capital regulation

8/10/2019 Capital Regulation

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BASEL III CAPITAL REGLULATIONS

Introduction:

The main objective of the Basel III framework issued by the Basel Committee on

Banking Supervision (BCBS) in ec! "#$# is to improve the banking sector%s ability toabsorb shocks arising from financial and economic stress& whatever the source& thusreducing the risk of spillover from financial sector to real economy! The reform packagewill amend certain provisions e'isting under Basel framework (C*+) and introducesome new concepts and re,uirements! These new global regulatory and supervisorystandards mainly seek to raise the ,uality and level of capital to ensure banks are betterable to absorb losses on both a going concern and a gone concern basis& increase therisk coverage of the capital framework& introduce leverage ratio to serve as a backstopto the risk-based capital measure& raise the standards for the supervisory reviewprocess and public disclosures etc! The macro prudential aspects of Basel are largelyenshrined in the capital buffers! Both the buffers i!e! the capital conservation buffer and

the countercyclical buffer are intended to protect the banking sector from periods ofe'cess credit growth!

A. Guidelines on Minimum Capital Reuirement

The Basel capital regulations continue to be based on three-mutually reinforcing

.illars& vi/! minimum capital re,uirements (.illar $)& supervisory review of capital

ade,uacy (.illar ")& and market discipline (.illar 0) of the Basel capital ade,uacy

framework! 1nder .illar $& the Basel framework will continue to offer the three distinct

options for computing capital re,uirement for credit risk and three other options for

computing capital re,uirement for operational risk& albeit with certain modifications 2

enhancements! These options for credit and operational risks are based on increasingrisk sensitivity and allow banks to select an approach that is most appropriate to the

stage of development of bank3s operations! The options available for computing capital

for credit risk are:-

a) Standardised *pproach&

b) +oundation nternal 4ating Based *pproach5 and

c) *dvanced nternal 4ating Based *pproach!

The options available for computing capital for operational risk are:-

a) Basic ndicator *pproach (B*)&

b) The Standardised *pproach (TS*)5 and

c) *dvanced 6easurement *pproach (*6*)!

7eeping in view the 4eserve Bank%s goal to have consistency and harmony with


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international standards& as also capital efficiency likely to accrue to the banks by

adoption of the advanced approaches& a time schedule was laid down in "##8 that all

commercial banks in ndia (e'cluding 9ocal *rea Banks and 4egional 4ural Banks) may

switch over to nternal 4ating Based *pproach (Both +oundation as well as *dvanced

nternal 4ating Based *pproach) for credit risk and *dvanced 6easurement *pproach

for operational risk by 0$!#0!"#$! *ccordingly& banks were advised to undertake aninternal assessment of their preparedness for migration to advanced approaches and

take a decision with the approval of their Boards24B& whether they would like to migrate

to any of the advanced approaches! Banks may choose a suitable date to apply for

implementation of advanced approach!

The provisions of Basel include:-

a) The Basel capital regulation has been implemented from *pril $& "#$0 in ndiain phases!

b) To ensure smooth transition to Basel & appropriate transitional arrangements

have been provided for meeting the minimum Basel capital ratios& fullregulatory adjustments to the components of capital etc! Conse,uently& Basel capital regulations would be fully implemented as on 6arch 0$& "#$;!

c) Banks are re,uired to maintain a minimum .illar $ Capital to 4isk-weighted*ssets 4atio (C4*4) of 8< on an on-going basis (other than capitalconservation buffer and Countercyclical capital buffer etc!)!

d) Capital re,uirements for the implementation of Basel guidelines are lower inthe initial periods and higher in later years!

e) Banks are re,uired to disclose the capital ratios computed under Basel capitalade,uacy framework from the ,uarter ending 0#!#=!"#$0!

f) The 4B may consider prescribing a higher level of minimum capital ratio for

each bank under .illar " framework on the basis of their respective risk profilesand their risk management systems!

g) Banks are re,uired to comply with the capital ade,uacy ratio at two levels vi/!consolidated (>roup) and standalone (Solo) level! *t consolidated level& thecapital ade,uacy ratio re,uirements of a bank measure the capital ade,uacy of abank based on its capital strength and risk profile after consolidating the assetsand liabilities of its subsidiaries2joint ventures2associates& etc! e'cept thoseengaged in insurance and any non-financial activities! The standalone levelcapital ade,uacy ratio re,uirements measure the capital ade,uacy of a bankbased on its standalone capital strength and risk profile! The overseasoperations of a bank through its branches will be covered in both the above

scenarios! +or the purpose of these guidelines& the subsidiary is an enterprisethat is controlled by another enterprise (known as the parent)& etc!

1nder the Basel framework& the total regulatory capital comprises of Tier (corecapital) and Tier " capital (supplementary capital)! n order to improve the ,uality and,uality of regulatory capital& capital will predominantly consist of Common ?,uity underBasel ! on-e,uity Tier $ and Tier " capital would continue to form part of regulatorycapital subject to eligibility criteria as laid down in Basel ! Banks have to comply with


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the regulatory limits and minima as prescribed under Basel capital regulations& on anongoing basis! To ensure smooth transition to Basel & appropriate transitionalarrangements have been provided for meeting the minimum Basel capital ratios& fullregulatory adjustments to the components of capital etc! Conse,uently& Basel capitalregulations would be fully implemented as on 6arch 0$& "#$;! n view of the gradual

phase-in of regulatory adjustments to the Common ?,uity component of Tier $ capitalunder Basel & certain specific prescriptions of Basel capital ade,uacy framework(e!g! rules relating to deductions from regulatory capital& risk weighting of investments inother financial entities etc!) will also continue to apply till 6arch 0$& "#$@!

Composition of Regulatory Capital

1nder Basel & Banks are re,uired to maintain a minimum .illar $ Capital to 4isk-

weighted *ssets 4atio (C4*4) of 8< on an on-going basis (other than capital

conservation buffer and countercyclical capital buffer etc!)! The 4B will take into

account the relevant risk factors and the internal capital ade,uacy assessments of each

bank to ensure that the capital held by a bank is commensurate with the bank%s overall

risk profile! This would include& among others& the effectiveness of the bank%s riskmanagement systems in identifying& assessing 2 measuring& monitoring and managing

various risks including interest rate risk in the banking book& li,uidity risk& concentration

risk and residual risk! *ccordingly& 4B will consider prescribing a higher level of

minimum capital ratio for each bank under the .illar " framework on the basis of their

respective risk profiles and their risk management systems! +urther& in terms of the

.illar " re,uirements& banks are e'pected to operate at a level well above the minimum

re,uirement!

The total regulatory capital fund will consist of the sum of the following categories:-

(i) Tier $ Capital (going-concern capitalA): comprises of:-(a) Common ?,uity Tier $ capital(b) *dditional Tier $ capital

(ii) Tier " Capital (gone-concern capitalA)

(A+rom regulatory capital perspective& going-concern capital is the capital which canabsorb losses without triggering bankruptcy of the bank! >one-concern capital is thecapital which will absorb losses only in a situation of li,uidation of the bank)!

Banks are re,uired to compute the Basel capital ratios in the following manner:-

Common ?,uity Tier $Capital 4atio

Common ?,uity Tier $ CapitalCredit 4isk 4*A 6arket 4isk 4* Dperational4isk 4*

Tier $ Capital 4atio ?ligible Tier $ CapitalCredit 4isk 4*A 6arket 4isk 4* Dperational4isk 4*


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Total Capital (C4*4E) ?ligible Total CapitalCredit 4isk 4* 6arket 4isk 4* Dperational4isk 4*

A 4* F 4isk weighted *ssets5E Capital to 4isk eighted *sset 4atio

Elements o! Capital !unds Indian Ban"s

(i) Common Euit# Tier $ capital

i) Common shares (*ll common shares should ideally be the voting shares asdetailed in 4B 6! Cir!)

ii) Stock surplus (share premium)iii) Statutory reservesiv) Capital reserves representing surplus arising out of sale proceeds of assetsv) Dther disclosed free reserves& if anyvi) Balance in .rofit G 9oss *ccount at the end of previous year

vii).rofit for current year calculated on ,uarterly basis as per the formula given in4B Cir! (9ess: 4egulatory adjustments2 deductions)

(ii) Additional Tier $ capitali) .erpetual on-cumulative .reference shares (.C.S)ii) Stock surplus (share premium)iii) ebt capital instrumentsiv) *ny other type of instruments as notified by 4B from time to time!

(9ess: 4egulatory adjustments2 deductions)

(iii) Tier % Capital

i) >eneral .rovisions and 9oss 4eservesii) ebt capital instruments issued by banksiii) .reference share capital instruments (.C.S24C.S24C.S)iv) Stock surplusesv) 4evaluation reserves at a discount of HHeneral .rovisions and 9oss 4eservesii) I!D! borrowings in foreign currencyiii) 4evaluation reserves at a discount of HHovt! e'posure would also apply to claims on4B& C>T6S?& and Credit 4isk >uarantee +und Trust for 9ow ncome Iousing(C4>+T9I)! The claims on ?C>C will attract a risk weight of "#

d. L*mount 4eceivable from >D% under *gricultural ebt aiver Scheme "##; is to

be treated as claim on >D and attract /ero risk weight whereas the amountoutstanding in the accounts covered by the ebt 4elief Scheme shall be treatedas a claim on the borrower and risk weighted as per the e'tant norms!

Claims on +oreign SovereignsClaims on +oreign Sovereigns in foreign currency would be as per the rating assigned asdetailed in the 4B circular! n case of claims dominated in domestic currency of +oreignSovereign met out of the resources in the same currency& the /ero risk weight would be


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applicable!

Claims on .ublic Sector ?ntities (.S?)Claims on domestic .S?s and .rimary ealers (.) would be risk weighted in thesame manner that of corporate and foreign .S?s as per the rating assigned by foreign

rating agencies as detailed in the Circular!

Dther claims

Claims on 6+& Bank for nternational Settlements (BS)& and eligible 6ultilateralevelopment Banks (6Bs) evaluated by the BCBS will be treated similar toclaims on scheduled banks at a uniform "#< risk weight!Similarly& claims onthe nternational +inance +acility for mmuni/ation (++m) will also attract atwenty per cent risk weight

Claims on Banks incorporated in ndia and +oreign Banks% branches in ndia& theapplicable risk weight is detailed in the 4B 6aster Circular!

Banks% investment in capital instruments of other banks such investments would

not be deducted& but would attract appropriate risk as detailed in the 4B 6!Circular!

Claims on corporate*sset +inance Companies (*+Cs) and on-Banking+inance Companies-nfrastructure +inance Companies (B+C-+C)& shall berisk weighted as per the ratings assigned by the rating agencies registeredwith the S?B and accredited by the 4B (etailed in the Circular)!

The claims on non-resident corporate will be risk weighted as per the ratingsassigned by international rating agencies!

4egulatory 4etail claims (both fund and non-fund based) which meet theMualifying criteria& vi/!

a) Orientation Criterion: ?'posure to individual person2s or to a small business(*verage annual turnover less than 4s! H# crore for last 0 years in case of e'istingor projected turnover in case of new units)5

b) Product Criterion: ?'posure (both fund-based and non fund-based) in form ofrevolving credits and lines of credit (incl! overdrafts)& term loans G leases (e!g!instalment loans and leases& student and educational loans) and small businessfacilities and commitments

c) Granularit# CriterionN Sufficient diversification to reduce the risk portfolio5and

d) Lo1 2alue o! indi2idual e*posures - The ma'imum aggregated retaile'posure to one counterpart should not e'ceed the absolute threshold limit of 4s!

H crore!

)ould attract ris" 1ei'0t o! 34( e'cept .*s! *s part of thesupervisory review process& the 4B would also consider whether the credit ,uality ofregulatory retail claims held by individual banks should warrant a standard risk weighthigher than @H

The 4* on claims secured by mortgage of residential properties would be as


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under:-

Category of 9oan 9TO 4atio (


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.* Iome 9oan claims secured by residential property& the risk weight shallbe $##< net of specific provisions! n case the specific provisions are at least"#< but less than H#< of the outstanding& the risk weight shall be @H< (net ofspecific provisions) and specific provisions are H#< or more the applicable riskweight is H#

Dther specified categories

Category 4isk eight(


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5e!initions and 'eneral terminolo'#

Counterpart# Credit Ris" -CCR/

CC4 is the risk that the counterparty to a transaction could default before the finalsettlement of the transaction3s cash flows!

Securities &inancin' Transactions -S&Ts/

S+Ts are transactions such as repurchase agreements& reverse repurchaseagreements& security lending and borrowing& collateralised borrowing and lending(CB9D) and margin lending transactions& where the value of the transactionsdepends on market valuations and the transactions are often subject to marginagreements!

6ed'in' Set

Iedging Set is a group of risk positions from the transactions within a singlenetting set for which only their balance is relevant for determining the e'posureamount or ?* under the CC4 standardised method!

Current E*posure

Current ?'posure is the larger of /ero& or the market value of a transaction orportfolio of transactions within a netting set with a counterparty that would be lostupon the default of the counterparty& assuming no recovery on the value of thosetransactions in bankruptcy! Current e'posure is often also called 4eplacementCost!

Credit 7aluation Ad+ustment

t is an adjustment to the mid-market valuation of the portfolio of trades withcounterparty! This adjustment reflects the market value of the credit risk due to anyfailure to perform on contractual agreements with counterparty! This adjustmentmay reflect the market value of the credit risk of the counterparty or the marketvalue of the credit risk of both the bank and the counterparty!

One8Sided Credit 7aluation Ad+ustment

t is a credit valuation adjustment that reflects the market value of the credit risk ofthe counterparty to the firm& but does not reflect the market value of the credit riskof the bank to the counterparty!

5e!ault Ris" Capital C0ar'e !or CCRThe e'posure amount for the purpose of computing for default risk capital chargefor counterparty credit risk will be calculated using the Current ?'posure 6ethod(C?6) as detailed in the Circular!

Capitali9ation o! mar"8to8mar"et counterpart# ris" losses -C7A capitalc0ar'e/


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n addition to the default risk capital re,uirement for counterparty credit risk& banks

are also re,uired to compute an additional capital charge to cover the risk ofmark-to-market losses on the e'pected counterparty risk (such losses beingknown as credit value adjustments& CO*) to DTC derivatives! The CO* capital

charge will be calculated in the manner as indicated in the 4B Circular!

&ailed Transactions

a. ith regard to unsettled securities and foreign e'change transactions& banksare e'posed to counterparty credit risk from trade date& irrespective of thebooking or the accounting of the transaction! Banks may develop andimplement suitable systems for tracking and monitoring the credit risk e'posurearising from unsettled transactions as appropriate for producing managementinformation that facilitates action on a timely basis!

b. Banks must closely monitor securities and foreign e'change transactions thathave failed& starting from the day they fail for producing managementinformation that facilitates action on a timely basis

c. +ailure of transactions settled through a delivery-versus-payment system (v.)&providing simultaneous e'changes of securities for cash& e'pose banks to a riskof loss on the difference between the transaction valued at the agreedsettlement price and the transaction valued at current market price (i!e! positivecurrent e'posure)!

d. +or v. Transactions - f the payments have not yet taken place five business

days after the settlement date& banks are re,uired to calculate a capital charge

by multiplying the positive current e'posure of the transaction by theappropriate factor as given in the Circular! n order to capture the information&

banks may upgrade their information systems in order to track the number of

days after the agreed settlement date and calculate the corresponding capital

charge!

e. +or non-v. transactions (free deliveries) after the first contractual payment2delivery leg& the bank that has made the payment will treat its e'posure as aloan if the second leg has not been received by the end of the business day!

E*ternal Credit Assessment

4B has identified various credit agencies whose ratings may be used by banks forthe purposes of risk weighting their claims for capital ade,uacy purposes under therevised framework as under:-

(a) Brickwork 4atings ndia .vt! 9imited (Brickwork)5(b) Credit *nalysis and 4esearch 9imited5(c) C4S9 9imited5(d) C4* 9imited5


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(e) ndia 4atings and 4esearch .rivate 9imited (ndia 4atings)5 and(f) S6? 4ating *gency of ndia 9td! (S6?4*)

nternational *gencies (where specified)

a. +itch

b. 6oodys5 and

c. Standard G .oor%s

Banks are re,uired to use the chosen credit rating agencies and their ratingsconsistently for each type of claim& for both risk weighting and risk managementpurposes! The revised framework recommends development of a mapping process toassign the ratings issued by eligible credit rating agencies to the risk weights availableunder the Standardised risk weighting framework! 1nder the +ramework& ratings havebeen mapped for appropriate risk weights applicable as per Standardised approach!The risk weight mapping for 9ong Term and Short Term 4atings are given in the

Circular!

Credit Ris" Miti'ation Tec0niues

Banks use a number of techni,ues to mitigate the credit risks to which they aree'posed! +or e'ample& e'posures may be collateralised in whole or in part by cash orsecurities& deposits from the same counterparty& guarantee of a third party& etc! n orderfor banks to obtain capital relief for any use of C46 techni,ues& certain minimumstandards for legal documentation must be met! *ll documentation used in collateralisedtransactions and guarantees must be binding on all parties and legally enforceable in allrelevant jurisdictions! Banks must have conducted sufficient legal review& which should

be well documented& to verify this re,uirement! Such verification should have a well-founded legal basis for reaching the conclusion about the binding nature andenforceability of the documents

+ew of such C46 techni,ues are given below:-

a) Collaterali9ed transactionsN

The credit e'posure is hedged in whole or part by collaterals by a counterparty(party to whom a bank has an on-or off balance sheet credit e'posure)or by athird party on behalf of the counterparty and banks have specific lien over the

collaterals 1nder the +ramework& banks are allowed to adopt either Simple *pproach or

Comprehensive *pproach! The former approach substitutes the riskweighting of the collateral for the risk weighting of the counterparty for thecollateraised portion of the e'posure and under the latter approach whichallows fuller offset of collaterals against e'posures! Comprehensive approachis being adopted by banks in ndia!

n the comprehensive approach& when taking collateral& banks will need to


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calculate their adjusted e'posure to a counterparty for capital ade,uacypurposes in order to take account of the effects of that collateral!

6air Cut

n the comprehensive approach& Banks are re,uired to adjust both the amount of the

e'posure to the counterparty and the value of any collateral received in support ofthat counterparty to take account of possible future fluctuations in the value of either&occasioned by market movements! These adjustments are referred to as Lhaircuts%!The application of haircuts will produce volatility adjusted amounts for both e'posureand collateral! The volatility adjusted amount for the e'posure will be higher than thee'posure and the volatility adjusted amount for the collateral will be lower than thecollateral& unless either side of the transaction is cash! n other words& the Lhaircut%for the e'posure will be a premium factor and the Lhaircut% for the collateral will be adiscount factor!

t may be noted that the purpose underlying the application of haircut is to capturethe market-related volatility inherent in the value of e'posures as well as of the

eligible financial collaterals! here the volatility-adjusted e'posure amount is greaterthan the volatility-adjusted collateral amount (including any further adjustment forforeign e'change risk)& banks shall calculate their risk-weighted assets as thedifference between the two multiplied by the risk weight of the counterparty!

Banks have two ways of calculating the haircuts vi/! (i) Standard supervisoryhaircuts5 using parameters set by the Basel Committee& and (ii) Dwn estimatehaircuts& using banks% own internal estimates of market price volatility! Banks in ndiashall use onl# t0e standard super2isor# 0aircutsfor both the e'posure as well asthe collateral! The Standard Supervisory Iaircuts (assuming daily mark-to-market&daily re-margining and a $# business-day holding period)& e'pressed aspercentages& are given in detail in the 4B Circular!

Eli'i:le &inancial Collateral in Compre0ensi2e approac0

Cash& >old& Securities issued by Central G State >overnments& 7O.& SC (no lock inperiod is operational)& 9C policies& ebt securities (rated by a chosen rating agency)&ebt Securities ( not rated by a chosen Credit 4ating *gency in respect of whichbanks should be sufficiently confident about the market li,uidity)& 1nits of 6utual +unds&etc! are eligible financial instruments for recognition in the Comprehensive *pproach!

Calculation o! capital reuirement

+or a collateralised transaction& the e'posure amount after risk mitigation is calculated

as follows:

?A F ma' J#& P? ' ($ Ie) - C ' ($ - Ic- If')QK

here:

?A F the e'posure value after risk mitigation

? F current value of the e'posure for which the collateral ,ualifies as a risk mitigant


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IeF haircut appropriate to the e'posure

C F the current value of the collateral receivedIc F haircut appropriate to the collateral

If'F haircut appropriate for currency mismatch between the collateral and e'posure

The e'posure amount after risk mitigation (i!e!& ?A) will be multiplied by the risk weight ofthe counterparty to obtain the risk-weighted asset amount for the collateralisedtransaction! (llustrative e'amples calculating the effect of Credit 4isk 6itigation isfurnished in the 4B Circular)!

b) On Balance S0eet Nettin'N

Dn-balance sheet netting is confined to loans2advances and deposits! 1nder thistechni,ue& banks have legally enforceable netting arrangements involving specific lienwith proof of documentation! Capital re,uirement is reckoned on the basis of net credite'posure! Banks may calculate capital re,uirements on the basis of net credit e'posures

subject to some conditions as listed in the Circular!

c) GuaranteesN

?'plicit& irrevocable& and unconditional guarantees may be taken as credit protection in

calculating capital re,uirements! >uarantees issued by entities with lower risk weight as

compared to the counterparty will lead to reduced capital charges since the protected

portion of the counterparty e'posure is assigned the risk weight of the guarantor&

whereas the uncovered portion retains the risk weight of the underlying counterparty!

etailed operational re,uirements for guarantees eligible for being treated as a C46

are given in the 4B Circular!

2. Capital c0ar'e !or Mar"et Ris"

6arket 4isk relates to risk of losses in on-balance sheet and off-balance sheet positionsarising on account of movement in market prices! The market risk positions subject tocapital charge re,uirement are risks pertaining to interest raterelated instruments intrading books and e,uities and &orei'n E*c0an'e ris" (including gold and otherprecious metals) in both trading and banking books!

Trading book for the purpose of capital ade,uacy will include:

a. Securities included under the Ield for Trading (I+T) categoryb. Securities included under the *vailable for Sale (*+S) categoryc. Dpen gold position limitsd. Dpen foreign e'change position limitse. Trading positions in derivatives& andf. erivatives entered into for hedging trading book e'posures!


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Banks are re,uired to manage the market risks in their books on an ongoing basis andensure that the capital re,uirements for market risks are being maintained on acontinuous basis& i!e! at the close of each business day! Banks are also re,uired tomaintain strict risk management systems to monitor and control intra-day e'posures tomarket risks!

Capital for market risk would not be relevant for securities which have already maturedand remain unpaid! These securities will attract capital only for credit risk! Dncompletion of 8# days delin,uency& these will be treated on par with .*s fordeciding the appropriate risk weights for credit risk!

Measurement o! capital c0ar'e !or Interest Rate Ris"

The capital charge for interest rate related instruments would apply to current marketvalue of the instruments in bank%s trading book and banks are re,uired to maintaincapital for market risks on an ongoing basis by mark to market their trading positions on

a daily basis!

The minimum capital re,uirement is measured2 e'pressed in two ways vi/! (i)Specific 4isk charge and (ii) >eneral 6arket 4isk (dealt separately)!

n view of possible longer holding period and higher risk thereto in respect of debtsecurities held under *+S category& banks are re,uired to hold capital charge formarket risk e,ual to or greater of the Specific 4isk Capital charge or *lternative TotalCapital Charge!

i) Specific 6arket 4isk

The capital charge for specific risk is designed to protect against an adverse movementin the price of an individual security owing to factors related to the individual issuer bothshort (short position is not allowed in ndia e'cept in derivatives) and long positions!The specific risk charges and *lternative Total Capital Charge for various kinds ofe'posures are detailed in Tabular +orm in the 4B Circular!

ii) >eneral 6arket 4iskt relates to charge towards interest rate risk in the portfolio& where long and shortposition (which is not allowed in ndia e'cept in derivatives G Central >ovt!securities) in different securities or instruments can be offset! The capital re,uirementsfor general market risk are designed to capture the risk of loss arising from changes inmarket interest rates!

>eneral 6arket 4isk is the sum of the following four components:-

a) The net short (short position is not allowed in ndia e'cept in derivatives) or longposition in the whole trading book5

b) a small proportion of the matched positions in each time-band (the Rverticaldisallowance)5


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c) a larger proportion of the matched positions across different time-bands (theRhori/ontal disallowance)& and

d) a net charge for positions in options& where appropriate!

The Basel Committee has suggested two broad methodologies for computation of

capital charge for market risks vi/! Standardised 6ethod and nternal 4isk 6anagementmodels method of which banks have been advised to adopt Standardised 6ethodas banks have not yet developed their nternal 4isk 6anagement system!

1nder the standardised method there are two principal methods of measuringmarket risk vi/! a Rmaturity method and a Rduration method! t has been decided toadopt standardised Rduration method as the same is more accurate method to arrivethe capital charge! *ccordingly& banks are re,uired to measure the general market riskcharge by calculating the price sensitivity (modified duration) of each positionseparately! The mechanics under the method - Time band and assumed changes inyield are detailed in the Circular for reference!

Measurement !or capital c0ar'e !or Euit# Ris"

The capital charge for e,uities would apply on their current market value in bank%strading book!The 6inimum capital re,uirement& to cover the risk of holding or takingpositions in e,uities in the trading book is detailed in the Circular! The instrumentscovered include e,uity shares& whether voting or non-voting& convertible securitiesthat behave like e,uities& for e'ample: units of mutual funds& and commitments to buy orsell e,uity!

Capital charge for specific risk (akin to credit risk) will be $$!"H< or capitalcharge in accordance with the risk warranted by e'ternal rating of the counterparty&

whichever is higher and specific risk is computed on banks3 gross e,uity positions(i!e! the sum of all long and all short e,uity positions - short e,uity position is&however& not allowed for banks in ndia)! n addition& the general market risk chargewill also be 8< on the gross e,uity positions! These capital charges will also beapplicable to all trading book e'posures& which are e'empted from capital markete'posure ceilings for direct investments!

Specific 4isk Capital Charge for banks% investment in Security 4eceipts will be $0!Heneral 6arket 4iskCapital Charge on them!

Measurement o! capital c0ar'e !or &orei'n E*c0an'e Ris"

The bank%s net open position in each currency shall be calculated by summing:

a) The net spot position (i!e! all asset items less all liability items& including accruedinterest& denominated in the currency in ,uestion)5


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b) The net forward position (i!e! all amounts to be received less all amounts to bepaid under forward foreign e'change transactions& including currency futures andthe principal on currency swaps not included in the spot position)5

c) >uarantees (and similar instruments) that are certain to be called and are likelyto be irrecoverable5

d) et future income2e'penses not yet accrued but already fully hedged (at thediscretion of the reporting bank)5e) epending on particular accounting conventions in different countries& any other

item representing a profit or loss in foreign currencies5f) The net delta-based e,uivalent of the total book of foreign currency options!

The open positions both +oreign e'change and gold are at present risk-weighted at$##< and the capital charge for market risks in foreign e'change and gold openposition is 8

e'change and gold transactions!

6easurement of capital charge for Credit efault Swap (CS) in the trading book&Capital charge for Counterparty Credit 4isk& Capital charge for Counterparty 4isk forCollaterised Transactions in CS& *ggregation of the capital charge for 6arket 4isks&Treatment for lli,uid .ositions& Oaluation 6ethodologies& etc! are detailed in the 4BCircular for reference!

3. Capital c0ar'e !or Operational Ris"

Dperational risk is termed as the risk of loss resulting from inade,uate or failed

internal processes& people and systems or from e'ternal events! This includes legal risk&but e'cludes strategic and reputational risk! 9egal risk includes& but is not limited to&e'posure to fines& penalties& or punitive damages resulting from supervisory actions&as well as private settlements!

Measurement Met0odolo'ies

Three methods for calculating operational risk capital charges in continuum of increasingsophistication and risk sensitivity are provided under C*+ vi/!

i) The Basic ndicator *pproach (B*)ii) The Standardised *pproach (TS*)& andiii)*dvanced 6easurement *pproach (*6*)!

Banks are advised& to begin with& to adopt the Basic ndicator *pproach (B*) and 4Bwould review the capital re,uirement under B* for general credibility and in case it isfound any la'ity& appropriate Supervisory action under .illar " will be considered!


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1nder B*& banks are re,uired to hold capital for operational risk e,ual to the averagepositive annual gross income over the previous 0 years! n case the gross income for anyyear is negative or /ero& the same should be e'cluded while calculating the average! 4Bwill initiate necessary supervisory action under .illar " in case the negative gross incomedistorts banks .illar capital charge (the working is illustrated in the 4B Circular)

B. Super2isor# Re2ie1 and E2aluation Process -SREP/ -Pillar %/

The objective of Supervisory 4eview .rocess (S4.) is to:-

a. ?nsure that banks have ade,uate capital to support all the risks in theirbusiness5 and

b. ?ncourage them to develop and use better risk management techni,ues formonitoring and managing their risks!

This in turn would re,uire a well-defined internal assessment process within banks throughwhich they assure the 4B that ade,uate capital is indeed held towards the various risks to

which they are e'posed! The process of assurance could also involve an active dialogue

between the bank and the 4B so that& when warranted& appropriate intervention could be

made to reduce the risk e'posure of the bank or augment 2 restore its capital! Thus& nternal

Capital *de,uacy *ssessment .rocess (C**.) is an important component of the S4.!

The main aspects to be addressed under S4.2C**. would include:-

a) The risks that are not fully captured by the minimum capital ratio prescribed under.illar $5

b) The risks that are not at all taken into account by the .illar $5 andc) The factors e'ternal to the bank!

The capital ade,uacy ratio prescribed under .illar $ is only the minimum and addressesonly the three risks vi/! credit& market and operation risks& holding of additional capital mightbe necessary for banks to take care of the possible under-estimation of risks under the.illar $ and the actual risk e'posure of a bank vis--vis the ,uality of its risk managementarchitecture! Some of the risks which are generally e'posed to but not fully captured in theregulatory C4*4 include:-

a) nterest rate risk in the banking book5

b) Credit concentration risk5

c) 9i,uidity risk5d) Settlement risk5

e) 4eputational risk5

f) Strategic risk5

g) 4isk of under-estimation of credit risk under the Standardised approach5

h) 6odel risk i!e!& the risk of under-estimation of credit risk under the 4B approaches5

i) 4isk of weakness in the credit-risk mitigants5


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j) 4esidual risk of securitisation& etc!

t is& therefore& only appropriate that the banks make their own assessment of their variousrisk e'posures& through a well-defined internal process& and maintain an ade,uate capitalcushion for such risks! Banks were advised to develop and put in place& with the approvalof their Boards& an C** .& in addition to a bank%s calculation of regulatory capitalre,uirements under .illar $& commensurate with their si/e& level of comple'ity& riskprofile and scope of operations! The C**. was operationalised w!e!f! 6arch "##; byforeign banks and 6arch "##8 by ndian Banks!

Based on the three mutually reinforcing .illars i!e! .illar $& .illar "& and .illar 0& theBasel Committee lays down four key principles under the S4. as under:-

a) Banks are re,uired to have a process for assessing their overall capitalade,uacy in relation to their risk profile and a strategy for maintaining theircapital levels!

b) ?valuation of banks% internal capital ade,uacy assessments and strategies

as well as their ability to monitor and ensure their compliance with theregulatory capital ratios by Supervisors!

c) Supervisors should e'pect banks to operate above the minimumregulatory capital ratios and should have the ability to re,uire banks to holdcapital in e'cess of the minimum!

d) Supervisors should intervene at an early stage to prevent capital from fallingbelow the minimum levels re,uired to support the risk characteristics of aparticular bank and should re,uire rapid remedial action if capital is notmaintained or restored!

The .rinciples a ; c relates to the supervisory e'pectations while others i!e! : ; d

deals with the role of the supervisors under .illar "! This necessitates evolvement of aneffective C**. for assessing their capital ade,uacy based on the risk profiles as wellas strategies for maintaining their capital levels! .illar " also re,uires the Supervisoryauthorities to put in place an evaluation process known as Super2isor# Re2ie1 andE2aluation Process -SREP/ and to initiate supervisory measures as may benecessary! This would also facilitate 4B to take suitable steps either to reducee'posure of the bank or augment2restore its capital!

Based on the principles& responsibilities have been casted on banks and Supervisorsunder S4?. and based on which banks are e'pected to operate above the minimumregulatory capital ratios commensurate with their individual risk profiles& etc! 1nder

S4?.& the 4B will assess the overall capital ade,uacy through comprehensiveevaluation along with *nnual +inancial nspection (*+) based relevant data and C**.document being received from banks and available information! C**. and S4?. are "important components of .illar "!

?very bank (e'cept 9*Bs G 44Bs) should have an C**. both at solo andconsolidated levels and the responsibility of designing and implementation of the C**.rests with the Board! Before embarking on new activities or introducing new products


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the senior management should identify and review the related risks arising from thesepotential new products or activities and ensure that the infrastructure and internalcontrols necessary to manage the related risks are in place!

Banks are re,uired to put in place an effective 6S which should provide the board and

senior management a clear and concise manner with timely and relevant informationconcerning their institutions% risk profile including risk e'posure!6S should be capableof capturing limit breaches (concentrations) and same should be promptly reported tosenior management& as well as to ensure that appropriate follow-up actions aretaken! 4isk management process should be fre,uently monitored and tested byindependent control areas and internal and e'ternal auditors!

The C**. should form an integral part of the management and decision-makingculture of a bank! The implementation of C**. should be guided by the principle ofproportionality and 4B e'pects degree of sophistication in the C**. in regard to riskmeasurement which should commensurate with the nature& scope& scale and the degree

of comple'ity in the bank%s business operations!

Dperational aspects of C**.

The C**. of banks is e'pected normally to capture the risk universe& vi/ !Credit 4isk&6arket 4isk& Dperational 4isk& interest rate risk in the banking book& creditconcentration risk and li,uidity risk! Dther risks include reputational risk and orbusiness or strategic risk& Dff-balance sheet ?'posure and Securitisation 4isk etc!(Oarious risks are briefly outlined in the 4B Circular)!

Bank%s risk management process including the C**. should be consistent with

the e'isting 4B guidelines on these risks! f banks adopt risk mitigation techni,ues&they should understand the risk to be mitigated and reckoning its enforceability andeffectiveness on the risk profile of the bank!

Sound Stress Testing .ractices

Stress testing that alerts bank management to adverse une'pected outcomes relatedto a broad variety of risks and provides an indication to banks of how much capitalmight be needed to absorb losses should large shocks occur! t is an importanttool that is used by banks as part of their internal risk management!6oreover&stress testing supplements other risk management approaches and measures!

Sound Compensation .ractices

4isk management must be embedded in the culture of a bank and should be underthe critical focus of the Senior 6anagement of the bank! +or developing andmaintaining a broad and deep risk management culture over time& compensationpolicies may be drawn which should be linked to longer-term capital preservation andthe financial strength of the firm& and should consider risk-adjusted performance


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measures! n addition& a bank should provide ade,uate disclosure regarding itscompensation policies to stakeholders!

C. Mar"et 5iscipline- (Pillar eneral isclosure for all banks5and Credit 4isk: isclosures for .ortfolios subject to the Standardised*pproach! These are to be made at least on a ,uarterly basis by banks! *lldisclosures must either be included in a bank%s published financial results2statements or at a minimum& must be disclosed on bank%s website!

Banks are re,uired to make disclosures in the prescribed format by 4B! Banks arealso re,uired to maintain a L4egulatory isclosures Section% on their website whereall information relating to disclosures will be made available to the marketparticipants! The link should be prominently provided on the home page of thewebsite so as to make it easily accessible! *n archive for at least three years of all


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templates relating to prior reporting periods should be made available by banks ontheir websites!

Post Marc0


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include reducing dividend payments& share buybacks and staff bonus payments! Banksmay also choose to raise new capital from the market as an alternative to conservinginternally generated capital! n the absence of raising capital from the market& the shareof earnings retained by banks for the purpose of rebuilding their capital buffers shouldincrease the nearer their actual capital levels are to the minimum capital re,uirement!

The capital conservation buffer can be drawn down only when a bank faces asystemic or idiosyncratic stress! * bank should not choose in normal times to operate inthe buffer range simply to compete with other banks and win market share! This aspectwould be specifically looked into by 4B during the S4?.! The banks which draw downtheir capital conservation buffer during a stressed period should also have a definiteplan to replenish the buffer as part of its C**. and strive to bring the buffer to thedesired level within a time limit agreed to with 4B during the S4?.!

The framework of capital conservation buffer will enable the banks to:-

a) Strengthen the ability of banks to withstand adverse economic environmentconditions&

b) Ielp increase banking sector resilience both going into a downturn5 and

c) .rovide the mechanism for rebuilding capital during the early stages of economic

recovery!

By retaining a greater proportion of earnings during a downturn& banks will be able to

help ensure that capital remains available to support the ongoing business operations 2

lending activities during the period of stress! Therefore& this framework is e'pected to

help reduce pro-cyclicality!

&rame1or"Banks are re,uired to maintain a capital conservation buffer of "!H< of 4* in the formof Common ?,uity Tier $ capital above the regulatory minimum capital re,uirement of8


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capital regulation

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