CAPITAL ADEQUACY

A measure of the financial strength of a bank or securities firm, usually expressed as a ratio of its capital to its assets. For banks, there is now a worldwide capital adequacy standard, drawn up by the Basel Committee of the Bank for International Settlements. The Basel Capital Accord, introduced from 1988, requires banks to have capital equal to a minimum of 8 per cent of their assets. In 2004, a revised framework, known as Basel II, was issued. Among its proposals are that capital requirements should be more risk sensitive and that greater use should be made of risk assessments produced by banks' internal systems. The revisions, which have sparked controversy, are being considered by national banking supervisors and implementation is due at the end of 2007. Regulators try to ensure that banks and other financial institutions have sufficient capital to keep them out of difficulty. This not only protects depositors, but also the wider economy, because the failure of a big bank has extensive knock-on effects. The risk of knock-on effects that have repercussions at the level of the entire financial sector is called systemic risk. Capital adequacy requirements have existed for a long time, but the two most important are those specified by the Basel committee of theBank for International Settlements.

BACKGROUND
Under capital requirements rules, credit institutions like banks must at all times maintain minimum financial capital, to cover the risks. Aim - to ensure financial soundness of such institutions, maintain customer confidence in the solvency of the institutions, ensure stability of financial system at large, and protect depositors against losses. Basel Committee on Banking Supervision established in 1974 to provide a forum for banking supervisory matters. Members are from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, UK and USA. Basel Committee not a formal regulatory authority, but has great influence over supervising authorities in many countries. Committee hopes to achieve common approaches and common standards across member countries, without detailed harmonisation of each member country's supervisory techniques. In 1988, recognising the emergence of larger more global financial services companies, the Committee introduced Basel Capital Accord (Basel I) to strengthen soundness and stability of international banking system by requiring higher capital ratios.

Since 1988, the framework of Basel I progressively introduced not only in member countries but also in virtually all other countries with active international banks. In June 1999, proposal issued for a new Capital Adequacy framework to replace Basel I. After extensive communication with banks and industry groups, the revised framework, Basel II issued in 2004. Basel II has been or will be implemented by regulators in most jurisdictions but with varying timelines and may be restricted methodologies. BASEL II The second of the Basel Accords. Purpose is to create an international standard that banking regulators can use when creating regulations about capital banks to be put aside to guard against financial and operational risks An international standard can help protect the international financial system from possible problems should a major bank or a series of banks collapse. Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through lending and investment practices. Greater the risk greater the amount of capital bank needs to hold to safeguard its solvency and overall economic stability.

THREE PILLARS OF BASEL FRAMEWORK

Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

1. Pillar 1 Minimum Capital Requirements (Addressing Risk),

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk).

Banks that decide to adopt the standardised ratings approach must rely on the ratings generated by external agencies. Certain banks used the IRB approach as a result. CAPITAL TYPES : 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 : Paid-Up Capital. Statutory Reserves. Other Disclosed Free Reserves : Reserves which are not kept side for meeting any specific liability. Capital Reserves : Surplus generated from sale of Capital Assets.

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 : Undisclosed Reserves and Paid-Up Capital Perpetual Preference Shares. Revaluation Reserves (at discount of 55%). Hybrid (Debt / Equity) Capital. Subordinated Debt. General Provisions and Loss Reserves.

2. PILLAR-2 : SUPERVISORY REVIEW PROCESS The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system. Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords.Covers Supervisory Review Process, describing principles for effective supervision. Supervisors obliged to evaluate activities, corporate governance, risk management and risk profiles of banks to determine whether they have to change or to allocate more capital for their risks (called Pillar 2 capital) Deals with regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I Also provides framework for dealing with all the other risks a bank may face, such as Systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk It gives banks a power to review their risk management system. RBI Rating : RBI conducts regular inspection on Banks system of Supervision, Control and Administration. RBI gives rating to Banks which may enable RBI to stipulate more than 9% CAR for the Bank. Higher CAR, thus, indicates poor rating granted by RBI to Bank.

3. PILLAR-3: MARKET DISCIPLINE This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk

exposures, risk assessment processes and the capital adequacy of the institution. It must be consistent with how the senior management including the board assess and manage the risks of the institution. When market participants have a sufficient understanding of a banks activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not. These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made anually. Institutions are also required to create a formal policy on what will be disclosed, controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies. The major elements of the market discipline framework of the revised capital adequacy norms are: Appropriate disclosures; Accounting disclosures; Frequency of disclosures; Proprietary and confidential information in terms of general disclosure principles and scope of application; Disclosure requirements; and risk exposure and assessment

IMPLEMENTATION PROGRESS
Regulators in most jurisdictions around the world plan to implement the new accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States' various regulators have agreed on a final approach.[9] They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will be available for smaller banks.[10] In India, Reserve Bank of India has implemented the Basel II standardized norms on 31 March 2009 and is moving to internal ratings in credit and AMA norms for operational risks in banks.

Existing RBI norms for banks in India (as of September 2010): Common equity (incl of buffer): 3.6%(Buffer Basel 2 requirement requirements are zero.); Tier 1 requirement: 6%. Total Capital : 9 % of risk weighted assets. Basel III asks for those ratios as 7-8.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) and 8.5-11% for tier 1 cap and 10.5 to 13.5 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks) In response to a questionnaire released by the Financial Stability Institute (FSI), 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.[11] The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions adopted it by 2008. Australia, through its Australian Prudential Regulation Authority, implemented the Basel II Framework on 1 January 2008. 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. CONCLUSION Basel II Framework lays down a more comprehensive measure and minimum standard for capital adequacy. Seeks to improve on existing rules by aligning regulatory capital requirements more closely to underlying risks that banks face. In addition, it intends to promote a more forward-looking approach to capital supervision, that encourages banks to identify the present and future risks, and develop or improve their ability to manage them.

Hence intended to be more flexible and better able to evolve with advances in markets and risk management practices. Basel II Accord attempts to fix glaring problems with the original accord. It does this by more accurately defining risk, but at the cost of considerable rule complexity.

IMPLICATIONS
The Basel Committee on Banking Supervision is a Guideline for Computing Capital for Incremental Risk. It is a new way of managing risk and asset-liability mismatches, like asset securitization, which unlocks resources and spreads risk, are likely to be increasingly used. The major challenge the country's financial system faces today is to bring informal loans into the formal financial system. By implementing Basel II norms, our formal banking system can learn many lessons from money-lenders. This was designed for the big banks in the BCBS member countries, not for smaller or less developed economies. Keeping in view the cost of compliance for both banks and supervisors, the regulatory challenge would be to migrate to Basel II in a non-disruptive manner. India is one of the early countries which subjected itself voluntarily to the FSAP of the IMF, and our system was assessed to be in high compliance with the relevant principles. With the gradual and purposeful implementation of the banking sector reforms over the past decade, the Indian banking system has shown significant improvement on various parameters, has become robust and displayed ample resilience to shocks in the economy. There is, therefore, ample evidence of the capacity of the Indian banking system to migrate smoothly to Basel II.