Banking Sector Reforms

When does RBI step in to monitor a Bank?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : CAR, Basel Norms

Mains level : Not Much

The Reserve Bank of India (RBI) has placed a private bank under tight monitoring and greater public scrutiny.

What is the news?

  • The XYZ Bank’s capital to risk weighted assets ratio (CRAR) dropped to around 13% at the end of March this year from 14.5% a year ago.
  • This has dropped below the Basel III in the past and it has even been placed under the prompt corrective action framework (PCA) by the RBI to deal with serious deteriorations in its financial position.
  • Under Basel-III norms banks are supposed to maintain their CRAR at 9% or above.

What is Capital Adequacy Ratio (CAR)?

  • Capital adequacy ratio is an indicator of the ability of a bank to survive as a going business entity in case it suffers significant losses on its loan book.
  • The CRAR is a ratio that compares the value of a bank’s capital (or net worth) against the value of its various assets weighted according to how risky each asset is.
  • It is used to gauge the risk of insolvency faced by a bank.

How do it affects bank functioning?

  • A bank cannot continue to operate if the total value of its assets drops below the total value of its liabilities as it would wipe out its capital (or net worth) and render the bank insolvent.
  • So, banking regulations such as the Basel-III norms try to closely monitor changes in the capital adequacy of banks in order to prevent major bank failures which could have a severe impact on the wider economy.
  • The capital position of a bank should not be confused with cash held by a bank in its vaults to make good on its commitment to depositors.

Alternatives for bank

  • The said Bank has been trying to issue additional shares in the open market through a rights issue in order to deal with its capital adequacy woes.
  • Through a rights issue, the bank will be able to raise more equity capital from existing shareholders.
  • This is in contrast to an initial public offering where shares are issued to new shareholders.

Back2Basics: Basel Norms

  • Basel is a city in Switzerland. It is the headquarters of the Bureau of International Settlement (BIS), which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations.
  • Basel guidelines refer to broad supervisory standards formulated by this group of central banks – called the Basel Committee on Banking Supervision (BCBS).
  • The set of the agreement by the BCBS, which mainly focuses on risks to banks and the financial system is called Basel accord.
  • The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
  • India has accepted Basel accords for the banking system.

Basel I

  • In 1988, BCBS introduced a capital measurement system called Basel capital accord, also called as Basel 1.
  • It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
  • The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
  • RWA means assets with different risk profiles.
  • For example, an asset-backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

Basel II

  • In June ’04, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which the committee calls it as pillars:
  • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
  • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
  • Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

Basel III

  • In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
  • A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
  • Also, the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
  • Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
  • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

 

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