DISCLOSURE

REQUIREMENTS OF BANKS

CAPITAL ADEQUACY
NORMS
 WHAT & WHY?

 Meaning of Capital Adequacy:

Capital adequacy is used to describe adequacy of
capital resources of a bank in relation to the risks
associated with its operations.

 Relevance:
Basel Committee on Banking Supervision –
published the first Basel Capital Accord (popularly
called as Basel I framework) in July, 1988.

It prescribes minimum capital adequacy

requirements in banks for maintaining the
soundness and stability of the International Banking
System
OBJECTIVES OF BASEL COMMITTEE FOR
RELEASING BASEL II NORMS AFTER BASEL I:

1. to stop reckless lending by bank

2. to strengthen the soundness and stability of the

banking system

3. to have a comparative footing of the banks of

different countries.
CAPITAL ADEQUACY NORMS IN INDIA

 With a view to adopting the Basel Committee on

Banking Supervision (BCBS) framework on
capital adequacy

 Reserve Bank of India decided in April 1992 to

introduce a risk asset ratio system for banks
(including foreign banks) in India as a capital
adequacy measure.
BASEL III NORMS:
 Basel Committee on Banking Supervision
(BCBS) released comprehensive reform package
entitled “Basel III: A global regulatory
framework for more resilient banks and banking
systems” (known as Basel III capital regulations)
in December 2010.

 The Basel III capital regulations have been

implemented from April 1, 2013 in India in
phases.

(Note – Capital Adequacy norms which we shall

study are based on Basel II norms.)
CAPITAL ADEQUACY RATIO:
 As per the prudential norms, all Indian scheduled
commercial banks (excluding regional rural banks) as
well as foreign banks operating in India are required
to maintain capital adequacy ratio.

 At present capital adequacy ratio is 9%.

 Capital adequacy ratio is worked out as below –

** Capital Fund consists of Tier I & Tier II Capital.

The CAR measures financial solvency of Indian and

foreign banks.
CAPITAL FUND – DIVIDED INTO 2 TIERS
TIER I CAPITAL TIER II CAPITAL
o Also known as Core  Comprises elements that
Capital. are less permanent in
o Provides the most nature or are less readily
permanent and readily
available support to a available than those
bank against unexpected comprising Tier I capital.
losses.
o Consists mainly of share
capital and disclosed
reserves and it is a bank’s
highest quality capital
because it is fully available
to cover losses

Under Basel II norms, Banks can lend only about 22 times of their
core Capital.
ELEMENTS OF TIER I CAPITAL:
(i) Paid-up capital (ordinary shares), statutory reserves, and
other disclosed free reserves, including share premium if
any.
(ii) Perpetual Non-cumulative Preference Shares (PNCPS)
eligible for inclusion as Tier I capital - subject to laws in
force from time to time.
(iii) Innovative Perpetual Debt Instruments (IPDI) eligible
for inclusion as Tier I capital, and
(iv) Capital reserves representing surplus arising out of sale
proceeds of assets
As reduced by:
i. intangible assets and losses in the current period and
those brought forward from previous period.
ii. Creation of deferred tax asset (DTA)results in an
increase in Tier I capital of a bank without any tangible
asset being added to the banks’ balance sheet. Therefore,
DTA, which is an intangible asset, should be deducted
from Tier I capital
ELEMENTS OF TIER II CAPITAL:
(a) Undisclosed reserves
(b) Revaluation reserves:
ICAI - It would be prudent to consider revaluation reserves
at a discount of 55% while determining their value for
inclusion in Tier I capital instead of Tier II capital under
extant regulations. Such reserves however will have to be
reflected on the face of the balance sheet as revaluation
reserves.
(c) General provisions and loss reserves:
General provisions and loss reserves (including general
provision on standard assets) may be taken only up to a
maximum of 1.25 per cent of weighted risk assets.

'Floating Provisions' held by the banks, which is general in

nature and not made against any identified assets, may be
treated as a part of Tier II capital within the overall ceiling of
1.25 percent of total risk weighted assets.

Excess provisions which arise on sale of NPAs would be eligible

Tier II capital subject to the overall ceiling of 1.25% of total
Risk Weighted Assets.
(d) Hybrid debt capital instruments
At present the following instruments have
been recognized and placed under this category:
i. Debt capital instruments which has a
combination of characteristics of both equity and
debt, eligible for inclusion as Upper Tier II capital;
and
ii. Perpetual Cumulative Preference Shares
(PCPS) / Redeemable Non-Cumulative Preference
Shares (RNCPS) / Redeemable Cumulative
Preference Shares (RCPS) as part of Upper Tier II
Capital.
(e) Subordinated debt
To be eligible for inclusion in the Tier-II
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 the Reserve Bank of India.
They often carry a fixed maturity and as they
approach maturity, they should be subjected to
progressive discount for inclusion in Tier-II capital.

Instrument with an initial maturity of less

than five years or with a remaining maturity of one
year should not be included as part of Tier-II
capital. Subordinated debt instrument will be
limited to 50% of Tier-I capital.
(f) Investment Reserve Account

In the event of provisions created on account

of depreciation in the ‘Available for Sale’ or ‘Held for
Trading’ categories being found to be in excess of
the required amount in any year, the excess should
be credited to the Profit & Loss account and an
equivalent amount (net of taxes, if any and net of
transfer to Statutory Reserves as applicable to such
excess provision) should be appropriated to an
Investment Reserve Account in Schedule 2 –
“Reserves & Surplus” under the head “Revenue and
other Reserves” in the Balance Sheet and would be
eligible for inclusion under Tier II capital within the
overall ceiling of 1.25 per cent of total risk weighted
assets prescribed for General Provisions/ Loss
Reserves.
(g) Treatment of foreign currency translation reserve

The Banks may, at their discretion, reckon foreign

currency translation reserve arising due to translation of financial
statements of their foreign operations in terms of Accounting
Standard (AS) 11 as common equity Tier 1 (CET1) capital at a
discount of 25% subject to meeting the following conditions:

(i) the FCTR are shown under Schedule 2: Reserves & Surplus in
the Balance Sheet of the bank;
(ii) the external auditors of the bank have not expressed a
qualified opinion on the FCTR

(h) Banks are allowed to include the ‘General Provisions on

Standard Assets’ and ‘provisions held for country exposures’ in
Tier II capital. However, the provisions on ‘standard assets’
together with other ‘general provisions/ loss reserves’ and
‘provisions held for country exposures’ will be admitted as Tier II
capital up to a maximum of 1.25 per cent of the total risk-weighted
assets.
DEDUCTIONS FROM TIER I AND TIER II
CAPITAL:
(a) Equity/non-equity investments in subsidiaries

The investments of a bank in the equity as

well as non-equity capital instruments issued by a
subsidiary, which are reckoned towards its
regulatory capital as per norms prescribed by the
respective regulator, should be deducted at 50 per
cent each, from Tier I and Tier II capital of the
parent bank, while assessing the capital adequacy
of the bank on 'solo' basis, under the Basel I
Framework.
(b) Credit Enhancements pertaining to Securitization
of Standard Assets

(i) Treatment of First Loss Facility:

The first loss credit enhancement provided by the
originator shall be reduced from capital funds and the
deduction shall be capped at the amount of capital
that the bank would have been required to hold for
the full value of the assets, had they not been
securitised. The deduction shall be made at 50% from
Tier I and 50% from Tier II capital.

(ii) Treatment of Second Loss Facility:

The second loss credit enhancement provided by the
originator shall be reduced from capital funds to the
full extent. The deduction shall be made 50% from
Tier I and 50% from Tier II capital.
(iii) Treatment of credit enhancements provided by
third party:
In case, the bank is acting as a third party service
provider, the first loss credit enhancement provided by it
shall be reduced from capital to the full extent as
indicated at para (i) above.

(iv) Underwriting by an originator:

Securities issued by the SPVs and devolved / held by the
banks in excess of 10 per cent of the original amount of
issue, including secondary market purchases, shall be
deducted 50% from Tier I capital and 50% from Tier II
capital.

(v) Underwriting by third party service providers:

If the bank has underwritten securities issued by SPVs
devolved and held by banks which are below investment
grade the same will be deducted from capital at 50% from
Tier I and 50% from Tier II.
RATIO OF TIER II CAPITAL TO TIER I
CAPITAL
 The quantum of Tier II capital is limited to a
maximum of 100% of Tier I Capital.

 This seeks to ensure that the capital funds of a

bank predominantly comprise of core capital
rather than items of a less permanent nature.

 It may be clarified that the Tier II capital of a

bank can exceed its Tier I capital; however, in
such a case, the excess will be ignored for the
purpose of computing the capital adequacy ratio.
RISK-ADJUSTED ASSETS

 For CAR purposes the entire assets side of the

Banks Balance Sheet is recalculated on the basis
of assigning risk weights to each category of
assets.

 This follows the principle of conservatism by

considering assets at their Risk Adjusted Values
rather than at their face value in calculating the
CAR.

 The Reserve Bank has assigned different risk

weights to different categories of assets.
IMPORTANT WEIGHTS FOR THE PURPOSE OF
ASCERTAINMENT OF CAR ARE AS FOLLOWS:

The risk adjusted value for any category of assets is determined by

multiplying the value of the category of an asset as per the balance
sheet with the risk weight assigned thereto.
REPORTING FOR CAPITAL ADEQUACY
NORMS

Banks should furnish an annual return. The

format for the returns is specified by the RBI
under Capital Adequacy Norms. The returns
should be signed by two officials who are
authorised to sign the statutory returns now being
submitted to the Reserve Bank.
 QUESTION FOR PRACTICE: (VERY IMPORTANT)
A commercial bank has the following capital funds and assets.
Segregate the capital funds into Tier I and Tier II capitals. Find out
the risk-adjusted asset and risk weighted assets ratio –
Capital Funds: (Figures in
₹ lakhs)
Equity Share Capital 48,000
Statutory Reserve 28,000
Capital Reserve (of which ₹ 280 lakhs were due to 1,210
Revaluation of assets and the balance due to sale
Assets:
Cash Balance with RBI 480
Balances with other Bank 1,250
Claims on Banks 2,850
Other Investments 78,250
Loans and Advances:
(i) Guaranteed by government 12,820
(ii) Guaranteed by public sector undertakings of Govt. of 70,210
India
(iii) Others 5,20,250
Premises, furniture and fixtures 18,200
Other Assets 20,120
Off-Balance Sheet Items:
Acceptances, endorsements, and letters of credit 3,70,250