Arunav Nayak

What is CAR?
Capital adequacy provides regulators with a means of
establishing whether banks and other financial
institutions have sufficient capital to keep them out of
difficulty. Regulators use a Capital Adequacy Ratio
(CAR), a ratio of a banks capital to its assets, to assess
risk.
CAR = (Banks Capital)/(Risk Weighted Assets)
= (Tier I Capital + Tier II Capital)/(Risk Weighted
Assets)
Concepts of Capital Adequacy
Norms
Tier I Capital

Tier II Capital

Risk Weighted Assets

Subordinated Debts
Risks Involved
Credit Risk

Market Risk
a) Interest Rate Risk
b) Foreign Exchange Risk
c) Commodity Price Risk etc.

Operational Risk


Basel I Norms
In 1988, the Basel I Capital Accord was created. The
general purpose was to:

1. Strengthen the stability of international banking
system.

2. Set up a fair and a consistent international banking
system in order to decrease competitive inequality
among international banks.



Basis of Capital in Basel - I
Tier I (Core Capital): Tier I capital includes stock issues
(or share holders equity) and declared reserves, such as
loan loss reserves set aside to cushion future losses or for
smoothing out income variations.

Tier II (Supplementary Capital): Tier II capital includes all
other capital such as gains on investment assets, long-term
debt with maturity greater than five years and hidden
reserves (i.e. excess allowance for losses on loans and
leases). However, short-term unsecured debts (or debts
without guarantees), are not included in the definition of
capital.





Risk Categorization
According to Basel I, the total capital should represent
at least 8% of the banks credit risk.
Risks can be:
The on-balance sheet risk (like risks associated with
cash & gold held with bank, government bonds,
corporate bonds etc.)
Market risk including interest rates, foreign
exchange, equity derivatives & commodities.
Non Trading off-balance sheet risks like forward
purchase of assets or transaction related debt assets
Limitations of Basel I Norms
Limited differentiation of credit risk

Static measure of default risk

No recognition of term-structure of credit risk

Simplified calculation of potential future counterparty
risk

Lack of recognition of portfolio diversification effects

Basel II Norms
Basel II norms are based on 3 pillars:
Minimum Capital Banks must hold capital against
8% of their assets, after adjusting their assets for risk

Supervisory Review It is the process whereby
national regulators ensure their home country banks
are following the rules.

Market Discipline It is based on enhanced
disclosure of risk




Risk Categorization
In the Basel II accord, Credit Risk, Market Risk and
Operational Risks were recognized.
Under Basel II, Credit Risk has three approaches
namely, standardized, foundation internal ratings-
based (IRB), and advanced IRB
Operational Risk has measurement approaches like
the Basic Indicator approach, Standardized approach
and the Advanced Measurement approach.



Impact on Banking Sector
Capital Requirement

Wider Market

Products

Customers
Advantages of Basel II over I
The discrepancy between economic capital and
regulatory capital is reduced significantly, due to that
the regulatory requirements will rely on banks own
risk methods.

More Risk sensitive

Wider recognition of credit risk mitigation.
Pitfalls of Basel II norms
Too much regulatory compliance

Over Focusing on Credit Risk

The new Accord is complex and therefore demanding
for supervisors, and unsophisticated banks

Strong risk differentiation in the new Accord can
adversely affect the borrowing position of risky
borrowers


Basel III Norms
Basel III norms aim to:

Improving the banking sector's ability to absorb
shocks arising from financial and economic stress

Improve risk management and governance

Strengthen banks' transparency and disclosures
Structure of Basel III Accord
Minimum Regulatory Capital Requirements based on
Risk Weighted Assets (RWAs) : Maintaining capital
calculated through credit, market and operational risk
areas.
Supervisory Review Process : Regulating tools and
frameworks for dealing with peripheral risks that
banks face
Market Discipline : Increasing the disclosures that
banks must provide to increase the transparency of
banks
Major changes in Basel - III
Better Capital Quality
Capital Conservation Buffer
Counter cyclical Buffer
Minimum Common Equity and Tier I Capital
requirements
Leverage Ratios
Liquidity Ratios
Systematically Important Financial Institutions



Basel III and its impact
On Banks


On Financial Stability


On Investors

References
Bank For International Settlements, Basel Committee
on Banking Supervisions,
http://www.bis.org/bcbs/index.htm
Investopedia,
http://www.investopedia.com/articles/economics/10/
understanding-basel-3-
regulations.asp#axzz26w2DIKab
Bank Credit Management by G.Vijayaraghavan,
Chapter 14, pp- 170 - 171

Thank You