Capital Adequacy Final

8/14/2019 Capital Adequacy Final

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CAPITAL ADEQUACY & PLANNING


INTRODUCTION

Capital is one of a number of factors considered when assessing the safety

and soundness of each financial institution.

The efficient functioning of markets requires participants to have confidence

in each other's stability and ability to transact business.

Capital rules help foster this confidence because they require each member

of the financial community to have, among other things, adequate capital.

This capital must be sufficient to protect a financial organisation's

depositors and counterparties from the risks of the institution's on- and off-

balance sheet risks.

Top of the list are credit and market risks; not surprisingly, banks are

required to set aside capital to cover these two main risks.

Capital standards should be designed to allow a firm to absorb its losses,

and in the worst case, to allow a firm to wind down its business without loss

to customers, counterparties and without disrupting the orderly functioning

of financial markets.

An adequate capital base acts as a safety net for the variety of risks that an

institution is exposed to in the conduct of its business.

It is available as a cushion to absorb possible losses and provides a basis

for confidence in the institution by depositors, creditors and others.

The regulation of capital is commonly viewed as the most important tool

available to financial institution regulators. It is the measure by which an

institutions solvency is assessed.

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MBA LECTURER


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MEANING OF CAPITAL

Capital is the investment in, or contribution to, the business of an institution

that ranks behind depositors and other creditors as to entitlement to

repayment or return on investment.

Capital provides a stable resource to absorb any losses and thus provide a

measure of protection to depositors and other creditors in the event of

liquidation.

The net worth of a business; that is, the amountby which its assets exceed

its liabilities.

The money,property, and othervaluables which collectively represent the

wealth of an individualor business.

The basicfunds and assets used by people, governments and businesses to

sustain and equip their income-earning activity.

The accountingconcept of capital refers toissued capitalandretained

earnings of the company, representing the owners' or shareholders' initial

contribution to the business and the wealth that generates.

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MBA LECTURER
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CAPITAL ADEQUACY

Percentageratio of afinancial institution'sprimary capitalto its assets

(loans andinvestments), used as a measure of itsfinancialstrength and

stability.

According to the CapitalAdequacyStandardset byBank for International

Settlements (BIS), banks must have a primary capitalbase equal to at least

eightpercentof their assets.

Amount of capital relative to a financial institution's loans and other assets.

Almost all banking regulators require that banks hold a certain minimum of

equity capital against their risk weighted assets.

TheBasel Committee on Bank Supervision, a coordinating body within the

Bank for International Settlements, supervises the administration of capital

reserves for central bankers around the world.

A ratio that can indicate a banks ability to maintain equity capital sufficient

to pay depositors whenever they demand their money and still have enough

funds to increase the banks assets through additional lending.

Banks list their capital adequacy ratios in their financial reports.

It is stated in terms of equity capital as a percent of assets.

Capital adequacy management is that the manager must decide the amount

of capital that bank should maintain and then acquire the needed capital.

An amount of money which a bank has to have in the form of stockholders'

capital, shown as a percentage of its assets.

Capital Adequacy Ratio (CAR)

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MBA LECTURER
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Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets

Ratio (CRAR), is a ratio of a bank's capitalto its risk.

This ratio is used to protect depositors and promote the stability and

efficiency of financial systems around the world.

Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."

National regulators track a bank's CAR to ensure that it can absorb a

reasonable amount of loss and are complying with their statutory Capital

requirements.

Capital adequacy ratios ("CAR") are a measure of the amount of a bank's

capitalexpressed as apercentage of its riskweightedcreditexposures. Capital adequacy ratio is defined as

whereRiskcan either be weightedassets ( ), or the respective national

regulator's minimum totalcapitalrequirement. If using risk weightedassets,

10%.

The percent threshold (10% in this case, a common requirement for

regulators conforming to theBasel Accords) is set by the national banking

regulator.

Two types of capital are measured:

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http://en.wikipedia.org/wiki/Ratiohttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Financial_capitalhttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Capital_requirementhttp://en.wikipedia.org/wiki/Capital_requirementhttp://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Financial_capitalhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Basel_Accordshttp://en.wikipedia.org/wiki/Ratiohttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Financial_capitalhttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Capital_requirementhttp://en.wikipedia.org/wiki/Capital_requirementhttp://en.wikipedia.org/wiki/Capital_(economics)http://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Financial_capitalhttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Basel_Accords


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Tier one capital, which can absorb losses without a bank being required to

cease trading, and

Tier two capital, which can absorb losses in the event of a winding-up and

so provides a lesser degree of protection to depositors.

USES OF CAR

1) Capital adequacy ratio is the ratio which determines the capacity of the

bank in terms of meeting the time liabilities and other risk such as credit

risk, operational risk, etc.

2) In the most simple formulation, a bank's capital is the "cushion" for

potential losses, which protect the bank's depositors or other lenders.

3) Banking regulators in most countries define and monitor CAR to protect

depositors, thereby maintaining confidence in the banking system.

4) CAR is similar to leverage; in the most basic formulation, it is comparableto the inverse ofdebt-to-equity leverage formulations.

5) Unlike traditionalleverage, however, CAR recognizes thatassets can have

different levels ofrisk.

Capital Adequacy of Financial Intermediaries (FI)

What is a Financial Intermediary (FI)

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MBA LECTURER
http://en.wikipedia.org/wiki/Capacityhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Inversehttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Ownership_equityhttp://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Capacityhttp://en.wikipedia.org/wiki/Credit_(finance)http://en.wikipedia.org/wiki/Bank_regulationhttp://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Inversehttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Ownership_equityhttp://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Risk


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The term financial intermediary includes Banks, Investment Companies, Insurance

Companies, Development Financial Institutions, Non-Banking Finance

Companies, Mutual Funds, etc. All these financial institutions assist in the transfer

of savings from economic units/individuals with excess money to those that need

capital for investments.

Need for Capital:

Financial Intermediaries need capital for two reasons:

1) To run operations of their business.

2) To safeguard against the losses, that may arise.

Adequate capital helps financial intermediaries to survive even during

substantial losses.

It gives time to re-establish the business and avoid any break in operations.

To ensure the good performance of FIs the regulatory authority (RBI) has

specified the minimum capital for the FI.

This requirement is called Capital Adequacy, and it is specified for Banks

and Non Banking Financial Corporations (NBFCs).

Computation of capital adequacy ratio (CAR) of banks:

For computation of CAR, we need to calculate:

Tier I capitalSAMRITI GOEL

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Tier II capital

Risk Weighted Assets (RWA)

Step 1: Compute Tier I capital:

Tier I capital is the most permanent and readily available support against

unexpected losses. It consists of:

1. Paid up equity capital

2. Statutory reserves

3. Capital reserves

4. Other disclosed free reserves

Less:

1. Equity investments in subsidiaries

2. Intangible assets

3. Current and Accumulated Losses, if any

Step 2: Compute Risk Weighted Assets

Step 3: Compute tier II capital

These are not permanent in nature or, are not readily available.

Tier II capital consists of-

a. Undisclosed reserves and cumulative perpetual preference shares

b. Revaluation Reserves (RR)

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c. General Provisions and Loss Reserves (GPLR)

d. Hybrid Debt Capital Instruments

e. Subordinated Debts

Note: Tier II capital cannot be more than Tier I capital.

Capital Adequacy Ratio:

Capital Adequacy Ratio = (Tier I capital + Tier II capital) / RWA

According to the present norm, the Capital Adequacy Ratio of bank as defined

earlier should be at least10%.

CAPITALPLANNING OR MANAGEMENT

Managing capital is the ongoing process of determining and maintaining

the quantity and quality of capital appropriate for an institution.

Managing capital adequacy requires a clear understanding of an

institutions capital requirements and capital position related thereto.

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MBA LECTURER


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Capital management is an important component in the safe and sound

management and the strategic planning of all institutions.

The objective of capital management is to ensure that, on the one hand,

capital is, and will continue to be, adequate to maintain confidence in the

safety and stability of the institution and that, on the other hand, the return

on capital is sufficient to satisfy the expectations of investors.

Although the particulars of capital adequacy and capital management will

differ among institutions, a comprehensive capital management programme

requires:

a. establishing and implementing sound and prudent policies governing

the quantity and quality of capital required to support the institution;

and

b. developing and implementing appropriate and effective procedures to

monitor, on an ongoing basis, the institutions capital requirements

and capital position to ensure that the institution meets its capital

requirements and will continue to meet its future capital

requirements.

Capital Management Procedures

Each licensee needs to develop and implement appropriate and effective

procedures to manage its capital position. Such capital management procedures

need to include, at a minimum:

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a. ongoing monitoring procedures to ensure that the institutions capital

position meets its minimum capital requirements; and

b. a process of capital planning to ensure that the institution will

continue to meet its future requirements.

When measuring capital adequacy it is not sufficient to consider only the

current capital position.

The conditions on which any such judgement is based will change over time.

Therefore, each licensee needs to have in place a capital planning process

in order to be prepared for changing conditions.

At a minimum, each institution should develop, at least annually, a plan formaintaining adequate capital.

A capital plan needs to :

see section for adjustments;

identify the underlying assumptions supporting the projection;

identify the quantity, quality and sources of additional capital required, ifany; assess the availability of any external sources identified;

and estimate the financial impact of raising additional capital.

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MBA LECTURER

Capital Adequacy Final

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