RBI/2007-2008/26
DBOD No. BP.BC. 4/21.01.002 / 2007-08

July 2, 2007

All Commercial Banks
(excluding  RRBs)

Dear Sir,

Master Circular- Prudential Norms on Capital Adequacy

Please refer to the Master Circular No. DBOD. BP. BC. 13/ 21.01.002/ 2006-2007 dated July 1, 2006 consolidating instructions/ guidelines issued to banks till June 30, 2006 on matters relating to prudential norms on capital adequacy. The Master Circular has been suitably updated by incorporating instructions issued up to 30th June 2007 and has also been placed on the RBI web-site (http: // www.rbi.org.in).

2. It may be noted that all relevant instructions on the above subject contained in the circulars listed in the Appendix have been consolidated. These instructions are applicable to all banks till March 30, 2008. However, for banks migrating to Basle II norms with effect from March 31, 2008, instructions contained in our circular DBOD. No. BP. BC.90 /20.06.001/2006-07 dated April 27, 2007 on "Implementation of the New Capital Adequacy Framework" will be applicable. For banks, which will not be migrating to Basle II, the instructions contained in this circular will continue to be applicable.

Yours faithfully,

(Prashant Saran)
Chief General Manager-in-Charge

Master Circular on ‘Prudential Norms on Capital Adequacy’

Purpose

The 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 in line with the Capital Adequacy Norms prescribed by Basel Committee.  This circular prescribes the risk weights for the balance sheet assets, non-funded items and other off-balance sheet exposures and the minimum capital funds to be maintained as ratio to the aggregate of the risk weighted assets and other exposures, as also, capital requirements in the trading book, on an ongoing basis.

Previous instructions

This master circular consolidates and updates the instructions on the above subject contained in the circulars listed in Annex 11.

Application
To all the commercial banks, excluding Regional Rural Banks

Structure

1. Introduction

1.1. Capital
1.2. Credit Risk
1.3. Market Risk

2.Guidelines

2.1. Components of Capital
2.2. Capital charge for Market risk
2.3. Capital adequacy for Subsidiaries
2.4. Procedure for computation of CRAR

3. Annex

4. Glossary

1. INTRODUCTION

This master circular covers instructions regarding the components of capital and capital charge required to be provided for by the banks for credit and market risks. It deals with providing explicit capital charge for credit and market risk and addresses the issues involved in computing capital charges for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and other precious metals) in both trading and banking books. Trading book for the purpose of these guidelines includes securities included under the Held for Trading category, securities included under the available for sale category, open gold position limits, open foreign exchange position limits, trading positions in derivatives, and derivatives entered into for hedging trading book exposures.

1.1. Capital

The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business. Capital is divided into tiers according to the characteristics/qualities of each qualifying instrument. For supervisory purposes capital is split into two categories: Tier I and Tier II. These categories represent different instruments’ quality as capital. Tier I capital consists mainly of share capital and disclosed reserves and it is a bank’s highest quality capital because it is fully available to cover losses. Tier II capital on the other hand consists of certain reserves and certain types of subordinated debt. The loss absorption capacity of Tier II capital is lower than that of Tier I capital.

1.2. Credit Risk

Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may fail to meet its obligations in accordance with agreed terms. It is the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or a counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio arising from actual or perceived deterioration in credit quality.

For most banks, loans are the largest and the most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off balance sheet. Banks increasingly face credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, inter-bank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options and in guarantees and settlement of transactions.

The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio, as well as, the risk in the individual credits or transactions. Banks should have a keen awareness of the need to identify measure, monitor and control credit risk, as well as, to determine that they hold adequate capital against these risks and they are adequately compensated for risks incurred.

1.3. Market Risk

Market risk refers to the risk to a bank resulting from movements in market prices in particular changes in interest rates, foreign exchange rates and equity and commodity prices. In simpler terms, it may be defined as the possibility of loss to a bank caused by changes in the market variables.  The Bank for International Settlements (BIS) defines market risk as “the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”. Thus, Market Risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as, the volatilities of those changes. 

2. GUIDELINES

2.1. Components of Capital

Capital funds: The capital funds for the banks are being discussed under two heads i.e. the capital funds of Indian banks and the capital funds of foreign banks operating in India.

2.1.1. Capital funds of Indian banks:For Indian banks, 'capital funds' would include the components Tier I capital and Tier II capital.

2.1.1.1. Elements of Tier I capital: The elements of Tier I capital include

i) Paid-up capital (ordinary shares), statutory reserves, and other disclosed free reserves, if any.
ii) Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital
iii) Perpetual non-cumulative preference shares eligible for inclusion as Tier I capital - subject to laws in force from time to time;
iv) Capital reserves representing surplus arising out of sale proceeds of assets.

The guidelines governing the Innovative Perpetual Debt Instruments eligible for inclusion as Tier I capital indicating the minimum regulatory requirements are furnished in Annex 1

2.1.1.2.  Elements of Tier II capital: The elements of Tier II capital include undisclosed reserves, revaluation reserves, general provisions and loss reserves, hybrid capital instruments, subordinated debt, deferred revenue expenditure under VRS and investment reserve account.

a. Undisclosed reserves

They can be included in capital, if they represent accumulations of post-tax profits and are not encumbered by any known liability and should not be routinely used for absorbing normal loss or operating losses. .

b. Revaluation reserves

It would be prudent to consider revaluation reserves at a discount of 55 percent while determining their value for inclusion in Tier II capital. Such reserves will have to be reflected on the face of the Balance Sheet as revaluation reserves.

c. General provisions and loss reserves

Such reserves can be included in Tier II capital if they are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses. Adequate care must be taken to see that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering general provisions and loss reserves to be part of Tier II capital. General provisions/loss reserves will be admitted up to a maximum of 1.25 percent of total risk weighted assets. 

'Floating Provisions' held by the banks, which is general in nature and not made against any identified assets, may be treated as a part of Tier II capital within the overall ceiling of 1.25 percent of total risk weighted assets, if such provisions are not netted off from gross NPAs to arrive at disclosure of net NPAs

d. Hybrid debt capital instruments

Those instruments  which have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital. At present following instruments have been recognized and placed under this category. 
i. Debt capital instruments eligible for inclusion as Upper Tier II capital; and
ii. Redeemable cumulative preference shares eligible for inclusion as Tier II capital - subject to laws in force from time to time.

The guidelines governing the instruments at (i) above, indicating the minimum regulatory requirements are furnished in Annex 2. 

e. Subordinated debt

i. To be eligible for inclusion in Tier II capital, the instrument   should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India. They often carry a fixed maturity, and as they approach maturity, they should be subjected to progressive discount, for inclusion in Tier II capital. Instruments with an initial maturity of less than 5 years or with a remaining maturity of one year should not be included as part of Tier II capital. The quantum of subordinated debt instruments eligible to be reckoned as Tier II capital will be limited to 50 percent of Tier I capital.
ii. Banks can raise, with the approval of their Boards, rupee-subordinated debt as Tier II capital, subject to the terms and conditions given in the Annex 3.
iii. Banks should indicate the amount of subordinated debt raised as Tier II capital by way of explanatory notes/ remarks in the Balance Sheet as well as in Schedule 5 to the Balance Sheet under ‘Other Liabilities & Provisions'.

f. Deferred Revenue Expenditure under VRS

In the case of public sector banks, the bonds issued to the VRS employees as a part of the compensation package, net of the unamortised VRS Deferred Revenue Expenditure, could be treated as Tier II capital, subject to compliance with the terms and conditions stipulated in para 2.1.1.2 (e)(ii).

g. Investment Reserve Account

In the event  of provisions created on account of depreciation in the ‘Available for Sale’ or ‘Held for Trading’ categories being found to be in excess of the required amount in any year, the excess should be credited to the Profit & Loss  account  and  an equivalent amount (net of taxes, if any and net of transfer to Statutory Reserves as applicable to such excess provision) should be appropriated to an Investment Reserve Account in Schedule 2 –“Reserves & Surplus” under the head “Revenue and other Reserves” and would be eligible for inclusion under Tier II within the overall ceiling of 1.25 per cent of total Risk Weighted Assets prescribed for General Provisions/ Loss Reserves.

h. Banks are allowed to include the ‘General Provisions on Standard Assets’ and ‘provisions held for country exposures’ in Tier II capital. However, the provisions on ‘standard assets’ together with other ‘general provisions/ loss reserves’ and ‘provisions held for country exposures’ will be admitted as Tier II capital up to a maximum of 1.25 per cent of the total risk-weighted assets.

2.1.2. Capital funds of foreign banks operating in India

For the foreign banks operating in India, 'capital funds' would include the two components i.e. Tier I capital and Tier II capital.

2.1.2.1. Elements of Tier I capital: The elements of Tier I capital include

i) Interest-free funds from Head Office kept in a separate account in Indian books specifically for the purpose of meeting the capital adequacy norms.
ii) Innovative Instruments  eligible for  inclusion as Tier I capital 
iii) Statutory reserves kept in Indian books.
iv) Remittable surplus retained in Indian books which is not repatriable so long as the bank functions in India.

2.1.2.2. Elements of Tier II capital: The elements of Tier II capital include the following elements.

a) Elements of Tier II capital as applicable to Indian banks.
b)  Head Office (HO) borrowings  raised in foreign currency (for inclusion in Upper Tier II Capital) subject to the  terms and conditions as mentioned at para 7 of Annex 2 to this circular. Foreign banks also would not require prior approval of RBI for raising subordinated debt in foreign currency through borrowings from Head Office for inclusion in Tier II capital.

2.1.2.3. Regarding the capital of foreign banks they are also required to follow the following instructions.

a) The foreign banks are required to furnish to Reserve Bank, (if not already done), an undertaking to the effect that the banks will not remit abroad the remittable surplus retained in India and included in Tier I capital as long as the banks function in India.
b) These funds may be retained in a separate account titled as 'Amount Retained in India for Meeting Capital to Risk-weighted Asset Ratio (CRAR) Requirements' under 'Capital Funds'.
c) An auditor's certificate to the effect that these funds represent surplus remittable to Head Office once tax assessments are completed or tax appeals are decided and do not include funds in the nature of provisions towards tax or for any other contingency may also be furnished to Reserve Bank.
d) Foreign banks operating in India are permitted to hedge their entire Tier I capital held by them in Indian books subject to the following conditions:
(i) The forward contract should be for tenor of one year or more and may be rolled over on maturity. Rebooking of cancelled hedge will require prior approval of Reserve Bank
(ii) The capital funds should be available in India to meet local regulatory and CRAR requirements. Therefore, foreign currency funds accruing out of hedging should not be parked in nostro accounts but should remain swapped with banks in India at all times.
(iii) Capital reserve representing surplus arising out of sale of assets in India held in a separate account and which is not eligible for repatriation so long as the bank functions in India.
(iv) Interest-free funds remitted from abroad for the purpose of acquisition of property and held in a separate account in Indian books.
(v) The net credit balance, if any, in the inter-office account with Head Office/overseas branches will not be reckoned as capital funds. However, any debit balance in Head Office account will have to be set-off against the capital.
(vi) Foreign banks in India may raise Head Office (HO) borrowings in foreign currency for inclusion as Tier I /Tier II capital subject to the same terms and conditions as  indicated at  para 7 of Annex 1 & 2. 
e) Foreign banks operating in India are also required to comply with the instructions on limits for Tier II elements and norms on cross holdings as applicable to Indian banks. The elements of Tier I & Tier II capital do not include foreign currency loans granted to Indian parties. The foreign banks are also required to follow the guidelines given at Annex 4 on the subordinated debt-head office borrowings in foreign currency raised by foreign banks operating in India for inclusion in Tier II capital

2.1.3 Deductions from computation of Capital funds:

2.1.3.1 Tier I capital: The following deductions should be made from Tier I capital
a) 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.
b) 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. However, it will attract 100% risk weight for capital adequacy purpose.
c) Creation of deferred tax asset (DTA) results in an increase in Tier I capital of a bank without any tangible asset being added to the banks’ balance sheet. Therefore, DTA, which is an intangible asset, should be deducted from Tier I capital.

2.1.3.2 Tier I & Tier II Capital Credit Enhancements pertaining to Securitization of Standard Assets

a) Treatment of First Loss Facility

The first loss credit enhancement provided by the originator shall be reduced from capital funds and the deduction shall be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised. The deduction shall be made at 50% from Tier I and 50% from Tier II capital.

b) Treatment of Second Loss Facility

The second loss credit enhancement provided by the originator shall be reduced from capital funds to the full extent. The deduction shall be made 50% from Tier I and 50% from Tier II capital. 

c) Treatment of credit enhancements provided by third party

In case, the bank is acting as a third party service provider, the first loss credit enhancement provided by it shall be reduced from capital to the full extent as indicated at para (a) above.

d) Underwriting by an originator

Securities issued by the SPVs  and devolved / held by the banks in excess of 10 per cent of the original amount of issue, including secondary market purchases,  shall be deducted 50% from Tier I capital and 50% from Tier II capital.

e) Underwriting by third party service providers
 
If the bank has underwritten securities issued by SPVs devolved and held by banks which are below investment grade will be deducted from capital at 50% from Tier I and 50% from Tier II.

2.1.4. Limit for Tier II elements

Tier II elements should be limited to a maximum of 100 percent of total Tier I elements for the purpose of compliance with the norms.

2.1.5. Norms on cross holdings

(i) A bank’s / FI’s investments in all types of instruments listed at 2.1.5 (ii) below, which are issued by other banks / FIs and are eligible for capital status for the investee bank / FI, will be limited to 10 per cent of the investing bank's capital funds (Tier I plus Tier II capital). 

(ii) Banks' / FIs' investment in the following instruments will be included in the prudential limit of 10 per cent referred to at 2.1.5(i) above.

a. Equity shares;
b. Innovative Perpetual Debt Instruments eligible as Tier I capital;
c. Preference shares eligible for capital status;
d. Subordinated debt instruments;
e. Debt capital Instruments qualifying for Upper Tier II status ; and
f. Any other instrument approved as in the nature of capital.

(iii) Banks / FIs should not acquire any fresh stake in a bank's equity shares, if by such acquisition, the investing bank's / FI's holding exceeds 5 per cent of the investee bank's equity capital.

(iv) Banks’ / FIs’ investments in the equity capital of subsidiaries are at present deducted from their Tier I capital for capital adequacy purposes. Investments in the instruments issued by banks / FIs which are listed at paragraph 2.1.5(ii) above, which are not deducted from Tier I capital of the investing bank/ FI, will attract 100 per cent risk weight for credit risk for capital adequacy purposes.

Note:

Following investments are excluded from the purview of the ceiling of 10 percent prudential norm prescribed above:

a) Investments in equity shares of other banks /FIs in India held under the provisions of a statute.
b) Strategic investments in equity shares of other banks/FIs incorporated outside India as romoters/significant shareholders (i.e. Foreign Subsidiaries / Joint Ventures / Associates).
c) Equity holdings outside India in other banks / FIs incorporated outside India.

2.1.6. Swap Transactions

Banks are advised not to enter into swap transactions involving conversion of fixed rate rupee liabilities in respect of Innovative Tier I/Tier II bonds into floating rate foreign currency liabilities.

2.1.7. Minimum requirement of capital funds

Banks are required to maintain a minimum CRAR of 9 percent on an ongoing basis.

2.2. Capital charge for Market risk

2.2.1. As an initial step towards prescribing capital requirement for market risk, banks were advised to:

i) assign an additional risk weight of 2.5 per cent on the entire investment portfolio;
ii) assign a risk weight of 100 per cent on the open position limits on foreign exchange and gold; and
iii) build up Investment Fluctuation Reserve up to a minimum of five per cent of the investments held in Held for Trading and Available for Sale categories in the investment portfolio.

2.2.2. Subsequently, keeping in view the ability of the banks to identify and measure market risk, it was decided to assign explicit capital charge for market risk. Thus banks are required to maintain capital charge for market risk on securities included in the Held for Trading and Available for Sale categories, open gold position, open forex position, trading positions in derivatives and derivatives entered into for hedging trading book exposures. Consequently, the additional risk weight of 2.5% towards market risk on the investment included under Held for Trading and Available for Sale categories is not required.

2.2.3. To begin with, capital charge for market risks is applicable to banks on a global basis. At a later stage, this would be extended to all groups where the controlling entity is a bank.

2.2.4. Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day. Banks are also required to maintain strict risk management systems to monitor and control intra-day exposures to market risks.

2.2.5. Capital charge for interest rate risk: The capital charge for interest rate related instruments and equities would apply to current market value of these items in bank’s trading book. The current market value will be determined as per extant RBI guidelines on valuation of investments. The minimum capital requirement is expressed in terms of two separate capital charges i.e. Specific risk charge for each security both for short and long positions and General market risk charge towards interest rate risk in the portfolio where long and short positions in different securities or instruments can be offset. In India short position is not allowed except in case of derivatives and Central Government Securities. The  banks  have to  provide the  capital charge for interest rate risk in the trading book other than derivatives as per the guidelines given below  for   both specific risk  and general risk after measuring the risk of holding or taking positions in debt securities and other interest rate related instruments in the trading book.

2.2.5.1. Specific risk: This refers to risk of loss caused by an adverse price movement of a security principally due to factors related to the issuer. The specific risk charge is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. The specific risk charge is graduated for various exposures under three heads i.e. claims on Government, claims on banks, claims on others and is given in Annex 5

2.2.5.2. General Market Risk:

The capital requirements for general market risk are designed to capture the risk of loss arising from changes in market interest rates. The capital charge is the sum of four components:

• the net short (short position is not allowed in India except in derivatives and Central Government Securities) or long position in the whole trading book;
• a small proportion of the matched positions in each time-band (the “vertical disallowance”);
• a larger proportion of the matched positions across different time-bands (the “horizontal disallowance”), and
• a net charge for positions in options, where appropriate.

2.2.5.3. Computation of capital charge for market risk: The Basel Committee has suggested two broad methodologies for computation of capital charge for market risks i.e. the Standardised method and the banks’ Internal Risk Management models (IRM) method. As banks in India are still in a nascent stage of developing internal risk management models, it has been decided that, to start with, banks may adopt the standardised method. Under the standardised method there are two principal methods of measuring market risk, a “maturity” method and a “duration” method. As “duration” method is a more accurate method of measuring interest rate risk, it has been decided to adopt Standardised Duration method to arrive at the capital charge. Accordingly, banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately.  Under this method, the mechanics are as follows:

• first calculate the price sensitivity (modified duration) of each instrument;
• next apply the assumed change in yield to the modified duration of each instrument between 0.6 and 1.0 percentage points depending on the maturity of the instrument as given in  Annex 6
• slot the resulting  capital charge measures into a maturity ladder with the fifteen time bands as set out in Annex 6;
• subject long and short positions (short position is not allowed in India except in derivatives and Central Government Securities) in each time band to a 5 per cent vertical disallowance designed to capture basis risk; and
• carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in Annex  7.

2.2.5.4. Capital charge for interest rate derivatives:
 
The measurement of capital charge for market risks should include all interest rate derivatives and off-balance sheet instruments in the trading book and derivatives entered into for hedging trading book exposures which would react to changes in the interest rates, like FRAs, interest rate positions, etc.
The details of measurement of capital charge for interest rate derivatives and options are furnished below.

2.2.5.5. Interest rate derivatives

The measurement system should include all interest rate derivatives and off-balance-sheet instruments in the trading book, which react to changes in interest rates, (e.g. forward rate agreements (FRAs), other forward contracts, bond futures, interest rate and cross-currency swaps and forward foreign exchange positions). Options can be treated in a variety of ways as described at para 2.2.5.5.2 below. A summary of the rules for dealing with interest rate derivatives is set out at the end of this section.

a) Calculation of positions

The derivatives should be converted into positions in the relevant underlying and be subjected to specific and general market risk charges as described in the guidelines. In order to calculate the capital charge, the amounts reported should be the market value of the principal amount of the underlying or of the notional underlying. For instruments where the apparent notional amount differs from the effective notional amount, banks must use the effective notional amount.

i. Futures and forward contracts, including Forward Rate Agreements (FRA)

These instruments are treated as a combination of a long and a short position in a notional government security. The maturity of a future or a FRA will be the period until delivery or exercise of the contract, plus - where applicable - the life of the underlying instrument. For example, a long position in a June three-month interest rate future (taken in April) is to be reported as a long position in a government security with a maturity of five months and a short position in a government security with a maturity of two months. Where a range of deliverable instruments may be delivered to fulfill the contract, the bank has flexibility to elect which deliverable security goes into the duration ladder but should take account of any conversion factor defined by the exchange.

ii. Swaps

Swaps will be treated as two notional positions in government securities with relevant maturities. For example, an interest rate swap under which a bank is receiving floating rate interest and paying fixed will be treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing and a short position in a fixed-rate instrument of maturity equivalent to the residual life of the swap. For swaps that pay or receive a fixed or floating interest rate against some other reference price, e.g. a stock index, the interest rate component should be slotted into the appropriate re-pricing maturity category, with the equity component being included in the equity framework. Separate legs of cross-currency swaps are to be reported in the relevant maturity ladders for the currencies concerned.

b) Calculation of capital charges for derivatives under the standardised methodology:

i.  Allowable offsetting of matched positions

Banks may exclude the following from the interest rate maturity framework altogether (for both specific and general market risk);

• Long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity.
• A matched position in a future or forward and its corresponding underlying may also be fully offset (the leg representing the time to expiry of the future should however be reported) and thus excluded from the calculation.

When the future or the forward comprises a range of deliverable instruments, offsetting of positions in the future or forward contract and its underlying is only permissible in cases where there is a readily identifiable underlying security which is most profitable for the trader with a short position to deliver. The price of this security, sometimes called the "cheapest-to-deliver", and the price of the future or forward contract should in such cases move in close alignment.

No offsetting will be allowed between positions in different currencies; the separate legs of cross-currency swaps or forward foreign exchange deals are to be treated as notional positions in the relevant instruments and included in the appropriate calculation for each currency.

In addition, opposite positions in the same category of instruments can in certain circumstances be regarded as matched and allowed to offset fully. To qualify for this treatment the positions must relate to the same underlying instruments, be of the same nominal value and be denominated in the same currency. In addition:

• for futures: offsetting positions in the notional or underlying instruments to which the futures contract relates must be for identical products and mature within seven days of each other;
• for swaps and FRAs: the reference rate (for floating rate positions) must be identical and the coupon closely matched (i.e. within 15 basis points); and
• for swaps, FRAs and forwards: the next interest fixing date or, for fixed coupon positions or forwards, the residual maturity must correspond within the following limits:
• less than one month hence: same day;
• between one month and one year hence: within seven days;
• over one year hence: within thirty days.

Banks with large swap books may use alternative formulae for these swaps to calculate the positions to be included in the duration ladder. The method would be to calculate the sensitivity of the net present value implied by the change in yield used in the duration method and allocate these sensitivities into the time-bands set out in Table 1 in Section 2.3.5.4.2( a)

ii. Specific risk

iii. Interest rate and currency swaps, FRAs, forward foreign exchange contracts and interest rate futures will not be subject to a specific risk charge. This exemption also applies to futures on an interest rate index (e.g. LIBOR). However, in the case of futures contracts where the underlying is a debt security, or an index representing a basket of debt securities, a specific risk charge will apply according to the credit risk of the issuer as set out in paragraphs above.

General market risk

General market risk applies to positions in all derivative products in the same manner as for cash positions, subject only to an exemption for fully or very closely matched positions in identical instruments as defined in paragraphs above. The various categories of instruments should be slotted into the maturity ladder and treated according to the rules identified earlier.

Table - Summary of treatment of interest rate derivatives

2.2.5.5.2. Treatment of Options

 In recognition of the wide diversity of banks’ activities in options and the difficulties of measuring price risk for options, alternative approaches are permissible as under:

• those banks which solely use purchased options will be free to use the simplified approach described in Section (a) below;
• those banks which also write options will be expected to use one of the intermediate approaches as set out in Section (b) below.

a) Simplified approach

In the simplified approach, the positions for the options and the associated underlying, cash or forward, are not subject to the standardised methodology but rather are "carved-out" and subject to separately calculated capital charges that incorporate both general market risk and specific risk. The risk numbers thus generated are then added to the capital charges for the relevant category, i.e. interest rate related instruments, equities, and foreign exchange as described in Sections 2.2.5 to 2.2.7 of this circular. Banks which handle a limited range of purchased options only will be free to use the simplified approach set out in Table 1, below for particular trades. As an example of how the calculation would work, if a holder of 100 shares currently valued at Rs.10 each holds an equivalent put option with a strike price of Rs.11, the capital charge would be: Rs.1,000 x 18% (i.e. 9% specific plus 9% general market risk) = Rs.180, less the amount the option is in the money (Rs.11 – Rs.10) x 100 = Rs.100, i.e. the capital charge would be Rs.80. A similar methodology applies for options whose underlying is a foreign currency or an interest rate related instrument.

Table 1 Simplified approach: capital charges

b) Intermediate approaches

i. Delta-plus method
 
The delta-plus method uses the sensitivity parameters or "Greek letters" associated with options to measure their market risk and capital requirements. Under this method, the delta-equivalent position of each option becomes part of the standardised methodology set out in Sections 2.2.5 to 2.2.7 with the delta-equivalent amount subject to the applicable general market risk charges. Separate capital charges are then applied to the gamma and vega risks of the option positions. Banks which write options will be allowed to include delta-weighted options positions within the standardised methodology set out in Sections 2.2.5 to 2.2.7 Such options should be reported as a position equal to the market value of the underlying multiplied by the delta.

However, since delta does not sufficiently cover the risks associated with options positions, banks will also be required to measure gamma (which measures the rate of change of delta) and vega (which measures the sensitivity of the value of an option with respect to a change in volatility) sensitivities in order to calculate the total capital charge. These sensitivities will be calculated according to an approved exchange model or to the bank’s proprietary options pricing model subject to oversight by the Reserve Bank of India⁶.

 Delta-weighted positions with debt securities or interest rates as the underlying will be slotted into the interest rate time-bands, as set out in Table at Annex 6 under the following procedure. A two-legged approach should be used as for other derivatives, requiring one entry at the time the underlying contract takes effect and a second at the time the underlying contract matures. For instance, a bought call option on a June three-month interest-rate future will in April be considered, on the basis of its delta-equivalent value, to be a long position with a maturity of five months and a short position with a maturity of two months⁷. The written option will be similarly slotted as a long position with a maturity of two months and a short position with a maturity of five months. Floating rate instruments with caps or floors will be treated as a combination of floating rate securities and a series of European-style options. For example, the holder of a three-year floating rate bond indexed to six month LIBOR with a cap of 15% will treat it as:

a. a debt security that reprices in six months; and

b. a series of five written call options on a FRA with a reference rate of 15%, each with a negative sign at the time the underlying FRA takes effect and a positive sign at the time the underlying FRA matures⁸.

The capital charge for options with equities as the underlying will also be based on the delta-weighted positions which will be incorporated in the measure of market risk described in Section 2.2.5. For purposes of this calculation each national market is to be treated as a separate underlying. The capital charge for options on foreign exchange and gold positions will be based on the method set out in Section 2.2.7. For delta risk, the net delta-based equivalent of the foreign currency and gold options will be incorporated into the measurement of the exposure for the respective currency (or gold) position.

In addition to the above capital charges arising from delta risk, there will be further capital charges for gamma and for vega risk. Banks using the delta-plus method will be required to calculate the gamma and vega for each option position (including hedge positions) separately. The capital charges should be calculated in the following way:

a. for each individual option a "gamma impact" should be calculated according to a Taylor series expansion as:
Gamma impact = ½ x Gamma x VU²
where VU = Variation of the underlying of the option.
b. VU will be calculated as follows:

• for interest rate options if the underlying is a bond, the price sensitivity should be worked out as explained. An equivalent calculation should be carried out where the underlying is an interest rate.
• for options on equities and equity indices; which are not permitted at present, the market value of the underlying should be multiplied by 9%;
• for foreign exchange and gold options: the market value of the underlying should be multiplied by 9%;

c. For the purpose of this calculation the following positions should be treated as the same underlying:

• for interest rates, each time-band as set out in Annex 6;¹¹
• for equities and stock indices, each national market;
• for foreign currencies and gold, each currency pair and gold;
  

d. Each option on the same underlying will have a gamma impact that is either positive or negative. These individual gamma impacts will be summed, resulting in a net gamma impact for each underlying that is either positive or negative. Only those net gamma impacts that are negative will be included in the capital calculation.

e. The total gamma capital charge will be the sum of the absolute value of the net  negative gamma impacts as calculated above.

f. For volatility risk, banks will be required to calculate the capital charges by multiplying the sum of the vegas for all options on the same underlying, as defined above, by a proportional shift in volatility of ± 25%.

g. The total capital charge for vega risk will be the sum of the absolute value of the individual capital charges that have been calculated for vega risk.

ii. Scenario approach

The scenario approach uses simulation techniques to calculate changes in the value of an options portfolio for changes in the level and volatility of its associated underlyings. Under this approach, the general market risk charge is determined by the scenario "grid" (i.e. the specified combination of underlying and volatility changes) that produces the largest loss. For the delta-plus method and the scenario approach the specific risk capital charges are determined separately by multiplying the delta-equivalent of each option by the specific risk weights set out in Section 2.2.5 and Section 2.2.6.

More sophisticated banks will also have the right to base the market risk capital charge for options portfolios and associated hedging positions on scenario matrix analysis. This will be accomplished by specifying a fixed range of changes in the option portfolio’s risk factors and calculating changes in the value of the option portfolio at various points along this "grid". For the purpose of calculating the capital charge, the bank will revalue the option portfolio using matrices for simultaneous changes in the option’s underlying rate or price and in the volatility of that rate or price. A different matrix will be set up for each individual underlying as defined in the preceding paragraph. As an alternative, at the discretion of each national authority, banks which are significant traders in options for interest rate options will be permitted to base the calculation on a minimum of six sets of time-bands. When using this method, not more than three of the time-bands as defined in Section 2.2.5 should be combined into any one set.

 The options and related hedging positions will be evaluated over a specified range above and below the current value of the underlying. The range for interest rates is consistent with the assumed changes in yield in Annex 6. Those banks using the alternative method for interest rate options set out in the preceding paragraph should use, for each set of time-bands, the highest of the assumed changes in yield applicable to the group to which the time-bands belong. The other ranges are ±9 % for equities and ±9 % for foreign exchange and gold. For all risk categories, at least seven observations (including the current observation) should be used to divide the range into equally spaced intervals.

The second dimension of the matrix entails a change in the volatility of the underlying rate or price. A single change in the volatility of the underlying rate or price equal to a shift in volatility of + 25% and - 25% is expected to be sufficient in most cases. As circumstances warrant, however, the Reserve Bank may choose to require that a different change in volatility be used and / or that intermediate points on the grid be calculated.

 After calculating the matrix, each cell contains the net profit or loss of the option and the underlying hedge instrument. The capital charge for each underlying will then be calculated as the largest loss contained in the matrix.

 In drawing up these intermediate approaches it has been sought to cover the major risks associated with options. In doing so, it is conscious that so far as specific risk is concerned, only the delta-related elements are captured; to capture other risks would necessitate a much more complex regime. On the other hand, in other areas the simplifying assumptions used have resulted in a relatively conservative treatment of certain options positions.

Besides the options risks mentioned above, the RBI is conscious of the other risks also associated with options, e.g. rho (rate of change of the value of the option with respect to the interest rate) and theta (rate of change of the value of the option with respect to time). While not proposing a measurement system for those risks at present, it expects banks undertaking significant options business at the very least to monitor such risks closely. Additionally, banks will be permitted to incorporate rho into their capital calculations for interest rate risk, if they wish to do so.

2.2.6. Measurement of capital charge for equity risk

Minimum capital requirement to cover the risk of holding or taking positions in equities in the trading book is set out below. This is applied to all instruments that exhibit  market behaviour similar to equities but not to non-convertible preference shares (which are covered by the interest rate risk requirements described earlier). The instruments covered include equity shares, whether voting or non-voting, convertible securities that behave like equities, for example: units of mutual funds, and commitments to buy or sell equity.  Capital charge for specific risk (akin to credit risk) will be 11.25%and specific risk is computed on the banks’ gross equity positions (i.e. the sum of all long equity positions and of all short equity positions – short equity position is, however, not allowed for banks in India). The general market risk charge will also be 9% on the gross equity positions.

Investments in shares and /units of VCFs may be assigned 150% risk weight for measuring the credit risk during first three years when these are held under HTM category. When these are held under or transferred to AFS, the capital charge for specific risk component of the market risk as required in terms of the present guidelines on computation of capital charge for market risk, may be fixed at 13.5% to reflect the risk weight of 150%. The charge for general market risk component would be at 9% as in the case of other equities

2.2.7. Measurement of capital charge for foreign exchange and gold open positions

Foreign exchange open positions and gold open positions are at present risk weighted at 100%. Thus, capital charge for foreign exchange and gold open position is 9% at present. These open positions, limits or actual whichever is higher, would continue to attract capital charge at 9%. This is in line with the Basel Committee requirement.

2.3. Capital Adequacy for Subsidiaries

2.3.1. The Basel Committee on Banking Supervision has proposed    that the New Capital Adequacy Framework should be extended to include, on a consolidated basis, holding companies that are parents of banking groups. On prudential considerations, it is necessary to adopt best practices in line with international standards, while duly reflecting local conditions.

2.3.2. Accordingly, banks may voluntarily build-in the risk weighted components of their subsidiaries into their own balance sheet on notional basis, at par with the risk weights applicable to the bank's own assets. Banks should earmark additional capital in their books over a period of time so as to obviate the possibility of impairment to their net worth when switchover to unified balance sheet for the group as a whole is adopted after sometime. Thus banks were asked to provide additional capital in their books in phases, beginning from the year ended March 2001.

2.3.3. A consolidated bank defined as a group of entities which include a licensed bank should maintain a   minimum    Capital to    Risk-weighted Assets Ratio (CRAR) as applicable to the parent bank on an ongoing basis. While computing capital  funds,  parent bank  may consider  the following points :

i. Banks are required to maintain a minimum capital to risk weighted assets ratio of 9%.  Non-bank subsidiaries are required to maintain the capital adequacy ratio prescribed by their respective regulators. In case of any shortfall  in the  capital adequacy ratio of any of the subsidiaries,  the parent  should  maintain  capital in  addition  to  its  own regulatory requirements to cover the shortfall.
 
ii. Risks inherent in deconsolidated entities  (i.e., entities which are not consolidated in the Consolidated  Prudential Reports) in the group need to be assessed and any  shortfall in  the  regulatory capital in the  deconsolidated  entities should be deducted (in equal proportion from Tier I and Tier II  capital)  from  the consolidated bank's  capital  in  the proportion of its equity stake in the entity.

2.4. Procedure for computation of CRAR

2.4.1. While calculating the aggregate of funded and non-funded exposure of a borrower for the purpose of assignment of risk weight, banks may ‘net-off’ against the total outstanding exposure of the borrower -

(a) advances collateralised by cash margins or deposits,
(b) credit balances in current or other accounts which are not earmarked for specific purposes and free from any lien,
(c)in respect of any assets where provisions for depreciation or for bad debts have been made
(d) claims received from DICGC/ ECGC and kept in a separate account pending adjustment, and
(e) subsidies received against  advances in respect of Government sponsored schemes and kept in a separate  account.

2.4.2. After applying the conversion factor as indicated in Annex 8, the adjusted off Balance Sheet value shall again be multiplied by the risk weight attributable to the relevant counter-party as specified.

2.4.3. Computation of CRAR for Foreign Exchange and Interest Rate related Contracts: Foreign exchange contracts include- Cross currency interest rate swaps, Forward foreign exchange contracts, Currency futures, Currency options purchased, and other contracts of a similar nature Foreign exchange contracts with an original maturity of 14 calendar days or less, irrespective of the  counterparty, may be assigned "zero" risk weight as per international practice.

As in the case of other off-Balance Sheet items, a two stage calculation prescribed below shall be applied:
(a) Step 1 - The notional principal amount of each instrument is multiplied by the conversion factor given below:

(b) Step 2 - The adjusted value thus obtained shall be multiplied by the risk weight age allotted to the relevant counter-party as given in II of Annex 8.

2.4.4. Computation of CRAR for  Interest Rate related Contracts::

Interest rate contracts   include the Single currency interest rate swaps, Basis swaps,Forward rate agreements, Interest rate futures, Interest rate options purchasedand other contracts of a similar nature

As in the case of other off-Balance Sheet items, a two stage calculation prescribed below shall be applied:

(a) Step 1 - The notional principal amount of each instrument is multiplied by the percentages given below:

(b) Step 2 -The adjusted value thus obtained shall be multiplied by the risk weightage allotted to the relevant counter-party as given in II of Annex 8.

2.4.5. Aggregation of capital charge for market risks

2.4.5.1. The capital charges for specific risk and general market risk are to be computed separately before aggregation.  For computing the total capital charge for market risks, the calculations may be plotted in the proforma as depicted in Table 2 below.

Table-2: Total capital charge for market risk 

2.4.6. Calculation of total risk-weighted assets and capital ratio

2.4.6.1. Arrive at the risk weighted assets for credit risk in the banking book and for counterparty credit risk on all OTC derivatives.

2.4.6.2. Convert the capital charge for market risk to notional risk weighted assets by multiplying the capital charge arrived at as above in Proforma by 100 ÷ 9 [the present requirement of CRAR is 9% and hence notional risk weighted assets are arrived at by multiplying the capital charge by (100 ÷ 9)]

2.4.6.3. Add the risk-weighted assets for credit risk as at 2.4.6.1 above and notional risk-weighted assets of trading book as at 2.4.6.2 above to arrive at total risk weighted assets for the bank.

2.4.6.4. Compute capital ratio on the basis of regulatory capital maintained  and risk-weighted assets.

2.4.7. Computation of capital available for market risk:
Capital required for supporting credit risk should be deducted from total capital funds to arrive at capital available for supporting market risk as illustrated in Table 3 below.

Table-3: Computation of Capital for Market Risk

2.5. Worked out Examples:

Two examples for computing capital charge for market risk and credit risk are given in Annex 9.

ANNEX 1

Terms and conditions for inclusion of Innovative Perpetual Debt Instruments as Tier I capital

The Innovative Perpetual Debt Instruments (Innovative Instruments) that may be issued as bonds or debentures by Indian banks should meet the following terms and conditions to qualify for inclusion as Tier I Capital for capital adequacy purposes.

Banks shall issue innovative instruments in Indian Rupees as well as in foreign currency. Banks may augment their capital funds through the issue of IPDI in foreign currency, subject to compliance with the under mentioned requirements:

The amount of innovative instruments to be raised may be decided by the Board of Directors of banks.

Innovative instruments shall not exceed 15 per cent of total Tier I capital. The above limit will be based on the amount of Tier I capital as on March 31 of previous year after deduction of goodwill and other intangible assets but before the deduction of investments. 

The innovative instruments shall be perpetual.

The interest payable to the investors may be either at a fixed rate or at a floating rate referenced to a market determined rupee interest benchmark rate. 

Innovative instruments shall not be issued with a ‘put option’. However banks may issue the instruments with a ‘call option’ subject to strict compliance with each of the following conditions:

The issuing bank may have a step-up option which may be exercised only once during the whole life of the instrument, in conjunction with the call option, after the lapse of ten years from the date of issue. The step-up shall not be more than 100 bps. The limits on step-up apply to the all-in cost of the debt to the issuing banks.

viii) Lock-In Clause

a) Innovative instruments shall be subjected to a lock-in clause in terms of which the issuing bank shall not be liable to pay interest, if

• the bank’s CRAR is below the minimum regulatory requirement prescribed by RBI;
or

• the impact of such payment results in bank’s CRAR falling below or remaining below the minimum regulatory requirement prescribed by RBI;

The claims of the investors in innovative instruments shall be

x) Discount

The innovative instruments shall not be subjected to a progressive discount for capital adequacy purposes since these are perpetual.

The total amount raised by a bank through IPDIs shall not be reckoned as liability for calculation of net demand and time liabilities for the purpose of reserve requirements and, as such, will not attract CRR/SLR requirements

Banks issuing innovative instruments shall submit a report to the Chief General Manager-in-charge, Department of Banking Operations & Development, Reserve Bank of India, Mumbai giving details of the debt raised, including the terms of issue specified at item 1 above together with a copy of the offer document soon after the issue is completed.

• A bank's investment in innovative instruments issued by other banks and financial institutions will be reckoned along with the investment in other instruments eligible for capital status while computing compliance with the overall ceiling of 10 percent for cross holding of capital among banks/FIs prescribed vide circular DBOD.BP.BC.No.3/ 21.01.002/ 2004-05 dated 6th July 2004 and also subject to cross holding limits.


• Bank's investments in innovative instruments issued by other banks/ financial institutions will attract a 100% risk weight for capital adequacy purposes.

Banks should not grant advances against the security of the innovative instruments issued by them.
6. DisclosureBanks may indicate the amount raised by issue of IPDI  by way of explanatory notes / remarks in the Balance Sheet as well as Schedule 5 under 'Other Liabilities & Provisions"

6. Raising of innovative Instruments for inclusion as Tier I capital by foreign banks in India

Foreign banks in India may raise Head Office (HO) borrowings in foreign currency for inclusion as Tier I capital subject to the same terms and conditions as mentioned in items 1 to 5 above for Indian banks. In addition, the following terms and conditions would also be applicable:

If the amount of innovative Tier I capital raised as Head Office borrowings shall be retained in India on a perpetual basis .

Rate of interest on innovative Tier I capital raised as HO borrowings should not exceed the on-going market rate. Interest should be paid at half-yearly rests.

Interest payments to the HO will be subject to applicable withholding tax.

The foreign bank raising innovative Tier I capital as HO borrowings should obtain a letter from its HO agreeing to give the loan for supplementing the capital base for the Indian operations of the foreign bank. The loan documentation should confirm that the loan given by Head Office shall be eligible for the same level of seniority of claim as the investors in innovative instruments capital instruments issued by Indian banks. The loan agreement will be governed by and construed in accordance with the Indian law.

The total eligible amount of HO borrowings shall be disclosed in the balance sheet under the head ‘Innovative Tier I capital raised in the form of Head Office borrowings in foreign currency’.

The total eligible amount of HO borrowing should remain fully swapped in Indian Rupees with the bank at all times.

vii) Reporting and certification

Details regarding the total amount of innovative Tier I capital raised as HO borrowings, along with a certification to the effect that the borrowing is in accordance with these guidelines, should be advised to the Chief General Managers-in-Charge of the Department of Banking Operations & Development (International Banking Section), Department of External Investments & Operations and Foreign Exchange Department (Forex Markets Division), Reserve Bank of India, Mumbai.

ANNEX 2

Terms and conditions applicable to Debt capital Instruments to qualify for inclusion as Upper Tier II Capital

The debt capital instruments that may be issued as bonds / debentures by Indian banks should meet the following terms and conditions to qualify for inclusion as Upper Tier II Capital for capital adequacy purposes.

1. Terms of Issue of Upper Tier II Capital instruments

i) Currency of issue

Banks shall issue Upper Tier II instruments in Indian Rupees. Instruments in foreign currency can be issued without seeking the prior approval of the Reserve Bank of India, subject to compliance with the under mentioned requirements:

The amount of Upper Tier II instruments to be raised may be decided by the Board of Directors of banks.

Upper Tier II instruments along with other components of Tier II capital shall not exceed 100% of Tier I capital. The above limit will be based on the amount of Tier I capital after deduction of goodwill and other intangible assets but before the deduction of investments. 

The Upper Tier II instruments should have a minimum maturity of 15 years.

The interest payable to the investors may be either at a fixed rate or at a floating rate referenced to a market determined rupee interest benchmark rate. 

Upper Tier II instruments shall not be issued with a ‘put option’.   However banks may issue the instruments with a ‘call option’ subject to strict compliance with each of the following conditions:

• Call options may be exercised only if the instrument has run for at least ten years;


• Call options shall be exercised only with the prior approval of RBI (Department of Banking Operations & Development). While considering the proposals received from banks for exercising the call option the RBI would, among other things, take into consideration the bank’s CRAR position both at the time of exercise of the call option and after exercise of the call option.

The issuing bank may have a step-up option which may be exercised only once during the whole life of the instrument, in conjunction with the call option, after the lapse of ten years from the date of issue. The step-up shall not be more than 100 bps. The limits on step-up apply to the all-in cost of the debt to the issuing banks.

• the bank’s CRAR is below the minimum regulatory  requirement prescribed by RBI, or


• the impact of such payment results in bank’s CRAR falling below or remaining below the minimum regulatory requirement prescribed by RBI.

The claims of the investors in Upper Tier II instruments shall be

The Upper Tier II instruments shall be subjected to a progressive discount for capital adequacy purposes as in the case of long-term subordinated debt over the last five years of their tenor. As they approach maturity these instruments should be subjected to progressive discount as indicated in the table below for being eligible for inclusion in Tier II capital.

Upper Tier II instruments shall not be redeemable at the initiative of the holder. All redemptions shall be made only with the prior approval of the Reserve Bank of India (Department of Banking Operations & Development).

xii) Other conditions

i. Upper Tier II instruments shall be fully paid-up, unsecured, and free of any restrictive clauses.
ii. Investment in Upper Tier II instruments by FIIs shall be within the limits as laid down in the ECB Policy for investment in debt instruments. In addition, NRIs shall also be eligible to invest in these instruments as per existing policy.
iii. Banks should comply with the terms and conditions, if any, stipulated by SEBI/other regulatory authorities in regard to issue of the instruments.

2. Compliance with Reserve Requirements

i) The funds collected by various branches of the bank or other banks for the issue and held pending finalisation of allotment of the Upper Tier II Capital instruments will have to be taken into account for the purpose of calculating reserve requirements.
ii) The total amount raised by a bank through Upper Tier II instruments shall be reckoned as liability for the calculation of net demand and time liabilities for the purpose of reserve requirements and, as such, will attract CRR/SLR requirements.

3. Reporting Requirements

Banks issuing Upper Tier II instruments shall submit a report to the Chief General Manager-in-charge, Department of Banking Operations & Development, Reserve Bank of India, Mumbai giving details of the debt raised, including the terms of issue specified at item 1 above together with a copy of the offer document soon after the issue is completed.

Banks shall not grant advances against the security of the Upper Tier II instruments issued by them.

Banks may indicate the amount raised by issue of Upper Tier II instruments  by way of explanatory notes / remarks in the Balance Sheet as well as Schedule 5 under 'Other Liabilities & Provisions

7. Raising of Upper Tier II Instruments by foreign banks in India

Foreign banks in India may raise Head Office (HO) borrowings in foreign currency for inclusion as Upper Tier II capital subject to the same terms and conditions as mentioned in items 1 to 5 above for Indian banks. In addition, the following terms and conditions would also be applicable:

If the amount of Upper Tier II capital raised as Head Office borrowings is in tranches, each tranche shall be retained in India for a minimum period of fifteen years.

Rate of interest on Upper Tier II capital raised as HO borrowings should not exceed the on-going market rate. Interest should be paid at half-yearly rests.

Interest payments to the HO will be subject to applicable withholding tax.

The foreign bank raising Upper Tier II capital  as HO borrowings should obtain a letter from its HO agreeing to give the loan for supplementing the capital base for the Indian operations of the foreign bank. The loan documentation should confirm that the loan given by Head Office shall be eligible for the same level of seniority of claim as the investors in Upper Tier II debt capital instruments issued by Indian banks. The loan agreement will be governed by and construed in accordance with the Indian law.

The total eligible amount of HO borrowings shall be disclosed in the balance sheet under the head ‘Upper Tier II capital raised in the form of Head Office borrowings in foreign currency’.

The total eligible amount of HO borrowing should remain fully swapped in Indian Rupees with the bank at all times.

Details regarding the total amount of Upper Tier II capital raised as HO borrowings, along with a certification to the effect that the borrowing is in accordance with these guidelines, should be advised to the Chief General Managers-in-Charge of the Department of Banking Operations & Development (International Banking Division), Department of External Investments & Operations and Foreign Exchange Department (Forex Markets Division), Reserve Bank of India, Mumbai.

ANNEX 3

Terms and conditions for issue of unsecured bonds as
Subordinated Debt by banks to raise Tier II capital

I. Rupee Subordinated Debt

To be eligible for inclusion in Tier II capital, terms of issue of the bonds as subordinated debt instruments should be in conformity with the following:

i) Amount
The amount of subordinated debt to be raised may be decided by the Board of Directors of the bank.

ii) Maturity period

a. Subordinated debt instruments with an initial maturity period of less than 5 years, or with a remaining maturity of one year should not be included as part of Tier II capital. Further, they should be subjected to progressive discount as they approach maturity at the rates shown below:

b. The bonds should have a minimum maturity of 5 years. However if the bonds are issued in the last quarter of the year i.e., from 1st January to 31st March, they should have a minimum tenure of sixty three months.

iii) Rate of interest

The interest rate should not be more than 200 basis points above the yield on Government of India securities of equal residual maturity at the time of issuing bonds. The instruments should be 'vanilla' with no special features like options, etc.

iv) Other conditions

The instruments should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India.

Necessary permission from Foreign Exchange Department should be obtained for issuing the instruments to NRIs/OCBs/FIIs.

Banks should comply with the terms and conditions, if any, set by SEBI/other regulatory authorities in regard to issue of the instruments.

In the case of foreign banks rupee subordinated debt should be issued by the Head Office of the bank, through the Indian branch after obtaining specific approval from Foreign Exchange Department.

2. Inclusion in Tier II capital

Subordinated debt instruments will be limited to 50 per cent of Tier-I Capital of the bank. These instruments, together with other components of Tier II capital, should not exceed 100% of Tier I capital.

3. Grant of advances against bonds

Banks should not grant advances against the security of their own bonds.

4. Compliance with Reserve Requirements

The total amount of Subordinated Debt raised by the bank has to be reckoned as liability for the calculation of net demand and time liabilities for the purpose of reserve requirements and, as such, will attract CRR/SLR requirements.

5. Treatment of Investment in subordinated debt

Investments by banks in subordinated debt of other banks will be assigned 100% risk weight for capital adequacy purpose. Also, the bank's aggregate investment in Tier II bonds issued by other banks and financial institutions shall be within the overall ceiling of 10 percent of the investing bank's total capital. The capital for this purpose will be the same as that reckoned for the purpose of capital adequacy.

II. Subordinated Debt in foreign currency and Subordinated Debt in the form of Foreign Currency Borrowings from Head Office by foreign banks Banks may take approval of RBI on a case-by-case basis.

III. Reporting Requirements

The banks should submit a report to Reserve Bank of India giving details of the capital raised, such as, amount raised, maturity of the instrument, rate of interest together with a copy of the offer document soon after the issue is completed.

ANNEX 4

Subordinated debt – Head Office borrowings
in foreign currency raised by foreign banks operating
in India for inclusion in Tier II capital

Detailed guidelines on the standard requirements and conditions for Head Office (HO) borrowings in foreign currency raised by foreign banks operating in India for inclusion , as subordinated debt in Tier II capital are as indicated below:-

Amount of borrowing

2. The total amount of HO borrowing in foreign currency will be at the discretion of the foreign bank. However, the amount eligible for inclusion in Tier II capital as subordinated debt will be subject to a maximum ceiling of 50% of the Tier I capital maintained in India, and the applicable discount rate mentioned in para 5 below. Further as per extant instructions, the total of Tier II capital should not exceed 100% of Tier I capital.

Maturity period

3. Head Office borrowings should have a minimum initial maturity of 5 years. If the borrowing is in tranches, each tranche will have to be retained in India for a minimum period of five years. HO borrowings in the nature of perpetual subordinated debt, where there may be no final maturity date, will not be permitted.

Features

4. The HO borrowings should be fully paid up, i.e. the entire borrowing or each tranche of the borrowing should be available in full to the branch(es) in India. It should be unsecured, subordinated to the claims of other creditors of the foreign bank in India, free of restrictive clauses and should not be redeemable at the instance of the HO.

Rate of discount

5. The HO borrowings will be subjected to progressive discount as they approach maturity at the rates indicated below:

Rate of interest

6. The rate of interest on HO borrowings should not exceed the on-going market rate. Interest should be paid at half yearly rests.

Withholding tax

7. The interest payments to the HO will be subject to applicable withholding tax.

Repayment

8. All repayments of the principal amount will be subject to prior approval of Reserve Bank of India, Department of Banking Operations and Development.

Documentation

9. The bank should obtain a letter from its HO agreeing to give the loan for supplementing the capital base for the Indian operations of the foreign bank. The loan documentation should confirm that the loan given by Head Office would be subordinated to the claims of all other creditors of the foreign bank in India. The loan agreement will be governed by, and construed in accordance with the Indian law. Prior approval of the RBI should be obtained in case of any material changes in the original terms of issue.

Disclosure

10. The total eligible amount of HO borrowings may be disclosed in the balance sheet under the head `Subordinated loan in the nature of long term borrowings in foreign currency from Head Office’.

Reserve requirements

11.The total amount of HO borrowings is to be reckoned as liability for the calculation of net demand and time liabilities for the purpose of reserve requirements and, as such, will attract CRR/SLR requirements.

Hedging

12. The total eligible amount of HO borrowing should remain fully swapped with banks at all times. The swap should be in Indian rupees.

Reporting & Certification

13. Such borrowings done in compliance with the guidelines set out above would not require prior approval of RBI. However, information regarding the total amount of borrowing raised from Head Office under this circular, along with a certification to the effect that the borrowing is as per the guidelines, should be advised to the Chief General Managers-in-Charge of the Department of Banking Operations & Development (International Banking Section), Department of External Investments & Operations and Foreign Exchange Department (Forex Markets Division), RBI, Mumbai.

ANNEX 5

CAPITAL CHARGE FOR SPECIFIC RISK

The category ‘claim on Government’ will include all forms of Government securities including dated Government securities, Treasury bills and other short-term investments and instruments where repayment of both principal and interest are fully guaranteed by the Government. The category 'Claims on others' will include issuers of securities other than Government and banks.

  ANNEX 6

DURATION METHOD
(Time bands and assumed changes in yield)

                       ANNEX 7

Horizontal Disallowances

Note: Capital charges should be calculated for each currency separately and then summed with no offsetting between positions of opposite sign. In the case of those currencies in which business is insignificant (where the turnover in the respective currency is less than 5 per cent of overall foreign exchange turnover), separate calculations for each currency are not required.  The bank may, instead, slot within each appropriate time-band, the net long or short position for each currency. However, these individual net positions are to be summed within each time-band, irrespective of whether they are long or short positions, to produce a gross position figure. In the case of residual currencies the gross positions in each time-band will be subject to the assumed change in yield set out in table with no further offsets.

ANNEX 10

Reporting Formats

Reporting format for the purpose of monitoring the capital ratio is given hereunder:
Name of bank: _____________________ Position as on: _____________

A. Capital Base

B. Risk Weighted Assets

C. Capital Ratio

D. Memo items

Banks should furnish data in the above format as on the last day of each calendar quarter to the Chief General Manager-in-Charge, Department of Banking Supervision, Central Office, World Trade Centre I, 3rd floor, Cuffe Parade, Mumbai 400 005 both in hard copy and soft copy. Soft copy in excel format may also be forwarded through e-mail to osmos@rbi.org.in and dbodmrg@rbi.org.in.

ANNEX 11

List of instructions and circulars superseded

Part – A

List of Circulars

List of Other Circulars containing Instructions/Guidelines/Directives related to Prudential Norms