Capital adequacy norms (1)

Capital Adequacy Norms - CAR, Introduction, India and
Concepts
Introduction to Capital Adequacy Norms

Along with profitability and safety, banks also give importance to Solvency. Solvency refers to
the situation where assets are equal to or more than liabilities. A bank should select its assets in
such a way that the shareholders and depositors' interest are protected .

1. Prudential Norms

The norms which are to be followed while investing funds are called "Prudential Norms." They
are formulated to protect the interests of the shareholders and depositors. Prudential Norms are
generally prescribed and implemented by the central bank of the country. Commercial
Banks have to follow these norms to protect the interests of the customers.
For international banks, prudential norms were prescribed by the Bank for International
Settlements popularly known as BIS. The BIS appointed aBasle Committee on Banking
Supervision in 1988.

2. Basel Committee

Basel committee appointed by BIS formulated rules and regulation for effective supervision of the
central banks. For this it, also prescribed international norms to be followed by the central banks.
This committee prescribed Capital Adequacy Norms in order to protect the interests of the
customers.

3. Definition of Capital Adequacy Ratio

Capital Adequacy Ratio (CAR) is defined as the ratio of bank's capital to its risk assets.
Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio
(CRAR).

India and Capital Adequacy Norms

The Government of India (GOI) appointed the Narasimham Committee in 1991 to suggest
reforms in the financial sector. In the year 1992-93 the Narasimhan Committee submitted its first
report and recommended that all the banks are required to have a minimum capital of 8% to the
risk weighted assets of the banks. The ratio is known as Capital to Risk Assets Ratio (CRAR).
All the 27 Public Sector Banks in India (except UCO and Indian Bank) had achieved the Capital
Adequacy Norm of 8% by March 1997.

The Second Report of Narasimham Committee was submitted in the year 1998-99. It
recommended that the CRAR to be raised to 10% in a phased manner. It recommended an
intermediate minimum target of 9% to be achieved by the year 2000 and 10% by 2002.

Concepts of Capital Adequacy Norms

Capital Adequacy Norms included different Concepts, explained as follows :-

1. Tier-I Capital

Capital which is first readily available to protect the unexpected losses is called as Tier-I Capital.
It is also termed as Core Capital.
Tier-I Capital consists of :-
1.Paid-Up Capital.

2.Statutory Reserves.

3.Other Disclosed Free Reserves : Reserves which are not kept side for meeting any specific
liability.

4.Capital Reserves : Surplus generated from sale of Capital Assets.

2. Tier-II Capital

Capital which is second readily available to protect the unexpected losses is called as Tier-II
Capital.
Tier-II Capital consists of :-
1.Undisclosed Reserves and Paid-Up Capital Perpetual Preference Shares.

2.Revaluation Reserves (at discount of 55%).

3.Hybrid (Debt / Equity) Capital.

4.Subordinated Debt.

5.General Provisions and Loss Reserves.

There is an important condition that Tier II Capital cannot exceed 50% of Tier-I Capital for arriving
at the prescribed Capital Adequacy Ratio.

3. Risk Weighted Assets

Capital Adequacy Ratio is calculated based on the assets of the bank. The values of bank's
assets are not taken according to the book value but according to the risk factor involved. The
value of each asset is assigned with a risk factor in percentage terms.

Suppose CRAR at 10% on Rs. 150 crores is to be maintained. This means the bank is expected
to have a minimum capital of Rs. 15 crores which consists of Tier I and Tier II Capital items
subject to a condition that Tier II value does not exceed 50% of Tier I Capital. Suppose the total
value of items under Tier I Capital is Rs. 5 crores and total value of items under Tier II capital is
Rs. 10 crores, the bank will not have requisite CRAR of Rs. 15 Crores. This is because a
maximum of only Rs. 2.5 Crores under Tier II will be eligible for computation .

4. Subordinated Debt

These are bonds issued by banks for raising Tier II Capital.

They are as follows :-

1.They should be fully paid up instruments.

2.They should be unsecured debt.

3.They should be subordinated to the claims of other creditors. This means that the bank's
holder's claims for their money will be paid at last in order of preference as compared with the
claims of other creditors of the bank.

4The bonds should not be redeemable at the option of the holders. This means the repayment of
bond value will be decided only by the issuing bank.

ASSET LIABILITY MANAGEMENT

Asset-liability management basically refers to the process by which an institution manages its
balance sheet in order to allow for alternative interest rate and liquidity scenarios. Banks and
other financial institutions provide services which expose them to various kinds of risks like
credit risk, interest risk, and liquidity risk. Asset liability management is an approach that
provides institutions with protection that makes such risk acceptable. Asset-liability management
models enable institutions to measure and monitor risk, and provide suitable strategies for their
management. It is therefore appropriate for institutions (banks, finance companies, leasing
companies, insurance companies, and others) to focus on asset-liability management when they
face financial risks of different types. Asset-liability management includes not only a
formalization of this understanding, but also a way to quantify and manage these risks. Further,
even in the absence of a formal asset-liability management program, the understanding of these
concepts is of value to an institution as it provides a truer picture of the risk/reward trade-off in
which the institution is engaged

Categories of risk

1.Credit risk: The risk of counter party failure in meeting the payment obligation on the
specific date is known as credit risk. Credit risk management is an important challenge for
financial institutions and failure on this front may lead to failure of banks

2. Capital risk: One of the sound aspects of the banking practice is the maintenance of adequate
capital on a continuous basis. There are attempts to bring in global norms in this field in order to
bring in commonality and standardization in international practices. Capital adequacy also
focuses on the weighted average risk of lending and to that extent, banks are in a position to
realign their portfolios between more risky and less risky assets.

3. Market risk: Market risk is related to the financial condition, which results from adverse
movement in market prices. This will be more pronounced when financial information has to be
provided on a marked-to-market basis since significant fluctuations in asset holdings could
adversely affect the balance sheet of banks. In the Indian context, the problem is accentuated
because many financial institutions acquire bonds and hold it till maturity. When there is a
significant increase in the term structure of interest rates, or violent fluctuations in the rate
structure, one finds substantial erosion of the value of the securities held .

4. Interest rate risk: It also considers change in impact on interest income due to changes in
the rate of interest. In other words, price as well as reinvestment risks require focus. In so far as
the terms for which interest rates were fixed on deposits differed from those for which they fixed
on assets, banks incurred interest rate risk i.e., they stood to make gains or losses with
everychange in the level of interest rates.As long as changes in rates were predictable both in
magnitude and in timing over the business cycle, interest rate risk was not seen as too serious, but
as rates of interest became more volatile, there was felt need for explicit means of monitoring and
controlling interest gaps.

5.. Liquidity risk It is the potential inability to generate adequate cash to cope with a decline in
deposits or increase in assets. To a large extent, it is an outcome of the mismatch in the maturity
patterns of assets and liabilities. First, the proportion of central government securities with longer
maturities in the Indian bond market, significantly increasing during the 1970s and 1980s,

affected the banking system because longer maturity securities have greater volatility for a given
change in interest rate structure.This problem gets accentuated in the context of change in the
main liability structure of the banks, namely the maturity period for term deposits. For instance in
1986, nearly 50% of term deposits had a maturity period of more than 5 years and only 20%, less
than 2 years for all commercial banks. But in 1992, only 17% of term deposits were more than 5
years whereas 38% were less than 2 years .

Risk measurement techniques

Gap analysis model:
Definition of 'Gap Analysis'
1) The process through which a company compares its actual performance to its expected
performance to determine whether it is meeting expectations and using its resources effectively.
Gap analysis seeks to answer the questions "where are we?" (current state) and "where do we
want to be?" (target state).

Value at Risk

Refers to the maximum expected loss that a bank can suffer over a target horizon, given a certain
confidence interval. It enables the calculation of market risk of a portfolio for which no historical
data exists. It enables one to calculate the net worth of the organization at any particular point of
time so that it is possible to focus on long-term risk implications of decisions that have already
been taken or that are going to be taken. It is used extensively for measuring the market risk of a
portfolio of assets and/or liabilities.

Duration model:
Duration is an important measure of the interest rate sensitivity of assets and liabilities as it takes
into account the time of arrival of cash flows and the maturity of assets and liabilities. It is the
weighted average time to maturity of all the preset values of cash flows. Duration basic-ally
refers to the average life of the asset or the liability.
DP/ p = D ( dR /1+R)
The above equation describes the percentage fall in price of the bond for a given increase in the
required interest rates or yields. The larger the value of the duration, the more sensitive is the
price of that asset or liability to changes in interest rates. As per the above equation, the bank will
be immunized from interest rate risk if the duration gap between assets and the liabilities is zero.
The duration model has one important benefit. It uses the market value of assets and liabilities

Gap analysis model:
Definition of 'Gap Analysis'
1) The process through which a company compares its actual performance to its expected
performance to determine whether it is meeting expectations and using its resources effectively.
Gap analysis seeks to answer the questions "where are we?" (current state) and "where do we
want to be?" (target state).

2) A method of asset-liability management that can be used to assess interest rate risk or liquidity
risk excluding credit risk. Gap analysis is a simple IRR measurement method that conveys the
difference between rate sensitive assets and rate sensitive liabilities over a given period of time.
This type of analysis works well if assets and liabilities are compromised of fixed cash flows.
Because of this a significant shortcoming of gap analysis is that it cannot handle options, as
options have uncertain cash flows.

Measures the direction and extent of asset-liability mismatch through either funding or maturity
gap. It is computed for assets and liabilities of differing maturities and is calculated for a set time
horizon. This model looks at the repricing gap that exists between the interest revenue earned &
the bank's assets and the interest paid on its liabilities over a particular period of time. GAP refers
to the differences between the book value of the rate sensitive assets and the rate sensitive
liabilities. Thus when there is a change in the interest rate, one can easily identify the impact of
the change on the net interest income of the bank

Interest Rate Risk (IRR)
The phased deregulation of interest rates and the operational flexibility given to banks in
pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk.
Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's
financial condition. Changes in interest rates affect both the current earnings (earnings
perspective) as also the net worth of the bank (economic value perspective). The risk from the
earnings' perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest
Margin (NIM). In the context of poor MIS, slow pace of computerisation in banks and the
absence of total deregulation, the traditional Gap analysis is considered as a suitable method to
measure the Interest Rate Risk. It is the intention of RBI to move over to modern techniques of
Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk at a
later date when banks acquire sufficient expertise and sophistication in MIS. The Gap or
Mismatch risk can be measured by calculating Gaps over different time intervals as at a given
date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets
(including off-balance sheet positions). An asset or liability is normally classified as rate sensitive
if:

i) within the time interval under consideration, there is a cash flow;

ii) the interest rate resets/reprices contractually during the interval;

iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, advances upto
Rs.2 lakhs, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where
interest rates are administered ; and

iv) it is contractually pre-payable or withdrawable before the stated maturities.

8.2 The Gap Report should be generated by grouping rate sensitive liabilities, assets and
offbalance sheet positions into time buckets according to residual maturity or next repricing
period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All
investments, advances, deposits, borrowings, purchased funds etc. that mature/reprice within a
specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also
rate sensitive if the bank expects to receive it within the time horizon. This includes final
principal payment and interim instalments. Certain assets and liabilities receive/pay rates that
vary with a reference rate. These assets and liabilities are repriced at pre-determined intervals and
are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed
during their currency, the advances portfolio of the banking system is basically floating. The
interest rates on advances could be repriced any number of occasions, corresponding to the
changes in PLR. The Gaps may be identified in the following time buckets:

i) upto 1 month
ii) Over one month and upto 3 months
iii) Over 3 months and upto 6 months
iv) Over 6 months and upto 12 months
v) Over 1 year and upto 3 years
vi) Over 3 years and upto 5 years
vii) Over 5 years
viii) Non-sensitive
The various items of rate sensitive assets and liabilities in the Balance Sheet may be classified as
explained in Appendix - II and the Reporting Format for interest rate sensitive assets and
liabilities is given in Annexure II.

8.3 The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than
RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate
whether the institution is in a position to benefit from rising interest rates by having a positive
Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a
negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate
sensitivity.
8.4 Each bank should set prudential limits on individual Gaps with the approval of the
Board/Management Committee. The prudential limits should have a bearing on the total assets,
earning assets or equity. The banks may work out earnings at risk, based on their views on
interest
rate movements and fix a prudent level with the approval of the Board/Management Committee.

8.5 RBI will also introduce capital adequacy for market risks in due course.

9. The classification of various components of assets and liabilities into different time buckets
for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices
I & II is the benchmark. Banks which are better equipped to reasonably estimate the behavioural
pattern, embedded options, rolls-in and rolls-out, etc of various components of assets and
liabilities on the basis of past data / empirical studies could classify them in the appropriate time
buckets, subject to approval from the ALCO / Board. A copy of the note approved by the ALCO /
Board may be sent to the Department of Banking Supervision.

NPA

NPA is a classification used by financial institutions that refer to loans that are in threat of default.
Once the borrower has failed to make interest or principal payments for 90 days the loan is
considered to be a non-performing asset. Non-performing assets are problematic for financial
institutions since they depend on interest payments for income. Troublesome pressure from the
economy can lead to a sharp increase in non-performing loans and often results in massive write-
downs.With a view to moving towards international best practices and to ensure greater
transparency, it has been decided to adopt the ‘90 days’ overdue’ norm for identification of NPA,
from the year ending March 31, 2004. Accordingly, with effect from March 31, 2004, a non-
performing asset (NPA) shall be a loan or an advance where;

*Interest and/or installment of principal remain overdue for a period of more than 90 days in
respect of a term loan,

*The account remains ‘out of order’ for a period of more than 90 days, in respect of
an Overdraft/Cash Credit (OD/CC),

*The bill remains overdue for a period of more than 90 days in the case of bills purchased and
discounted,

*Interest and/or installment of principal remains overdue for two harvest seasons but for a period
not exceeding two half years in the case of an advance granted for agricultural purposes, and

*Any amount to be received remains overdue for a period of more than 90 days in respect of
other accounts.

Reasons for growing NPAs

1. Economic slowdown - The global economy is still in the throes of an economic crisis
that is looming large both in the US and Europe. There is a general slackening of
domestic economic activity in India both in manufacturing and the services sectors. A
sluggish economy will have a direct impact on the balance sheets and profitability of
many firms who have availed of loans from the banking industry. Over a period of time,
some of the hard hit firms will be compelled to default on their loans. There is a
groundswell of expert opinion in India that NPAs are more an outcome of economic
factors rather than any internal systemic failures.

2. High interest rates - It is a known fact that interest rates have been revised upwards, 10
times in the past two years with a view to curb inflation. High interest rate increases the
cost of funds to the credit users and has a debilitating effect especially on the repayment
capacity of small and medium enterprises. Banks need to maintain their Net Interest
Margin and hence pass on any interest rate hike to the borrowers. A high rate of inflation

dilutes the quality of assets of the banking sector. Weak supply demand scenario, high
borrowing or leveraging and intense competition contribute to loan defaults.
3. New reporting system - Indian banks are to report NPAs from April 2012 in a computer
recognized / identified format. It is stated that almost 90% of all banks' loan portfolio is
under the computerized system of NPA reporting or system based reporting. The
discretion of bank managers in classifying assets according to their local judgment is
eliminated. This change in reporting pattern makes identification of NPAs a machine
driven objective activity. However, credit risk analysis does have a subjective and
judgmental element to it.
4. Aviation sector - The Indian banking system has a total exposure of around Rs. 40,000
crores to the ailing aviation sector. SBI alone has an exposure of 5,000 crores to the
aviation industry. It is common knowledge that many airlines are either in the red or
marginally profitable. According to an RBI report, nearly three-fourths of the top Banks’
loans to the aviation sector are either impaired or restructured. Kingfisher airlines and Air
India have been the significant aviation borrowers whose performance is below par.

Capital adequacy norms (1)

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