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Capital Adequacy Ratio-What is it?


Posted Date: 17-Mar-2009  Last Updated:   Category: Banking    
Author: Member Level: Gold    Points: 30


Do yo know that what is Capital Adequacy Ratio and why it is important. In this article read about the detailed information of Capital Adequacy Ratio-What is it?



Bank capital plays a very important role in the safety and soundness of individual banks and the banking system.Basel Committee for Bank Supervision (BCBS) has prescribed a set of norms for the capital requirement for the banks in 1988 known as Basel Accord I.These norms ensure that capital should be adequate to absorb unexpected losses or risks involved.If there is higher risk,then it would be needed to backed up with Capital and Vice versa.All the countries establish their own guidelines for risk based capital framework known as Capital Adequacy Norms. Capital Adequacy measures the strength of the bank.Capital Adequacy Ratio is also known as Capital Risk Weighted Assets Ratio.

The focus of Capital Adequacy Ratio under Basel I norms was on credit risk and was calculated as follows:

Capital Adequacy Ratio = Tier I Capital+Tier II Capital / Risk Weighted Assets

Basel Committee has revised the guidelines in the year June 2001 known as Basel II Norms.There are Three Pillars of Basel Accord II.

1.Minimum Capital Requirement: Based on certain calculations minimum capital requirement has to be maintained.
2.The Supervisory Review Process: The Central Bank (RBI) of the country has to ensure that each bank has an adequate capital to adopt better management techniques.
3.Market Discipline: There should be a mandatory disclosure on risk management practices with transparency.

Capital Adequacy Ratio in New Accord of Basel II:

Capital Adequacy Ratio = Total Capital(Tier I Capital+Tier II Capital)/ Market Risk+ Credit Risk + Operation Risk

Calculation of Capital Adequacy Ratio:

Total Capital:

Total Capital constitutes of Tier I Capital and Tier II Capital less shareholding in other banks.

Tier I Capital = Ordinary Capital+Retained Earnings& Share Premium - Intangible assets.

Tier II Capital = Undisclosed Reserves+General Bad Debt Provision+ Revaluation Reserve + Subordinate debt+ Redeemable Preference shares

Tier III Capital:
Tier III Capital includes subordinate debt with a maturity of at least 2 years. This is addition or substitution to the Tier II Capital t6o cover market risk alone.Tier III Capital should not cover more than 250% of Tier I capital allocated to market risk.

Types of Risks involved in Basel II & their computation:

Credit Risk:
If the counter party do not settle the dues within the stipulated time or thereafter,this type of risk arises. It includes risks on derivatives, replacement risk and Principal risk. For measuring the risk the following approach are used:
a) Standardised Approach
b) Internal Rating Based Foundation Approach
c) Internal Rating Based Advanced Approach

Market Risk:
This is the risk or loss arising on or off Balance Sheet due to the movement of prices in foreign currencies,commodities,equities and bonds.With regard to market risk,there are two method for computation.
a) Standardised Approach
b) Internal Model Approach

Operation Risk:
This type of risk or loss results from inadequate or failure in the corporate governance or internal processes,people or system.RBI adopts the following measurement techniques for calculation
a) Basic Indicator Approach
b) Standardised Approach
c) Advanced Measurement Approach

Though different approaches are available for calculation of Risk, RBI advises Indian Banks to adopt the standardized approach initially before transition to Advanced Approaches.

Standardised Approach:
Basel Committee for Banking Supervision (BCBS) suggests various risk weighted percentages for different category of assets in the Balance Sheet and Off Balance sheet items (such as guarantees,letter of Credit,Underwriting,Sale &repurchase of transaction etc) known as Risk Buckets. The BCBS has fixed various risk weights from 0% to 100% based on the risk perceived on each of that particular on and off balance sheet items.
In case of Balance sheet asset, the face value of credit risk asset amount should be multiplied by risk bucket to arrive at the amount of risk weighted asset exposure.
For off balance sheet items,the face value credit risk exposure amount has to be multiplied with credit conversion factor to arrive at the credit risk exposure.Then,it has to be multiplied to relevant weight percentage to arrive at amount risk of risk weighted exposure.

Banks have to disclose Tier I capital,Tier II Capital under disclosure norms in the Balance Sheet.They also have to submit a report on capital funds,conversion of on and off balance sheet items,calculation of risk weighted assets,capital to risk asset ratio.

Minimum Requirement of Capital Adequacy Ratio(CAR):

Under Basel II norms,8% is the prescribed Capital Adequacy Norm.
In case of Scheduled Commercial Banks CAR= 9%
For New Private Sector Banks CAR = 10%
For Banks undertaking Insurance Business CAR = 10%
and For Local Area Banks CAR =15%

At the end of March 2008, there were 2 Scheduled Commercial Banks(1 Private Sector Bank & 1 Foreign bank)having 0-9% of Capital Adequacy Ratio,55 Scheduled Commercial Banks( 28 Public Sector Banks,17 Private Sector Banks & 10 Foreign Banks)were having CAR between 10%-15% and 22 Scheduled Commercial Banks (19 Foreign Banks & 3 Private Sector Banks) having CAR of 15% and above according to RBI Publications.


Reference: www.rbi.org.in


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