Indian Economy, 5th edition (61 page)

(iii)
The provision of the capital adequacy ratio (CAR) norm.

The capital adequacy ratio (CAR) norm has been the last provision to emerge in the area of regulating the banks in such a way that they can sustain the probable risks and uncertainties of lending. It was in 1988 that the central banking bodies of the developed economies agreed upon such a provision, the CAR—also known as the
Basel Accord
35
. The Accord was agreed upon at Basel, Switzerland at a meeting of the Bank for International Settlements (BIS).
36
It was at this time that the
Basel-I
norms of the capital adequacy ratio were agreed upon—a requirement was imposed upon the banks to maintain a certain amount of free capital (
i.e. ratio
) to their
assets
37
(i.e loans and investments by the banks) as a cushion against probable losses in investments and loans. In 1988, this ratio capital was decided to be 8 per cent. It means that if the total investments and loans forwarded by a bank amounts to
`
100, the bank needs to maintain a
free capital
38
of
`
8 at that particular time.
The capital adequacy ratio is the percentage of total capital to the total risk - weighted assets
(see reference 39).

Capital Adequacy Ratio (CAR), a measure of a bank’s capital, is expressed as a percentage of a bank’s risk weighted credit exposures:

CAR= Total of the Tier 1 & Tier 2 capitals
÷
Risk Weighted Assets

Also known as ‘Capital to Risk Weighted Assets Ratio (CRAR)’ this ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital were measured as per the
Basel II
norms –
Tier 1
capital, which can absorb losses without a bank being required to cease trading, and
Tier 2
capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. The new norms (
Basel III
) has devised a third category of capital-
Tier 3
capital.

The RBI introduced the
capital-to-risk weighted assets ratio
(CRAR) system for the banks operating in India in 1992 in accordance with the standards of the BIS—as part of the financial sector reforms.
39
In the coming years the Basel norms were extended to term-lending institutions, primary dealers and non-banking financial companies (NBFCs), too. Meanwhile the BIS came up with another set of the CAR norms, popularly known as
Basel-II.
The RBI guidelines regarding the CAR norms in India have been as given below:

1.
Basel-I
norm of the CAR was to be achieved by the Indian banks by March 1997.

2.
The CAR norm was raised to 9 per cent with effect from March 31, 2000 (
Narasimham Committee-II had recommended to raise it to 10 per cent in 1998
).
40

3.
Foreign banks as well as Indian banks with foreign presence to follow
Basel-II norms
w.e.f. March 31, 2008 while other scheduled commercial banks to follow it not later than March 31, 2009. The Basel-II norm for the CAR is 12 per cent.
41

Why to maintain CAR?

The basic question which comes to mind is as to why do the banks need to hold capital in the form of CAR norms?
Two
reasons
42
have been generally forwarded for the same:

(i)
Bank capital helps to prevent bank failure, which arises in case the bank cannot satisfy its obligations to pay the depositors and other creditors. The low capital bank has a negative net worth after the loss in its business. In other words, it turns into insolvent capital, therefore, acts as a cushion to lessen the chance of the bank turning insolvent.

(ii)
The amount of capital affects returns for the owners (equity holders) of the bank.

Basel Accords

The Basel Accords (i.e. Basel I, II and now Basel III) are a set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. They are of paramount importance to the banking world and are presently implemented by over 100 countries across the world. The BIS Accords were the outcome of a long-drawn-out initiative to strive for greater international uniformity in prudential capital standards for banks’ credit risk. The objectives of the accords could be summed up
43
as:

(i)
to strengthen the international banking system;

(ii)
to promote convergence of national capital standards; and

(iii)
to iron out competitive inequalities among banks across countries of the world.

The
Basel Capital Adequacy Risk-related Ratio Agreement of 1988 (
i.e. Basel I
) was not a legal document. It was designed to apply to internationally active banks of member countries of the Basel Committee on Banking Supervision (BCBS) of the BIS at Basel, Switzerland. But the details of its implementation were left to national discretion. This is why Basel I looked G10-centric.
44

The first Basel Accord, known as
Basel I
, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk (the risk a financial institution faces due to an unexpected loss), categorizes the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are required to have a risk weight of 8% or less.

The second Basel Accord, known as
Basel II
, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the
three pillars
. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements.

The third Basel Accord, known as
Basel III
is a comprehensive set of reform measures aimed to strengthen the regulation, supervision and risk management of the banking sector. These measures aim
45
to:

(i)
improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source

(ii)
improve risk management and governance

(iii)
strengthen banks’ transparency and disclosures.

The capital of the banks has been classified into
three tiers
as given below:

Tier 1 Capital:
A term used to describe the capital adequacy of a bank – it can absorb losses without a bank being required to cease trading. This is the
core measure
of a bank’s financial strength from a regulator’s point of view (this is the
most reliable
form of capital). It consists of the types of financial capital considered the most reliable and liquid, primarily stockholders’ equity and disclosed reserves of the bank- equity capital can’t be redeemed at the option of the holder and disclosed reserves are the liquid assets available with the bank itself.

Tier 2 Capital:
A term used to describe the capital adequacy of a bank – it can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. Tier II capital is secondary bank capital (the
second most reliable
forms of capital). This is related to Tier 1 Capital. This capital is a measure of a bank’s financial strength from a regulator’s point of view. It consists of accumulated after-tax surplus of retained earnings, revaluation reserves of fixed assets and long-term holdings of equity securities, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt and undisclosed reserves.

Tier 3 Capital:
A term used to describe the capital adequacy of a bank – considered the
tertiary capital
of the banks which are used to meet/support market risk, commodities risk and foreign currency risk. It includes a variety of debt other than Tier 1 and Tier 2 capitals. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to Tier 2 capital. To qualify as Tier 3 capital, assets must be limited to 250 per cent of a bank’s Tier 1 capital, be unsecured, subordinated and have a minimum maturity of two years.

Disclosed Reserves
are the total liquid cash and the SLR assets and of the banks that may be used any time. This way they are part of its
core capital
(Tier 1).
Undisclosed Reserves
are the unpublished or hidden reserves of a financial institution that may not appear on publicly available documents such as a balance sheet, but are nonetheless real assets, which are accepted as such by most banking institutions but cannot be used at will of the bank. That is why they are part of its
secondary capital
(Tier 2).

Basel III Provisions
46

The new provisions have defined the capital of the banks in different way – they consider common equity and retained earnings as the predominant component of capital (as the past) but they restrict inclusion of items such as deferred tax assets, mortgage-servicing rights and investments in financial institutions to no more than 15% of the common equity component. These rules aim to improve the
quantity
and
quality
of the capital.

While the key capital ratio has been raised to 7% of risky assets, according to the new norms, Tier-I capital that includes common equity and perpetual preferred stock will be raised from 2 to 4.5% starting in phases from January 2013 to be completed by January 2015. In addition, banks will have to set aside another 2.5% as a
contingency
for future stress. Banks that fail to meet the buffer would be unable to pay dividends, though they will not be forced to raise cash.

The new norms are based on renewed focus of central bankers on ‘macro-prudential stability’. The global financial crisis following the crisis in the US sub-prime market has prompted this change in approach. The previous set of guidelines, popularly known as
Basel II
focused on ‘macro-prudential regulation’. In other words, global regulators are now focusing on financial stability of the system as a whole rather than micro regulation of any individual bank.

Banks in the West, which are market leaders for the most part, face low growth, an erosion in capital due to sovereign debt exposures and stiffer regulation – they will have to reckon with a permanent decline in their returns on equity thanks to enhanced capital requirements under the new norms. In contrast, Indian banks - and those in other emerging markets such as China and Brazil – are well-placed to maintain their returns on capital consequent to Basel III. The financial experts have opined that Basel III looks changing the economic landscape in which banking power shifts towards the emerging markets.

Preparing PSBs for Basel III Capital Compliance

As capital is a key measure of banks’ capacity for generating loan assets and is essential for balance sheet expansion, the Government of India (GoI) has regularly invested additional capital in the PSBs to support their growth and keep them financially sound so as to ensure that the growing credit needs of the economy are adequately met. A sum of Rs. 12,000 crore was infused in seven PSBs during 2011-12 to enable them to maintain a minimum Tier-I CRAR of 8 per cent and also to increase shareholding of the GoI in them.

In 2012-13 also, the Government has infused capital in PSBs to augment their Tier-I capital so that they maintain their Tier-I CRAR at a comfortable level and remain compliant with the stricter capital adequacy norms
47
under Basel III. This will also support internationally active PSBs in their national and international banking operations undertaken through their subsidiaries and associates. An amount of Rs. 12, 517 crore was allocated by the GoI for the year 2012-13 on January 10, 2013.

The
High Level Committee
to assess the capitalization of PSBs in the next 10 years, headed by the Finance Secretary has recommended various options for funding of PSBs. Given the budgetary constraints, it may not be feasible for the government to infuse huge sums into the PSBs. This is why the Committee has recommended the formation of a
‘non-operating financial holding company’
(HoldCo)
under a special
act of Parliament
with the following key objectives –

i.
To act as an investment company for the GoI;

ii.
To hold a major portion of the GoI’s holdings in all PSBs;

iii.
To raise long-term debt from domestic and international markets to infuse equity into PSBs; and

iv.
To service the debt from within its sources.

Due to weakening of the RRBs also their sponsor banks have been incurring huge NPAs. RRBs have played a pivotal role in credit delivery in rural areas, particularly to the agriculture sector – to enhance their outreach and provide banking services more effectively to rural masses, RRBs need to undertake a continuous process of technology and capital upgradation. With a view to bringing the CRAR of RRBs up to at least 9 per cent,
Dr K C Chakrabarty Committee
recommended recapitalisation support to the extent of Rs. 2,200 crore to 40 RRBs in 21 States. Pursuant to the recommendation of the Committee, recapitalization amount is to be shared by the stakeholders in proportion to their shareholding in RRBs, i.e. 50 per cent central government, 15 per cent concerned state government, and 35 per cent the concerned sponsor banks. The re-capitalisation will continue upto March 2014.