Banks deal in public money as t hey lend and invest funds they generate in the form of deposits. This exposes

them to solvency risk. After the major banking crisis in U.S. which took place between 2007-2010, the banks

of US and Europe led by the Bank for International Settlement (BIS), came up with a comprehensive set of

norms for banks known as Basel Accord, which was assumed to address the solvency risk of banks across the

globe. Basel norms are applicable in India with minor modifications made by the Reserve Bank of India. This

paper throws light on the calculation of capital Requirement to Asset Ratio (CRAR) of on balance items of the

banks under pillar I of the Basel Norms. Calculation of Capital Requirement to Assets Ratio calculation

The typical nature of banks is that they deal in public money. They advance funds to the customers and invest

in equity, debt and derivative instruments..This makes the banks vulnerable if the investment goes bad and

advances are not recovered on time. The former case exposes the banks to credit risk, whereas, the latter,

exposes them to market risk. These risks, push the banks towards insolvency. Credit risk, featuring large

mortgage market exposure, was the major reason of the closure of Lehman Brothers, an international

investment bank. Basel norms for banks suggest to hold minimum capital of 9% by them in India of their

respective total risk weighted assets to avoid solvency risk. As a risk management principle, provisions are

made for average risk or mean risk, whereas, for standard deviation of risk, we are required to keep capital. In

the same line, Basel norms suggest the banks to keep capital in the form of tier I, tier II and tier III capital. This

funded assets only.

Banks are exposed to market risk due to interest rate changes, foreign exchange rate changes, and inflation

related matters like equity risk, commodity risk, etc. Market risk is comprised of three elements I.e interest rate

risk, foreign exchange related risk (including gold), and equity risk. They form major part of the trading book

of the bank. They contribute to total capital requirement for market risk in their respective proportions.

All those risks that cannot be put either in the category of credit risk or market risk, are put under the category

of operational risk.Operational risk includes risks like personnel risk, system risk, IT failure risk, liquidity risk,

money laundering risk, etc.

All the above mentioned risks force the banks towards insolvency. To avoid solvency risk, banks are suggested

to maintain minimum capital, which is 8% of their risk weighted assets as per international standard but, in

2014). Capital requirement regulations under Basel I, did not increase the capital ratio of banks in the

developing countries. This implies that while deciding the regulations, factors like business, environment, legal

and cultural factors must be considered ( M Erchad Hussain, M Kabir Hassan). Standard determinants of

capital structure do have power in explaining both book capital and market leverage ( Monica Octavia, Rayan

Brown, 2010). In response to international financial developments after the global financial tsunami in 2008,

the Bank for International Settlements (BIS) proposed BASEL III in 2010, whereby banks have to increase

their minimum capital adequacy ratios year by year with a goal of 10.5% in 2019 ( Yang Li, Yi- Kai Chen,

Feng Sheng Chien, Wen Chih Lee, Yi- Ching Hsu). The capital adequacy ratio determines the ratio of a bank’s

core capital to the assets and off balance sheet liabilities, weighted by the risk. It has been specified that the

value of this coefficient cannot be lower than 8% (Malgorzata Bialas, Adrian Solek, 2010). The positive

banks listed on the Indonesia stock exchange, there is a negative and significant relationship with return on

asset. Capital adequacy ratio mediates the effect of non - performing loans on return on assets ( Ni Kadek

Mareti Swandawi, Ni Ketut Purnawati, 2021) Capital adequacy ratio has a positive correlation with the

financial stability of Vietnamese commercial banks during 2010-2020 ( Minh Sang Nguyen, 2021).

Examining a sample of 560US bank holding companies for a period of 2003-2009, results reveal that the

holding company has a Tier I capital ratio of less than 6%. This is the level below which US bank regulators

do not regard banks as being well capitalized (Heba Abou-El- Sood, 2016).

For the smooth flow of creditin an economy, it is essential that banks should be financially sound so as to meet

the various requirements of other fields. Capital adequacy ratio (CAR) is one of the measures which ensures

Banks encounter with the credit risk as a result of credit quality deterioration ( Goyal, 2010). For the purpose

of assigning risk weights, risks, are categorized as a. exposure to central and state government carrying 0% risk

weight, b. public sector banks carrying risk weight ranging from 0-20%, and c. others carrying carrying 100%

risk weight ( Hull C. John, “Risk Management and Financial Institution”, ISBN 81-317-482-9; First

Impression, p184),

flaws. The categorical risk weights were not only crudely calibrated but they permitted and indeed encouraged

regulatory arbitrage. For example, OECD member countries such as Greece or Iceland received the same zero

percent risk weighting for their debt as the United States and the United Kingdom. The same was true with

respect to the uniform 100 percent risk weight.

2010).

risk under pillar I of Basel norms.

3. To understand the treatments of investments under banking book (HTM), and trading book (AFS and HFT)

categories.

The capital requirement to Assets Ratio (CRAR) of any bank depended on capital requirements for credit risk

market risk and operational risk. The capital requirements, in turn, depended on the risk weighted assets for

these types of risk separately. Under standardized approach, risk weighted assets for credit risk depended on

various risk weights assigned to various assets of the bank. The book value of an asset when multiplied by the

assigned risk weight gave risk weighted value of the asset.To calculate risk weighted assets for market risk, the

or capital adequacy ratio (CAR).

To explain the process of calculating capital adequacy ratio ( pillar I of Basel II), example cited on RBI’s web

site had been taken, analyzed and explained. In the context of credit risk, standardized approach was

considered, as the banks in India are still passing through a nascent stage of risk management. Under the

approach, risk weights as provided by the RBI, were assigned to various on balance sheet items, which

provided risk weighted assets for credit risk. To calculate the capital charge for market risk, standard duration

approach was used which covered the general market risk. To calculate capital charge for specific risk, the

capital charges prescribed by the RBI were followed. To calculate capital charge for operational risk, the basic

indicator approach, as suggested by the RBI at introductory level had been considered.

- 20% in case of public sector banks, and 100% in case of ‘others’ category. This 100% risk weight for ‘others’

category acts as a flaw of the standardized approach , as a potential private sector customer can unnecessarily

be assigned a risk weight of 100%. A bank’s assets can be divided into ‘fund based’ and ‘non- fund based’

assets. The assets which involve fund of the bank are funded assets and those which do not affect the fund of

the bank are known as ‘non - funded’ assets.

general market risk, whereas, foreign exchange position including gold qualified only for general market risk

capital charge always equals General market risk refers to adverse movements in prices of interest rate related

securities due to change in interest rates. Under standardized duration approach, it is measured with the help of

per cent change in yield. The model helps in calculating the capital charges for interest rate related securities.

Operational risk capital charge, based on the basic indicator approach, is calculated by multiplying the average

gross annual income of the bank of previous three years, if positive, from 15%(α).

In the light of the above discussion, the process of calculating capital adequacy ratio of banks in India has

been explained in details.

Due to the very nature of the banks, the risk management becomes all pervasive across sectors and, banks are

no exception. Banks deal in public money which is accepted by them as deposits which are then lent to

assets to address liquidity risk and decreasing bank leverage. By decreasing bank leverage it was sought by the

authorities to lessen the dependency of banks on debt capital.

Here we will focus on pillar I, as to how to calculate capital adequacy ratio for the banks.

Others - Rs.500 crore

(AFS) Categories. Trading books are excluded while calculating risk weighted assets of credit risk. Hence the

risk weighted assets for credit risk would be as under.

Details of assets

market value

Risk weight in

%

Trading book investments qualify for risk weighted assets for market risk. In other words held for the trading

[HFT] category and available for sale[AFS] category qualify for market risk and not credit risk. Market risk

comprises both specific risk and general market risk.

For specific market risk, capital charges have already been suggested by the RBI.

Other securities: Rs 300 crore @9% = RS 27 Crore[9% capital charge always = 100 % risk weight].

Total of specific market risk is 1+2+3=0+5.325+27 = 32.325 crore

1/5/2003