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Indian Financial System

Notes Bank capital provides a cushion against temporary losses and signals that the bank has a basis of
continuity and that its constituents have reason to look at banks difficulties in a long-term
perspective.
Bank capital is generally less than 10% of assets whereas non-financial firms have capital assets
ratios in the range of 40-60%.

Relatively small unanticipated losses can significantly affect bank capital and threaten bank
solvency. In 1990-91, before the advent of banking sector reforms, the ratio of paid-up capital
and reserves to deposits, the capital base of public sector banks at 2.85% was quite low by
international standards. Ownership of banks by government resulted in complacency about
capital ratio. Lack of proper disclosure norms led many banks to keep the problems under
cover.
Capital is the contrepiece of regulatory policies. Bank regulators stipulate minimum requirements
to promote safety and soundness in the banking system. Shareholders are not the concern of
regulators. With the progressive privatisation of public sector banks, shareholders with
significant stakes in the bank will act to control risk-taking to protect their investment. The
shareholding of the Government of India and the Reserve Bank constituted 1.8% and 59.7% in
the case of State Bank of India, respectively. Other banks which are not fully owned by Government
of India are Bank of Baroda (66.6%), Bank of India (76.6%), Corporation Bank (68.3%), Dena Bank
(71.0%) and Oriental Bank of Commerce (66.5%). Existing norms permit dilution up to 51%
through the issue of fresh capital by public sector banks. There are 14 banks in the public sector
which are fully owned by Government of India. The private sector banks can raise capital in the
form of equity issues without the approval of the RBI.

Capital Adequacy

Financial risk increases the probability of banks insolvency. Bank regulators are concerned
about the downside risk of banks and they focus on lower end of the distribution of bank
earnings. The variability of earnings from the regulators viewpoint should not lead to elimination
of capital and insolvency of bank. Shareholders on the other hand are concerned with the
expected return and require higher earnings per share as bank profitability becomes more
variable. They have to be compensated for the bank risk.
The problem of financial risk is not solved by stipulating high capital requirement. High
requirement may inhibit the efficiency and competitiveness of the banking system and may act
as a constraint on the lending operations of the bank. Banks may not allocate funds in the most
efficient manner. Relatively high capital requirement for banks as compared to other providers
of financial services may also constrain the rate at which bank assets may be expanded, impairing
their competitive strength.

9.11 Risk Adjusted Capital Requirements

The Basic Committee on Banking Regulations and Supervisory Practices appointed by the Bank
for International Settlements (BIS) has prescribed certain capital standards to be followed by
commercial banks. The proposal for risk based capital rules was adopted in 1988 by the Committee.
The rationale for the proposal was that empirical evidence did not disclose any obvious
relationship between bank capital and failure risk. The proposed norms apart from being closely
related to failure risk, would also promote convergence of supervisory policies on the adequacy
of capital among countries with major international banking centers. The Basel Agreement was
signed in June, 1988 by 12 industrialised nations. US banks had to comply with the norms by
close of 1992.

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