The role of banks in global and national economies is very important. The banking industry holds reliance of the entire economy and it is important for the authorities to maintain control over the practices of banks. The most common objectives of banking regulations are
- Prudential Objectives: to reduce the level of risk to bank creditors i.e. to protect the depositors.
- Systemic risk reduction—to reduce the risk of failure of banks
- Avoid misuse of banks—to reduce the risk of banks being used for criminal purposes such as money laundering
- To protect banking confidentiality
- Credit allocation—to direct credit to favored sectors
General Principles of Banking Regulation
The general principles that deal with the banking regulation include Minimum requirements, supervisory review and market discipline. They have been discussed below:
Certain minimum requirements are imposed on banks, which are closely tied to the level of risk exposure for a certain sector of the bank. The most important minimum requirements include the Capital Requirements and Reserve Requirements.
- Capital Requirements:The capital requirement sets a framework on how banks must handle their capital in relation to their assets. The first international level capital requirements were introduced by the Basel Capital Accords in 1988. The current framework of capital requirements is called Basel III.
- Reserve Requirements: The reserve requirement sets the minimum reserves each bank must hold to demand deposits and banknotes. Reserve requirements have also been used in the past to control the stock of banknotes and/or bank deposits. Required reserves have at times been gold coin, central bank banknotes or deposits, and foreign currency.
This includes licensing by the regulator, obtaining undertakings, giving directions, imposing penalties or revoking the bank’s license.
The central bank requires the banks to publicly disclose financial and other information, and depositors and other creditors. The bank is thus made subject to market discipline.
Basel Committee on Banking Supervision
The secretariat of Bureau of International Settlement (BIS); which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations; are located in Basel, a city in Switzerland. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities established in 1974 by the governors of the central banks of G-10. This committee provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It has 27 members including India and major economies of the world.
Box: The 27 countries are Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. Out of them 12 are permanent members.
The Basel Committee on Banking Supervision (BCBS) had introduced a capital measurement system in 1988. It was called Basel capital accord or Basel-I. The focus of Basel-I was entirely on credit risk. It gave a structure of risk weighted assets (RWA). RWA implies that the assets with different risk profiles are given different risk weights. For example, personal loans would carry higher loans in comparison to loans that are backed by assets. The Basel-I fixed minimum capital requirement at 8% of risk weighted assets (RWA). India adopted Basel 1 guidelines in 1999.
The Basel-II guidelines were published by BCBS in 2004. These guidelines refined the Basel-I norms on the base of three parameters as follows:
- Banks should maintain a minimum capital adequacy requirement of 8% of risk assets
- Banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks
- Mandatory disclosure of risk exposure.
Basel II norms in India and overseas are yet to be fully implemented.
The Basel-III guidelines were issued in 2010 as a response to global financial crisis of 2008. The idea was to further strengthen the banking system. It was felt that the quality and quantity under Basel-II were insufficient to contain any further risk; so the Basel-III norms aim at making banking activities more capital-intensive. The objective of these guidelines is to achieve a resilient banking system by focusing on four key banking parameters viz. capital, leverage, funding and liquidity. The ultimate aim is to:
- Improve the banking sector’sability to absorb shocks arising from financial and economic stress.
- Improve risk management and governance
- Strengthen banks’ transparency and disclosures.
In Banking Industry, Capital refers to the stock of Financial Assets which is capable of generating income. The Capital Adequacy Ratio is a thermometer of Bank’s health, because it is the ratio of its capital to its risk. So simply, Capital Adequacy Ratio = Capital ÷ Risk.
Thus, Capital Adequacy can indicate the capacity of the Bank’s ability to absorb the possible losses. The Regulators check CAR to monitor the health of the Bank, because a good CAR protects the depositors and maintains the faith and confidence in the banking system.
Capital to Risk (Weighted) Assets Ratio (CRAR)
CRAR is a standard metric to measure balance sheet strength of banks. BASEL I and BASEL II are global capital adequacy rules that prescribe a minimum amount of capital a bank has to hold given the size of its risk weighted assets. The old rules mandate banks to back every Rs. 100 of commercial loans with Rs. 9 of capital irrespective of the nature of these loans. The new rules suggest the amount of capital needed depends on the credit rating of the customer.
Banks compute the CRAR as follows:
Total capital ratio (CRAR) = Eligible Total Capital / RWA for (Credit risk + Market risk + Operational risk)
Tier-1 and Tier-2 Capital
The Basel accords define two tiers of the Capital in the banks to provide a point of view to the regulators. The Tier-I Capital is the core capital while the Tier-II capital can be said to be subordinate capitals.
Tier 1 mainly includes permanent shareholders’ equity (which includes issued and fully paid ordinary shares / common stock and perpetual non-cumulative preference shares) and disclosed reserves (or profits created or increased by appropriations of retained earnings or other surplus, e.g.: share premiums, retained profit, general reserves and legal reserves). On the other hand, Tier-II includes undisclosed reserves and other subordinate capital. The following table differentiates between Tier-1 and Tier-2 capital.
Apart from the above, the banks may also at the discretion of their central bank employ a third tier of capital which consists of short-term subordinated debt for the sole purpose of meeting a proportion of the capital requirements for market risks. This is called Tier-III capital.
Three pillars of Basel-III
Basel III has three mutually reinforcing pillars as follows:
- Pillar 1 : Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) : Maintaining capital calculated through credit, market and operational risk areas.
- Pillar 2 : Supervisory Review Process : Regulating tools and frameworks for dealing with peripheral risks that banks face.
- Pillar 3: Market Discipline : Increasing the disclosures that banks must provide to increase the transparency of banks
Currently, the bank’s capital comprises Tier 1 and Tier 2 capital. The restriction is that Tier 2 capital cannot be more than 100% of Tier 1 capital. Under Basel III, with an objective of improving the quality of capital, the Tier 1 capital will predominantly consist of Common Equity. Common Equity is the amount that all common shareholders have invested in a company. Most importantly, this includes the value of the common shares themselves. It also includes retained earnings and additional paid-in capital. Thus, most important part of the common equity comprises the Paid up Capital + retained earnings.
- Although the minimum total capital requirement will remain at the current 8% level, Under Basel-III, the capital adequacy requirement was raised to 10.50%.
- Basel III norms prescribe minimum common equity of 4.5 per cent.
Elements of Common Equity
The seven elements of Common Equity include the following:
- Common shares (paid-up equity capital) issued by the bank which meet the criteria for classification as common shares for regulatory purposes;
- Stock surplus (share premium) resulting from the issue of common shares; .
- Statutory reserves;
- Capital reserves representing surplus arising out of sale proceeds of assets;
- Other disclosed free reserves, if any;
- Balance in Profit & Loss Account at the end of the previous financial year;
- Current year profits can be reckoned on quarterly basis provided incremental NPA provision at end of any of 4 quarters of previous financial year have not deviated more than 25% from average of the 4 quarters.
Deductions: Regulatory adjustments / deductions to be made from total of 1 to 7.
The Capital Conservation Buffer
The banks will require to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress.
The countercyclical buffer has been introduced with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.
Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis. A 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
Under Basel III, a framework for liquidity risk management has to be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively.
Key differences between Base-II and Basel-III
The following table summarizes the key differences between Basel-II and Basel-III requirements.
Risk weighted assets
The Risk Weighted Assets (RWA) refer to the fund based assets such as Cash, Loans, Investments and other assets but their value is assigned a risk weight (for example 100% for corporate loans and 50% for mortgage loans) and the credit equivalent amount of all off- balance sheet activities. Each credit equivalent amount is also assigned a risk weight.
Degree of risk expressed % weights assigned by the Reserve Bank of India
The degree of risk expressed % weights assigned by the Reserve Bank of India. The following table shows the Risk weights for some important assets assigned by RBI in an increasing order.
In the above table we can have a broad idea that the assets which are in the form of Cash, Government Guaranteed securities, against the LIC policies etc. are safest assets with 0% Risk weighted assigned to them. On the other hand, the venture Capital Investment as a part of Capital Market exposure has the maximum risk weight assigned to them.
How does this work?
Let’s take this example, For a AAA client, the risk weight is 20%, which means banks have to set aside its own capital of Rs. 1.80 for every Rs 100 loan (this means 20% of 9% of Rs. 100). Similarly, in case of 100% risk weight (such as capital markets exposures) , banks have to keep aside its own capital of Rs 9 on the loan.
Calculation of the Ratio
Under Basel-III, banks are to compute ratio as follows:
- CommonEquity Tier-I Capital Ratio = Common Equity Tier-I Capital / RWA for ( Credit risk + Market risk + Operational risk)
- Tier-I capital ratio = Tier-I Capital / RWA for (Credit risk + Market risk + Operational risk)
- Total capital ratio (CRAR) = Eligible Total Capital / RWA for (Credit risk + Market risk + Operational risk)