Index To RBI Circulars

RBI No.2006-2007/58
IDMD.PDRS.03 /03.64.00/2007-08

July 02, 2007

ANNEX

CAPITAL FUNDS & CAPITAL REQUIREMENTS

General Guidelines

1.0 General

Capital Funds would include the following elements:

In case any PD is having substantial interest/ (as defined for NBFCs) exposure by way of loans and advances not related to business relationship in other Group companies, such amounts will be deducted from its Tier I capital.

Tier II capital includes the following:-

(i) Undisclosed reserves and cumulative preference shares other than those which are compulsorily convertible into equity. Cumulative Preferential shares should be fully paid-up and should not contain clauses which permit redemption by the holder.

(ii) Revaluation reserves discounted at a rate of fifty five percent;

(iii) General provisions and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, up to the maximum of 1.25 percent of total risk weighted assets;

(iv) Hybrid debt capital instruments, which combine certain characteristics of equity and certain characteristics of debt.

Subordinated debt:

a) To be eligible for inclusion in Tier II capital, the instrument should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India. It often carries a fixed maturity, and as it approaches maturity, it should be subjected to progressive discount, for inclusion in Tier II capital. Instruments with an initial maturity of less than 5 years or with a remaining maturity of one year should not be included as part of Tier II capital. Subordinated debt instruments eligible to be reckoned as Tier II capital will be limited to 50 percent of Tier I capital.

b) The subordinated debt instruments included in Tier II capital may be subjected to discount at the rates shown below:

Tier III capital is the capital issued to meet solely the market risk capital charge in accordance with the criteria as laid down below.

The principal form of eligible capital to cover market risk consists of shareholders' and retained earnings (Tier I Capital) and supplementary capital (Tier II Capital). But PDs may also employ a third tier of capital ('Tier III'), consisting of short-term subordinated debt, as defined below, for the sole purpose of meeting a portion of the capital requirements for market risks.

For short-term subordinated debt to be eligible as Tier III Capital, it needs, if circumstances demand, to be capable of becoming part of PD's permanent capital and available to absorb losses in the event of insolvency. It must, therefore, at a minimum;

(i) be unsecured, subordinated and fully paid up;

(ii) have an original maturity of at least two years;

(iii) not be repayable before the agreed repayment date unless the RBI agrees;

(iv) be subject to a lock-in clause that neither interest nor principal may be paid (even at maturity) if such payment means that the PD falls below or remains below its minimum capital requirement.

Guidelines relating to the issue of Subordinated Debt Instruments under Tier II and Tier III Capital are furnished below:

i) The amount of Subordinated Debt to be raised may be decided by the Board of Directors of the PD.

ii) The interest rate spread of the instrument over the yield of equal residual maturity of the Government of India dated security at the time of issue shall not exceed 200 bps.

iii) The instruments should be 'plain vanilla' with no special features like options, etc.

iv) The debt securities shall carry a credit rating from a Credit Rating Agency registered with the Securities and Exchange Board of India.

v) The issue of Subordinated Debt instruments should comply with the guidelines issued by SEBI vide their circular SEBI/MRD/SE /AT/36/2003/30/09 dated September 30, 2003 as amended from time to time, wherever applicable.

vi) In case of issue of unlisted issues of Subordinated Debt, the disclosure requirements as prescribed by the SEBI for listed companies in terms of the above guidelines should be complied with.

vii) Necessary permission from the Foreign Exchange Department of the Reserve Bank of India should be obtained for issuing the instruments to NRIs/FIIs. PDs should comply with the terms and conditions, if any, prescribed by SEBI/other regulatory authorities in regard to issue of the instruments.

viii) Investments by PDs in Subordinated Debt of other PDs/banks will be assigned 100% risk weight for capital adequacy purpose. Further, the PD’s aggregate investments in Tiers II and III bonds issued by other PDs, banks and financial institutions shall be restricted upto 5 percent of the investing PD's total capital. The capital for this purpose will be the same as that reckoned for the purpose of capital adequacy.

ix) The PDs should submit a report to the Internal Debt Management Department, Reserve Bank of India giving details of the capital raised, such as, amount raised, maturity of the instrument, rate of interest together with a copy of the offer document, soon after the issue is completed.

PDs are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) norm of 15 percent on an ongoing basis.

In calculating eligible capital, it will be necessary first to calculate the PDs’ minimum capital requirement for credit risk, and thereafter its market risk requirement, to establish how much Tier I and Tier II capital is available to support market risk. Eligible capital will be the sum of the whole of the PDs’ Tier I capital, plus all of its Tier II capital under the limits imposed as summarized in Annex C. Tier III capital will be regarded as eligible only if it meets the criteria set out in para 2.3 above.

The details of credit risk weights for the various on-balance sheet items and off-balance sheet items based on the degree of credit risk and methodology of computing the risk weighted assets for the credit risk are listed in Annex A. The procedure for calculating capital charge for market risk is detailed in Annex B.

In order to ensure consistency in the calculation of the capital requirements for credit and market risks, an explicit numerical link will be created by multiplying the measure of market risk by 6.67 (i.e., the reciprocal of the credit risk ratio of 15%) and adding the resulting figure to the sum of risk-weighted assets compiled for credit risk purposes. The ratio will then be calculated in relation to the sum of the two, using as the numerator only eligible capital as given in Annex C.

All PDs should report the position of their capital adequacy in PDR III return on a quarterly basis. The PDR III statement is given in Annex D.

5.1 The guidelines on diversification of activities by stand-alone Primary Dealers have been issued vide circular IDMD. PDRS.26/03.64.00/2006-07 dated July 4, 2006.

5.2 The capital charge for market risk (Value-at-Risk calculated at 99 per cent confidence interval, 15-day holding period, with multiplier of 3.3) for the activities defined below should not be more than 20 per cent of the NOF as per the last audited balance sheet:

1. Investment / trading in equity and equity derivatives

2. Investment in units of equity oriented mutual funds

3. Underwriting public issues of equity

5.3 PDs may calculate the capital charge for market risk on the stock positions / underlying stock positions/ units of equity oriented mutual funds using Internal Models (Value-at-Risk based) based on the guidelines prescribed in Appendix III of Annex D. PDs may continue to provide for credit risk arising out of equity, equity derivatives and equity oriented mutual funds as prescribed Annex A.

In order to capture interest rate risk arising out of interest rate derivative business, all PDs are advised to report the interest rate derivative transactions, as per the format enclosed in Annex G, to the Chief General Manager, Internal Debt Management Department, RBI, Central Office, Mumbai, as on last Friday of every month.

All the on-balance sheet items are assigned percentage weights as per degree of credit risk. The value of each asset/item is to be multiplied by the relevant risk weight to arrive at risk adjusted value of the asset, as detailed below. The aggregate of the Risk Weighted Assets will be taken into account for reckoning the minimum capital ratio.

The credit risk exposure attached to off-Balance Sheet items has to be first calculated by multiplying the face value of each of the off-Balance Sheet items by ‘credit conversion factor’ as indicated in the table below. This will then have to be again multiplied by the weights attributable to the relevant counter-party as specified above under balance sheet items.

* For guidelines on calculation of notional positions underlying the equity derivatives, please refer to section A.2, Annex B (Measurement of Market Risk)

Note: Cash margins/deposits shall be deducted before applying the Conversion Factor.

For the trading/hedging positions in Interest Rate related contracts, such as, interest rate swaps, forward rate agreements, basis swaps, interest rate futures, interest rate options, exchange traded interest rate derivatives and other contracts of similar nature, risk weighted asset and the minimum capital ratio will be calculated as per the two steps given below.

The notional principal amount of each instrument is to be multiplied by the conversion factor given below:

The adjusted value thus obtained shall be multiplied by the risk weightage allotted to the relevant counter-party as specified below:

(d) Foreign Exchange Contracts (if permitted):

Like the interest rate contracts, the outstanding contracts should be first multiplied by a conversion factor as shown below:

This will then have to be again multiplied by the weights attributable to the relevant counter-party as specified above.

Foreign exchange contracts with an original maturity of 14 calendar days or less, irrespective of the counterparty, may be assigned 'zero' risk weight as per international practice.

Market risk may be defined as the possibility of loss caused by change in market variables. The objective in introducing the capital adequacy for market risk is to provide an explicit capital cushion for the price risk to which the PDs are especially exposed in their portfolio.

The methods for working out the capital charge for market risks are the standardised model and the internal risk management framework based model. PDs would continue to calculate capital charges based on the standardised method as also under the internal risk management framework based (VaR) model and maintain the higher of the two requirements. However, where price data is not available for specific category of assets, then PDs may follow the standardised method for computation of market risk. In such a situation, PDs shall disclose to Reserve Bank of India, details of such assets and ensure that consistency of approach is followed. PDs should obtain Reserve Bank of India’s permission before excluding any category of asset for calculations of market risk. The Bank would normally consider the instruments of the nature of fixed deposits, commercial bills etc., for this purpose. Such items will be held in the books till maturity and any diminution in the value will have to be provided for in the books.

Note: In case of underwriting commitments, following points should be adhered to:

a. In case of devolvement of underwriting commitment for government securities, 100% of the devolved amount would qualify for the measurement of market risk.

b. In case of underwriting under merchant banking issues (other than G-secs), where price has been committed/frozen at the time of underwriting, the commitment is to be treated as a contingent liability and 50% of the commitment should be included in the position for market risk. However, 100% of devolved position should be subjected to market risk measurement.

The methodology for working out the capital charges for market risk on the portfolio is explained below:

Under standardized method, duration method would continue to apply as hitherto. Under this, the price sensitivity of all interest rate positions viz., Dated securities, Treasury bills, Bills purchased/Discounted, Commercial papers, PSU/FI/Corporate Bonds, Special Bonds, Mutual fund units and derivative instruments like IRS, FRAs, Interest Rate Futures etc., including underwriting commitments/devolvement and other contingent liabilities having interest rate/equity risk will be captured.

In duration method, the capital charge is the sum of four components given below:

a) the net short or long position in the whole trading book;

b) a small proportion of the matched positions in each time-band (the "vertical disallowance’’);

c) a larger proportion of the matched positions across different time-bands (the "horizontal disallowance’’) ;

d) a net charge for positions in options, where appropriate

However, under the duration method, PDs with the necessary capability may, with Reserve Bank of India’s permission use a more accurate method of measuring all of their general market risks by calculating the price sensitivity of each position separately. PDs must select and use the method on a consistent basis and the system adopted will be subjected to monitoring by Reserve Bank of India. The mechanics of this method are as follows:

i) First calculate the price sensitivity of all instruments in terms of a change in interest rates of between 0.6 and 1.0 percentage points depending on the duration of the instrument (as per Table 1 given below );

ii) Slot the resulting sensitivity measures into a duration-based ladder with the thirteen time-bands set out in Table 1;

iii) Subject the lower of the long and short positions in each time-band to a 5% capital charge towards vertical disallowance designed to capture basis risk;

iv) Carry forward the net positions in each time-band for horizontal offsetting across the zones subject to the disallowances set out in Table 2.

Note : Points iii and iv above are applicable only where opposite positions exist as explained at Note above.

The measurement system should include all interest rate derivatives and off balance-sheet instruments in the trading book which react to changes in interest rates, (e.g. forward rate agreements (FRAs), other forward contracts, bond futures, interest rate positions).

The derivatives should be converted into positions in the relevant underlying and become subject to market risk charges as described above. In order to calculate the market risk as per the standardized method described above, the amounts reported should be the market value of the principal amount of the underlying or of the notional underlying.

These instruments are treated as a combination of a long and a short position in a notional government security. The maturity of a future or a FRA will be the period until delivery or exercise of the contract, plus - where applicable - the life of the underlying instrument. For example, a long position in a June three-month interest rate future taken in April is to be reported as a long position in a government security with a maturity of five months and a short position in a government security with a maturity of two months. Where a range of deliverable instruments may be delivered to fulfill the contract, the PD has flexibility to elect which deliverable security goes into the maturity or duration ladder but should take account of any conversion factor defined by the exchange. In the case of a future on a corporate bond index, positions will be included at the market value of the notional underlying portfolio of securities.

Swaps will be treated as two notional positions in government securities with relevant maturities. For example, an interest rate swap under which a PD is receiving floating rate interest and paying fixed will be treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing and a short position in a fixed-rate instrument of maturity equivalent to the residual life of the swap. For swaps that pay or receive a fixed or floating interest rate against some other reference price, e.g. a stock index, the interest rate component should be slotted into the appropriate repricing maturity category, with the equity component being included in the equity framework.

PDs may exclude from the interest rate maturity framework altogether (long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon and maturity. A matched position in a future or forward and its corresponding underlying may also be fully offset, and thus excluded from the calculation. When the future or the forward comprises a range of deliverable instruments, offsetting of positions in the future or forward contract and its underlying is only permissible in cases where there is a readily identifiable underlying security which is most profitable for the trader with a short position to deliver. The leg representing the time to expiry of the future should, however, be reported. Security, sometimes called the 'cheapest-to-deliver', and the price of the future or forward contract should in such cases move in close alignment.

In addition, opposite positions in the same category of instruments can in certain circumstances be regarded as matched and allowed to offset fully. To qualify for this treatment the positions must relate to the same underlying instruments can be of the same nominal value. In addition:

(i) for futures: offsetting positions in the notional or underlying instruments to which the futures contract relates must be for identical products and mature within seven days of each other;

(ii) for swaps and FRAs: the reference rate (for floating rate positions) must be identical and the coupon closely matched (i.e. within 15 basis points); and

(iii) for swaps, FRAs and forwards: the next interest fixing date or, for fixed coupon positions or forwards, the residual maturity must correspond within the following limits:

less than one month hence: same day;

between one month and one year hence: within seven days;

over one year hence: within thirty days.

PDs with large swap books may use alternative formulae for these swaps to calculate the positions to be included in the duration ladder. One method would be to first convert the payments required by the swap into their present values. For that purpose, each payment should be discounted using zero coupon yields, and a single net figure for the present value of the cash flows entered into the appropriate time-band using procedures that apply to zero (or low) coupon bonds; these figures should be slotted into the general market risk framework as set out earlier. An alternative method would be to calculate the sensitivity of the net present value implied by the change in yield used in the duration method and allocate these sensitivities into the time-bands set out in Table 1. Other methods which produce similar results could also be used. Such alternative treatments will, however, only be allowed if:

the supervisory authority is fully satisfied with the accuracy of the systems being used;

the positions calculated fully reflect the sensitivity of the cash flows to interest rate changes and are entered into the appropriate time-bands;

General market risk applies to positions in all derivative products in the same manner as for cash positions, subject only to an exemption for fully or very closely-matched positions in identical instruments as defined in above paragraphs. The various categories of instruments should be slotted into the maturity ladder and treated according to the rules identified earlier.

Equity derivatives and off balance-sheet positions which are affected by changes in equity prices should be included in the measurement system. This includes futures and swaps on both individual equities and on stock indices. The derivatives are to be converted into positions in the relevant underlying.

In order to calculate the market risk as per the standardized method for credit and market risk, positions in derivatives should be converted into notional equity positions:

futures and forward contracts relating to individual equities should in principle be reported at current market prices;

futures relating to stock indices should be reported as the marked-to-market value of the notional underlying equity portfolio;

equity swaps are to be treated as two notional positions

PDs normally would not be dealing in foreign exchange transactions. However, by virtue of they having been permitted to raise resources under FCNR(B) loans route, subject to prescribed guidelines, may end up holding open foreign exchange position. This open position in equivalent rupees arrived at by marking to market at FEDAI rates will be subject to a flat market risk charge of 15%.

The PDs should calculate the capital requirement based on their internal Value at Risk (VaR) model for market risk, as per the following minimum parameters:

(a) 'Value-at-risk' must be computed on a daily basis.

(b) In calculating the value-at-risk, a 99^th percentile, one-tailed confidence interval is to be used.

(c) An instantaneous price shock equivalent to a 15-day movement in prices is to be used, i.e. the minimum 'holding period' will be fifteen trading days.

(d) Interest rate sensitivity of the entire portfolio should be captured on an integrated basis by including all fixed income securities like Government securities, Corporate/PSU bonds, CPs and derivatives like IRS, FRAs, Interest rate futures etc., based on the mapping of the cash flows to work out the portfolio VaR. Wherever data for calculating volatilities is not available, PDs may calculate the volatilities of such instruments using the G-Securities curve with appropriate spread. However, the details of such instruments and the spreads applied have to be reported and consistency of methodology should be ensured.

(e) Instruments which are part of trading book, but found difficult to be subjected to measurement of market risk may be applied a flat market risk measure of 15%. The instruments likely to be applied the flat market risk measure are units of MF, Unquoted Equity, etc., and added arithmetically to the measure obtained under VaR in respect of other instruments.

(f) Underwriting commitments as explained at the beginning of the Annex should also be mapped into the VaR framework for risk measurement purposes.

(g) The unhedged foreign exchange position arising out of the foreign currency borrowings under FCNR(B) loans scheme would carry a market risk of 15% as hitherto and the measure obtained will be added arithmetically to the VaR measure obtained for other instruments.

(h) The choice of historical observation period (sample period) for calculating value-at-risk will be constrained to a minimum length of one year and not less than 250 trading days. For PDs who use a weighting scheme or other methods for the historical observation period, the 'effective' observation period must be at least one year (that is, the weighted average time lag of the individual observations cannot be less than 6 months).

(i) The capital requirement will be the higher of :

i the previous day's value-at-risk number measured according to the above parameters specified in this section and

ii the average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a multiplication factor prescribed by Reserve Bank of India (3.3 presently).

(j) No particular type of model is prescribed. So long as the model used captures all the material risks run by the PDs, they will be free to use models, based for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations or EVT etc.

(k) The criteria for use of internal model to measure market risk capital charge are given in Annex E.

The capital adequacy requirements for the PDs will comprise

the capital charge for credit risk requirements as indicated in Annex A, plus

the capital charge for market risk requirements as indicated in Annex B

In working out the eligible capital, the PDs are required to first calculate their minimum capital requirements for credit risk and only afterwards the capital charge towards market risk requirements. The total capital funds will represent the capital available to meet both the credit as also the market risks.

Of the 15% capital charge for credit risk, at least 50% should be met by Tier I capital, that is the total of Tier II Capital, if any, shall not exceed one hundred per cent of Tier I Capital, at any point of time, for meeting the capital charge for credit risk.

Subordinated debt as capital should not exceed 50% of tier II capital.

The total of Tier III Capital, if any, shall not exceed two hundred and fifty per cent of the Tier I Capital that is available for meeting market risk capital charge i.e. excess over the credit risk capital requirements.

The total of Tier II and Tier III capital eligible for working out the total capital funds should not exceed 100% of Tier I capital.

The overall capital adequacy ratio will be calculated by establishing an explicit numerical link between the credit risk and the market risk factors, by multiplying the market risk capital charge with 6.67 i.e. the reciprocal of the minimum credit risk capital charge of 15 %. The resultant figure is added to the sum of risk weighted assets worked out for credit risk purpose. The numerator for calculating the overall ratio will be the PD’s Tier I, Tier II and the Tier III Capital after head room deductions, if any. The calculation of capital charge is illustrated in PDR III format, which is enclosed as Annex D.

Appendix I - Details of the various on-balance sheet and off-balance sheet items, the risk weights assigned and the risk adjusted value of assets has to be reported in this annex as usual. Revised format enclosed.

Appendix II - Details of the market risk charge using the standardised model as usual. Revised format enclosed.

Appendix III - Details of market risk using the internal model as per the format enclosed.

Appendix IV - Details of back-testing results for the previous quarter, giving the details of VaR predicted by the model, the actual change in the value of the portfolio and the face value of the portfolio.

Appendix V - Details of stress testing, giving details of the change in the value of the portfolio for a given change in the yield and on specific date to be advised by Reserve Bank of India. Format enclosed.

* The above Appendices (in printable form) may be sent by e-mail to pdrsidmc@rbi.org.in

1. In order that the internal model is effective, it should be ensured that :

the PD's risk management system is conceptually sound and its implementation is certified by external auditors;

the PD has sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit, and back office areas;

the PD has a proven track record of reasonable accuracy in measuring risk (back testing);

the PD regularly conducted stress tests along the lines discussed in Para B.4 below

2. In addition to these general criteria, PDs using internal models for capital purposes will be subject to the requirements detailed in Sections B.1 to B.5 below.

The extent to which PDs meet the qualitative criteria contained herein will influence the level at which the RBI will ultimately set the multiplication factor referred to in Section B.3 (b) below, for the PD. Only those PDs, whose models are in full compliance with the qualitative criteria, will be eligible for use of the minimum multiplication factor. The qualitative criteria include:

a) The PD should have an independent risk control unit that is responsible for the design and implementation of the system. The unit should produce and analyse daily reports on the output of the PD's risk measurement model, including an evaluation of the relationship between measures of risk exposure and trading limits. This unit must be independent from trading desks and should report directly to senior management of the PD.

b) The unit should conduct a regular back testing programme, i.e. an ex-post comparison of the risk measure generated by the model against actual daily changes in portfolio value over longer periods of time, as well as hypothetical changes based on static positions.

c) Board of Directors and senior management should be actively involved in the risk control process and must regard risk control as an essential aspect of the business to which significant resources need to be devoted. In this regard, the daily reports prepared by the independent risk control unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions in positions taken by individual traders and reductions in the PD’s overall risk exposure.

d) The PD’s internal risk measurement model must be closely integrated into the day-to-day risk management process of the institution. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the PD’s market risk profile.

e) The risk measurement system should be used in conjunction with internal trading and exposure limits. In this regard, trading limits should be related to the PD’s risk measurement model in a manner that is consistent over time and that it is well-understood by both traders and senior management.

f) A routine and rigorous programme of stress testing should be in place as a supplement to the risk analysis based on the day-to-day output of the PD’s risk measurement model. The results of stress testing should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the Board of Directors. Where stress tests reveal particular vulnerability to a given set of circumstances, prompt steps should be taken to manage those risks appropriately.

g) PDs should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system. The risk measurement system must be well documented, for example, through a manual that describes the basic principles of the risk management system and that provides an explanation of the empirical techniques used to measure market risk.

h) An independent review of the risk measurement system should be carried out regularly in the PD’s own internal auditing process. This review should include both the activities of the trading desks and of the risk control unit. A review of the overall risk management process should take place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum:

the adequacy of the documentation of the risk management system and process;

the organisation of the risk control unit ;

the integration of market risk measures into daily risk management;

the approval process for risk pricing models and valuation systems used by front and back-office personnel;