Capital Funds

  • Equity contribution of owners.
  • The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business.
  • Capital is divided into different tiers according to the characteristics / qualities of each qualifying instrument. For supervisory purposes capital is split into two categories: Tier I and Tier II.

Tier I Capital

  • A term used to refer to one of the components of regulatory capital.
  • It consists mainly of share capital and disclosed reserves (minus goodwill, if any).
  • Tier I items are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital.

Tier II Capital

  • Refers to one of the components of regulatory capital.
  • Also known as supplementary capital, it consists of certain reserves and certain types of subordinated debt.
  • Tier II items qualify as regulatory capital to the extent that they can be used to absorb losses arising from a bank’s activities.
  • Tier II’s capital loss absorption capacity is lower than that of Tier I capital.

Revaluation reserves

  • Revaluation reserves are a part of Tier-II capital.
  • These reserves arise from revaluation of assets that are undervalued on the bank’s books, typically bank premises and marketable securities.
  • The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets and the subsequent deterioration in values under difficult market conditions or in a forced sale.

Leverage

  • Ratio of assets to capital.

Capital reserves

  • That portion of a company’s profits not paid out as dividends to shareholders.
  • They are also known as undistributable reserves and are ploughed back into the business.

Deferred Tax Assets

Unabsorbed depreciation and carry forward of losses which can be set-off against future taxable income which is considered as timing differences result in deferred tax assets. The deferred Tax Assets are accounted as per the Accounting Standard 22.

Deferred Tax Liabilities

Deferred tax liabilities have an effect of increasing future year’s income tax payments, which indicates that they are accrued income taxes and meet definition of liabilities.

Subordinated debt

Refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor, subordinated debt only has a secondary claim on repayments, after other debt has been repaid.

Hybrid debt capital instruments

  • In this category, fall a number of capital instruments, which combine certain characteristics of equity and certain characteristics of debt.
  • Each has a particular feature, which can be considered to affect its quality as capital.
  • Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital.

BASEL Committee on Banking Supervision

  • The BASEL Committee is a committee of bank supervisors consisting of members from each of the G10 countries.
  • The Committee is a forum for discussion on the handling of specific supervisory problems.

It coordinates the sharing of supervisory responsibilities among national authorities in respect of banks’ foreign establishments with the aim of ensuring effective supervision of banks’ activities worldwide.

BASEL Capital accord

  • The BASEL Capital Accord is an Agreement concluded among country representatives in 1988 to develop standardised risk-based capital requirements for banks across countries.
  • The Accord was replaced with a new capital adequacy framework (BASEL II), published in June 2004.
  • BASEL II is based on three mutually reinforcing pillars hat allow banks and supervisors to evaluate properly the various risks that banks face. These three pillars are:
  • Minimum capital requirements, which seek to refine the present measurement framework
  • Supervisory review of an institution’s capital adequacy and internal assessment process;
  • Market discipline through effective disclosure to encourage safe and sound banking practices

Risk Weighted Asset

  • The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number.
  • Risk weight for different assets vary e.g. 0% on a Government Dated Security and 20% on a AAA rated foreign bank etc.

CRAR(Capital to Risk Weighted Assets Ratio)

  • Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and operational risk.
  • The higher the CRAR of a bank the better capitalized it is.

Credit Risk

  • The risk that a party to a contractual agreement or transaction will be unable to meet its obligations or will default on commitments.
  • Credit risk can be associated with almost any financial transaction.
  • BASEL-II provides two options for measurement of capital charge for credit risk.
  1. Standardised approach (SA) – Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its assets by assigning risk weights based on the rating assigned by the external credit rating agencies.
  2. Internal rating based approach (IRB) – The IRB approach, on the other hand, allows banks to use their own internal ratings of counterparties and exposures, which permit a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks.

Market risk

  • Market risk is defined as the risk of loss arising from movements in market prices or rates away from the rates or prices set out in a transaction or agreement.
  • The capital charge for market risk was introduced by the BASEL Committee on Banking Supervision through the Market Risk Amendment of January 1996 to the capital accord of 1988 (BASEL I Framework).
  • There are two methodologies available to estimate the capital requirement to cover market risks:
  1. The Standardised Measurement Method: This method, currently implemented by the Reserve Bank, adopts a ‘building block’ approach for interest-rate related and equity instruments which differentiate capital requirements for ‘specific risk’ from those of ‘general market risk’. The ‘specific risk charge’ is designed to protect against an adverse movement in the price of an individual security due to factors related to the individual issuer. The ‘general market risk charge’ is designed to protect against the interest rate risk in the portfolio.
  2. The Internal Models Approach (IMA): This method enables banks to use their proprietary in-house method which must meet the qualitative and quantitative criteria set out by the BCBS and is subject to the explicit approval of the supervisory authority.

Operational Risk

The revised BASEL II framework offers the following three approaches for estimating capital charges for operational risk:

  1. The Basic Indicator Approach (BIA): This approach sets a charge for operational risk as a fixed percentage (“alpha factor”) of a single indicator, which serves as a proxy for the bank’s risk exposure.
  2. The Standardised Approach (SA): This approach requires that the institution separate its operations into eight standard business lines, and the capital charge for each business line is calculated by multiplying gross income of that business line by a factor (denoted beta) assigned to that business line.
  3. Advanced Measurement Approach (AMA): Under this approach, the regulatory capital requirement will equal the risk measure generated by the banks’ internal operational risk measurement system. In India, the banks have been advised to adopt the BIA to estimate the capital charge for operational risk and 15% of average gross income of last three years is taken for calculating capital charge for operational risk.

Internal Capital Adequacy Assessment Process (ICAAP)

  • In terms of the guidelines on BASEL II, the banks are required to have a board-approved policy on internal capital adequacy assessment process (ICAAP) to assess the capital requirement as per ICAAP at the solo as well as consolidated level.
  • The ICAAP is required to form an integral part of the management and decision-making culture of a bank. ICAAP document is required to clearly demarcate the quantifiable and qualitatively assessed risks.
  • The ICAAP is also required to include stress tests and scenario analyses, to be conducted periodically, particularly in respect of the bank’s material risk exposures, in order to evaluate the potential vulnerability of the bank to some unlikely but plausible events or movements in the market conditions that could have an adverse impact on the bank’s capital.

Supervisory Review Process (SRP)

  • Supervisory review process envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority.
  • The objective of the SRP is to ensure that the banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks.

Market Discipline

Market Discipline seeks to achieve increased transparency through expanded disclosure requirements for banks.

Credit risk mitigation

Techniques used to mitigate the credit risks through exposure being collateralised in whole or in part with cash or securities or guaranteed by a third party.

Mortgage Back Security

A bond-type security in which the collateral is provided by a pool of mortgages. Income from the underlying mortgages is used to meet interest and principal repayments.

Derivative

A derivative instrument derives its value from an underlying product. There are basically three derivatives

a) Forward Contract-

  • A forward contract is an agreement between two parties to buy or sell an agreed amount of a commodity or financial instrument at an agreed price, for delivery on an agreed future date.
  • Future Contract- Is a standardized exchange tradable forward contract executed at an exchange. In contrast to a futures contract, a forward contract is not transferable or exchange tradable, its terms are not standardized and no margin is exchanged.
  • The buyer of the forward contract is said to be long on the contract and the seller is said to be short on the contract.

b) Options-

  • An option is a contract which grants the buyer the justify, but not the obligation, to buy (call option) or sell (put option) an asset, commodity, currency or financial instrument at an agreed rate (exercise price) on or before an agreed date (expiry or settlement date).
  • The buyer pays the seller an amount called the premium in exchange for this justify.
  • This premium is the price of the option.

c) Swaps-

  • Is an agreement to exchange future cash flow at pre-specified Intervals.
  • Typically one cash flow is based on a variable price and other on affixed one.

Non Performing Assets (NPA)

An asset, including a leased asset, becomes non performing when it ceases to generate income for the bank.

Net NPA

Gross NPA – (Balance in Interest Suspense account + DICGC/ECGC claims received and held pending adjustment + Part payment received and kept in suspense account + Total provisions held).

Coverage Ratio

Equity minus net NPA divided by total assets minus intangible assets.

Slippage Ratio

(Fresh accretion of NPAs during the year/Total standard assets at the beginning of the year)*100

Restructuring

  • A restructured account is one where the bank, grants to the borrower concessions that the bank would not otherwise consider.
  • Restructuring would normally involve modification of terms of the advances/securities, which would generally include, among others, alteration of repayment period/ repayable amount/ the amount of installments and rate of interest.
  • It is a mechanism to nurture an otherwise viable unit, which has been adversely impacted, back to health.

Substandard Assets

  • A substandard asset would be one, which has remained NPA for a period less than or equal to 12 months.
  • Such an asset will have well defined credit weaknesses that jeopardize the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.

Doubtful Asset

  • An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
  • A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, – on the basis of currently known facts, conditions and values – highly questionable and improbable.