Introduction to Capital Adequacy Norms

Introduction to Capital Adequacy Norms

Along with profitability and safety, banks also give importance to Solvency. Solvency refers to the situation where assets are equal to or more than liabilities. A bank should select its assets in such a way that the shareholders and depositors' interest are protected.

Image Credits © light_breeze2010 .

1. Prudential Norms

The norms which are to be followed while investing funds are called " Prudentia Prudentiall Norms Norms." ." They are formulated to protect the interests of the shareholders shareholders and deposito depositors. rs. Prudential Norms are generally prescribed and implemented by the central bank of the country. Commerci Commercial al Banks have to follow these norms to protect the interests of the customers. For inte internat rnationa ionall ban banks, ks, prud prudenti ential al norm norms s were prescribed prescribed by the Bank for Inte Internat rnationa ionall Settlements popularly known as BIS BIS.. The BIS appointed a Basle Committee on Banking Supervision in 1988.

2. Basel Committee

Basel committee appointed by BIS formulated rules and regulation for effective supervision of  the central banks. For this it, also prescribed international norms to be followed by the central banks. This committee prescribed Capital Adequacy Norms in order to protect the interests of  the customers.

3. Definition of Capital Adequacy Ratio

Capital Adequacy Ratio (CAR) is defined as the ratio of bank's capital to its risk assets. Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR).

India and Capital Adequacy Norms

The Government of India (GOI) appointed the Narasimham Committee in 1991 to suggest reforms in the financial sector. In the year 1992-93 the Narasimhan Committee submitted its first report and recommended that all the banks are required to have a minimum capital of 8% to the risk weighted assets of the banks. The ratio is known as Capital to Risk Assets Ratio (CRAR) . All the 27 Public Sector Banks in India (except UCO and Indian Bank) had achieved the Capital Adequacy Norm of 8% by March 1997. The Th e Se Seco cond nd Re Repo port rt of Nar Naras asimh imham am Com Commit mittee tee wa was s su subm bmitt itted ed in the yea yearr 19 1998 98-99 -99.. It recommended that the CRAR to be raised to 10% in a phased manner. It recommended an intermediate minimum target of 9% to be achieved by the year 2000 and 10% by 2002.

Concepts of Capital Adequacy Norms

Capital Adequacy Norms included different Concepts, explained as follows :-

1. Tier-I Capital

Capital which is first readily available to protect the unexpected losses is called as Tier-I Capital. It is also termed as Core Capital. Tier-I Capital consists of :1.

Paid id-U -Up p Capita tal. l.

2.

Stat St atut uto ory Re Rese serv rves es..

3.

Other Disclosed Free Reserves : Reserves which are not kept side for meeting any

specific liability. 4.

Capital Reserves : Surplus generated from sale of Capital Assets.

2. Tier-II Capital

Capital which is second readily available to protect the unexpected losses is called as Tier-II Capital. Tier-II Capital consists of :-

1.

Undisclo Und isclosed sed Reserv Reserves es and and Paid-Up Paid-Up Capita Capitall Perpetual Perpetual Prefe Preferenc rence e Shares. Shares.

2.

Reval Re valua uatio tion n Rese Reserve rves s (at (at disco discoun untt of 55% 55%). ).

3.

Hybr Hy brid id (De (Debt bt / Equ Equit ity) y) Cap Capit ital al..

4.

Subord rdin ina ate ted d Deb Debt.

5.

Gene Ge neral ral Pro Provis vision ions s and and Los Loss s Rese Reserve rves. s.

There is an important condition that Tier II Capital cannot exceed 50% of Tier-I Capital for  arriving at the prescribed Capital Adequacy Ratio.

3. Risk Weighted Assets

Capital Adequacy Ratio is calculated based on the assets of the bank. The values of bank's assets are not taken according to the book value but according to the risk factor involved. The value of each asset is assigned with a risk factor in percentage terms.

Suppose CRAR at 10% on Rs. 150 crores is to be maintained. This means the bank is expected to have a minimum capital of Rs. 15 crores which consists of Tier I and Tier II Capital items subject to a condition that Tier II value does not exceed 50% of Tier I Capital. Suppose the total value of items under Tier I Capital is Rs. 5 crores and total value of items under Tier II capital is Rs. 10 crores, the bank will not have requisite CRAR of Rs. 15 Crores. This is because a maximum of only Rs. 2.5 Crores under Tier II will be eligible for computation.

4. Subordinated Debt

These are bonds issued by banks for raising Tier II Capital. They are as follows :1.

They Th ey sho should uld be ful fully ly paid paid up ins instru trume ments nts..

2.

They Th ey sho shoul uld d be un unse secu cure red d debt debt..

3.

They The y should should be subordi subordinate nated d to the claims claims of of other credi creditors. tors. This This means means that that the bank's bank's

holder's claims for their money will be paid at last in order of preference as compared with the claims of other creditors of the bank. 4.

The bond bonds s should should not not be redeem redeemable able at the optio option n of the the holders. holders. This This means means the the

repayment of bond value will be decided only by the issuing bank.

Capital Adequacy Ratio The Committee on Banking Regulations and Supervisory Practices (Basel Committee) had released the guidelines on capital measures and capital standards in July 1988 which were been accepted by Central Banks in various countries including RBI. In India it has been implemented by RBI w.e.f. 1.4.92 Objectives of CAR : The fundamental objective behind the norms is to strengthen the soundness and stability of the banking system. Capital Adequacy Ratio or CAR or CRAR : It is ratio of capital fund to risk weighted assets expressed in percentage terms i.e. Minimum requirements of capital fund in India: India : * Existing Banks 09 % * New Private Sector Banks 10 % * Banks undertaking Insurance business 10 % * Local Area Banks 15% Tier I Capital should at no point of time be less than 50% of the total capital. This implies that Tier II cannot be more than 50% of the total capital.

Capital fund Capital Fund has two tiers - Tier I capital include *paid-up capital *statutory reserves *other disclosed free reserves *capital reserves representing surplus arising out of sale proceeds of assets. Minus *equity investments in subsidiaries, *intangible assets, and *losses in the current period and those brought forward from previous periods to work out the Tier I capital. Tier II capital consists of: *Un-disclosed reserves and cumulative perpetual preference shares: *Revaluation Reserves (at a discount of 55 percent while determining their value for inclusion in Tier II capital) *General Provisions and Loss Reserves upto a maximum of  1.25% of weighted risk assets: *Investment fluctuation reserve not subject to 1.25% restriction *Hybrid debt capital Instruments (say bonds): *Subordinated debt (long term unsecured loans: Risk weighted assets - Fund Based : Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets. Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the offbalance sheet items by the credit conversion factor. This will then have to be again multiplied by the relevant weightage. Reporting requirements : Banks are also required to disclose in their balance sheet the

quantum of Tier I and Tier II capital fund, under disclosure norms. An annual return has to be submitted by each bank indicating capital funds, conversion of off-balance sheet/non-funded exposures, calculation of risk -weighted assets, and calculations of capital to risk assets ratio,