Equity represents equity paid, preferred shares that may be compulsorily converted into equity, free reserves, the balance of the share contribution account and capital reserves that represent a surplus of the proceeds of the sale of assets, excluding reserves formed by the revaluation of the asset, less the balance of accumulated losses, the carrying amount of intangible assets and deferred selling expenses, if any. Subordinated debt securities are classified as lower Tier 2 debt instruments, generally have a maturity of at least 10 years and rank primarily for Tier 1 capital, but take precedence over senior debts with respect to receivables over liquidation proceeds. In order to ensure that the amount of principal outstanding does not decrease sharply after the maturity of a lower Tier 2 issue and, for example, is not replaced, the regulator requires that the amount to be classified as Tier 2 capital be reduced on a linear basis for a term of less than 5 years (for example, An issue of 1 billion would be worth only 800 million euros when calculating the capital 4 years before maturity). The rest is considered a top-tier show. For this reason, many lower Category 2 instruments were issued as 5-year issues with no 10-year call (i.e. final maturity after 10 years, but cancellable after 5 years). If the problem is not called, it has a big step – similar to level 1 – making the call more likely. An important part of banking regulation is to ensure that companies operating in the sector are managed prudently. The aim is to protect the companies themselves, their customers, the government (which is responsible for the costs of deposit insurance in the event of a bank collapse) and the economy by establishing rules to ensure that these institutions have sufficient capital to ensure the pursuit of a safe and efficient market and are able to withstand foreseeable problems. Typically, different asset classes have different risk weights associated with them. The calculation of risk weights depends on the bank adopting the standardized approach or the IRB approach under Basel II.
[3] The Basel Committee on Banking Supervision drafted a document in 1988 recommending certain standards and regulations for banks. It was called Basel I, and the committee published a revised framework known as Basel II. The main recommendation of this paper is that banks should have sufficient capital to reach at least 8% of their risk-weighted assets. [5] More recently, the Committee published another revised framework known as Basel III. [6] The calculation of the amount of risk-weighted assets depends on the revision of the Basel Accord followed by the financial institution. Most countries have implemented a version of this regulation. [7] The 5 Cs of the credit – character, cash flow, guarantee, conditions and restrictive covenants – have been replaced by a single criterion. While international standards for banks` capital were included in the 1988 Basel I Accord, Basel II makes significant changes to the interpretation, if not the calculation, of the capital requirement.
The Basel Committee on Banking Supervision first recommended these standards and regulations for banks in a document entitled Basel I. The recommendation was that banks should have enough capital to cover at least 8% of their RWA. The final step in determining the risk-adjusted capital ratio is to divide all adjusted capital by RWA. This calculation gives the risk-adjusted capital ratio. The higher the risk-adjusted capital ratio, the better the financial institution`s ability to withstand an economic downturn. In India, Tier 1 capital is defined as “Tier I capital” means “equity”, which is reduced by investments in shares of other non-bank financial companies and in outstanding shares, debentures, bonds, loans and advances, including finance by hire-purchase and leasing to subsidiaries and companies in the same group, and a total of ten per cent of its own fund; and perpetual debt securities issued annually by a systemically important non-bank non-bank finance company, provided that they do not exceed 15% of that company`s total Tier I capital as at 31 March of the preceding fiscal year; (according to the Prudential Standards (Reserve Bank) Guidelines for Non-Bank Financial Corporations (Not Accepted or Held), 2007) In the context of NBFCs in India, Tier I capital is nothing more than net equity. A general provision is made when an entity knows that a loss has occurred but is unsure of the exact nature of that loss. In accordance with pre-IFRS accounting standards, general provisions were generally made to insure future losses. Since these were not losses incurred, regulators tended to count them as capital.
The denominator of this ratio is somewhat complicated, as each asset held must be valued based on its ability to function as intended. For example, a revenue-generating plant is not sure to generate positive cash flows. Positive cash flows could depend on the cost of capital, factory repairs, maintenance, labor negotiations, and many other factors. Basel II aimed to extend the standard rules set out in the previous version and to promote the effective use of disclosure as a means of strengthening markets. Basel III further refined the document, stating that the calculation of the RWA would depend on the version of the document followed. For example, it has been reported[8] that the Australian Commonwealth Bank is valued at 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured at 10.1% if the bank were under the jurisdiction of the Prudential Regulation Authority of the United Kingdom. This shows that international differences in the implementation of the rule can vary considerably in their degree of stringency. Then, the value of risk-weighted assets (RWA) is measured. The value of RWA is the sum of each asset multiplied by the individual risk attributed to it.
This number is given as a percentage and reflects the probability that the asset will retain its value, i.e. not become worthless. Bank for International Settlements. “History of the Basel Committee”. Retrieved 30 July 2021. They consist of instruments that combine certain characteristics of equity and debt. They can be included in the additional capital if they are able to bear continuous losses without triggering a liquidation. The capital ratio is the percentage of a bank`s capital in its risk-weighted assets. The weights are defined by risk sensitivity indicators, the calculation of which is prescribed in accordance with the relevant Agreement. Basel II stipulates that the total capital ratio must not be less than 8%.
The financial crisis of 2007 and 2008 was caused by financial institutions investing in subprime mortgages, which presented a much higher risk of default than bank managers and regulators thought possible. When consumers began to default on their mortgages, many financial institutions lost significant amounts of capital and some became insolvent. The risk-adjusted capital ratio measures the resilience of a financial institution`s balance sheet by focusing on capital resources to survive a particular economic risk or recession. The higher the institution`s capital, the higher its capital ratio, which should lead to a higher probability that the company will remain stable in the event of a severe economic downturn. For example, cash and government bonds are almost 100% likely to remain solvent. Mortgages would likely have a medium risk profile, while derivatives would have to be assigned a much higher risk quotient. Basel III, a set of international banking regulations, has established some guidelines to avoid this problem in the future. Regulators are now insisting that each bank must group its assets by risk category so that the amount of capital required matches the level of risk of each type of investment. Basel III uses the ratings of certain assets to determine their risk ratios. The goal is to prevent banks from losing large amounts of capital when a particular asset class loses a lot of value. Risk-weighted assets (also known as RWA) are a bank`s off-balance-sheet, risk-weighted assets or exposures. [1] This type of asset calculation is used to determine a financial institution`s capital requirement or capital adequacy ratio (CAR).
In the Basel I Accord published by the Basel Committee on Banking Supervision, the Committee explains why the use of a risk-weighted approach is the preferred method that banks should use for the calculation of capital:[2] Regulators consider several instruments to assess the risk of a particular asset class. Since a high percentage of bank assets are loans, regulators consider both the source of the loan repayment and the underlying value of the collateral. A loan for a commercial property, for example, generates interest and repayment payments based on tenants` rental income. If the building is not fully leased, the property may not generate enough income to repay the loan. Since the building serves as collateral for the loan, banking supervision also takes into account the market value of the building itself. Bankers must weigh the potential return of an asset class against the amount of capital they must hold for the asset class. Determining total adjusted capital is the first step in determining the risk-adjusted capital ratio. Total adjusted capital is the sum of equity and quasi-equity instruments, adjusted for their equity content.
In EU countries, the capital requirements of Basel III have been implemented through the CRD IV package, which generally refers to both EU Directive 2013/36/EU and EU Regulation 575/2013. Regulatory capital requirements are usually (but not always) imposed at both the level of individual banking companies and at the level of the group (or sub-group). This may therefore mean that a banking group has several different regulatory capital regimes at different levels, each under the supervision of a different supervisory authority. [6] Sometimes it includes instruments that are initially issued with fixed interest rates (e.B. .