CAPITAL ADEQUACY NORMS

INTRODUCTION

Bank capital plays a very important role in the safety and soundness of individual banks and the
banking system. Basel Committee for Bank Supervision (BCBS) has prescribed a set of norms
for the capital requirement for the banks in 1988 known as Basel Accord I. These norms ensure
that capital should be adequate to absorb unexpected losses or risks involved. If there is higher
risk, then it would be needed to backed up with Capital and Vice versa. All the countries
establish their own guidelines for risk based capital framework known as Capital Adequacy
Norms. The recent finalization of the new minimum regulatory capital requirements drafted by
the Basel Committee on Banking Supervision1 (henceforth known as Basel II) has generated
significant debate among academics, policy makers and industry practitioners.

This interest stems both from the importance of these rules on banking systems around the world,
as well as from the fact that the new rules represent a radical departure from the existing (Basel
I) framework. Several different strands in the literature have recently emerged, focusing on the
framework’s theoretical merits, on specific parts of the Accord (e.g. operational risk, different
Pillars), on the potential impact on banking systems, and on practical implementation issues.

The Basel Committee on Banking Supervision is a committee comprising of senior bank

supervisory authority and central bank representatives from the G-10 countries. The Committee
does not possess any formal supranational supervisory authority, but it formulates (by consensus)
broad supervisory standards and promotes best practices in the expectation that each country will
implement them in ways most appropriate to its circumstances.

Capital Adequacy measures the strength of the bank. Capital Adequacy Ratio is also known as
Capital Risk Weighted Assets Ratio.

The focus of Capital Adequacy Ratio under Basel I norms was on credit risk and was calculated
as follows:

Capital Adequacy Ratio = Tier I Capital+ Tier II Capital / Risk Weighted Assets

.Capital Adequacy Ratio in New Accord of Basel II:

Capital Adequacy Ratio = Total Capital(Tier I Capital+Tier II Capital)/ Market Risk+ Credit
Risk + Operation Risk
Basel I
The Basel I Capital Accord, published in 19883, represented a major breakthrough in the
international convergence of supervisory regulations concerning capital adequacy. Its main
objectives were to promote the soundness and stability of the international banking system and to
ensure a level playing field for internationally active banks. This would be achieved by the
imposition of minimum capital requirements for credit (including country transfer) risk, although
individual supervisory authorities had discretion to build in other types of risk or apply stricter
standards. Even though it was originally intended solely for internationally active banks in G-10
countries, it was eventually recognized as a global standard and adopted by over 120 countries
around the world.

The framework defined the constituents of ‘regulatory capital’ (numerator of the solvency
formula) and set the risk weights for different categories of on- and off-balance sheet exposures
(denominator of the solvency formula). The risk weights, which were intentionally kept to a
minimum (only five categories/buckets), reflected relative credit riskiness across different types
of exposures. The minimum ratio of regulatory capital to total risk-weighted assets (RWA) was
set at 8%, of which the ‘core capital’ element (a more restrictive definition of eligible capital
known as Tier 1 capital) would be at least 4%.

Overview of Basel II

Following the publication of successive rounds of proposals between 1999 and 2003, active and
broad consultations with all interested parties, and related quantitative impact studies, the Basel
Committee members agreed in mid-2004 on a revised capital adequacy framework (Basel II).
The framework will be implemented in most G-10 countries as of year-end 2006, although its
most advanced approaches will require one further year of impact studies or “parallel running”
and will therefore be available for implementation one year later. For banks adopting the IRB
approach for credit risk.

The main objective of the framework is to further strengthen the soundness and stability of the
international banking system via better risk management, by bringing regulatory capital
requirements more in line with (and thus codifying) current bank good practices. This will be
achieved by making credit capital requirements significantly more risksensitive and by
introducing an operational risk capital charge.
Basel II consists of a broad set of supervisory standards to improve risk management pillars

 Pillar 1, Minimum regulatory capital, which addresses minimum requirements for

credit, market and operational risks
 Pillar 2, Supervisory review, which provides guidance on the supervisory oversight
process
 Pillar 3, Market discipline, which requires banks to publicly disclose key information on
their risk profile and capitalization as a means of encouraging market discipline.
Compared to Basel I, the scope of application is broader and includes, on a fully consolidated
basis, all major internationally active banks at every tier within a banking group (i.e. full sub-
consolidation), as well as at the level of the group’s holding company10.

Types of Risks involved in Basel II & their computation:

Credit Risk:
If the counter party do not settle the dues within the stipulated time or thereafter,this type of risk
arises. It includes risks on derivatives, replacement risk and Principal risk. For measuring the risk
the following approach are used:
a) Standardised Approach
b) Internal Rating Based Foundation Approach
c) Internal Rating Based Advanced Approach
Market Risk:
This is the risk or loss arising on or off Balance Sheet due to the movement of prices in foreign
currencies,commodities,equities and bonds.With regard to market risk,there are two method for
computation.
a) Standardised Approach
b) Internal Model Approach

Operation Risk:
This type of risk or loss results from inadequate or failure in the corporate governance or internal
processes,people or system.RBI adopts the following measurement techniques for calculation
a) Basic Indicator Approach
b) Standardised Approach
c) Advanced Measurement Approach

Though different approaches are available for calculation of Risk, RBI advises Indian Banks to
adopt the standardized approach initially before transition to Advanced Approaches.

Pillar 1

Credit Risk
Credit risk has been traditionally defined as default risk, i.e. the risk of loss from a
borrower/counterparty’s failure to repay the amount owed (principal or interest) to the bank on a
timely manner based on a previously agreed payment schedule. A more comprehensive
definition would actually include value risk, i.e. the risk of loss of value from a borrower
migrating to a lower credit rating (opportunity cost of not pricing the loan correctly for its new
level of risk) without having defaulted. In order to protect themselves against volatility in the
level of default/value losses (as well as other types of

risk), banks have adopted methodologies that allow them to quantify such risks and thereby
derive the amount of capital required to support their business – what is referred to as economic
capital. The building blocks of economic capital for default-related credit risk are discussed
below.

It should be noted that the calculation of economic capital takes a purely ‘economic’ view of the
business, which often differs from the one represented by financial statements. For example,
when there is a credit deterioration of the borrower, the resulting value loss is

often not shown (at least immediately) in the bank’s balance sheet and income statements. This
is because many credit exposures are recorded on an accrual basis as opposed to market/fair
value, meaning that a loss in the value of a downgraded loan is not realized until the loan
 actually defaults or is sold to a third party at arm’s length. As a result, economic capital models
that feed into risk adjusted return on capital (RAROC) performance measures often paint a
different, more realistic and dynamic picture of a bank’s profitability than what is shown in
traditional financial statements

PD The Probability of Default is the likelihood that a loan will not be repayed and fall into
default. This PD will be calculated for each company who have a loan. The credit
history of the counterparty and nature of the investment will all be taken into account
to calculate the PD figures. Many banks will use external ratings agencies such as
Standard and Poors. However, banks are also encouraged to use their own Internal
Rating Methods as well.

LGD The amount of funds that is lost by a bank or other financial institution when a
borrower defaults on a loan. Academics suggest that there are several methods for
calculating the loss given default, but the most frequently used method compares
actual total losses to the total potential exposure at the time of default

EAD A total value that a bank is exposed to at the time of default. Each underlying
exposure that a bank has is given an EAD value and is identified within the bank’s
internal system. Using the internal ratings board (IRB) approach, financial institutions
will often use their own risk management default models to calculate their respective
EAD systems

RAROC An adjustment to the return on an investment that accounts for the element of risk.
Risk-adjusted return on capital (RAROC) gives decision makers the ability to
compare the returns on several different projects with varying risk levels. RAROC
was popularized by Bankers Trust in the 1980s as an adjustment to simple return on
capital (ROC).

Expected Versus Unexpected Loss

Although credit losses naturally fluctuate over time and with economic conditions, there is
(ceteris paribus) a statistically measured, long-run average loss level. Assume for example that,
based on historical performance, a bank has come to expect around 1% of its loans to default
every year, with an average recovery rate of 50%. In that case, the

bank’s expected loss (EL) for a credit portfolio of $1 billion is $5 million (i.e. $1 billion x 1% x
50%). As can be deduced, EL is based on three parameters:

 The likelihood that default will take place over a specified time horizon (probability of
default or PD)
 The amount owned by the counter party at the moment of default (exposure at default
or EAD)
 The fraction of the exposure, net of any recoveries, which will be lost following default
event (loss given default or LGD)

Since PD is normally specified on a one-year basis 13, the product of these three factors is the
one-year EL as follows:

EL = PD x EAD x LGD

EL can be aggregated at various different levels (e.g. individual loan or entire credit portfolio),
although it is typically calculated at the transaction level; it is normally mentioned either as an
absolute amount or as a percentage of transaction size. It is also both customer- and facility-
specific, since two different loans to the same customer can have a very different EL due to
differences in EAD and/or LGD.

It is important to note that EL (or, for that matter, credit quality) does not by itself constitute risk;
if losses always equalled their expected levels, then there would be no uncertainty. Instead, EL
should be viewed as an anticipated “cost of doing business” and should therefore be incorporated
in loan pricing and ex ante provisioning.

Credit risk, in fact, arises from variations in the actual loss levels, which give rise to the so-called
unexpected loss (UL). Statistically speaking, UL is simply the standard deviation of EL (see
Figure 1). As will be described later, the need for bank capital stems from the desire to cushion
against loss volatility (UL) at a certain confidence level.
 The Committee proposes two approaches, viz., Standardised and Internal
Rating Based (IRB) for estimating regulatory capital.

Standardised Approach

Under the standardised approach, preferential risk weights in the range of 0%, 20%, 50%, 100%
and 150% would be assigned on the basis of ratings given by external credit assessment
institutions.

IRB Approach

The Committee proposes two approaches – foundation and advanced – as an alternative to

standardised approach for assigning preferential risk weights.

Under the foundation approach, banks, which comply with certain

minimum requirements viz. comprehensive credit rating system with

capability to quantify Probability of Default (PD) could assign preferential

risk weights, with the data on Loss Given Default (LGD) and Exposure at

Default (EAD) provided by the national supervisors.

Under the advanced approach, banks would be allowed to use their own estimates of PD, LGD
and EAD, which could be validated by the supervisors. Under both the approaches, risk weights
would be expressed as a single continuous function of the PD, LGD and EAD. The IRB
approach, therefore, does not rely on supervisory determined risk buckets as in the case of
standardised approach. The Committee has proposed an IRB approach for retail loan portfolio,
having homogenous characteristics distinct from that for the corporate portfolio. The Committee
is also working towards developing an appropriate IRB approach relating to project finance.

Market Risk
Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions
arising from movements in market prices. The market risk positions subject to capital charge
requirement are:
(i) The risks pertaining to interest rate related instruments and equities in the trading book; and
(ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both
banking and trading books).
Trading book for the purpose of capital adequacy will include:
(i) Securities included under the Held for Trading category
(ii) Securities included under the Available for Sale category
(iii) Open gold position limits
(iv) Open foreign exchange position limits
(v) Trading positions in derivatives, and
(vi) Derivatives entered into for hedging trading book exposures.
Capital for market risk would not be relevant for securities, which have already matured and
remain unpaid. These securities will attract capital only for credit risk. On completion of 90 days
delinquency,

Operational risk
Operational risk is defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. This definition includes legal risk, but
excludes strategic and reputational risk. Legal risk includes, but is not limited to, exposure to
fines, penalties, or punitive damages resulting from supervisory actions, as well as private
settlements.
The New Capital Adequacy Framework outlines three methods for calculating operational risk
capital charges in a continuum of increasing sophistication and risk sensitivity: (i) the Basic
Indicator Approach (BIA); (ii) the Standardised Approach (TSA); and (iii) Advanced
Measurement Approaches (AMA).
Banks are encouraged to move along the spectrum of available approaches as they develop more
sophisticated operational risk measurement systems and practices.
The New Capital Adequacy Framework provides that internationally active banks and banks
with significant operational risk exposures are expected to use an approach that is more
sophisticated than the Basic Indicator Approach and that is appropriate for the risk profile of the
institution. However, to begin with, banks in India shall compute the capital requirements for
operational risk under the Basic Indicator Approach. Reserve Bank will review the capital
requirement produced by the Basic Indicator Approach for general credibility, especially in
relation to a bank’s peers and in the event that credibility is lacking, appropriate supervisory
action under Pillar 2 will be considered..

Minimum Requirement of Capital Adequacy Ratio(CAR):

Under Basel II norms,8% is the prescribed Capital Adequacy Norm.

In case of Scheduled Commercial Banks CAR= 9%
For New Private Sector Banks CAR = 10%
For Banks undertaking Insurance Business CAR = 10%
and For Local Area Banks CAR =15%

Objectives of CAR : The fundamental objective behind the norms is to strengthen the soundness
and stability of the banking system.

Minimum requirements of capital fund in India:

* Existing Banks 09 %
* New Private Sector Banks 10 %
* Banks undertaking Insurance business 10 %
* Local Area Banks 15%

PILLAR II
Supervisory Review and Evaluation Process (SREP)
The objective of the SRP is to ensure that the banks have adequate capital to support all the risks
in their business as also to encourage them to develop and use better risk management techniques
for monitoring and managing their risks. This in turn would require a well-defined internal
assessment process within the banks through which they assure the RBI that adequate capital is
indeed held towards the various risks to which they are exposed. The process of assurance could
also involve an active dialogue between the bank and the RBI so that, when warranted,
appropriate intervention could be made to either reduce the risk exposure of the bank or augment
/ restore its capital. Thus, ICAAP is an important component of the SRP.
 The main aspects to be addressed under the SRP, and therefore, under the ICAAP, would
include:
(a) the risks that are not fully captured by the minimum capital ratio prescribed
under Pillar 1;
(b) the risks that are not at all taken into account by the Pillar 1; and
(c) the factors external to the bank.
Since the capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is
only the regulatory minimum level, addressing only the three specified risks (viz., credit, market
and operational risks), holding additional capital might be necessary for the banks, on account of
both – the possibility of some under-estimation of risks under the Pillar 1 and the actual risk
exposure of a bank vis-à-vis the quality of its risk management architecture. Illustratively, some
of the risks that the banks are generally exposed to but which are not captured or not fully
captured in the regulatory CRAR would include:
(a) Interest rate risk in the banking book;
(b) Credit concentration risk;
(c) Liquidity risk;
(d) Settlement risk;
(e) Reputational risk;
(f) Strategic risk;
(g) Risk of under-estimation of credit risk under the Standardised
approach;
(h) “Model risk” i.e., the risk of under-estimation of credit risk under the IRB approaches;
(i) Risk of weakness in the credit-risk mitigants;
(j) Residual risk of securitisation, etc.
It is, therefore, only appropriate that the banks make their own assessment of their various risk
exposures, through a well-defined internal process, and maintain an adequate capital cushion for
such risks.

The Basel II document of the Basel Committee lays down the following four key principles in
regard to the 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, as well as their ability to monitor and ensure their compliance with
the regulatory capital ratios. Supervisors should take appropriate supervisory action if they are
not satisfied with the result of this process.
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 required to support the risk characteristics of a particular bank
and should require rapid remedial action if capital is not maintained or restored.

PILLAR III
Market Discipline
The aim is to encourage market discipline by developing a set of disclosure requirements which
will allow market participants to assess key pieces of information on the scope of application,
capital, risk exposures, risk assessment processes, and hence the capital adequacy of the
institution.
Banks, including consolidated banks, should provide all Pillar 3 disclosures, both qualitative and
quantitative, as at end March each year along with the annual financial statements. With a view
to enhance the ease of access to the Pillar 3 disclosures, banks may make their annual disclosures
both in their annual reports as well as their respective web sites. Banks with capital funds of
Rs.100 crore or more should make interim disclosures on the quantitative aspects, on a stand
alone basis, on their respective websites as at end September each year.
all banks with capital funds of Rs. 500 crore or more, and their significant bank subsidiaries,
must disclose their Tier I capital, total capital, total required capital and Tier I ratio and total
capital adequacy ratio, on a quarterly basis on their respective websites.

Securitizations
The Basel Committee introduces a separate securitization framework that aims to align
regulatory capital treatment to the actual credit risk incurred by such exposures. Banks must
apply the framework for determining regulatory capital requirements on exposures that arise
from traditional or synthetic securitizations, or similar structures that contain features common to
both. Given the multitude of ways in which securitizations may be structured, their eligibility and
related capital treatment must be determined on the basis

of economic substance rather than legal form. An originating bank may exclude (nonretained)
securitized exposures from the calculation of risk-weighted assets only if specific operational
requirements that ensure true and complete risk transfer are fulfilled. The framework includes a
Standardized and an IRB Approach for securitization exposures, depending on the method by
which the underlying exposures are treated. The former approach applies ECAI assessments that
are generally mapped to risk weights,
with specific treatment applied to unrated securitization exposures, credit risk mitigants and early
amortization features. The latter approach utilizes three different methods to derive regulatory
capital requirements:

 Ratings-Based Approach (RBA) for rated exposures, or where a rating can be inferred
(subject to specific operational requirements); the risk weights depend on the
external/inferred rating, whether the rating is long- or short-term, the granularity of the
underlying pool and the seniority of the position
 Internal Assessment Approach for asset-backed commercial paper-related exposures
such as liquidity facilities and credit enhancements; banks can use (subject to specific
operational requirements) the ir internal credit assessments of such exposures, which
must be mapped to equivalent external credit rating agency ratings in order to determine
the appropriate RBA risk weights to use
 Supervisory Formula in all other instances; this is based on five bank-supplied inputs
(IRB capital charge had the underlying exposures not been securitized, the tranche’s
credit enhancement level and thickness, and the pool’s effective number of exposures and
weighted average LGD).

For a bank using the IRB Approach, the maximum capital requirement for its securitization
exposures is equal to the IRB capital requirement that would have been assessed against the
underlying exposures had they not been securitized.