Reciprocal Cross-Holdings

Reciprocal Cross-Holdings

Subject: Economy

Section: Indian Economy

Context:

A clause in the Reserve Bank of India’s Master Circular on Basel-III Capital Regulations relating to ‘Reciprocal Cross-Holdings in the Capital of Banking, Financial, and Insurance Entities’ may prevent banks from going all out to invest in LIC’s IPO.

Concept :

According to the Circular, banks are required to apply a “corresponding deduction approach” to reciprocal cross-holdings in the capital of other banks, financial institutions, and insurance entities.

As LIC has investments in the form of equity, Additional Tier (AT)-1 and Tier-2 capital in various banks, investments made by the latter in the corporation’s upcoming IPO could impact their capital adequacy.

So, banks will need to assess whether the returns they may get from investing in LIC’s IPO more than offsets the capital deduction impact of the investment. This will require full deduction from the regulatory capital of the investing entity (bank) to the extent of the investment to be made by them in LIC.

Concept:

Reciprocal cross holding means a holding by a bank of the regulatory capital fund instruments or other capital instruments issued by financial sector entities where those entities also hold own funds instruments of the regulatory capital issued by the bank.

Law?

In regards to cross holding of capital where the Basel is of the view that reciprocal cross-holdings of bank capital artificially designed to inflate capital position of banks should be deducted, RBI has said that a 10% limit of the total capital be prescribed up to which cross-holdings of capital and other regulatory investments could be permitted and any excess investments above the limit would be deducted from total capital.

Bank Capital

According to Basel-III norms, banks’ regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier-1 (CET-1) and Additional Tier-1 (AT-1) capital.

• Tier 1 capital is a bank’s core capital and includes disclosed reserves—that appears on the bank’s financial statements—and equity capital. This money is the funds a bank uses to function on a regular basis and forms the basis of a financial institution’s strength.
  • Common Equity Tier 1 capital includes equity instruments where returns are linked to the banks’ performance and therefore the performance of the share price. They have no maturity. CET1 is the highest quality of capital, and can absorb losses immediately as they occur. This category includes common shares, retained earnings, accumulated other comprehensive income, and qualifying minority interest, minus certain regulatory adjustments and deductions.

• Additional Tier 1 Capital includes noncumulative, non redeemable preferred stock and related surplus, and qualifying minority interest. These instruments can also absorb losses, although they do not qualify for CET1.
• Together, CET and AT-1 are called Common Equity. Under Basel III norms, minimum requirement for Common Equity Capital has been defined.
• Tier 2 capital is a bank’s supplementary capital. Undisclosed reserves, subordinated term debts, hybrid financial products, and other items make up these funds.