Risk & Risk Management:

Any uncertainty or any probability of an uncertain event occurring and resulting into some
sort of loss or damage is defined as Risk.

For Financial Institutions, Banks and NBFCs also have risk for the loans they give and the
investments they make. These entities lend or invest with the objective of receiving interest
income or making returns and also that the principal amount lent or invested will be received
back. If these funds fail to come back or the returns/yields are not received on expected
lines, the FIs/Banks/NBFCs will find it difficult to pay back its own sources of funds such as
depositors or investors and also to pay interest to depositors and returns to its investors.

In view of the above, the management of Risk in such entities assumes greater importance.
Risk Management can be thus defined as a process by which risks in an organization is
identified, assessed, prioritized and addressed so as to minimize the risk.

BASEL
Basel is a city in Switzerland which is also the headquarters of Bearu of International
Settlement (BIS). BIS was established on 17th May 1930, and is world’s oldest international
financial organization. The collapse in 1974 of Bankhaus Herstatt in Germany and of the
Franklin National Bank in the US; prompted the G10 central bank Governors to set up the
Basel Committee on Banking Supervision (BCBS). BCBS was formed in the end of 1974 by
the Central Bank Governors of the Group of G10 countries

The Committee's members were from Belgium, Canada, France, Germany, Italy, Japan,
Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States.
The Basel Capital Accord is an Agreement concluded among country representatives in
1988 to develop standardised risk-based capital requirements for banks across countries. A
document titled, ‘International Convergence of Capital Measurement and Capital Standards’,
popularly known today as Basel-I was finalized and released in July 1988 and
Implementation by end-1992. The purpose of the Accord is to ensure that financial
institutions have enough capital on account to meet the obligations and absorb unexpected

Indian Context
The Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for
banks (including foreign banks) in India as a capital adequacy measure in line with the
Capital Adequacy Norms prescribed by Basel Committee

The basic approach of capital adequacy framework is that a bank should have sufficient
capital to provide a stable resource to absorb any losses arising from the risks in its
business.

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BASEL I
The Basel I guidelines issued in 1988 primarily focused on capital charge for credit risk,
which was a simple “broad-brush” approach

Essentially, under the Basel I, the balance sheet assets, non-funded items and other off-
balance sheet exposures are assigned prescribed risk weights and banks have to maintain
unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of the
risk weighted assets and other exposures on an ongoing basis.

The Framework was updated in November 2005 to include trading activities and the
treatment of double default effects and a comprehensive version of the framework was
issued in June 2006 incorporating the constituents of capital and the 1996 amendment to the
Capital Accord to incorporate Market Risk.

Basel I guidelines issued by RBI discusses Capital, Credit Risk, Market Risk, Capital
Charge and procedure for computation of Capital Adequacy Ratio (CRAR).

In this module, Market Risk and Capital Charge for Market Risk, Capital Charge for
Credit Default Swaps, Capital Charge for subsidiaries is excluded

Components of Capital
Under Basel I guidelines, Banks were required to maintain a minimum CRAR of 9 per cent
on an ongoing basis.

Capital is divided into tiers according to the characteristics/qualities of each qualifying

instrument.

For supervisory purposes capital is split into two categories: Tier I and Tier II.

These categories represent different instruments’ quality as capital.

Elements of Tier I Capital: Tier I capital is a bank’s highest quality capital because it is fully
available to cover losses.

The elements of Tier I capital include:

(i) Paid-up capital (ordinary shares), statutory reserves, and other disclosed free
reserves, if any;
(ii) Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion as Tier I
capital - subject to laws in force from time to time;*
(iii) Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital;**
(iv) Capital reserves representing surplus arising out of sale proceeds of assets.

* The broad guidelines for inclusion of Perpetual Non-cumulative Preference Shares

(PNCPS) as Tier I capital are as under:

Limit: The outstanding amount of Tier I Preference Shares along with Innovative
Tier 1 instruments shall not exceed 40 per cent of total Tier I capital at any point
of time. The above limit will be based on the amount of Tier I capital after
deduction of goodwill and other intangible assets but before the deduction of
investments. Tier I Preference Shares issued in excess of the overall ceiling of
40 per cent shall be eligible for inclusion under Upper Tier II capital, subject to
limits prescribed for Tier II capital. However, investors' rights and obligations
would remain unchanged.

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Amount: The amount of PNCPS to be raised may be decided by the Board of
Directors of banks

Maturity: The PNCPS shall be perpetual

Options
(i) PNCPS shall not be issued with a 'put option' or ‘step up option'.
(ii) However, banks may issue the instruments with a call option at a particular
date. But the call option on the instrument is permissible after the instrument is
run for at least 10 years and Call option is run with the prior approval of RBI.

Dividend
The rate of dividend payable to the investors may be either a fixed rate or a
floating rate referenced to a market determined rupee interest benchmark rate

Seniority of Claim
The claims of the investors in PNCPS shall be senior to the claims of investors in
equity shares and subordinated to the claims of all other creditors and the
depositors

Grant of Advances
Banks should not grant advances against the security of the PNCPS issued by
them

Classification in the Balance sheet

These instruments will be classified as capital and shown under 'Schedule I-
Capital' of the Balance sheet

** The broad guidelines for inclusion of innovative Perpetual Debt

Instrument (IPDI) as Tier I capital are as under:

Nature:
The Innovative Perpetual Debt Instruments (Innovative Instruments) may be
issued as bonds or debentures by Indian banks.

Limit:
The total amount raised by a bank through innovative instruments shall not
exceed 15 per cent of total Tier I Capital. The eligible amount will be computed
with reference to the amount of Tier I Capital as on March 31 of the previous
financial year, after deduction of goodwill, Deferred Tax Assets (DTA) and other
intangible assets but before the deduction of investments.

Innovative instruments in excess of the above limits shall be eligible for inclusion
under Tier II, subject to limits prescribed for Tier II capital. However, investors’
rights and obligations would remain unchanged

Amount: The amount of innovative instruments to be raised may be decided by

the Board of Directors of banks

Maturity: The innovative instruments shall be perpetual

Options
Innovative instruments shall not be issued with a ‘put option’ or a ‘step-up
option’.

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 However banks may issue the instruments with a call option subject to strict
compliance with each of the following conditions:
(a) Call option may be exercised after the instrument has run for at least ten
years; and
(b) Call option shall be exercised only with the prior approval of RBI

Rate of Interest
The interest payable to the investors may be either a fixed rate or a floating rate
referenced to a market determined rupee interest benchmark rate

Seniority of claim:
The claims of the investors in innovative instruments shall be:
a) Superior to the claims of investors in equity shares; and
b) Subordinated to the claims of all other creditors

Grant of Advances
Banks should not grant advances against the security of the innovative
instruments issued by them.

Classification in the Balance Sheet

Banks may indicate the amount raised by issue of IPDI in the Balance Sheet
under schedule 4 “Borrowings

Elements of Tier II Capital: Tier II Capital consists of certain reserves and certain types
of subordinated debt. The loss absorption capacity of Tier II capital is lower than that of
Tier I capital. When returns of the investors of the capital issues are counter guaranteed
by the bank, such investments will not be considered as Tier I/II regulatory capital for the
purpose of capital adequacy.

The elements of Tier II capital include:

(i) Undisclosed Reserves

They can be included in capital, if they represent accumulations of post-tax profits
and are not encumbered by any known liability and should not be routinely used
for absorbing normal loss or operating losses.

(ii) Revaluation Reserves

Revaluation reserves at a discount of 55 per cent have been permitted to be
considered for determining their value for inclusion in Tier II capital. Such
reserves will have to be reflected on the face of the Balance Sheet as revaluation
reserves.

(iii) General Provisions and Loss Reserves

Such reserves can be included in Tier II capital if they are not attributable to the
actual diminution in value or identifiable potential loss in any specific asset and
are available to meet unexpected losses.

Adequate care has to be taken to see that sufficient provisions have been made
to meet all known losses and foreseeable potential losses before considering
general provisions and loss reserves to be part of Tier II capital.

General provisions/loss reserves will be admitted up to a maximum of 1.25

percent of total Risk Weighted Assets.

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 'Floating Provisions' held by the banks, which is general in nature and not made
against any identified assets, may be treated as a part of Tier II capital within the
overall ceiling of 1.25 percent of total Risk Weighted Assets.

Excess provisions which arise on sale of NPAs would be eligible Tier II capital
subject to the overall ceiling of 1.25% of total Risk Weighted Assets.

(iv) Hybrid Debt Capital Instruments

Those instruments which have close similarities to equity; in particular when they
are able to support losses on an ongoing basis without triggering liquidation, may
be included in Tier II capital.

At present the following instruments have been recognized and placed under this
category:
(a) Debt capital instruments eligible for inclusion as Upper Tier II capital*
(b) Perpetual Cumulative Preference Shares (PCPS) / Redeemable Non-
Cumulative Preference Shares (RNCPS) / Redeemable Cumulative
Preference Shares (RCPS) as part of Upper Tier II Capital.**

* The broad guidelines for inclusion of Debt Capital Instruments as Tier II

capital are as under:

Limit: Upper Tier II instruments along-with other components of Tier II Capital

shall not exceed 100% of Tier I capital. The said limit will be based on the
amount of Tier I capital after deduction of Goodwill and other intangible assets
but before the deduction of investments.

Amount: The amount of Upper Tier II instruments to be raised may be decided

by the Board of Directors of banks

Currency of Issue:
Banks shall issue Upper Tier II Instruments in Indian Rupees.

Instruments in foreign currency can also be issued without seeking the prior
approval of the Reserve Bank of India, subject to compliance with the under
mentioned requirements:
(a) Upper Tier II Instruments issued in foreign currency should comply with all
terms and conditions (except the ‘step-up option’) applicable as issued by
RBI on January 25, 2006, unless specifically modified.
(b) The total amount of Upper Tier II Instruments issued in foreign currency shall
not exceed 25 per cent of the unimpaired Tier I Capital. This eligible amount
will be computed with reference to the amount of Tier I Capital as on March
31 of the previous financial year, after deduction of goodwill and other
intangible assets but before the deduction of investments.

Maturity: The Upper Tier II instruments should have a minimum maturity of 15

years.

Options
Upper Tier II instruments shall not be issued with a ‘put option’ or a ‘step-up
option’. However banks may issue the instruments with a ‘call option’ subject to
strict compliance with each of the following conditions:
 Call options may be exercised only if the instrument has run for at least ten
years;
 Call options shall be exercised only with the prior approval of RBI.

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Rate of Interest
The interest payable payable to the investors may be either a fixed rate or a
floating rate referenced to a market determined rupee interest benchmark rate

Seniority of Claim
The claims of the investors in Upper Tier II instruments shall be
 Superior to the claims of investors in instruments eligible for inclusion in Tier I
capital; and
 Subordinate to the claims of all other creditors.

Discount:
The Upper Tier II instruments shall be subjected to a progressive discount for
capital adequacy purposes as in the case of long-term subordinated debt over
the last five years of their tenor. As they approach maturity these instruments
should be subjected to progressive discount as indicated in the table below for
being eligible for inclusion in Tier II capital

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20

Redemption:
Upper Tier II instruments shall not be redeemable at the initiative of the holder.
All redemptions shall be made only with the prior approval of the Reserve Bank of
India (Department of Banking Regulation).

Grant of Advances
Banks should not grant advances against the security of the Upper Tier II
instruments issued by them

Classification in the Balance Sheet

Banks have to indicate the amount raised by issue of Upper Tier II instruments by
way of explanatory notes / remarks in the Balance Sheet as well as under the
head” Hybrid debt capital instruments issued as bonds/debentures” under
Schedule 4 - ' Borrowings

** The broad guidelines for Perpetual Cumulative Preference Shares

(PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) /
Redeemable Cumulative Preference Shares (RCPS) as part of Upper Tier
II Capital are as under:

Characteristics of the instruments

(a) These instruments could be either perpetual (PCPS) or dated (RNCPS and
RCPS) instruments with a fixed maturity of minimum 15 years.
(b) The perpetual instruments shall be cumulative. The dated instruments could
be cumulative or non-cumulative

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Limits
The outstanding amount of these instruments along with other components of Tier
II capital shall not exceed 100 per cent of Tier I capital at any point of time. The
above limit will be based on the amount of Tier I capital after deduction of
goodwill and other intangible assets but before the deduction of investments.

Amount
The amount to be raised may be decided by the Board of Directors of banks.

Options
(i) These instruments shall not be issued with a 'put option' or ‘step-up option’.
(ii) However, banks may issue the instruments with a call option at a particular
date subject to strict compliance with each of the following conditions:
(a) The call option on the instrument is permissible after the instrument
has run for at least ten years; and
(b) Call option shall be exercised only with the prior approval of RBI
(Department of Banking Regulation).

Coupon
The coupon payable to the investors may be either at a fixed rate or at a floating
rate referenced to a market determined rupee interest benchmark rate.

Redemption / repayment of redeemable Preference Shares included in Upper

Tier II

a) All these instruments shall not be redeemable at the initiative of the holder.
b) Redemption of these instruments at maturity shall be made only with the prior
approval of the Reserve Bank of India (Department of Banking Regulation.

Seniority of claim
The claims of the investors in these instruments shall be senior to the claims of
investors in instruments eligible for inclusion in Tier I capital and subordinate to
the claims of all other creditors including those in Lower Tier II and the depositors.
Amongst the investors of various instruments included in Upper Tier II, the claims
shall rank pari-passu with each other.

Amortization for the purpose of computing CRAR

The Redeemable Preference Shares (both cumulative and non-cumulative) shall
be subjected to a progressive discount for capital adequacy purposes over the last
five years of their tenor, as they approach maturity as indicated in the table below
for being eligible for inclusion in Tier II capital.

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20

Grant of advances against these instruments

Banks should not grant advances against the security of these instruments issued
by them.

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 Classification in the balance sheet
These instruments will be classified as borrowings under Schedule 4- Borrowings
of the Balance sheet as item No.1.

(v) Subordinated Debt

Banks can raise, with the approval of their Boards, rupee-subordinated debt as
Tier II capital, subject to the terms and conditions broadly outlined below:

Terms of issue of bond

To be eligible for inclusion in Tier – II Capital, terms of issue of the bonds as
subordinated debt instruments should be in conformity with the following:

Amount
The amount of subordinated debt to be raised may be decided by the Board of
Directors of the bank.

Maturity period
(a) Subordinated debt instruments with an initial maturity period of less than 5
years, or with a remaining maturity of one year should not be included as part
of Tier-II Capital. They should be subjected to progressive discount as they
approach maturity at the rates shown below:

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20

(b) The bonds should have a minimum maturity of 5 years. However if the bonds
are issued in the last quarter of the year i.e. from 1st January to 31st March,
they should have a minimum tenure of sixty three months.

Rate of interest
The coupon rate would be decided by the Board of Directors of banks.

Options
Subordinated debt instruments shall not be issued with a 'put option' or ‘step-up
option’. However banks may issue the instruments with a call option subject to
strict compliance with each of the following conditions:

(a) Call option may be exercised after the instrument has run for at least five
years; and
(b) Call option shall be exercised only with the prior approval of RBI
(Department of Banking Regulation).

Inclusion in Tier II capital

Subordinated debt instruments will be limited to 50 per cent of Tier-I Capital of the
bank. These instruments, together with other components of Tier II capital, should
not exceed 100% of Tier I capital.

Grant of advances against bonds

Banks should not grant advances against the security of their own bonds.

Page 8 of 65
 Treatment of Investment in subordinated debt
Investments by banks in subordinated debt of other banks will be assigned 100%
risk weight for capital adequacy purpose. Also, the bank's aggregate investment in
Tier II bonds issued by other banks and financial institutions shall be within the
overall ceiling of 10 percent of the investing bank's total capital. The capital for this
purpose will be the same as that reckoned for the purpose of capital adequacy.

Classification in the Balance Sheet: These instruments should be classified

under 'Schedule 4 – Borrowings’ of the Balance sheet

(vi) Investment Reserve Account

In the event of provisions created on account of depreciation in the ‘Available for
Sale’ or ‘Held for Trading’ categories being found to be in excess of the required
amount in any year, the excess should be credited to the Profit & Loss account and
an equivalent amount (net of taxes, if any and net of transfer to Statutory Reserves
as applicable to such excess provision) should be appropriated to an Investment
Reserve Account in Schedule 2 –“Reserves & Surplus” under the head “Revenue
and other Reserves” in the Balance Sheet and would be eligible for inclusion under
Tier II capital within the overall ceiling of 1.25 per cent of total risk weighted assets
prescribed for General Provisions/ Loss Reserves.

(vii) General Provisions on Standard Assets and Provisions held for country
exposures
Banks are allowed to include the ‘General Provisions on Standard Assets’ and
‘provisions held for country exposures’ in Tier II capital. However, the provisions on
‘standard assets’ together with other ‘general provisions/ loss reserves’ and
‘provisions held for country exposures’ will be admitted as Tier II capital up to a
maximum of 1.25 per cent of the total risk-weighted assets.

Deductions from computation of Capital funds:

Deductions from Tier I Capital: The following deductions should be made from Tier I
capital:
(a) Intangible assets and losses in the current period and those brought forward from
previous periods should be deducted from Tier I capital;
(b) Creation of deferred tax asset (DTA) results in an increase in Tier I capital of a bank
without any tangible asset being added to the banks’ balance sheet. Therefore, DTA,
which is an intangible asset, should be deducted from Tier I capital.

Deductions from Tier I and Tier II Capital

(a) Equity/non-equity investments in subsidiaries

The investments of a bank in the equity as well as non-equity capital instruments
issued by a subsidiary, which are reckoned towards its regulatory capital as per
norms prescribed by the respective regulator, should be deducted at 50 per cent
each, from Tier I and Tier II capital of the parent bank, while assessing the capital
adequacy of the bank on 'solo' basis, under the Basel I Framework.

(b) Credit Enhancements pertaining to Securitization of Standard Assets

(i) Treatment of First Loss Facility

The first loss credit enhancement provided by the originator shall be reduced
from capital funds and the deduction shall be capped at the amount of capital
that the bank would have been required to hold for the full value of the assets,

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 had they not been securitised. The deduction shall be made at 50 per cent
from Tier I and 50 per cent from Tier II capital.

(ii) Treatment of Second Loss Facility

The second loss credit enhancement provided by the originator shall be

reduced from capital funds to the full extent. The deduction shall be made 50
per cent from Tier I and 50 per cent from Tier II capital.

(iii) Treatment of credit enhancements provided by third party

In case, the bank is acting as a third party service provider, the first loss credit
enhancement provided by it shall be reduced from capital to the full extent as
indicated at para (i) above;

(iv) Underwriting by an originator

Securities issued by the SPVs and devolved / held by the banks in excess of
10 per cent of the original amount of issue, including secondary market
purchases, shall be deducted 50 per cent from Tier I capital and 50 per cent
from Tier II capital;

(v) Underwriting by third party service providers

If the bank has underwritten securities issued by SPVs devolved and held by
banks which are below investment grade the same will be deducted from
capital at 50 per cent from Tier I and 50 per cent from Tier II.

Limit for Tier II elements

Tier II elements should be limited to a maximum of 100 per cent of total Tier I elements for
the purpose of compliance with the norms.

Cross Holding
(i) A bank’s / FI’s investments in all types of following instruments, which are issued by
other banks / FIs and are eligible for capital status for the investee bank / FI, will be
limited to 10 per cent of the investing bank's capital funds (Tier I plus Tier II capital).

a. Equity shares;
b. Preference shares eligible for capital status;
c. Innovative Perpetual Debt Instruments eligible as Tier I capital;
d. Subordinated debt instruments;
e. Debt capital Instruments qualifying for Upper Tier II status; and
f. Any other instrument approved as in the nature of capital.

(ii) Banks / FIs should not acquire any fresh stake in a bank's equity shares, if by such
acquisition, the investing bank's / FI's holding exceeds 5 per cent of the investee bank's
equity capital.
(c) An indicative list of institutions which may be deemed to be financial institutions for
capital adequacy purposes is as under:

 Banks,
 Mutual funds,
 Insurance companies,
 Non-banking financial companies,
 Housing finance companies,

Page 10 of 65
  Merchant banking companies,
 Primary dealers

(d) Investments excluded from the purview of the ceiling of 10 per cent
The following investments are excluded from the purview of the ceiling of 10 per cent
prudential norm prescribed above:
a) Investments in equity shares of other banks /FIs in India held under the provisions of
a statute.
b) Strategic investments in equity shares of other banks/FIs incorporated outside India
as promoters/significant shareholders (i.e. Foreign Subsidiaries / Joint Ventures /
Associates).
c) Equity holdings outside India in other banks / FIs incorporated outside India.

Swap Transactions
Banks are not allowed to enter into swap transactions involving conversion of fixed rate
rupee liabilities in respect of Innovative Tier I/Tier II bonds into floating rate foreign currency
liabilities.

Credit Risk:
Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may
fail to meet its obligations in accordance with agreed terms. It is the possibility of losses
associated with diminution in the credit quality of borrowers or counterparties. In a bank’s
portfolio, losses stem from outright default due to inability or unwillingness of a customer or a
counterparty to meet commitments in relation to lending, trading, settlement and other
financial transactions. Alternatively, losses result from reduction in portfolio arising from
actual or perceived deterioration in credit quality.

For most banks, loans are the largest and the most obvious source of credit risk; however,
other sources of credit risk exist throughout the activities of a bank, including in the banking
book and in the trading book, and both on and off balance sheet. Banks increasingly face
credit risk (or counterparty risk) in various financial instruments other than loans, including
acceptances, inter-bank transactions, trade financing, foreign exchange transactions,
financial futures, swaps, bonds, equities, options and in guarantees and settlement of
transactions.

The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by
maintaining credit risk exposure within acceptable parameters. Banks need to manage the
credit risk inherent in the entire portfolio, as well as, the risk in the individual credits or
transactions. Banks should have a keen awareness of the need to identify, measure, monitor
and control credit risk, as well as, to determine that they hold adequate capital against these
risks and they are adequately compensated for risks incurred.

Capital Charge for Credit Risk

Banks, under Basel I, are required to manage the credit risks in their books on an ongoing
basis and ensure that the capital requirements for credit risks are being maintained on a
continuous basis, i.e. at the close of each business day.

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BASEL II
Reserve Bank of India vide its Circular No. RBI/2006-2007/357 DBOD. No. BP. BC. 90 /
20.06.001/ 2006-07 dated April 27, 2007 issued Basel II final guidelines.

The Revised Framework sought to arrive at significantly more risk-sensitive approaches to

capital requirements. The Revised Framework provided a range of options for determining
the capital requirements for credit risk and operational risk to allow banks and supervisors to
select approaches that are most appropriate for their operations and financial markets.

The Framework consists of three-mutually reinforcing Pillars, viz.

a) Minimum capital requirements,

b) Supervisory review of capital adequacy, and
c) Market discipline.

Pillar 1 (Minimum capital requirements):

Basel II offers three distinct options for computing capital requirement for credit risk and
three other options for computing capital requirement for operational risk. These options for
credit and operational risks are based on increasing risk sensitivity and allow banks to select
an approach that is most appropriate to the stage of development of bank's operations.

The options available for computing capital for credit risk are:
a) Standardised Approach,
b) Foundation Internal Rating Based Approach and
c) Advanced Internal Rating Based Approach.

The options available for computing capital for operational risk are Basic Indicator Approach,
Standardised Approach and Advanced Measurement Approach

Pillar 2 (Supervisory review of capital adequacy)

In terms of the Pillar 2 requirements, banks are expected to operate at a level well above the
minimum requirement

The Reserve Bank will take into account the relevant risk factors and the internal capital
adequacy assessments of each bank to ensure that the capital held by a bank is
commensurate with the bank’s overall risk profile. This would include, among others, the
effectiveness of the bank’s risk management systems in identifying, assessing / measuring,
monitoring and managing various risks including interest rate risk in the banking book,
liquidity risk, concentration risk and residual risk. Accordingly, the Reserve Bank will
consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2
framework on the basis of their respective risk profiles and their risk management systems.

Banks in India shall compute the capital requirements for operational risk under the Basic
Indicator Approach. Reserve Bank will review the capital requirement produced by the Basic
Indicator Approach for general credibility, especially in relation to a bank’s peers and in the
event that credibility is lacking, appropriate supervisory action under Pillar 2 will be
considered.

Under the Basic Indicator Approach, banks must hold capital for operational risk equal to the
average over the previous three years of a fixed percentage of positive annual gross income.
Figure for any year in which annual gross income is negative or zero is to be excluded from
both - the numerator and denominator when calculating the average.

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Pillar 3 (Market Discipline):
The purpose of Market discipline in the Revised Framework is to complement the minimum
capital requirements (detailed under Pillar 1) and the supervisory review process (detailed
under Pillar 2). The aim is to encourage market discipline by developing a set of disclosure
requirements which Basel II Final Guidelines will allow market participants to assess key
pieces of information on the scope of application, capital, risk exposures, risk assessment
processes, and hence the capital adequacy of the institution.

On perusal of above three Pillars of Basel II, it understood that Basel II is:

• More risk sensitive

• Treatment based on exposure characteristics
• Takes into account quality of risk management system
• Introduced a capital charge for operational risk
• Change in risk management practices (ICAAP)
• Improved disclosures

Basel II guidelines issued by RBI discusses Capital, Capital Charge for Credit Risk,
External Credit assessments, Credit Risk Mitigation, Capital Charge for Market Risk,
Capital Charge for Operational Risk and Market Discipline.

In this module, Capital Charge for Market Risk, Capital Charge for Operational Risk is
excluded

Components of Capital (Under Basel II)

Under Basel II, Banks are required to maintain a minimum Capital to Risk-weighted Assets
Ratio (CRAR) of 9 percent on an ongoing basis as was prescribed under Basel I guidelines.

Elements of Tier I Capital:

For Indian Bank:

(i) Paid-up equity capital, statutory reserves, and other disclosed free reserves, if any;
(ii) Capital reserves representing surplus arising out of sale proceeds of assets.
(iii) Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital;*
(iv) Any other type of instrument generally notified by RBI from time to time for inclusion in
Tier I capital.

It may be noted that Perpetual Non-cumulative Preference Shares (PNCPS) eligible for
inclusion as Tier I capital (under Basel I) has NOT been included under Basel II.
RBI has also prescribed elements of Tier 1 capital for foreign banks in India. Since they are
not applicable to our bank, they have not been included in this module.

* The broad guidelines for inclusion of innovative Perpetual Debt Instrument

(IPDI) as Tier I capital are as under:

Nature:
The Innovative Perpetual Debt Instruments (Innovative Instruments) may be issued
as bonds or debentures by Indian banks.

Limit:
The total amount raised by a bank through innovative instruments shall not exceed
15 per cent of total Tier I Capital. The eligible amount will be computed with
reference to the amount of Tier I Capital as on March 31 of the previous financial

Page 13 of 65
 year, after deduction of goodwill, Deferred Tax Assets (DTA) and other intangible
assets but before the deduction of investments.

Innovative instruments in excess of the above limits shall be eligible for inclusion
under Tier II, subject to limits prescribed for Tier II capital. However, investors’
rights and obligations would remain unchanged

Amount: The amount of innovative instruments to be raised may be decided by the

Board of Directors of banks

Maturity: The innovative instruments shall be perpetual

Options
Innovative instruments shall not be issued with a ‘put option’.

However banks may issue the instruments with a call option subject to strict
compliance with each of the following conditions:
(a) Call option may be exercised after the instrument has run for at least ten years;
and
(b) Call option shall be exercised only with the prior approval of RBI

Rate of Interest
The interest payable to the investors may be either a fixed rate or a floating rate
referenced to a market determined rupee interest benchmark rate

Seniority of claim:
The claims of the investors in innovative instruments shall be:
a) Superior to the claims of investors in equity shares; and
b) Subordinated to the claims of all other creditors

Grant of Advances
Banks should not grant advances against the security of the innovative instruments
issued by them.

Limits on eligible Tier 1 capital

The Innovative perpetual debt instruments, eligible to be reckoned as Tier 1 capital,
will be limited to 15 percent of total Tier 1 capital as on March 31 of the previous
financial year. The above limit will be based on the amount of Tier 1 capital as on
March 31 of the previous financial year, after deduction of goodwill, Deferred Tax
Assets (DTA) and other intangible assets but before the deduction of investments.
Innovative instruments in excess of the limit shall be eligible for inclusion under Tier
2, subject to limits prescribed for Tier 2 capital.

Elements of Tier 2 Capital:

a) Revaluation reserves
These reserves often serve as a cushion against unexpected losses, but they are
less permanent in nature and cannot be considered as ‘Core Capital’. Revaluation
reserves arise from revaluation of assets that are undervalued on the bank’s books,
typically bank premises. The extent to which the revaluation reserves can be relied
upon as a cushion for unexpected losses depends mainly upon the level of certainty
that can be placed on estimates of the market values of the relevant assets, the
subsequent deterioration in values under difficult market conditions or in a forced
sale, potential for actual liquidation at those values, tax consequences of revaluation,
etc. Therefore, it would be prudent to consider revaluation reserves at a discount of

Page 14 of 65
 55 percent while determining their value for inclusion in Tier 2 capital. Such reserves
will have to be reflected on the face of the Balance Sheet as revaluation reserves.

b) General provisions and loss reserves

Such reserves, if they are not attributable to the actual diminution in value or
identifiable potential loss in any specific asset and are available to meet unexpected
losses, can be included in Tier 2 capital. Adequate care must be taken to see that
sufficient provisions have been made to meet all known losses and foreseeable
potential losses before considering general provisions and loss reserves to be part of
Tier 2 capital. Banks are allowed to include the ‘General Provisions on Standard
Assets', Floating Provisions ‘Provisions held for Country Exposures’, and ‘Investment
Reserve Account’ in Tier 2 capital. However, these four items will be admitted as Tier
2 capital up to a maximum of 1.25 per cent of the total risk-weighted assets.

c) Hybrid debt capital instruments

In this category, fall a number of debt capital instruments, which combine certain
characteristics of equity and certain characteristics of debt. Each has a particular
feature, which can be considered to affect its quality as capital. Where these
instruments have close similarities to equity, in particular when they are able to
support losses on an ongoing basis without triggering liquidation, they may be
included in Tier 2 capital. Banks in India are allowed to recognise funds raised
through debt capital instrument which has a combination of characteristics of both
equity and debt, as Upper Tier 2 capital provided the instrument complies with the
regulatory requirements specified broadly as under:

Nature:
The debt capital instruments that may be issued as bonds / debentures by Indian
banks

Amount:
The amount of Upper Tier 2 instruments to be raised may be decided by the Board of
Directors of banks.

Limits
Upper Tier 2 instruments along with other components of Tier 2 capital shall not
exceed 100% of Tier 1 capital. The above limit will be based on the amount of Tier 1
capital after deduction of goodwill, DTA and other intangible assets but before the
deduction of investments.

Maturity period
The Upper Tier 2 instruments should have a minimum maturity of 15 years.

Rate of interest
The interest payable to the investors may be either at a fixed rate or at a floating rate
referenced to a market determined rupee interest benchmark rate.

Options
(i) Upper Tier 2 instruments shall not be issued with a ‘put option’.
(ii) However banks may issue the instruments with a call option subject to strict
compliance with each of the following conditions:
(a) Call option may be exercised only if the instrument has run for at least ten
years;
(b) Call option shall be exercised only with the prior approval of RBI

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 Seniority of Claim
The claims of the investors in Upper Tier II instruments shall be
 Superior to the claims of investors in instruments eligible for inclusion in Tier I
capital; and
 Subordinate to the claims of all other creditors.

Discount:
The Upper Tier II instruments shall be subjected to a progressive discount for capital
adequacy purposes as in the case of long-term subordinated debt over the last five
years of their tenor. As they approach maturity these instruments should be
subjected to progressive discount as indicated in the table below for being eligible for
inclusion in Tier II capital

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20

Redemption:
Upper Tier II instruments shall not be redeemable at the initiative of the holder. All
redemptions shall be made only with the prior approval of the Reserve Bank of India
(Department of Banking Regulation).

Upper Tier 2 capital instruments in foreign currency

Banks may augment their capital funds through the issue of Upper Tier 2 Instruments
in foreign currency without seeking the prior approval of the Reserve Bank of India,
subject to certain conditions:

Grant of Advances
Banks should not grant advances against the security of the Upper Tier II instruments
issued by them

Subordinated debt
To be eligible for inclusion in Tier 2 capital, the instrument should be fully paid-up,
unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and
should not be redeemable at the initiative of the holder or without the consent of the Reserve
Bank of India. They often carry a fixed maturity, and as they approach maturity, they should
be subjected to progressive discount, for inclusion in Tier 2 capital. Instruments with an initial
maturity of less than 5 years or with a remaining maturity of one year should not be included
as part of Tier 2 capital.

Subordinated debt instruments eligible to be reckoned as Tier 2 capital shall comply with the
regulatory requirements broadly as under:

Amount
The amount of subordinated debt to be raised may be decided by the Board of
Directors of the banks.

Maturity period
(a) Subordinated debt instruments with an initial maturity period of less than 5
years, or with a remaining maturity of one year should not be included as part

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 of Tier-II Capital. Further, they should be subjected to progressive discount as
they approach maturity at the rates shown below:

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20

(b) The bonds should have a minimum maturity of 5 years. However if the bonds
are issued in the last quarter of the year i.e. from 1st January to 31st March,
they should have a minimum tenure of sixty three months.

Rate of interest:
The interest payable to the investors may be either at a fixed rate or at a floating rate
referenced to a market determined rupee interest benchmark rate. The instruments
should be 'vanila' with no special features like options etc.

Inclusion in Tier 2 capital

Subordinated debt instruments will be limited to 50 per cent of Tier-I Capital of the
bank. These instruments, together with other components of Tier 2 capital, should
not exceed 100% of Tier 1 capital.

Grant of advances against bonds

Banks should not grant advances against the security of their own bonds.

Treatment of Investment in subordinated debt

Investments by banks in subordinated debt of other banks will be assigned 100% risk
weight for capital adequacy purpose. Also, the bank's aggregate investment in Tier 2
bonds issued by other banks and financial institutions shall be within the overall
ceiling of 10 percent of the investing bank's total capital. The capital for this purpose
will be the same as that reckoned for the purpose of capital adequacy.

Subordinated Debt in foreign currency

Banks may take approval of RBI on a case-by-case basis.

Limits on Tier 2 Capital

Upper Tier 2 instruments along with other components of Tier 2 capital shall not exceed
100% of Tier 1 capital. This limit will be based on the amount of Tier 1 after deduction of
goodwill, DTA and other intangible assets but before deduction of investments.

Subordinated debt instruments eligible for inclusion in Lower Tier 2 capital will be limited to
50 percent of Tier 1 capital after all deductions.

Deductions from capital

a) Intangible assets and losses in the current period and those brought forward from
previous periods should be deducted from Tier 1 capital.
b) The DTA computed as under should be deducted from Tier 1 capital:
i) DTA associated with accumulated losses; and
ii) The DTA (excluding DTA associated with accumulated losses), net of DTL.
Where the DTL is in excess of the DTA (excluding DTA associated with
accumulated losses), the excess shall neither be adjusted against item (i) nor
added to Tier 1 capital.

Page 17 of 65
Any gain-on-sale arising at the time of securitisation of standard assets, as per extant
guidelines, should be deducted from Tier 1 capital.

In terms of guidelines on securitisation of standard assets, banks are allowed to amortise the
profit over the period of the securities issued by the SPV. The amount of profits thus
recognised in the profit and loss account through the amortisation process need not be
deducted.

Securitisation exposures, as per guidelines shall be deducted from regulatory capital and the
deduction must be made 50% from Tier 1 and 50% from Tier 2, except where expressly
provided otherwise. Deductions from capital may be calculated net of any specific provisions
maintained against the relevant securitisation exposures

An indicative list of institutions which may be deemed to be financial institutions for capital
adequacy purposes is as under:

 Banks,
 Mutual funds,
 Insurance companies,
 Non-banking financial companies,
 Housing finance companies,
 Merchant banking companies,
 Primary dealers

CRAR (Basel II)

Banks are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of
9 percent on an ongoing basis

The minimum capital maintained by banks on implementation of the Basel II Framework is

subject to a prudential floor, which shall be the higher of the following amounts:

a) Minimum capital required to be maintained as per the Framework;

b) A specified per cent of the minimum capital required to be maintained as per the
Basel I framework for credit and market risks. The specified per cent will
progressively decline.

Banks were encouraged to maintain, at both solo and consolidated level, a Tier 1 CRAR of
at least 6%. Banks which were below this level had to achieve this ratio on or before March
31, 2010.

The Tier 1 CRAR and Total CRAR is to be computed in the following manner:

Eligible Tier 1 capital funds

Tier 1 CRAR =
Credit Risk RWA + Market Risk RWA + Operational Risk RWA

Eligible Total Capital Funds*

Total CRAR =
Credit Risk RWA + Market Risk RWA + Operational Risk RWA

* Eligible total capital funds = Eligible Tier 1 capital funds + Eligible Tier 1 capital funds)

Page 18 of 65
Market Discipline:
The purpose of Market discipline (Pillar 3) in the Basel II Framework is to complement the
minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2).

The aim is to encourage market discipline by developing a set of disclosure requirements

which will allow market participants to assess key pieces of information on the scope of
application, capital, risk exposures, risk assessment processes, and hence the capital
adequacy of the institution.

Under Pillar 1, banks use specified approaches/ methodologies for measuring the various
risks they face and the resulting capital requirements. It is believed that providing disclosures
that are based on a common framework is an effective means of informing the market about
a bank’s exposure to those risks and provides a Consistent and comprehensive disclosure
framework that enhances comparability

Banks, should provide all Pillar 3 disclosures, both qualitative and quantitative, as at end
March each year along with the annual financial statements and the disclosures should be
subjected to adequate validation.

All banks with capital funds of Rs. 500 crore or more, and their significant bank subsidiaries,
must disclose their Tier 1 capital, total capital, total required capital and Tier 1 ratio and total
capital adequacy ratio, on a quarterly basis on their respective websites. A bank should
decide which disclosures are relevant for it based on the materiality concept. Information
would be regarded as material if its omission or misstatement could change or influence the
assessment or decision of a user relying on that information for the purpose of making
economic decisions.

Internal Risk Based (IRB) Approach:

RBI on 07-07-2009 vide its circular inter alia advised banks that they can apply for migrating
to Internal Rating Based Approach (IRB) for calculation of capital charge for Credit Risk from
01.04.2010.

The Basel II framework provides two broad methodologies to banks to calculate capital
requirements for credit risk, namely, Standardised Approach (SA) and Internal Rating Based
(IRB) Approach.

The IRB approach is again classified into Foundation IRB (FIRB) approach and Advanced
IRB (AIRB) approach.

The Standardised Approach measures credit risk based on external credit assessments, and

The IRB Approach allows banks, subject to the approval of RBI, to use their own internal
estimates for some or all of the credit risk components [Probability of Default (PD), Loss
Given Default (LGD), Exposure at Default (EAD) and Effective Maturity (M)] in determining
the capital requirement for a given credit exposure.

IRB approach to capital calculation for credit risk is based upon measures of unexpected
losses (UL) and expected losses (EL). The risk components and riskweight functions
(equations by which risk components are transformed into capital requirements and risk
weighted assets) detailed in this guideline help to calculate capital requirements for the UL
portion. For EL, the bank must compare the sufficiency of eligible provisions against EL
(generally for corporate, sovereign, bank and retail exposures) amounts and adjust the
regulatory capital accordingly.

Page 19 of 65
Expected Losses (EL):
While it is never possible to know in advance the losses a bank will suffer in a
particular year, a bank can forecast the average level of credit losses it can
reasonably expect to experience. These losses are referred to as Expected Losses
(EL). Financial institutions view Expected Losses as a cost component of doing
business, and manage them by a number of means, including through the pricing of
credit exposures and through provisioning.

Unexpected Losses (UL):

One of the functions of bank capital is to provide a buffer to protect a bank’s debt
holders against peak losses that exceed expected levels. Peak losses do not occur
every year, but when they occur, they can potentially be very large. Losses above
expected levels are usually referred to as Unexpected Losses (UL) - institutions know
they will occur now and then, but they cannot know in advance their timing or
severity. Interest rates, including risk premia, charged on credit exposures may
absorb some components of unexpected losses, but the market will not support
prices sufficient to cover all unexpected losses. Capital is needed to cover the risks
of such peak losses, and therefore it has a loss-absorbing function.

Probability of Default (PD):

Probability that the borrower will default within one year horizon.

Loss Given Default (LGD)

Bank’s economic loss upon the default of a debtor/borrower.

Exposures at Default (EAD)

Gross exposure/potential gross exposure under a facility (i.e. the amount that is
legally owed to the bank) at the time of default by a borrower.

Effective Maturity (M)

Effective maturity of the underlying should be gauged as the longest possible
remaining time before the borrower is scheduled to fulfil its obligation.

Purchased Receivables:
A pool of receivables purchased by the bank from another entity. Among others, this
may also include those exposures when a bank is buying loans from other banks.

Dilution Risk:
This arises out of the possibility of reduction in the amount of total purchased
receivables through cash or non cash credits to receivables’ obligors. Suppose an
entity has supplied some goods to a buyer on credit basis, recorded the future
payments due as receivables, and subsequently sells the receivables to a bank. In
this scenario, if the bank buying the receivables sees the possibility that because of
the agreement between seller of the receivables and the buyer of the goods (like on
account of return of goods sold, dispute regarding product quality, promotional
discount offered by the supplier etc.), there is a chance of material decrease in the
amount of the receivables after purchasing the same, it has to account for dilution
risk.

Eligible Guarantor
Specific entities which can provide guarantee on behalf of the borrower, by virtue of
which the lender may have a direct claim on those entities and these guarantees
given should be referenced to a specific exposure or a pool of exposures.

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Exposures:
Under the IRB approach, to arrive at the risk weighted assets (RWA) for exposures, banks
may categorise banking-book exposures into broad asset classes with different underlying
risk characteristics, subject to the definitions elaborated subsequently. There are broadly six
asset classes. They are:

i. Corporate,
ii. Sovereign,
iii. Bank,
iv. Retail,
v. Equity, and
vi. Others

It is the responsibility of banks to convince RBI that the categorisation of exposures in

different asset classes is appropriate and consistent over time given their business practices.

Different Approaches under IRB

For the corporate (except in case of some of the specialised lending subclasses), sovereign
and bank asset classes, there are two IRB approaches to derive the capital requirement for
credit risk:

I. Foundation IRB approach (FIRB)

II. Advanced IRB approach (AIRB)

Under the FIRB, banks are generally expected to provide their own estimates of PD and rely
on the supervisory estimates for other risk components, namely LGD, EAD and M.

While under the AIRB, banks provide their own estimates of PD, LGD and EAD, and their
own calculation of M.

Under both approaches, banks are required to use the relevant IRB risk weighted function,
for the purpose of deriving the capital requirement for Unexpected Loss (UL) for the relevant
exposures.

Estimation of Risk components for Corporate, Sovereign and Bank exposures

 Probability of Default (PD)

PD estimation should always be borrowers specific i.e. all exposures to a single
borrower will be assigned a single PD.

Banks must use information and techniques that take appropriate account of the long-
run experience when estimating the average PD (i.e. long term average PD) for each
rating grade.

For example, banks may use one or more of the three specific techniques:
 Internal default experience,
 mapping to external data, and
 Statistical default models.

 Loss Given Default (LGD)

LGD is usually shown as the percentage of EAD that the bank might lose in case the
borrower defaults. It depends, among others, on the type and amount of collateral as
well as the type of borrower and the expected proceeds from the work out (e.g. sales
proceeds from sales of collaterals/securities) of the assets.

Page 21 of 65
 LGD is exposure specific i.e., different exposures to the same borrower may have
different LGDs.

Estimates of LGD for exposures in the corporate, sovereign and bank asset classes
must be based on a minimum data observation period that should ideally cover at least
one complete cycle but, in any case, must not be shorter than a period of seven years
from at least one source. If the available observation period spans a longer period from
any source and the data are relevant and material, this longer period must be used.

A bank must estimate LGD for each of the corporate, sovereign and bank exposures.
There are two approaches by which the banks can calculate LGD of an exposure under
the IRB Approach:

a. A foundation approach
b. An advanced approach

 Exposure at Default (EAD)

Exposure at Default gives an estimate of the amount outstanding (drawn amounts plus
likely future drawdown of yet undrawn lines) when the borrower defaults.

On and off balance sheet items will get different treatment under Exposure at Default
and it needs to be calculated for each exposure individually. But EAD for both the on
and off balance sheet items are measured gross of specific provisions or partial write
off.

There are two approaches by which the banks can calculate EAD under the IRB
Approach:

a) EAD under Foundation IRB

b) EAD under Advanced IRB approach.

 Effective maturity (M)

For banks using the F-IRB approach, effective maturity (M) will be 2.5 years except for
repo-style transactions where the effective maturity will be 6 months.

RBI may, however, subsequently choose to require all banks (those using the
foundation approach) to measure M for each facility using the definition provided by RBI
in its circular (even if the bank is using foundation IRB)

Banks using A-IRB approach are required to measure effective maturity for each facility
using a formula prescribed by RBI.

The derivation of risk-weighted assets is dependent on estimates of the PD, LGD, EAD and,
in some cases, effective maturity (M), for a given exposure.

Rules for Retail Exposure

RBI would evaluate at periodic intervals, the bank’s processes and estimates of PD, LGD,
EAD assigned to the retail portfolio with reference to the default experience for these
exposures.

As part of the supervisory review and evaluation process, the RBI would also consider
whether the credit quality of regulatory retail claims held by individual banks should warrant
a more conservative estimate of PD, LGD and EAD than that arrived by the banks

Page 22 of 65
 Sub Classification of retail assets
Within the retail asset class category, banks are required to identify separately three
sub-classes of exposures:
(a) Exposures secured by residential properties,
(b) Qualifying revolving retail exposures and
(c) all other retail exposures
subject to the condition that these exposures broadly meet the retail asset criteria

Retail exposures which may not be categorised either under (a) Exposures secured
by residential properties and/or (b) qualifying revolving retail exposures will fall under
‘other retail’ asset category which may include agricultural and allied activities and
SME loans provided these comply with retail criteria.

 Approach for Retail Exposure

For retail assets, there is no distinction between Foundation and Advanced approaches
and hence banks have to calculate their own PD, LGD and EAD. There is no maturity
adjustment necessary in the risk weight function for capital calculation

 Calculation of PD & LGD

For each identified homogeneous pool of exposures, banks are expected to provide an
estimate of the PD and LGD associated with the pool, subject to the prescribed
minimum requirements in this guideline.

Further, the PD for retail exposure is greater of the one year PD associated with the
internal borrower grade to which the pool has been assigned or 0.03%.

The minimum data observation period for PD and LGD estimates for retail exposure is 5
years.

However, the banks may give different weight-age to historic data provided it can
demonstrate that more recent data is a better predictor of loss rates.

Further, because of the potential for very long cycles in house prices, LGDs for retail
exposures secured by residential properties cannot be set below 20% for using in the
formula given for the purpose (with correlation applicable for exposures secured by
residential mortgage properties)

 Calculation of EAD
All retail exposures (both on and off balance sheet) are measured gross of specific
provisions or partial write offs.

The EAD on drawn amounts should not be less than the sum of
(i) The amount by which a bank’s regulatory capital would be reduced if the
exposure is fully written off and
(ii) Any specific provisions and partial write-offs.

For retail off balance sheet items, banks must use their own estimates of Credit
Conversion Factors subject to the prescribed minimum requirements for EAD in the
guidelines.

The minimum data observation period for EAD estimates for retail exposure is 5 years.

The Risk weight functions for three different classes of retail exposures (Not in Default) are
prescribed and must be used by banks along with their estimates of PD, LGD and EAD for
calculation of capital and risk weighted assets

Page 23 of 65
WHY BASEL II FAILED DURING FINANCIAL CRISIS – Accusations

 The global financial crisis mostly happened in the areas of trading book /off balance
sheet derivatives / market risk and inadequate liquidity risk management
 Banks suffered heavy losses in their trading book
 Banks did not have adequate capital to cover the losses
 There was heavy reliance on short term wholesale funding
 Unsustainable maturity mismatch
 Insufficient liquidity assets to raise finance during stressed period
 The average level of capital required by the new discipline is inadequate
 The capital accord, interacting with fair-value accounting caused remarkable losses
 Capital requirements based on the Basel II regulations are Cyclical.
 Wrong assumption that banks’ internal models for measuring risk exposures are
superior
 The Framework provides incentives to intermediaries to deconsolidate from balance
sheet some very risky exposures

Page 24 of 65
BASEL III
Basel III reforms are the response of Basel Committee on Banking Supervision (BCBS) to
improve the banking sector’s ability to absorb shocks arising from financial and economic
stress, whatever the source, thus reducing the risk of spill over from the financial sector to
the real economy.

Basel III is intended to strengthen the regulatory system for banks and other financial firms
and to raise capital standards, to implement strong international compensation standards
aimed at ending practices that lead to excessive risk-taking, to improve the over-the-counter
derivatives market and to create more powerful tools to hold large global firms to account for
the risks they take. Consequently, the Basel Committee on Banking Supervision (BCBS)
released comprehensive reform package entitled “Basel III: A global regulatory framework
for more resilient banks and banking systems” (known as Basel III capital regulations) in
December 2010.

Basel III reforms strengthen the bank-level i.e. micro prudential regulation, with the intention
to raise the resilience of individual banking institutions in periods of stress. Besides, the
reforms have a macro prudential focus also, addressing system wide risks, which can build
up across the banking sector, as well as the pro-cyclical amplification of these risks over
time.

These new global regulatory and supervisory standards mainly seek to raise the quality and
level of capital to ensure banks are better able to absorb losses on both a going concern and
a gone concern basis, increase the risk coverage of the capital framework, introduce
leverage ratio to serve as a backstop to the risk-based capital measure, raise the standards
for the supervisory review process (Pillar 2) and public disclosures (Pillar 3) etc. The macro
prudential aspects of Basel III are largely enshrined in the capital buffers. Both the buffers
i.e. the capital conservation buffer and the countercyclical buffer are intended to protect the
banking sector from periods of excess credit growth.

Reserve Bank of India issued Guidelines based on the Basel III reforms on capital regulation
on May 2, 2012, to the extent applicable to banks operating in India. The Basel III capital
regulation has been implemented from April 1, 2013 in India in phases and it was envisaged
to be fully implemented as on March 31, 2019.

Basel III guidelines issued by RBI under Pillar I discusses Capital, Capital Charge for
Credit Risk, External Credit assessments, Credit Risk Mitigation, Capital Charge for
Market Risk, Capital Charge for Operational Risk and Market Discipline.

Basel III guidelines under Pillar II also discussed Supervisory Review and Evaluation
Process (SREP) under which banks were required to have a Board-approved policy on
Internal Capital Adequacy Assessment Process (ICAAP) and to assess the capital
requirement as per the said ICAAP.

Basel III guidelines under Pillar III discussed Market Discipline.

The RBI also introduced following Frameworks under Basel III

a) Capital Conservation Buffer Framework

b) Leverage Ratio Framework
c) Counter-cylical Capital Buffer Framework

In this module Capital Charge for Market Risk, Capital Charge for Operational Risk is
excluded.

Page 25 of 65
The Basel III capital regulations continue to be based on three-mutually reinforcing Pillars,
viz. minimum capital requirements, supervisory review of capital adequacy, and market
discipline of the Basel II capital adequacy framework.

Under Pillar 1, the Basel III framework continues to offer the three distinct options for
computing capital requirement for credit risk and three other options for computing capital
requirement for operational risk, albeit with certain modifications / enhancements.

These options for credit and operational risks are based on increasing risk sensitivity and
allow banks to select an approach that is most appropriate to the stage of development of
bank's operations.

The options available for computing capital for credit risk are as under:

a) Standardised Approach,
b) Foundation Internal Rating Based Approach and
c) Advanced Internal Rating Based Approach.

The options available for computing capital for operational risk are

a) Basic Indicator Approach (BIA),

b) The Standardised Approach (TSA) and
c) Advanced Measurement Approach (AMA).

The Basel III capital regulations are being implemented in India with effect from April 1,
2013. Banks have to comply with the regulatory limits and minima as prescribed under Basel
III capital regulations, on an ongoing basis. Basel III capital regulations were envisaged to be
fully implemented as on March 31, 2019.

A bank has to comply with the capital adequacy ratio requirements at two levels:

(a) The consolidated (“Group”) level3 capital adequacy ratio requirements, which
measure the capital adequacy of a bank based on its capital strength and risk profile
after consolidating the assets and liabilities of its subsidiaries / joint ventures /
associates etc. Excep7t those engaged in insurance and any non-financial activities;
and
(b) The standalone (“Solo”) level capital adequacy ratio requirements, which measure
the capital adequacy of a bank based on its standalone capital strength and risk
profile.

Accordingly, overseas operations of a bank through its branches will be covered in both the
above scenarios.

Banks are required to maintain a minimum Pillar 1 Capital to Risk-weighted Assets Ratio
(CRAR) of 9% on an on-going basis (other than capital conservation buffer and
countercyclical capital buffer etc.).

The Reserve Bank will take into account the relevant risk factors and the internal capital
adequacy assessments of each bank to ensure that the capital held by a bank is
commensurate with the bank’s overall risk profile. This would include, among others, the
effectiveness of the bank’s risk management systems in identifying, assessing / measuring,
monitoring and managing various risks including interest rate risk in the banking book,
liquidity risk, concentration risk and residual risk.

Page 26 of 65
Accordingly, the Reserve Bank will consider prescribing a higher level of minimum capital
ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles
and their risk management systems.

Further, in terms of the Pillar 2 requirements, banks are expected to operate at a level well
above the minimum requirement.

RBI has prescribed that a bank should compute Basel III capital ratios in the following
manner:

Common Equity Tier 1 Common Equity Tier 1 Capital

Capital Ratio = Credit Risk RWA+ Market Risk RWA+ Operational Risk RWA

Eligible Tier 1 Capital

Tier 1 Capital Ratio =
Credit Risk RWA+ Market Risk RWA+ Operational Risk RWA

Total Capital Ratio = Eligible Total Capital

(CRAR) Credit Risk RWA+ Market Risk RWA+ Operational Risk RWA

The above is a mathematical calculation and CRAR will increase either if

a) The Numerator increases (Capital in the above formula) or
b) If the denominator decreases (Total Risk Weighted Assets ) or
c) Both of the above together.

Banks in India are required to maintain a minimum CRAR of 10.875% on an on-going basis
including Capital Conservation Buffer (CCB) w.e.f. 31.03.2018. Further, banks also have to
comply with the regulatory limits and minimum as prescribed under Basel III Capital
regulations, on an on-going basis.

It may be observed that the concept of Common Equity Tier 1 capital has been introduced
under Basel III

Components of Capital
Total regulatory capital will consist of the sum of the following categories:

(i) Tier 1 Capital (going-concern capital)

From regulatory capital perspective, going-concern capital is the capital which can
absorb losses without triggering bankruptcy of the bank.

Tier 1 Capital has two components

(a) Common Equity Tier 1

(b) Additional Tier 1

Elements of Common Equity Tier 1 Capital (For Indian Banks)

Elements of Common Equity component of Tier 1 capital will comprise the following:

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(i) Common shares (paid-up equity capital) issued by the bank should meet
below mentioned criteria for classification as common shares for regulatory
purposes:

 All common shares should ideally be the voting shares. However, in rare
cases, where banks need to issue non-voting common shares as part of
Common Equity Tier 1 capital, they must be identical to voting common
shares of the issuing bank in all respects except the absence of voting
rights. Limit on voting rights will be applicable based on the provisions of
respective statutes governing individual banks.

 Represents the most subordinated claim in liquidation of the bank.

 Entitled to a claim on the residual assets which is proportional to its share

of paid up capital, after all senior claims have been repaid in liquidation
(i.e. has an unlimited and variable claim, not a fixed or capped claim).

 Principal is perpetual and never repaid outside of liquidation (except

discretionary repurchases / buy backs or other means of effectively
reducing capital in a discretionary manner that is allowable under relevant
law as well as guidelines, if any, issued by RBI in the matter).

 The bank does nothing to create an expectation at issuance that the

instrument will be bought back, redeemed or cancelled nor do the statutory
or contractual terms provide any feature which might give rise to such an
expectation.

 Distributions are paid out of distributable items. As regards ‘distributable

items’, it is means that the dividend on common shares will be paid out of
current year’s profit only.

 There are no circumstances under which the distributions are obligatory.

Non-payment is therefore not an event of default.

 Distributions are paid only after all legal and contractual obligations have
been met and payments on more senior capital instruments have been
made. Thus there should be no preferential distributions, including in
respect of other elements classified as the highest quality issued capital.

 It is the paid up capital that takes the first and proportionately greatest
share of any losses as they occur. Within the highest quality capital, each
instrument absorbs losses on a going concern basis proportionately and
pari passu with all the others.

 The paid up amount is classified as equity capital (i.e. not recognised as a

liability) for determining balance sheet insolvency.
 The paid up amount is classified as equity under the relevant accounting
standards.

 It is directly issued and paid up and the bank cannot directly or indirectly
have funded the purchase of the instrument. Banks should also not extend
loans against their own shares.

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  The paid up amount is neither secured nor covered by a guarantee of the
issuer or related entity nor subject to any other arrangement that legally or
economically enhances the seniority of the claim.

 Paid up capital is only issued with the approval of the owners of the issuing
bank, either given directly by the owners or, if permitted by applicable law,
given by the Board of Directors or by other persons duly authorised by the
owners.

 Paid up capital is clearly and separately disclosed in the bank’s balance

sheet.

(ii) Stock surplus (share premium) resulting from the issue of common shares;

(iii) Statutory reserves;

(iv) Capital reserves representing surplus arising out of sale proceeds of assets;

(v) Other disclosed free reserves, if any;

(vi) Balance in Profit & Loss Account at the end of the previous financial year;

(vii) Banks may reckon the profits in current financial year for CRAR calculation on
a quarterly basis provided the incremental provisions made for non-performing
assets at the end of any of the four quarters of the previous financial year have
not deviated more than 25% from the average of the four quarters. The amount
which can be reckoned would be arrived at by using the following formula:

EPt= {NPt – 0.25*D*t}

Where;

EPt = Eligible profit up to the quarter ‘t’ of the current financial year; t varies
from 1 to 4
NPt = Net profit up to the quarter ‘t’
D= average annual dividend paid during last three years

(viii) While calculating capital adequacy at the consolidated level, common shares
issued by consolidated subsidiaries of the bank and held by third parties (i.e.
minority interest) which meet the criteria for inclusion in Common Equity Tier 1
capital; and

(ix) Less: Regulatory adjustments / deductions applied in the calculation of

Common Equity Tier 1 capital [i.e. to be deducted from the sum of items (i) to
(viii)].

Criteria for Classification as Common Shares for Regulatory Purposes

Common Equity is recognised as the highest quality component of capital and is the primary
form of funding which ensures that a bank remains solvent. Therefore, under Basel III,
common shares to be included in Common Equity Tier 1 capital must meet the criteria as
listed out above.

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Additional Tier 1 Capital – Indian Banks

A. Elements of Additional Tier 1 Capital

Additional Tier 1 capital will consist of the sum of the following elements:

(i) Perpetual Non-Cumulative Preference Shares (PNCPS)

The broad guidelines for inclusion of Perpetual Non-cumulative Preference Shares

(PNCPS) under regulatory requirements as Additional Tier I capital are as under:

 The PNCPS will be issued by Indian banks, subject to extant legal provisions
only in Indian rupees

 Paid up Status: The instruments should be issued by the bank (i.e. not by any
‘SPV’ etc. set up by the bank for this purpose) and fully paid up.

 Amount: The amount of PNCPS to be raised may be decided by the Board of

Directors of banks.

 Limits: While complying with minimum Tier 1 of 7% of risk weighted assets, a

bank cannot admit, Perpetual Non-Cumulative Preference Shares (PNCPS)
together with Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital,
more than 1.5% of risk weighted assets. However, once this minimum total Tier
1 capital has been complied with, any additional PNCPS and PDI issued by the
bank can be included in Total Tier 1 capital reported. Excess PNCPS and PDI
can be reckoned to comply with Tier 2 capital if the latter is less than 2% of
RWAs i.e. while complying with minimum Total Capital of 9% of risk weighted
assets.

 Maturity Period The PNCPS shall be perpetual i.e. there is no maturity date
and there are no step-ups or other incentives to redeem.

 Dividend: The rate of dividend payable to the investors may be either a fixed
rate or a floating rate referenced to a market determined rupee interest
benchmark rate.

The bank must have full discretion at all times to cancel distributions/payments
and dividend pushers are prohibited.

Dividend pusher: An instrument with a dividend pusher obliges the issuing bank
to make a dividend/coupon payment on the instrument if it has made a
payment on another (typically more junior) capital instrument or share.

 Classification in the Balance sheet

These instruments will be classified as capital and shown under 'Schedule I-
Capital' of the Balance sheet

 Optionality
PNCPS shall not be issued with a 'put option'. However, banks may issue the
instruments with a call option at a particular date subject to following conditions:
(a) The call option on the instrument is permissible after the instrument has run
for at least five years;
(b) To exercise a call option a bank must receive prior approval of
RBI(Department of Banking Regulation); and

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 (c) A bank must not do anything which creates an expectation that the call will
be exercised. and
(d) Banks must not exercise a call unless:
(i) They replace the called instrument with capital of the same or better
quality and the replacement of this capital is done at conditions
which are sustainable for the income capacity of the bank; or
(ii) The bank demonstrates that its capital position is well above the
minimum capital requirements after the call option is exercised.

 Seniority of Claim
The claims of the investors in PNCPS shall be senior to the claims of investors in
equity shares, subordinated to the claims of PDIs, all Tier 2 regulatory capital
instruments, depositors and general creditors of the bank and all other creditors
and is neither secured nor covered by a guarantee of the issuer nor related entity
or other arrangement that legally or economically enhances the seniority of the
claim vis-à-vis bank creditors

(ii) Stock surplus (share premium) resulting from the issue of instruments included in
Additional Tier 1 capital;

(iii) Debt capital instruments

The broad guidelines for inclusion of Perpetual Debt Instrument (IPDI) under
regulatory requirements as Additional Tier I capital are as under

 Nature: The Perpetual Debt Instruments may be issued as bonds or debentures

by Indian banks.

 Paid-in Status: The instruments should be issued by the bank (i.e. not by any
‘SPV’ etc. set up by the bank for this purpose) and fully paid-in.

 Amount: The amount of PDI to be raised may be decided by the Board of

Directors of banks.

 Limits: While complying with minimum Tier 1 of 7% of risk weighted assets, a

bank cannot admit, Perpetual Debt Instruments (PDI) together with Perpetual
Non-Cumulative Preference Shares (PNCPS) in Additional Tier 1 Capital, more
than 1.5% of risk weighted assets. However, once this minimum total Tier 1 capital
has been complied with, any additional PNCPS and PDI issued by the bank can
be included in Total Tier 1 capital reported. Excess PNCPS and PDI can be
reckoned to comply with Tier 2 capital if the latter is less than 2% of RWAs i.e.
while complying with minimum Total Capital of 9% of risk weighted assets.

 Maturity Period: The PDIs shall be perpetual i.e. there is no maturity date and
there are no step-ups or other incentives to redeem.

 Rate of Interest: The interest payable to the investors may be either at a fixed
rate or at a floating rate referenced to a market determined rupee interest
benchmark rate.

 Optionality PDIs shall not have any ‘put option’. However, banks may issue the
instruments with a call option at a particular date subject to following conditions:

(a) The call option on the instrument is permissible after the instrument has run for
at least five years;

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 (b) To exercise a call option a bank must receive prior approval of RBI
(Department of Banking Regulation);
(c) A bank must not do anything which creates an expectation that the call will be
exercised.
(d) Banks must not exercise a call unless:
(i) They replace the called instrument with capital of the same or better
quality and the replacement of this capital is done at conditions which
are sustainable for the income capacity of the bank or
(ii) The bank demonstrates that its capital position is well above the
minimum capital requirements after the call option is exercised.

Minimum refers to Common Equity Tier 1 of 8% of RWAs (including

capital conservation buffer of 2.5% of RWAs) and Total capital of
11.5% of RWAs including additional capital requirements identified
under Pillar 2.

 Seniority of Claim
The claims of the investors in instruments shall be
(i) Superior to the claims of investors in equity shares and perpetual non-
cumulative preference shares;
(ii) subordinated to the claims of depositors, general creditors and
subordinated debt of the bank;
(iii) is neither secured nor covered by a guarantee of the issuer nor related
entity or other arrangement that legally or economically enhances the
seniority of the claim vis-à-vis bank creditors.

 Classification in the Balance sheet

These instruments will be classified as capital and shown under 'Schedule 4 –
Borrowings' in the Balance sheet

(iv) Revaluation reserves at a discount of 55%;

(Included as Tier I capital as per RBI Circular No DBR.No.BP.BC.83/21.06.201/2015-
16 dated 01.03.2016.

Revaluation reserves often serve as a cushion against unexpected losses, but

they are less permanent in nature and cannot be considered as ‘Core Capital’.
Revaluation reserves arise from revaluation of assets that are undervalued on
the bank’s books, typically bank premises. The extent to which the revaluation
reserves can be relied upon as a cushion for unexpected losses depends mainly
upon the level of certainty that can be placed on estimates of the market values
of the relevant assets, the subsequent deterioration in values under difficult
market conditions or in a forced sale, potential for actual liquidation at those
values, tax consequences of revaluation, etc. Therefore, RBI has considered it
as prudent to consider revaluation reserves at a discount of 55% while
determining their value for inclusion in Tier 2 capital. Such reserves will have to
be reflected on the face of the Balance Sheet as revaluation reserves.

(v) Any other type of instrument generally notified by the Reserve Bank from time to time
for inclusion in Additional Tier 1 capital;

(vi) While calculating capital adequacy at the consolidated level, Additional Tier 1
instruments issued by consolidated subsidiaries of the bank and held by third parties
which meet the criteria for inclusion in Additional Tier 1 capital; and

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(vii) Less: Regulatory adjustments / deductions applied in the calculation of Additional Tier
1 capital [i.e. to be deducted from the sum of items (i) to (v)].

Criteria for Classification as Additional Tier 1 Capital for Regulatory Purposes

Under Basel III, Non-common equity elements to be included in Tier 1 capital should absorb
Losses while the bank remains a going concern.

Towards this end, one of the important criteria for Additional Tier 1 instruments is that these
instruments should have principal loss absorption through either

(i) Conversion into common shares or

(ii) A write-down mechanism, which allocates losses to the instrument at an objective
pre-specified trigger point.

Under Basel III, the criteria for instruments to be included in Additional Tier 1 capital have
been modified to improve their loss absorbency.

Therefore, in order for an instrument issued by a bank to be included in Additional (i.e. non-
common) Tier 1, in addition to criteria for individual types of non-equity regulatory capital
instruments, it must also meet or exceed minimum requirements set out.

Basel III requires that the terms and conditions of all non-common Tier 1 capital instruments
issued by a bank must have a provision that requires such instruments, at the option of the
relevant authority, to either be written off or converted into common equity upon the
occurrence of the trigger event

LOSS ABSORPTION OF ADDITIONAL TIER 1 (AT1) INSTRUMENTS AT THE PRE-

SPECIFIED TRIGGER

Loss Absorption Features

One of the criteria for AT1 capital instruments requires that these instruments should have
principal loss absorption at an objective pre-specified trigger point through either:

(i) Conversion to common shares, or

(ii) A write-down mechanism which allocates losses to the instrument.

The write-down will have the following effects:

(a) Reduce the claim of the instrument in liquidation;
(b) Reduce the amount re-paid when a call is exercised; and
(c) Partially or fully reduce coupon/dividend payments on the instrument.

Accordingly, banks may issue AT1 instruments with either conversion to common shares or
write-down (temporary or permanent) mechanism.

When a paid-up instrument is fully and permanently written-down, it ceases to exist

resulting in extinguishment of a liability of a bank (a non-common equity instrument)
and creates CET1. A temporary write-down is different from a conversion and a
permanent write-down i.e. the original instrument may not be fully extinguished.
Generally, the par value of the instrument is written-down (decrease) on the
occurrence of the trigger event and which may be written-up (increase) back to its
original value in future depending upon the conditions prescribed in the terms and
conditions of the instrument. The amount shown on the balance sheet subsequent to

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 temporary write-down may depend on the precise features of the instrument and the
prevailing accounting standards

The pre-specified trigger for loss absorption through conversion / write-down of Additional
Tier 1 instruments (PNCPS and PDI) must be at least Common Equity Tier 1 capital of
6.125% of RWAs. The Write-down of any Common Equity Tier 1 capital shall not be required
before a write-down of any Additional Tier 1 capital instrument.

The conversion / write-down mechanism (temporary or permanent) which allocates losses to

the Additional Tier 1 instruments (AT1) instruments must generate Common Equity Tier 1
(CET1) under applicable Indian Accounting Standards. The instrument will receive
recognition in AT1 capital only upto the extent of minimum level of CET1 generated (i.e. net
of contingent liability recognised under the Indian Accounting Standards, potential tax
liabilities, etc., if any) by a full write-down / conversion of the instrument

The aggregate amount to be written-down / converted for all AT1 instruments on breaching
the trigger level must be at least the amount needed to immediately return the bank’s CET1
ratio to the trigger level or, if this is not possible, the full principal value of the instruments.
Further, the issuer should have full discretion to determine the amount of AT1 instruments to
be converted / written-down subject to the amount of conversion/write-down not exceeding
the amount which would be required to bring the CET1 ratio to 8% of RWAs (minimum CET1
of 5.5% + capital conservation buffer of 2.5%).

The conversion / write-down may be allowed more than once in case a bank hits the pre-
specified trigger level subsequent to the first conversion / write-down which was partial.

The conversion / write-down of AT1 instruments are primarily intended to replenish the
equity in the event it is depleted by losses. Therefore, banks should not use conversion /
write-down of AT1 instruments to support expansion of balance sheet by incurring further
obligations / booking assets. Accordingly, a bank whose Common Equity ratio slips below
8% due to losses and is still above 6.125% i.e. trigger point, should seek to expand its
balance sheet further only by raising fresh equity from its existing shareholders or market
and the internal accruals.

(ii) Tier 2 Capital (gone-concern capital)

From regulatory capital perspective Gone-concern capital is the capital which will
absorb losses only in a situation of liquidation of the bank

Under Basel III, there will be a single set of criteria governing all Tier 2 debt capital
instruments.

Elements of Tier 2 Capital (For Indian Banks)

(viii) General Provisions and Loss Reserves

a. Provisions or loan-loss reserves held against future, presently unidentified

losses, which are freely available to meet losses which subsequently
materialize, will qualify for inclusion within Tier 2 capital. Accordingly, General
Provisions on Standard Assets, Floating Provisions, incremental provisions in
respect of unhedged foreign currency exposures, Provisions held for Country
Exposures, Investment Reserve Account, excess provisions which arise on
account of sale of NPAs and ‘countercyclical provisioning buffer’ will qualify
for inclusion in Tier 2 capital. However, these items together will be admitted
as Tier 2 capital up to a maximum of 1.25% of the total credit risk-weighted
assets under the standardized approach. Under Internal Ratings Based (IRB)

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 approach, where the total expected loss amount is less than total eligible
provisions, banks may recognise the difference as Tier 2 capital up to a
maximum of 0.6% of credit-risk weighted assets calculated under the IRB
approach.
b. Provisions ascribed to identified deterioration of particular assets or loan
liabilities, whether individual or grouped should be excluded. Accordingly, for
instance, specific provisions on NPAs, both at individual account or at portfolio
level, provisions in lieu of diminution in the fair value of assets in the case of
restructured advances, provisions against depreciation in the value of
investments will be excluded.

(ix) Debt Capital Instruments issued by the banks;

The Tier 2 debt capital instruments that may be issued as bonds / debentures by
Indian banks should meet the following broad terms and conditions to qualify for
inclusion as Tier 2 Capital for capital adequacy purposes including loss
absorbency through conversion/write –down/write off at the point of non-viability.

Paid-in Status: The instruments should be issued by the bank (i.e. not by any
‘SPV’ etc. set up by the bank for this purpose) and fully paid-in.

Amount: The amount of these debt instruments to be raised may be decided by

the Board of Directors of banks.

Maturity Period: The debt instruments should have a minimum maturity of five
years and there are no step-ups or other incentives to redeem.

Discount: The debt instruments shall be subjected to a progressive discount for

capital adequacy purposes. As they approach maturity these instruments should
be subjected to progressive discount as indicated in the table below for being
eligible for inclusion in Tier 2 capital.

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20

Rate of Interest:
(i) The interest payable to the investors may be either at a fixed rate or at a
floating rate referenced to a market determined rupee interest benchmark
rate.
(ii) The instrument cannot have a credit sensitive coupon feature, i.e. a coupon
that is reset periodically based in whole or in part on the banks’ credit
standing. Banks desirous of offering floating reference rate may take prior
approval of the RBI (DBR) as regard permissibility of such reference rates.

Optionality
The debt instruments shall not have any ‘put option’. However, it may be callable
at the initiative of the issuer only after a minimum of five years:
(a) To exercise a call option a bank must receive prior approval of RBI
(Department of Banking Regulation); and

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 (b) A bank must not do anything which creates an expectation that the call will
be exercised. For example, to preclude such expectation of the instrument
being called, the dividend / coupon reset date need not be co-terminus with
the call date. Banks may, at their discretion, consider having an appropriate
gap between dividend / coupon reset date and call date; and
(c) Banks must not exercise a call unless:
(i) They replace the called instrument with capital of the same or better
quality and the replacement of this capital is done at conditions which are
sustainable for the income capacity of the bank; or
(ii) The bank demonstrates that its capital position is well above the minimum
capital requirements after the call option is exercised

The use of tax event and regulatory event calls may be permitted. However,
exercise of the calls on account of these events is subject to the
requirements set out by RBI. RBI will permit the bank to exercise the call only
if the RBI is convinced that the bank was not in a position to anticipate these
events at the time of issuance of these instruments as explained in case of
Additional Tier 1 instruments.

Seniority of Claim
The claims of the investors in instruments shall be
(i) Senior to the claims of investors in instruments eligible for inclusion in
Tier 1 capital;
(ii) Subordinate to the claims of all depositors and general creditors of the
bank; and
(iii) Is neither secured nor covered by a guarantee of the issuer or related
entity or other arrangement that legally or economically enhances the
seniority of the claim vis-à-vis bank creditors.

Terms of Issue of Tier 2 Debt Capital Instruments in Foreign Currency

Banks may issue Tier 2 Debt Instruments in Foreign Currency without seeking
the prior approval of the Reserve Bank of India, subject to fulfilment of certain
terms and conditions.

Classification in the Balance Sheet

The amount raised by way of issue of Tier 2 debt capital instrument may be
classified under ‘Schedule 4 – Borrowings’ in the Balance Sheet

(x) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares

(PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) /
Redeemable Cumulative Preference Shares (RCPS)] issued by the banks;

Criteria for Inclusion of Perpetual Cumulative Preference Shares (PCPS)/

Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable
Cumulative Preference Shares (RCPS) as Part of Tier 2 Capital

Paid-in Status
The instruments should be issued by the bank (i.e. not by any ‘SPV’ etc. set up
by the bank for this purpose) and fully paid-in.

Amount
The amount to be raised may be decided by the Board of Directors of banks.

Maturity Period

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These instruments could be either perpetual (PCPS) or dated (RNCPS and
RCPS) instruments with a fixed maturity of minimum five years and there should
be no step-ups or other incentives to redeem. The perpetual instruments shall be
cumulative. The dated instruments could be cumulative or non-cumulative.

Amortisation
The Redeemable Preference Shares (both cumulative and non-cumulative) shall
be subjected to a progressive discount for capital adequacy purposes over the
last five years of their tenor, as they approach maturity as indicated in the table
below for being eligible for inclusion in Tier 2 capital

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20

Coupon
The coupon payable to the investors may be either at a fixed rate or at a floating
rate referenced to a market determined rupee interest benchmark rate. Banks
desirous of offering floating reference rate may take prior approval of the RBI
(DBR) as regard permissibility of such reference rates.

Optionality
These instruments shall not be issued with a 'put option'. However, banks may
issue the instruments with a call option at a particular date subject to following
conditions:
(a) The call option on the instrument is permissible after the instrument has run
for at least five years; and
(b) To exercise a call option a bank must receive prior approval of RBI
(Department of Banking Regulation ); and
(c) A bank must not do anything which creates an expectation that the call will be
exercised. For example, to preclude such expectation of the instrument being
called, the dividend / coupon reset date need not be co-terminus with the call
date. Banks may, at their discretion, consider having an appropriate gap
between dividend / coupon reset date and call date; and

(d) Banks must not exercise a call unless:

(i) They replace the called instrument with capital of the same or better
quality and the replacement of this capital is done at conditions which
are sustainable for the income capacity of the bank; or
(ii) The bank demonstrates that its capital position is well above the
minimum capital requirements after the call option is exercised.

Minimum refers to Common Equity Tier 1 of 8% of RWAs (including

capital conservation buffer of 2.5% of RWAs) and Total Capital of 11.5%
of RWAs including and additional capital identifies under Pillar 2.

Seniority of Claim
The claims of the investors in instruments shall be:
(i) senior to the claims of investors in instruments eligible for inclusion in
Tier 1 capital;

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 (ii) subordinate to the claims of all depositors and general creditors of the
bank; and
(iii) is neither secured nor covered by a guarantee of the issuer or related
entity or other arrangement that legally or economically enhances the
seniority of the claim vis-à-vis bank creditors.

Classification in the Balance Sheet

These instruments will be classified as ‘Borrowings’ under Schedule 4 of the
Balance Sheet under item No. I (i.e. Borrowings).

(xi) Stock surplus (share premium) resulting from the issue of instruments included in
Tier 2 capital;

(xii) While calculating capital adequacy at the consolidated level, Tier 2 capital
instruments issued by consolidated subsidiaries of the bank and held by third
parties which meet the criteria for inclusion in Tier 2 capital;

(xiii) Any other type of instrument generally notified by the Reserve Bank from time to
time for inclusion in Tier 2 capital; and

(xiv) Less: Regulatory adjustments / deductions applied in the calculation of Tier 2

capital [i.e. to be deducted from the sum of items (i) to (vii)].

Criteria for Classification as Tier 2 Capital for Regulatory Purposes

Basel III requires that the terms and conditions of all Tier 2 capital instruments (like Tier 1
capital Instruments) issued by a bank must have a provision that requires such instruments,
at the option of the relevant authority, to either be written off or converted into common
equity upon the occurrence of the trigger event

Therefore, in order for an instrument issued by a bank to be included in Tier 2 capital, in

addition to criteria for individual types of non-equity regulatory capital instruments, it must
also meet or exceed minimum requirements set out.

Loss Absorption features for Tier 2 capital should be same as that of Additional Tier 1
capital as discussed in foregoing paragraphs.

Regulatory Adjustments /Deductions

The following regulatory adjustments / deductions will be applied to regulatory capital both at
solo and consolidated level.

a) Goodwill and all Other Intangible Assets

b) Deferred Tax Assets (DTAs)
c) Cash Flow Hedge Reserve
d) Shortfall of the Stock of Provisions to Expected Losses
e) Gain-on-Sale Related to Securitisation Transactions
f) Cumulative Gains and Losses due to Changes in Own Credit Risk on Fair Valued
Financial Liabilities
g) Defined Benefit Pension Fund Assets and Liabilities
h) Investments in Own Shares (Treasury Stock)
i) Investments in the Capital of Banking, Financial and Insurance Entities

Limits and Minima

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 (i) As a matter of prudence, it has been decided that scheduled commercial banks
(excluding LABs and RRBs) operating in India shall maintain a minimum total capital
(MTC) of 9% of total risk weighted assets (RWAs) i.e. capital to risk weighted assets
(CRAR). This will be further divided into different components as described below :

(ii) Common Equity Tier 1 (CET1) capital must be at least 5.5% of risk-weighted assets
(RWAs) i.e. for credit risk + market risk + operational risk on an ongoing basis.

(iii) Tier 1 capital must be at least 7% of RWAs on an ongoing basis. Thus, within the
minimum Tier 1 capital, Additional Tier 1 capital can be admitted maximum at 1.5% of
RWAs.

(iv) Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9% of RWAs on an
ongoing basis. Thus, within the minimum CRAR of 9%, Tier 2 capital can be admitted
maximum up to 2%.

(v) If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital
ratios, then the excess Additional Tier 1 capital can be admitted for compliance with
the minimum CRAR of 9% of RWAs.

(vi) In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are
also required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in the
form of Common Equity Tier 1 capital. Thus, with full implementation of capital ratios
and CCB the capital requirements are summarised as follows:

S.No. Regulatory Capital As % to RWAs

(i) Minimum Common Equity Tier 1 Ratio 5.5
(ii) Capital Conservation Buffer (comprised of Common 2.5
Equity)
(iii) Minimum Common Equity Tier 1 Ratio plus Capital 8.0
Conservation Buffer [(i)+(ii)]
(iv) Additional Tier 1 Capital 1.5
(v) Minimum Tier 1 Capital Ratio [(i) +(iv)] 7.0
(vi) Tier 2 Capital 2.0
(vii) Minimum Total Capital Ratio (MTC) [(v)+(vi)] 9.0
(viii) Minimum Total Capital Ratio plus Capital 11.5
Conservation Buffer [(vii)+(ii)]

Transition to Basel III

RBI, in order to ensure smooth migration to Basel III without aggravating any near term
stress, prescribed phase wise transitional arrangement. The transitional arrangements for
capital ratios began as on April 1, 2013. The phase-in arrangements for banks operating in
India are indicated in the following Table
(% of RWAs)
Minimum 01.04.13 31.03.14 31.03.15 31.03.16 31.03.17 31.03.18 31.03.19 31.02.20
Capital
ratios
Minimum 4.5 5 5.5 5.5 5.5 5.5 5.5 5.5
Common
Equity Tier 1
(CET1)
Capital - - - 0.625 1.25 1.875 1.875 2.50
conservation

Page 39 of 65
buffer (CCB)
Minimum 4.5 5 5.5 6.125 6.75 7.375 7.375 8.00
CET1+ CCB
Minimum 6 6.5 7 7 7 7 7 7
Tier 1 capital
Minimum 9 9 9 9 9 9 9 9
Total
Capital*
Minimum 9 9 9 9.625 10.25 10.875 10.875 11.50
Total Capital
+CCB
Phase-in of 20 40 60 80 100 100 100 100
all
deductions
from CET1
(in %) #
* The difference between the minimum total capital requirement of 9% and the Tier 1
requirement can be met with Tier 2 and higher forms of capital;
# The same transition approach will apply to deductions from Additional Tier 1 and Tier 2
capital

Capital Charge for Credit Risk

The risk weights for calculation of CRAR for credit risk were prescribed vide RBI Circular
DBR.No.BP.BC.3/21/01.002/2015-16 DATED 01.07.2015.

In terms of the RBI guidelines, our Bank has implemented Standardized Approach w.e.f.
31.03.2009. In Standardized Approach of Credit Risk under Basel III, the loan assets have
been classified into following major categories (Reference: RBI Circular
DBR.No.BP.BC.1/21.06.201/2015-16 dated 01.07.2015)

Claims on Domestic/Foreign Sovereigns

 FB and NFB claims on the central government and the central government guaranteed
claims shall attract zero risk weight.
 Bank’s exposure to State Governments along with the investments in State Government
securities shall have zero risk weight. However, State Government guaranteed claims
shall be assigned a 20 per cent risk weight
 Claims on the RBI, DICGC, Credit Guarantee Fund Trust for Micro and Small
Enterprises (CGTMSE) and Credit Risk Guarantee Fund Trust for Low Income Housing
(CRGFTLIH) shall carry zero risk weight whereas claims on ECGC will bear a risk
weight of 20 per cent.
 Claims on foreign sovereign will attract risk weight as per the ratings assigned to those
sovereign / sovereign claims by international rating agencies, namely S&P, Fitch and
Moody’s rating.

Claims on Public Sector Entities (PSEs)/ Primary Dealers

 Claims on Domestic Public Sector Entities/Primary Dealers will attract risk weight in a
manner similar to claims on Corporates.
 Claims on foreign Public Sector Entities will attract risk weight as per risk ratings
assigned by the international rating agencies

 Claims on Banks:
All claims on scheduled banks having applicable minimum Common Equity Tier 1
(CET1) + applicable Capital Conservation Buffer (CCB) will attract 20% risk weight.

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 Other banks having applicable minimum CET1 + applicable CCB will attract 100% risk
weight. However, banks not having applicable minimum CET1 + applicable CCB would
attract risk weight upto 625% depending upon the level of CET1 + applicable CCB.
Claim on foreign banks will be risk weighted as per the ratings assigned by international
rating agencies.

Claims on Corporates / AFCs / HFCs / NBFC-IFCs / NBFC - IDFs

 Claims on corporates shall include all FB and NFB exposure excluding those which
are included under Sovereign, Bank, Regulatory Retail, Residential Mortgage, Non
Performing Assets and other Specified Categories.
 Claims on corporates, exposures on Asset Finance Companies (AFCs) and Non
Banking Finance Companies-Infrastructure Finance Companies (NBFC-IFC) shall
attract risk weights in the range of 20% to 150% depending upon the ratings
assigned by the External Credit Rating Agencies approved by the RBI.
 Risk weight on claims on AFCs would continue to be governed by credit rating of the
AFCs, except that claims which attract a risk weight of 150 % under NCAF shall be
reduced to a level of 100 %.
 RBI has approved/accredited seven agencies/companies, for the purpose of risk
weighting the bank’s claims for capital adequacy purposes.

The approved/accredited credit rating agencies are

a) Brickwork Rating
b) CARE
c) CRISIL
d) ICRA
e) India Rating (FITCH)
f) Infomerics
g) SMERA

This means that rating assigned to any credit limit or investment instrument, by any
of the above named seven agencies can only be accepted by bank for assigning risk
weight for credit or investment exposure.

 These rating agencies assign rating to the long term instruments/credit facilities as
well as to the long term instruments/credit facilities. These long term and short term
ratings have been mapped to the appropriate risk weights applicable as per the
Standardised Approach under the Basel II Framework.

 Depending on the contractual maturity of bank loan facility, the rating as well as the
respective risk weight are as under:

Long Term: The bank loan facilities having contractual maturity of more than one
year.

Short Term: The bank loan facilities having contractual maturity upto one year.

 Nomenclature of rating assigned by Rating Agencies and respective risk weight is as

under:

Risk Weight for Domestic Long Term Claims on Corporate, AFC and NBFC-IFCs

Domestic AAA AA A BBB BB & Unrated

Rating Below

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 Risk weight 20 30 50 100 150 100

Risk Weight for Domestic Short Term Claims on Corporates, AFC and NBFC-IFCs

Domestic A1+ A1 A2 A3 A4 & D Unrated

Rating
Risk weight 20 30 50 100 150 100

In case of Long/Short Term Debt Instruments, modifiers {"+" (plus) / "-"(minus)} can
be used with the rating symbols. The modifiers reflect the comparative standing
within the category, however, the same does not affect the respective risk weight
category.

 Non-Banking Financial Companies (NBFC-ND-SI), other than AFCs, NBFC-IFCs and

NBFC-IDF, regardless of the amount of claim, shall be uniformly risk weighted at
100%

 Claims on Non-resident corporates shall be risk weighted as per the ratings

assigned by international rating agencies. The applicable risk weights are tabulated
below:

S&P/ Fitch Ratings AAA t o AA A BBB to BB Below BB Unrated

Moody’s Rating Aaa to Aa A Baa to Ba Below Ba Unrated
Risk Weight (%) 20% 50% 100% 150% 100

Multiple Rating Assessments

(i) If there is only one rating by a chosen credit rating agency for a particular
claim, that rating would be used to determine the risk weight of the claim.
(ii) If there are two ratings accorded by chosen credit rating agencies which map
into different risk weights, the higher risk weight should be applied.
(iii) If there are three or more ratings accorded by chosen credit rating agencies
with different risk weights, the ratings corresponding to the two lowest risk
weights should be referred to and the higher of those two risk weights should
be applied. i.e., the second lowest risk weight.

As a general rule, banks should use only solicited rating from the chosen credit rating
agencies. No ratings issued by the credit rating agencies on an unsolicited basis
should be considered for risk weight calculation as per the Standardised Approach

A rating would be treated as solicited only if the issuer of the instrument has
requested the credit rating agency for the rating and has accepted the rating
assigned by the agency.

Claims Included in the Regulatory Retail Portfolio:

Exposures (including both Fund-based and non fund based) shall be classified as retail
claims for regulatory capital purposes if they meet the four criteria listed below. Claims in this
portfolio shall be assigned a risk-weight of 75%, except if RBI mandates otherwise.

(i) Qualifying criterion

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 The exposure (both fund-based and non-fund-based) is to an individual person or
persons or to a small business; Person under this clause would mean any legal person
capable of entering into contracts and would include but not be restricted to individual
and HUF; small business would include partnership firm, trust, private limited
companies, public limited companies, co-operative societies etc. Small business is one
where the total average annual turnover is less than Rs 50.00 Crore. The turnover
criterion is linked to the average of the last three years in the case of existing entities;
projected turnover in the case of new entities; and both actual and projected turnover
for entities which are yet to complete three years.

(ii) Product criterion

The exposure is in the form of revolving credits, lines of credit (including overdrafts),
term loans and leases (e.g. installment loans and leases, student and educational
loans) and small business facilities and commitments.

(iii) Granularity criterion

The Regulatory Retail portfolio should be sufficiently diversified to reduce the risk in
the portfolio. This shall result in a 75 per cent risk weight for the same. One can meet
this criterion by ensuring that aggregate exposure to one counterpart does not exceed
0.2% of the overall regulatory retail portfolio. Aggregate exposure is defined as gross
amount of all forms of debt exposure that individually meets the above mentioned
criteria. Similarly one counterpart means one or several entities that may be
considered as single beneficiary. NPAs under retail loans are to be excluded from the
overall regulatory retail portfolio while assessing the granularity criterion for risk-weight
purposes.

(iv) Low value of individual exposures

The maximum aggregated retail exposure to one counterpart should not be more than
the absolute threshold limit of Rs. 5 Crore.

Absolute threshold is defined as higher of the sanctioned limits or the actual

outstanding, for all FB and NFB facilities. It includes all forms of off-balance sheet
exposures. For term loans and EMI based facilities, where there is no scope for
redrawing any portion of the sanctioned amounts, exposure shall mean the actual
outstanding.

However, the following claims, both fund based and non-fund based, shall be excluded from
the regulatory retail portfolio:

 Exposures by way of investments in securities (such as bonds and equities), whether

listed or not
 Mortgage Loans to the extent that they qualify for treatment as claims secured by
residential property or claims secured by commercial real estate
 Loans and Advances to bank’s own staff which are fully covered by superannuation
benefits and / or mortgage of flat / house
 Consumer Credit, including Personal Loans and credit card receivables
 Capital Market Exposures
 Venture Capital Funds

 All unrated claims on Corporates, Asset Finance Companies (AFCs) and NBFC –
Infrastructure Finance Companies (NBFC – IFCs) having aggregate exposure from
banking system of more than Rs 200.00 crore will attract a risk weight of 150%.

This means that if our Bank has exposure (given loans or invested in any instrument) in
any Company, AFC or NBFC-IFC which has total exposure of more than Rs 200.00

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 crore from all banks including ours and is not rated by any RBI approved Credit rating
agency, or bank will have to assign a risk weight of 150% to such exposure.

 All claims on Corporates, Asset Finance Companies (AFCs) and NBFC – Infrastructure
Finance Companies (NBFC – IFCs) having aggregate exposure from banking system of
more than Rs 100.00 crore, which were rated earlier and subsequently have become
unrated will attract a risk weight of 150%.

 For Individual housing loans, sanctioned on or after 07.06.2017, The Loan to Value
(LTV) ratio, Risk Weights and Standard Asset Provisioning rates shall be as follows:

Category of LTV ratio (%) Loan sanctioned Loan sanctioned

loan up to 07.06.2017 on or after
07.06.2017
Upto Rs 30 ≤ 80 35 35%
lakh > 80 and ≤ 90 50 50%
Above Rs 30 ≤ 75 35 35%
lakh and
upto Rs 75 > 75 and ≤ 80 50
lakh
Above Rs 75 50%
≤ 75 75
lakh

LTV ratio should be computed as a percentage with total outstanding in the account
(viz. “principal + accrued interest + other charges pertaining to the loan” without any
netting) in the numerator and the realisable value of the residential property
mortgaged to the bank in the denominator.

 Restructured housing loans shall be risk weighted at 25% higher than the
applicable Risk weight and housing loans extended at teaser rates shall attract a
higher provisioning of 2%.
 All other claims secured by residential property shall be assigned the higher of
risk weight applicable to the counterparty or to the purpose for which finance has
been extended. Furthermore, exposure to intermediaries for on-lending purposes
shall not be included under claims secured by residential property. Rather, they
will be treated as corporate or regulatory retail claims as the case may be.

Claims Secured by Commercial Real Estate

 Claims secured by the Commercial Real Estate will attract risk weight of 100%.
 The loans to the residential housing projects under the Commercial Real Estate (CRE)
Sector exhibit lesser risk and volatility than the CRE Sector taken as a whole, RBI has
carved out a separate sub-sector called Commercial Real Estate – Residential
Housing (CRE-RH) from the CRE Sector and claims secured by CRE-RH will attract
risk weight of 75%.
 CRE-RH shall consist of loans to builders/developers for residential housing projects
(except for captive consumption).The CRE-RH shall ordinarily not include non-
residential commercial real estate.
 Integrated housing projects comprising of some commercial space (e.g. shopping
complex, school, etc.) shall also be classified under CRE-RH, provided that the
commercial area in the residential housing project does not exceed 10 per cent of the

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 total Floor Space Index (FSI) of the project. (FSI is the ratio of a building’s total
permissible floor area to the size of the piece of land upon which it is built).
 In case the FSI of the commercial area in the predominantly residential housing
complex exceeds the ceiling of 10 per cent, the project loans should be classified as
CRE and not CRE-RH.

Claims under Specified Categories

 Claims on Venture Capital Fund: Claims on Venture Capital Fund will attract risk
weight of 150%.
 Claims on Capital Market Exposure: Capital Market Exposure will attract a higher
risk weight of 125% or a risk weight warranted by the external rating of the
counterparty, whichever is higher.
 Claims on NBFC-ND-SI: The claims on the rated as well as unrated NBFC-ND-SI
(other than AFCs), regardless of the amount of claim, shall be uniformly risk weighted
at 100%. As regards the claims on AFCs, risk weights would be governed by the
external credit rating of the AFC, except that claims that attract a risk weight of 150%
under the Basel – III Capital Regulation shall be reduced to a level of 100%.
 Claims on Consumer Credit: Consumer credit including personal loans and credit
card receivables but excluding educational loan will attract risk weight @ 125%.
However, as gold and gold jewellery are eligible financial collaterals, the counter party
exposure in respect of personal loans against gold and gold jewellery shall be worked
out under the comprehensive approach after netting the value of security from
outstanding loan and then applying risk weight of 125%.
 Unhedged Foreign Currency Exposure: The extent of unhedged foreign currency
exposures of entities continues to be significant and this can increase the probability of
default in times of high currency volatility. It was, therefore, required incremental
capital requirements for bank exposures to entities with unhedged foreign currency
exposures (i.e. over and above the present capital requirements) as per following:

Likely Loss/EBID (%) Incremental Capital Requirement

Up to 75 per cent 0
More than 75 per cent 25 per cent increase in the risk weight

Other Assets

Claims on Bank’s own staff which are fully covered by superannuation benefits and/or
mortgage of flat/house will attract 20% risk weight. Other loans and advances to Bank’s own
staff shall be classified as Regulatory Retail

Risk Weights for unsecured portion of NPAs

The unsecured portion of NPA net of specific provision and partial write offs shall be risk
weighted as under:

S.No. Particulars Residential Other NPAs

Mortgage
1 Specific provisions are less than 20% of 100% 150%
outstanding amount of NPA
2 Specific provisions are at least 20% and less 75% 100%
than 50% of outstanding amount of NPA
3 Specific provisions are at least 50% of 50% 50%
outstanding amount of NPA

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 Only eligible collateral recognized for credit risk mitigation purposes shall be included
while estimating the secured portion of the NPA.

 If NPA is fully secured by the collateral that are not recognised for credit risk mitigation
purposes, either independently or along with other eligible collateral, a 100% risk weight
may apply, net of specific provisions, when provisions reach 15 per cent of the
outstanding amount:
 Claims secured by residential property and classified as NPA are risk weighted at 100%
net of specific provisions. If the specific provisions are at least 20 % but less than 50%
of the outstanding amount, risk weight applicable to the loan net of specific provisions
shall be 75%. If the specific provisions are 50% or more, the applicable risk weight will
be 50%.

Off Balance Sheet Items

 Non market related off balance sheet items such as direct credit substitutes and trade &
performance related contingent items are also subject to risk weights. First credit
equivalent amount in relation to these items is determined by multiplying the contracted
amount of that transaction by the relevant Credit Conversion Factor (CCF) and then the
stipulated Risk Weight is applied to arrive at the Risk Weighted Asset (RWA).
 Under the RBI guidelines, Risk Weight is also applicable where the fund based facility is
undrawn or partially undrawn and the same is not unconditionally cancellable. The
amount of undrawn facility shall be included in the non market related off balance sheet
item after application of relevant CCF.
 In terms of RBI guidelines, the Bank has implemented Standardized Approach as
prescribed as on 31.03.09.
 The credit conversion factors for non-market related off-balance sheet transactions are
prescribed as under
S.No. Instruments CCF
1 Direct credit substitutes e.g. general guarantees of 100%
indebtedness (including standby L/Cs serving as financial
guarantees for loans and securities, credit enhancements,
liquidity facilities for securitisation transactions), and
acceptances (including endorsements with the character of
acceptance).

(i.e., the risk of loss depends on the credit worthiness of the

counterparty or the party against whom a potential claim is
acquired)
2 Certain transaction-related contingent items (e.g. performance 50%
bonds, bid bonds, warranties, indemnities and standby letters
of credit related to a particular transaction).
3 Short-term self-liquidating trade letters of credit arising from the 20%
movement of goods (e.g. documentary credits collateralised by
the underlying shipment) for both issuing bank and confirming
bank
4 Sale and repurchase agreement and asset sales with 100%
recourse, where the credit risk remains with the bank.
(These items are to be risk weighted according to the type of
asset and not according to the type of counterparty with whom
the transaction has been entered into.)
5 Forward asset purchases, forward deposits and partly paid 100%

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 shares and securities, which represent commitments with
certain drawdown.
(These items are to be risk weighted according to the type of
asset and not according to the type of counterparty with whom
the transaction has been entered into.)
6 Lending of banks’ securities or posting of securities as 100%
collateral by banks, including instances where these arise out
of repo style transactions (i.e., repurchase / reverse
repurchase and securities lending / securities borrowing
transactions)
7 Note issuance facilities and revolving / non-revolving 50%
underwriting facilities
8 Commitments with certain drawdown 100%
9 Other commitments (e.g., formal standby facilities and credit
lines) with an original maturity of
a) up to one year 20%
b) over one year 50%

Similar commitments that are unconditionally cancellable at 0%

any time by the bank without prior notice or that effectively
provide for automatic cancellation due to deterioration in a
borrower’s credit worthiness
10 Take-out Finance in the books of taking-over institution
(1) Unconditional take-out finance 100%
(2) Conditional take-out finance 50%

An indicative list of Financial Guarantees, attracting a CCF of 100 per cent is as

under:
• Guarantees for Credit Facilities;
• Guarantees in lieu of repayment of financial securities;
• Guarantees in lieu of margin requirements of exchanges;
• Guarantees for mobilisation advance, advance money before the commencement
of a project and for money to be received in various stages of project
implementation;
• Guarantees towards revenue dues, taxes, duties, levies etc. in favour of Tax/
Customs / Port / Excise Authorities and for disputed liabilities for litigation
pending at courts;
• Credit Enhancements;
• Liquidity facilities for securitisation transactions;
• Acceptances (including endorsements with the character of acceptance);
• Deferred Payment Guarantees

An indicative list of Performance Guarantees, attracting a CCF of 50 per cent is as

under:
• Bid bonds;
• Performance bonds and export performance guarantees;
• Guarantees in lieu of security deposits / earnest money deposits (EMD) for
participating in tenders;
• Retention money guarantees;
• Warranties, indemnities and standby letters of credit related to particular
transaction.

Unconditional Cancellability Clause (UCC)

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 Keeping in view (refer point No. 9 above in the table above) that for commitments
that are unconditionally cancellable at any time by the bank without prior notice or
that effectively provide for automatic cancellation due to deterioration in a borrower’s
credit worthiness, the Credit Conversion factor (CCF) is Zero. As such the resultant
Risk Weighted Asset is Zero.
However, for this the bank has to demonstrate that they are actually able to cancel
any undrawn commitments in case of deterioration in a borrower’s credit worthiness
failing which the credit conversion factor applicable to such facilities which are not
cancellable will apply.

The following examples will help to understand the above concept of unconditional
cancellability clause.

(a) In the case of a cash credit facility for Rs.100 lakh (which is not unconditionally
cancellable) where the drawn portion is Rs. 60 lakh, the undrawn portion of Rs.
40 lakh will attract a CCF of 20 per cent (since the CC facility is subject to review
/ renewal normally once a year) and CCF at point No. 9 (a) will apply). The credit
equivalent amount of Rs. 8 lakh (20% of Rs.40 lakh) will be assigned the
appropriate risk weight as applicable to the counterparty / rating to arrive at the
risk weighted asset for the undrawn portion. The drawn portion (Rs. 60 lakh) will
attract a risk weight as applicable to the counterparty / rating.

(b) A TL of Rs. 700 crore is sanctioned for a large project which can be drawn down
in stages over a three year period. The terms of sanction allow draw down in
three stages – Rs. 150 crore in Stage I, Rs. 200 crore in Stage II and Rs. 350
crore in Stage III, where the borrower needs the bank’s explicit approval for draw
down under Stages II and III after completion of certain formalities. If the borrower
has drawn already Rs. 50 crore under Stage I, then the undrawn portion would be
computed with reference to Stage I alone i.e., it will be Rs.100 crore. If Stage I is
scheduled to be completed within one year, the CCF will be 20% and if it is more
than one year then the applicable CCF will be 50 per cent.

Since the bank has to demonstrate its ability actually to cancel any undrawn
commitments, our bank has issued instructions vide RMD, HO circular dated 06-01-
2018 that a suitable condition be incorporated in the terms and conditions of sanction
of any credit facility/limit.

Effective from April 1, 2019, the undrawn portion of cash credit/ overdraft limits sanctioned to
the large borrowers having aggregate fund based working capital limit of Rs 150.00 crore
and above from the banking system, irrespective of whether unconditionally cancellable or
not, shall attract a credit conversion factor of 20 percent.

Investments in the Capital of Banking, Financial and Insurance Entities

Limits on a Bank’s Investments in the Capital of Banking, Financial and Insurance

Entities:

(i) A bank’s investment in the capital instruments issued by banking, financial and
insurance entities is subject to the following limits:

a. A bank’s investments in the capital instruments issued by banking, financial and

insurance entities should not exceed 10% of its capital funds, after all prescribed
deductions.

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 b. Banks should not acquire any fresh stake in a bank's equity shares, if by such
acquisition, the investing bank's holding exceeds 5% of the investee bank's equity
capital.
c. Under the provisions of Section 19(2) of the Banking Regulation Act, 1949, a
banking company cannot hold shares in any company whether as pledge or
mortgagee or absolute owner of an amount exceeding 30% of the paid-up share
capital of that company or 30% of its own paid-up share capital and reserves,
whichever is less.
d. Equity investment by a bank in a subsidiary company, financial services company,
financial institution, stock and other exchanges should not exceed 10% of the
bank's paid-up share capital and reserves.
e. Equity investment by a bank in companies engaged in non-financial services
activities would be subject to a limit of 10% of the investee company’s paid up share
capital or 10% of the bank’s paid up share capital and reserves, whichever is less.
f. Equity investments in any non-financial services company held by (a) a bank; (b)
entities which are bank’s subsidiaries, associates or joint ventures or entities
directly or indirectly controlled by the bank; and (c) mutual funds managed by AMCs
controlled by the bank should in the aggregate not exceed 20% of the investee
company’s paid up share capital.
g. A bank’s equity investments in subsidiaries and other entities that are engaged in
financial services activities together with equity investments in entities engaged in
non-financial services activities should not exceed 20% of the bank’s paid-up share
capital and reserves. The cap of 20% would not apply for investments classified
under ‘Held for Trading’ category and which are not held beyond 90 days.

(ii) An indicative list of institutions which may be deemed to be financial institutions other
than banks and insurance companies for capital adequacy purposes is as under:

 Asset Management Companies of Mutual Funds / Venture Capital Funds / Private

Equity Funds etc;
 Non-Banking Finance Companies;
 Housing Finance Companies;
 Primary Dealers;
 Merchant Banking Companies;
 Entities engaged in activities which are ancillary to the business of banking under
the B.R. Act, 1949; and
 Central Counterparties (CCPs).

(iii) Investments made by a banking subsidiary/ associate in the equity or non- equity
regulatory capital instruments issued by its parent bank should be deducted from such
subsidiary's regulatory capital following corresponding deduction approach, in its capital
adequacy assessment on a solo basis. The regulatory treatment of investment by the
non-banking financial subsidiaries / associates in the parent bank's regulatory capital
would, however, be governed by the applicable regulatory capital norms of the
respective regulators of such subsidiaries / associates.

Treatment of a Bank’s Investments in the Capital Instruments Issued by Banking,

Financial and Insurance Entities within Limits

The investment of banks in the regulatory capital instruments of other financial entities
contributes to the inter-connectedness amongst the financial institutions. In addition, these
investments also amount to double counting of capital in the financial system. Therefore,
these investments have been subjected to stringent treatment in terms of deduction from
respective tiers of regulatory capital. A schematic representation of treatment of banks’
investments in capital instruments of financial entities is shown in Figure below. Accordingly,

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all investments in the capital instruments issued by banking, financial and insurance entities
within the limits mentioned in above paragraph will be subject to the following rules:

The investments held in AFS / HFT category may be reckoned at their market values,
whereas, those held in HTM category may be reckoned at values appearing in the
Balance sheet of the Bank.

Investments in the Capital Instruments of Banking, Financial and Insurance Entities

that are outside the scope of regulatory consolidation

In the entities where the bank does not In the entities where the bank owns
own more than 10% of the common share more than 10% of the common share
capital of individual entity capital of individual entity

Aggregate of investments in capital EQUITY NON-

instruments of all such entities and (i) Equity COMMON
compare with 10% of bank’s own investments in EQUITY
Common Equity insurance All such
subsidiaries will investment will
be fully be deducted
deducted from following
banks’ Common corresponding
Equity deduction
(ii) Compare approach
aggregated
equity
investments (i.e.
excluding equity
investments in
the insurance
subsidiaries)
with 10% of
bank’s Common
Equity after
deduction at (i)
above

Investments less Investments Investments More than 10%

than 10% will be more than less than 10% will be
risk weighted 10% will be will be risk deducted from
according to deducted weighted at Common
banking book following 250% Equity
and trading book corresponding
rules deduction
approach

(A) Reciprocal Cross- Holdings in the Capital of Banking, Financial and Insurance
Entities
Reciprocal cross holdings of capital might result in artificially inflating the capital
position of banks. Such holdings of capital will be fully deducted. Banks must apply a
“corresponding deduction approach” to such investments in the capital of other
banks, other financial institutions and insurance entities. This means the deduction

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 should be applied to the same component of capital (Common Equity, Additional Tier
1 and Tier 2 capital) for which the capital would qualify if it was issued by the bank
itself. For this purpose, a holding will be treated as reciprocal cross holding if the
investee entity has also invested in any class of bank’s capital instruments which
need not necessarily be the same as the bank’s holdings.
(B) Investments in the Capital of Banking, Financial and Insurance Entities which
are outside the Scope of Regulatory Consolidation and where the Bank does
not Own more than 10% of the Issued Common Share Capital of the Entity

i) The regulatory adjustment described in this section applies to investments in the

capital of banking, financial and insurance entities that are outside the scope of
regulatory consolidation and where the bank does not own more than 10% of the
issued common share capital of the entity. In addition:

(a) Investments include direct, indirect and synthetic holdings of capital

instruments. For example, banks should look through holdings of index
securities to determine their underlying holdings of capital.

(b) Holdings in both the banking book and trading book are to be included.
Capital includes common stock (paid-up equity capital) and all other types of
cash and synthetic capital instruments (e.g. subordinated debt).

(c) Underwriting positions held for five working days or less can be excluded.
Underwriting positions held for longer than five working days must be
included.

(d) If the capital instrument of the entity in which the bank has invested does not
meet the criteria for Common Equity Tier 1, Additional Tier 1, or Tier 2
capital of the bank, the capital is to be considered common shares for the
purposes of this regulatory adjustment.

(e) With the prior approval of RBI a bank can temporarily exclude certain
investments where these have been made in the context of resolving or
providing financial assistance to reorganise a distressed institution.

ii) If the total of all holdings listed in paragraph (i) above, in aggregate exceed 10%
of the bank’s Common Equity (after applying all other regulatory adjustments in
full listed prior to this one), then the amount above 10% is required to be
deducted, applying a corresponding deduction approach. This means the
deduction should be applied to the same component of capital for which the
capital would qualify if it was issued by the bank itself.

Accordingly, the amount to be deducted from common equity should be

calculated as the total of all holdings which in aggregate exceed 10% of the
bank’s common equity (as per above) multiplied by the common equity holdings
as a percentage of the total capital holdings. This would result in a Common
Equity deduction which corresponds to the proportion of total capital holdings
held in Common Equity.

Similarly, the amount to be deducted from Additional Tier 1 capital should be

calculated as the total of all holdings which in aggregate exceed 10% of the
bank’s Common Equity (as per above) multiplied by the Additional Tier 1 capital
holdings as a percentage of the total capital holdings. The amount to be
deducted from Tier 2 capital should be calculated as the total of all holdings
which in aggregate exceed 10% of the bank’s Common Equity (as per above)

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 multiplied by the Tier 2 capital holdings as a percentage of the total capital
holdings.

iii) If, under the corresponding deduction approach, a bank is required to make a
deduction from a particular tier of capital and it does not have enough of that tier
of capital to satisfy that deduction, the shortfall will be deducted from the next
higher tier of capital (e.g. if a bank does not have enough Additional Tier 1
capital to satisfy the deduction, the shortfall will be deducted from Common
Equity Tier 1 capital).

iv) Investments below the threshold of 10% of bank’s Common Equity, which are
not deducted, will be risk weighted. Thus, instruments in the trading book will be
treated as per the market risk rules and instruments in the banking book should
be treated as per the standardised approach or internal ratings-based approach
(as applicable). For the application of risk weighting the amount of the holdings
which are required to be risk weighted would be allocated on a pro rata basis
between the Banking and Trading Book. However, in certain cases, such
investments in both scheduled and non-scheduled commercial banks will be fully
deducted from Common Equity Tier 1 capital of investing bank.

v) For the purpose of risk weighting of investments in as indicated in para (iv)

above, investments in securities having comparatively higher risk weights will be
considered for risk weighting to the extent required to be risk weighted, both in
banking and trading books. In other words, investments with comparatively poor
ratings (i.e. higher risk weights) should be considered for the purpose of
application of risk weighting first and the residual investments should be
considered for deduction.

(C) Significant Investments in the Capital of Banking, Financial and Insurance

Entities which are outside the Scope of Regulatory Entities which are outside
the Scope of Regulatory Consolidation

(i) The regulatory adjustment described in this section applies to investments in the
capital of banking, financial and insurance entities that are outside the scope of
regulatory consolidation where the bank owns more than 10% of the issued
common share capital of the issuing entity or where the entity is an affiliate of
the bank.

In addition

 Investments include direct, indirect and synthetic holdings of capital instruments.

For example, banks should look through holdings of index securities to
determine their underlying holdings of capital.

 Holdings in both the banking book and trading book are to be included. Capital
includes common stock and all other types of cash and synthetic capital
instruments (e.g. subordinated debt).

 Underwriting positions held for five working days or less can be excluded.
Underwriting positions held for longer than five working days must be included.

 If the capital instrument of the entity in which the bank has invested does not
meet the criteria for Common Equity Tier 1, Additional Tier 1, or Tier 2 capital of

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 the bank, the capital is to be considered common shares for the purposes of this
regulatory adjustment

 With the prior approval of RBI a bank can temporarily exclude certain
investments where these have been made in the context of resolving or
providing financial assistance to reorganise a distressed institution.

(ii) Investments other than Common Shares

All investments included in para (i) above which are not common shares must be
fully deducted following a corresponding deduction approach. This means the
deduction should be applied to the same tier of capital for which the capital would
qualify if it was issued by the bank itself. If the bank is required to make a deduction
from a particular tier of capital and it does not have enough of that tier of capital to
satisfy that deduction, the shortfall will be deducted from the next higher tier of
capital (e.g. if a bank does not have enough Additional Tier 1 capital to satisfy the
deduction, the shortfall will be deducted from Common Equity Tier 1 capital).

(iii) Investments which are Common Shares

All investments included in para (i) above which are common shares and which
exceed 10% of the bank’s Common Equity (after the application of all regulatory
adjustments) will be deducted while calculating Common Equity Tier 1 capital. The
amount that is not deducted (upto 10% if bank’s common equity invested in the
equity capital of such entities) in the calculation of Common Equity Tier 1 will be risk
weighted at 250%. However, in certain cases, such investments in both scheduled
and non-scheduled commercial banks will be fully deducted from Common Equity
Tier 1 capital of investing bank.

With regard to computation of indirect holdings through mutual funds or index funds, of
capital of banking, financial and insurance entities which are outside the scope of regulatory
consolidation as mentioned above, the following rules may be observed:

(i) If the amount of investments made by the mutual funds / index funds / venture capital
funds / private equity funds / investment companies in the capital instruments of the
financial entities is known; the indirect investment of the bank in such entities would
be equal to bank’s investments in these entities multiplied by the percent of
investments of such entities in the financial entities’ capital instruments.

(ii) If the amount of investments made by the mutual funds / index funds / venture capital
funds / private equity funds / investment companies in the capital instruments of the
investing bank is not known but, as per the investment policies / mandate of these
entities such investments are permissible; the indirect investment would be equal to
bank’s investments in these entities multiplied by maximum permissible limit which
these entities are authorized to invest in the financial entities’ capital instruments.

(iii) If neither the amount of investments made by the mutual funds / index funds /
venture capital funds / private equity funds in the capital instruments of financial
entities nor the maximum amount which these entities can invest in financial entities
are known but, as per the investment policies / mandate of these entities such
investments are permissible; the entire investment of the bank in these entities would
be treated as indirect investment in financial entities. Banks must note that this
method does not follow corresponding deduction approach i.e. all deductions will be
made from the Common Equity Tier 1 capital even though, the investments of such
entities are in the Additional Tier 1 / Tier 2 capital of the investing banks.

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Application of these rules at consolidated level would mean:

(i) Identifying the relevant entities below and above threshold of 10% of common share
capital of investee entities, based on aggregate investments of the consolidated
group (parent plus consolidated subsidiaries) in common share capital of individual
investee entities.

(ii) Applying the rules as stipulated in paragraphs above and segregating investments
into those which will be deducted from the consolidated capital and those which will
be risk weighted. For this purpose,

 Investments of the entire consolidated entity in capital instruments of investee

entities will be aggregated into different classes of instruments.
 The consolidated Common Equity of the group will be taken into account.

Sometimes certain investors such as Employee Pension Funds have subscribed to

regulatory capital issues of commercial banks concerned. These funds enjoy the counter
guarantee by the bank concerned in respect of returns. When returns of the investors of the
capital issues are counter guaranteed by the bank, such investments will not be considered
as regulatory capital for the purpose of capital adequacy.

The equity investments in non-financial subsidiaries should be fully deducted from the
consolidated and solo CET1 capital of the bank respectively, after making all the regulatory
adjustments as indicated in RBI guidelines.

The intra-group exposures beyond permissible limits subsequent to March 31, 2016, if any,
would be deducted from Common Equity Tier 1 capital of the bank.

Credit Risk Mitigation (CRM) Techniques

Banks use a number of techniques to mitigate the credit risks to which they are exposed. For
example, exposures may be collateralised in whole or in part by cash or securities, deposits
from the borrower, guarantee of a third party, etc. The Basel II approach to credit risk
mitigation allows a wider range of credit risk mitigant to be recognised for regulatory capital
purposes than is permitted under the Basel I Framework provided these techniques meet the
requirements for legal certainty.

A collateralised transaction is one in which:

(i) Banks have a credit exposure and that credit exposure is hedged (secured) in
whole or in part by collateral posted by a counterparty (borrower).
(ii) Banks have a specific lien on the collateral and the requirements of legal
certainty are met.

Basel II Framework allowed banks to adopt either the simple approach, which, similar to the
1988 Accord (Basel I), substitutes the risk weighting of the collateral for the risk weighting of
the counterparty for the collateralised portion of the exposure (generally subject to a 20%
floor), or the comprehensive approach, which allows fuller offset of collateral against
exposures, by effectively reducing the exposure amount by the value ascribed to the
collateral.

Banks in India have to adopt the Comprehensive Approach, which allows fuller offset of
collateral against exposures, by effectively reducing the exposure amount by the value
ascribed to the collateral. Under this approach, banks which take eligible financial collateral

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(e.g. cash or securities, etc), are allowed to reduce their credit exposure to a counterparty
when calculating their capital requirements to take account of the risk mitigating effect of the
collateral. The legal certainty would inter-alia include obtaining and maintain enforceable
security interest e.g. by registering it with a registrar.

In order for collateral to provide protection, the credit quality of the counterparty and the
value of the collateral must not have a material positive correlation. For example, securities
issued by the counterparty - or by any related group entity - would provide little protection
and so would be ineligible

RBI has prescribed a list of eligible financial collaterals, method of valuation of these
collaterals and haircut thereon etc., which would help the Bank in reducing the exposure
amount by permitting offset of such collaterals against the exposure

Under Standardized Approach, the following securities (either primary or collateral) are
eligible for treatment as credit risk mitigant:

i. Cash (as well as certificates of deposit or comparable instruments issued by the lending
bank) or deposit with the bank which is incurring the counter-party exposure;
ii. Gold: Gold would include both bullion and Jewellery. However, the value of the
collateralized jewellery should be benchmarked to 99.99 purity;
iii. Securities issued by Central and State Governments;
iv. Kisan Vikas Patra and National Savings Certificates provided no lock in period is
operational and if they can be encashed within the holding period;
v. Life insurance policies with a declared surrender value of an insurance company which
is regulated by an insurance sector regulator;
vi. Debt securities rated by a recognised Credit Rating Agency where these are either:
a) At least BBB- when issued by public sector entities; or
b) At least A3 for short-term debt instruments.
vii. Debt securities not rated by a recognised Credit Rating Agency where these are:
a) Issued by a bank; and
b) Listed on a recognised exchange; and
c) Classified as senior debt; and
d) All rated issues of the same seniority by the issuing bank that are rated at least
BBB- or A3 by a chosen Credit Rating Agency ; and
e) The bank holding the securities as collateral has no information to suggest that the
issue justifies a rating below BBB- or A3 (as applicable) and;
f) Banks should be sufficiently confident about the market liquidity of the security.
viii. Units of Mutual funds regulated by the securities regulator of the jurisdiction of the
bank’s operation where:
a) A price for the units is publicly quoted daily i.e., where the daily NAV is available in
public domain; and
b) Mutual fund is limited to investing in the instruments listed in this paragraph.
(Equities including convertible bonds are no longer part of CRM)

 Bank is required to compute Capital Adequacy Ratio (CRAR) as per Basel III, at the
end of each quarter.

Procedure for computation of CRAR

While calculating the aggregate of funded and non-funded exposure of a borrower for the
purpose of assignment of risk weight, banks may ‘net-off’ against the total outstanding
exposure of the borrower –

(a) Advances collateralised by cash margins or deposits

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(b) Credit balances in current or other accounts which are not earmarked for specific
purposes and free from any lien;
(c) in respect of any assets where provisions for depreciation or for bad debts have been
made;
(d) claims received from DICGC/ ECGC and kept in a separate account pending
adjustment; and
(e) Subsidies received against advances in respect of Government sponsored schemes
and kept in a separate account.

After applying the conversion factor as indicated in above, the adjusted off Balance Sheet
value shall again be multiplied by the risk weight attributable to the relevant counter-party as
specified.

CAPITAL CONSERVATION BUFFER

To enable Banks to build up capital buffer during normal times, which can be utilised during
stressed times, the capital conservation buffer (CCB) has been introduced. The requirement
is based on simple capital conservation rules designed to avoid breaches of minimum capital
requirements.

Outside the period of stress, banks should hold buffers of capital above the regulatory
minimum. When buffers have been drawn down, one way banks should look to rebuild them
is through reducing discretionary distributions of earnings. This could include

a) Reducing dividend payments,

b) Share buybacks and
c) Staff bonus payments.
d) Banks may also choose to raise new capital from the market as an alternative to
conserving internally generated capital.

However, if a bank decides to make payments in excess of the constraints imposed as

explained above, the bank, with the prior approval of RBI, would have to use the option of
raising capital from the market equal to the amount above the constraint which it wishes to
distribute.

The capital conservation buffer can be drawn down only when a bank faces a systemic or
idiosyncratic stress.

A bank should not choose in normal times to operate in the buffer range simply to compete
with other banks and win market share. This aspect would be specifically looked into by
Reserve Bank of India during the Supervisory Review and Evaluation Process (SREP as
discussed below in subsequent paragraphs).

If, at any time, a bank is found to have allowed its capital conservation buffer to fall in normal
times, particularly by increasing its risk weighted assets without a commensurate increase in
the Common Equity Tier 1 Ratio (although adhering to the restrictions on distributions), this
would be viewed seriously. In addition, such a bank will be required to bring the buffer to the
desired level within a time limit prescribed by Reserve Bank of India.

The banks which draw down their capital conservation buffer during a stressed period should
also have a definite plan to replenish the buffer as part of its Internal Capital Adequacy
Assessment Process (ICAAP) and strive to bring the buffer to the desired level within a time
limit agreed to with Reserve Bank of India during the Supervisory Review and Evaluation
Process.

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The framework of capital conservation buffer will strengthen the ability of banks to withstand
adverse economic environment conditions, will help increase banking sector resilience both
going into a downturn, and provide the mechanism for rebuilding capital during the early
stages of economic recovery. Thus, by retaining a greater proportion of earnings during a
downturn, banks will be able to help ensure that capital remains available to support the
ongoing business operations / lending activities during the period of stress. Therefore, this
framework is expected to help reduce pro-cyclicality.

Banks are required to maintain a capital conservation buffer of 2.5%, comprised of Common
Equity Tier 1 capital, above the regulatory minimum capital requirement of 9%.

Capital distribution constraints will be imposed on a bank when capital level falls within this
range. However, they will be able to conduct business as normal when their capital levels fall
into the conservation range as they experience losses. Therefore, the constraints imposed
are related to the distributions only and are not related to the operations of banks. The
distribution constraints imposed on banks when their capital levels fall into the range
increase as the banks’ capital levels approach the minimum requirements. The Table below
shows the minimum capital conservation ratios a bank must meet at various levels of the
Common Equity Tier 1 capital ratios.

Minimum capital conservation standards for individual bank

Common Equity Tier 1 Ratio after including the Minimum Capital Conservation Ratios
current periods retained earnings (expressed as a percentage of earnings)
5.5% - 6.125% 100%
>6.125% - 6.75% 80%
>6.75% - 7.375% 60%
>7.375% - 8.0% 40%
>8.0% 0%

For example, a bank with a Common Equity Tier 1 capital ratio in the range of 6.125% to
6.75% is required to conserve 80% of its earnings in the subsequent financial year (i.e.
payout no more than 20% in terms of dividends, share buybacks and discretionary bonus
payments is allowed).

Basel III minimum capital conservation standards apply with reference to the applicable
minimum CET1 capital and applicable CCB. Therefore, during the Basel III transition period,
banks may refer to the Table below for meeting the minimum capital conservation ratios at
various levels of the Common Equity Tier 1 capital ratios:

Minimum Capital Conservation Standards for Individual banks

Common Equity Tier 1 Ratio after including the current Minimum Capital
periods retained earnings Conservation Ratios
As on As on As on (expressed as % of
March 31, 2016 March 31, 2017 March 31, 2018 earnings)
5.5% - 5.65625% 5.5% - 5.8125% 5.5% - 5.96875% 100%
>5.65625% - >5.8125% - >5.96875% - 80%
5.8125% 6.125% 6.4375%
>5.8125% - >6.125% - >6.4375% - 60%
5.96875% 6.4375% 6.90625%
>5.96875% - >6.4375% - 6.75% >6.90625% - 40%
6.125% 7.375%
>6.125% >6.75% >7.375% 0%

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The Common Equity Tier 1 ratio includes amounts used to meet the minimum Common
Equity Tier 1 capital requirement of 5.5%, but excludes any additional Common Equity Tier 1
needed to meet the 7% Tier 1 and 9% Total Capital requirements.

For example, a bank maintains Common Equity Tier 1 capital of 9% and has no Additional
Tier 1 or Tier 2 capital. Therefore, the bank would meet all minimum capital requirements,
but would have a zero conservation buffer and therefore, the bank would be subjected to
100% constraint on distributions of capital by way of dividends, share-buybacks and
discretionary bonuses.

LEVERAGE RATIO FRAMEWORK

Leverage Ratio

The Basel III leverage ratio is defined as the capital measure (the numerator) divided by the
exposure measure (the denominator), with this ratio expressed as a percentage

Capital Measure
Leverage Ratio =
Exposure Measure

Capital Measure
The capital measure for the leverage ratio is the Tier 1 capital of the risk-based capital
framework, taking into account various regulatory adjustments / deductions and the
transitional arrangements. In other words, the capital measure used for the leverage ratio at
any particular point in time is the Tier 1 capital measure applying at that time under the risk-
based framework

Exposure Measure
A bank’s total exposure measure is the sum of the following exposures:
(a) On-balance sheet exposures;
(b) Derivative exposures;
(c) Securities financing transaction (SFT) exposures; and
(d) Off- balance sheet (OBS) items.

Unless specified differently, banks must not take account of physical or financial collateral,
guarantees or other credit risk mitigation techniques to reduce the exposure measure.

Rationale and Objective

An underlying cause of the global financial crisis was the build-up of excessive on- and off-
balance sheet leverage in the banking system. In many cases, banks built up excessive
leverage while apparently maintaining strong risk-based capital ratios.

During the most severe part of the crisis, the banking sector was forced by the market to
reduce its leverage in a manner that amplified downward pressure on asset prices. This
deleveraging process exacerbated the feedback loop between losses, falling bank capital
and contraction in credit availability.

Therefore, under Basel III, a simple, transparent, non-risk based leverage ratio has been
introduced. The leverage ratio is calibrated to act as a credible supplementary measure to
the risk based capital requirements and is intended to achieve the following objectives:

(a) Constrain the build-up of leverage in the banking sector to avoid destabilising
deleveraging processes which can damage the broader financial system and the
economy; and

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(b) Reinforce the risk-based requirements with a simple, non-risk based “backstop”
measure.

At the time, Basel III guidelines were issued in 2015, Indian banking system was operating at
a leverage ratio of more than 4.5%. The final minimum leverage ratio were to be stipulated
taking into consideration the final rules prescribed by the Basel Committee by end-2017.
During this period, Reserve Bank was to monitor individual banks against an indicative
leverage ratio of 4.5%.

COUNTERCYCLICAL CAPITAL BUFFER FRAMEWORK

Countercyclical Capital Buffer

As discussed above, in December 2010, the Basel Committee on Banking Supervision

published Basel III framework for more resilient bank and banking system which presents
regulatory standards on bank capital adequacy and liquidity including countercyclical capital
buffer (CCCB)

The countercyclical capital buffer (CCCB) is intended to protect the banking sector against
the losses that could be caused by cyclical systemic risks. Counter cyclical capital buffer
requirement requires banks to add capital at times when credit is growing rapidly, so that the
buffer can be reduced when the financial cycle turns. Banks can use the additional capital
buffers they have built up during the growth phase of the financial cycle to cover losses that
may arise during periods of stress and to continue supplying create to the real economy.

RBI has laid broad guidelines on CCCB as under:

The aim of the Countercyclical Capital Buffer (CCCB) regime is two fold.

Firstly, it requires banks to build up a buffer of capital in good times which may be used to
maintain flow of credit to the real sector in difficult times.

Secondly, it achieves the broader macro-prudential goal of restricting the banking sector
from indiscriminate lending in the periods of excess credit growth that have often been
associated with the building up of system-wide risk.

The Basel III framework envisages the countercyclical capital buffer to be calculated
as the weighted average of the buffers in effect in the jurisdictions to which banks
have a credit exposure. It is implemented as an extension of the capital conservation
buffer. It consists entirely of Common Equity Tier 1 capital and, if the minimum buffer
requirements are breached, capital distribution constraints will be imposed on the
bank. Consistent with the capital conservation buffer, the constraints imposed relate
only to capital distributions, not the operation of the bank.

RBI has prescribed that the CCCB may be maintained in the form of Common Equity Tier 1
(CET 1) capital or other fully loss absorbing capital only, and the amount of the CCCB may
vary from 0 to 2.5% of total risk weighted assets (RWA) of the banks.

If, as per the Reserve Bank of India directives, banks are required to hold CCCB at a given
point in time, the same may be disclosed in a prescribed format. The CCCB decision would
normally be pre-announced with a lead time of 4 quarters. However, depending on the
CCCB indicators, the banks may be advised to build up requisite buffer in a shorter span of
time.

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The credit-to-GDP gap shall be the main indicator in the CCCB framework in India. However,
it shall not be the only reference point and shall be used in conjunction with GNPA growth.
The Reserve Bank of India shall also look at other supplementary indicators for CCCB
decision such as incremental C-D ratio for a moving period of three years (along with its
correlation with credit-to-GDP gap and GNPA growth), Industry Outlook (IO) assessment
index (along with its correlation with GNPA growth) and interest coverage ratio (along with its
correlation with credit-to-GDP gap). While taking the final decision on CCCB, the Reserve
Bank of India may use its discretion to use all or some of the indicators along with the credit-
to-GDP gap.

Credit-to-GDP gap is the difference between credit-to-GDP ratio and the long term trend
value of credit-to-GDP ratio at any point in time

The CCCB framework shall have two thresholds, viz., lower threshold and upper threshold,
with respect to credit-to-GDP gap.

a) The lower threshold (L) of the credit-to-GDP gap where the CCCB is activated shall
be set at 3 percentage points, provided its relationship with GNPA remains
significant. The buffer activation decision will also depend upon other supplementary
indicators.

b) The upper threshold (H) where the CCCB reaches its maximum shall be kept at 15
percentage points of the credit-to-GDP gap. Once the upper threshold of the credit-
to-GDP gap is reached, the CCCB shall remain at its maximum value of 2.5 per cent
of RWA, till the time a withdrawal is signalled by the Reserve Bank of India.

c) In between 3 and 15 percentage points of credit-to-GDP gap, the CCCB shall

increase gradually from 0 to 2.5 per cent of the RWA of the bank but the rate of
increase would be different based on the level/position of credit-to-GDP gap between
3 and 15 percentage points. If the credit-to-GDP gap is below 3 percentage points
then there will not be any CCCB requirement.

For all banks operating in India, CCCB shall be maintained on a solo basis as well as on
consolidated basis

Banks will be subject to restrictions on discretionary distributions (may include dividend

payments, share buybacks and staff bonus payments) if they do not meet the
requirement on countercyclical capital buffer which is an extension of the requirement for
capital conservation buffer (CCB).

Assuming a concurrent requirement of CCB of 2.5% and CCCB of 2.5% of total RWAs,
the required conservation ratio (restriction on discretionary distribution) of a bank, at
various levels of CET1 capital held is illustrated in Table below:

Individual bank minimum capital conservation ratios, assuming a requirement of

2.5% each of capital conservation buffer and CCCB
Common Equity Tier 1 Ratio bands Minimum Capital Conservation Ratios
(expressed as % of earnings)
>5.5% - 6.75% 100%
>6.75% - 8.0% 80%
>8.0% - 9.25% 60%
>9.25% - 10.50% 40%
>10.50% 0%

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 The CET 1 ratio bands are structured in increments of 25% of the required CCB and
CCCB prescribed by the Reserve Bank of India at that point in time. A separate
illustrative table is given below with an assumption of CCCB requirement at 1%.

Individual bank minimum capital conservation standards, when a bank is

subject to a 2.5% CCB and 1% CCCB
Common Equity Tier 1 Ratio bands Minimum Capital Conservation Ratios
(expressed as % of earnings)
> 5.5% - 6.375%* 100%
> 6.375% - 7.25% 80%
> 7.25% - 8.125% 60%
> 8.125% - 9.00% 40%
> 9.00% 0%
* (6.375=5.50+0.625+0.250)

As the total requirement of CCB and CCCB is 2.5% and 1% respectively, at each band,
0.625% and 0.250% of RWA are being added for CCB and CCCB respectively.

Banks must ensure that their CCCB requirements are calculated and publicly disclosed
with at least the same frequency as their minimum capital requirements.

SUPERVISORY REVIEW AND EVALUATION PROCESS (SREP)

As discussed in foregoing, the Capital Adequacy Framework rests on three components or

three Pillars. Pillar 1 is the Minimum Capital Ratio while Pillar 2 and Pillar 3 are the
Supervisory Review Process (SRP) and Market Discipline, respectively.

The objective of the SRP is to ensure that banks have adequate capital to support all the
risks in their business as also to encourage them to develop and use better risk
management techniques for monitoring and managing their risks.

This in turn require a well-defined internal assessment process within banks through which
they assure the RBI that adequate capital is indeed held towards the various risks to which
they are exposed.

The process of assurance could also involve an active dialogue between the bank and the
RBI so that, when warranted, appropriate intervention could be made to either reduce the
risk exposure of the bank or augment / restore its capital. Thus, a Board-approved policy on
Internal Capital Adequacy Assessment Process (ICAAP) is an important component of the
SRP.

The main aspects to be addressed under the SRP, and therefore, under the ICAAP, would
include:
(a) The risks that are not fully captured by the minimum capital ratio prescribed under
Pillar 1;
(b) The risks that are not at all taken into account by the Pillar 1; and
(c) The factors external to the bank.

Since the capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is
only the regulatory minimum level, addressing only the three specified risks (viz., credit,
market and operational risks), holding additional capital might be necessary for banks, on
account of both – the possibility of some under-estimation of risks under the Pillar 1 and the
actual risk exposure of a bank vis-à-vis the quality of its risk management architecture.

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Some of the risks that the banks are generally exposed to but which are not captured or not
fully captured in the regulatory CRAR would include:

(a) Interest rate risk in the banking book;

(b) Credit concentration risk;
(c) Liquidity risk;
(d) Settlement risk;
(e) Reputational risk;
(f) Strategic risk;
(g) Risk of under-estimation of credit risk under the Standardised approach;
(h) Model risk i.e., the risk of under-estimation of credit risk under the IRB approaches;
(i) Risk of weakness in the credit-risk mitigants;
(j) Residual risk of securitisation, etc.

The Basel Committee laid down the following four key principles in regard to the SRP
envisaged under Pillar 2:

Principle 1: Banks should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital levels.

Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their compliance
with the regulatory capital ratios. Supervisors should take appropriate supervisory action if
they are not satisfied with the result of this process.

Principle 3: Supervisors should expect banks to operate above the minimum regulatory
capital ratios and should have the ability to require banks to hold capital in excess of the
minimum.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from
falling below the minimum levels required to support the risk characteristics of a particular
bank and should require rapid remedial action if capital is not maintained or restored.

Banks’ responsibilities:
(a) Banks should have in place a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital levels (Principle
1)
(b) Banks should operate above the minimum regulatory capital ratios (Principle 3)

Supervisors’ responsibilities
(a) Supervisors should review and evaluate a bank’s ICAAP. (Principle 2)
(b) Supervisors should take appropriate action if they are not satisfied with the results of
this process. (Principle 2)
(c) Supervisors should review and evaluate a bank’s compliance with the regulatory
capital ratios. (Principle 2)
(d) Supervisors should have the ability to require banks to hold capital in excess of the
minimum. (Principle 3)
(e) Supervisors should seek to intervene at an early stage to prevent capital from falling
below the minimum levels. (Principle 4)
(f) Supervisors should require rapid remedial action if capital is not maintained or
restored. (Principle 4)

Thus, the ICAAP and SREP are the two important components of Pillar 2 and could be
broadly defined as follows:

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The ICAAP comprises a bank’s procedures and measures designed to ensure the following:

(a) An appropriate identification and measurement of risks;

(b) An appropriate level of internal capital in relation to the bank’s risk profile; and

(c) Application and further development of suitable risk management systems in the
bank.

The SREP consists of a review and evaluation process adopted by the supervisor, which
covers all the processes and measures defined in the principles listed above. Essentially,
these include the review and evaluation of the bank’s ICAAP, conducting an independent
assessment of the bank’s risk profile, and if necessary, taking appropriate prudential
measures and other supervisory actions.

MARKET DISCIPLINE:
The purpose of Market discipline (Pillar 3) in the Basel II Framework is to complement the
minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2).

The aim is to encourage market discipline by developing a set of disclosure requirements

which will allow market participants to assess key pieces of information on the scope of
application, capital, risk exposures, risk assessment processes, and hence the capital
adequacy of the institution.

Under Pillar 1, banks use specified approaches/ methodologies for measuring the various
risks they face and the resulting capital requirements. It is believed that providing disclosures
that are based on a common framework is an effective means of informing the market about
a bank’s exposure to those risks and provides a Consistent and comprehensive disclosure
framework that enhances comparability

Banks are required to make Pillar 3 disclosures at least on a half yearly basis, irrespective of
whether financial statements are audited, with the exception of following disclosures:

(i) Capital Adequacy;

(ii) Credit Risk: General Disclosures for All Banks; and
(iii) Credit Risk: Disclosures for Portfolios Subject to the Standardised Approach.

The disclosures as indicated at (i), (ii) and (iii) above will be made at least on a quarterly
basis by banks.

All the disclosures should be subjected to adequate validation.

All disclosures must either be included in a bank’s published financial results / statements or,
at a minimum, must be disclosed on bank’s website. A bank should decide which disclosures
are relevant for it based on the materiality concept. Information would be regarded as
material if its omission or misstatement could change or influence the assessment or
decision of a user relying on that information for the purpose of making economic decisions.

Banks should have a formal disclosure policy approved by the Board of directors that
addresses the bank’s approach for determining what disclosures it will make and the internal
controls over the disclosure process. In addition, banks should implement a process for
assessing the appropriateness of their disclosures, including validation and frequency.

RBI has set out the templates for banks to make disclosures.

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COMMITMENT RATIO
As per ALM Policy, the Bank has prescribed a Commitment Ratio (Total off-balance sheet
exposures such as Bank Guarantees, Letters of Credit, Forward Exchange Contract, Letter
of Comfort, Unavailed Limits and Contingent Liability of the Bank to Net Worth of the Bank
as on the last year) not exceeding 10.00 times of Net Worth (Maximum) on an ongoing
basis.

SUBSTANTIAL EXPOSURE
As per RBI guidelines vide RBI Circular No.DBR.No.BP.BC.1/21.06.201/2015-16 on Master
Circular –Basel III Capital Regulation dated 01.07.2015, banks as a prudent practice, may
like to ensure that their aggregate exposure (including non-funded exposures) to all ‘large
borrowers’ does not exceed at any time, 800 per cent of their ‘capital funds’ (as defined for
the purpose of extant exposure norms of the RBI). The ‘large borrower’ for this purpose
could be taken to mean as one to whom the bank’s aggregate exposure (funded as well as
non-funded) exceeds 10 per cent of the bank’s capital funds.

Keeping in view the above mentioned RBI guidelines, our Bank has prescribed threshold
limit for identification of Substantial Exposure account and has also prescribed exposure
ceiling for aggregate exposure towards such account as under:

Particulars Threshold / Exposure Ceiling

Threshold limit for Substantial Exposure A/C (FB+NFB) exceeding 5% of Capital Fund
Aggregate Exposure towards Substantial Should not exceed 500% of Capital Fund
Exposure A/C

LARGE EXPOSURES FRAMEWORK

Reserve Bank of India vide Circular No DBR.NO.BP.BC.43/21.01.003/2016-17 dated
01.12.2016 issued guidelines on banks' Large Exposures (LE).
The brief summary of the guidelines are as under:
 Under the Large Exposure Framework (LEF), the sum of all exposure values of a bank
to a counterparty or a group of connected counterparties is defined as a ‘Large
Exposure (LE)’, if it is equal to or above 10 percent of the bank’s eligible capital base
(i.e., Tier 1 capital).
 All aspects of the LE Framework must be implemented in full by March 31, 2019 and the
extant exposure norms applicable to single/group of connected counterparties will no
longer be applicable from that date.
 Banks must gradually adjust their exposures so as to comply with the LE limit with
respect to their eligible capital base by that date.
 The proposed guidelines of large exposure limit is based on Eligible Capital Funds (Tier
1) of the Bank as against Total Capital Fund (Tier 1+Tier 2) of the Bank in the existing
guidelines.

NON VIABLE BANK:

A bank which owing to its financial and other difficulties, may no longer remain a going
concern on its own in the opinion of the Reserve Bank unless appropriate measures are
taken to revive its operations and thus, enable it to continue as a going concern. The
difficulties faced by a bank should be such that these are likely to result in financial losses
and raising the Common Equity Tier 1 capital of the bank should be considered as the most
appropriate way to prevent the bank from turning non-viable. Such measures would include
write-off / conversion of non-equity regulatory capital into common shares in combination
with or without other measures as considered appropriate by the Reserve Bank.

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In rare situations, a bank may also become non-viable due to non-financial problems, such
as conduct of affairs of the bank in a manner which is detrimental to the interest of
depositors, serious corporate governance issues, etc. In such situations raising capital is not
considered a part of the solution and therefore, may not attract provisions of this framework.

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