CAPITAL ADEQUACY REQUIREMENTS OF BANKSBASEL I & II

PRESENTED BY: Prerna Garg A65 Megha Jain A68

NEED FOR CAPITAL

Servicing its depositors Discharging the responsibility of infrastructural investment Acquiring assets Establishing branch network Entering into fund based activities Maintaining net worth requirements

TRADITIONAL MEASURES OF CAPITAL ADEQUACY

Equity Ratio - ratio of equity capital over loans and investments Ratio of Paid up Capital to Reserves Capital-Deposit Ratio
used previously in USA & UK high C-D ratio implies low risk for depositors Extent varies on the quality of assets into which the deposits are converted

So
To assess the adequacy of capital based on the quality of assets, the Capital to Risk Weighted Assets Ratio (CRAR) or the Capital Adequacy Ratio (CAR) was introduced in 1988 by the BASEL Capital Adequacy Accord

THE BASEL COMMITTEE ON BANKING SUPERVISION (BCBS)

BCBS was formed under the auspices of BIS (Bank for International Settlements- An international clearing bank for Central banks) in 1974 due to the need for uniform capital standards. The Basel Committee, established by the centralbank Governors of the G-10 countries. The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States.

BASEL IS CONSTANT WIP

1988 Basel Accord I 1999 Consultative paper (Proposal to replace 1988 accord with Basel II) 2004 The Final Accord 2006 - Implementation in G10+3 countries Implementation across EU Implementation in Emerging Markets

BASEL ACCORD I (1988)

Principal purposes:
To ensure an adequate level of capital in the international banking system To create a more level playing field so that banks could no longer build business volume without adequate capital backing

The Basel Accord I became a World standard with well over 100 countries applying the framework to their banking system

BASEL ACCORD I (1988)

Requires the banks to hold capital equal to at least 8% of its Risk Weighted Assets - CAR The definition of capital is broadly into two tiers Tier 1 and Tier 2 Weights are assigned to each asset depending on its riskiness. Assets are classified into four buckets (0%, 20%, 50%, 100%) according to their debtor category.

CAPITAL ADEQUACY NORMS

To assess the CAR, three aspects are relevant:
Composition of Capital Composition of Risk Weighted Assets Assigning Risk Weights

COMPOSITION OF CAPITAL
Tier 1 Capital
- core capital
- most permanent and readily available support against unexpected losses

Tier 2 Capital
- supplementary capital

- not permanent in nature and not readily available

TIER 1 CAPITAL
Consists of :
Paid up capital Statutory reserves Disclosed free reserves Capital reserves representing surplus arising out of sale proceeds of asset

Equity investments in subsidiaries, intangible assets and losses will be deducted from Tier 1 capital

TIER 1 CAPITAL FOR FOREIGN BANKS OPERATING IN INDIA

Consists of :
Interest free funds from head office kept in a separate account in the Indian books specifically for the purpose of meeting the Capital Adequacy norms Statutory reserves kept in Indian books Remittable surplus retained in Indian books which is not repatriable so long as the bank functions in India

TIER 2 CAPITAL
Consists of :
Undisclosed reserves and Cumulative perpetual preference shares
Revaluation reserves General provisions and loss reserves Hybrid debt capital instruments Subordinated debt

COMPONENTS OF TIER 2
Undisclosed Reserves
- absorb expected losses
- present accumulations of post tax profits - not encumbered by any known liability

Cumulative perpetual preference shares

- should be fully paid up

- should not contain clauses which permit redemption by the holder

CONTINUED
Revaluation Reserves
- Arise from revaluation of assets that are undervalued in the books, typically premises and marketable securities - Their reliability depends on the accuracy of estimates of market value of the assets, the subsequent deterioration in asset value, or in forced sale, the actual liquidation value etc. - Need to be discounted to a minimum of 55% when including in tier 2 capital

CONTINUED
General Provisions and loss revenues
- Are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses. - They are admitted up to a maximum of 1.25 percent of weighted risk assets.

Hybrid Debt Capital Instruments

- Combine characteristics of both Debt and Equity - Where these Instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation

CONTINUED
Subordinated Debt
- 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. - Should have a minimum initial maturity of 5 years. - Should have a minimum remaining maturity of 1 year. - Limited to 50 percent of Tier 1 Capital. - Subjected to progressive discounts as they approach maturity.

DISCOUNTED RATES FOR SUBORDINATED DEBT

Remaining Term to Maturity
More than 4 but less than 5
More than 3 but less than 4 More than 2 but less than 3

Discount Rate
20 percent
40 percent 60 percent

More than 1 but less than 2

Does not exceed 1 year

80 percent
100 percent

POINTS TO NOTE
The sum of Tier 1 and Tier 2 capitals will represent the capital funds for the computation of CAR. The total of Tier 2 elements can be a maximum of 100 percent of the total of Tier 1 elements. Investment by banks in the subordinated debt of the other banks shall be subject to the ceiling of 5 percent of their investment in shares or corporate bodies. A banks total investment in the Tier 2 Bonds issued by other banks and financial institutions shall be permitted to a maximum of 10 percent of its total capital, the same as used for computing CAR.

RISK ADJUSTED ASSETS

Risk adjusted assets would mean weighted aggregate of funded and non funded items. Degrees of credit risk expressed as a percentage weighting are assigned to Balance sheet items. Conversion factors are assigned to Off-Balance Sheet items. Investment in all securities should be assigned a risk weight of 2.5 percent for market risk in addition to credit risk. The value of each asset is multiplied by the relevant weights to produce risk-adjusted values of assets and offbalance sheet items. The aggregate is taken into account for reckoning the minimum capital ratio.

RISK WEIGHTS
0%
- Cash - Claims on Central government and Central Banks denominated in national currency - Loans guaranteed by Government of India/ State Government - Investment in Government securities - Investment in other approved securities guaranteed by Central/State Government - Investment in securities where payment of interest and repayment of principal is guaranteed by Central/State Government. E.g. Indira/ Kisan Vikas Patra

CONTINUED
20%
- Investment in approved securities where payment of interest and repayment of principal is not guaranteed by the Central/State Govt. - Claims on commercial banks and Public Financial Institutions - Investment in securities which are guaranteed by banks or PFIs - Investments in bonds issued by other banks or PFIs - Loans and advances granted to staff of banks which are fully covered by superannuation benefits and mortgage of flat or house.

CONTINUED
50%
- Investment in mortgage backed securities of residential assets of housing finance companies which are recognised by National Housing Bank - Advances covered by ECGC/DICGC - Housing loans to individuals against the mortgage of residential property

CONTINUED
100%
- Claims on private sector - Investments in subordinated debt instruments and bonds issued by other banks or public financial institutions for the Tier 2 capital - Deposits with SIDBI/NABARD in lieu of the shortfall in lending to priority sector - Furniture, fixtures and premises - Loans granted to public sector undertakings of government of India - Loans granted to public sector undertakings of State governments

OFF-BALANCE SHEET ITEMS

The credit risk exposure of such items is calculated by multiplying the face amount of each of such item by the credit conversion factor This is then multiplied by the risk weight attributed Examples: - Certain transaction-related contingent items - Short term self-liquidating trade-related contingencies - Forward assert purchases, forward deposits and partly paid up shares and securities - Sale and repurchase agreement and asset sales with recourse, where the credit risk remains with the bank

EXAMPLE
1. Funded risk assets Amount (Rs. (1) *(2) (rs. Crore) Particulars Crore) (1) RW (%) (3) Cash and Bank Balance with RBI 188.36 0 0 Money at call and short notice 212.5 0 0 Investments GOI Securities 601.13 2.5 15.03 Certificate of deposits 4.65 22.5 1.05 Other approved securities 352.16 2.5 8.80 others 27.77 102.5 28.46 Advances guaranteed by GOI 359.87 0 0.00 Others 918.09 100 918.09 Fixed assets 147.94 100 147.94 Other assets 81.85 100 81.85 Total 1201.22

CONTINUED
2. Off-Balance sheet items Amount (Rs. (1) *(2) (rs. Crore) Crore) (1) RW (%) (3) 131.33 78.52 100 100 131.33 78.52 209.85

Particulars Guarantees given on behalf of constituents Forward exchange contracts (2141.45 * .02 + 713.82*.05) Total

Total risk Weighted asset = Rs. 1411.07 crores

CONTINUED
Capital
Tier 1 = Equity + statutory reserves + capital reserves
Equity investments in subsidiaries = 11.6 + 94.26 + 20.29 37.13 = Rs. 89.02 crores

Tier 2
Particulars Amount (Rs. Crore) Amount considered (Rs. Crores) 36.62 1 36.62 34.88 0.45 15.696 36.29 1 or 1.25% of 17.64 RWA whichever is lower 69.956 1 - Discount rate

undisclosed reserves Revaluation reserves General provisions and loss reserves total

Total capital = 89.02 + 69.95 = Rs 158.98 crores

CONTINUED
Capital Adequacy ratio = Capital Risk Weighted Assets = 158.98 1411.07 = 11.3 % Which is more than the stipulated requirement

EXISTING BASEL CAPITAL ACCORD WHY CHANGE?

1988 Capital Accord served the industry well, but Insufficiently sensitive to risk - Very broad categories of risk weights. - E.g. A loan to Reliance is deemed as risky as a loan to Haldirams Very limited account of risk mitigation - does not sufficiently recognise credit risk mitigation techniques, such as collateral and guarantees. No incentive structure to improve risk measurement and risk management practice

CONTINUED
Perverse incentives leading to regulatory arbitrage - To lend to poorer quality credits - To securitise better quality assets - A flat 8 percent charge for claims on the private sector has given banks an incentive to move high quality assets off their balance sheet, thus reducing the average quality of their loan portfolios. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. Therefore, the Basel Committee decided to propose a more risk-sensitive framework in June 1999.

BASEL II: A MAJOR PARADIGM SHIFT

The Existing Accord Focus on a single risk measure The New Accord More emphasis on banks internal methodologies, supervisory review & market discipline

One size fits all

Flexibility, menu of approaches, capital incentives for good risk management Increased risk sensitivity

Broad brush structure

BASEL II STRUCTURE
New Basel Capital Accord
Pillar 1 Quantitative Minimum Capital Requirements Pillar 2 Qualitative Supervisory Review Process Pillar 3 Market Forces Market Discipline

Calculation of capital requirements Credit risk Operational risk Advanced Approaches Trading book (market risk)

Process for assessing overall capital adequacy Banks are expected to operate above the minimum regulatory capital ratios Early intervention by supervisors

Disclosure requirements Capital structure Risk exposures Capital adequacy

RISK COMPONENTS TO CAPITAL ADEQUACY CALCULATION

Unchanged

8% Credit Risk + Market Risk + Operational Risk

Total Capital

Significantly Refined

Relatively Unchanged

New

(Could be set higher under pillar 2)

CAPITAL ADEQUACY UNDER BASEL II PILLAR I

Market risk As per Basel Accord I Credit risk
(a) Standardised approach more granular version of Basel I (b) Foundation Internal Rating Based Approach (IRB) uses banks own credit ratings (c) Advanced IRB other inputs also determined by bank

Operational risk
(a) Basic indicator approach - % of revenue (b) Standard indicator approach - % of revenue/assets, by line of business (c) Advanced Measurement Approach internal models etc

PILLAR 1 CREDIT RISK

Standardised approach
Risk weights (largely) a function of external ratings
Credit assessment Risk-weight AAA to AA20% A+ to A50% BBB+ to Below BB- Unrated BB100% 150% 100%

IRB approaches (Foundation and Advanced)

Risk weights a function of internal credit ratings Theoretically unlimited number of grades (minimum 7 for performing loans) Does not allow banks themselves to determine all the elements needed to calculate their own capital requirements. Determined through a combination of the quantitative inputs provided by banks and the formulae specified by the Committee.

INTERNAL RATING BASED APPROACH (IRB)

The IRB calculation of risk-weighted assets for exposure to sovereigns, banks or corporates depends on four quantitative inputs: Probability of Default (PD), which measures the likelihood that the borrower will default over a given time-horizon Loss Given Default (LGD), which measures the proportion of the exposure that will be lost if a default occurs Exposure at Default (EAD) which, for loan commitments, measures the amount of the facility that is likely to be drawn if a default occurs Maturity (M), which measures the remaining economic maturity of the exposure

FOUNDATION AND ADVANCED IRB APPROACH - A COMPARISON Foundation IRB PD LGD

Provided by banks, based on own estimates. Supervisory rules set by the committee the committee Supervisory rules set by the committee or at National Discretion, by Banks own estimate

Advanced IRB
Provided by banks, based on own estimates. Provided by banks, based on own estimates.

EGD Supervisory rules set by

M

Provided by banks, based on own estimates. Provided by banks, based on own estimates.

PILLAR 1 OPERATIONAL RISK

In the Basel II framework, operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events. In the near term operational risk is not likely to attain the precision with which market and credit risk can be quantified. This has posed obvious challenges to the incorporation of the New Accord. Approaches to operational risk are continuing to evolve rapidly.

PILLAR II: SUPERVISORY REVIEW PROCESS

Inclusion of a supervisory element Requires Bank Management
- developing an internal capital assessment process - Setting targets for capital commensurate with banks particular risk profile

The process subject to supervisory review and intervention

PILLAR III: MARKET DISCIPLINE

Enhanced disclosure by banks
- Areas covered are calculation of capital adequacy and risk assessment methods - Detailed requirements on internal methodologies for credit risk, credit risk mitigation techniques and asset securitization

These norms are set up basically to ensure that market participants can understand the risk profiles and adequacy of capital

MAINTENANCE OF CRAR
The initial Capital to Risk-weighted Ratio (CRAR) was initially set at 8 % However, to meet the international standards,this has been raised to 9% with effect from March 31, 2000. At the end of March 2002, there were 25 PSBs with a CRAR exceeding the stipulated 9% The implementation of Basel New Accord has been estimated to be completed by end-2006

THRUST AREAS
Areas to be considered by an organisation while preparing for Basel II
Reviewing existing frameworks Deciding the approach for risk measurement and management Building flexible and scalable system Developing reliable, efficient disclosure reporting Communicating the approach Finding the right IT partner for the compliance

CONCLUSION
Basel II Offers a variety of options in addition to the standard approach to measuring risk. Paves the way for financial institutions to proactively control risk in their own interest and keep capital requirement low. But.. Requires strategising risk management for the entire enterprise, building huge data warehouses, crunching numbers and performing complex calculations. Poses great challenges of compliance for banks and financial institutions. Increasingly, banks and securities firms world over are getting their act together.

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