Banking is one of the highly leveraged business, meaning that it is a business which relies heavily on borrowed money. Most of the banking business is done on account of borrowed money i.e. deposits obtained from public etc. The own capital is must for every business. Basel accord vide its forms I, II and III stipulates norms for maintaining compulsory capital. Capital in any business is must to absorb the losses.
Now let us first understand the capital:- Capital is the longest term funds brought by the owners for carrying on business. Banks have two types of capital: i.e. Tier I capital (also called Core Capital) and Tier II Capital (also called Supplementary capital)
Tier I capital consists of :- Paid Up Capital, Reserves and Surplus and Capital Reserves
Tier 2 ( Supplementary Capital ) consists of :- Undisclosed Reserves, Revaluation Reserves, General Provisions and Loss Reserves, Hybrid Debt Capital Instruments, Subordinate Term Debt
Assets ( i.e. Loan and Advance and other assets) of banks were grouped in five categories carrying risk weights of zero, ten, twenty, fifty, and up to one hundred percent, for example home country sovereign debt having zero risk, investment in corporate bond carried 100% risk. The various categories of credit were assigned different risk weights for example a housing loan was given different weightage than a business loan.
Banks were required to maintain a minimum capital risk asset ratio of 9 per cent on an ongoing basis.
Due to certain limitations of Basel I like difference between Regulatory Capital and Economic Capital ( Economic Capital is minimum amount of capital required to be maintained by the firm to remain in business and solvent, the economic capital is calculated internally by the firm whereas regulatory capital is prescribed by the regulatory authority like RBI), Basel II was implemented. Basel II shifted focus from only Credit Risk to i) CREDIT RISK, ii) MARKET RISK and iii) OPERATIONAL RISK. The three pillars of Basel II accord are:
Minimum Capital requirements
- Pillar 1 relates to the MINIMUM CAPITAL REQUIREMENTS that each bank must hold to cover its exposure to credit, market and operational risk. The capital is calculated for three major components of risk which a bank faces: credit risk, operational risk and market risk.
- The credit risk is calculated through three different approaches i.e. 1. Standardized approach, 2. IRB or Internal Rating Based approach and 3. Advanced IRB approach.
- Operational Risk is also calculated through three different approaches:- Basic Indicator Approach, Standardized approach, Advanced measurement approach.
- Market Risk is calculated through Modified Duration and VaR approach.
- Pillar 2 is concerned with SUPERVISORY REVIEW of capital adequacy that aim to ensure that a bank’s capital level is sufficient to cover its overall risk
- Pillar 3 relates to MARKET DISCIPLINE and details minimum levels of public disclosure
The Basel II has been superseded by Basel III due to certain in-adequacies like major reliance on Credit rating agencies.
CAPITAL REQUIREMENT FOR BASEL II AND BASEL III
BASEL II: Minimum capital requirement under Basel II is 9% CRAR (Capital to Risk Weighted Asset Ratio) out of which 6% is to be maintained through Tier I Capital and remaining 3% can be maintained through Tier II Capital.
The Basel III capital regulations continue to be based on three-mutually reinforcing Pillars (same as Basel II),
Minimum Capital Requirements
Supervisory Review Of Capital Adequacy And
The Basel III capital regulations are being implemented in India with effect from April 1, 2013 and would be fully implemented as on March 31, 2018 which has now been extended to March 31, 2019.
COMPONENTS OF CAPITAL
The banks have to maintain minimum capital equivalent to and not less than 9% of their Total Risk Weighted Assets. This is also called Capital to Risk Weighted Assets (CRAR). The regulatory capital of 9% will consist of Tier I Capital and Tier II Capital in the following manner:-
(i) TIER 1 CAPITAL (going-concern capital):- must be at least 7% of Risk Weighted Assets (RWAs) on an ongoing basis. However this 7% capital can be formed through minimum Common Equity Tier 1 Capital of 5.5% and Additional Tier I Capital of 1.5% of RWAs. Therefore, a bank must have minimum Common Equity of 5.5% of its Risk Weighted Assets.
(ii) TIER 2 CAPITAL (gone-concern capital): Tier 2 capital can be admitted maximum up to 2%.
Capital conservation Buffer of 2.5% to be maintained. Capital conservation buffer is to be built during good times and is to be utilized by banks during tough times. It is a part of Tier I Capital. Thus total CRAR required will be 11.50%. Now for simplicity we can split 11.5% again as under:-
5.5% Common Equity Capital (Tier I Capital)
1.5% Additional Capital (Tier I Capital)
2.00% Tier II Capital
2.50% Capital Conservation Buffer (Tier I Capital)
Thus under BASEL III, the tier II capital stands reduced from 3% to 2%.