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At first sight bank is a business or industry a segment of the service sector in any economy. But the failure of a bank may have far greater damaging impact on an economy than any other kind of business or commercial activity. Basically, modern economies are heavily dependent on banks today
than in the past—banks are today called the backbone of economies. Healthy functioning of banks is today essential for the proper functioning of an economy. As credit creation (i.e., loan disbursals) of banks are highly risky business, the depositors’ money depends on the banks’ quality of lending. More importantly, the whole payment system, public as well as private, depends on banks. A bank’s failure has the potential of creating chaos in an economy. This is why governments of the world pay special attention to the regulatory aspects of the banks. Every regulatory provision for banks tries to achieve a simple equation, i.e., “how the banks should maximise their credit creation by minimising the risk and continue functioning permanently”. In the banking business risks are always there and cannot be made ‘zero’—as any loan forwarded to any individual or firm (irrespective of their credit- worthiness) has the risk of turning out to be a bad debt (i.e., NPA in India)— the probability of this being 50 per cent. But banks must function so that economies can function. Finally, the central banks of the world started devising tools to minimise the risks of banking at one hand and providing cushions (shock-absorbers) to the banks at the other hand so that banks do not go bust (i.e., shut down after becoming bankrupt). Providing cushion/shock-absorbers to banks has seen three major developments:35
(i) The provision of keeping a cash ratio of total deposits mobilised by the banks (known as the CRR in India);
(ii) the provision of maintaining some assets of the deposits mobilised by the banks with the banks themselves in non-cash form (known as the SLR in India); and
(iii) The provision of the capital adequacy ratio (CAR) norm.
The capital adequacy ratio (CAR) norm has been the last provision to emerge in the area of regulating the banks in such a way that they can sustain the probable risks and uncertainties of lending. It was in 1988 that the central banking bodies of the developed economies agreed upon such a provision, the CAR—also known as the Basel Accord.36 The accord was agreed upon at Basel, Switzerland at a meeting of the Bank for International Settlements (BIS).37 It was at this time that the Basel-I norms of the capital adequacy ratio were agreed upon—a requirement was imposed upon the banks to
maintain a certain amount of free capital (i.e., ratio) to their assets38 (i.e., loans and investments by the banks) as a cushion against probable losses in investments and loans. In 1988, this ratio capital was decided to be 8 per cent. It means that if the total investments and loans forwarded by a bank amounts to Rs. 100, the bank needs to maintain a free capital 39 of Rs. 8 at that particular time. The capital adequacy ratio is the percentage of total capital to the total risk—weighted assets (see footnote 40).
CAR, a measure of a bank’s capital, is expressed as a percentage of a bank’s risk weighted credit exposures:
CAR= Total of the Tier 1 & Tier 2 capitals ÷ Risk Weighted Assets
Also known as ‘Capital to Risk Weighted Assets Ratio (CRAR)’ this ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital were measured as per the Basel II norms: Tier 1 capital, which can absorb losses without a bank being required to cease trading, and Tier 2 capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. The new norms (Basel III) has devised a third category of capital, i.e.,Tier 3 capital.
The RBI introduced the capital-to-risk weighted assets ratio (CRAR) system for the banks operating in India in 1992 in accordance with the standards of the BIS—as part of the financial sector reforms.40 In the coming years the Basel norms were extended to term-lending institutions, primary dealers and non-banking financial companies (NBFCs), too. Meanwhile, the BIS came up with another set of CAR norms, popularly known as Basel-II. The RBI guidelines regarding the CAR norms in India have been as given below:
(i) Basel-I norm of the CAR was to be achieved by the Indian banks by March 1997.
(ii) The CAR norm was raised to 9 per cent with effect from March 31, 2000 (Narasimham Committee-II had recommended to raise it to 10 per cent in 1998).41
(iii) Foreign banks as well as Indian banks with foreign presence to follow
Basel-II norms, w.e.f. 31 March, 2008 while other scheduled
commercial banks to follow it not later than 31 March, 2009. The Basel- II norm for the CAR is 12 per cent.42
The basic question which comes to mind is as to why do the banks need to hold capital in the form of CAR norms? Two reasons43 have been generally forwarded for the same:
(i) Bank capital helps to prevent bank failure, which arises in case the bank cannot satisfy its obligations to pay the depositors and other creditors. The low capital bank has a negative net worth after the loss in its business. In other words, it turns into insolvent capital, therefore, acts as a cushion to lessen the chance of the bank turning insolvent.
(ii) The amount of capital affects returns for the owners (equity holders) of the bank.
The Basel Accords (i.e., Basel I, II and now III) are a set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. They are of paramount importance to the banking world and are presently implemented by over 100 countries across the world. The BIS Accords were the outcome of a long-drawn-out initiative to strive for greater international uniformity in prudential capital standards for banks’ credit risk. The objectives of the accords could be summed up44
as:
(i) to strengthen the international banking system;
(ii) to promote convergence of national capital standards; and
(iii) to iron out competitive inequalities among banks across countries of the world.
The Basel Capital Adequacy Risk-related Ratio Agreement of 1988 (i.e., Basel I) was not a legal document. It was designed to apply to internationally active banks of member countries of the Basel Committee on Banking Supervision (BCBS) of the BIS at Basel, Switzerland. But the details of its implementation were left to national discretion. This is why Basel I looked G10-centric.45
The first Basel Accord, known as Basel I
focuses on the capital adequacy of financial institutions. The capital adequacy risk (the risk a financial institution faces due to an unexpected loss), categorises the assets of financial institution into five risk categories (0 per cent, 10 per cent, 20 per cent, 50 per cent, 100 per cent). Banks that operate internationally are required to have a risk weight of 8 per cent or less.
The second Basel Accord, known as
Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements.
The third Basel Accord, known as Basel III is a comprehensive set of reform measures aimed to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to46:
(i) improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source be;
(ii) improve risk management and governance; and
(iii) strengthen banks’ transparency and disclosures.
The capital of the banks has been classified into three tiers as given below:
Tier 1 Capital: A term used to describe the capital adequacy of a bank—it can absorb losses without a bank being required to cease trading. This is the core measure of a bank’s financial strength from a regulator’s point of view (this is the most reliable form of capital). It consists of the types of financial capital considered the most reliable and liquid, primarily stockholders’ equity and disclosed reserves of the bank—equity capital can’t be redeemed at the option of the holder and disclosed reserves are the liquid assets available with
the bank itself.
Tier 2 Capital: A term used to describe the capital adequacy of a bank—it can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. Tier II capital is secondary bank capital (the second most reliable forms of capital). This is related to Tier 1 Capital. This capital is a measure of a bank’s financial strength from a regulator’s point of view. It consists of accumulated after-tax surplus of retained earnings, revaluation reserves of fixed assets and long-term holdings of equity securities, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt and undisclosed reserves.
Tier 3 Capital: A term used to describe the capital adequacy of a bank— considered the tertiary capital of the banks which are used to meet/support market risk, commodities risk and foreign currency risk. It includes a variety of debt other than Tier 1 and Tier 2 capitals. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to Tier 2 capital. To qualify as Tier 3 capital, assets must be limited to 250 per cent of a bank’s Tier 1 capital, be unsecured, subordinated47 and have a minimum maturity of two years.
Disclosed Reserves are the total liquid cash and the SLR assets of the banks that may be used any time. This way they are part of its core capital (Tier 1). Undisclosed Reserves are the unpublished or hidden reserves of a financial institution that may not appear on publicly available documents such as a balance sheet, but are nonetheless real assets, which are accepted as such by most banking institutions, but cannot be used at will by the bank. That is why they are part of its secondary capital (Tier 2).
The new provisions have defined the capital of the banks in different way. They consider common equity and retained earnings as the predominant component of capital (as the past), but they restrict inclusion of items such as deferred tax assets, mortgage-servicing rights and investments in financial institutions to no more than 15 per cent of the common equity component. These rules aim to improve the quantity and quality of the capital.
While the key capital ratio has been raised to 7 per cent of risky assets, according to the new norms, Tier-I capital that includes common equity and perpetual preferred stock will be raised from 2 to 4.5 per cent starting in phases from January 2013 to be completed by January 2015. In addition, banks will have to set aside another 2.5 per cent as a contingency for future stress. Banks that fail to meet the buffer would be unable to pay dividends, though they will not be forced to raise cash.
The new norms are based on renewed focus of central bankers on ‘macro- prudential stability’. The global financial crisis following the crisis in the US sub-prime market has prompted this change in approach. The previous set of guidelines, popularly known as Basel II focused on ‘macro-prudential regulation’. In other words, global regulators are now focusing on financial stability of the system as a whole, rather than micro regulation of any individual bank.
Banks in the West, which are market leaders for the most part, face low growth, an erosion in capital due to sovereign debt exposures and stiffer regulation. They will have to reckon with a permanent decline in their returns on equity thanks to enhanced capital requirements under the new norms. In contrast, Indian banks—and those in other emerging markets such as China and Brazil—are well-placed to maintain their returns on capital consequent to Basel III. Financial experts have opined that Basel III looks changing the economic landscape in which banking power shifts towards the emerging markets.