CAPITAL ADEQUACY

SEM 3 TM
 Minimum Capital
• Should be enough to absorb maximum losses
 Capital for Credit Risk
• Standardised Approach
• IRB Foundation Approach
• IRB Advanced Approach
 Capital for Operational risk
• Basic Indicator Approach
• Standardised Approach
• Advanced Measurement Approach
• Basel I Capital –
– Minimum Capital Ratio (8%) *
(Credit Risk + Market Risk)
• Basel II Capital –
– Minimum Capital Ratio (8%) *
(Credit Risk + Market Risk + Operational Risk)
• IRB Approach
– Bank’s internal assessment of the risk parameters
serve as primary inputs to capital calculation.
 IRB
1) P.D. – Likelihood that the borrower will
default over a given time period.
2) L.G.D. – Proportion of the exposure that will
be lost, should default occurs
3) E.A.D. – Amount likely to be drawn in the
event of a default
4) M – Residual Maturity of the exposure
• Operational Risk – BIA – 15% of average gross
income over three years
 Three Pillars of Basel II
• The Basel II accord rests on three pillars :
1) Pillar 1 :- Minimum Capital Requirement
2) Pillar 2 :- Supervisory Review Process
3) Pillar 3 :- Market Discipline
 Pillar 1 – Minimum Capital
Requirements
• It prescribes a risk sensitive calculation of capital
requirements The Basel I accord provided global
standards for minimum capital requirements for
banks. Capital requirement is based on the value
and nature of assets
• The total capital ratio must not be lower than 8%.
• Supplementary capital comprises subordinated
debt of more than five years’ maturity, loan loss
reserves etc.
 Pillar 2 – Supervisory Review Process
• It envisages the establishment of suitable risk
management systems in banks and their review
by the supervisory authority.
• Basel II document of the Basel Committee lays
down the following four principals in regard to
the Supervisory Review Process (SRP):-
• Principle 1 :- Banks should have a process for
assessing their overall capital adequacy in
relation to their risk profile and a strategy for
maintaining their capital levels.
• Principle 2 :- Supervisors should review and
evaluate the banks’ internal capital adequacy
assessments and strategies.
• Principle 3 :- Supervisors should expect banks
to operate above the minimum regulatory
capital ratios and should have the ability to
require the banks to hold capital in excess of
the minimum.
• Principle 4 :- Supervisors should seek to
intervene at an early stage to prevent capital
from falling below the minimum levels.
 Rationale for Basel II over Basel I
PARAMETER BASEL I BASEL II

Approach to capital •“One size fits all” •Encourages risk sensitivity

adequacy •Standardized capital •Differential capital across
charge regardless of rating exposure classes and rating
•Covered credit risk and grades
market risk •Also covers operational risk
Classification of No distinct classification Exposure classification in
exposure of exposure Credit Risk (8)- Corporate,
Retail, Sovereign, Inter-bank,
Asset Management etc
Prescription for No specific recommendation •Specific guidelines provided
disclosures and •Disclosure requirements
regulatory oversight pertaining to risk information
made more stringent

Implementation Details of implementation •Overall parameters specified

approach schedule left to the regulator •Detailed implementation
schedule to be stipulated for
each bank
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 Basel II - The Three Pillars

Basel II
Framework

Pillar 1 – Pillar 2-
Pillar 3 –
Minimum Capital Supervisory
Market Discipline
Requirements Review Process

11/29/2018 Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai. 14
 Types of Risk and approaches

Different Risk under Basel II

Operational
Credit Risk Market Risk
Risk

Internal Basic
Standardized Advanced
Ratings Indicator Standardized
Approach Measurement
Based Approach

Foundation Advanced General

Specific Risk
Market Risk

11/29/2018 Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai. 15
 Other Risks…

• Business Strategy Risk

• Environment Risk

• Group Risk

• Control Risk

• Liquidity Risk

• Reputation Risk

11/29/2018 Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai. 16
 RBI Norms for Basel II..contd

 Risk weights for exposure to corporates

Credit rating AAA AA A BBB and Unrated

by domestic
rating agencies
below

Risk weight 20% 50% 100% 150% 100%

 Risk weights for exposure to retail exposures

Secured by mortgages on residential property linked to loan to value ratio
(LTV)
– LTV of less than or equal to 80% – Risk weight of 75%
– LTV of more than 80% - Risk weight of 100%
– Other retail exposures – 75%

11/29/2018 Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai. 17
 Ground Realities to Basel II – Challenges at home
• Costly Database Creation and Maintenance Process

• Paucity of Credit Rating Agencies

• Additional Capital Requirement

• Relative Advantage to Large Banks

• Risk Sensitivity

• IT infrastructure

• Communication gap

• Cross Border Issues for Foreign Banks

11/29/2018 Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai. 18
• ICAAP ( Internal Capital Adequacy Assessment
Process) and SREP (Supervisory Review and
Evaluation Process) are the two important
components of Pillar 2.
• The ICAAP comprises a bank’s procedure and
measures designed to ensure the following :-
(a) An appropriate identification and
measurement of risks.
(b) An appropriate level of internal capital in
relation to the bank’s risk profile.
(c) Application and further development of
suitable risk management systems in the
bank.
• The SREP consists of :
– a review and evaluation process adopted by the
supervisor.
– These include the review and evaluation of the
bank’s ICAAP, conducting an independent
assessment of the bank’s risk profile.
 ICAAP To Be A Forward-Looking
Process
• The ICAAP should be forward looking in nature.
• It should take into account the expected /
estimated future developments.
• The banks shall have an explicit, board approved
capital plan. The plan shall outline :
- the bank’s capital needs
- the bank’s anticipated capital utilization
- the bank’s desired level of capital
- limits related to capital
- a general contingency plan for dealing with
divergences and unexpected events.
 ICAAP To Be A Risk-Based Process
• Banks shall set their capital targets, which are
consistent with their risk profile and operating
environment.
• A Bank shall have in place a sound ICAAP,
which shall include all material risk exposures
incurred by the bank.
 Pillar 3 – Market Discipline
• It seeks to achieve increased transparency
through expanded disclosure requirements for
banks.
• Market Discipline is to compliment the Pillar 1
and Pillar 2.
• It provides disclosure requirements for banks
using Basel-II framework.
Qualitative & Quantitative Disclosures
1. Scope of application
2. Capital structure
3. Capital adequacy
4. Credit Risk – general disclosures
5. Credit Risk – disclosures for portfolios, under
standardized approach
6. Credit Risk – disclosures for portfolios, under
IRB approaches
 Constituents Of Capital
• Tier I Capital
• Tier II Capital
• Tier III Capital
 Tier I Capital
• Consists of superior quality instruments and is
the mainstay of the capital of a bank.

• Innovative instruments like perpetual debt can

also form a part of Tier I capital.
 Tier I Capital - Constituents
• Permanent shareholders’ equity (paid up
capital)
• Statutory reserves and Disclosed free Reserves
• Innovative Tier I capital
 Tier II Capital
• Consists of revaluation reserves, general
reserves, hybrid debt capital and subordinated
term debt and investment reserve.
 Tier II Capital - Constituents
• Revaluation Reserves
• General Provisions / general loan-loss
Reserves
• Hybrid debt capital instruments
• Subordinated debt
 Tier II Capital - Constituents
• Revaluation Reserves
• General Provisions / general loan-loss
Reserves
• Hybrid debt capital instruments
• Subordinated debt
 Treatment of Market Risks
• The capital requirements for market risk are
subdivided into following two subcomponents of
market risk:-
Specific Risk – defined as the risk of loss caused
by an adverse price movement of a security due
principally to factors related to the issuer of the
security. It includes the risk that an individual
debt or equity security moves by more or less
than the general market in day-to-day trading and
event risk. It exists for both long and short
positions, as it is essentially price risk.
• General Market risk – defined as the risk of
loss caused by an adverse market movement
unrelated to any specific security or issuer.
Both general market and specific risks cause
changes in the market price of an instruments.
 BASEL III
• BASEL III requirements will be phased in gradually
from 1 January 2013.

• Liquidity Coverage Ratio (LCR)

– Stock of high quality liquid assets = > 100%
Net Cash Outflows over a 30-day period

• Net Stable Funding Ratio (NSFR)

– Available amount of stable funding = > 100%
Required amount of stable funding
 BASEL III CAPITAL RATIOS
2011 2012 2013 2014 2015 2016 2017 2018 2019
SUPERVISORY PARALLEL RUN PHASE (PUBLIC EFFECTIVE JAN
MONITORING DISCLOSURE AS OF Jan 2015) 2018

MIN TIER 1 4.0% 4.0% 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
CAPITAL
MIN TOTAL 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
CAPITAL
MIN TOTAL 8.0% 8.0% 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
CAPITAL PLUS
CAPITAL
CONVERSION
BUFFER
 BASEL - III
• A set and reform measures developed by BCBS to
strengthen the regulation, supervision and risk
management of banking sector.
• The measures focus on :
- improving ability of the Banking sector to
absorb shocks arising from financial and
economic stress.
- improve risk management and governance
- strengthen transparency and disclosures of
banks
-Micro prudential and macro prudential
supervision.
 BASEL - III
• Seeks to address four key aspects identified as
the main cause of global crisis.
- Quality and composition of capital
(Enhancing Tier I capital requirement and
introduction of capital buffers, strict
definition of capital).
- Liquidity crunch due to borrowing short and
lending long (Introduction of ratios to stress
testing of a financial institutions ability to
withstand liquidity pressures).
 BASEL - III
• Balance sheet leveraging (Introduction of
Leverage ratios to improve balance sheet
structure).
• Inconsistencies in Accounting and valuation
practices (Computation of capital charges
based on covered international accounting
standards).
 Reverse Repo Rate
• Definition of 'Reverse Repo Rate'
•
Definition: Reverse repo rate is the rate at which the
central bank of a country (Reserve Bank of India in case of
India) borrows money from commercial banks within the
country. It is a monetary policy instrument which can be
used to control the money supply in the country.
Description: An increase in the reverse repo rate will
decrease the money supply and vice-versa, other things
remaining constant. An increase in reverse repo rate means
that commercial banks will get more incentives to park
their funds with the RBI, thereby decreasing the supply of
money in the market.
 5. Ratios and Rates
(Per cent)
2016 2017
Item/Week Ended Jun. 24 May 26 Jun. 2 Jun. 9 Jun. 16 Jun. 23
1 2 3 4 5 6
Ratios
Cash Reserve Ratio 4.00 4.00 4.00 4.00 4.00 4.00
Statutory Liquidity Ratio 21.25 20.50 20.50 20.50 20.50 20.50
Cash-Deposit Ratio 4.82 4.72 .. 4.77 .. ..
Credit-Deposit Ratio 75.62 72.00 .. 72.40 .. ..
Incremental Credit-Deposit Ratio 2.36 121.10 .. 104.30 .. ..
Investment-Deposit Ratio 28.76 30.57 .. 30.73 .. ..
Incremental Investment-Deposit Ratio 49.93 -94.53 .. -120.57 .. ..
Rates
Policy Repo Rate 6.50 6.25 6.25 6.25 6.25 6.25
Reverse Repo Rate 6.00 6.00 6.00 6.00 6.00 6.00
Marginal Standing Facility (MSF) Rate 7.00 6.50 6.50 6.50 6.50 6.50
Bank Rate 7.00 6.50 6.50 6.50 6.50 6.50
Base Rate 9.30/9.70 9.10/9.60 9.10/9.60 9.10/9.60 9.10/9.60 9.10/9.60
MCLR (Overnight) 8.90/9.15 7.75/8.10 7.75/8.10 7.75/8.10 7.75/8.10 7.75/8.10
Term Deposit Rate >1 Year 7.00/7.60 6.25/6.90 6.25/6.90 6.25/6.90 6.25/6.90 6.25/6.90
Savings Deposit Rate 4.00 4.00 4.00 4.00 4.00 4.00
Call Money Rate (Weighted Average) 6.33 6.04 6.05 6.11 6.07 6.08
91-Day Treasury Bill (Primary) Yield 6.77 6.85 6.31 6.27 6.27 6.27
182-Day Treasury Bill (Primary) Yield .. .. 6.39 .. 6.33 ..
364-Day Treasury Bill (Primary) Yield 6.90 6.96 .. 6.43 .. 6.38
10-Year G-Sec Par Yield (FIMMDA) 7.55 7.49 6.65 6.53 6.53 6.64
RBI Reference Rate and Forward Premia
INR-US$ Spot Rate (₹ Per Foreign Currency) 68.01 64.59 64.42 64.26 64.59 64.54
INR-Euro Spot Rate (₹ Per Foreign Currency) 75.10 72.33 72.27 71.98 72.05 72.08
Forward Premia of US$ 1-month 6.35 4.92 4.75 4.76 4.83 4.74
3-month 6.32 4.83 4.81 4.79 4.83 4.77
6-month 6.12 4.71 4.72 4.64 4.71 4.65