving them off-balance sheet. It can include securitization of residential mortgages, commercial mortgages, credit card receivables, student loans, trade receivables and loans to insurance policy holders. This way banks raise funds in the market rather than borrowing from other banks.
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Capital Adequacy & Basel Norms: Focus on Credit Risk
Asset backed securities were first issued in the USA during 1970’s. The first issue in the UK was in 1985.When a bank asset is securitized, the different functions traditionally played by the bank are unbundled, a structure known as “pass through”. The unbundled functions include: o Loan Origination: The borrower is located usually through the bank marketing the loan. Credit Analysis: The likelihood of the loan being repaid by the borrower is evaluated Loan Servicing: Ensuring that the loan is serviced Credit Support: An evaluation is made of the feasibility of supporting the borrower should there be a change in the borrowers creditworthiness at any time during the duration of the loan Funding Function: Funding of the loan is secured through creation of deposit products that are attractive to retail and wholesale customers Servicing Function: Administration and enforcement of the loan contract. Warehousing: That the loan is one among the many homogenous loans held in the portfolio.
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The traditional bank uses the funds collected from depositors to fund loans. If the underlying loan assets are securitized, the bank may perform the function of loan origination only. These mortgages are sold subsequently to a “special purpose vehicle” (SPV).Using an investment banker/merchant banker the SPV sells the securities, backed by the pooled cash flows of the individual mortgages. The securities are usually backed by a guarantee of a bank or an underwriting/insurance company so that they can be awarded an investment rating by a public rating agency(Note: The four approved credit rating agencies in India are CRISIL,ICRA,FITCH,CARE) Securitization helps bankers in a volatile interest rate environment. It helps to unbundle the interest rate risk from the credit risk. The originating bank(which may be good) in assessing the credit risk can pass on the interest rate risk to another institution which may have a competitive advantage in managing interest rate risk. Securitization also helps manage the credit risk management because if a bank finds its lending to be too concentrated in a given sector, it can securitize some of its lending to reduce exposure. In some extreme conditions, a bank may resort to securitization to raise funds to improve liquidity. Eg: The Bank of England after suffering heavy losses in the late eighties found
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Capital Adequacy & Basel Norms: Focus on Credit Risk
that it could not raise funds. Hence it decided to sell of its credit card portfolio to improve its funding position. However it failed in 1991.
Calculating Capital Adequacy:
CRAR = (Eligible total Capital funds) divided by (Credit Risk RWA + Market Risk RWA + Op Risk RWA)
Summary of the Calculation of the Numerator: Is detailed in the Appendix A
Summary for calculating the denominator: Risk+Operational Risk)
viz Total Risk Assets (Credit Risk+Market
Approaches to measure credit risk: ? ? ? Standardized Approach Foundation Internal Ratings Approach Advanced Internal Ratings Approach
Approaches to measure market risk: ? ? Standardized Approach Internal Models Approach
Approaches to measure operational risk ? ? ? Basic Indicator Approach Standardized Approach Internal measurement Approach
Approaches to measure Credit Risk: Standardized Approach ? Standardized Approach
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Capital Adequacy & Basel Norms: Focus on Credit Risk
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Risk weights rationalized (in comparison to Basel I) and made more risk-sensitive. Risk weights ranging from 0% to 150%. Prescribed risk weights for specified categories.
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Illustration : Risk Weights for Sovereigns:
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AAA to AA-? Risk Weight (Sovereigns) Corporates 0%
A+ to A-
BBB+ to BBB-
BB+ to B-
Below B-
Unrated
20%
50%
100%
150%
100%
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20%
50%
100%
NA
150%
100%
Note: The unrated class can trigger an adverse selection process where the unrated entities give up their ratings to benefit from the risk weight of 100% rather than 150%. Also in many countries, corporate and banks are not required to acquire a rating to fund their activities. Therefore the fact that the borrower has no rating does not necessarily signal low credit quality. The accord tries to strike a balance and stipulates that the national regulators have some flexibility ? ? ? External rating based risk weights for corporate exposure (exposure in excess of Rs. 5 crore). Asset category of Regulatory Retail introduced. Application of Credit Risk mitigation allowed i.e. certain securities are recognized for credit risk mitigation and are allowed to be deducted from exposure after application of haircuts and risk weight is applied on the amount net of credit risk mitigation.
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Capital Adequacy & Basel Norms: Focus on Credit Risk
Illustration: Calculation of Risk Weights and Credit Equivalents (Amounts in Rs Crores)
Items
Balance Sheet Amount
Credit Conversion Factor (3)
Credit Equivalent Amount (4)=(2)*(3)
Risk Weight (5)
(1) (2)
Risk Weighted Amt (6)=(4)*(5)
Cash Advance agnst Specified Sec Invest in Govt Securities Claims on banks Advances ECGC Off-Balance Sheet Items Other Advances Total Weighted Assets Risk with
100 800
NA NA
100 800
0.00% 0.00%
0 0
15000
NA
15000
2.50%
375
3000 8000
NA NA
3000 8000
20% 50%
600 4000
4000
50%
2000
100%
2000
16000
NA
16000
100%
16000 22975
Notes: 1. The outstanding balances of the funded assets are multiplied by the prescribed risk weights to arrive at the total risk weighted assets and the capital requirement thereon. 2. For off balance sheet items (Contingent Liabilities- eg Letters of Credit and Guarantees) there is a chance that they may or may not materialize. The probability of such items crystallizing differs with the type of items. However the bank needs to make a provision incase these liabilities translate into credit exposures and therefore the risk weights are calculated in a two stage process:
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Capital Adequacy & Basel Norms: Focus on Credit Risk
a. The off balance sheet items are converted into their credit equivalents by multiplying them by the “”credit conversion factor” b. The risk weights are calculated by multiplying the credit equivalents with the respective risk weights.
Illustration of Calculation of Capital Adequacy: Capital Elements Balance Sheet Amount Paid-Up Capital Disclosed Reserves Subordinated Debt General Prov 300 1800 300 1800 300 1800 Tier-1 Tier-2 Eligible Comp
250
250
250
400
400
287.18 (lmtd to 1.25% of RWA)
Total
2750
2100
650
2637.18
Calculation of CRAR and Core CRAR: CRAR= Eligible Capital Funds / RWA * 100 = 2637.18/22975*100 = 11.47% Core CRAR = Tier 1 Capital / RWA * 100 = 2100 / 22975 * 100 = 9.14% Core CRAR should be more than 50% of the minimum CRAR prescribed. At present the minimum CRAR is 9% hence more than 4.5%.
Approaches to measure Credit Risk: Advanced Approach Internal Rating Based (IRB) Approaches ? Allows measurement of risk on the basis of internal rating by bank. The computation rests on 4 factors
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Capital Adequacy & Basel Norms: Focus on Credit Risk
? ? ? ?
Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Under IRB (Foundation) Approach, PD to be assessed by bank and LGD & EAD to be provided by the Regulator. Under IRB (Advanced) Approach, all the factors are to be assessed by the bank.
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Expected Loss = PD*LGD*EAD
Illustration: The BIS proposes the Benchmark Risk Weight (BRW) for including the maturity effects on credit risk and capital weights. The function depends upon the default probability DP.The benchmark example refers to a specific case of a 3 year asset, with various default probabilities and a loss give default (lgd) of 50%.Three representative points show the sensitivity of risk weights to the annualized default probability. DP% BRW % 0.03 14 0.7 100 20 625
For DP=0.7%, the BRW is 100% and the maximum risk weight for DP=20% reaches 625%.This value is a cap for all maturities and all default probabilities. The weight profile with varying DP is more sensitive than the standardized approach weights which vary in the range 20% to 150% for all maturities over 1 year. The weights increase less than proportionately until they reach the cap. Currently banks are still following the standardized approach for credit risk computation.
Pillar 2: Supervisory Review Process:
The second pillar aims at ensuring that banks have a sound internal process in place to assess the adequacy of capital based upon a thorough evaluation of its risks. The Basle Committee found 4 basic principles that should inspire supervisor’s policies. 1. Banks should have a process for assessing the overall capital in relation to their risk profile and strategy for maintaining their capital levels. 2. Supervisors should review and evaluate banks internal capital adequacy assessments and strategies as well as their ability to monitor and ensure compliance with regulatory ratios. Appropriate action must be taken if process not found satisfactory.
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Capital Adequacy & Basel Norms: Focus on Credit Risk
3. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum 4. Early intervention by supervisors to prevent capital from falling below the minimum levels Corrective action to be taken if capital not maintained or restored
Pillar 3: Market Discipline
The accord emphasizes the potential for market discipline to reinforce capital regulations and other supervisory efforts in promoting the safety and soundness in banks and FI’s. Core disclosures and discipline to convey vital information is important for market discipline. The accord emphasizes the potential for market discipline to reinforce capital regulations and other supervisory efforts in promoting safety in banks. Disclosures are subject to “materiality “if its omission or misstatement can influence or change the decision of any user relying on that information. *******
Commercial Banking November 2009 Page 14
doc_760221336.pdf
The report about what is capital adequacy? How it is calculated? What are the capital requirements, what is basel 1 and basel 2 framework.
Capital Adequacy & Basel Norms: Focus on Credit Risk
Why is Capital Adequacy important? The answer lies in this simple question itself. For any business to survive and grow, it should have ”adequate” or enough capital such that it can absorb any shocks or deal with any unforeseen events as and when they occur. Indian banks have functioned in an insulated environment, where the RBI and the Government policies have influence their functioning. However as the global boundaries for cross border trade and exchange of money seem to become more seamless, the need for Indian banks to be able to compete on a global platform becomes greater. The government along with the RBI is slowly unpeeling the closed kernel of rigid rules and regulations within which banks have been forced to operate so far, it wants to ensure that there is a gradual effort to build up on the Indian banks preparedness and capital availability to withstand global competition. The need for adequate capitalization is also because banks deal in depositor’s money which represents the savings of the masses. These funds rejuvenate businesses across the country. If banks are not well capitalized then a minor shock can send the fates of millions crashing. Hence a sound risk management strategy and processes are very important for a bank to prevent and increase their ability to minimize any major debacle. Capital Adequacy is important because: ? ? Bank’s deal in the depositors money A sound capital base coupled with proper risk management and monitoring systems helps the bank pre-empt, avoid and absorb losses if they occur.
The Basle Committee for Banking Supervision (BCBS) was formed by the Bank for International Supervision in 1974. It has its headquarters in Basle, Switzerland and hence the accord is popularly known as the Basel Accord. Its members are the central banks of the G-10 nations. The backdrop for the Capital Accord was the anxiety on the increase in the number of bank failures particularly in the 1980’s and these countries came together under the aegis of the Bank for International Settlements (BIS) in Basle. The committee was headed by Mr. Peter Cooke and released a document called “The agreed framework on international convergence of capital measures and capital standards”. This accord was meant for the G-10 countries and the committee hoped that the banks having international operations would also comply with the same by 1992. Over 140 accepted the recommendations of the accord including India. The objectives of the capital accord were as follows: 1. Strengthen the soundness of the banks by boosting capital positions 2. Promote the stability of the global banking system 3. Create a level playing field for banks to compete by removing competitive inequality in the form of differing national capital adequacy standards. The accord sought to: 1. Make the regulatory capital more sensitive to differences in the risk profiles among banks
Commercial Banking November 2009 Page 1
Capital Adequacy & Basel Norms: Focus on Credit Risk
2. Take into account the off-balance sheet exposures in determining capital adequacy. 3. Lower the disincentives to hold liquid and low risk assets. The RBI issued capital adequacy guidelines in April 1992. As per the guidelines, all scheduled commercial banks (except RRB’s) were required to maintain a minimum Capital to Risk –weighted assets ratio (CRAR) of 8% on an ongoing basis up to the year ending 31 March 1999. With effect from the year ending 31 March 2000, banks are required to maintain a minimum CRAR of 9%. The Capital Accord or the Basel I norms were accepted and implemented in India in 1992. Basel 2 overcame some of the shortcomings of the maiden version viz Basel 1. These were: ? ? There was no capital charge for Operational Risk in Basel 1. There was a “broad bush” approach that was used wherein all the sovereigns had a risk weight of 0% while all the corporates had a risk weight of 100%. Hence there was no distinction made between the different companies as all were clubbed in the same category. The factor that capital requirement of a bank also depends upon the effectiveness of managing risks was not considered Capital charge for Market risk was absent in the original Basel I document. This wase introduced subsequently through amendment in 1996.
?
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Main Banking Risks Credit /Operational /Market /Forex Liquidity /Credit
Can generate Expected Losses
Can generate Unexpected Losses
Can be covered by: Provisions
Can be covered by: Capital
Basel II aims at stronger and more stable banking systems and fine tuning the computational standards of minimum regulatory capital. The three pillars of Basel II are:
Commercial Banking November 2009 Page 2
Capital Adequacy & Basel Norms: Focus on Credit Risk
Pillar 1: Minimum Capital Requirement: ? The calculation of minimum capital has been re-defined, for a more extensive coverage of all banking risks and their economic substance
Pillar 2: Supervisory Review. ? Focus on a reinforcement role by national (local) regulators
Pillar 3: Market Discipline ? Increased financial disclosure requirements on Bank’s risk profile & level of capitalization
Explanation of the Basle Pillars:
Pillar 1: Minimum Capital Requirement: Under the Basel II accord, the banks capital is divided into two components: ? ? Tier 1 Capital ( banks core capital) Tier 2 Capital (other sources of funds that are long term in nature) Pillar 1 Banks Capital
Tier 1 ? ? Core Capital Tangible net worth ? ?
Tier 2 Various other sources of funds Hybrid Debt ?
Tier 3 Not currently used in India
Commercial Banking November 2009 Page 3
Capital Adequacy & Basel Norms: Focus on Credit Risk
Capital Adequacy calculation =
Eligible total Capital funds (Credit Risk RWA + Market Risk RWA + Op Risk RWA) Composition of Tier 1 Capital “
? ? ? Paid-up equity capital, statutory reserves, and other disclosed free reserves. Capital reserves representing surplus arising out of sale of proceeds of assets. Innovative perpetual debt instruments (IPDI) eligible for inclusion in Tier 1 capital in compliance with regulatory requirements (limited to 15% of total Tier 1 capital as on March 31 of the previous financial year). Perpetual Non-Cumulative Preference Shares (PNCPS) in compliance with regulatory requirements (not exceeding 40% of total Tier 1 capital at any point of time). Any other type of instrument generally notified by RBI from time to time for inclusion in Tier 1 capital. IPDI / PNCPS in excess of the limit shall be eligible for inclusion under Tier 2, subject to limits prescribed for Tier 2 capital. Explanation of terms used: ? IPDI: Also known as Innovative Perpetual Debt Instruments. These can be issued as bonds or debentures by banks for raising Tier I capital. The minimum tenor is 15 years. Hence its borrowed money but it has the characteristics of equity since it can remain with the bank for a long time. The amount issued under such instruments cannot exceed 15% of the total Tier 1 eligible capital These instruments will be issued in Indian Rupees.RBI approval is required for foreign currency instruments. These instruments can have fixed rate or a floating rate linked to a rupee benchmark interest rate. A put option is not allowed, however a call option is allowed after 10 years. The issuing bank cannot pay interest on such instruments if their CRAR falls below the limit prescribed by the RBI. Other banks can invest in such instruments, however the risk weight age assigned will be 100 %. ( Note: Put option absent – means that the buyer cannot ask for redemption. A call option for the issuer means that the issuing bank can redeem the debt instrument after RBI approval) PNCPS: Also known as Perpetual Non-Cumulative Preference shares. In simple terms if this has to be explained is as follows:
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Capital Adequacy & Basel Norms: Focus on Credit Risk
If a bank has not paid dividends in Year 1, then incase it has a stellar Year 2, it can pay a dividend for Year 2 however it cannot pay the dividend for Year 1 in Year 2. Hence the terminology non cumulative is used to describe such instruments. The outstanding amount of these shares along with innovative Tier 1 instruments cannot exceed 40% of Tier 1 capital at any time. The amount in excess of 40% can be included in Upper Tier 2 capital. The amount and maturity of such PNCPs have to be decided by the Board of Directors of the banks subject to certain restrictions. PNCPS cannot be issued with a “put option”. Banks can have a call option after 10 years which can be exercised with the approval of the RBI.PNCPS is shown as capital in the Schedule-1 of the Balance Sheet. PNCPS should be fully paid-up, unsecured and free of any restrictive clauses. No advance can be taken against the security of such instruments. NRI’s and FII’s are allowed subject to certain limits (Investments by FII’s and NRI’s have to be within the overall limit of 49% and 24% of the issue respectively. Investment by a single FII cannot exceed 10% of the issue and investment by a single NRI cannot exceed 5% of the issue). Advances against the security of these instruments, is not allowed. An investment in PNCPS issued by other banks attracts 100% risk weight for CRAR purposes and has to be within the overall ceiling of 10% of the investing banks capital funds. Redeemable Preference Shares (both cumulative and non cumulative) are subject to a progressive “discount” for CRAR purposes as they approach maturity. Hence Tier II capital needs to be replenished.
Composition of Tier 2 Capital:
? ? Revaluation Reserves Denoting revaluation of fixed assets (at a discount of 55%) General Provisions and Loss reserves – general provisions on Standard assets, Floating Provisions, Provisions for Country Exposures, Investment Reserve Account and excess provisions which arise on account of sale of NPAs) – should not exceed 1.25% of total risk weighted assets Hybrid debt capital instruments – Upper Tier 2 capital – Perpetual Cumulative Preference Shares (PCPS), Redeemable Non-cumulative Preference Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS) Subordinated debt – For inclusion in Tier 2 capital, the instrument should be 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 or without the consent of RBI. Subordinated debt instruments with an initial maturity of less than 5 years or having a remaining maturity of one year are not included as part of Tier II capital. They are limited to 50% of Tier I capital. Banks re required to indicate the amount of subordinated debt raised as Tier II by way of explanatory notes in the Balance Sheet as well as under Schedule 5 under “Other Liabilities &Provisions”These instruments carry a fixed maturity and as they approach maturity they are subject to progressive discount for inclusion in Tier 2 capital at the rates given below:
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Remaining maturity of the Instruments Less than 1 year More than 1 year and less than 2 years More than 2 years and less than 3 years More than 3 years and less than 4 years More than 4 years and less than 5 years
Rate of Discount 100% 80% 60% 40% 20%
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IPDI in excess of 15% of Tier 1 capital PNCPS in excess of overall ceiling of 40% Explanation of terms used: ? Perpetual Cumulative Preference Shares (PCPS)/Redeemable Non-Cumulative Preference Shares (RNCPS)/Redeemable Cumulative Preference Shares (RCPS). These instruments can be either cumulative perpetual PCPS or dated RNCPS and RCPS non-perpetual instruments with a fixed maturity of minimum 15 years. The amounts raised are dependant on the Board of Directors of Banks and have to conform to the norm that the outstanding amounts of these instruments along with other components of Tier 2 capital shall not exceed 100% of the Tier 1 capital at any point .These instruments shall not be issued with a “put” option. Banks can retain the call option permissible provided the instrument has run for 10 years which can be exercised with the prior approval of the RBI. Such funds will be classified as borrowings under Schedule 4. Redemptions of such instruments have to be made with the prior approval of the RBI. The bank can exercise a step-up option once in conjunction with the call option after the lapse of 10 years from the date of issue. The step-up shall not be more than 100 bps. (Note: The relationship between percentage changes and basis points can be summarized as follows: 1% change = 100 basis points, and 0.01% = 1 basis point. So, a bond whose yield increases from 5% to 5.5% is said to increase by 50 basis points; or interest rates that have risen 1% are said to have increased by 100 basis points.).The coupon payable to investors can be at a fixed or floating rate. Redemption at maturity shall be with the prior approval of the RBI. Investments by FII’s and NRI’s have to be within the overall limit of 49% and 24% of the issue respectively. Investment by a single FII cannot exceed 10% of the issue and investment by a single NRI cannot exceed 5% of the issue. An advance against the security of these instruments is not allowed.
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Limits on Tier II Capital
Upper Tier 2 instruments along with other components of Tier 2 capital should not exceed 100% of Tier 1 capital. The above limit will be based on the amount of Tier 1 capital after deduction of Goodwill, DTA and other intangible asset but before deduction of investments.
Deductions from Capital:
? Intangible assets and losses in the current period and those brought forward from previous period to be deducted from Tier 1 capital. Deferred Tax Assets to be deducted from Tier 1 capital. Any gain on sale arising at the time of securitization of standard assets, if recognized, should be deducted entirely from Tier 1 capital. Deduction of Securitization exposure 50% from Tier 1 and 50% from Tier 2 capital. Investments in financial subsidiaries and associates – The entire investments in the paid-up equity of the financial entities (including insurance entities), which are not consolidated for capital purposes with the bank, where such investment exceed 30% of the paid up equity of such financial entities and entire investments in other instruments eligible for regulatory capital status of those entities, shall be deducted, at 50% from Tier 1 and 50% from Tier 2 capital. Explanation of terms used: ? Intangible Assets : Eg : Goodwill need to be deducted from the shareholders equity while arriving at the capital adequacy ratio o Deferred Tax Asset: Commonly arise due to difference in Company Laws and Tax Laws. For eg: A windmill project normally has a life of 10 years. The Companies Act permits depreciation of 10% but Income Tax laws permit 80%.Because of this, t he entire tax on the income will be saved. If normal depreciation would have been charged every year, tax would be paid. Thus the saved tax actually pertains to the future years. To provide a correct picture to the shareholders, the taxes which pertain to the future years need to be separated and shown in the balance sheet. The extra tax paid which pertains to the future years is shown as deferred tax asset. The deferred tax asset every year gets reduced to the extent it pertains to that year and becomes part of general reserve. Thus it gets depleted completely
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Securitization: Involves turning traditional non-marketed balance sheet assets (eg: loans) into marketable securities and moving them off-balance sheet. It can include securitization of residential mortgages, commercial mortgages, credit card receivables, student loans, trade receivables and loans to insurance policy holders. This way banks raise funds in the market rather than borrowing from other banks.
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Asset backed securities were first issued in the USA during 1970’s. The first issue in the UK was in 1985.When a bank asset is securitized, the different functions traditionally played by the bank are unbundled, a structure known as “pass through”. The unbundled functions include: o Loan Origination: The borrower is located usually through the bank marketing the loan. Credit Analysis: The likelihood of the loan being repaid by the borrower is evaluated Loan Servicing: Ensuring that the loan is serviced Credit Support: An evaluation is made of the feasibility of supporting the borrower should there be a change in the borrowers creditworthiness at any time during the duration of the loan Funding Function: Funding of the loan is secured through creation of deposit products that are attractive to retail and wholesale customers Servicing Function: Administration and enforcement of the loan contract. Warehousing: That the loan is one among the many homogenous loans held in the portfolio.
o
o o
o
o o
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The traditional bank uses the funds collected from depositors to fund loans. If the underlying loan assets are securitized, the bank may perform the function of loan origination only. These mortgages are sold subsequently to a “special purpose vehicle” (SPV).Using an investment banker/merchant banker the SPV sells the securities, backed by the pooled cash flows of the individual mortgages. The securities are usually backed by a guarantee of a bank or an underwriting/insurance company so that they can be awarded an investment rating by a public rating agency(Note: The four approved credit rating agencies in India are CRISIL,ICRA,FITCH,CARE) Securitization helps bankers in a volatile interest rate environment. It helps to unbundle the interest rate risk from the credit risk. The originating bank(which may be good) in assessing the credit risk can pass on the interest rate risk to another institution which may have a competitive advantage in managing interest rate risk. Securitization also helps manage the credit risk management because if a bank finds its lending to be too concentrated in a given sector, it can securitize some of its lending to reduce exposure. In some extreme conditions, a bank may resort to securitization to raise funds to improve liquidity. Eg: The Bank of England after suffering heavy losses in the late eighties found
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that it could not raise funds. Hence it decided to sell of its credit card portfolio to improve its funding position. However it failed in 1991.
Calculating Capital Adequacy:
CRAR = (Eligible total Capital funds) divided by (Credit Risk RWA + Market Risk RWA + Op Risk RWA)
Summary of the Calculation of the Numerator: Is detailed in the Appendix A
Summary for calculating the denominator: Risk+Operational Risk)
viz Total Risk Assets (Credit Risk+Market
Approaches to measure credit risk: ? ? ? Standardized Approach Foundation Internal Ratings Approach Advanced Internal Ratings Approach
Approaches to measure market risk: ? ? Standardized Approach Internal Models Approach
Approaches to measure operational risk ? ? ? Basic Indicator Approach Standardized Approach Internal measurement Approach
Approaches to measure Credit Risk: Standardized Approach ? Standardized Approach
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Risk weights rationalized (in comparison to Basel I) and made more risk-sensitive. Risk weights ranging from 0% to 150%. Prescribed risk weights for specified categories.
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Illustration : Risk Weights for Sovereigns:
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AAA to AA-? Risk Weight (Sovereigns) Corporates 0%
A+ to A-
BBB+ to BBB-
BB+ to B-
Below B-
Unrated
20%
50%
100%
150%
100%
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20%
50%
100%
NA
150%
100%
Note: The unrated class can trigger an adverse selection process where the unrated entities give up their ratings to benefit from the risk weight of 100% rather than 150%. Also in many countries, corporate and banks are not required to acquire a rating to fund their activities. Therefore the fact that the borrower has no rating does not necessarily signal low credit quality. The accord tries to strike a balance and stipulates that the national regulators have some flexibility ? ? ? External rating based risk weights for corporate exposure (exposure in excess of Rs. 5 crore). Asset category of Regulatory Retail introduced. Application of Credit Risk mitigation allowed i.e. certain securities are recognized for credit risk mitigation and are allowed to be deducted from exposure after application of haircuts and risk weight is applied on the amount net of credit risk mitigation.
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Illustration: Calculation of Risk Weights and Credit Equivalents (Amounts in Rs Crores)
Items
Balance Sheet Amount
Credit Conversion Factor (3)
Credit Equivalent Amount (4)=(2)*(3)
Risk Weight (5)
(1) (2)
Risk Weighted Amt (6)=(4)*(5)
Cash Advance agnst Specified Sec Invest in Govt Securities Claims on banks Advances ECGC Off-Balance Sheet Items Other Advances Total Weighted Assets Risk with
100 800
NA NA
100 800
0.00% 0.00%
0 0
15000
NA
15000
2.50%
375
3000 8000
NA NA
3000 8000
20% 50%
600 4000
4000
50%
2000
100%
2000
16000
NA
16000
100%
16000 22975
Notes: 1. The outstanding balances of the funded assets are multiplied by the prescribed risk weights to arrive at the total risk weighted assets and the capital requirement thereon. 2. For off balance sheet items (Contingent Liabilities- eg Letters of Credit and Guarantees) there is a chance that they may or may not materialize. The probability of such items crystallizing differs with the type of items. However the bank needs to make a provision incase these liabilities translate into credit exposures and therefore the risk weights are calculated in a two stage process:
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a. The off balance sheet items are converted into their credit equivalents by multiplying them by the “”credit conversion factor” b. The risk weights are calculated by multiplying the credit equivalents with the respective risk weights.
Illustration of Calculation of Capital Adequacy: Capital Elements Balance Sheet Amount Paid-Up Capital Disclosed Reserves Subordinated Debt General Prov 300 1800 300 1800 300 1800 Tier-1 Tier-2 Eligible Comp
250
250
250
400
400
287.18 (lmtd to 1.25% of RWA)
Total
2750
2100
650
2637.18
Calculation of CRAR and Core CRAR: CRAR= Eligible Capital Funds / RWA * 100 = 2637.18/22975*100 = 11.47% Core CRAR = Tier 1 Capital / RWA * 100 = 2100 / 22975 * 100 = 9.14% Core CRAR should be more than 50% of the minimum CRAR prescribed. At present the minimum CRAR is 9% hence more than 4.5%.
Approaches to measure Credit Risk: Advanced Approach Internal Rating Based (IRB) Approaches ? Allows measurement of risk on the basis of internal rating by bank. The computation rests on 4 factors
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? ? ? ?
Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Under IRB (Foundation) Approach, PD to be assessed by bank and LGD & EAD to be provided by the Regulator. Under IRB (Advanced) Approach, all the factors are to be assessed by the bank.
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Expected Loss = PD*LGD*EAD
Illustration: The BIS proposes the Benchmark Risk Weight (BRW) for including the maturity effects on credit risk and capital weights. The function depends upon the default probability DP.The benchmark example refers to a specific case of a 3 year asset, with various default probabilities and a loss give default (lgd) of 50%.Three representative points show the sensitivity of risk weights to the annualized default probability. DP% BRW % 0.03 14 0.7 100 20 625
For DP=0.7%, the BRW is 100% and the maximum risk weight for DP=20% reaches 625%.This value is a cap for all maturities and all default probabilities. The weight profile with varying DP is more sensitive than the standardized approach weights which vary in the range 20% to 150% for all maturities over 1 year. The weights increase less than proportionately until they reach the cap. Currently banks are still following the standardized approach for credit risk computation.
Pillar 2: Supervisory Review Process:
The second pillar aims at ensuring that banks have a sound internal process in place to assess the adequacy of capital based upon a thorough evaluation of its risks. The Basle Committee found 4 basic principles that should inspire supervisor’s policies. 1. Banks should have a process for assessing the overall capital in relation to their risk profile and strategy for maintaining their capital levels. 2. Supervisors should review and evaluate banks internal capital adequacy assessments and strategies as well as their ability to monitor and ensure compliance with regulatory ratios. Appropriate action must be taken if process not found satisfactory.
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3. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum 4. Early intervention by supervisors to prevent capital from falling below the minimum levels Corrective action to be taken if capital not maintained or restored
Pillar 3: Market Discipline
The accord emphasizes the potential for market discipline to reinforce capital regulations and other supervisory efforts in promoting the safety and soundness in banks and FI’s. Core disclosures and discipline to convey vital information is important for market discipline. The accord emphasizes the potential for market discipline to reinforce capital regulations and other supervisory efforts in promoting safety in banks. Disclosures are subject to “materiality “if its omission or misstatement can influence or change the decision of any user relying on that information. *******
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