CAPITAL ADEQUACY AND BASEL NORMS

Capital Adequacy Ratio is the percentage of total capital to the total risk of weighted assets of the bank. In simpler terms it the percentage of capital the banks has to maintain in order to handle risk situations

where the banks run out of money. It is used to protect the depositors and promote the stability and efficiency of financial systems around the world.

CRAR = total of Tier 1 and Tier 2 capital divided by risk weighted assets.

TIER 1 CAPITAL: it can absorb losses without bank being required to cease trading.

TIER 2 CAPITAL: can absorb losses in the event of a winding up and provide lesser degree of protection to depositors.

TIER 3 CAPITAL: given by the latest Basel III norms it is the capital adequate for banks known as Tertiary Capital which is used to meet/support market risks, commodities risk and foreign currency.

RBI introduced CRAR (CAPITAL TO RISK WEIGHTED ASSET RATIO) system for banks operating in India in 1992 in accordance with standards of BIS as part of financial sector reforms.

BASEL NORMS

Bureau of International Settlement (BIS) fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations. Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called the BASEL COMMITTEE ON BANKING SUPERVISION (BCBS).

The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord. The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system.

BASEL I

In 1988, BCBS introduced CAPITAL MEASUREMENT SYSTEM called BASEL CAPITAL ACCORD, also called as Basel 1. It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks. Naturally if the capital with the banks is adequate to cover the risks

( e.g. a power plant) they have invested in, then the bank is safe. The minimum capital requirement was fixed at 8% of RISK WEIGHTED ASSETS (RWA). RWA means assets with different risk profiles.

Basel II

In 2004, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord. The guidelines were based on three parameters.

1. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets,
2. Banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that is  credit  and  increased disclosure requirements.
3. Banks need to mandatorily disclose their risk exposure, etc to the central bank.

Basel III

• In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
• A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Too much short-term funding makes the banks prone to risks. Banks generally rely on short-term funding because it is profitable.