Capital Buffers

  • July 1, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Capital Buffers 

Context:

India’s scheduled commercial banks (SCBs) as well as non banking financial companies have sufficient capital buffers to withstand any shock that may emanate from the pandemic or the ongoing geopolitical tensions in Europe, the Reserve Bank of India said in its biannual Financial Stability Report (FSR) released on Thursday.

According to the report, Stagflation risks are mounting,as tightening financial conditions threaten to restrain the pace of growth

Details:

  • SCBs maintained robust capital positions, with the capital to risk weighted assets ratio (CRAR) rising to a new high of 16.7%.
  • The gross non-performing assets (GNPA) ratio slipped to a six-year low of 5.9% and net non-performing assets (NNPA) ratio fell to 1.7% in March 2022.
  • The provisioning coverage ratio (PCR) increased to 70.9% in March 2022, from 67.6% in March 2021

Concept:

Capital requirements as per Basel Norms:

  • The Basel Committee on Banking Supervision (BCBS) issues Basel Norms for international banking regulations.
  • The goal of these norms is to strengthen the international banking system by coordinating banking regulations around the world.
  • The Basel Committee has currently issued three guidelines to achieve its goal: Basel I, II, and III.

Basel I

  • It was introduced in 1988.
  • It was almost entirely concerned with credit risk.
  • It established the capital and risk-weighting structure for banks.
  • The required minimum capital was set at 8% of risk-weighted assets (RWA).
  • RWA refers to assets with varying risk profiles. For example, an asset backed by collateral would be less risky than a personal loan with no collateral.
  • Capital is divided into two categories: Tier 1 capital and Tier 2 capital.
    • Tier 1 capital is the bank’s core capital because it is the primary measure of the bank’s financial strength. The majority of core capital is made up of disclosed reserves (also known as retained earnings) and paid-up capital. It also includes non-cumulative and non-redeemable preferred stock.
    • Tier 2 capital – It is used as supplemental funding since it is less reliable than the first tier.It consists of undisclosed reserves, preference shares, and subordinate debt.
  • In 1999, India adopted the Basel 1 guidelines.

Basel II

  • In 2004, Basel II guidelines were published by BCBS.
  • These were the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which the committee calls it as pillars.
    • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets
    • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
    • Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank.
  • Basel II norms in India and overseas are yet to be fully implemented though India follows these norms.
Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital to its risk. It is also known as the Capital to Risk (Weighted) Assets Ratio (CRAR). In other words, it is the ratio of a bank’s capital to its risk-weighted assets and current liabilities. This ratio is utilized to secure depositors and boost the efficiency and stability of financial systems all over the world.

This is calculated by summing a bank’s tier 1 capital and tier 2 capitals and dividing the total by its total risk-weighted assets.

Basel III

  • In 2010, Basel III guidelines were released.
  • These guidelines were introduced in response to the financial crisis of 2008.
  • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
    • Capital: The capital adequacy ratio is to be maintained at 12.9%. The minimum Tier 1 capital ratio and the minimum Tier 2 capital ratio have to be maintained at 10.5% and 2% of risk-weighted assets respectively.In addition, banks have to maintain a capital conservation buffer of 2.5%. Counter-cyclical buffer is also to be maintained at 0-2.5%.
    • Leverage: The leverage rate has to be at least 3 %. The leverage rate is the ratio of a bank’s tier-1 capital to average total consolidated assets.
    • Funding and Liquidity: Basel-III created two liquidity ratios: LCR and NSFR. The liquidity coverage ratio (LCR) will require banks to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. The goal is to ensure that banks have enough liquidity for a 30-days stress scenario if it were to happen. The Net Stable Funds Rate (NSFR) requires banks to maintain a stable funding profile in relation to their off-balance-sheet assets and activities. NSFR requires banks to fund their activities with stable sources of finance (reliable over the one-year horizon). The minimum NSFR requirement is 100%.

Therefore, LCR measures short-term (30 days) resilience, and NSFR measures medium-term (1 year) resilience.

  • The deadline for the implementation of Basel-III was March 2019 in India. It was postponed to March 2020. In light of the coronavirus pandemic, the RBI decided to defer the implementation of Basel norms.
The Provisioning Coverage Ratio 

  • It is the percentage of bad assets that the bank has to provide for from their own funds.
  • In other words, it is the ability of banks to service its debt and meet its financial obligations such as interest payments or dividends.
  • Provision Coverage Ratio (PCR) = Provisions/Gross NPA
  • RBI has initially set a 70% benchmark as PCR. This means the bank has to set aside 70% of its loans as a provisional buffer. The higher the PCR, the better it is for the banks as it is useful when their NPAs grow at a faster rate. Ideally, a PCR above 70% is good.

Gross non-performing assets vs Net non-performing assets:

  • Gross non-performing assets is a term used by financial institutions to refer to the sum of all the unpaid loans which are classified as non-performing loans.
  • Credit institutions offer loans to their customers who fail to be honoured and within ninety days, financial institutions are obligated to classify them as non-performing assets because they are not receiving either principle or net payments.
  • Net non-performing assets is a term used by credit institutions to refer to the sum of the non-performing loans less provision for bad and doubtful debts. Credit institutions tend to provide a precautionary amount to cover the unpaid debts.
  • Therefore, if one deducts provision for unpaid debts from the unpaid debts, the resulting amount refers to the net non-performing assets.
Tips:

  • Stagflation refers to an economy that is experiencing a simultaneous increase in inflation and stagnation of economic output. Stagflation was first recognized during the 1970s when many developed economies experienced rapid inflation and high unemployment as a result of an oil shock.

Capital Buffers