Capital Adequacy ratios are a measure of the amount of a banks capital in relation to the amount of its credit exposures. These ratios are generally expressed as percentage.
The reason for having minimum capital adequacy ratios is to make sure that banks can bare a certain level of losses before it becomes insolvent, and before depositors funds are lost.
The "Basle Committee", established in 1974 (centred in the Bank for International Settlements), represents central banks and financial supervisory authorities of the major industrialised countries (the G10 countries). The committee ensures effective supervision of banks by setting and promoting international standards on a global basis. Its principal interest is in the area of capital adequacy ratios.
Basel III
Basel III which was released in December, 2010 is the third in the series of Basel
Accords. These accords deal with risk management aspects for the banking
sector. In a nut shell we can say that Basel iii is the global regulatory standard
(agreed upon by the members of the Basel Committee on Banking Supervision) on
bank capital adequacy, stress testing and market liquidity risk.
"Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk
management of the banking sector. This latest Accord now seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency.
Basel 3 measures aim to:
→ improve the banking sector's ability to absorb shocks arising from financial
and economic stress, whatever the source
→ improve risk management and governance
→ strengthen banks' transparency and disclosures.
Thus we can say that Basel III guidelines are aimed at to improve the ability of banks to withstand periods of economic and financial stress as the new guidelines are more stringent than the earlier requirements for capital and liquidity in the banking sector.
The Basel III which is to be implemented by banks in India as per the guidelines
issued by RBI from time to time, will be challenging task not only for the banks
but also for GOI. It is estimated that Indian banks will be required to raise Rs
6,00,000 crores in external capital in next nine years or so i.e. by 2020 (The
estimates vary from organisation to organisations.
Three Pillars of Basel II Norms :
Basel III: Three Pillars Still Standing :
Basel III has essentially been designed to address the weaknesses that become too
obvious during the 2008 financial crisis world faced. The intent of the Basel
Committee seems to prepare the banking industry for any future economic
downturns.. The framework enhances bank-specific measures and includes macroprudential regulations to help create a more stable banking sector.
The basic structure of Basel III remains unchanged with three mutually
reinforcing pillars.
Pillar 1 : Minimum Regulatory Capital Requirements based on Risk Weighted
Assets (RWAs) : Maintaining capital calculated through credit, market and
operational risk areas.
Pillar 2 : Supervisory Review Process : Regulating tools and frameworks for dealing with peripheral risks
that banks face.
Pillar 3: Market Discipline : Increasing the disclosures that banks must provide to increase the transparency of banks
Major Changes Proposed in Basel III over earlier Accords i.e. Basel I and Basel II?
What are the Major Features of Basel III ?
(a) Better Capital Quality : One of the key elements of Basel 3 is the introduction of much stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress.
(b) Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress.
(c) Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has been introduced with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of common equity or
other fully loss-absorbing capital.
(d) Minimum Common Equity and Tier 1 Capital Requirements : The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total
risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%.
Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer.
(e) Leverage Ratio: A review of the financial crisis of 2008 has indicated that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not risk-weighted).
This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively.
(g) Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential framework, systemically important banks will be expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.
Capital Adequacy Ratio
A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.
Capital Adequacy Ratio (CAR)
Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."
Investopedia explains 'Capital Adequacy Ratio - CAR'
This ratio is used to protect depositors and promote the steadiness and competence of financial systems around the world.
Two types of capital are measured: tier one capital, that absorbs losses without a bank being required to cease trading, and tier two capital, that absorbs losses at the time of winding-up and thus provides a lesser amount of protection to depositors.
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital.
Capital in this sense is related to, but different from, the accounting concept of shareholders' equity. Both Tier 1 and Tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord. Tier 2 capital represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.
Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.
The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses, which are covered by provisions, reserves and current year profits. In Basel I agreement, Tier 1 capital is a minimum of 4% ownership equity but investors generally require a ratio of 10%. Tier 1 capital should be greater than 150% of the minimum requirement.
The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country's central bank). Most central banks follow the Basel Committee on Banking Supervision (BCBS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while certain loans have a risk weight at 100% of their face value. The BCBS is a part of the Bank of International Settlements (BIS). Under BCBS guidelines total RWA is not limited to Credit Risk. It contains components for Market Risk (typically based on value at risk (VAR) and Operational Risk. The BCBS rules for calculation of the components of total RWA have seen a number of changes following the Financial Crisis.
As an example, assume a bank with $2 of equity receives a client deposit of $10 and lends out all $10. Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk weighting of 90%, the bank now holds risk-weighted assets of $9 ($10*90%). Using the original equity of $2, the bank's Tier 1 ratio is calculated to be $2/$9 or 22%.
There are two different conventions for calculating and quoting the Tier 1 capital ratio:
Tier 1 common capital ratio and
Tier 1 total capital ratio
Preferred shares and non-controlling interests are included in the Tier 1 total capital ratio but not the Tier 1 common ratio. As a result, the common ratio will always be less than or equal to the total capital ratio. In the example above, the two ratios are the same.
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base. These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord. National regulators of most countries around the world have implemented these standards in local legislation. In the calculation of regulatory capital, Tier 2 is limited to 100% of Tier 1 capital.
Undisclosed Reserves
Undisclosed reserves are not common, but are accepted by some regulators where a bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank. They must be accepted by the bank's supervisory authorities. Many countries do not accept this as an accounting concept or a legitimate form of capital.
Revaluation Reserves
A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its head-offices and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve. The reserve may arise out of a formal revaluation carried through to the bank's balance sheet, or a notional addition due to holding securities in the balance sheet valued at historic cost. Basel II also requires that the difference between the historic cost and the actual value be discounted by 55% when using these reserves to calculate Tier 2 capital.
General Provisions
A general provision is created against losses which have not yet been identified. They qualify for inclusion in Tier 2 capital as long as they are not created against a known deterioration in value. They are limited to
1.25% of RWA (Risk-weighted assets) for banks using the standardized approach
0.6% of credit risk-weighted assets for banks using the IRB approach
Hybrid Instruments
Hybrids are instruments that have some characteristics of both debt and equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the bank, they may be counted as capital. Perpetual preferred stocks carrying a cumulative fixed charge are hybrid instruments. Cumulative perpetual preferred stocks are excluded from Tier 1.
Subordinated Term Debt
Subordinated debt is debt that ranks lower than ordinary depositors of the bank. Only those with a minimum original term to maturity of five years can be included in the calculation of this form of capital; they must be subject to proper amortization arrangements.
Risk weighted assets
Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. In the Basel I accord published by the Basel Committee on Banking Supervision, the Committee explains why using a risk-weight approach is the preferred methodology which banks should adopt for capital calculation.
it provides an easier approach to compare banks across different geographies
off-balance-sheet exposures can be easily included in capital adequacy calculations
banks are not deterred from carrying low risk liquid assets in their books
Usually, different classes of assets have different risk weights associated with them. The calculation of risk weights is dependent on whether the bank has adopted the standardized or IRB approach under the Basel II framework.
Some assets, such as debentures, are assigned a higher risk than others, such as cash or government securities/bonds. Since different types of assets have different risk profiles, weighing assets based on the level of risk associated with them primarily adjusts for assets that are less risky by allowing banks to discount lower-risk assets. In the most basic application, government debt is allowed a 0% "risk weighting"- that is, they are subtracted from total assets for purposes of calculating the CAR.
A document was written in 1988 by the Basel Committee on Banking Supervision which recommends certain standards and regulations for banks. This was called Basel I, and the Committee came out with a revised framework known as Basel II. More recently, the committee has published another revised framework known as Basel III. The main recommendation of this document is that banks should hold enough capital to equal at least 8% of its risk-weighted assets. The calculation of the amount of risk-weighted assets depends on which revision of the Basel Accord is being followed by the financial institution. Most countries have implemented some version of this regulation.
Car and basel 3
The final guidelines of Basel III norms aim at strengthening the banking system in the country to resist all kinds of risk and financial shocks.
A committee of central banks of various countries in which RBI is also a member, based in Basel, Switzerland, framed guidelines that tries to strengthen banking systems across the world after the huge banking crisis in 2008 and in 2009.
The prevailing norms specify that banks maintain Tier-I capital or core capital and Tier-II containing instruments with debt-like features, whereas Basel III has introduced many elements of capital like a clearly defined common capital that measures core equity in relation to its total risk weighted assets. Simply at various levels, they asses the bank's financial strength and the capital conservation buffers (CCB)
The new norms will be made effective from January 1, 2013 and will be fully implemented by March 31, 2018 in a phased manner. The main point is that by FY'14 banks need to achieve a minimum Core Equity Tier-I (CETI) capital adequacy of 5 percent and by FY'18 it has to be increased to 8 percent
Some professionals claim that Basel III is not meant for Indian banks, but insist they are relevant in addressing problems which could arise as domestic banks transform into organisations similar to their global counterparts over the next decade. From an investor perspective, there would be no impact of Basel III on the share market investors' perception in the valuation of Indian banks
Transition to Basel III will not be any challenge since most banks have a common equity capital ratio which is above the prescribed requirements of 4.5 per cent, stipulated under Basel III. Yet, the transition timeline (till 2018) should suffice for banks in raising the required amount of equity and prepare the market and the system to adjust.
By and large, bankers concede that the Indian banking system is already stable, far less complex and well-capitalised as compared to banks across the globe. Still, they believe that Basel III is a step in the right direction in terms of preparing the domestic banks to address or prevent some of those challenges faced by their global counterparts.
Basel III would be more an issue of growth than solvency for domestic banks, more so for public sector banks (PSBs) because they are at the mercy of the government with regard to their capital needs. "Frequent dilutions will be required to support growth and also simultaneously maintain capital adequacy ratio levels,"
Impact immediate
The immediate impact of the Basel III capital regime will be benign as the CETI ratio of many domestic banks is already close to 8 per cent or higher. However, the shortfall will be likely between FY'16 and FY'18, mostly for government banks with loan growth outpacing internal capital generation and the minimum capital ratios stepping up. The additional equity will be needed for business growth and for creating a buffer above the regulatory minimum.
Reports of many rating agencies suggest that banks in India will require Rs 3.9 to R5 trillion as capital over the next six years to comply with Basel III norms. Of this, CETI requirements will be Rs 1.3 to 2 trillion; Rs 1.9 trillion for additional tier-I; and Rs 1 trillion for tier-II, which is "achievable so long as banks can find investors for the riskier additional tier I capital,"
This requirement can turn out to be higher (by another Rs 1.3 trillion) in case the investor appetite is low for non-equity tier-I capital instruments, adds Agrawal. PSBs will account for bulk (80 per cent) of the requirement and need regular infusion from the government. The largest of them is the State Bank of India and its associate banks, reflecting their significant share in the banking system.
The new norms also ask banks to maintain a minimum of 5.5 per cent in common equity by March 31, 2015 as against the current 3.6 per cent, apart from creating a capital conservation buffer (CCB) consisting of common equity of 2.5 per cent by March 31, 2018. CCB is designed to ensure that banks build up capital buffers during normal times which can be drawn down as and when losses are incurred during a stressed period. However, RBI is yet to announce final guidelines on counter-cyclical capital buffer.
More for capital adequacy
Basel III also hiked the minimum overall capital adequacy to 11.5 per cent by March 31, 2018 as against the current 9 per cent. Over 80 per cent of common equity need relates to public sector banks (PSBs) and the government share would be Rs 0.3 to Rs 0.8 trillion in the total equity need of PSBs as per the government average stake in PSBs at around 58 per cent. "Incremental equity requirement appears manageable, considering past trends in capital mobilisation," ICRA points out, adding, "Banks raised over Rs 1.0 trillion in equity during 2007-08 to 2011-12, of which around 54 per cent were mobilised by PSBs and 46 per cent by private banks."
ICRA also warns that "if banks are unable to mop up the required additional tier-I and the gap is bridged by raising common equity, then the incremental equity requirement may go up to a high of Rs 3.2 to Rs 4.0 trillion over the next six years, of which the Centre's share will be Rs 1.2 to Rs 1.7 trillion." It would also be wrong to assume that the government won't provide money for PSBs, counters Agrawal. In the last four years, the government has given a total of Rs 55,000 crore to PSBs, he says.
While the equity target may appear easy at first glance, it may not be so eventually as RBI has also introduced loss-absorption features in the additional tier-I capital instruments, say experts. These features can limit investor appetite to invest in banks' instruments as profitability will be under cloud though ICRA thinks higher core capital will help improve credit ratings of banks in the long run.
When it comes to private players, most of them are already well-capitalised, so transition to Basel III may not impact their earnings significantly. "In fact, private banks' competitive position can improve when PSBs raise their lending yields. But, at the same time, the upside potential for private banks can be limited by the higher minimum core capital requirement," says ICRA.
Fitch Ratings, however, points out that domestic banks raised only about $2.5 billion of common equity from the markets in FY'11 and FY'12 combined. Unless planned, PSBs may face risks of a sudden shortfall in capital during FY'16, requiring additional support by from the government.
Enough time
Most public sector bankers are neither worried about the timeline as there is enough time to raise capital, if required. "If annual credit growth is around 15 per cent, then there will not be any problem, but if it is to be 20 per cent a year, then banks will be under some pressure. But, by and large, I don't see any hassle in complying with the norms," says IDBI Bank Executive Director R K Bansal.
CMDs of Union Bank of India and Indian Overseas Bank maintain that Basel III will force banks to plough back a larger chunk of their profit into the balance sheet. Banks may have to lower dividend payouts and retain more profit as capital, they said.
Although the total capital adequacy ratio (CAR) stipulated at 9 per cent under Basel III, unchanged from what the regulator prescribes in India currently, domestic banks will now need to raise more money than under the current Basel II norms because several capital instruments cannot be included under the new definition. Perpetual debt, for instance, now qualifies as a tier-I instrument which will be excluded under Basel III, forcing banks to raise more equity. So the challenge for banks is not in transitioning to Basel III, but in their capital-raising ability because at 20 to 25 per cent credit growth, they would need capital at a higher threshold, which could impact their return on equity, especially for PSBs.
While implementation of Basel III norms will help in improving the capital base of the banks in the country, the credit growth of some lenders may suffer, said S & P in its report released on Friday.
The stringent norms by the Reserve Bank of India to implement BASEL III standards will bridge the gap between India and its Asian peers for the risk-adjusted capital criterion. But, it will also pose a challenge of constant capital infusion.
"The draft guidelines may negatively affect the credit growth of a few banks," said the report. But overall, the guidelines — if implemented — will benefit Indian banks' stand-alone credit profiles, it added.
S & P is of the view that the Indian banks will be able to implement the Basel III guidelines within the time frame despite the stringent guidelines given by the banking regulator. The RBI's guidelines are more stringent than what the Basel Committee on Banking Supervision (BCBS) has proposed. In addition, the RBI expects banks to meet these requirements in a relatively shorter time frame, S & P said.
Indian banks would require additional Rs 8 lakh crore to meet the minimum capital adequacy under Basel III norms, ratings agency Crisil has said. The amount is over and above their earnings in the transition period between 2013 and 2019.
According to the Basel III guidelines released in 2010, banks across the globe would need a minimum capital adequacy ratio of 10.5 per cent, which includes seven per cent of core equity, 1.5 per cent of non-equity Tier-I capital and two per cent of Tier-II capital. The countercyclical buffer of up to 2.5 per cent would increase the total capital requirement to 13 per cent.
"Indian banks are well capitalised and would be able to meet the leverage and liquidity requirements under Basel III," said Pawan Agarwal, director (corporate and government ratings), Crisil. According to evaluation by the ratings agency, the overall capital adequacy ratio of Indian banks, on an average, was 14.1 per cent as on March 31. The Reserve Bank of India is expected to issue draft guidelines by December.
Assuming the government maintains 51 per cent stake and bank credit grows around 20 per cent every year, around Rs 6 lakh crore would be required, which includes Tier-I capital of Rs 3.5 lakh crore in public sector banks.
The challenge, however, is to replace existing hybrid instruments worth Rs 1.25 lakh crore, a part of Tier-I capital, with those permitted under Basel-III norms. The new standards would allow hybrid instruments such as Tier-I perpetual bonds and upper Tier-II bonds with a 'write off' clause that enables automatic conversion into equity, when required. "Lack of adequate appetite may lead to higher premium for new instruments," said Agarwal.
Crisil said while new measures would strengthen Indian banks, their profitability is likely to be hit, given the higher core equity capital and liquidity requirements. The ratings agency estimates the return on equity would decline by around two-three per cent for banks with low core capital. While rating banks, there would be an increased focus on their capability to raise the required capital.
