Basel 3: Capital Adequacy Ratio

WHAT IS BASEL III ?

Basel III is an international regulatory accord formulated by the Basel Committee that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector.

It builds on the Basel I and Basel II documents, and seeks to improve the banking sector’s ability to deal with financial stress, improve risk management, and strengthen banks’ transparency.

CAPITAL ADEQUACY RATIO (CAR)

Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital in relation to its risk weighted assets and current liabilities. It provides the regulators with a means of establishing whether banks and other financial institutions have sufficient capital to keep them out of difficulties.

The capital adequacy ratio, also known as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world.

CALCULATION OF CAPITAL ADEQUACY RATIO

The formula for calculating CAR is –

CAR = Tier 1 Capital + Tier 2 Capital / Risk Weighted Assets

The capital adequacy ratio is calculated by dividing a bank’s capital by its risk-weighted assets. The capital used to calculate the capital adequacy ratio is divided into two tiers.

  • TIER 1 CAPITAL – It consists of equity capital, ordinary share capital, intangible assets and audited revenue reserves. Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. This capital is permanently and easily available to cushion losses suffered by a bank without it being required to stop operating.
  • TIER 2 CAPITAL – It is supplementary capital of the bank and it includes undisclosed Reserves, General Loss reserves , hybrid debt capital instruments and subordinated debts with an original maturity of at least five years.

RISK WEIGHTED ASSETS :

The risk weighted assets take into account credit risk, market risk and operational risk.

CREDIT RISK – It  is defined as the potential that a bank’s borrower or counterparty may fail to meet its obligations in accordance with agreed terms.

MARKET RISK – The risk to a bank resulting from movements in market prices in particular changes in interest rates, foreign exchange rates & equity & commodity prices.

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.

IMPORTANCE OF CAPITAL ADEQUACY RATIO

The capital adequacy ratios ensure the efficiency and stability of a nation’s financial system by lowering the risk of banks becoming insolvent.

A high capital adequacy ratio is considered favourable , since it indicates stable financial condition of the bank.

Under Basel III, all banks are required to have a Capital Adequacy Ratio of at least 8%. Since Tier 1 Capital is more important, banks are also required to have a minimum amount of this type of capital. Under Basel III, Tier 1 Capital divided by Risk-Weighted Assets needs to be at least 6%.

However, as per RBI norms, Indian scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a CAR of 12%.

 

Accounting & Finance for Banking

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