Capital Adequacy Ratio?

The capital adequacy ratio measures the ability of a bank to meet its obligations by
comparing its capital to its assets.  Regulatory authorities monitor this ratio to see if any
banks are at risk of failure. The intent behind their monitoring is to protect the financial
system from the negative effects of any bank failures, which includes protecting the funds of
bank depositors.

How to Calculate the Capital Adequacy Ratio

To calculate the capital adequacy ratio, add together the amounts of Tier 1 and Tier 2 capital
and then divide by the total amount of risk-weighted assets. The formula is as follows:
Capital adequacy ratio = (Tier 1 capital + Tier 2 capital) ÷ Risk-weighted assets

When this ratio is high, it indicates that a bank has an adequate amount of capital to deal
with unexpected losses. When the ratio is low, a bank is at a higher risk of failure, and so
may be required by the regulatory authorities to add more capital.

Tier 1 capital
 It can absorb losses without requiring a bank to stop trading.
 This includes ordinary share capital, equity capital, audited revenue reserves,
and intangible assets.
 It is also referred to as core capital.
 This is permanently available capital that can be used to absorb losses incurred
by a bank without forcing it to cease operations.
Tier 2 capital
 This can absorb losses if the bank goes bankrupt, providing depositors with a
lesser level of protection.
 Unaudited reserves, unaudited retained earnings, and general loss reserves make
up this category.
 This capital absorbs losses after a bank loses all of its tier 1 capital and is used
to cushion losses if the bank is winding up.

Risk-weighted assets
  These assets are used to determine the minimum amount of capital that banks
should hold in order to reduce their insolvency risk.
 The capital required for all types of bank assets is determined by risk
assessment.

Importance of Capital Adequacy Ratio

 The CAR is set by central banks and bank regulators to prevent commercial
banks from taking on too much leverage and becoming insolvent.
 The CAR is necessary to ensure that banks have enough leeway to absorb a
reasonable amount of loss before becoming insolvent and losing depositors'
funds.
 A bank with a high CRAR/CAR is considered safe/healthy and likely to meet
its financial obligations.
 When a bank is being wound up, depositors' funds take precedence over the
bank's capital, so depositors will lose their savings only if the bank suffers a
loss greater than its capital.
 As a result, the higher the CAR, the greater the protection for depositors' funds
held by the bank.
 The CAR contributes to the stability of an economy's financial system
by lowering the risk of bank insolvency.

Conclusion
At the time of the company's dissolution, the depositors' assets are more valuable than
the company's own finances. CAR ensures that there is a layer of safety in place for the
bank to manage its own risk-weighted assets before it can manage the assets of its
depositors.

Basel III norms have prescribed a CAR of 8%. Indian public sector banks must maintain

a CAR of 12%, while Indian scheduled commercial banks must maintain a CAR of 9%.

Basel norms
  Basel norms or Basel accords are the international banking regulations issued by
the Basel Committee on Banking Supervision.

 The Basel norms is an effort to coordinate banking regulations across the globe, with
the goal of strengthening the international banking system.

 It is the set of the agreement by the Basel committee of Banking

Supervision which focuses on the risks to banks and the financial system.

What is the Basel committee on Banking Supervision?

 The Basel Committee on Banking Supervision (BCBS) is the primary global

standard setter for the prudential regulation of banks and provides a forum for
regular cooperation on banking supervisory matters for the central banks of different
countries.

 It was established by the Central Bank governors of the Group of Ten countries

in 1974.

 The committee expanded its membership in 2009 and then again in 2014. The
BCBS now has 45 members from 28 Jurisdictions, consisting of Central Banks and
authorities with responsibility of banking regulation.

 It provides a forum for regular cooperation on banking supervisory matters.

 Its objective is to enhance understanding of key supervisory issues and improve the

quality of banking supervision worldwide.

Why these norms?

 Banks lend to different types of borrowers, and each carries its own risk.

 They lend the deposits of the public as well as money raised from the market i.e.,
equity and debt.

 This exposes the bank to a variety of risks of default and as a result they fall at

times.

 Therefore, Banks have to keep aside a certain percentage of capital as security against
the risk of non – recovery.
  The Basel committee has produced norms called Basel Norms for Banking to tackle
this risk.

Why the name Basel?

 Basel is a city in Switzerland.

 It is the headquarters of the Bureau of International Settlement (BIS), which

fosters cooperation among central banks with a common goal of financial stability and
common standards of banking regulations.

 It was founded in 1930.

 The Basel Committee on Banking Supervision is housed in the BIS offices in

Basel, Switzerland.

What are these norms?

The Basel Committee has issued three sets of regulations which are known as Basel-I, II, and
III.

 Basel-I

o It was introduced in 1988.

o It focused almost entirely on credit risk.

o Credit risk is the possibility of a loss resulting from a borrower's failure to

repay a loan or meet contractual obligations. Traditionally, it refers to the risk
that a lender may not receive the owed principal and interest.

o It defined capital and structure of risk weights for banks.

o The minimum capital requirement was fixed at 8% of risk weighted assets

(RWA).

o RWA means assets with different risk profiles.

o For example, an asset backed by collateral would carry lesser risks as

compared to personal loans, which have no collateral.

o India adopted Basel-I guidelines in 1999.

 Basel-II
 o In 2004, Basel II guidelines were published by BCBS.

o These were the refined and reformed versions of Basel I accord.

o The guidelines were based on three parameters, which the committee calls

it as pillars.

 Capital Adequacy Requirements: Banks should maintain a minimum

capital adequacy requirement of 8% of risk assets

 Supervisory Review: According to this, banks were needed to develop

and use better risk management techniques in monitoring and
managing all the three types of risks that a bank faces, viz. credit,
market and operational risks.

 Market Discipline: This needs increased disclosure requirements.

Banks need to mandatorily disclose their CAR, risk exposure, etc to
the central bank.

o Basel II norms in India and overseas are yet to be fully implemented

though India follows these norms.

 Basel III

o In 2010, Basel III guidelines were released.

o These guidelines were introduced in response to the financial crisis of 2008.

o A need was felt to further strengthen the system as banks in the developed
economies were under-capitalized, over-leveraged and had a greater reliance
on short-term funding.

o It was also felt that the quantity and quality of capital under Basel II were
deemed insufficient to contain any further risk.

 The guidelines aim to promote a more resilient banking system by focusing on four
vital banking parameters viz. capital, leverage, funding and liquidity.

o Capital: The capital adequacy ratio is to be maintained at 12.9%. The

minimum Tier 1 capital ratio and the minimum Tier 2 capital ratio have to be
maintained at 10.5% and 2% of risk-weighted assets respectively.
  In addition, banks have to maintain a capital conservation buffer of
2.5%. Counter-cyclical buffer is also to be maintained at 0-2.5%.

o Leverage: The leverage rate has to be at least 3 %. The leverage rate is the

ratio of a bank’s tier-1 capital to average total consolidated assets.

o Funding and Liquidity: Basel-III created two liquidity ratios: LCR and

NSFR.

 The liquidity coverage ratio (LCR) will require banks to hold a

buffer of high-quality liquid assets sufficient to deal with the cash
outflows encountered in an acute short term stress scenario as specified
by supervisors.

 This is to prevent situations like “Bank Run”. The goal is to

ensure that banks have enough liquidity for a 30-days stress
scenario if it were to happen.

 The Net Stable Funds Rate (NSFR) requires banks to maintain a

stable funding profile in relation to their off-balance-sheet assets and
activities. NSFR requires banks to fund their activities with stable
sources of finance (reliable over the one-year horizon).

 The minimum NSFR requirement is 100%. Therefore, LCR

measures short-term (30 days) resilience, and NSFR measures
medium-term (1 year) resilience.

 The deadline for the implementation of Basel-III was March 2019 in India. It was
postponed to March 2020. In light of the coronavirus pandemic, the RBI decided to
defer the implementation of Basel norms by further 6 months.

o Extending more time under Basel III means lower capital burden on the banks
in terms of provisioning requirements, including the NPAs.

o This extension would impact the perception of Indian Banks and central banks
in the eyes of the global players.

Bank run
It occurs when a large number of customers of a bank or other financial institution withdraw
their deposits simultaneously over concerns of the bank's solvency. As more people withdraw
their funds, the probability of default increases, prompting more people to withdraw their
deposits.

Countercyclical capital buffer (CCCB)

 Following Basel-III norms, central banks specify certain capital adequacy norms for
banks in a country. The CCCB is a part of such norms and is calculated as a fixed
percentage of a bank’s risk-weighted loan book.

o The key respect in which the CCCB differs from other forms of capital
adequacy is that it works to help a bank counteract the effect of a downturn or
distressed economic conditions.

o With the CCCB, banks are required to set aside a higher portion of their
capital during good times when loans are growing rapidly, so that the capital
can be released and used during bad times, when there’s distress in the
economy.

 Although the RBI had proposed the CCCB for Indian banks in 2015 as part of its
Basel-III requirements, it hasn’t actually required the CCCB to be maintained,
keeping the ratio at zero percent ever since.

 This is based on the RBI’s review of the credit-GDP gap, the growth in GNPA, the
industry outlook assessment index, interest coverage ratio and other indicators, as part
of the first monetary policy of every financial year.