CAPITAL ADEQUACY RATIO -- BASEL II

CAPITAL ADEQUACY RATIO / CAR / CRAR

The objective is to strengthen the capital base of banks with reference to their risk weighted assets, expressed in the form of a capital adequacy ratio as under:

CRAR= (Capital Fund / Risk Weighted Assets) x 100

(a) Minimum CAR as per Basel II recommendations : 08 %

(b) Minimum CAR in India as per RBI guidelines : 09% **

** Out of this 6% should be Tier I by 31.3.2010, if already not so.

Tier II cannot be more than 50% of the total capital as per Basel I.

Three Pillars of Basel II:

1st Pillar - Minimum Capital Standard (to be complied with by bank)

2nd Pillar - Supervisory Review (to be carried by RBI based on Internal capital Adequacy Assessment Process - ICAAP of the bank & by following RBI's Supervisory Review and Evaluation Process-SREP)

3rd Pillar - Market Discipline. (through different types of disclosure in the balance sheet)

Capital fund in Basel II:

There are two Tiers of Capital Fund, Tier I (permanent capital) and Tier II (supplementary capital). The components of these are:

Tier I components includes:

1.paid-up capital

2. statutory reserves

3. other disclosed free reserves

4. capital reserves representing surplus arising out of sale proceeds of assets.

5. Investment Fluctuation Reserve.

6. Innovative Perpetual Debt Instruments*

7. Perpetual Non-Cumulative Preference shares. (PNCPS)*

*Both not to be more than 40% of Tier I (IPDI alone max 15%). There is no maturity period. There is call option after 10 years.

Minus

1. equity investments in subsidiaries,

2. intangible assets, and

3. losses in the current period and those brought forward from previous periods

Tier II includes:

1. Un-disclosed reserves and cumulative perpetual preference shares:

2. Revaluation Reserves (at a discount of 55 percent while determining their value for inclusion in Tier II capital)

3. General Provisions and Loss Reserves upto a maximum of 1.25% of weighted risk assets:

4. Hybrid debt capital Instruments (say bonds):

5. Subordinated debt (long term unsecured loans)

6. Debt capital instruments min maturity 15 years

7. Redeemable cumulative preference shares.

8. Redeemable non-cumulative preference shares.

9. Perpetual cumulative preference shares.

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Approaches for risk calculation

(a) Credit Risk : ++Standard Approach, Internal rating Based approach (comprise of foundation approach & advance approach)

(b) Market Risk: Standard Approach (comprising maturity method & ++duration method), Internal risk based approach

(c) Operational Risk: ++Basic Indicator Approach, Standard Approach, Advance Measurement Approach

++These have been implemented in the first phase. Other approaches to be implemented later on.

1. Internal Models Approach for market risk - earliest date to make application to RBI : Apr 1, 2010. Likely date of approval by RBI: Mar 31, 2011

2a. Standardised Approach for operational risk - earliest date to make application to RBI : Apr 1, 2010. Likely date of approval by RBI: Sep 30, 2010

2b. Advanced Measurement Approach For Operational Risk - earliest date to make application to RBI : Apr 1, 2012. Likely date of approval by RBI: Mar 31, 2014

3. Internal ratings-based approaches for credit risk (foundation- as well as advanced - earliest date to make application to RBI : Apr 1, 2012. Likely date of approval by RBI: Mar 31, 2014

Risk weighted assets

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. RWA in non-fund exposure include transactions such as LC, bank guarantee, forward contracts etc. These are first converted into funded-values by using conversion factor and later on the risk weight is applied.

RISK TERMS

CREDIT RISK :

Risk on account of possible default by the borrower in meeting his commitments

MARKET RISK:

Risk on account of trading in securities

OPERATIONAL RISK:

Risk on account of failure of internal processes, procedures etc.

LIQUIDITY RISK:

Risk of inability of a bank to meet its liabilities due to mismatch in inflows from assets and liabilities (it is part of market risk)

SETTLEMENT RISK:

Risk of default by a bank in meeting its obligations due to its capacity to repay

COUNTRY RISK:

When non-performance by a counter party is due to restrictions imposed by the Govt. of the counter party (non-performance due to external factors).

INTEREST RATE RISK:

Risk due to changes in interest rates leading to effect on profit and loss of the bank. It is part of market risk.

LEGAL RISK:

Risk on account of deficiency in loan documentation (it is part of operational risk)

FOREX RISK:

Risk on account of fluctuation in forex rates

SYSTEMIC RISK:

Risk to a system on account of failure of other related systems.

REPUTATION RISK:

Risk to reputation of a bank on account of engaging services of 3rd parties for certain banking jobs.

ASSET - LIABILITY MANAGEMENT IN BANKS

1. It has been implemented wef April 01, 1999.

2. What is ALM : ALM is the management of structure of balance sheet (liabilities and assets) in such a way that the net earning from interest is maximised within the overall risk-preference (present and future) of the institutions.

3. Residual maturity : It is the time period which a particular asset or liability will still take to mature i.e. become due for payment (instalments, say in case of term loan).

4. Maturity buckets are different time intervals (10 for the time being, namely next day, 2-7 days, 8-14 days, 15-28, 29-90, 91-180, 181-365 days, 1-3 years, 3-5 and above 5 years), in which value of an asset or liability is placed depending upon its residual maturity.

5. Mismatch position : When in a particular maturity bucket, the amount of maturing liabilities or assets does not match, such position is called a mismatch position, which creates liquidity surplus or liquidity crunch position and depending upon the interest rate movement, such situation may turnout to be risky for the bank.

6. Ceiling on mismatch position : Mismatches for cash flows for next day to 15-28 days' buckets to be kept to minimum (not to exceed 5% for next day, 10% for 2-7 days, 15% for 8-14 days and 20% for 15-28 days, each of cash outflows for those buckets).

7. Role of ALCO : Asset-Liability Committee is the top most committee to oversee implementation of ALM system, to be headed by CMD or ED. ALCO would consider product pricing for both deposits and advances, the desired maturity profile of the incremental assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate current interest rates view of the bank and base its decisions for future business strategy on this view.

8. Benefits of ALM : It enables bank managements to take business decisions in a more informed framework with an eye on the risks that bank is exposed to.