First Lessons

CAPITAL ADEQUACY IN INDIAN BANKS

Background

The Committee on Banking Regulations and Supervisory Practices (Basle Committee) had released the guidelnes on capital measures and capital standards in July 1988 which have been accepted by Central Banks in various countries including RBI.

Objectives of CAR


The fundamental objective behind the norms is to strengthen the soundness and stability of the banking system.

The broad detail of the capital framework which has been implemented in India by RBI w.e.f. 1.4.92 is given as under:


Capital Adequacy Ratio or CAR

It is ratio of capital fund to risk weighted assets expressed in percentage terms.

Capital fund

Capital Fund has two tiers - Tier I and Tier II. While Tier I capital (also known as core capital), provides the most permanent and readily available support to a bank against unexpected losses, Tier II capital contains elements that are less permanent in nature or are less readily available.

Tier I capital include
paid-up capital, statutory reserves, other disclosed free reserves and capital reserves representing surplus arising out of sale proceeds of assets. Equity investments in subsidiaries, intangible assets, and losses in the current period and those brought forward from previous periods, will be deducted from Tier I capital.


Tier II of the capital consists of:
•Un-disclosed reserves and cumulative perpetual preference shares: •Revaluation Reserves (at a discount of 55 percent while determining their value for inclusion in Tier II capital) •General Provisions and Loss Reserves upto a maximum of 1.25% of weighted risk assets: •Hybrid debt capital Instruments: •Subordinated debt: These debts also known as bonds are subject to certain limitation and are also subject to progressive discount based on remaining maturity period.


Risk weighted assets

Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets. For instance, where RBI prescribed zero risk weight to an assets (say cash), the value of that asset for the purpose of risk will be taken as nil, irrespective of its actual value. Similarly the risk weightage of 2.5% for Govt. securities mean that the value of investment in Govt. securities for the purpose of risk weighted assets shall be taken at 2.5% of their actual value.


Off-Balance sheet (Non-funded) Items -

The credit risk exposure attached to off-balance sheet items has to be first calculated by multiplying the face amount of each of the off-balance sheet items by the credit conversion factor. This will then have to be again multiplied by the relevant weightage.


Minimum requirements of capital fund-RBI stipulations

•Banks are required to maintain capital adequacy ratio at 9% wef March 2000, as per present guidelines out of which Tier II cannot be more than Tier I capital (in other words it can be maximum of 50% of capital fund). Banks may voluntarily build-in the risk weighted components of their subsidiaries into their own balance sheet on notional basis, at par with the risk weights applicable to the bank’s own assets, wef March 2001.

Reporting requirements

•Banks should furnish an annual return indicating capital funds, conversion of off-Balance Sheet/non-funded exposures, calculation of risk weighted assets, and calculations of capital to risk assets ratio.

* Banks are also required to disclose in their balance sheet the quantum of Tier I and Tier II capital fund, under disclosure norms.

New framework


•Basle I Committee had recommended CAR framework for credit risk only during 1988, which RBI had implemented during 1992. Subsequently the market risk for investment in securities, including Govt. securities, was implemented in India wef March 31, 2000. Meanwhile Basle II, in June 1999, suggested capital adequacy not only for credit and market risk but for operational risk also. The new framework will come into effect by 2005 and replace the earlier framework of 1988.
•In terms of the new framework, the capital fund will comprise Tier I (shareholders’ equity and retained profits), Tier II (supplementary capital) and Tier III capital (subordinated debt with a minimum maturity of 2 years). Risk on the other hand, would comprise Credit Risk + Market Risk + Operational Risk.
•Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. So far, the measurement of operational risk has not been quantified but the committee has suggested a 20% risk weight for the operational risk.

To monitor the operational risk, the information technology and MIS systems are expected to play very important role. The risk management is expected to lead to lower capital requirement but to implement risk management, banks will have to invest heavily in technology.

DIGITAL SIGNATURES

For centuries, a document was considered authentic only if it carried the signatures of the authorised person and paper was the most common medium to carry the signature. In the information technology age, the paper is slowly disappearing and the business transactions are being executed electronically. The digital signature has been accorded legal sanctity in many countries including India by special legislations.


What is a digital signature (DS) ?

DS is a signature in electronic form attached to an electronic record. It is a tool for message origination, authentication and non-repudiation that affixes a coded message to the document, data or messages and guarantees the identity of the sender.


What purpose does a digital signature serve ?

It is executed or adopted by a person with intent to sign the record. DS identifies the origin of the message, ensures the integrity of the message, verifies the identity of the sender and authenticates that identity.


Is DS equivalent to handwritten signature ?

DS is generically the electronic equivalent of the handwritten signature. In India, the Information Technology Act 2000 considers a digital signature as a personalised thumb print. It defines it to mean authentication of an electronic record by a person in whose name the digital signature certificate is issued by means of an electronic method.


How can we ensure that electronic document is properly authorised ?


Through encryption (which is process of converting normal text to a coded message) and decryption (the process of convererting the coded text to its original plan text form) and signature certification, the authentication is ensured. DS certificates are essential for establishing whether the authorisation is from the purported owner.


What is a digital certificate ?

A DC essentially consists of a public key certification information, with information of the user such as name and ID. DS uses a pair of mathematically related signing keys (the private key), known only to the person signing.



What is the potential business areas for DS ?

Presently the insurance, health care and brokerage houses are the users of DS but with the passage of time the applicability areas are likely to multiply.



What are the likely benefits from this process ?

It is possible to hold and handle voluminous electronic records in a much easier manner that was not possible through paper records. Incessant delay in term of paper work are possible. There could be reduction of fraud, forgery and impersonation. The non-feasibility of the duplication of well designed and managed private keys reduce the possibility of fraud. DS ensure the integrity of the transmitted documents and provides the source of the document.



What is status in India?

India has enacted the legislation for facilitating and regulating e-commerce including digital signatures. The Act authorises Govt. to license and supervise activities of certifying authorities which are empowered to issue digital signature certificates. NSE has allowed trading members to use digital signatures on contract notes. However many issues remain to be addressed before DS replace the handwritten signature. Many individuals may not choose to do business in electronically, using digital signatures.

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