CAIIB BFM Module D Unit 2 : Capital Adequacy – The Basel Norms

28/09/2023

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CAIIB Paper 2 BFM Module D Unit 1 : Capital Adequacy – The Basel Norms (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 2 (Bank Financial Management) includes an important topic called “Capital Adequacy – The Basel Norms”. Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.

In this article, we are going to cover all the necessary details of CAIIB Paper 2 (BFM) Module D (BALANCE SHEET MANAGEMENT) Unit 2 : Capital Adequacy – The Basel Norms, Aspirants must go through this article to better understand the topic, Capital Adequacy – The Basel Norms and their Management and practice using our Online Mock Test Series to strengthen their knowledge of Capital Adequacy – The Basel Norms. Unit 2 : Capital Adequacy – The Basel Norms

Scope Of Application

The revised capital adequacy norms are applicable uniformly to all Commercial Banks (except Cooperative Banks, Local Area Banks and Regional Rural Banks), both at the solo level (global position) as well as at the consolidated level. A Consolidated bank is defined as a group of entities where a licensed bank is the controlling entity.
A consolidated bank will include all group entities under its control, except the exempted entities. A consolidated bank may exclude group companies, which are engaged in insurance business and businesses not pertaining to financial services. A consolidated bank should maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) as applicable to a bank on an ongoing basis.

Three Pillars of Basel-III

PILLAR-I: Minimum Capital Requirements

The capital ratio continues to be calculated using the definition of regulatory capital and risk-weighted assets. The definition of eligible regulatory capital largely continues to be as defined in the earlier accord of 1988 and amended to include Tier-III capital as prescribed in January 96 and September 97.
Thus the term capital would include Tier-I or core capital, Tier-II or supplemental capital, and Tier-III capital. Tier- III capital, provided under the Basel II guidelines which took care of market risk of the banks, has since been phased out with the introduction of Basel III guidelines. The total capital ratio must not be lower than 8% (9% in India).
Core capital consists of paid up capital, free reserves and unallocated surpluses, less specified deductions. Any capital requirement arising in respect of credit and counter¬party risk needs to be met by Tier-I and Tier-II capital. Supplementary capital comprises subordinated debt of more than five years’ maturity, loan loss reserves, revaluation reserves (which is now part of Tier-I capital in India), investment fluctuation reserves, and limited life preference shares. Tier-II capital is restricted to 100% of Tier-I capital as before.
The scope of risk weighted assets is expanded to include certain additional aspects of market risk and also operational risk. The area of operational risk is brought under the ambit of risk-weighted assets for the first time. Total risk weighted assets include the capital requirement for market risk and operational risk multiplied by 12.5,e. reciprocal of the minimum capital requirement of 8% along with risk weighted assets for credit risk.

Total Risk weighted assets = Risk weighted assets for credit risk +12.5*Capital requirement for market risk+12.5*Capital requirement for operational risk. The individual component of risk-weighted assets is dealt with in detail in Module B, (Risk Management).

Thus the Basel-III accord, which has undergone a subtle change from Basel II, does not merely prescribe minimum capital requirement, but envisages processes of supervisory review and market discipline. The revised framework is more risk sensitive than the 1988 accord. There are incentives for those banks, which have better risk management capabilities.

The Three Pillars of Basel III is given in the form of a diagram below:

PILLAR 2 – Supervisory Review Process

The capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is only the regulatory minimum level, addressing only the three specified risks (viz., credit, market and operational risks) and holding additional capital might be necessary for the banks, on account of

The possibility of some underestimation of risks under the Pillar 1 and The actual risk exposure of a bank vis-a-vis the quality of its risk management architecture. Illustratively, some of the risks that the banks are generally exposed to, but which are not captured or not fully captured in the regulatory CRAR would include:

Interest rate risk in the banking book, which is part of market risk.
Credit concentration risk, which is normally part of credit risk.
Liquidity risk, for convenience sake included as part of market risk.
Settlement risk, which is also called as counter-party risk and is part of credit risk.
Reputational risk, which is equivalent to operational risk.
Strategic risk, which is equivalent to operational risk.
Risk of under-estimation of credit risk under the Standardised approach – Credit risk.
“Model risk” i.e., the risk of under-estimation of credit risk under the IRB approaches – Credit risk.
Risk of weakness in the credit-risk mitigants – Credit risk.
Residual risk of securitisation, etc. – can be part of Credit and Market risk.
Climate Risk
Payment & Settlement Risk

It is therefore, only appropriate that the banks make their own assessment of their various risk exposures, through a well-defined internal process, and maintain an adequate capital cushion for such risks. Further it is recognised that there is no one single approach for conducting the ICAAP and the market consensus in regard to the best practice for undertaking ICAAP, which is yet to emerge.

The ICAAP document should include the capital adequacy assessment and projections of capital requirement for the ensuing year, along with the plans and strategies for meeting the capital requirement and should also be approved by the Board.

Guidelines for the SRP of the RBI and the ICAAP of the Banks

While the Basel-I framework was confined to the prescription of only minimum capital requirements for banks, the Basel-II framework expanded this approach not only to capture certain additional risks in the minimum capital ratio, but also includes two additional areas – the Supervisory Review Process and Market Discipline through increased disclosure requirements for banks. The Basel III framework has also maintained the same approach. Thus,

The Basel Capital Adequacy Framework rests on the following three mutually-reinforcing pillars:

Pillar 1: Minimum Capital Requirements – which prescribes a risk-sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk in addition to market and credit risk.
Pillar 2: Supervisory Review Process (SRP) – which envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority.
Pillar 3: Market Discipline – which seeks to achieve increased transparency through expanded disclosure requirements for banks.

The Basel Committee has also laid down the following four key principles in regard to the SRP envisaged under Pillar 2:

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2: Supervisors should review and evaluate the banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with the regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require the banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Banks’ Responsibilities

Banks should have in place a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels (Principle 1)
Banks should operate above the minimum regulatory capital ratios (Principle 3)

Supervisors’ Responsibilities

Supervisors should review and evaluate a bank’s ICAAP. (Principle 2)
Supervisors should take appropriate action if they are not satisfied with the results of this process. (Principle 2)
Supervisors should review and evaluate a bank’s compliance with the regulatory capital ratios. (Principle2)
Supervisors should have the ability to require banks to hold capital in excess of the minimum. (Principle 3)
Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels. (Principle 4)
Supervisors should require rapid remedial action if capital is not maintained or restored. (Principle 4)

ICAAP to be a Forward-looking Process

The ICAAP should be forward looking in nature, and thus, should take into account the expected/ estimated future developments such as strategic plans, macro-economic factors, etc., including the likely future constraints in the availability and use of capital.
As a minimum, the management of a bank shall develop and maintain an appropriate strategy that would ensure that the bank maintains adequate capital commensurate with the nature, scope, scale, complexity and risks inherent in the bank’s on-balancesheet and off-balance-sheet activities, and should demonstrate as to how the strategy dovetails with the macro-economic factors.
Thus, the banks shall have an explicit, Board-approved capital plan which should spell out the institution’s objectives in regard to level of capital, the time horizon for achieving those objectives, and in broad terms, the capital planning process and the allocate responsibilities for that process.

The plan shall outline:

The bank’s capital needs;
The bank’s anticipated capital utilisation;
The bank’s desired level of capital;
Limits related to capital;
A general contingency plan for dealing with divergences and unexpected events.

ICAAP to be a Risk-based Process

The adequacy of a bank’s capital is a function of its risk profile. Banks shall, therefore, set their capital targets, which are consistent with their risk profile and operating environment.
At a minimum, a bank shall have in place a sound ICAAP, which shall include all material risk exposures incurred by the bank. There are some types of risks (such as reputation risk and strategic risk) which are less readily quantifiable; for such risks, the focus of the ICAAP should be more on qualitative assessment, risk management and mitigation than on quantification of such risks.
Banks’ ICAAP document should clearly indicate the risks for which a quantitative measure is warranted, and the risks for which a qualitative measure is considered to be the correct approach.

An Illustrative Outline of the ICAAP Document

What is an ICAAP document?

The ICAAP Document would be a comprehensive paper furnishing detailed information on the ongoing assessment of the bank’s entire spectrum of risks, how the bank intends to mitigate those risks and how much current and future capital is necessary for the bank, reckoning other mitigating factors.
The purpose of the ICAAP document is to apprise the Board of the bank on these aspects as also to explain to the RBI the bank’s internal capital adequacy assessment process and the banks’ approach to capital management. The ICAAP could also be based on the existing internal documentation of the bank.
The ICAAP document submitted to the RBI should be formally approved by the bank’s Board. It is expected that the document would be prepared in a format that would be easily understood at the senior levels of management and would contain all the relevant information necessary for the bank and the RBI to make an informed judgment as to the appropriate capital level of the bank and its risk management approach.
Where appropriate, technical information on risk measurement methodologies, capital models, if any, used and all other work carried out to validate the approach (e.g. board papers and minutes, internal or external reviews) could be furnished to the RBI as appendices to the ICAAP Document.

Contents

The ICAAP Document should contain the following sections:

Executive Summary
Background
Summary of Current and Projected Financial and Capital Positions
Capital Adequacy
Firm-wide Rick Oversight and Specific Aspects of Risk Management
Key Sensitivities and Future Scenarios
Aggregation and Diversification
Testing and Adoption of the ICAAP
Use of the ICAAP within the Bank

PILLAR 3 – Market Discipline

Banks’ disclosures should be consistent with how senior management and the Board of directors assess and manage the risks of the bank. Under Pillar 1, banks use specified approaches/methodologies for measuring the various risks they face and the resulting capital requirements.
The key idea behind various types of disclosures by banks to the market is to make the market, when it possesses full and critical information about a bank, a disciplinary agent thereby exercising a salutary effect on the bank in particular and the market in general.
Market Discipline leads to better Corporate Governance. Corporate governance is the system of rules, practices and processes by which a company/bank is directed and controlled. Market discipline contributes to a safe and sound banking environment. That is the reason the 19th Century Victorian Banker and Economist Walter Bagehot said,’ A well-run bank needs no capital. No amount of capital will rescue a badly run bank’.

Guiding Principles for Banks’ Pillar 3 Disclosures

The Basel Committee on Banking Supervision (BCBS) has agreed upon the following five guiding principles on Pillar 3 disclosures:

Principle 1: Disclosures should be clear.
Principle 2: Disclosures should be comprehensive.
Principle 3: Disclosures should be meaningful to users.
Principle 4: Disclosures should be consistent over time.
Principle 5: Disclosures should be comparable across banks.

Scope and Frequency of Disclosures

Pillar 3 applies at the top on consolidated level of the banking group to which the Capital Adequacy Framework applies. Disclosures related to individual banks within the groups would not generally be required to be made by the parent bank. An exception to this arises in the disclosure of capital ratios by the top consolidated entity where an analysis of significant bank subsidiaries within the group is appropriate, in order to recognise the need for these subsidiaries to comply with the Framework and other applicable limitations on the transfer of funds or capital within the group. Pillar 3 disclosures will be required to be made by the individual banks on a stand-alone basis when they are not the top consolidated entity in the banking group. Banks are required to make Pillar 3 disclosures at least on a half yearly basis, irrespective of whether financial statements are audited, with the exception of following disclosures:

Capital Adequacy;
Credit Risk: General Disclosures for All Banks; and
Credit Risk: Disclosures for Portfolios Subject to the Standardised Approach.

The disclosures as indicated at (i), (ii) and (iii) above will be made at least on a quarterly basis by banks.

All disclosures must either be included in a bank’s published financial results/statements or, at a minimum, must be disclosed on bank’s website. If a bank finds it operationally inconvenient to make these disclosures along with published financial results/statements, the bank must provide in these financial results/statements, a direct link to where the Pillar 3 disclosures can be found on the bank’s website. The Pillar 3 disclosures should be made concurrent with publication of financial results/statements. A common template is to be used by banks to report the details of their regulatory capital after March 31, 2017 which is designed to meet the Basel III requirement to disclose all regulatory adjustments.

Validation

The disclosures should be subjected to adequate validation. Since information in the annual financial statements would generally be audited, the additional material published with such statements must be consistent with the audited statements. In addition, supplementary material (such as Management’s Discussion and Analysis) that is published should also be subjected to sufficient scrutiny (e.g., internal control assessments, etc.) to satisfy the validation issue. Presently, Pillar 3 disclosures will not be required to be audited by an external auditor, unless specified.

Materiality

A bank should decide which disclosures are relevant for it based on the materiality concept. Information would be regarded as material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decisions.

Proprietary and Confidential Information

Proprietary information encompasses information (for example on products or systems), that if shared with competitors would render a bank’s investment in these products/systems less valuable, and hence would undermine its competitive position. Information about customers is often confidential, in that it is provided under the terms of a legal agreement or counterparty relationship.

General Disclosure Principle

Banks should have a formal disclosure policy approved by the Board of Directors that addresses the banks’ approach for determining what disclosures they will make, the internal controls over the disclosure process and the process for assessing the appropriateness of disclosures including validation and frequency.

Presentation of the Disclosure Requirements

The disclosure requirements are presented either in the form of templates or of tables. Templates must be completed with quantitative data in accordance with the definitions provided. Tables generally relate to qualitative requirements, but quantitative information is also required in some instances. Banks may choose the format they prefer when presenting the information requested in tables. The Master Circular on Basel III Regulations issued by Reserve Bank of India has prescribed the following disclosure tables;

Name of the head of the banking group to which the framework applies

Qualitative Disclosures:

List of group entities considered for consolidation
List of group entities not considered for consolidation both under the accounting and regulatory scope of consolidation

Quantitative Disclosures:

Any restrictions or impediments on transfer of funds or regulatory capital within the banking group:

Table DF-2: Capital Adequacy

Table DF-3: Credit Risk: General Disclosures for all Banks

Table DF-4: Credit Risk: Disclosures for Portfolios – Subject to the Standardised Approach

Table DF-5: Credit Risk Mitigation: Disclosures for Standardised approaches

Table DF-6: Securitisation Exposures: Disclosure for Standardised Approach

Table DF-7: Market risk in trading Book

Table DF-8: Operational risk

Table DF-9: Interest Rate Risk in the Banking Book (IRRBB)

Table DF-10: General Disclosure for exposures related to counter party credit risk.

The Master Circular issued by Reserve Bank of India also contains other details required to be disclosed by the Banks. It may be noted that beyond disclosure requirements as set forth in these guidelines, banks are responsible for conveying their actual risk profile to market participants. The information banks disclose must be adequate to fulfil this objective. In addition to the specific disclosure requirements as set out in the guidelines, banks operating in India should also make additional disclosures in the following areas: