[Economy Q] Basel III Norms: Tier 1 and Tier 2 Capital meaning useDEVENDRA VISHWAKARMA
- Why BASEL?
- What is BASEL?
- What are BASEL Capital adequacy requirements (CAR)?
- BASEL-III norms
- Criticism of BASEL norms
- 2007-08: Subprime crisis in USA, after their banks loaned money to “subprime” borrowers i.e. people without capacity to repay the loan.
- The resultant housing bubble and its collapse, led to economic downturn throughout the world.
- To prevent such crisis in future, there is need for common banking regulation across globe. BASEL norms aim to achieve this.
What is BASEL?
- BASEL is a city of Switzerland.
- BASEL norms were initially designed in 1988. Later updated in 2004 and 2011. They prescribe ‘safe-lending’ norms to banks.
- At present we are at BASEL-III norms stage.
What are BASEL Capital adequacy requirements (CAR)?
Let’s understanding using a technically incorrect example. First a bank needs to calculate its “Risk weighted assets”.
Numbers only for illustration
|Product||x risk*||total amount loaned|
|home loan||30%||20 crores|
|commercial loan||60%||30 crores|
|total risk weighted assets (RWA)||100%||100 crores|
- To sustain this loan business, a Bank needs to have ‘sufficient’ capital under BASEL norms. For example, if a bank has total risk weighed assets worth Rs.100 crore then…
- It needs to have total capital adequacy of 9 crore rupees.
- out of which, 7 crore in tier-1 and 2 crores in tier-2 capital.
To express this in a formula
Basel Capital adequacy requirement (CAR)= 9% of RWA (Risk weighted assets)
BASEL CAR= [7% of RWA in T1] + [2% of RWA in T2]
|common shares||Debts (bonds)|
|preferential shares||hybrid instruments such as “optionally fully convertible debentures”|
|highest liquidity i.e. can be sold easily to gather cash and ward off any crisis.||less liquid than Tier-1 capital|
|This capital is further classified into Upper T2 and lower T2. But such technicalities are not asked in competitive exams or generic interviews so ignore it.|
- Anyways, point being- if a bank wants to loan 100 crore money (risk weight assets) then it ought to have 9 crore as “total capital adequacy”.
- if not, then they need to arrange money by borrowing via debt or equity route.
- Public sector banks of India (PSB) need total 2.4 lakh crore rupees to comply with BASEL-III norms.
- These were to be implemented from March 2018, as per initial order of RBI
- but Indian banks showed inability to raise so much capital in so little time
- Hence RBI governor Raghuram Rajan extended the deadline to March 2019.
- Public sector banks also hoped that Government of India would give them necessary capital from tax payer’s money
- But the new Finance minister Arun Jaitley has declined. In Budget 2014, he announced that banks themselves will have to raise money by selling shares to public, in a phase manner. Although Government will continue to remain the majority shareholder.
Criticism of BASEL norms
- Reserve bank of India, already has sufficient “backup” mechanisms to prevent banking crisis in India- such as Cash reserve ratio (CRR), Statutory liquidity ration (SLR), all banks are required to make fortnightly reporting to RBI about their finance and operations and so on.
- One shoe doesn’t fit all. Just because American Banks were so imprudent in their functioning and ran into trouble, doesn’t mean WE the Indian banks need be so overcautious and keep so much of money aside for ‘safety’. It could be given to the needy customers and businessmen.