Capital is an important component of business. It is the base on which the whole business depends. Capital is the wealth of business or it is the difference between assets and liabilities. Money that is invested in business is thus called capital. Capital is used in making factory or buying a share or stock.
Capital comprises of goods or cash used to earn income by investing in business.
It is also called net worth as it is the amount of assets in excess of liabilities. According to 'Marx', it is the capital that dominates the relations in society. He argued that classicists have viewed capital just as commodity but capital is of higher significance.
Success of any business is based on right amount of capital; this is known as capital adequacy.
Capital adequacy for a bank is optimum money kept aside as shareholders capital. The optimum level is such that the creditors can be paid fairly at the time of risk and bank can overcome any danger.
Off-site Monitoring and Surveillance System (OSMOS) introduced in 1995 as a tool for supervision of commercial banks, was introduced with the aim to supplement the on-site inspections. Under off-site system, 12 returns (called DSB returns) were called from the financial institutions (23 after 2000: when CAMEL Model introduced), with focus on supervisory concerns such as capital adequacy, asset quality, large credits and concentrations, connected lending, earnings and risk exposures (viz. currency, liquidity and interest rate risks).
In 1995, RBI had set up a working group under the chairmanship of Shri S. Padmanabhan to review the banking supervision system. The Committee certain recommendations and based on such suggestions a rating system for domestic and foreign banks based on the international CAMELS model combining financial management and systems and control elements was introduced for the inspection cycle commencing from July 1998. It recommended that the banks should be rated on a five point scale (A to E) based on the lines of international CAMELS rating model.
Capital adequacy is measured by:
The ratio of capital to risk-weighted assets (CRAR): Capital as a proportion of assets. 8% is recommended by BASEL II. This means for every Re 1 asset a loan of Rs.12 (100/8) can be given not more than that.
Debt-Equity Ratio: The proportion of equity as debt. An increase over time reduces efficiency.
Advance to Assets Ratio: The ratio of loans given vis-a vis deposits received and other investments made. An increase over time would decrease efficiency thus increase in assets and advances together is recommended to win stakeholders trust.
G-Secs to Investments: The most secure investment is in Government securities; it fetches low return but is deemed to be most secure. An increase signifies efficiency.
I. The ratio of capital to risk-weighted assets (CRAR)
Measured as percentage of total assets (8 % of risk weighted assets according to BASEL II), thus called capital adequacy ratio (CAR). It is also known as capital to risk weighted assets ratio (CRAR). CAR depicts financial stability and strength of a bank. Bank of international settlement (BIS, Basel: Switzerland) has set up capital adequacy standard for OECD countries as 8%, now followed by most of the countries. A strong capital foundation strengthens confidence in depositors
History of Basel Accords:
Basel I committee was formulated in 1974, after liquidation of Bank Herstatt by German regulators and came into existence after the banks in 1988. Its' focus was on credit risk mainly. Due to stringent and inflexible norms, BASEL I became unpopular and it was replaced by BASEL II accord, which introduced increased sophistication in lending and risk operations. BASEL II directives are enshrined in a EU doctrine: Capital Requirements Directive (CRD) and are law through out EU. It is laid down by BIS (Bank of International Settlement), the guide of central banks of more than 100 countries all over the world.
BASEL I and BASEL II:
BAESL I had stringent norms as it required banks to calculate capital adequacy based on single risk weight for each of asset classes. BASEL II expanded its' ambit and allows lenders to use their own risk valuation models to reach minimum required capital, in order to inculcate risk management in lenders.
BASEL II is based on three pillars vis a vis BASEL I which is said to cover only credit risk. The three pillars are:
The first pillar ensures minimum capital requirement: it ensures credit risk which can be measured by any of the three approaches outlined by BIS, namely standardized approach, internal ratings based approach (IRB) or securitization approach. Operational risk and trading book upkeep is also undertaken by this norm. Pillar 1 requires the calculation of risk weights to determine basic minimum capital .Pillar 1 also requires lenders to assess their market and operational risk and provide capital to cover such risk.
Second pillar ensures: Supervisory review process which trains the staff and requires installation of MIS, which is compulsorily sent to central bank. Lenders are required to assess risks to their business not captured in Pillar 1, for which additional capital may be required (for example the risk caused by interest rate mismatches between assets and liabilities).
Third pillar ensures market discipline: to make stakeholders aware of the real situation and at the same time to keep a check on leakage on sensitive information which may dismay market efficiency. Pillar 3 requires lenders to publish information on their approach to risk management and is designed to raise standards through greater transparency.
Implementation of BASEL II: EU has introduced it from first January 008, however many other countries have delayed the implementation to first January 2009. In India banks have been directed to comply with effect from 1.1. 2009.
Components of CAR:
II types of capital (Tier I and Tier II) are mentioned: Tier I capital, which has potential to absorb loss without banks closure, and Tier II capital, which has ability to absorb losses upon winding-up and thus provides a smaller degree of security to depositors.
Tier I capital: It is known as primary capital or core capital. It consists of paid up capital (equity shares), disclosed reserves, retained earnings, minority interest in subsidiaries, non cumulative irredeemable preference shares.
Tier II capital: Known as secondary/supplementary capital, it is not usually disclosed and comprises of general loss reserves, undisclosed reserves, cumulative irredeemable preference shares, mandatory convertible notes, perpetual subordinate term debt (limited) etc.
Tier I capital exceeds Tier II capital.
Tier III capital s yet another term used in banking fraternity: It is capital held by banks to convene part of their market risks, which includes greater variety of debt 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. Tier III capital supports market risk, commodity risk and foreign/international currency risk. To be eligible as tier 3 resources, assets must be limited to 250% of a banks tier 1 capital, be unsecured, subordinated and have a minimum maturity of two years.
The formula laid down for calculating capital adequacy ratio or capital to risk weighted assets ratio is:
Risk weighted assets - Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets.
Basel norms establish that cash and government securities carry a 0% risk weight and loans against residential mortgage carry a 50% risk weight. All other loans to borrowers carry 100% risk weight.
Importance of CRAR:
Determines capacity of banks to meet liabilities: A bank is liable to pay back the deposits of its customers along with interest. The lenders must feel confident while depositing their hard earned money in a bank, in other words it is a cushion against potential loss for stakeholders.
CRAR recognizes different intensity of risk of assets: Different assets have different risk profile; calculation of CRAR enables a bank to take calculated risks with caution.
Assurance regarding equity against risk weighted balance sheet assets: CRAR norm encourages banks to keep ample equity capital to support its assets, thus winning the trust of all stakeholders.
Uniform international guidelines for capital adequacy: BASEL I did set uniform guidelines for capital adequacy in G-10 countries. In United States, risk-based capital adequacy formula was raised from 5.5% of total assets to 8%, half of which had to be from Tier 1 capital; and 4% in other types of qualifying capital. BASEL II has furthered the same cause in a more liberal manner.
Eliminates disincentive in holding low risk/liquid assets: The 8% requirement of CRAR has eliminated the taboo of being less aggressive. The bank having adequate CRAR are treated as better than the risky ones. This generates more clientele and thus enhances profits.
.
Analysis of efficiency of 27 PSBs in terms of CAR for 9 years from 2000 to 2008 and conclusion in terms of allocation of ranking of PSBs.
The banks have been following Basel I norm and are expected to follow the norm of 9% CAR. Slope of CAR for 9 year has been tested for efficiency. If the slope is more than 0 the banks' performance is efficient otherwise not. The hypothesis for the same is tested at 5% level of significance and the conclusion is drawn accordingly.
How the values have been take. In which terms: cr, % etc
Ratio made
Then slope analysis
