Capital adequacy norms

Basel I, Basel II, Basel III, Capital Adequacy Norms

1. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah CAPITAL ADEQUACY NORMS

2. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Importance of Capital for Banks Capital is a key ingredient for safe and sound banks and here is why. Banks take on risks and may suffer losses if the risks materialize. To stay safe and protect people’s deposits, banks have to be able to absorb such losses and keep going in good times and bad. That’s what bank capital is used for.

3. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah How Much Capital Bank Should Hold???? The answer lies in the risks it takes. The bigger the risks, the more capital it needs. That’s why it’s essential that banks continuously assess the risks they are exposed to and the losses they may incur. Their assessments are checked and challenged by banking supervisors. Supervisors are responsible for monitoring banks’ financial health, and checking their capital levels is an important part of this.

4. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah What is Capital ? Put simply, capital is the money that a bank has obtained from its shareholders and other investors and any profit that it has made and not paid out. Consequently, if a bank wants to expand its capital base, it can do so for example by issuing more shares or retaining profits, rather than paying them out as dividends to shareholders. Overall, every bank has two sources of funds: capital and debt. Debt is the money that it has borrowed from its lenders and will have to pay back. Debt includes among other things deposits from customers, debt securities issued and loans taken out by the bank. Funds from these two sources are employed by the bank in a number of ways, for example to give loans to customers or to make other investments. These loans and other investments are the bank’s assets, along with funds that are held as cash.

5. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah A bank’s Balance Sheet:

6. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah How does Capital keep Banks Safe? Capital acts like a financial cushion against losses. When, for example, many borrowers are suddenly unable to pay back their loans, or some of the bank’s investments fall in value, the bank will make a loss and without a capital cushion might even go bankrupt. However, if it has a solid capital base, it will use it to absorb the loss and continue to operate and serve its customers.

7. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Banks uses Capital to absorb losses

8.  Banks in the process of financial interme diati on are confronted with various kinds of financial and non-financial risks viz.:  Credit Risk  Liquidity Risk  Market Risk  Operational Risk Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Risk Exposure

9.  Loan s an d advance s giv e n b y t h e bank s t o its customers is are an Asset to the bank .  A loan (an asset for the bank) turns as NPA when the EMI, principal or interest component for the loan is not paid within 90 days from the due date .  Thus a Bad Loan is a n asset that ceases to generate any income for the bank Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Non Performing Assets

10. The Basel Committee on Banking Supervision was established in 1974, by the Bank of International Settlements (BIS). In order to help the banks to recognize the different kinds of risks and to take adequate steps An international organization founded in Basel, Switzerland in 1930 to serve as a Bank for Central banks. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Risk Management Through Basel Committee

11. As per Basel Committee guidelines issued capital adequacy was considered panacea for risk management . All banks were advised to have Capital Adequacy Ratio (CAR) at least 8%. CAR is the ratio of capital to risk weighted assets and it provides the cushion to the depositors in case of bankruptcy . Committee consisting of members from each of the G10 countries . It is represented by central bank governors of each of the G10 countries. Thirteen industrialized Nations that meet on an annual basis to consult each other on international financial matters. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Risk Management Through Basel Committee

12.  The member countries a r e: F r ance , Ge r m an y, B e lgi u m , It a l y, J a pan , the Netherlands, Sweden, the United Kingdom, the United States and Canada, with Switzerland, Luxembourg, Spain  It meets regularly 4 times a year. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Risk Management Through Basel Committee

13. The basic approach of capital adequacy framework is that a bank should have sufficient c api t a l to pro v id e a s t abl e r esou r ce to ab s or b any losses arising from the risks in its business . For supervisory purposes capital is split into two categories : Tier I and Tier II. These categories represent different instruments’ quality as capital: Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework

14.  Tier I Capital consists:  E qu it y Ca p it a l (S h a r e ho l d e r s ' Funds)  Disclosed Reserves : Premium over shares, Retained earnings, Legal reserve  It is a bank’s highest quality capital because it is fully available to cover losses . Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework

15.  Lega l r e s e r v e s a r e t h e on l y as s e t s t h a t are permitted by government regulations.  Divided into The two asset categories:  Req u i re d R e s erv e ( V a u lt c a s h & R eserve deposits )  Excess Reserve (Reserve for loan purposes) Legal Reserve: Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework

16. Vault Cash (Required Reserve)  Paper bills and metal coins kept on the bank premises, both the vault and teller drawers.  To satisfy currency withdrawal demands of depositors.  Vault cash is not part of the official M1 money supply.  M1 includes only the paper bills and metal coins that is in circulation and held by the nonbank public. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework

17.  Reserve deposits are the one that regulators require .  These are deposits that banks keep with the Reserve Bank Of India System .  Required reserves are specified as a fraction of outstanding deposits--usually about 3 percent -15 percent Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework Reserve Deposits (Required Reserve) Excess Reserve  Any legal (or total) reserves over and above those required by regulators are excess reserves .  These excess reserves are used for loans, which makes them exceedingly important to the banking industry .

18.  Tier II capital Consists :  Undisclosed reserves  Revaluation reserves  General provisions  Subordinated debt  Hybrid Instruments.  This capital is less permanent in nature.  The loss absorption capacity of Tier II capital is lower than that of Tier I capital. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework

19.  Undisclosed reserves are not common.  They are accepted by some regulators where a bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank.  Many countries do not accept this as an accounting concept or a legitimate form of capital Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework Undisclosed Reserve

20.  Revaluation reserve is created when a bank has an asset revalued and an increase in value is brought to account.  Example: A bank owns the land and building of its head-offices and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework Revaluation Reserve

21.  Adequate care must be taken to ensure that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering as part of Tier II Capital. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework General Provisions and Loss Reserve

22. D E B T a n d  Have some characteristics of both EQUITY.  These are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the bank, they may be counted as capital. Example: Preferred stock usually carries no voting rights but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework Hybrid Instruments

23. Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the Normal debt.  A typical example for this would be when a promoter of a company invests money in the form of debt, rather than in the form of stock.  Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy. It has minimum maturity period is 5 years. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Capital Adequacy Framework Subordinated Term Debt

24.  The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk.  Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets.  Carrying risk weights of zero (for gilts bond ), ten, twenty, fifty, and up to one hundred percent ( Corporate debt ).  It standardizes risk-based capital requirements for banks across countries as per following measurement: Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel I Norm

25. CAR = Tier I + Tier II Risk Weighted Assets  A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel I Norm Capital to Risk Weighted Assets Ratio

26. • • It c a n b e ar r i v e d s i m p l y b y m ul t i p l y i n g i t w i th factor that reflects its risk. • Low risk assets are multiplied by a low number, high risk assets by 100% (i.e. 1). Risk weighted assets is a measure of the amount of a banks assets, adjusted for risk. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel I Norm Risk Weighted Assets

27. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel I Norm Risk Weighted Assets The main use of risk weighted assets is to calculate Tier1 and Tier 2 capital adequacy ratios. If its capital is 10% of its assets, then it can lose 10% of its assets without becoming Insolvent. Insolvency is simply being unable to pay liabilities; Liabilities > Assets

28. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm Basel II is the second set of international banking regulations defined by the Basel Committee on Bank Supervision (BCBS). It is an extension of the regulations for minimum capital requirements as defined under Basel I. The Basel II framework operates under three pillars: Capital adequacy requirements Supervisory review Market discipline

29. Pillar 1 includes 3 risks now, operational risk + credit risk + market risk to meet international standards.  Commercial banks in India adopt Standardized Approach(SA) for credit risk.  Standardized Approach , the rating assigned by the eligible external credit rating agencies, largely supports the measure of credit risk. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm

30. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm Banks rely upon the ratings assigned by the external credit rating agencies chosen by the RBI for assigning risk weights for capital adequacy purposes. As: a) Credit Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd. and d) ICRA Ltd.  International credit rating agencies : a) Fitch; b) Moody's; and c) Standard & Poor's.

31.  Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets.  The risk weights associated with the particular rating grades as determined by RBI for each eligible credit rating agency as well as the aggregated risk weighted assets. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm

32.   Pillar 2: Supervisory Review Process (SRP) — The establishment of suitable risk management systems in banks and their review by the supervisory authority (RBI). As in terms of the Pillar 2 requirements of the New Capital Adequacy Framework, banks are expected to operate at a level well above the minimum requirement Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm

33. Pillar 3: Market Discipline — seeks to achieve increased transparency through expanded disclosure requirements tor banks. For such comprehensive disclosure, IT structure must be in place for supporting data collection and generating MIS which is compatible with Pillar 3 requirements Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm

34. Computation of CRAR under BASEL II Basel II Tier I CRAR = Tier I capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA) Basel II Total CRAR = Total capital / (Credit Risk RWA + Operational Risk RWA + Market Risk RWA) RWA - risk weighted assets Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm

35. Basel II Mandates Capital to Risk Weighted Assets Ratio (CRAR) of 8% and Tier I capital of 6%. The RBI has stated that Indian banks must have a CRAR of minimum 9%, effective March 31, 2009. The Government of India has stated that public sector banks must have a capital cushion with a CRAR of at least 12%, higher than the threshold of 9% prescribed by the RBI. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm

36.  Failure to adhere to Basel II can attract RBI action including restricting lending and investment activities.  However, private sector banks as well as public sector banks are likely to comply with Basel II norms since March 31, 2009 Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel II Norm

37. What is "Basel III" A global regulatory standard on bank capital adequacy stress testing and market liquidity risk With a set of reform measures to improve Regulation supervision and risk management Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm

38. Reducing profitability of small banks and threat of takeover Lack of comprehensive approach to address risks Self-regulation in area of asset securitization Lack of safety Ina b ili t y t o stren g then the sta b ili t y o f finan c ial s ystem Failure to achieve large capital reductions Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Why Basel III Norm

39. To minimize the probability of recurrence of crises to greater extent To improve the banking sector's ability to absorb shocks arising from financial and economic stress . To improve risk management and governance To strengthen banks' transparency and disclosures. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Aim Of Basel III

40. Bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress. Macro prudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Target of Basel III

41. Micro- prudential elements To minimize the risk contained with individual institutions The elements are: Definition of capital Enhancing risk coverage of capital leverage ratio International liquidity framework Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm

42. Macro- prudential elements To take care of the issues relating to the systemic risk The elements are: Leverage ratio Capital conservation buffer Countercyclical capital buffer Addressing the procyclicality of provisioning requirements Addressing interconnectedness Addressing the too- big to- fail problems Addressing reliance on external credit rating agencies. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm

43. Pillar 1- Minimum Capital Requirements Calculate Required C apital based on Market risk Credit risk Operational risk Used to monitor funding concentration Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm

44. Pillar 2- Supervisory Review Process Bank should have strong internal process Adequacy of capital based on risk evaluation Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Pillar 3 – Enhanced Disclosure Provide market discipline Intends to provide information about banks exposure to risk

45. The relationship among the three pillars: Second pillar – supervisory review process to ensure the first pillar intended to ensure that the banks have adequate capital Third pillar – compliments first and second pillar a discipline followed by the bank such as disclosing capital structure, tier-i and tier-ii capital and approaches to assess the capital adequacy i.e. assessment of the first pillar. Model of commercial banks interpret first pillar as a closure threshold rather than bank’s asset allocation Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm

46. The new and stricter regulations of the basel3 like higher capital requirements, the new liquidity standard, the increased risk coverage, the new leverage ratio or a combination of the different requirements will be difficult to adopt by the banks Banks have to take a number of actions to meet the various new regulatory ratios , restoring of data Banks must be able to calculate and report the new ratios. Which requires the huge implementation effort. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Challenges of B asel III Implementation:

47. Banks usually have 3 types of challenges Functional challenges Technical challenges Organizational challenges Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Challenges of B asel III Implementation:

48. Developing specifications for the new regulatory requirements, such as the mapping of positions (assets and liabilities) to the new liquidity and funding categories in the LCR and NSFR calculations . the specification of the new requirements for trading book positions and within the CCR framework (e.g. CVA) as well as adjustments of the limit systems with regard to the new capital and liquidity ratios . Crucial is the integration of new regulatory requirements into existing capital and risk management as some measures to improve new ratios (e.g. liquidity ratios) might have a negative effect on existing figures. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Functional Challenges

49. The technical challenges includes the availability of data, data completeness, and data quality and data consistency to calculate the new ratios. The financial reporting system with regard to the new ratios and the creation of effective interfaces with the existing risk management systems. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Technic al Challenges

50. Th e o p e r ation a l challen g e s i n c ludes s t ricter c a p ital definition lowers banks’ available capital. At the same time the risk w e ighted ( R W A) for assets sec u ri t iz a t ion s , tra d ing book p o sitions and c e r tain c o u n terpa r ty cre d it risk e xpo s ures a r e si g nif i cantly increased . The stricter capital requirements, the introduction of the LCR and NSFR will force banks to rethink their liquidity position, and potentially require banks to increase their stock of high-quality liquid assets and to use more stable sources of funding. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Operatio nal Challenges

51. Basel III also introduces a non-risk based leverage ratio of 3 percent. Group1 banks are failed in maintaining the this leverage ratio The banks will experience increased pressure on their Return on Equity (RoE) due to increased capital and liquidity costs, which along with increased RWAs will put pressure on margins across all segments Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm

52. Capital… Indian banks need to raise Rs 1.5 lakh crore to Rs 1.75 lakh crore as capital to meet the BASEL- III requirements. Can PSU banks mobilize this sort of capital? - Pro b ably go v er n m e nt is N O, Th e alte r n a te t o the either t o redu c e shareholding below 50% or slowdown PSU growth Can private banks raise this sort of money? - They probably can, because Rs 500 billion was raised in last 5 years Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Indian Scenario

53. Problems for PSUs Capital adequacy ratio - has been stipulated at 9%, unchanged from what the regulator requires in India currently, banks here will need to raise more money than under the current Basel II norms because several capital instruments cannot be included under the new definition. Ex: Perpetual Bond Maintaining an 8% tier I capital ratio More additions to non-performing assets Unamortized expenditure on pension liabilities Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Indian Scenario

54. The Indian economy is also expected to grow at an annual growth rate of 8-9% for next 10 years or so. This would undoubtedly necessitate a considerable growth in bank capital. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Indian Scenario

55. Issues relating to SLR and LCR India, banks are statutorily required to hold minimum reserves of high-quality liquid assets at 24% of net demand and time liabilities. The proportion of liquid assets in total assets of b a nks wi l l in c rease s u b s t a ntiall y , if the S L R rese r ves are not r eckon e d towar d s t h e LCR (Liquidity coverage ratio) and banks are to meet the e n ti r e LCR with ass e ts, there b y low e r ing a d dition a l their liqu i d in c ome significantly. RBI i s e xamining t o what e x tent the SLR requirements could be reckoned tow a rds the liquidity requirement under Basel III. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Indian Scenario

56. Retail banks will be affected least, though institutions with very low capital ratios may find themselves under significant pressure. Corporate banks will be affected primarily in specialized lending and trade finance. Investment banks will find several core businesses profoundly affected, particularly trading and securitization businesses. Balance sheet restructuring and business-model adjustments could potentially mitigate up to 40 percent of Basel III’s RoE impact, on an average. Government banks may have to sacrifice growth Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Profitability

57. The impact of credit requirements on the profitability of banks would depend upon sensitivity of lending rates to capital structure of banks and sensitivity of the credit growth to the lending rates. When banks with low core Tier I shore up their capital to around 9% required, their return on equity (RoE) could drop by 1-4%. Basel III will force banks to plough back a larger chunk of their profit into the balance sheet. Banks might have to rationalize dividend policies so that more profit could be retained and used as capital, indicating a lower dividend for the government. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Profitability

58. Demonstrate that the banking system is recovering well from the global financial crisis of 2008 and has been developing the resilience to future shocks . Contribute to a bank’s competitiveness by delivering better management insight into the business, allowing it to take advantage of future opportunities . Strengthen the financial system of both developing and developed countries by addressing the weaknesses in the measurement of risk under Basel II framework . Delivers a much safer financial system with reduced probability of banking crises at affordable costs. The impact of costs is minimized through long phase-in. It is expected that as the proportion of equity in the capital structure of banks rises, it would reduce the incremental costs of raising further equity as well as non-common equity capital. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm Benefits Of Implementation

59. The Reserve Bank’s approach has been to adopt Basel III capital and liquidity guidelines with more conservatism and at a quicker pace. The impact of these rules is not going to be onerous and there will be considerable advantage in adopting Basel III by our banks. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah Basel III Norm RBI’s Approach

60. Swayam S iddhi College of Mgt & Research SSCMR Presentor : Prof. Rahul Shah THANK YOU…!!!