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BFM MODULE – D
Chapter 27: CAPITAL ADEQUACY
THE BASEL-II OVERVIEW (PART-I)
What will we study?
*What is BASEL-II?
*What is CAPITAL ADEQUACY?

INTRODUCTION:
Whey we call it BASEL?
Central Bank Governors of the Group of 10
Countries formed a committee of banking
Supervisory authorities in 1975.
This Committee usually meets at the Bank of
International Settlement (BIS) in Basel, Switzerland.
Hence it has come to be known as the Basel
Committee.
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TheBaselCommi t
teepr
ovidedtheframewor
kfor
capi
taladequacyi
n1988,whichisknownasthe
Basel
-Iaccord.
The1988BaselAccor
dledt
osigni
fi
canti
ncr
eases
i
nthecapi
talhel
dbybanksovert
henext10year
s.
Itdeser
vesagr
eatdealofcr
edi
tfori
mpr
ovi
ngt
he
stabi
li
tyoft
hegl
obalbanki
ngsyst
em.
Howev
er,
ithadcer
tai
nsi
gni
fi
cantweaknesses.
TheBasel
-Inormsforr
iskwei
ght
swer
emor
eofa
st
rai
ghtj
acketnat
ure.
Forexampl
e,al
lexposur
est
osov
erei
gnswer
e
gi
ven0%r i
skweight
.
Al
lbankexposur
eshadar
iskwei
ghtof20%.
Cor
por
ateadv
anceshadar
iskwei
ghtof100%.
Suchr i
gidappr
oachwithoutanyconsi der
ati
onf or
thestrengt
hsorweaknessesofi ndiv
idualenti
ties
wast hemainshort
comi ngoftheBasel -
Iaccord,
e.g.
,alll
oansbyabankt oacor porat
ionhavear i
sk
weightof100%andr equir
ethesameamountof
capit
al.
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Example:Aloantoacor
porati
onwit
haAAAcr
edi
t
rat
ingistr
eatedint
hesamewayasonetoa
corpor
ati
onwi t
haBcreditr
ati
ng.
Smal
lti
cketl
oans(
ret
aill
endi
ng)al
socar
ri
edar
isk
wei
ghtof100%.
Toovercomet heshortcomingsofBaselI ,t
heBasel
Commi tt
eeofBanki ngSupervisi
on( BCBS)rel
eased
the“I
nternati
onalConvergenceofCapi t
al
MeasurementandCapi talStandards:ARevised
Framewor k”onJune26, 2004.
Acompr ehensi
vev er
sionoftheRev
ised
Framewor kwasissuedinJune2006,whichi
sa
compil
ationoftheJune2004BaselIIFr
amework.
TheRev i
sedFrameworkseekstoarr
iveat
si
gnifi
cantl
ymoreri
sk-
sensiti
veapproachest
o
capi
talrequi
rement
s.
Itprovidesarangeofoptionsf ordeter
miningthe
capitalrequi
rementsforcreditri
skandoper at
ional
risktoallowbanksandsuper v i
sorstoselect
approachest hataremostappr opri
ateforthei
r
operationsandf i
nanci
almar kets.
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TheRev i
sedFramewor kconsistsoft
hree-mut
ual
ly
rei
nforci
ngpil
lars,
v i
z.,
mi ni
mum capi
tal
requi
rements,supervi
soryrevi
ewofcapital
adequacy,andmar ketdisci
pli
ne.

BASEL-
II–REVI
SEDFRAMEWORK:
TheRevisedFrameworkconsi
stsoft
hree-
mut
ual
ly
rei
nfor
cingPil
lar
s,v
iz.
,
1-
Mini
mum capi
talr
equi
rement
s,
2-
Super
visor
yrev
iewofcapi
taladequacy
3-Mar
ketdi
sci
pli
ne.
UnderPi l
lar1,t
heFramewor koffer
st hr
eedi
sti
nct
optionsforcomput i
ngcapit
alrequi
r ementfor
creditri
skandt hr
eeotheropti
onsf orcomputing
capitalr
equirementforoper
ati
onalr isk.
Theseopti
onsforcreditandoper ati
onalri
sksare
basedonincr
easingrisk-sensi
ti
vi
t yandall
owbanks
tosel
ectanapproacht hatismostappr opri
ateto
thest
ageofdevelopmentofbank' soperat
ions.
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Theopt
ionsav
ail
abl
eforcomput
ingcapi
talf
or
cr
edi
tri
skare:
1-
Standar
disedAppr
oach(
opt
edbyI
ndi
anbank)
2-Foundat
ionI
nter
nalRat
ingBasedAppr
oach
3-Adv
ancedI
nter
nalRat
ingBasedAppr
oach.

Theopt
ionsav
ail
abl
eforcomput
ingMar
ketr
iskar
e
1-
Standar
dizeddur
ati
onappr
oach
(
opt
edbyI
ndi
anbank)
2-
Standar
disedmat
uri
tyappr
oach
3-
Int
ernalmodel
sappr
oach(
suchasVAR)

Theopti
onsavai
labl
eforcomput
ingcapi
talf
or
oper
ati
onalr
iskare
1-
Basi
cIndi
cat
orAppr
oach(
opt
edbyI
ndi
anbank)
2-
Standar
disedAppr
oachand
3-
Adv
ancedMeasur
ementAppr
oach.
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SCOPEOFAPPLI
CATI
ON:

Therevisedcapit
aladequacynor msar eappli
cabl
e
uni
formlytoallCommer cialBanks(except
Cooperativ
eBanks,LocalAr eaBanksandRegi onal
RuralBanks),
bothatthesol olevel(
globalposi
ti
on)
aswellasattheconsolidatedlevel.
AConsoli
dat
edbankisdef
inedasagroupof
ent
it
ieswher
eali
censedbankisthecont
rol
li
ng
ent
it
y.
Aconsoli
datedbankwil
lincl
udeal
lgroupenti
ti
es
underi
tscontr
ol,
excepttheexempt
edentit
ies.
Aconsol i
datedbankmayexcl udegr
oupcompani es,
whichar eengagedi
ni nsur
ancebusinessand
businessesnotpert
ainingtofi
nanci
alservi
ces.
Aconsolidatedbankshoul
dmai nt
ainami ni
mum
Capi
taltoRisk-wei
ghtedAsset
sRat i
o(CRAR)as
appl
icabl
et oabankonanongoi ngbasis.
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KeepinginviewtheReserveBank'sgoalt ohave
consist
encyandhar monywithinternat
ional
standar
ds,itwasdecidedthatallcommer cial
banksinIndia(excl
udi
ngCo- operat
iveBanks,Local
AreaBanksandRegi onalRuralBanks)shalladopt
St
andar
disedAppr
oach(
SA)f
orcr
edi
tri
sk
Basi
cIndi
cat
orAppr
oach(
BIA)f
oroper
ati
onalr
isk
Standar
disedDur
ati
onAppr
oach(
SDA)f
ormar
ket
ri
sks.
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BFM MODULE – D
Chapter 27: CAPITAL ADEQUACY
THE BASEL-II OVERVIEW (PART-II)
What will we study?
*What is PILLAR-I (Minimum Capital Requirement)?

THREE PILLAR OF BASEL-II

Pillar-I: Minimum Capital Requirement

PILLAR-I– MINIMUM CAPITAL REQUIREMENTS

Thedef i
nit
ionofel
igi
bleregul
ator
ycapitall
argel
y
continuest obeasdefinedint
heearli
eraccordof
1988andamendedt oincl
udeTier
-II
Icapit
alas
prescribedinJanuary96andSeptember97.
Thust
het
erm capi
talwoul
dincl
ude
Ti
er-
Iorcor
ecapi
tal
,
Ti
er-
IIorsuppl
ement
alcapi
tal
,and
Ti
er-
II
Icapi
tal
.
TierII
Icapi
tal,whi
chtookcareofmarketri
skoft
he
bankshassi ncebeenphasedoutwiththe
i
nt r
oducti
onofBaselIIIgui
del
ines.
Thet
otalcapi
talr
ati
oshoul
dbemi
mimum 8%.
(
9%i
nIndi
a).
Corecapit
alconsi
stsofpai
dupcapital,
free
reser
vesandunall
ocatedsur
pluses,
lessspeci
fi
ed
deducti
ons.
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Supplementarycapit
alcompr i
sessubor dinated
debtofmor ethanfiv
ey ears’matur
it
y,loanl oss
reserves,
reval
uati
onr eser
ves(whichisnowpar tof
Tier-
Icapit
alinI
ndia),i
nvestmentfl
uctuat i
on
reserves,
andlimit
edlifepref
erenceshar es.
Ti
er-
IIcapi
tali
srest
ri
ctedt
o100%ofTi
er-
Icapi
tal
asbefore.
Tier-
II
I(Present
lynotall
owedbyRBI)capi
tal
consistsofshort-
ter
m subordi
nat
eddebtforthe
solepurposeofmeet ingapropor
ti
onofthecapit
al
requir
ementf ormarketri
sk.
Ti
er-
II
Icapi
talwillbeli
mitedt
o250%ofabank’s
Ti
er-
Icapi
talthatisrequi
redt
osuppor
tmarketr
isk.

Tier-
II
Icapitalwasprovi
dedundert heBaselII
guideli
nes,butRBIhasnotpermittedthiscapi
talfor
Banksi nIndia.Wi
ththeint
roduct
ionofBaselI I
I,
thiscapit
alwasphasedoutbyBCBSal so.
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Anycapit
alrequi
rementar
isi
ngi
nrespectofcr
edit
andcounter-
part
yri
skneedstobemetbyTier-
Iand
Tier
-I
Icapi
tal.
Thescopeofri
skweightedassetsi
sexpandedto
i
ncludecer
tai
naddit
ionalaspect
sofmarketri
sk
andalsooper
ati
onalri
sk.
Theareaofoper
ati
onalr
iski
sbroughtundert
he
ambitofr
isk-
wei
ghtedasset
sforthefi
rstt
ime.
Capi
taladequacyrat
io=Regul
ator
yCapi
tal
/Tot
al
ri
skweightasset
s
Totalri
skweight
edasset sincludethecapi t
al
requi
rementformarketriskandoper ationalri
sk
multi
pli
edby12.5,i
.e.recipr
ocaloft hemi ni
mum
capit
alrequi
rementof8%( I
nI ndi
a,t
her iskweight
hasbeencappedat11. 11si ncethemi nimum
capit
alrequi
rementis9%)
al
ongwi
thr
iskwei
ght
edasset
sforcr
edi
tri
sk.
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ThusTot
alRi
skwei
ght
edasset
s=
Riskweight
edassetsforcr editr
isk+12.5*
Capi
tal
requi
rementformarketrisk+12.5*Capi
tal
requi
rementforoper
ationalrisk.
ThusTot
alRi
skwei
ght
edasset
s(I
NINDI
A)=
Riskweight
edassetsforcr editr
isk+11.
11*Capi
tal
requi
rementformarketrisk+11.11*Capi
tal
requi
rementforoper
ationalrisk.

Pi
ll
ar2:Super
visor
yRev
iew:
1.Ev
aluat
eri
skassessment
2.Ensuresoundnessandi
ntegr
it
yofbank’
sinter
nal
processestoassesst
headequacyofcapi
tal
3.Ensur
emaintenanceofmini
mum capitalwi
th
promptcor
rect
iveacti
on(PCA)forshor
tfal
l
4.Pr
escr
ibedi
ff
erent
ialcapi
tal
,wher
enecessar
yi.
e.
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wher
ethei
nter
nalpr
ocessesar
esl
ack.
Pi
ll
ar3:Mar
ketDi
sci
pli
ne:
1-Enhancedi
scl
osur
es
2-Cor
edi
scl
osur
esandsuppl
ement
arydi
scl
osur
es
3-Di
scl
osur
esshoul
dbemadeonhal
fyear
lybasi
s.

Thust heBasel
-I
Iaccorddoesnotmer el
yprescr
ibe
minimum capit
alrequi
rement,butenv
isages
processesofsupervi
soryr
eviewandmar ket
di
scipline.
Therevi
sedfr
amewor
kismor
eri
sksensi
ti
vet
han
the1988ccor
d.
Therear
eincent
ivesf
ort
hosebanks,whi
chhav
e
bett
erri
skmanagementcapabi
li
ti
es.