A. Capital Adequacy

While banks’ income mainly comes out of lending and investment activities, they utilize the funds deposited with them by Customers for these purposes. When their investment or lending decisions go wrong, it result into loss to the bank.

In order that the banks involve their own funds adequately to bear such losses, RBI prescribed capital adequacy norms. Presently, all commercial banks are required to have a minimum capital of 8 per cent to the Risk Weighted Assets of Banks. This ratio is known as CRAR, i.e., Capital to Risk Assets Ratio. This was raised to 9 per cent by 31st March 2000.

‘Capital’ for the purpose of this norm is divided into two parts, viz., Tier I and Tier II Capital.

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(i) Tier I Capital:

It consists of paid-up capital, Banks’ Statutory Reserves, Free Re­serves (those not earmarked for meeting any specific liability) and capital reserves arising out of sale “proceeds of any assets. It will not include reserves arising out of revaluation of assets. However, accumulated losses, investments in banks’ subsidiaries and any intangible assets like Goodwill will be deducted from the above items to arrive at the minimum. Capital adequacy.

(ii) Tier II Capital:

It consists of paid-up value of Perpetual Preference Shares, Revalua­tion Reserves, paid-up value of unsecured Bonds issued as subordinated debt, General Provi­sions and Loss Reserves. It should be noted that certain items like Revaluation Reserves, etc., are not taken 100% of their value for this purpose.

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Their value is discounted to certain percentage e.g., Revaluation Reserves discounted to the extent of 55 per cent and only the balance sum is included in Tier II Capital. Another condition is that Tier II Capital cannot exceed 50% of Tier I Capital for the purpose of arriving at the prescribed capital adequacy ratio.

Students are reminded that detailed natty gritty and complexities involved in their calculation or understanding of the subject is not discussed here. The basic objective of explaining the various concepts is only to educate the students about their applicability and the meaning and importance of such new concepts in the Indian Banking Scenario.

(iii) Risk Weighted Assets:

The requisite percentage of capital adequacy discussed above should be maintained with reference to various assets of the banks. However, the assets are not taken at their book value. The value of each asset is assigned with the risk factor in percentage terms.

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CRAR at 9 per cent on Rs.150 crore is required to be maintained. Hence, in such a situation the bank is expected to have a minimum capital of Rs.13.50 crore which can con­sist of Tier I and Tier II capital items subject to Tier II value not exceeding that of Tier I value.

Again to illustrate, supposing the total value of items indicated under Tier I heading amounts to Rs. 6.00 crore and that of Tier II amounts to Rs. 8.00 crore, the bank will be failing to maintain the requisite CRAR of Rs.13.50 crore as a maximum of only Rs. 3.00 crore under Tier II (being the maximum at 50 per cent of Tier I capital) will be eligible for computation.

(iv) Subordinated Debt:

These are bonds issued by banks for raising Tier II capital having the following features:

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They should be fully paid up instruments

They should be unsecured debt

They should be subordinated to the claims of other creditors (It means that the bond holders’ claim for their money will rank last in order of preference as com­pared to claims of other creditors of banks).

The bonds should not be redeemable at the option of the holders. In other words repayment of the bond value will be decided only by the issuing bank.

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B. Income Recognition

Irksome from an asset (like Loans and Advances of Banks) can be taken to Profit and Loss A/c only if the income is actually received. Income should not be booked on accrual basis. In other words, incomes like interest earned but not received will not be allowed to be credited to Profit and Loss Account.