Capital Adequacy Ratio

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 Equity
 Long Term Debt
 Reserves

 Accounting Capital: One kind of accounting capital is working capital.

This represents funds available in the near term with which to acquire
other investments. It's defined as:
working capital = current assets - current liabilities

 Economic capital: economic capital is the amount of risk capital, assessed

on a realistic basis, which a firm requires to cover the risks that it is
running or collecting as a going concern, such as market risk, credit
risk, legal risk, and operational risk. It is the amount of money which is
needed to secure survival in a worst-case scenario.

 Regulatory capital :Regulatory capital is the amount of capital required

by regulation and/or regulator.(Tier-I and II)
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An asset is anything that can be sold for value. A liability is an
obligation that must eventually be paid, and, hence, it is a claim
on assets. The owner's equity in a bank is often referred to
as bank capital, which is what is left when all assets have been
sold and all liabilities have been paid. The relationship of the
assets, liabilities, and owner's equity of a bank is shown by the
following equation:

Bank Assets = Bank Liabilities + Bank Capital

A bank uses liabilities to buy assets, which earns its income. By using
liabilities, such as deposits or borrowings, to finance assets, such as loans to
individuals or businesses, or to buy interest earning securities, the owners of
the bank can leverage their bank capital to earn much more than would
otherwise be possible using only the bank's capital.

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Need for capital
• Supports bank’s operations (source of funds)
• To finance start-up cost of capital investment
• Provides cushion against unexpected losses stemming
from credit, market and operational risks – thus
maintains solvency of a bank
• Encourages depositors’ confidence
• Encourages shareholders’ interest in governance of the
bank
• Regulatory comfort as bank insolvency is costly to the
economy
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How much capital??
 Before Basel standards, regulators set minimum capital
requirements in absolute terms or as gearing ratio.
 After Basel, capital is aligned to the quantum of risks
carried by a bank.
 Elimination of probability of bank insolvency is not
possible hence the present capital standards aim to ensure
that a bank would not be insolvent under an acceptable
probability.
 Measuring losses to quantify the level of capital
requirement is the core issue.

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 In 1998 BIS Accord was the first attempt to set
international risk based standards for Capital Adequacy.
12 members of BASEL COMMITTEE worked to measure,
understand and manage risk.

 Capital Adequacy Ratio (CAR), also known as Capital to

Risk (Weighted) Assets Ratio (CRAR), is the ratio of
a bank's capital to its risk.

 CRAR= Capital/Risk Weighted Assets.

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The capital conservation buffer is designed to ensure that banks build up capital
buffers outside periods of stress which can be drawn down as losses are incurred.
The requirement is based on simple capital conservation rules designed to avoid
breaches of minimum capital requirements. This could include reducing dividend
payments, share-backs and staff bonus payments. Banks may also choose to raise
new capital from the private sector as an alternative to conserving internally
generated capital.
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The countercyclical capital buffer aims to ensure that banking sector capital
requirements take account of the macro-financial environment in which banks
operate. Its primary objective is to use a buffer of capital to achieve the broader
macro sensible goal of protecting the banking sector from periods of excess
aggregate credit growth that have often been associated with the build-up of
system-wide risk.

Due to its countercyclical nature, the countercyclical capital buffer regime may also
help to lean against the build-up phase of the credit cycle in the first place. In
downturns, the government should help to reduce the risk that the supply of credit
will be constrained by regulatory capital requirements that could undermine the
performance of the real economy and result in additional credit losses in the
banking system.
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The NSFR will require banks to maintain a stable funding profile in relation to the
composition of their assets and off-balance sheet activities. A sustainable funding
structure is intended to reduce the likelihood that disruptions to a bank’s regular
sources of funding will erode its liquidity position in a way that would increase the
risk of its failure and potentially lead to broader systemic stress. The NSFR limits
overreliance on short-term wholesale funding, encourages better assessment of
funding risk across all on- and off-balance sheet items, and promotes funding
stability

Systemically Important Financial Institutions (SIFI) : As part of the macro-

prudential framework, systemically important banks will be expected to
have loss-absorbing capability beyond the Basel III requirements.
Options for implementation include capital surcharges, contingent
capital.

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  Total regulatory capital will consist of the sum of the
following categories

• Tier 1 Capital (going-concern capital)

 (a) Common Equity Tier 1

 (b) Additional Tier 1

• Tier 2 Capital (gone-concern capital)

From regulatory capital perspective, going-concern capital is the capital

which can absorb losses without triggering bankruptcy of the bank. Gone-
concern capital is the capital which will absorb losses only in a situation of
liquidation of the bank.
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 Common shareholding’s equity and retained
earnings
 Stock surplus (share premium)
 Balance in Profit & Loss Account at the end of
the previous financial year
 Capital reserves representing surplus arising out
of sale proceeds of assets
 Statutory liquidity reserves
 Other disclosed free reserves (currency
deposits, A small fraction of the total deposits )
• Less: Regulatory adjustments / deductions
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 Perpetual Non-Cumulative Preference Shares
(PNCPS)
 Debt capital instruments
 Additional Tier 1 instruments issued by
consolidated subsidiaries of the bank and held by
third parties
• Less: Regulatory adjustments / deductions

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 Debt Capital Instruments issued by the banks
 General Provisions and Loss Reserves for lease and
loan losses not exceed 1.25% of credit to RWA
 Perpetual preferred stock not qualifying for Tier 1
capital
 Hybrid Capital instruments and equity contract
notes(Perpetual preferred stocks carrying a cumulative
fixed charge are hybrid instruments)
 Subordinated debt and intermediate-term preferred
stock
 Revaluation reserves at a discount of 55%
• Less: Regulatory adjustments / deductions
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 Goodwill/Intangible assets
 Deferred Tax assets/Liabilities
 Cash flow hedge reserves
 Gain-on-Sale Related to Securitization Transactions
 Cumulative Gains and Losses due to Changes in
Own Credit Risk on Fair Valued Financial Liabilities
 Defined Benefit Pension Fund Assets and Liabilities
 Investments in Own Shares (Treasury Stock)
 Investments in the Capital of Banking, Financial
and Insurance Entities etc…

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0% Cash
Treasury securities
Balance due from government

20% Cash in the process of collection

Mortgage backed security
Interbank deposits and guaranteed claims
Assets collateralized by securities guaranteed by Govt.
Securities issued and direct claims on Govt sponsored agencies

50% Loan and multifamily properties

Home mortgage loan with 80% loan to value ratio
Local Govt local bonds

100% All type of consumer and commercial loans

Long term claims , construction loan, commercial paper and Pvt issued
debt , Investment in unconsolidated subsidiaries, JVs or associated
companies, Mortgage securities with residual characteristics.
All other assets , including intangible assets not deducted from capital
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 A bid bond is a debt secured by a bidder for a construction job or similar
type of bid-based selection process for the purpose of providing a
guarantee to the project owner that the bidder will take on the job if selected
 A performance bond , also known as a contract bond, is a surety
bond issued by an insurance company or a bank to guarantee satisfactory
completion of a project by a contractor.
 Sales with recourse means liability for the asset sold falls upon the seller.
The seller of an asset bears responsibility for the nonperformance of the
item.
 A repurchase agreement (repo) is a form of short-term borrowing for
dealers in government securities. The dealer sells the government securities
to investors, usually on an overnight basis, and buys them back the
following day.
 A type of long-term financing (usually) on a piece of real property. Long-
term take-out loans replace interim financing, such as a short-term
construction loan. They are usually mortgages with fixed payments that are
amortizing.
 a loan drawdown is when someone withdraws funds from a loan facility.
Practical Law says lenders often allow drawdowns to give money advances
to borrowers and set interest rates based on these short borrowing periods.

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Conversio Assets
n Factor
50% 20% RW
Performance standby LOC conveyed to others participants,
participation in commitments more than 1 yr.
100% Financial standby LOC conveyed to others
50% RW
0% Unused commitments with maturity 1 yr or less
Other unused commitments and a separate credit decisions is made
20% Commercial Letter of Credit and similar instruments
50% Performance standby LOC less those conveyed to others
Unused commitments with maturity 1 yr or less those conveyed to
others
Revolving underwriting facilities, note issuance and similar
arrangements
100% Financial standby LOC less those conveyed to others
Participation in acceptance acquired, securities loaned, Farm credit
loans, sale and repurchase agreements, forward agreements and
subordinated propositions of mortgage pooled securities
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 Banks are required to maintain a minimum Pillar 1 Capital to Risk-
weighted Assets Ratio (CRAR) of 9% on an on-going basis (other
than capital conservation buffer and countercyclical capital buffer
etc.)

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 Principle 1: overall capital adequacy in relation to their risk profile.
 Principle 2: evaluate internal capital adequacy assessments (ICCAP)
and ensure with regulatory capital
 Principle 3: supervisors should expect bank to operate the minimum
capital ratios and have 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.

Bank Responsibilities:
Supervisors Responsibilities:
ICCAP: STRCUTURAL ASPECTS, REVIEW OF ICCAP, principle of
proportionality
ICCAP FORWARD LOOKING: Risk based process, Stress Test and
Scenario Analysis, etc.

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 Pillar III ensures disclosures requirements for banks using Basel-II
framework. These disclosures will allow market participants to assess
key information and make informed decisions about a bank.

List of 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 approach
7. Credit Risk Mitigation- disclosures for standardized and IRB
8. Securitization- disclosures for standardized and IRB
9. Market Risk-disclosures under standardized approach
10. Market Risk-disclosures under internal models approach
11. Operational Risk
12. Equities- disclosure for banking book positions
13. Internal Rate risk in the banking book(IRRBB)
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 Moodle Assignment

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Example
Calculate capital adequacy ratio i.e. total capital to risk weighted exposures
ratio for Small Bank Inc. using the following information:
The bank's Tier 1 Capital and Tier 2 Capital are $200,000 and $300,000
respectively.

Exposure Risk Weight

Government Treasury held as 1,500,000 0%
asset
Loans to Corporates 15,000,000 10%
Loans to Small Businesses 8,000,000 20%
Guarantees and other non- 6,000,000 10%
balance sheet exposures

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