IIBF CAIIB | BFM | PRUDENTIAL NORMS LIKE CAPITAL ADEQUACY
In April 1992, RBI introduced a risk asset ratio system for the banks. This system was introduced in line with capital adequacy norms that have been described by the Basel committee. Under it, risk weights have been prescribed for the balance sheet assets as well as other off-balance sheet exposures and minimum capital funds that are required to be maintained as a ratio to the aggregate of risk-weighted assets & other exposures on an ongoing basis.
This requirement is applicable to all commercial banks except RRBs.
In this article, we will read instructions in relation to the components of capital and capital charge to be provided for credit and market risks as well as foreign exchange risk by the banks and computation of capital charges for interest rates related to equities either held for trading or for hedging.
CAPITAL: Under the capital adequacy framework, the first thing that banks need is if they have sufficient capital so as to provide stable resources to absorb any laws that arise on account of business risks.
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Capital has been categorized into tiers as per the characteristics of each qualifying instrument:
Tier-I capital contains capital and disclosed deserves that is the banks’ highest quality capital because of the capability to cover full loss.
Tier-II capital contains reserves and subordinated debt whose capacity to observe loss is lower than that of Tier-I.
Before we move forward with the capital adequacy norms, we must know what is credit and market risk:
Credit Risk: It is a risk that the borrower might feel to repeat the amount that has been loaned to him or her. In other words, the possibility of loss is related to the diminution of the credit quality of the counterparty.
In cases of banks, using losses rise on the default that happens either because the customer is unable or unwilling to pay the amount loaned.
In some other cases, losses may also arise on account of actual or perceived deterioration and quality of the credit.
In most cases, banks face the largest risk on account of credit even though there are also other risks associated with the account holders. This credit risk happens in financial instruments that include acceptances, trade finances, transactions of foreign exchange, swaps, equities, bonds, inter-bank transactions, options, and guarantees settlement transactions.
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Market Risk: The risk that may occur due to changes in interest rates, exchange rates, and the prices of equity and commodity because of the movements in their market prices.
In other words, the possibility that a loss may occur because of changes and market variables is known as market risk.
BIS (Bank for International Settlements) has defined market risk as the risk that due to changes in the on and off-balance sheet positions will adversely change due to the moments in equity and interest rate markets, currency exchange rates, or commodity prices.
REQUIREMENT OF CAPITAL ADEQUACY NORMS:
In the above scenario, capital saves the bank. A sufficient capital also increases the depositor’s confidence. This is the primary reason for adequacy of capital has been made a prerequisite for the licensing of new banks as well as to continue the business of Banking.
As per section 11 of the Banking Regulation Act, a cooperative Bank can only commence or carry on the business of Banking if it has a minimum of Rs.1,00,000.00 value in its capital and reserves.
Other than that, RBI also (from time to time) prescribes a minimum capital at the entry point to set up a Primary Cooperative Bank.
Share linking to Borrowings
Primary Urban Co-Operative Banks (UCB) have been increasing their share capital by linking it to the member’s borrowings. To regulate the same, RBI has prescribed the following norms:
- If borrowings are unsecured, linkage to 5% of the borrowings
- If borrowings are secured, linkage to 2.5% of the borrowings
- If borrowings are secured & taken by SSIs, linkage to 2.5% of the borrowings. Of this 2.5%, the 1% is collected at the beginning & the rest of 1.5% is collected in the next two years.
The above percentage is applied to the total paid-up share capital. If a member already holds 5% of the paid-up share capital, he or she would not be required to subscribe to any additional share capital as per the above share linking norms.
In simple words, a member who has borrowed money is required to hold shares as per the above share linking terms or for an amount which is the total paid-up share capitals’ 5%, whichever is lower.
The state governments have been requested to do the amendments in their State Cooperative Societies Act to dispense with the above norms.
Any pending amendments to the State Co-operative Societies Act, the Urban Co-operative Banks are required to adhere or follow as per the above-mentioned share linking to borrowing norms & ceiling requirements on individual share-holding.
The co-operative banks (on a continuous basis) that adhere to the ‘capital to risk-weighted assets ratio’ i.e CRAR = 12% have been exempted from the extant mandatory share linking norms with effect from 15-11-2010.
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CAPITAL ADEQUACY NORMS
The traditional way to ensure the sufficiency of capital was unable to capture all the elements of risks that are present in different types of on and off-balance sheet assets of the business.
The Basel I framework (the first Basel Capital Accord) that has been published by the Basel Committee on Banking Supervision (popularly called as Basel I framework) had prescribed the minimum capital adequacy requirements for the banks to maintain the soundness & stability of the International Banking System and to reduce the competitive inequality that exists among the international banks.
The basic features of the 1988’s Capital Accord are mentioned as under:
- By the end of 1992, the Minimum Capital Requirement = 8%
- Capital Tier approach:
- Core Capital: Equity and Disclosed Reserves
- Supplementary Capital: It includes the General Loan Loss Reserves, Revaluation Reserves & Other Hidden Reserves, and Hybrid Capital Instruments & Subordinate Debts
- Capital’s 50% is to be taken = core capital.
- Risk Weights for different categories: Weight has been prescribed for different exposure categories of banks which range from 0-127.5%. This depends upon the risk that assets carry.
The risk weight of different categories are as follows:
Commercial Loan Assets = 100%,
Inter-Bank Assets = 20%;
Sovereign Paper = 0%.
In the year 2002, the requirement to maintain the capital funds in the form of %age of risk-weighted assets was made applicable to all Urban Co-operative Banks. This %age has been prescribed 9% from the year 2005. And in further amendments to the original Basel Accord via the 1996 amendment, a capital charge has been prescribed for market-related exposures.
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