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Unit 10: Financial Services

There has been a clear shift towards those entities that are able to offer products and services in Notes
the most innovative and cost-efficient manner. The financial sector will need to adopt a customer-
centric business focus. It will also have to create value for its shareholders as well as its customers,
competing for the capital necessary to fund growth as well as for customer market share.

10.3 Prudential Norms for Capital Adequacy

Capital adequacy standards form an integral part of prudential banking sector regulation. Capital
standards all over the world are converging at the behest of the Basel Committee on Banking
Supervision towards the so called Basel II norms.
Capital adequacy is an indicator of the financial health of the banking system. It is measured by
the Capital to Risk-weighted Asset Ratio (CRAR), defined as the ratio of a bank's capital to its
total risk-weighted assets. Financial regulators generally impose a capital adequacy norm on
their banking and financial systems in order to provide for a buffer to absorb unforeseen losses
due to risky investments. A well adhered to capital adequacy regime does play an important
role in minimizing the cascading effects of banking and financial sector crises.

With a view to adopting the Basle Committee framework on capital adequacy norms which
takes into account the elements of risk in various types of assets in the balance sheet as well as
off-balance sheet business and also to strengthen the capital base of banks, Reserve Bank of India
decided in April 1992 to introduce a risk asset ratio system for banks (including foreign banks)
in India as a capital adequacy measure.
Essentially, under the above system the balance sheet assets, non-funded items and other
off-balance sheet exposures are assigned weights according to the prescribed risk weights and
banks have to maintain unimpaired minimum capital funds equivalent to the prescribed ratio
on the aggregate of the risk weighted assets and other exposures on an ongoing basis.

Capital Funds

1. Capital funds of Indian banks: For Indian banks, 'capital funds' would include the following
elements:
(a) Elements of Tier I capital
(i) Paid-up capital, statutory reserves, and other disclosed free reserves, if any.
(ii) Capital reserves representing surplus arising out of sale proceeds of assets.

(b) Equity investments in subsidiaries, intangible assets and losses in the current period
and those brought forward from previous periods, should be deducted from Tier I
capital.
(c) In the case of public sector banks which have introduced Voluntary Retirement
Scheme (VRS), in view of the extra-ordinary nature of the event, the VRS related
Deferred Revenue Expenditure would not be reduced from Tier I capital.
(d) Elements of Tier II capital

(i) Undisclosed reserves and cumulative perpetual preference shares: These often have
characteristics similar to equity and disclosed reserves. These elements have
the capacity to absorb unexpected losses and can be included in capital, if they
represent accumulations of post-tax profits and not encumbered by any known
liability and should not be routinely used for absorbing normal loss or
operating losses. Cumulative perpetual preference shares should be fully
paid-up and should not contain clauses which permit redemption by the holder.

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