EXECUTIVE SUMMARY

SBI offer various loans and advances to its customers to achieve their financial plans. A customer is satisfied only when the banker knows, understands and meets the needs the needs and expectations of the customer. Weighted assets is a measure of the amount of a banks assets, adjusted for risk. By adjusting the amount of each loan for an estimate of how risky it is, we can transform this percentage into a rough measure of the financial stability of a bank. The main use of risk weighted assets is to calculate tier 1 and tier 2 capital adequacy ratios. Basel I used a comparatively simple system of risk weighing. Capital adequacy ratios are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures. The minimum capital adequacy ratios have been developed to ensure banks can absorb a reasonable level of losses before becoming insolvent. A minimum capital adequacy ratio serves to protect depositors and promote the stability and efficiency of the financial system. Two types of capital are measured - tier one capital which can absorb losses without a bank being required to cease trading, e.g. ordinary share capital, and tier two capital which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors, e.g. subordinated debt.

CHAPTER I

INTRODUCTION

1.1 INTRODUCTION TO CAPITAL ADEQUACY

Risk weighted assets is a measure of the amount of a banks assets, adjusted for risk. The nature of a banks business means it is usual for almost all of a banks assets will consist of loans to customers. Comparing the amount of capital a bank has with the amount of its assets gives a measure of how able the bank is to absorb losses. It its capital is 10% of its assets, then it can lose 10% of its assets without becoming insolvent. Capital Adequacy Central Bank Governors of the ten countries formed a committee of banking supervisory in 1975. This committee usually meets at the BIS in Basel, Switzerland. Hence it has come to know as the Basel Committee. The Basel Committee provided the framework for capital adequacy in 1988. The Basel II accord is expected to establish a minimum level of capital for international active bank. National regulatory are free to set higher standards for international active bank. National regulatory are free to set higher standards for minimum capital. Capital Adequacy Ratios Capital adequacy ratios are a measure of the amount of a banks capital expressed as a percentage of its risk weighted credit exposures.

The Basel Capital Accord sets minimum capital adequacy ratios that supervisory authorities are encouraged to apply. These are: Tier one capital to total risk weighted credit exposures to be not less than 4 per cent. Total capital (i.e. tier one plus tier two less certain deductions) to total risk weighted credit exposures to be not less than 8 per cent. There are some further standards applicable to tier two capital: Tier two capital may not exceed 100 percent of tier one capital Lower tier two capital may not exceed 50 percent of tier one capital Lower tier two capital is amortized on a straight line basis over the last five years of its life.

1.2 STATEMENT OF THE PROBLEM

With the implementation of Basel I and Basel II norms, the Indian Banks are forced to maintain adequate capital in both tier I and tier II. CAR is calculated taking into account the RWA. Capital Adequacy Ratio is a measure of the amount of a banks capital expressed as a percentage of its risk weighed credit exposures. Thus the present study entitled A Study on Capital Adequacy of State Bank of India has been taken off.

1.3 Objectives of the Study

To study the concept of Capital Adequacy in view of Basel I and Basel II norms. To check whether the bank has complied with the Basel II norms by using ratios.

1.4 Research Methodology

The present study is a case study of State Bank of India. The data required for the study were collected from secondary sources. The data required were collected from the records of SBI and RBI web sites. The collected data were compiled and analyzed using ratios. The ratios used include Tangible Common Equity ratio and Capital Adequacy ratio.

1.5 Period of the Study

The present study has taken into account three years of data from 2006-07 to 2008-09.

1.6 Limitations of the Study

Due to paucity of time, more years of data could not be taken. The data were kept confidential and hence, it was difficult to access the adequate data.

1.7 Chapterisation

Chapter I deals with introduction to Risk Weighted Assets, Capital Adequacy, Statement of Problem, Objective of the Study, Research Methodology, Limitations and Chapterisation. Chapter II deals with the profile of Indian Banking Industry and that of State Bank of India. Chapter III deals with Basel I and Basel II norm for capital adequacy. Chapter IV deals with the analysis and interpretation of data & information. Chapter V deals with the findings, suggestion and conclusion that derived from the study.

CHAPTER II

PROFILES

2.1 PROFILE OF THE INDIAN BANKING INDUSTRY

The Indian Banking industry, which is governed by the Banking Regulation Act of India, 1949 can be broadly classified into two major categories, non-scheduled banks and scheduled banks. Scheduled banks comprise commercial banks and the co-operative banks. In terms of ownership, commercial banks can be further grouped into nationalized banks, the State Bank of India and its group banks, regional rural banks and private sector banks (the old/ new domestic and foreign). These banks have over 67,000 branches spread across the country.

The first phase of financial reforms resulted in the nationalization of 14 major banks in 1969 and resulted in a shift from Class banking to Mass banking. This in turn resulted in a significant growth in the geographical coverage of banks. Every bank had to earmark a minimum percentage of their loan portfolio to sectors identified as priority sectors. The manufacturing sector also grew during the 1970s in protected environs and the banking sector was a critical source. The next wave of reforms saw the nationalization of 6 more commercial banks in 1980. Since then the number of scheduled commercial banks increased four-fold and the number of bank branches increased eight-fold.

After the second phase of financial sector reforms and liberalization of the sector in the early nineties, the Public Sector Banks (PSB) s found it extremely difficult to compete with the new private sector banks and the foreign banks. The new private sector banks first made their appearance after the guidelines permitting them were

issued in January 1993. Eight new private sector banks are presently in operation. These banks due to their late start have access to state-of-the-art technology, which in turn helps them to save on manpower costs and provide better services. Indian banking system is based on strong fundamentals and more specially PSUs will become stronger in the face of foreign bank competition. Although PSU's do have qualified manpower , up-graded technology , vast infrastructure , network and growing professionalism and have the capability to effectively provide diversified products and customized solutions in the light of emerging competition but rather than hitting the market overnight with aggressive strategies ,they might choose a cautious ,slow and calculated "watch ,pause and proceed" strategy for long term sustainability and market positioning. Their national character and identity with the masses and high domestic presence and reach in rural and semi urban areas are the greatest strength which are crucial in Indian environment dominated by sociocultural and psychological factors. Their past history, growth and development and more specially their firm standing in the face of recent global recession are quite reflective of their intrinsic strength and their readiness for future .PSUs have learnt hardways all these years and grown so well. They have a very good feel of the Indian market and I personally feel that in the longer run they will capitalise on their strengths and opportunities and out play foreign bank competition .We shall never underestimate them .Foreign banks may talk high fi but PSUs understand the grassroot realities. Performance shall not be judged by profitability or business volume but by the economic and social contribution which perhaps will be the point PSUs will be scoring over.

2.2 PROFILE OF STATE BANK OF INDIA

The State Bank of India (SBI) is the largest commercial bank in India in terms of profits, assets, deposits, branches and employees. State Bank of India was constituted through an act of Parliament in 1955.The Bank is actively involved since 1973 in non-profit activity called Community Services Banking. All branches and administrative offices throughout the country sponsor and participate in large number of welfare activities and social causes. Business is more than banking because it touches the lives of people anywhere in many ways. SBI is the only bank in India to be ranked among the top 100 banks in the world and among the top 20 banks in Asia in the annual survey by The Banker. SBI has eight business units, namely corporate banking; international banking and domestic banking for concentrating on core areas; associate banks division for looking after the working of these banks; credit division to monitor the overall credit; and three other business units, namely finance, corporate development in house works. The bank has a network of 66 offices/branches in 29 countries spanning all time zones. The SBI`s international presence is supplemented by a group of overseas and NRI branches in India and correspondent links with over 522 leading banks of the world. SBI`s offshore joint ventures and subsidiaries enhance its global stature. Keeping in view the exponential growth achieved in self help group (SHG) financing in the recent past and good repayments (over 90%) under the scheme, the bank has decided to credit link 1,000,000 SHGs by the end of march 2008. The bank is entering into many new businesses with strategic tie ups Pension Funds, General Insurance, Custodial Services, Private Equity, Mobile Banking, Point of Sale Merchant Acquisition, Advisory Services,

structured products etc each one of these initiatives having a huge potential for growth. The Bank is forging ahead with cutting edge technology and innovative new banking models, to expand its Rural Banking base, looking at the vast untapped potential in the hinterland and proposes to cover 100,000 villages in the next two years. It is also focusing at the top end of the market, on whole sale banking capabilities to provide Indias growing mid / large Corporate with a complete array of products and services. It is consolidating its global treasury operations and entering into structured products and derivative instruments. Today, the Bank is the largest provider of infrastructure debt and the largest arranger of external commercial borrowings in the country. It is the only Indian bank to feature in the Fortune 500 list. The Bank is changing outdated front and back end processes to modern customer friendly processes to help improve the total customer experience. With about 8500 of its own 10000 branches and another 5100 branches of its Associate Banks already networked, today it offers the largest banking network to the Indian customer. The Bank is also in the process of providing complete payment solution to its clientele with its over 8500 ATMs, and other electronic channels such as Internet banking, debit cards, mobile banking, etc. With four national level Apex Training Colleges and 54 learning Centres spread all over the country the Bank is continuously engaged in skill enhancement of its employees. Some of the training programes are attended by bankers from banks in other countries. The bank is also looking at opportunities to grow in size in India as well as internationally. It presently has 82 foreign offices in 32 countries across the globe. It has also 7 Subsidiaries in India SBI Capital Markets, SBICAP Securities, SBI

DFHI, SBI Factors, SBI Life and SBI Cards - forming a formidable group in the Indian Banking scenario. It is in the process of raising capital for its growth and also consolidating its various holdings. Throughout all this change, the Bank is also attempting to change old mindsets, attitudes and take all employees together on this exciting road to Transformation. In a recently concluded mass internal communication programme termed Parivartan the Bank rolled out over 3300 two day workshops across the country and covered over 130,000 employees in a period of 100 days using about 400 Trainers, to drive home the message of Change and inclusiveness. The workshops fired the imagination of the employees with some other banks in India as well as other Public Sector Organizations seeking to emulate the programme. SBI along with its associate banks offer a wide range of banking products and services across its different client markets. The bank has entered the market of term lending to corporates and infrastructure financing, traditionally the domain of the financial institutions. It has increased its thrust in retail assets in the last two years, and has built a strong market position in housing loans. SBI, through its non-banking subsidiaries, offers a host of financial services, viz., merchant banking, fund management, factoring, primary dealership, broking, investment banking and credit cards. SBI has commenced its life insurance business by setting up a subsidiary, SBI Life Insurance Company Limited, which is a joint venture with Cardiff S.A., one of the largest insurance companies in France. SBI currently holds 74% equity in the joint venture. SBI will maintain a good earnings profile in the medium term despite high pressure on yields due to the increasing competition in the banking sector. SBIs earning profile is characterised by consistency in the return on assets (PAT/Average Assets), at around 1% per annum for the past three years, and

diverse income streams. State Bank of India is entering the private equity sector by picking up close to 20% equity stake in Sage Capital Funds Management, an asset management company (AMC) floated by Sage Capital. The company has started a USD 200-million fund, Sage Capital Value Fund, that will invest in Indian companies, as a volatile capital market pushes down valuations of firms prompting this class of investors to value-pick stocks in the world`s second-fastest growing economy.

CHAPTER III

BASEL I

&

BASEL

II
NORMS FOR BANKS

Central Bank Governors of the Group of Ten Countries formed a Committee of banking supervisory authorities in 1975. This Committee usually meets at the Bank of International Settlement (BIS) in Basel, Switzerland. Hence it has come to be known as the Basel Committee. The Basel Committee provided the framework for capital adequacy in 1988, which is known as the Basel I accord. The norms for adequacy of capital used to differ from bank and country to country. Japanese banks used to consider capital to the extent of 1 to 2 % of their assets level as adequate. Banks in some European countries used to require 8 10 % of their assets as their capital. The Basel Committee addressed the issue of standardization and provided the requisite framework. It defined components of capital, allotted risk weights to different types or categories of assets and pronounced as to what should be the minimum ratio of capital to sum total of riskweighted assets. The Basel-I norms for risk weights were more of a straightjacket nature. For example, all exposures to sovereigns were given 0% risk weight. All bank exposures had a risk weight of 20%. Corporate advances had a risk weight of 100%. Such rigid approach without any consideration for the strengths or weaknesses of individual entities was the main shortcoming of the Basel-I accord. The position that an excellent corporate such as L & T could have less risk weight than some of the banks was not recognized under this accord. This accord continued to be operative for about fifteen years, of course with some modifications from time to time. It came for a total overhaul and review during the last few years. The first round of proposal for changes in the Basel-I accord came up for deliberations and consultative process in June 1999. An extensive consultative process was initiated and the supervisory authorities across the world were roped

in this exercise. After five years of deliberations, the framework for capital adequacy was finalized with the approval of all the ten members of the Basel Committee in June 2004. The report of the Committee is titled as International Convergence of Capital Measurement and Capital Standards A revised framework. The Committee intends that the revised framework would be implemented by the end of year 2006. In India, the parallel runs commenced in April 2006 and implementation was complete on 31st March 2007. The fundamental objective of the Committee was to revise the 1988 accord and strengthen the soundness and stability of the banking system. The revised framework would promote the adoption of stronger risk management practices by banks. The revised framework provides greater use of assessment of risk provided by Banks internal systems as inputs to capital calculations. It demands capital allocation for operational risk for the first time. It provides a range of options for determining capital requirements for credit risk and operational risk. It also emphasizes the need for consistency in approach. The Basel-II accord is expected to establish a minimum level of capital for internationally active banks. National regulators are free to set higher standards for minimum capital. The revised framework is perceived as more forward-looking approach and has a capacity to evolve with time. The new capital accord will require banks to manage risks by not only allocating regulatory capital but also by disclosing greater risk information and setting standards for risk management processes. Basel-II provides incentives for banks to invest and increase the sophistication of their internal risk management capabilities in order to gain reductions in capital. This will help them to increase a banks lending which in turn will give higher returns and value to its shareholders.

Generally, banks consider a regulatory requirement as an administrative burden with little or no benefit to their bottom line. However, the Basel capital requirements are viewed as an opportunity to demonstrate their credentials. The reputation of a bank is very important. Banks would ensure compliance with the Basel standards to show themselves as good practitioners in risk management. SCOPE OF APPLICATION The Basel II accord aligns regulatory capital with the banks risk profiles. The Basel Committee recognizes that home country supervisors have an important role in leading the enhanced cooperation between home and host country supervisors that will be required for the effective implementation. The Basel II accord rests on three pillars. First Pillar Second Pillar Third Pillar Minimum capital requirements Supervisory review process Market discipline

The first pillar would replace the existing one-size-fits-all framework for the assessment of capital with several options for the banks. The second pillar provides guidelines for supervisors to ensure that each bank has robust internal processes for risk management and the adequacy of capital is assessed properly. The third pillar puts in place disclosure norms about risk management practices and allocation of regulatory capital. This pillar helps to strengthen market discipline as a compliment to supervisory efforts. Banks and supervisors are required to give appropriate attention to the second and third pillars. The revised framework will be mainly applicable to internationally active banks. All banking and other relevant financial activities (other than insurance) conducted within a

group containing an internationally active bank will be captured through a consolidation process. The revised accord provides incentives to banks to improve their risk management systems. The components of the three pillars are presented below: Pillar 1: Minimum Capital Requirement

The capital ratio continues to be calculated using the definition of regulatory capital and risk-weighted assets. The definition of eligible regulatory capital largely continues to be as defined in the earlier accord of 1988 and amended to include Tier-3 capital as prescribed in January 96 and September 97. Thus the term capital would include Tier-1 or core capital, Tier-2 or supplemental Core capital consists of paid up capital, free reserves and unallocated surpluses, less specified deductions. Supplementary capital comprises subordinated debt of more than five years maturity, loan loss reserves, revaluation reserves, investment fluctuation reserves, and limited life preference shares. Tier-2 capital is restricted to 100% of Tier-1 capital as before and long term subordinated debt may not exceed 50% of Tier-I capital. Tier-3 capital consists of short term subordinated debt for the sole purpose of meeting a proportion of the capital requirement for market risk. Short term bond must have an original maturity of at least two years. Tier-3 capital will be limited to 250% of a banks tier-1 capital that is required to support market risk. This means that a minimum of about 28.5% of market risk needs to be supported by tier-1 capital. Please note that any capital requirement arising in respect of credit and counter-party risk needs to be met by tier 1 and 2 capital.

The scope of risk weighted assets is expanded to include certain additional aspects of market risk and also operational risk. The area of operational risk is brought under the ambit of risk-weighted assets for the first time. Total risk weighted assets include the capital requirement for market risk and operational risk multiplied by 12.5 (i.e. reciprocal of the minimum capital requirement of 8%) along with risk weight assets for credit risk. Thus Total Risk weighted assets = Risk weighted assets for credit risk + 12.5 * Capital requirement for market risk + 12.5 * Capital requirement for operational risk We shall look at these individual components of risk-weighted assets in detail in the following units. Pillar 2: Supervisory Review 1. Evaluate risk assessment 2. Ensure soundness and integrity of banks internal processes to assess the adequacy of capital 3. Ensure maintenance of minimum capital with PCA for shortfall 4. Prescribe differential capital, where necessary i.e. where the internal processes are slack. Pillar 3: Market Discipline 1. Enhance disclosures

2. Core disclosures and supplementary disclosures 3. Timely at least semiannual disclosures Thus the Basel-II accord does not merely prescribe minimum capital requirement, but envisages processes of supervisory review and market discipline. The revised framework is more risk sensitive then the 1988 accord. There are incentives for those banks, which have better risk management capabilities.

CHAPTER IV

ANALYSIS & INTERPRETATION

RISK WEIGHTED ASSETS; Risk weighted assets is a measure of the amount of a banks assets, adjusted for risk. The nature of a bank's business means it is usual for almost all of a bank's assets will consist of loans to customers. Comparing the amount of capital a bank has with the amount of its assets gives a measure of how able the bank is to absorb losses. If its capital is 10% of its assets, then it can lose 10% of its assets without becoming insolvent. By adjusting the amount of each loan for an estimate of how risky it is, we can transform this percentage into a rough measure of the financial stability of a bank. It is not a particularly accurate measure because of the difficulties involved in estimating these risks. These difficulties are exacerbated by the motivation banks have to distort it. The main use of risk weighted assets is to calculate tier 1 and tier 2 capital adequacy ratios. Risk weighting adjusts the value of a asset for risk, simply by multiplying it be a factor that reflects its risk. Low risk assets are multiplied by a low number, high risk assets by 100% (i.e. 1). Suppose a bank has the following assets: 1C in gilts, 2c secured by mortgages, and 3 of loans to businesses. The risk weightings used as 0% for gilts (a risk free asset), 50% for mortgages, and 100% for the corporate loans. The banks risk weighted assets are (0 1C) + (50% 2C) + (100% 3C) = 4c. Basel I used a comparatively simple system of risk weighting that is used in the calculation above. Each class of asset was assigned a fixed risk weight. Basel II

uses a different classification of assets with some types having weightings that depend on the borrowers credit rating or the banks own risk models. Banks have a motive to take on more risk. If they win their bets, the shareholders (and management) take the profit, if they lose then the loss us likely to be shared with debt holders or governments (as banks are rarely allowed to fail). Part of the motivation for Basel II was that banks were able to work around the Basel I system by selecting riskier business within each asset class. Given this it seems remiss to have allowed the banks to use their own risk models, especially given that model risk was quite high even without the incentives the banks had to manipulate the models to understate risk.

CALCULATION OF RISK WEIGHTED ASSETS

TANGIBLE COMMON EQUITY RATIO The tangible common equity ratio (TCE ratio) is a measure of the financial soundness of banks. It is more conservative than the usual capital adequacy ratios (including tier 1) because it excludes preference share capital and all intangible assets. The TCE ratio is also usually calculated using actual total assets with no risk weighting. It is: Tangible common equity total tangible assets

In other words it is the shareholders funds belonging to ordinary shareholders as a proportion of a bank's tangible assets (most of which are usually loans to customers).

The TCE ratio became prominent because it became evident, during the credit crunch, that some banks had apparently healthy capital adequacy ratios only because of large amounts of preference share capital and intangible assets of uncertain value such as deferred tax. With the banks' own risk models discredited, a simple and conservative measure was useful to both regulators and investors. Table 4.1 YEAR TCE TTA TCER TANGIBLE COMMON EQUITY RATIO 2007 526 2676 19.65% 2008 631 3139 20% 2009 634 3574 17%

Sources: SBI Records. Results computed.

TCE= Tangible Common Equity TTA= Total Tangible Assets TCER=Tangible Common Equity Ratio

GRAPHICAL REPRESENTATION

Chart 4.1

Tangible Common Equity Ratio trend

INTERPRETATION Considering the trend of the Tangible Common Equity Ratio for the last three years, it has increased in 2008 from 19.65% to 20%. But, in 2009 it has decreased to 17%. This shows that the financial soundness has come down in 2009. But still, according to Basel II standards, the firm is doing good with its financial reserves.

CAPITAL ADEQUACY Central bank governors of the ten countries formed a committee of banking supervisory in 1975.This committee usually meets at the of international settlement

(BIS) in Basel, Switzerland. Hence it has come to know as the Basel committee. The Basel committee provided the framework for capital adequacy in 1988. The Basel-2 accord is expected to establish a minimum level of capital for international active bank. National regulatory are free to set higher standards for minimum capital. The new capital accord will require banks to manage risk by not only allocating regulatory capital but also by disclosing greater risk information and setting standards for risk management processes.basel-2 provides incentives for banks to invest and increase the sophistication of their internal risk management capabilities in order to gain reducing in capital. This will help them to increase a banks lending which in turn will give higher returns and value to its shareholders. Regulators try to ensure that banks and other financial institutions have sufficient capital to keep them out of difficulty. This not only protects depositors, but also the wider economy, because the failure of a big bank has extensive knock-on effects. The risk of knock-on effects that have repercussions at the level of the entire financial sector is called systemic risk. Capital adequacy requirements have existed for a long time, but the two most important are those specified by the Basel committee of the Bank for International Settlements. Basel 1 defined capital adequacy as a single number that was the ratio of a banks capital to its assets. There are two types of capital, tier one and tier two. The first is primarily share capital, the second other types such as preference shares and

subordinated debt. The key requirement was that tier one capital was at least 8% of assets. Each class of asset has a weight of between zero and 1 (or 100%). Very safe assets such as government debt have a zero weighting, high risk assets (such as unsecured loans) have a rating of one. Other assets have weightings somewhere in between. The weighted value of an asset is its value multiplied by the weight for that type of asset. In addition to specifying levels of capital adequacy, most countries have regulator run guarantee funds that will pay depositors at least part of what they are owed. It is also usual for regulators to intervene to prevent outright bank defaults MINIMUM CAPITAL REQUIREMENTS The term capital would include Tier-1 or core capital, Tire- 2 or supplemental capital, and Tier-3 capital. The total capital ratio must not be lower than 8%. Core capital consists of paid up capital, free reserve and unallocated surplus, less specified deductions. The minimum of 8% of risk weighted assets must be met by Tier-1 plus Tier-2 capital, 4% of risk weighted assets must be core tire-1 capital.

Table 4.2 Assets

CAPITAL REQIREMENT FOR 2008-09 Risk weight 0 0 0.2 0.5 CAPITAL ADEQUACY RATIO

Cash and equivalent Govt securities Interbank loan Mortgage loan

Capital adequacy ratios are a Ordinary loan 1.0 measure of the amount of a bank's Standby letter of credit 1.0 capital expressed as a percentage of its risk weighted credit exposures. Minimum capital adequacy ratios have been developed to ensure banks can absorb a reasonable level of losses before becoming insolvent. Applying minimum capital adequacy ratios serves to protect depositors and promote the stability and efficiency of the financial system. The purpose of having minimum capital adequacy ratios is to ensure that banks can absorb a reasonable level of losses before becoming insolvent, and before depositors funds are lost. Applying minimum capital adequacy ratios serves to promote the stability and efficiency of the financial system by reducing the likelihood of banks becoming insolvent. When a bank becomes insolvent this may lead to a loss of confidence in the financial system, causing financial problems for other banks and perhaps threatening the smooth functioning of financial markets.

It also gives some protection to depositors. In the event of a winding-up, depositors' funds rank in priority before capital, so depositors would only lose money if the bank makes a loss which exceeds the amount of capital it has. The higher the capital adequacy ratio, the higher the level of protection available to depositors.

Development of Minimum Capital Adequacy Ratios

The "Basle Committee" (centred in the Bank for International Settlements), which was originally established in 1974, is a committee that represents central banks and financial supervisory authorities of the major industrialised countries (the G10 countries). The committee concerns itself with ensuring the effective supervision of banks on a global basis by setting and promoting international standards. Its principal interest has been in the area of capital adequacy ratios. In 1988 the committee issued a statement of principles dealing with capital adequacy ratios. This statement is known as the "Basle Capital Accord". It contains a recommended approach for calculating capital adequacy ratios and recommended minimum capital adequacy ratios for international banks. The Accord was developed in order to improve capital adequacy ratios (which were considered to be too low in some banks) and to help standardise international regulatory practice. It has been adopted by the OECD countries and many developing countries. The Reserve Bank applies the principles of the Basle Capital Accord in India.

Capital

The calculation of capital (for use in capital adequacy ratios) requires some adjustments to be made to the amount of capital shown on the balance sheet. Two types of capital are measured in India - called tier one capital and tier two capital. Tier one capital is capital which is permanently and freely available to absorb losses without the bank being obliged to cease trading. An example of tier one capital is the ordinary share capital of the bank. Tier one capital is important because it safeguards both the survival of the bank and the stability of the financial system. Tier two capital is capital which generally absorbs losses only in the event of a winding-up of a bank, and so provides a lower level of protection for depositors and other creditors. It comes into play in absorbing losses after tier one capital has been lost by the bank. Tier two capital is sub-divided into upper and lower tier two capital. Upper tier two capital has no fixed maturity, while lower tier two capital has a limited life span, which makes it less effective in providing a buffer against losses by the bank. An example of tier two capital is subordinated debt. This is debt which ranks in priority behind all creditors except shareholders. In the event of a winding-up, subordinated debt holders will only be repaid if all other creditors (including depositors) have already been repaid. The Basle Capital Accord also defines a third type of capital, referred to as tier three capital. Tier three capital consists of short term subordinated debt. It can be used to provide a buffer against losses caused by market risks if tier one and tier two capital are insufficient for this. Market risks are risks of losses on foreign exchange and interest rate contracts caused by changes in foreign exchange rates and interest rates. The Reserve Bank does not require capital to be held against market risk, so does not have any requirements for the holding of tier three capital.

The composition and calculation of capital are illustrated by the first step of the capital adequacy ratio calculation example shown later in this article. Credit Exposures Credit exposures arise when a bank lends money to a customer, or buys a financial asset (e.g. a commercial bill issued by a company or another bank), or has any other arrangement with another party that requires that party to pay money to the bank (e.g. under a foreign exchange contract). A credit risk is a risk that the bank will not be able to recover the money it is owed. The risks inherent in a credit exposure are affected by the financial strength of the party owing money to the bank. The greater this is, the more likely it is that the debt will be paid or that the bank can, if necessary, enforce repayment. Credit risk is also affected by market factors that impact on the value or cash flow of assets that are used as security for loans. For example, if a bank has made a loan to a person to buy a house, and taken a mortgage on the house as security, movements in the property market have an influence on the likelihood of the bank recovering all money owed to it. Even for unsecured loans or contracts, market factors which affect the debtor's ability to pay the bank can impact on credit risk. The calculation of credit exposures recognises and adjusts for two factors:

On-balance sheet credit exposures differ in their degree of riskiness (e.g. Government Stock compared to personal loans). Capital adequacy ratio calculations recognise these differences by requiring more capital to be held against more risky exposures. This is done by weighting credit exposures according to their degree of riskiness. A broad brush approach is taken to

defining degrees of riskiness. The type of debtor and the type of credit exposures serve as proxies for degree of riskiness (e.g. Governments are assumed to be more creditworthy than individuals, and residential mortgages are assumed to be less risky than loans to companies). The Reserve Bank defines seven credit exposure categories into which credit exposures must be assigned for capital adequacy ratio calculation purposes.

Off-balance sheet contracts (e.g. guarantees, foreign exchange and interest rate contracts) also carry credit risks. As the amount at risk is not always equal to the nominal principal amount of the contract, off-balance sheet credit exposures are first converted to a "credit equivalent amount". This is done by multiplying the nominal principal amount by a factor which recognises the amount of risk inherent in particular types of off-balance sheet credit exposures. After deriving credit equivalent amounts for offbalance sheet credit exposures, these are weighted according to the riskiness of the counterparty, in the same way as on-balance sheet credit exposures. Nine credit exposure categories are defined to cover all types of off-balance sheet credit exposures.

The credit exposure categories and the risk weighting process are illustrated by the second step of the calculation example. Minimum Capital Adequacy Ratios The Basle Capital Accord sets minimum capital adequacy ratios that supervisory authorities are encouraged to apply. These are:

tier one capital to total risk weighted credit exposures to be not less than 4 percent;

total capital (i.e. tier one plus tier two less certain deductions) to total risk weighted credit exposures to be not less than 8 percent;

There are some further standards applicable to tier two capital:

tier two capital may not exceed 100 percent of tier one capital; lower tier two capital may not exceed 50 percent of tier one capital; lower tier two capital is amortised on a straight line basis over the last five years of its life.

The Reserve Bank will not register banks in India that do not meet these standards - and maintaining the minimum standards is always made a condition of registration.

If the registered bank is incorporated in India, then the minimum standards apply to the financial reporting group of the bank. If the registered bank is a branch of an overseas bank, then it is the capital adequacy ratios of the whole overseas bank (and not the branch) which are relevant. Overseas banks which operate as branches are registered in India on the condition that they comply with the capital adequacy ratio requirements imposed by the financial authorities in their home country and that these requirements are no less than those recommended by the Basle Capital Accord.

When a registered bank falls below the minimum requirements it must present a plan to the Reserve Bank (which is publicly disclosed) aimed at restoring capital adequacy ratios to at least the minimum level required.

Even though a bank may have capital adequacy ratios above the minimum levels recommended by the Basle Capital Accord, this is no guarantee that the bank is "safe". Capital adequacy ratios are concerned primarily with credit risks. There are also other types of risks which are not recognised by capital adequacy ratios e.g.. inadequate internal control systems could lead to large losses by fraud, or losses could be made on the trading of foreign exchange and other types of financial instruments. Also capital adequacy ratios are only as good as the information on which they are based, e.g. if inadequate provisions have been made against problem loans, then the capital adequacy ratios will overstate the amount of losses that the bank is able to absorb. Capital adequacy ratios should not be interpreted as the only indicators necessary to judge a bank's financial soundness.

Table 4.3 Capital Adequacy Ratio

Exposure Type Unsecured loans Fixed Assets Total Risk Weighed Assets Source: SBI records 3349775 422630 577863.5 Amount 2007 435521 117217 2008 537403 153929 2009 742073 206827 Risk Weight 50% 100% Risk Weight Exposures 2007 217760.5 117217 2008 268701.5 153929 2009 371036.5 206827 9.34 11.6 10 C A Ratio (in %) 2007 2008 2009

GRAPHICAL REPRESENTATION

Chart 4.2

Capital Adequacy Ratio trend

INTERPRETATION

According to Based norms the last three years the capital adequacy ratio is with minimum level the bank maintain the adequate capital structure. Though the ratio has come down in the year 2009, the ratio is always under the Basel-II norms limit which 12.5% (for both tier-I and tier-II) throughout the three years that are considered. So, according to Basel-II norms, the bank is performing well.

CHAPTER V

SUMMARY OF FINDINGS, SUGGESTION AND CONCLUSION

FINDINGS

GENERAL FINDINGS
Meeting capital requirement is a big challenge in the near future. The Capital Adequacy Ratio is the ratio of a bank capital to its risk weighted assets. Stress in some sector of the economy like real estate could lead to an increase in Non-Performing Assets.

SPECIFIC FINDINGS
Tangible common equity ratio for the current year is 17% which is less than last year because of global financial crisis. The bank had enough cushion in its tier II structures to raise funds.

SUGGESTIONS
Risk based supervision is to be strengthened.

CONCLUSION
Capital adequacy ratios measure the amount of a bank's capital in relation to the amount of its risk weighted credit exposures. The risk weighting process takes into account, in a stylized way, the relative riskiness of various types of credit exposures that banks have, and incorporates the effect of balance sheet contracts on credit risk. The higher the capital adequacy ratios a bank has, the greater the level of unexpected losses it can absorb before becoming insolvent.