Amulyadhan Rout

Capital Adequacy
&
Basel Committee
Asset Classification of Banks
Income Recognition, Asset Classification (IRAC)
➢ In line with the international practices and as per the
recommendations made by the Committee on the Financial
System (Chairman Shri M. Narasimham), the RBI has
introduced, prudential norms for income recognition, asset
classification.
➢ This is for loan portfolio of the banks so as to move towards
greater consistency and transparency in the published
accounts.
➢ Banks are urged to ensure that while granting loans and
advances, realistic repayment schedules may be fixed on the
basis of cash flows with borrowers.
Asset Classification of Banks
Non-performing Asset (NPA)
An asset, including a leased asset, becomes non-performing
when it ceases to generate income for the bank.
➢ A non-performing asset (NPA) is a loan or an advance where;
➢ Interest and/ or instalment of principal remains overdue for a
period of more than 90 days in respect of a term loan
➢ The instalment of principal or interest thereon remains
overdue for two crop seasons for short duration crops
➢ In respect of derivative transactions, the overdue receivables
representing positive mark-to-market value of a derivative
contract, if these remain unpaid for a period of 90 days from
the specified due date for payment.
Classification will be done borrower-wise & not facility-wise
Asset Classification of Banks
Asset Classification
Banks are required to classify non-performing assets further into
the following three categories based on the period for which the
asset has remained nonperforming and the realizability of the
dues:
a. Substandard Assets
b. Doubtful Assets
c. Loss Assets
Asset Classification of Banks
a. Sub-Standard Assets
Account which has remained in NPA category for a period of
not more than 12 months. As to realizability these accounts
show credit weakness and there is distinct possibility that the
Bank will sustain some loss if the deficiencies are not
corrected.
b. Doubtful Assets
Account which remained in NPA category for more than 12
months. A loan classified as Doubtful has all the weaknesses
inherent to Sub-Standard assets with added characteristic
that the full recovery of the advance is highly improbable due
to erosion of security value or fraud or such other reasons.
Asset Classification of Banks
c. Loss Assets
Account where Loss has been identified by the bank or
Internal Auditors or External Auditors or by RBI Inspector but
the amount has not been written off. It is an asset which is
considered uncollectible although there may be some
salvage or recovery value.
Asset Classification of Banks
Special Mentioned Account (SMA)
a. SMA-0
Principal or interest payment not overdue for more than 30
days but account showing signs of incipient stress

b. SMA-1
Principal or interest payment overdue between 31-60 days

c. SMA-2
Principal or interest payment overdue between 61-90 days
Asset Classification of Banks
Reversal of Income:
➢ If any advance, including bills purchased and discounted,
becomes NPA, the entire interest accrued and credited to
income account in the past periods, should be reversed if the
same is not realized.
➢ This will apply to Government Guaranteed advances also.
➢ In respect of NPAs, fees, commission and similar income that
have accrued should cease to accrue in the current period
and should be reversed with respect to past periods, if
uncollected.
Reasons of NPA
What are key reasons of NPA?
a. Economic downturns
b. Borrower default
c. Inadequate Credit Appraisal
d. Deficiency in Due Diligence of Borrowers
e. Poor Asset Management by Bank official
Impact of NPA on Banks /FIs
Why do banks worry about an account turning into an NPA?
a. Revenue Loss
b. Brand Image
c. Higher Provisions
d. RBI Action
e. Stock Market Crash
f. Banks do not have sufficient funds for other development
projects, thus impacting the economy.
g. The curb in further investments may lead to the rise of
unemployment.
h. Banks are forced to increase interest rates to maintain a profit
margin.
Impact of NPA on Borrowers
Key Impact of NPA on borrowers
a. CIBIL Score: The NPA impacts the borrower’s
creditworthiness, thus hurting their CIBIL Score.
b. Brand Image: An NPA impacts the goodwill of the borrower.
c. Future Funding Issues: Banks will be apprehensive about
sanctioning a loan to a borrower whose account is an NPA.
d. Impact on other Group Entities: An NPA doesn’t only impact
the borrower but also the other group entities.
e. Attrition of Employees: Mostly senior executives will leave
the organization.
f. Reduction of Creditors: Organization will fail to garner credit
supply
NPA Management by Banks
Steps taken to manage and reduce NPA levels
RBI has put in place various measures to manage and reduce the
NPA levels in the banking system. Some of the steps taken by
banks and financial institutions to manage and reduce NPA levels
are as follows:
1. Loan /Financial Restructuring
2. Asset Reconstruction Companies (ARCs)
3. Recovery Mechanisms
4. One Time Settlements
5. Write-offs
Capıtal Adequacy Ratio
What is Capital Adequacy Ratio (CAR) ?
CAR is a measurement of a bank's available capital expressed
as a percentage of a bank's risk-weighted credit exposures.

▪ CAR also known as Capital-to-Risk Weighted Assets

Ratio (CRAR), is used to protect depositors and promote
the stability and efficiency of financial systems around
the world.

▪ Two types of capital are measured: 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.
Capıtal Adequacy Ratio
Rationale of CAR
▪ The credit risk attached to the assets depends on the bank’s
entity lending loans.
▪ For example, the risk attached to a loan it is lending to the
government is 0%, but the amount of loan lent to individuals
is very high in percentage.
▪ A very high ratio can indicate that the bank is not utilizing its
capital optimally by lending to its customers.
▪ Regulators worldwide have introduced Basel 3, which
requires them to maintain higher capital concerning the risk
in the company’s books to protect the financial systems from
another major crisis.
Capıtal Adequacy Ratio
Rationale of CAR
➢ The capital adequacy ratio determines financial institutions’
economic capability or ability to meet obligations utilizing the
assets and capital.
➢ One can calculate the ratio by dividing the bank’s capital by
risk-weighted assets.
➢ The ratio represents a percentage. Usually, a higher ratio
indicates safety. Conversely, a low ratio means the bank does
not have sufficient capital for risk concerning assets.
Subsequently, it can give rise to an adverse crisis in the
recession.
➢ It plays a critical role in determining banks’ globally post-
subprime dilemma.
Capıtal Adequacy Ratio
What Does the Capital Adequacy Ratio (CAR)
Tell?
▪ The reason minimum CARs are critical is to make
sure that banks have enough cushion to absorb a
reasonable amount of losses before they become
insolvent and consequently lose depositors’ funds.
▪ The CAR ensure the efficiency and stability of a
nation’s financial system by lowering the risk of
banks becoming insolvent.
▪ Generally, a bank with a high CAR is considered
safe and likely to meet its financial obligations.
Capıtal Adequacy Ratio
How to improve the capital adequacy ratio?
➢ Banks can boost the CAR by raising the regulatory capital
levels and the capital ratio numerator.
➢ In addition, they also retain the CAR by reducing the risk
concerning weighted assets.
➢ Therefore, it is considered the capital ratio denominator.

Is a higher capital adequacy ratio good?

➢ A high capital adequacy ratio is good because it shows that
the bank can manage unexpected losses due to adequate
capital availability.
Capıtal Adequacy Ratio
Necessity of maintaining CAR
➢ Banks are required to maintain a minimum CAR as a
regulatory measure to ensure their financial stability and
ability to absorb potential losses.
➢ Here are the key reasons why banks are required to maintain
the CAR:
a. Risk mitigation
b. Protecting depositors and creditors
c. Enhancing confidence and stability
d. Regulatory compliance
e. International Standards and Basel Accords
Hıstory of Capıtal Adequacy

➢ 1900-late 1930s: Capital to Deposit Ratio (The Office of

Comptroller of the Currency [OCC] adopted the 10%
minimum)
➢ Late 1930s: Capital to Total Assets
➢ No capital ratios (Banks were buying US Government bonds)
➢ 1945-late 1970s: Capital to “Risk Assets” Ratio (FED and
FDIC), Capital to Total Assets Ratio (FDIC)
Capital Adequacy Requirements
Capital Adequacy Requirements (Bank’s Safety and Soundness)
1. Provide a buffer against bank losses
2. Protects creditors in the event of bank fails
3. Creates disincentive for excessive risk taking
4. Ensuring Solvency of Banks
5. Limits The Amount of Credit Creation (Capital adequacy ratios
mandate that a certain amount of the deposits be kept aside whenever
a loan is being made)
6. Multi-Tiered Capital
7. Risk Weighting
Capital Requirements
Tier I Capital (Core Capital )
➢ Paid up capital
➢ Statutory reserves
➢ Disclosed free reserves
➢ Innovative Perpetual Debt Instruments (IPDI)

Less: Equity investments in subsidiary

➢ Intangible assets
➢ Current & brought-forward losses
Capital Requirements
Tier II Capital (Supplementary Capital)
I. General Loan-loss Provisions
II. Undisclosed Reserves (other provisions against probable
losses)
III. Asset Revaluation Reserves
IV. Subordinated Term Debt (5+ years maturity)
V. Hybrid (debt/equity) instruments

Tier 2 capital is considered less reliable than Tier 1 capital

because it is more difficult to accurately calculate and more
difficult to liquidate.
Capital Requirements
Tier III Capital
Tier III capital is tertiary capital, which many banks hold to
support their market risk, commodities risk, and foreign currency
risk, derived from trading activities.
➢ Tier 3 capital consisted of low-quality, unsecured debt issued
by banks before the Great Financial Crisis.
➢ Many banks held tier 3 capital to cover their market,
commodities, and foreign currency risks derived from trading
activities.
➢ What this really means is that banks used loans from other
banks to cover any losses they took while trading on several
markets.
➢ Under the Basel III Accords, Tier III capital was required to be
phased out starting Jan. 1, 2013, and removed from accounts
by Jan. 1, 2022
Basel Committee : Introduction
The Basel Committee : 1988: Capital charge for credit risk.
The Basel Accords were formed with the goal of creating an
international regulatory framework for managing credit risk
and market risk. Their key function is to ensure that banks hold
enough cash reserves to meet their financial obligations and
survive in financial and economic distress.
Basel Committee: Main Goals
1. Improve the quality of banking supervision worldwide
2. Promote more effective corporate governance
3. Close gaps in international supervisory coverage
4. Level the playing field among international banks
5. Establish a safer and sounder banking system as a
precondition for sustainable growth of an economy
Why Basel Accord?
Why Basel Accord?
▪ Basel Committee on Banking Supervision (BCBS) 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.”
▪ The set of the agreement by the BCBS, which mainly focuses
on risks to banks and the financial system is called Basel
Accords /Basel Norms.
▪ The purpose of the accord is to ensure that financial
institutions have enough capital on account to meet
obligations and absorbs unexpected losses.
Why Capital Adequacy & Basel Accord?
▪ Liquidation of Bankhaus Herstatt in West Germany
▪ Ripple Effect
Bank for International Settlements (BIS)
▪ Established on 17 May 1930, the Bank for International
Settlements (BIS) is the world's oldest international financial
organisation. The BIS has 60 member central
banks, representing countries from around the world that
together make up about 95% of world GDP.
▪ The head office is in Basel, Switzerland and there are two
representative offices: in the Hong Kong Special
Administrative Region of the People's Republic of China and
in Mexico City.
Why Capital Adequacy & Basel Accord?
Bank for International Settlements (BIS)
▪ The mission of the BIS is to serve central banks in their pursuit
of monetary and financial stability, to foster international
cooperation in those areas and to act as a bank for central
banks.
▪ In broad outline, the BIS pursues its mission by:
• Fostering discussion and facilitating collaboration among central banks
• Supporting dialogue with other authorities that are responsible for
promoting financial stability
• Carrying out research and policy analysis on issues of relevance for
monetary and financial stability
• Acting as a prime counterparty for central banks in their financial
transactions
• Serving as an agent or trustee in connection with international financial
operations.
Basel I : Introduction

Simple Approach
Four pillars:
▪ Constituents of Capital
▪ Risk Weighting
▪ Target Standard Ratio
▪ Transitional and implementing arrangements.
Basel I
Basel Committee: Main Goals
▪ The purpose was to prevent international banks from building
business volume without adequate capital backing
▪ The focus was on credit risk
▪ Set minimum capital standards for banks
Basel I
Committee‘s Worldwide focus
▪ Committee tries to address issues relevant for all
jurisdictions worldwide
▪ Committee has developed over time close cooperation with
non-members
▪ Core Principles Liaison Group (13 Countries, 16 jurisdictions,
IMF, WB)
▪ Sixteen Regional Groups of Banking Supervisors
▪ International Conferences of Banking Supervisors (ICBS) s
Basel I
Principal policies developed by the Committee
▪ Core Principles for Effective Banking Supervision
▪ Capital Adequacy Framework
▪ Principles for sharing supervisory responsibility for banks’
foreign establishments
▪ Many other policy papers, e.g. risk management guidelines,
on the Committee’s website (www.bis.org/bcbs)
Basel I: Capital Requirements
▪ Capital was set at 8% and was adjusted by a loan’s
credit risk weight
▪ Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%,
and 100%
Commercial loans, for example, were assigned to the 100%
risk weight category
 To calculate required capital, a bank would multiply the assets
in each risk category by the category’s risk weight and then
multiply the result by 8%
 Thus a $100 commercial loan would be multiplied by 100%
and then by 8%, resulting in a capital requirement of $8
Critique of Basel I
Basel-I accord was criticized for:
▪ Taking a too simplistic approach to setting credit risk weights
▪ Ignoring other types of risk
Examples:
I. The lack of risk sensitivity: For instance, a corporate loan to a small
company with high leverage consumes the same regulatory capital as a
loan to an AAA-rated large corporate company (8%) because they are
both risk weighted at 100%.
II. The limited collateral recognition: The list of eligible collateral and
guarantors is rather limited, compared to those effectively used by the
banks to mitigate their risks.
III. The incomplete coverage of risk sources: Basel I focused only on credit
risk. An amendment made to Basel I in 1996 :Market Risk Amendment
filled an important gap. But there are still other risk types like
operational risk, reputation risk, and strategic risk not covered by the
regulatory requirements.
Critique of Basel I
Examples: contd…
IV. The “one-size-fits-all” approach: The requirements are virtually the
same, no matter the bank’s risk level, sophistication, and activity type.
V. The arbitrary measure: The 8% ratio for capital is arbitrary and not
based on explicit solvency targets.
VI. The lack of diversified recognition: The credit-risk requirements are all
additive, and diversification through granting loans to various sectors
and regions is not recognized.

➢ Basel I was more relevant for banks that had retail and commercial
banking units, like JPMorgan, Wells Fargo, and other banks in an ETF like
the Financial Select Sector.
➢ For investment banks like Morgan Stanley and Goldman Sachs, there was
no separate market risk discussion in Basel I.
Shortcomings of Basel I

Pitfalls of Basel
1. Limited differentiation of Credit Risk (only 5)
2. Static measure of Default Risk
3. No recognition of Term Structure of Credit Risk
4. Simplified calculation of potential failure on counterparty risk
5. The lack of risk sensitivity
6. The limited collateral recognition
7. The incomplete coverage of risk portfolios
Critique of Basel I

❖ Although Basel I was beneficial to bank supervision, the time

had come to move to a more sophisticated regulatory
framework.
❖ The Basel II proposal was the answer to those shortcomings
as we shall see in the next article of the series.
Thank You