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Equity contribution of owners. The basic approach of capital adequacy framework
is that a bank should have sufficient capital to provide a stable resource to absorb
any losses arising from the risks in its business. Capital is divided into different
tiers according to the characteristics / qualities of each qualifying instrument.
For supervisory purposes capital is split into two categories: Tier I and Tier II. |
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A term used to refer to one of the components of regulatory capital. It consists
mainly of share capital and disclosed reserves (minus goodwill, if any). Tier I
items are deemed to be of the highest quality because they are fully available to
cover losses Hence it is also termed as core capital. |
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Refers to one of the components of regulatory capital. Also known as supplementary
capital, it consists of certain reserves and certain types of subordinated debt.
Tier II items qualify as regulatory capital to the extent that they can be used
to absorb losses arising from a bank's activities. Tier II's capital loss absorption
capacity is lower than that of Tier I capital. |
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Revaluation reserves are a part of Tier-II capital. These reserves arise from revaluation
of assets that are undervalued on the bank's books, typically bank premises and
marketable securities. The extent to which the revaluation reserves can be relied
upon as a cushion for unexpected losses depends mainly upon the level of certainty
that can be placed on estimates of the market values of the relevant assets and
the subsequent deterioration in values under difficult market conditions or in a
forced sale. |
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Ratio of assets to capital. |
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That portion of a company's profits not paid out as dividends to shareholders. They
are also known as undistributable reserves and are ploughed back into the business. |
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Unabsorbed depreciation and carry forward of losses which can be set-off against
future taxable income which is considered as timing differences result in deferred
tax assets. The deferred Tax Assets are accounted as per the Accounting Standard
22. |
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Deferred tax liabilities have an effect of increasing future year's income tax payments,
which indicates that they are accrued income taxes and meet definition of liabilities. |
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Refers to the status of the debt. In the event of the bankruptcy or liquidation
of the debtor, subordinated debt only has a secondary claim on repayments, after
other debt has been repaid. |
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In this category, fall a number of capital instruments, which combine certain characteristics
of equity and certain characteristics of debt. Each has a particular feature, which
can be considered to affect its quality as capital. Where these instruments have
close similarities to equity, in particular when they are able to support losses
on an ongoing basis without triggering liquidation, they may be included in Tier
II capital. |
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The BASEL Committee is a committee of bank supervisors consisting of members from
each of the G10 countries. The Committee is a forum for discussion on the handling
of specific supervisory problems. It coordinates the sharing of supervisory responsibilities
among national authorities in respect of banks' foreign establishments with the
aim of ensuring effective supervision of banks' activities worldwide. |
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The BASEL Capital Accord is an Agreement concluded among country representatives
in 1988 to develop standardised risk-based capital requirements for banks across
countries. The Accord was replaced with a new capital adequacy framework (BASEL
II), published in June 2004. BASEL II is based on three mutually reinforcing pillars
hat allow banks and supervisors to evaluate properly the various risks that banks
face. These three pillars are:
Minimum capital requirements, which seek to refine the present measurement framework
supervisory review of an institution's capital adequacy and internal assessment
process;
market discipline through effective disclosure to encourage safe and sound banking
practices |
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The notional amount of the asset is multiplied by the risk weight assigned to the
asset to arrive at the risk weighted asset number. Risk weight for different assets
vary e.g. 0% on a Government Dated Security and 20% on a AAA rated foreign bank
etc. |
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Capital to risk weighted assets ratio is arrived at by dividing the capital of the
bank with aggregated risk weighted assets for credit risk, market risk and operational
risk. The higher the CRAR of a bank the better capitalized it is. |
The risk that a party to a contractual agreement or transaction will be unable to
meet its obligations or will default on commitments. Credit risk can be associated
with almost any financial transaction. BASEL-II provides two options for measurement
of capital charge for credit risk
1.standardised approach (SA) - Under the SA, the banks use a risk-weighting schedule
for measuring the credit risk of its assets by assigning risk weights based on the
rating assigned by the external credit rating agencies.
2. Internal rating based approach (IRB) - The IRB approach, on the other hand, allows
banks to use their own internal ratings of counterparties and exposures, which permit
a finer differentiation of risk for various exposures and hence delivers capital
requirements that are better aligned to the degree of risks. The IRB approaches
are of two types:
a) Foundation IRB (FIRB):The bank estimates the Probability of Default (PD)
associated with each borrower, and the supervisor supplies other inputs such as
Loss Given Default (LGD) and Exposure At Default (EAD).
b) Advanced IRB (AIRB):In addition to Probability of Default (PD), the bank
estimates other inputs such as EAD and LGD. The requirements for this approach are
more exacting. The adoption of advanced approaches would require the banks to meet
minimum requirements relating to internal ratings at the outset and on an ongoing
basis such as those relating to the design of the rating system, operations, controls,
corporate governance, and estimation and validation of credit risk components, viz.,
PD for both FIRB and AIRB and LGD and EAD for AIRB. The banks should have, at the
minimum, PD data for five years and LGD and EAD data for seven years. In India,
banks have been advised to compute capital requirements for credit risk adopting
the SA. |
Market risk is defined as the risk of loss arising from movements in market prices
or rates away from the rates or prices set out in a transaction or agreement. The
capital charge for market risk was introduced by the BASEL Committee on Banking
Supervision through the Market Risk Amendment of January 1996 to the capital accord
of 1988 (BASEL I Framework). There are two methodologies available to estimate the
capital requirement to cover market risks:
1) The Standardised Measurement Method: This method, currently implemented by the
Reserve Bank, adopts a 'building block' approach for interest-rate related and equity
instruments which differentiate capital requirements for 'specific risk' from those
of 'general market risk'. The 'specific risk charge' is designed to protect against
an adverse movement in the price of an individual security due to factors related
to the individual issuer. The 'general market risk charge' is designed to protect
against the interest rate risk in the portfolio.
2) The Internal Models Approach (IMA): This method enables banks to use their proprietary
in-house method which must meet the qualitative and quantitative criteria set out
by the BCBS and is subject to the explicit approval of the supervisory authority. |
The revised BASEL II framework offers the following three approaches for estimating
capital charges for operational risk:
1) The Basic Indicator Approach (BIA): This approach sets a charge for operational
risk as a fixed percentage ("alpha factor") of a single indicator, which serves
as a proxy for the bank's risk exposure.
2) The Standardised Approach (SA): This approach requires that the institution separate
its operations into eight standard business lines, and the capital charge for each
business line is calculated by multiplying gross income of that business line by
a factor (denoted beta) assigned to that business line.
3) Advanced Measurement Approach (AMA): Under this approach, the regulatory capital
requirement will equal the risk measure generated by the banks' internal operational
risk measurement system. In India, the banks have been advised to adopt the BIA
to estimate the capital charge for operational risk and 15% of average gross income
of last three years is taken for calculating capital charge for operational risk. |
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In terms of the guidelines on BASEL II, the banks are required to have a board-approved
policy on internal capital adequacy assessment process (ICAAP) to assess the capital
requirement as per ICAAP at the solo as well as consolidated level. The ICAAP is
required to form an integral part of the management and decision-making culture
of a bank. ICAAP document is required to clearly demarcate the quantifiable and
qualitatively assessed risks. The ICAAP is also required to include stress tests
and scenario analyses, to be conducted periodically, particularly in respect of
the bank's material risk exposures, in order to evaluate the potential vulnerability
of the bank to some unlikely but plausible events or movements in the market conditions
that could have an adverse impact on the bank's capital. |
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Supervisory review process envisages the establishment of suitable risk management
systems in banks and their review by the supervisory authority. The objective of
the SRP is to ensure that the banks have adequate capital to support all the risks
in their business as also to encourage them to develop and use better risk management
techniques for monitoring and managing their risks. |
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Market Discipline seeks to achieve increased transparency through expanded disclosure
requirements for banks. |
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Techniques used to mitigate the credit risks through exposure being collateralised
in whole or in part with cash or securities or guaranteed by a third party. |
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A bond-type security in which the collateral is provided by a pool of mortgages.
Income from the underlying mortgages is used to meet interest and principal repayments. |
A derivative instrument derives its value from an underlying product. There are
basically three derivatives
a) Forward Contract- A forward contract is an agreement between two parties to buy
or sell an agreed amount of a commodity or financial instrument at an agreed price,
for delivery on an agreed future date. Future Contract- Is a standardized exchange
tradable forward contract executed at an exchange. In contrast to a futures contract,
a forward contract is not transferable or exchange tradable, its terms are not standardized
and no margin is exchanged. The buyer of the forward contract is said to be long
on the contract and the seller is said to be short on the contract.
b) Options- An option is a contract which grants the buyer the right, but not the
obligation, to buy (call option) or sell (put option) an asset, commodity, currency
or financial instrument at an agreed rate (exercise price) on or before an agreed
date (expiry or settlement date). The buyer pays the seller an amount called the
premium in exchange for this right. This premium is the price of the option.
c) Swaps- Is an agreement to exchange future cash flow at pre-specified Intervals.
Typically one cash flow is based on a variable price and other on affixed one. |
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Duration (Macaulay duration) measures the price volatility of fixed income securities.
It is often used in the comparison of interest rate risk between securities with
different coupons and different maturities. It is defined as the weighted average
time to cash flows of a bond where the weights are nothing but the present value
of the cash flows themselves. It is expressed in years. The duration of a fixed
income security is always shorter than its term to maturity, except in the case
of zero coupon securities where they are the same. |
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Modified Duration = Macaulay Duration/ (1+y/m), where 'y' is the yield (%), 'm'
is the number of times compounding occurs in a year. For example if interest is
paid twice a year m=2. Modified Duration is a measure of the percentage change in
price of a bond for a 1% change in yield. |
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An asset, including a leased asset, becomes non performing when it ceases to generate
income for the bank. |
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Gross NPA - (Balance in Interest Suspense account + DICGC/ECGC claims received and
held pending adjustment + Part payment received and kept in suspense account + Total
provisions held). |
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Equity minus net NPA divided by total assets minus intangible assets. |
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(Fresh accretion of NPAs during the year/Total standard assets at the beginning
of the year)*100 |
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A restructured account is one where the bank, grants to the borrower concessions
that the bank would not otherwise consider. Restructuring would normally involve
modification of terms of the advances/securities, which would generally include,
among others, alteration of repayment period/ repayable amount/ the amount of installments
and rate of interest. It is a mechanism to nurture an otherwise viable unit, which
has been adversely impacted, back to health. |
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A substandard asset would be one, which has remained NPA for a period less than
or equal to 12 months. Such an asset will have well defined credit weaknesses that
jeopardize the liquidation of the debt and are characterised by the distinct possibility
that the banks will sustain some loss, if deficiencies are not corrected. |
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An asset would be classified as doubtful if it has remained in the substandard category
for a period of 12 months. A loan classified as doubtful has all the weaknesses
inherent in assets that were classified as substandard, with the added characteristic
that the weaknesses make collection or liquidation in full, - on the basis of currently
known facts, conditions and values - highly questionable and improbable. |
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An asset would be classified as doubtful if it has remained in the substandard category
for a period of 12 months. A loan classified as doubtful has all the weaknesses
inherent in assets that were classified as substandard, with the added characteristic
that the weaknesses make collection or liquidation in full, - on the basis of currently
known facts, conditions and values - highly questionable and improbable. |
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A loss asset is one where loss has been identified by the bank or internal or external
auditors or the RBI inspection but the amount has not been written off wholly. In
other words, such an asset is considered uncollectible and of such little value
that its continuance as a bankable asset is not warranted although there may be
some salvage or recovery value. |
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Off-Balance Sheet exposures refer to the business activities of a bank that generally
do not involve booking assets (loans) and taking deposits. Off-balance sheet activities
normally generate fees, but produce liabilities or assets that are deferred or contingent
and thus, do not appear on the institution's balance sheet until and unless they
become actual assets or liabilities. |
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The credit equivalent amount of a market related off-balance sheet transaction is
calculated using the current exposure method by adding the current credit exposure
to the potential future credit exposure of these contracts. Current credit exposure
is defined as the sum of the positive mark to market value of a contract. The Current
Exposure Method requires periodical calculation of the current credit exposure by
marking the contracts to market, thus capturing the current credit exposure. Potential
future credit exposure is determined by multiplying the notional principal amount
of each of these contracts irrespective of whether the contract has a zero, positive
or negative mark-to-market value by the relevant add-on factor prescribed by RBI,
according to the nature and residual maturity of the instrument. |