Module: 2 - Capital Adequacy Ratio - Basle Accord 1988

The growing concern of commercial banks regarding international competitiveness and capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries, to be achieved by year-end 1992. The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The document consists of two broad sections, which cover:

1. The definition of capital and

2. The structure of risk weights.

The Basel Accord 1988 for the first time brought out the need that the capital of a bank should be directly in proportion not only to its risk-based assets, but also to the risk-weight age (quality) thereof. The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of the G10 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition. Capital is necessary for banks as a cushion against losses and it provides an incentive for the owners of the business to manage it in a prudent manner.

The 1988 Accord requires internationally active banks in the G10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their risk-content. The definition of capital is set (broadly) in two tiers, Tier 1 being shareholders' equity and retained earnings and Tier 2 being additional internal and external resources available to the bank. The bank has to hold at least half of its measured capital in Tier 1 form.

A portfolio approach is taken to the measure of risk, with assets classified into four buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that some assets (essentially bank holdings of government assets such as Treasury Bills and bonds) have no capital requirement, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claim. However, virtually all claims on the non-bank private sector receive the standard 8% capital requirement. There is also a scale of charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc. This is the only complex section of the 1988 Accord and requires a two-step approach whereby banks convert their off-balance-sheet positions into a credit equivalent amount through a scale of conversion factors, which then are weighted according to the counterparty's risk weighting.

The 1988 Accord has been supplemented a number of times, with most changes dealing with the treatment of off-balance-sheet activities. A significant amendment was enacted in 1996, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument.

The two principal purposes of the Accord were to ensure an adequate level of capital in the international banking system and to create a "more level playing field" in competitive terms so that banks could no longer build business volume without adequate capital backing. These two objectives have been achieved. The merits of the Accord were widely recognized and during the 1990s the Accord became an accepted world standard, with well over 100 countries applying the Basel framework to their banking system.

However, there also have been some less positive features. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. The simple bucket approach with a flat 8% charge for claims on the private sector has given banks an incentive to move high quality assets off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the 1988 Accord does not sufficiently recognize credit risk mitigation techniques, such as collateral and guarantees. These are the principal reasons why the Basel Committee decided to propose a more risk-sensitive framework in June 1999. The second accord is also finalised now and is to come into operation from the end of year 2006. Broad outlines of the second accord are given in Annexure I.

We will study more about the 1988 Accord in Module No.2.

Banks in India are regulated in terms of the Banking Regulations Act 1949. The Act earlier specified the authorised capital of a commercial bank at Rs.100 Crore. In other words there was originally no stipulation regarding the minimum capital that a commercial bank should possess. On the contrary there was a restriction on the maximum capital. This suited the private banks, which were happy to have a low capital base to financially leverage the full benefit. The banks were able to declare huge dividends even with a normal profit taking advantage of the low capital base. The banks could not realize the inherent risk, though bank failures were quite common in those days. RBI was coming to the help of the depositors of these failed banks and was in the routine course merging them with one or other of the stronger public sector banks, after initially granting failed private bank a moratorium for 6 months.

Another threat faced by the private banks in those days on account of their low capital base, was that they became easy pray for being taken over (hostile take over) by ambitious industrial houses. This problem was well illustrated during the debate in Parliament, in 1992, while discussing the amendment to The Banking Companies (acquisition and transfer of undertakings) Act, 1970 as under: -

"The problem of weak capital base of banks has worried the financial community both here and abroad. Inadequate capitalisation is the main cause of bank failures, hostile take-over and financial instability in general. It is well acknowledged that Indian banks are seriously under-capitalised."

".. on the serious under capitalisation of private banks-even through this Bill deals with the public sector banks- I would like to take a moment. This under capitalisation of private banks is also a matter of grave concern. Many small banks are falling prey to hostile takeover by larger monopoly industrial houses. We have the case of Bank of Sangli is attempted hostile takeover by Mittals; Madura Bank by Kotak Mahindra; Bank of Rajasthan by Bagurs; Syrian Catholic Bank by the House of Birlas; and Nedugali Bank by the now famous FFSI. We also know that the Bank of Karad was manipulated and controlled by a few brokers only because it had a paid up capital of only Rs.30 lac while it had a business turnover of over Rs. 80 Crore. And the whole action knows what happens when the financial and industrial houses get hold of small private sector banks. We have seen how a few banks have really wrecked havoc with the entire financial system of this country. So, the Government will have to seriously formulate firm guidelines to stop such hostile takeovers which subvert the concept of social control of banks and reverses the spirit of bank's nationalisation which Shrimati Indira Gandhi brought in."

On account of Government ownership, displaying themselves as "Undertakings fully owned by the Government of India", the public sector banks were initially not affected by this problem, of inadequate capital. However the dark days were not far off from them.

The Government nationalized the major commercial banks in the years 1970 (first batch) and again in 1980 (2nd batch). This brought about 80% of the banking system in the country within the fold of government control.

Nationalisation of banks saw a rapid expansion of banking and banking habits in the country. After two decades of Nationalisation as at the beginning of the year 1991, there were more than 50000 branches of commercial banks, (a ten-fold increase) with a considerable spread in rural and semi-urban centres. Commercial banks accepted a dominant role in financing agriculture and allied activities ushering green revolution with a spurt in agricultural production making the country self-sufficient and surplus (exportable surplus) thus providing an assured food security, a white revolution taking the country to number one position in the world in the production of milk and milk products. The aggregate deposits of the Banks, which were at a base level of Rs.5300 Crore at the time of nationalisation spurted to Rs.50,000 Crore (ten fold) by 1995 and Rs.l00,000 Crore by 2000 A.D.

Extensive financing of exports, small-scale industries, technical entrepreneurs, self-employed professionals, small artisans and retailers created a new segment of prosperity in the country. Today in India there are 300 million persons representing a new middle and upper middle class, with a corresponding reduction in the percentage of people below poverty line.

All these achievements could not have been possible, but for the bold step of Nationalisation and accepting a new culture and policy of development banking by the State-owned Banks.

It was a contrast of good objectives, but wrong internal policies and mismanagement of growth opportunities. Social banking was deemed the opposite of prudent banking. There were annual targets for deposit mobilization, targets for priority sector lending, opening branches in rural and semi-urban centres, but no care for profitability and providing earnings and strengthening the viability and the capital base. Earning profits was considered a non-priority area.

The health of banks is determined by many factors, the most significant being a strong capital base, adequate provisioning, the nature of investments made, the quality of asset management, the skill and commitment of officials, quantity and quality of informational data, the internal incentive mechanisms and above all the nature of governmental interference, in particular by the monetary authorities of the country in question.

It is a keen social vision, but total blindness towards maintaining one's own house in order. It was the record of public sector banks. Each and everyone of the above mentioned parameters for healthy development of banking was discarded.

Since the Seventies the Scheduled Commercial Banks (SCBs) of India functioned totally as captive capsule units cut off from international banking and unable to participate in the structural transformations, the sweeping changes, and the new type of lending products emerging in the global banking Institutions.

Since the beginning of the Eighties, the International Financial Markets were witnessing revolutionary structural changes in terms of financial instruments and the nature of lenders and borrowers. On the one hand there is a declining role for the Banks in direct financial intermediation. On the other hand there is enormous increase in securitised lending, the growth of new financial facilities of raising funds directly from investors. There is also the growth of innovative techniques such as interest rate swaps, financial and foreign exchange futures and foreign exchange and interest rate options.

While such revolutionary changes were taking place in the global arena, the Indian Banking context was completely insulated and kept captive up to the beginning of the Nineties, on account of directed policies on major business and operational matters, in particular those relating to credit, investment, rate of interest etc. Basic policy parameters were decided by RBI and the Finance Ministry and Banks had little options in this respect. This carried Indian Banking two decades behind International banking. This phenomenon had to be urgently remedied in the Nineties, when Government had to introduce the sweeping Reforms in the Financial and Banking Sector.

The individual identities of public sector banks were maintained, but they were regimented and controlled and in fact operated from outside as per the dictations of the Reserve Bank of India and Finance Ministry. Credit dispensation was directed, Rate of Interest similarly directed. Top management and senior executives of the Banks by virtue of this lost completely the skills & initiative or innovative working or to acquire skills for facing challenges. The twenty-seven public sector banks with the result became co-marching entities and not vibrant mutually competing enterprises.

The crisis in the nationalized banks coincided with the economic crisis faced by the Country in the early Nineties. Government initiated the Economic reforms followed by reforms in the financial and banking sector. Prudential norms were introduced to be followed by the banks in the year 1993. RBI candidly describes the conditions of the nationalized banks at the eve of this change.

In the peak crisis period in early Nineties, when the first Series of Banking Reforms were introduced, the working position of the State-owned banks exhibited the severest strain. Commenting on this situation the Reserve Bank of India in its web site has pointed out as under:

"Till the adoption of prudential norms relating to income recognition, asset classification, provisioning and capital adequacy, twenty-six out of twenty-seven public sector banks were reporting profits (UCO Bank was incurring losses from 1989-90). In the first post-reform year, i.e., 1992-93, the profitability of the PSBs as a group turned negative with as many as twelve nationalised banks reporting net losses. By March 1996, the outer time limit prescribed for attaining capital adequacy of 8 per cent, eight public sector banks were still short of the prescribed."

Consequently PSBs in the post reform period came to be classified under three categories as

• Healthy banks (th-ose that are currently showing profits and hold no accumulated losses in their balance sheet)

• Banks showing currently profits, but still continuing to have accumulated losses of prior years carried forward in their balance sheets

• Banks, which are still in the red, i.e. showing losses in the past and in the present.

It was in this background that the Banking Regulator enforced Capital Adequacy norms to the Indian Banks. Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian banks. According to these guidelines, the banks will have to identify their Tier-I and Tier-II capital and assign risk weights to the assets. Having done this they will have to assess the Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR, which the Indian banks are required to meet, is set at 8 percent at present to be achieved before the year 1996. It was subsequently increased TO 9%. Presently the CRAR is 10%. This may further increase if the provisions of the Second Basel Accord are implemented in the year 2006.