What is CAR?

 Capital adequacy provides regulators with a means of

establishing whether banks and other financial
institutions have sufficient capital to keep them out of
difficulty. Regulators use a Capital Adequacy Ratio
(CAR), a ratio of a bank’s capital to its assets, to assess
risk.
 CAR = (Bank’s Capital)/(Risk Weighted Assets)
= (Tier I Capital + Tier II Capital)/(Risk Weighted
Assets)
Concepts of Capital Adequacy
Norms
 Tier I Capital

 Tier II Capital

 Risk Weighted Assets

 Subordinated Debts
Risks Involved
 Credit Risk

 Market Risk
a) Interest Rate Risk
b) Foreign Exchange Risk
c) Commodity Price Risk etc.

 Operational Risk
Basel – I Norms
In 1988, the Basel I Capital Accord was created. The
general purpose was to:
1. Strengthen the stability of international banking
system.
2. Set up a fair and a consistent international banking
system in order to decrease competitive inequality
among international banks.
Basis of Capital in Basel - I
 Tier I (Core Capital): Tier I capital includes stock issues
(or share holders equity) and declared reserves, such as
loan loss reserves set aside to cushion future losses or for
smoothing out income variations.

 Tier II (Supplementary Capital): Tier II capital includes all

other capital such as gains on investment assets, long-term
debt with maturity greater than five years and hidden
reserves (i.e. excess allowance for losses on loans and
leases). However, short-term unsecured debts (or debts
without guarantees), are not included in the definition of
capital.
Risk Categorization
According to Basel I, the total capital should represent
at least 8% of the bank’s credit risk.
Risks can be:
 The on-balance sheet risk (like risks associated with
cash & gold held with bank, government bonds,
corporate bonds etc.)
 Market risk including interest rates, foreign
exchange, equity derivatives & commodities.
 Non Trading off-balance sheet risks like forward
purchase of assets or transaction related debt assets
Limitations of Basel – I Norms
 Limited differentiation of credit risk
 Static measure of default risk
 No recognition of term-structure of credit risk
 Simplified calculation of potential future counterparty
risk
 Lack of recognition of portfolio diversification effects
Basel – II Norms
Basel – II norms are based on 3 pillars:
 Minimum Capital – Banks must hold capital against
8% of their assets, after adjusting their assets for risk

 Supervisory Review – It is the process whereby

national regulators ensure their home country banks
are following the rules.

 Market Discipline – It is based on enhanced

disclosure of risk
Risk Categorization
In the Basel – II accord, Credit Risk, Market Risk and
Operational Risks were recognized.
Under Basel – II, Credit Risk has three approaches
namely, standardized, foundation internal ratings-
based (IRB), and advanced IRB
Operational Risk has measurement approaches like
the Basic Indicator approach, Standardized approach
and the Advanced Measurement approach.
Impact on Banking Sector
 Capital Requirement

 Wider Market

 Products

 Customers
Advantages of Basel II over I
 The discrepancy between economic capital and
regulatory capital is reduced significantly, due to that
the regulatory requirements will rely on banks’ own
risk methods.

 More Risk sensitive

 Wider recognition of credit risk mitigation.

Pitfalls of Basel – II norms
 Too much regulatory compliance

 Over Focusing on Credit Risk

 The new Accord is complex and therefore demanding

for supervisors, and unsophisticated banks

 Strong risk differentiation in the new Accord can

adversely affect the borrowing position of risky
borrowers
Structure of Basel II
Pillar 1:Minimum Capital Requirements
• Pillar 1 aligns the minimum capital requirements
more closely to actual risks of bank's economic loss.

• revised risks:
√ Credit risk
√ Operational risk
√ Market risk
Pillar 1:Minimum Capital
Requirements(cont.)
• Credit risk
√ The standardised approach
√ Foundation internal ratings based (IRB) approach
√ Advanced IRB approach
• Operational risk
√ Basic indicator approach
√ Standardized approach
√ Advanced measurement approach
• Market risk
√ standardized approach
√ internal models approach
Pillar 2:Supervisory Review Process
• Pillar 2 requires banks to think about the whole spectrum
of risks they might face including those not captured at all
in Pillar 1 such as interest rate risk.
• Coverage in Pillar 2:
√ risks that are not fully covered by Pillar 1
√ Credit concentration risk
√ Counterparty credit risk
√ Risks that are not covered by Pillar 1
√ Interest rate risk in the banking book
√ Liquidity risk
√ Business risk
√ Stress testing
Pillar 3:Market Discipline

 Pillar 3 is designed to increase the transparency of

lenders' risk profile by requiring them to give details of
their risk management and risk distributions.
Weaknesses of Basel II
 The quality of capital.

 Pro-cyclicality.

 Liquidity risk.

 Systemic banks.