AKNOWLEDGEMENT

In preparation of this assignment. I had to take the help and

guidance of some respected persons, who deserve deepest
gratitude, as the completion of this assignment gave me much
pleasure. I would like to show my gratitude to Sir Kalyan Das,
course instructor for giving me an opportunity to write this
assignment. I would also like to thank my classmates who
helped me in completing the assignment.
 Introduction to Capital Adequacy Norms

Along with profitability and safety, banks also give importance to

Solvency. Solvency refers to the situation where assets are equal to
or more than liabilities. A bank should select its assets in such a way
that the shareholders and depositors' interest are protected.

1. Prudential Norms
The norms which are to be followed while investing funds are
called "Prudential Norms." They are formulated to protect the
interests of the shareholders and depositors. Prudential Norms
are generally prescribed and implemented by the central bank
of the country. Commercial Banks have to follow these norms
to protect the interests of the customers.
For international banks, prudential norms were prescribed by
the Bank for International Settlements popularly known as BIS.
The BIS appointed a Basle Committee on Banking Supervision
in 1988.
2. Basel Committee
Basel committee appointed by BIS formulated rules and
regulation for effective supervision of the central banks. For
this it, also prescribed international norms to be followed by the
central banks. This committee prescribed Capital Adequacy
Norms in order to protect the interests of the customers.
3. Definition of Capital Adequacy Ratio
Capital Adequacy Ratio (CAR) is defined as the ratio of bank's
capital to its risk assets. Capital Adequacy Ratio (CAR) is also
known as Capital to Risk (Weighted) Assets Ratio (CRAR).
  India and Capital Adequacy Norms
The Government of India (GOI) appointed the Narasimham
Committee in 1991 to suggest reforms in the financial sector.
In the year 1992-93 the Narasimham Committee submitted its
first report and recommended that all the banks are required to
have a minimum capital of 8% to the risk weighted assets of
the banks. The ratio is known as Capital to Risk Assets Ratio
(CRAR). All the 27 Public Sector Banks in India (except UCO
and Indian Bank) had achieved the Capital Adequacy Norm of
8% by March 1997.
The Second Report of Narasimham Committee was submitted
in the year 1998-99. It recommended that the CRAR to be
raised to 10% in a phased manner. It recommended an
intermediate minimum target of 9% to be achieved by the year
2000 and 10% by 2002.
 Concept of Capital Adequacy Norms
Capital Adequacy Norms included different Concepts,
explained as follows:-
1. Tier-I Capital

Capital which is first readily available to protect the

unexpected losses is called as Tier-I Capital. It is also termed
as Core Capital.
Tier-I Capital consists of :-
 Paid-Up Capital.
 Statutory Reserves
 Other Disclosed Free Reserves- Reserves which are not
kept side for meeting any specific liability.
 Capital Reserves- Surplus generated from sale of Capital
Assets.
2. Tier-II Capital
Capital which is second readily available to protect the
unexpected losses is called as Tier-II capital.
Tier-II capital consist of-
Undisclosed Reserves and Paid-Up Capital Perpetual
Preference Shares.
 Revaluation Reserves (at discount of 55%
 Hybrid (Debt / Equity) Capital.
 Subordinated Debt.
 General Provisions and Loss Reserves.
There is an important condition that Tier II Capital cannot
exceed 50% of Tier-I Capital for arriving at the prescribed
Capital Adequacy Ratio.
3. Risk Weighted Assets
Capital Adequacy Ratio is calculated based on the assets of the
bank. The values of bank's assets are not taken according to the
book value but according to the risk factor involved. The value
of each asset is assigned with a risk factor in percentage terms.

4. Subordinated Debt
These are bonds issued by banks for raising Tier II Capital.
They are as follows:-
 They should be fully paid up instruments.
 They should be unsecured debt.
 They should be subordinated to the claims of other
creditors. This means that the bank's holder's claims for
their money will be paid at last in order of preference as
compared with the claims of other creditors of the bank.
 The bonds should not be redeemable at the option of the
holders. This means the repayment of bond value will be
decided only by the issuing bank.
ASSET LIABILITY MANAGEMENT

Asset-liability management basically refers to the process by

which an institution manages its balance sheet in order to
allow for alternative interest rate and liquidity scenarios.
Banks and other financial institutions provide services which
expose them to various kinds of risks like credit risk, interest
risk, and liquidity risk. Asset liability management is an
approach that provides institutions with protection that makes
such risk acceptable. Asset-liability management models
enable institutions to measure and monitor risk, and provide
suitable strategies for their management. It is therefore
appropriate for institutions (banks, finance companies, leasing
companies, insurance companies, and others) to focus on
asset-liability management when they face financial risks of
different types. Asset-liability management includes not only
a formalization of this understanding, but also a way to
quantify and manage these risks. Further, even in the absence
of a formal asset-liability management program, the
understanding of these concepts is of value to an institution as
it provides a truer picture of the risk/reward trade-off in which
the institution is engaged.

Categories of risk
1. Credit risk: The risk of counter party failure in meeting the
payment obligation on the specific date is known as credit risk.
Credit risk management is an important challenge for financial
institutions and failure on this front may lead to failure of
banks

2. Capital risk: One of the sound aspects of the banking

practice is the maintenance of adequate capital on a
continuous basis. There are attempts to bring in global norms
in this field in order to bring in commonality and
standardization in international practices. Capital adequacy
also focuses on the weighted average risk of lending and to
that extent, banks are in a position to realign their portfolios
between more risky and less risky assets.

3. Market risk: Market risk is related to the financial

condition, which results from adverse movement in market
 prices. This will be more pronounced when financial
information has to be provided on a marked-to-market basis
since significant fluctuations in asset holdings could adversely
affect the balance sheet of banks. In the Indian context, the
problem is accentuated because many financial institutions
acquire bonds and hold it till maturity. When there is a
significant increase in the term structure of interest rates, or
violent fluctuations in the rate structure, one finds substantial
erosion of the value of the securities held.
4. Interest rate risk: It also considers change in impact on
interest income due to changes in the rate of interest. In other
words, price as well as reinvestment risks require focus. In so
far as the terms for which interest rates were fixed on deposits
differed from those for which they fixed on assets, banks
incurred interest rate risk i.e., they stood to make gains or
losses with everychange in the level of interest rates.As long
as changes in rates were predictable both in magnitude and in
timing over the business cycle, interest rate risk was not seen
as too serious, but as rates of interest became more volatile,
there was felt need for explicit means of monitoring and
controlling interest gaps.

5. Liquidity risk: It is the potential inability to generate

adequate cash to cope with a decline in deposits or increase in
assets. To a large extent, it is an outcome of the mismatch in
the maturity patterns of assets and liabilities. First, the
proportion of central government securities with longer
maturities in the Indian bond market, significantly increasing
during the 1970s and 1980s, affected the banking system
because longer maturity securities have greater volatility for a
given change in interest rate structure. This problem gets
accentuated in the context of change in the main liability
structure of the banks, namely the maturity period for term
deposits.
NPA
NPA is a classification used by financial institutions that refer
to loans that are in threat of default. Once the borrower has
failed to make interest or principal payments for 90 days the
loan is considered to be a non-performing asset. Non-
performing assets are problematic for financial institutions
since they depend on interest payments for income.
Troublesome pressure from the economy can lead to a sharp
increase in non-performing loans and often results in massive
writedowns.With a view to moving towards international best
practices and to ensure greater transparency, it has been
decided to adopt the ‘90 days’ overdue’ norm for
identification of NPA, from the year ending March 31, 2004.
Accordingly, with effect from March 31, 2004, a
nonperforming asset (NPA) shall be a loan or an advance
where;

*Interest and/or instalment of principal remain overdue for a

period of more than 90 days in respect of a term loan,

*The account remains ‘out of order’ for a period of

more than 90 days, in respect of an Overdraft/Cash
Credit (OD/CC),

*The bill remains overdue for a period of more than 90 days

in the case of bills purchased and discounted,
*Interest and/or instalment of principal remains overdue for
two harvest seasons but for a period not exceeding two half
years in the case of an advance granted for agricultural
purposes, and

*Any amount to be received remains overdue for a period of

more than 90 days in respect of other accounts.

Reasons for growing NPAs

1. Economic slowdown - The global economy is still in
the throes of an economic crisis that is looming large
both in the US and Europe. There is a general
slackening of domestic economic activity in India both
in manufacturing and the services sectors. A sluggish
economy will have a direct impact on the balance sheets
and profitability of many firms who have availed of
loans from the banking industry. Over a period of time,
some of the hard hit firms will be compelled to default
on their loans. There is a groundswell of expert opinion
in India that NPAs are more an outcome of economic
factors rather than any internal systemic failures.

2. High interest rates - It is a known fact that interest

rates have been revised upwards, 10 times in the past
two years with a view to curb inflation. High interest
rate increases the cost of funds to the credit users and
 has a debilitating effect especially on the repayment
capacity of small and medium enterprises. Banks need
to maintain their Net Interest Margin and hence pass on
any interest rate hike to the borrowers. A high rate of
inflation dilutes the quality of assets of the banking
sector. Weak supply demand scenario, high borrowing
or leveraging and intense competition contribute to loan
defaults.

3. New reporting system - Indian banks are to report

NPAs from April 2012 in a computer recognized /
identified format. It is stated that almost 90% of all
banks' loan portfolio is under the computerized system
of NPA reporting or system based reporting. The
discretion of bank managers in classifying assets
according to their local judgment is eliminated. This
change in reporting pattern makes identification of
NPAs a machine driven objective activity. However,
credit risk analysis does have a subjective and
judgmental element to it.

4. Aviation sector - The Indian banking system has a total

exposure of around Rs. 40,000 crores to the ailing
aviation sector. SBI alone has an exposure of 5,000
crores to the aviation industry. It is common knowledge
that many airlines are either in the red or marginally
profitable. According to an RBI report, nearly three-
fourths of the top Banks’ loans to the aviation sector are
either impaired or restructured. Kingfisher airlines and
Air India have been the significant aviation borrowers
whose performance is below par.