10 capital adequacy norms

8/9/2019 10 Capital Adequacy Norms

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Overview of TheBasel Norms – I, II

& III


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What is CAR?Capital adequacy provides regulators with a

means of establishing whether banks andother nancial institutions have sucientcapital to keep them out of dicultyRegulators use a Capital Adequacy Ratio!CAR"# a ratio of a bank$s capital to its assets#to assess risk

CAR % !&ank$s Capital"'!Risk Weighted Assets"

% !(ier ) Capital * (ier )) Capital"'!RiskWeighted

Assets"


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Concepts of Capital

Adequacy +orms (ier ) Capital

(ier )) Capital

Risk Weighted Assets

,ubordinated -ebts


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.ow do banks make

money?&y playing /term0 of funds1 2ong v's short&y playing risk levels3 accept lower risk and

place in higher risk3 play safety as a marketmantra-ispersed source v's concentrated use (rading in the market

4ssentially by taking risk


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Risk Definition and featuresRisk: Event likely to cause loss/variability/damage to income

and reputationFeatures:

Fairly known- Cannot be avoided.robabilistic and generic!scertainable" alt#oug# not always $uantifiableEssential for intermediation process.

Risk and Reward go toget#er%nterrelated/ Collectively eaustive but not

mutually e&clusive

Risk is an opportunity


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'ources of Risk

Decision "%ndecision(usiness cycles/

'easonalityEconomic/Fiscal

c#angesolicy C#anges

)arket movementsEvents

olitical compulsions

Regulations*uman resources" skill

setsCompetition

+ec#nology,on-availability of

information


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Risks )nvolvedCredit Risk - Default/delay: Impacts Solvency-Capacity to

service obligation

Market Risk

a) Interest Rate Risk- Canges in te market rate causing

income variability

b) !oreign "#cange Risk- !luctuation in currency rates$

prices becoming adverse for te company

c) Commodity %rice Risk

&perational Risk - !ailure of Men$ Macine$ Monitoring$

Metods


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.ow to manage risk

.edging

45posure limits

Reserves and 6rovisioning

More importantly by having

adequate capital


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&asel 7 ) +orms

)n 89::# the &asel ) Capital Accord was created

(he general purpose was to1

8 ,trengthen the stability of internationalbanking system

; ,et up a fair and a consistent international

banking system in order to decrease competitiveinequality among international banks


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&asis of Capital in &asel 3)

Tier I (Core Capital):

(ier ) capital includes stock issues !or shareholders equity" and declared reserves# such as loanloss reserves set aside to cushion future losses or

for smoothing out income variations

Tier II (Supplementary Capital):

(ier )) capital includes all other capital such as

gains on investment assets# long3term debt withmaturity greater than ve years and hiddenreserves !ie e5cess allowance for losses on loansand leases" .owever# short3term unsecured debts

!or debts without guarantees"# are not included in


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Risk Categori gold held with bank# governmentbonds# corporate bonds etc"

arket risk including interest rates# foreigne5change# equity derivatives > commodities

+on (rading o@3balance sheet risks like forwardpurchase of assets or transaction related debt

assets

i i i f l


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2imitations of &asel 7 )+orms

2imited di@erentiation of credit risk1 (here arefour broad risk weightings !=# ;=# B= and8="# as shown in igure8# based on an :=minimum capital ratio

,tatic measure of default risk1 (he assumptionthat a minimum := capital ratio is sucient toprotect banks from failure does not take intoaccount the changing nature of default risk+o recognition of term3structure of credit risk1 (he capital charges are set at the same levelregardless of the maturity of a credit e5posure


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,implied calculation of potential future

counterparty risk1 (he current capitalrequirements ignore the di@erent level of risksassociated with di@erent currencies andmacroeconomic risk

2ack of recognition of portfolio diversicatione@ects1 )n reality# the sum of individual riske5posures is not the same as the risk

reduction through portfolio diversication (herefore# summing all risks might provideincorrect Dudgment of risk


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&asel 7 )) +orms &asel 7 )) norms are based on E pillars1

inimum Capital 7 &anks must hold capital against:= of their assets# after adDusting their assets for risk

,upervisory Review 7 )t is the process wherebynational regulators ensure their home country banksare following the rules

arket -iscipline 7 )t is based on enhanced disclosureof risk


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Risk Categori


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)mpact on &anking ,ector

Capital Requirement

Wider arket

6roducts

Customers


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Advantages of &asel ))

over ) (he discrepancy between economic capital

and regulatory capital is reduced signicantly#due to that the regulatory requirements willrely on banks$ own risk methods

ore Risk sensitive

Wider recognition of credit risk mitigation


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6itfalls of &asel 7 )) norms (oo much regulatory compliance

Fver ocusing on Credit Risk

(he new Accord is comple5 and thereforedemanding for supervisors# and

unsophisticated banks

,trong risk di@erentiation in the new Accordcan adversely a@ect the borrowing position of

risky borrowers


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&asel 7 ))) +orms &asel 7 ))) norms aim to1

)mproving the banking sectorHs ability toabsorb shocks arising from nancial andeconomic stress

)mprove risk management and governance

,trengthen banksH transparency anddisclosures


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,tructure of &asel 7 )))

Accordinimum Regulatory Capital Requirements

based on Risk Weighted Assets !RWAs" 1aintaining capital calculated through credit#market and operational risk areas

,upervisory Review 6rocess 1 Regulating toolsand frameworks for dealing with peripheralrisks that banks face

arket -iscipline 1 )ncreasing the disclosuresthat banks must provide to increase thetransparency of banks


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aDor changes in &asel 3

)))&etter Capital Juality

Capital Conservation &u@er

Counter cyclical &u@erinimum Common 4quity and (ier ) Capital

requirements

2everage Ratios

2iquidity Ratios,ystematically )mportant inancial )nstitutions


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&asel ))) and its impactFn &anks

Fn inancial ,tability

Fn )nvestors


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Than !ou

10 capital adequacy norms

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