Banking Regulation and Capital: CAIIB Paper 2 (Module D), Unit 2

Banking Regulation and Capital: CAIIB Paper 2 (Module D), Unit 2

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 2: Banking Regulation and Capital” of “Module D: Balance Sheet Management” from “Paper 2: Bank Financial Management (BFM)”

Capital and Banking Regulation

Capital

• Maximisation of return is one of the key objectives of business. Anybody would like to do business with minimum capital and earn maximum returns. However, other entities such as vendors, customers, lenders, employees that deal with such a business venture would like to deal with a strong business unit. A lender would like to ensure that the debt equity ratio is reasonable.
• A vendor would like to get paid in time and he would therefore look at the financial position of the company. One of the important parameters the of financial strength is capital or net worth. Thus it becomes important to have adequate capital and demonstrate that the owners have good stakes in the business. A banking business is no exception to this.

Systemic Risk and Banking Regulation

• Systemic risk is the risk that a default by one financial institution will create a ‘ripple effect that leads to defaults by other financial institutions and threatens the stability of the financial system. There are huge numbers of over-the-counter transactions between banks. If Bank A fails, Bank B may take a huge loss on the transactions it has with Bank A.
• This in turn could lead to Bank B failing. Bank C that has many outstanding transactions with both Bank A and Bank B might then take a large loss and experience severe financial difficulties, and so on.

The 1988 BIS Accord

The 1988 BIS (Bank for International Settlements) Accord was the first attempt to set international risk-based standards for capital adequacy. It has been subject to much criticism as being too simple and somewhat arbitrary. But we should not forget that it was the first attempt by BIS to bring the banks under capital regulation and subsequent Bbasel prescriptions improved upon the risk management practices of the banks keeping the 1988 accord as the base/foundation.

The Cooke Ratio

The Basel-I accord of 1988 addressed the requirement of standardisation in terms of capital adequacy and benchmark of 8% of CRAR was prescribed for international banks. Thus a relationship of risk-weighted assets to capital was put in place. In India Banks are required to maintain minimum 9% CRAR.

CRAR = Capital/Risk Weighted Assets.

In are calculating the Cooke ratio, both on-balance-sheet and off-balance-sheet items are considered. They used to calculate bank’s total risk-weighted assets. It is a measure of the bank’s total credit exposure.

Capital and its Components

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 tiers according to the characteristics/qualities of each qualifying instrument. For supervisory purposes, capital is split into two categories: Tier-I and Tier-II. These categories represent different instruments’ quality as capital. Tier-I capital consists mainly of share capital and disclosed reserves and it is a bank’s highest quality capital because it is fully available to cover losses. Tier-II capital on the other hand consists of certain reserves and certain types of subordinated debt. The loss absorption capacity of Tier- II capital is lower than that of Tier-I capital.

Elements of Tier-1 Capital: The Tier-I capital is also called as ‘Going Concern Capital’. It consists of the sum of Common Equity Tier-I capital and Additional Tier-I capital.

The elements of Common Equity Tier-I capital include:

• Paid-up capital (ordinary shares), statutory reserves, and other disclosed free reserves
• Stock surplus (share premium), resulting from the issue of common shares
• Capital reserves representing surplus arising out of sale proceeds of assets
• Revaluation reserve, as reflected on the face of the Balance sheet, at a discount of 55% while determining their value for inclusion in Tier-I capital.

The elements of Additional Tier-I capital include:

• Perpetual Non-Cumulative Preference Shares (PNCPS)
• Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier-1 capital
• Debt capital instruments eligible for inclusion in Additional Tier-I capital

Elements of Tier-II capital: The Tier II capital is also called as ‘Gone Concern Capital’. The elements of Tier-II capital include: undisclosed reserves, general provisions and loss reserves, hybrid capital instruments, subordinated debt and investments reserve account.

• General Provisions and Loss Reserves: General provisions/loss including floating provisions, which are general in nature and not made against any identified assets, will be admitted upto maximum of 1.25% of total risk weighted assets. The excess provision on account of sale of NPAs, can also be included under general provision, subject to the maximum of 1.25% of RWAs.
• Hybrid Debt capital instruments. These instruments having close similarities to equity when they are able to support losses on an ongoing basis without triggering liquidation, may be included in Tier-II capital. At present, the following instruments have been recognised and placed under this category:

Debt capital instruments eligible for inclusion as Tier-II capital; and

Perpetual Cumulative Preference Shares (PCPS)/Redeemable Non-Cumulative Preference Shares (RNCPS)/Redeemable Cumulative Preference Shares (RCPS) as part of Upper Tier-II Capital. Banks in India have not raised funds under these instruments so far.

• Investment Reserve: Excess provisions on account of depreciation in the ‘Available for Sale’ or ‘Held ‘ for Trading categories in any year should be credited to the Profit & Loss account and an equivalent amount (net of taxes, if any and net of transfer to Statutory Reserves as applicable to such excess provision) should be appropriated to an Investment Reserve Account in Schedule 2 -“Reserves & Surplus” under the head “Revenue and other Reserves” in the Balance Sheet. This would be eligible for inclusion under Tier-II capital within the overall ceiling of 1.25 per cent of total risk weighted assets prescribed for General Provisions/Loss Reserves.

Deductions from Tier-1 Capital

The following deductions should be made from Tier-I capital:

• Intangible assets and losses in the current period and those brought forward from previous periods should be deducted from Tier-I capital;
• Creation of deferred tax asset (DTA) results in an increase in Tier-I capital of a bank without any tangible asset being added to the banks’ balance sheet. Therefore, DTA, which is an intangible asset, should be deducted from Tier-I capital.

Deduction from Tier-I and Tier-II Capital

(a) Equity/Non-Equity Investments in Subsidiaries

The investments of a bank in the equity as well as non-equity capital instruments issued by a subsidiary, should be deducted at 50% each, from Tier-I and Tier-Il capital of the bank,

(b) Credit Enhancements Pertaining to Securitisation of Standard Assets

• Treatment of First Loss Facility: The first loss credit enhancement provided by the originator shall be reduced from capital funds and the deduction shall be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised. The deduction shall be made at 50% from Tier-I and 50% from Tier-II capital.
• Treatment of Second Loss Facility: The second loss credit enhancement provided by the originator shall be reduced from capital funds to the full extent. The deduction shall be made 50% from Tier-I and 50% from Tier-II capital.
• Treatment of Credit Enhancements Provided by Third Party: In case, the bank is acting as a third party service provider, the first loss credit enhancement provided by it shall be reduced from capital to the full extent as in the case of treatment of first loss facility.
• Underwriting by an Originator: Securities issued by the SPVs and devolved/held by the banks in excess of 10 per cent of the original amount of issue, including secondary market purchases, shall be deducted 50% from Tier-I capital and 50% from Tier-II capital.
• Underwriting by Third Party Service Providers: If the bank has underwritten securities issued by SPVs devolved and held by banks, which are below investment grade, the same will be deducted from capital at 50% from Tier-I and 50% from Tier-II.

Limit for Tier- II Elements

Tier-II elements should be limited to a maximum of 100% of total Tier-I elements for the purpose of compliance the norms.

Under the Basel III regime which is presently effective from January, 2013 onwards, the Tier-I and Tier-II capital structure is suitably re-organized. Banks have to implement Basel III fully by April, 2021. When Basel III would be fully implemented, capital structure of the Bank would be as per The Table given below:

Capital Conservation Buffer and its objective:

The capital conservation buffer (CCB) is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down, as losses are incurred during a stressed period. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements. Banks are required to maintain a capital conservation buffer of 2.5%, comprised of Common Equity Tier-I capital, above the regulatory minimum capital requirement of 9%.

The below table shows the minimum capital conservation ratios a bank must meet at various levels of the Common Equity Tier-I capital ratios.

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