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14-2

NARSIMHAN COMMITTEE

REFORMS

I & II

The Management Of

Capital

The purpose of this session is to discover why

capital – particularly equity capital – is so

important for financial institutions, to learn

how managers and regulators assess the

adequacy of an institution’s capital position,

and to explain the ways that management can

raise new capital.

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14-4

SW Analysis of Indian Banking

Strength

Massive Branch Network

Weaknesses

Scarcity of skilled manpower

New branches incurred losses for prolonged period

specially those in rural and semi-urban centers

Customer service deteriorated

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SW Analysis of Indian Banking

Weaknesses

Lack of competition

Low capital base

Low productivity

High intermediation cost

Technology use minimum

No proper risk management system

Prudential norms were weak

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14-6

SW Analysis of Indian Banking

Weaknesses

Indifferent attitude of bank officials at all levels

Monitoring by central office becomes difficult in view

of large geographical spread

Increasing overdue in advances

Political interference

High degree of directed credit

Impounding of huge resources of banks due to high

CRR and SLR

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14-7

Recommendations

Deregulation of interest rates

Preemption of banks’ resources through SLR and CRR to be reduced

No further nationalisation of banks

Branch licensing to be abolished

RBI policy towards foreign banks should be more liberal

There should be level playing field between foreign and domestic banks

Streamlining and rationalisation of foreign operations of indian banks

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14-8

Recommendations

Internal organisation of banks be left to

judgment of individual banks

Computerisation should be speedier to handle

ever growing volumes

Individual banks should be free to make their

own recruitment

Duality of control between RBI and Ministry of

Finance should end

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14-9

Recommendations

Appointment of CMD should be free from

political interference

Capital of banks should be raised to

4% by March 1993

8% by March 1996

Of which 50% to be Tier I capital

Banks should access capital markets for raising

capital

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14-10

Recommendations

Banks should not take into account income from NPA where interest remains past due for a period of 180 days

Assets should be classified under four categories and provision made as under:

Standard Nil

Sub-standard 10% of total outstanding

Doubtful 100% of security shortfall

20% to 50% depending on the

period asset is doubtful

Loss asset 100% provision or writeoff

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14-11

Recommendations

Criterion for income recognition to be

recognised by tax authorities

Special tribunals be set up for speedy recovery

of bank dues

Establishment of Asset Reconstruction Fund

Bad and doubtful assets to be transferred to

ARF in a phased manner

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14-12

Recommendations

Banks to be restructured on the following lines

3 to 4 large international banks

8 to 10 national banks having all India network

Local Area Banks operating in specific regions

RRBs confined to rural areas

The revised system should be market driven and

based on profitability considerations and brought

about throughout a process of mergers and

acquisitions

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14-13

Tasks Performed By Capital

Provides a Cushion Against Risk of Failure

Provides Funds to Help Institutions Get Started

Promotes Public Confidence

Provides Funds for Growth

Regulator of Growth

Role in Growth of Bank Mergers

Regulatory Tool to Limit Risk Exposure

Protects the Government’s Deposit Insurance System

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14-14

Types of Capital

Common Stock

Preferred Stock

Surplus

Undivided Profits

Equity Reserves

Subordinated Debentures

Minority Interest in

Consolidated

Subsidiaries

Equity Commitment

Notes

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14-15

Reasons for Capital Regulation

To Limit the Risk of Failures

To Preserve Public Confidence

To Limit Losses to the Central Government

Arising from Deposit Insurance Claims

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14-16

The Basle Agreement on

International Capital Standards

An International Treaty Involving the U.S.,

Canada, Japan and the Nations of Western

Europe to Impose Common Capital

Requirements On All Banks Based in

Those Countries

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14-17

Tier 1 Capital

Common Stock and Surplus

Undivided Profits

Qualifying Noncumulative Preferred Stock

Minority Interests in the Equity Accounts of Consolidated Subsidiaries

Selected Identifiable Intangible Assets Less Goodwill and Other Intangible Assets

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14-18

Tier 2 Capital

Allowance for Loan and Lease Losses

Subordinated Debt Capital Instruments

Mandatory Convertible Debt

Cumulative Perpetual Preferred Stock with Unpaid Dividends

Equity Notes

Other Long Term Capital Instruments that Combine Debt and Equity Features

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14-19

Basle Agreement Capital

Requirements

Ratio of Core Capital (Tier 1) to Risk Weighted

Assets Must Be At Least 4 Percent

Ratio of Total Capital (Tier 1 and Tier 2) to

Risk Weighted Assets Must Be At Least 8

Percent

The Amount of Tier 2 Capital Limited to 100

Percent of Tier 1 Capital

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14-20

Calculating Risk-Weighted Assets

Compute Credit-Equivalent Amount of Each Off-

Balance Sheet (OBS) Item

Find the Appropriate Risk-Weight Category for Each

Balance Sheet and OBS Item

Multiply Each Balance Sheet and Credit-Equivalent

OBS Item By the Correct Risk-Weight

Add to Find the Total Amount of Risk-Weighted

Assets

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14-21

What Was Left Out of the Original

Basle Agreement

The Most Glaring Hole with the Original Basle Agreement is its Failure to Deal with Market Risk

In 1995 the Basle Committee Announced New Market Risk Capital Requirements for Their Banks

In the U.S. Banks Can Create Their Own In-House Models to Measure Their Market Risk Exposure

Regulators Would Then Determine the Amount of Capital Required Based Upon Their Estimate

Banks That Continuously Estimate Their Market Risk Poorly Would Be Required to Hold Extra Capital

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14-22

Basle II

Aims to Correct the Weaknesses of Basle I

Three Pillars of Basle II:

Capital Requirements For Each Bank Are Based on

Their Own Estimated Risk Exposure

Supervisory Review of Each Bank’s Risk

Assessment Procedures and the Adequacy of Its

Capital

Greater Disclosure of Each Bank’s True Financial

Condition

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14-23

Capital Adequacy Categories Based

on Prompt Corrective Action

Well Capitalized

Adequately Capitalized

Undercapitalized

Significantly Undercapitalized

Critically Undercapitalized

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14-24

Internal Capital Growth Rate

= ROE X Retention Ratio

= Profit Margin X Asset Utilization

X Equity Multiplier X Retention

Ratio

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14-25

Planning to Meet a Bank’s Capital

Needs

Raising Capital Internally

Dividend Policy

Internal Capital Growth Rate

Raising Capital Externally

Issuing Common Stock

Issuing Preferred Stock

Issuing Subordinated Notes and Debentures

Selling Assets and Leasing Facilities

Swapping Stock for Debt Securities

Choosing the Best Alternative