Capital Adequacy Norms Common Capital Ratios Commerce YouTube Lecture Handouts

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Capital Adequacy Norms Commerce
  • Capital is a source of funds not a use of funds.
  • A capital requirement/regulatory capital/capital adequacy is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets.
  • It ensures that financial institutions do not take on excess leverage and risk becoming insolvent.
  • Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm՚s balance sheet.
  • They should not be confused with reserve requirements, which govern the assets side of a bank՚s balance sheet — in particular, the proportion of its assets it must hold in cash or highly-liquid assets.
  • The main international effort to establish rules around capital requirements has been the Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements. This sets a framework on how banks and depository institutions must calculate their capital.
  • After obtaining the capital ratios, the bank capital adequacy can be assessed and regulated.
  • In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I.
  • In June 2004 this framework was replaced by a significantly more complex capital adequacy framework commonly known as Basel II.
  • Following the financial crisis of 2007 – 08, Basel II was replaced by Basel III, which will be gradually phased in between 2013 and 2019.
  • Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR) , is the ratio of a bank՚s capital to its risk. National regulators track a bank՚s CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirement.
  • It is a measure of a bank՚s capital.
  • It is expressed as a percentage of a bank՚s risk-weighted credit exposures.
  • The enforcement of regulated levels of this ratio is intended to protect depositors and promote stability and efficiency of financial systems around the world.
  • Two types of capital are measured:
    • tier one capital, which can absorb losses without a bank being required to cease trading, and
    • tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
  • The risk-based capital guidelines are supplemented by a leverage ratio requirement.
  • To be adequately capitalized, a bank holding company must have
    • a Tier 1 capital ratio of at least 4 % ,
    • a combined Tier 1 and Tier 2 capital ratio of at least 8 % , and
    • a leverage ratio of at least 4 % , and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels.
  • To be well-capitalized, a bank holding company must have
    • a Tier 1 capital ratio of at least 6 % ,
    • a combined Tier 1 and Tier 2 capital ratio of at least 10 % , and
    • a leverage ratio of at least 5 % , and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels.
  • The tier 1 capital ratio is the ratio of a bank՚s core tier 1 capital — that is, its equity capital and disclosed reserves — to its total risk-weighted assets.
  • The Tier 1 capital ratio is the ratio of a bank՚s core equity capital to its total risk-weighted assets (RWA) . It is a key measure of a bank՚s financial strength that has been adopted as part of the Basel III Accord on bank regulation.
  • The major components of Tier 1 capital are
    • equity share capital,
    • equity share premium,
    • statutory reserves,
    • general reserves,
    • special reserve (Section 36 (i) (viii) ) and
    • capital reserves (other than revaluation reserves) .
  • Tier 1 capital is the primary funding source of the bank.
  • It holds nearly all of the bank՚s accumulated funds. These funds are generated specifically to support banks when losses are absorbed so that regular business functions do not have to be shut down.
  • Tier 2 capital is the second layer of capital that a bank must keep as part of its required reserves.
  • This tier is comprised of revaluation reserves, general provisions, subordinated term debt, and hybrid capital instruments. There are two levels of Tier 2 capital — upper level and lower-level capital.
  • Undisclosed reserves are not common, but are accepted by some regulators where a bank has made a profit but the profit has not appeared in normal retained profits or in general reserves of the bank.
  • A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example is the situation where a bank owns the land and building of its head-offices and bought the properties for $ 100 a century ago. A current revaluation is likely to reflect a large increase in value. The increase would be added to a revaluation reserve. The reserve may arise out of a formal revaluation carried through to the bank՚s balance sheet, or a notional addition due to holding securities in the balance sheet valued at historic cost.
  • A general provision is created against losses which have not yet been identified. The provision qualifies for inclusion in Tier 2 capital as long it is not created against a known deterioration in value. The general provision is limited to 1.25 % of Risk-weighted assets for banks using the standardized approach 0.6 % of credit risk-weighted assets for banks using the Internal Ratings-Based approach, IRB approach
  • Hybrids are instruments that have some characteristics of both debt and equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the bank, they may be counted as capital. Perpetual preferred stocks carrying a cumulative fixed charge are hybrid instruments. Cumulative perpetual preferred stocks are excluded from Tier 1.
  • Subordinated debt is debt that ranks lower than ordinary depositors of the bank. Only those with a minimum original term to maturity of five years can be included in the calculation of this form of capital; they must be subject to proper amortization arrangements.

Common Capital Ratios

  • CET 1 Capital Ratio
  • Tier 1 capital ratio = Tier 1 capital/Credit risk-adjusted assets value ⩾ 6 %
  • Total capital (Tier 1 and Tier 2) ratio
  • Leverage Ratio

MCQs

1. Tier ________ can absorb losses without a bank being required to cease trading.

Answer: Tier 1

2. Name the components of Tier 1 & Tier 2 Capital.

Answer: The major components of Tier 1 capital are equity share capital, equity share premium, statutory reserves, general reserves, special reserve (Section 36 (i) (viii) ) and capital reserves (other than revaluation reserves) .

Tier 2 is comprised of revaluation reserves, general provisions, subordinated term debt, and hybrid capital instruments.

3. Tier two capital, which can absorb losses in the event of a winding-up and so provides a higher degree of protection to depositors – True/False?

Answer: False (Lesser degree)

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