Basel accord is a global capital measures and capital standards which stipulate on how much capital a bank should have in place in relation to the risk it undertakes. The guidelines on above regulatory standards are formulated by Basel committee on banking supervision (BCBS). Basel committee is constituted by Governors of Central Banks of G-10 nations in 1974. The first guidelines issued by Basel Committee are known as 1st accord of Basel or BaseI I accord. The second round of formulated guidelines on capital measures and capital standards by Basel Committee came into existence in June 2006 (The detailed guideline issued during 2007). This accord is known as Basel II accord. In July 2009 BCBS formulated guidelines on capital measures and capital standards and made some changes and enhancements to Basel II accord. This is known as 3rd accord of Basel or Basel III accord. Since the committee’s headquarter is in BASEL (Switzerland), it is called Basel Committee. It has now nearly 30 member nations including India, with 12 nations as permanent members.
Minimum total capital requirement
Under the Basel Accord, BCBS fixed the minimum requirement of capital funds for banks at “8” per cent of the total risk weighted assets*.
*The Risk Weighted Asset (RWA) is a measurement designed to evaluate the element of risk involved in each asset held by the bank. For example Cash held by bank is an asset with zero risk, where as other assets of the bank such as loans and advances, guarantees etc., are vulnerable to risk of default. Thus, such assets are called risk weighted assets. Banks make provisions on those risk weighted assets to meet future unforeseen losses.
What are Tier I & Tier II Capital?
Tier 1 capital comprises the following;
- Paid up Capital
- Statutory Reserve
- Other disclosed free reserve.
- Capital Reserve which represents surplus arising out of the sale proceeds of the assets.
- Investment fluctuation Reserves
- Innovative Perpetual Debt Instruments (IPDI)
- Perpetual Noncumulative preference shares
Less: ( Equities in subsidiaries, Intangible assets, Losses (Current period and past carried forward)
Tier II capital is broader measure of tier I capital. Tier II capital is alienated into lower and upper tiers. The upper tier consists of undated subordinated debt on which the bank can defer the interest payments and assets like revaluation reserves. Other subordinate debts are classified as lower tier II capital.
Tier II capital consist of following;
- Undisclosed reserves.
- Revaluation Reserves*
- General provisions and Loss Reserves
- Hybrid debt capital such as Bonds.
- Long term unsecured loans.
- Debt Capital instruments.
- Redeemable cumulative Preference Shares.
- Perpetual Cumulative preference shares
- Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier 2 capital;
Less: Regulatory adjustments / deductions applied in the calculation of Tier 2 capital
*On a review of the existing capital adequacy guidelines, the Reserve Bank of India made some amendments to the treatment of certain balance sheet items for the purposes of determining banks’ regulatory capital. Accordingly Revaluation reserves arising from change in the carrying amount of a bank’s property consequent upon its revaluation would be considered as common equity tier 1 capital (CET1) instead of Tier 2 capital as hitherto.
The Reserve Bank of India has allowed banks to issue additional Tier 1 capital instruments, the principal amount of which would absorb losses, either through conversion into common shares or a write-down mechanism that allocates the losses to the instruments, either temporarily or permanently. The limits on admissibility of excess additional Tier 1 and Tier 2 capital for computing and reporting Tier 1 capital and CRAR (capital adequacy ratio) have been withdrawn. Accordingly, a bank having met the minimum capital requirements may admit excess additional Tier 1 and Tier 2 capital for the purpose of reporting. (Hindu Businessline dated 01.09.2014)
Basel III accord recommends for the Common Equity component of Tier 1 (CET1) capital
Basel III accord recommends for the Common Equity component of Tier 1 (CET1) capital. It also suggested amendments to, Basel II guidelines in respect of definition of Capital, Risk Coverage, Capital Charge for Credit Risk, External Credit Assessments, Credit Risk Mitigation and Capital Charge for Market Risk. Supervisory Review and Evaluation Process under Pillar 2, is also being modified.
Components of CET1: The Common Equity component of Tier 1 (CET1) capital is bank’s core equity capital compared with its total risk-weighted assets. The Tier 1 common equity ratio excludes any preferred shares or non-controlling interests while determining the calculation. Thus CET1 ratio differs from the Tier 1 capital ratio which is based on the sum of its equity capital and disclosed reserves, and sometimes non-redeemable, non-cumulative preferred stock.
CET 1 capital will comprise the following:
1. Common shares (paid-up equity capital) issued by the bank which meet the criteria
for, classification as common shares for regulatory purposes.
2. Stock surplus (share premium) resulting from the issue of common shares;
3. Statutory reserves;
4. Capital reserves representing surplus arising out of sale proceeds of assets;
5. Other disclosed free reserves, if any;
6. Balance in Profit & Loss Account at the end of the previous financial year;
7. While calculating capital adequacy at the consolidated level, common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority Interest), which meet the criteria for inclusion in Common Equity Tier 1 capital .
Capital adequacy ratios:
For implementation of Basel III Capital Regulations, a bank has to raise capital in relation to the risk it undertakes. The Capital Adequacy Ratio (CAR), prescribed by RBI under Basel II was, for every Rs.100 of their commercial loans, banks should be backed by Rs.9 of their capital (applicable to public sector and old private sector banks) irrespective of nature of loan. However, the new rule suggests the amount of capital needed, depends upon the credit rating of the customer. The credit rating of the customer is useful in assessing probability of incurring loss on these assets secured from each customer which may vary depending upon quality of securities held. As per Basel III capital regulation the minimum total capital including capital conservation buffer (CCB) should be 9% up to March 2015 and it should be raised to 9.625%,10.25%,10.875% and 11.5% respectively for the year 2016,2017,2018 and 2019.
Tier I Capital Adequacy Ratio is arrived as under;
Tier I capital adequacy ratio (CAR) =Common Equity Tier I capital ×100 ÷ Risk Weighted Assets.
The Tier II, ratio is measured in the same way capital adequacy ratio of Tier 1, is measured.
Tier II capital adequacy ratio (CAR) = Tier II capital ×100÷ Risk Weighted Asset.
The Tier II Capital adequacy ratio is more pertinent and has broader metric compared to Tier I capital. Tier II reveals what magnitude of banks asset could be lost. It also gives hindsight, how entire loss could be wrapped up by different stake holders at a particular point of time.
- Basel III : Capital treatment of Banks’ Balance Sheet items
- Key difference between Basel II and Basel III framework