RBI/2008-09/51
UBD.PCB. MC. No. 6/09.18.201/2008-09

July 1, 2008

The Chief Executive Officers of
All Primary (Urban) Co-operative Banks 
Dear Sir/Madam,

Prudential Norms on  Capital Adequacy – Master Circular -UCBs

As you are aware, guidelines on capital adequacy norms were introduced for the UCBs vide circular UBD.No.POT.PCB.Cir.No.45/09.116.00/2000-01   April 25, 2001. Since then, number of circulars have been issued on the subject. The enclosed Master Circular consolidates and updates all the instructions/guidelines on the subject issued up to June 30, 2008

Yours faithfully,

(A.K Khound )
Chief General Manager-in-Charge.

MASTER CIRCULAR ON CAPITAL ADEQUACY

Contents

CAPITAL ADEQUACY

Introduction

Capital acts as a buffer in times of crisis or poor performance by a  bank. Sufficiency of capital also instils depositors’ confidence. As such, adequacy of capital is one of the pre-conditions for licensing of a new bank as well as its continuance in business. 

2 Statutory Requirements

In terms of the provisions contained in Section 11 of Banking Regulation Act (AACS), no co-operative bank shall commence or carry on banking business unless the aggregate value of its paid up capital and reserves is not less than one lakh of rupees. In addition, under Section 22 (3) (d) of the above Act, the Reserve Bank prescribes the minimum entry point capital (entry point norms) from time to time, for setting-up of a new UCB.

3 Share linking to Borrowings

Traditionally, UCBs have been augmenting their share capital by linking the same to the borrowings of the members. The Reserve Bank has prescribed the following share linking norms:

(i) 5% of the borrowings, if the borrowings are on unsecured basis.

(ii) 2.5% of the borrowings, in case of secured borrowings.

(iii) In case of secured borrowings by SSIs, 2.5% of the borrowings, of which 1% is to be collected initially and the balance of 1.5% is to be collected in the course of next 2 years.

The traditional approach to sufficiency of capital does not capture the risk elements in various types of assets in the balance sheet as well as in the off-balance sheet business and compare the capital to the level of the assets.

4 Capital Adequacy Norms -

The Basel Committee on Banking Supervision*  had published the first Basel Capital Accord  (popularly called as Basel I framework ) in July, 1988 prescribing minimum capital adequacy requirements in banks for maintaining the soundness and stability of the International Banking System  and to diminish existing source of competitive inequality among international banks.  The basic features of the Capital Accord of 1988 were  as under:

(i) Minimum Capital Requirement of 8 % by end of 1992.

(ii) Tier approach to capital :

• Core Capital: Equity, Disclosed Reserves
• Supplementary Capital: General Loan Loss Reserves, Other Hidden Reserves, Revaluation Reserves, Hybrid Capital Instruments and Subordinate Debts
• 50% of the capital to be reckoned as core capital.

(iii) Risk Weights for different categories of exposure of banks ranging from 0 % to 100 % depending upon the riskiness of the assets. While commercial loan assets had a risk weight of 100%, inter-bank assets were assigned  20% risk weight; sovereign paper carried 0 % risk weight

Further, vide 1996 amendment to the original Basel Accord,  capital charge was prescribed for market  related exposures.

  * The Basel Committee is a committee of bank supervisors drawn from 13 member countries (Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, The Netherlands, Spain, Sweden, Switzerland, United Kingdom, United States of America). It was founded in 1974 to ensure international cooperation among a number of supervisory authorities. It usually meets at the Bank for International Settlements in Basel, Switzerland where its permanent Secretariat is located.

5Capital to Risk Asset Ratio (CRAR) for UCBs:

5.1 CRAR framework, as advocated by Basel Accord, has been adopted by most of the regulatory authorities as the basis of measurement of capital adequacy, which takes into account the element of risk associated with various types of assets reflected in the balance sheet as well as in respect of off-balance sheet items and the level of capital held by the banks. RBI introduced a minimum CRAR  of  8% in 1992, for the commercial banks based on the recommendations of the Committee on Financial Sector Reforms (Narsimham Committee I), in a phased manner. 

5.2 The Reserve Bank had constituted a High Power Committee on Urban Cooperative Banks (Chairman:  Shri K. Madhava Rao) in May 1999 to review their performance and to suggest necessary measures to strengthen them. The committee felt that the continued financial stability of UCBs could not be ensured unless they were subjected to the CRAR discipline. The committee recommended that CRAR norms should be implemented in respect of UCBs on account of the following reasons:

i) CRAR serves as a buffer, which can absorb the unforeseen losses a UCB may incur in future;

ii) UCB sector is an important segment of the financial system and exclusion of this segment from CRAR discipline would undermine the stability of the whole system; and

iii) UCBs perform the same banking functions as commercial banks and are subject to similar risks. To exempt UCBs from the CRAR discipline would, therefore, be untenable.

5.3        Pursuant to the recommendations of the High Power Committee ( Madhavrao Committee), UCBs were brought under the CRAR discipline with effect form March 31,  2002, in a phased manner.  Accordingly, UCBs were  advised to adhere to capital adequacy standards over a period of three years as indicated below:
Table 1

5.4 Essentially, under the capital adequacy framework, the balance sheet assets, and off-balance sheet items have been assigned weights according to the prescribed risk weights as indicated in Annex I. The value of each asset/item shall be multiplied by the relevant weights to arrive at the risk-adjusted values of assets and of off-balance sheet items.  The aggregate will be taken into account for reckoning the minimum capital ratio. 

UCBs are required to  maintain  minimum ‘Capital Funds’ equivalent to the prescribed ratio on the aggregate of risk weighted assets and other off-balance sheet exposures on an ongoing basis.

6Capital Funds

6.1 It may be noted that  'Capital Funds' for the purpose of capital adequacy standard consist of both Tier I and Tier II  Capital as defined  in the following paragraphs.

6.2 Tier I capital

Tier I would include the following items:

(i) Paid-up share capital collected from regular members having voting powers.

(ii) Free Reserves as per the audited accounts. Reserves, if any, created out of revaluation of fixed assets or those created to meet outside liabilities should not be included in the Tier I Capital. Free reserves shall exclude all reserves / provisions which are created to meet anticipated loan losses, losses on account of fraud etc., depreciation in investments and other assets and other outside liabilities. While the amounts held under the head "Building Fund" will be eligible to be treated as part of free reserves, "Bad and Doubtful Reserves" shall be excluded.

(iii) Capital Reserve representing surplus arising out of sale proceeds of assets.

(iv) Any surplus (net) in Profit and Loss Account i.e. balance after appropriation towards dividend payable, education fund, other funds whose utilisation is defined,  asset loss, if any, etc.

NOTE: (i) Amount of intangible assets, losses in current year and those brought forward  from previous periods, deficit in NPA provisions, income wrongly recognized on non performing assets , provision required for liability devolved on bank, etc. will be deducted from Tier I Capital.

(ii) For a fund to be included in the Tier I Capital, the Fund/ Reserve should satisfy two criteria viz., the reserve/ fund should be created as an appropriation of profit and should be free reserve and not a specific reserve. However, if the same has been created not by appropriation of profit but by a charge on the profit then this fund is in effect a provision and hence will be eligible for being reckoned only as Tier II capital as defined below and subject to a limit of 1.25% of risk weight assets provided it is not attributed to any identified potential loss or diminution in value of an asset or a known liability.

6.3 Tier II Capital

Tier II capital would include the following items:

6.3.1Undisclosed Reserves

These often have characteristics similar to equity and disclosed reserves. They have the capacity to absorb unexpected losses and can be included in capital, if they represent accumulation of profits and not encumbered by any known liability and should not be routinely used for absorbing normal loss or operating losses.

6.3.2 Revaluation Reserves

These reserves often serve as a cushion against unexpected losses, but they are less permanent in nature and cannot be considered as 'Core Capital'. Revaluation reserves arise from revaluation of assets that are undervalued in the bank's books. The typical example in this regard is bank premises and marketable securities. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market value of the relevant assets, the subsequent deterioration in values under difficult market conditions or in a forced sale, potential for actual liquidation of those values, tax consequences of revaluation, etc. Therefore, it would be prudent to consider revaluation reserves at a discount of 55 % when determining their value for inclusion in Tier II Capital i.e. only 45% of revaluation reserve should be taken for inclusion in Tier II Capital. Such reserves will have to be reflected on the face of the balance sheet as revaluation reserves.

6.3.3 General Provisions and Loss Reserves 

These would include such provisions of general nature appearing in the books of the bank which are not attributed to any identified potential loss or a diminution in value of an asset or a known liability.  Adequate care must be taken to ensure that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering any amount of general provision as part of Tier II capital as indicated above.  To illustrate : excess provision in respect of Bad and Doubtful Debts, general provision for Standard Assets etc. could be considered for inclusion under this category.  Such provisions which are considered for inclusion in Tier II capital will be admitted upto 1.25% of total weighted risk assets.

NOTE: where the excess provisions are used for showing lower net NPAs, the same cannot be reckoned for Tier II capital.

6.3.4 Investment Fluctuation Reserve

Balance, if any, in the Investment Fluctuation Reserve Fund of the bank. 
 
6.3.5 Hybrid Debt Capital Instruments

Under this category, there are a number of capital instruments, which combine certain characteristics of equity and certain characteristics of debt.  Each has a particular feature which can be considered to affect its qualify as capital.  Where these instruments 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.

6.3.6 Subordinated Debt

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 bank's supervisory authorities.  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.  Subordinated debt instruments will be limited to 50 percent of Tier I capital.

NOTE :  (a)    At  present  UCBs  do not issue instruments of the type indicated at (v) and (vi) above
(b)    It may be noted  that  the total of Tier II elements will be limited to a  maximum of 100 percent of total Tier I elements for the purpose of compliance with the norms.

7.Capital for Market Risk:

7.1 The Basel Committee on Banking Supervision (BCBS) had issued an  amendment to the Capital Accord in 1996 to incorporate market risks. It contains comprehensive guidelines to provide explicit capital charge for market risks. Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions, which are subject to capital charge are as under:

• The risks pertaining to interest rate related instruments and equities in the trading book; and
• Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

7.2 As an initial step towards prescribing capital requirement for market risks, UCBs were advised to assign an additional risk weight of 2.5 per cent on almost the entire investment portfolio. It may, however, be noted that the additional risk weights are clubbed with the risk weight prescribed in the Annex and  banks are not requited to provide for the same separately.

8.Measures to augment capital funds

 8.1 At present, Co-operative Societies Acts of various States prescribe quantitative ceiling on amount of share capital which can be held by an individual member in a cooperative society. This quantitative ceiling puts a limitation on urban co-operative banks to enlarge their capital base. The issue has been taken up with Registrars of Cooperative Societies of States separately urging them to remove quantitative restrictions to enable banks to achieve CRAR norms prescribed by Reserve Bank of India. Since bringing in amendments to state statutes is a slow process, pending amendments to the State Co-operative Societies Acts, such of those UCBs, which are unable to meet the CRAR indicated in the Table 1 above, shall :

(i) necessarily appropriate not less than 50% of their net profits to Reserve Fund/Statutory Reserve Fund/General Reserve by whatever nomenclature it is addressed in the respective State Act. Apart from the above stipulation,

(ii) no urban co-operative bank should declare dividend more than 20% if the precribed CRAR norms are not attained by it.

8.2 All UCBs are required to endeavour to strengthen their capital funds and achieve the prescribed level of CRAR. They should review the existing level of capital funds vis-à-vis the prescribed level and chalk out strategy to achieve the requisite ratio, where it is not already attained.

9 Returns

 Banks should furnish to the respective Regional Offices  annual return indicating (i) capital funds, (ii) conversion of off-balance sheet/non-funded exposures, (iii) calculation of risk weighted assets, and (iv) calculation of capital funds and risk assets ratio. The format of the return is given in the Annex II. The returns should be signed two officials who are authorized to sign the statutory returns submitted to Reserve Bank.

Annex I

B. Off-Balance Sheet Items
    
The credit risk exposure attached to off-Balance Sheet items has to be first calculated by multiplying the face amount of each of the off-Balance Sheet items by `credit conversion factors' as indicated in the table below. This will then have to be again multiplied by the weights attributable to the relevant counter-party as specified above.

Note : At present, UCBs may not be undertaking most of the off balance sheet transactions. However, keeping in view their potential for expansion, risk-weights are indicated against various off balance sheet items, which, perhaps UCBs may undertake in future.

II. Additional Risk Weights in respect of Overseas  Operations of Banks (Applicable to Authorised Dealers only)
1. Foreign Exchange and Interest Rate related
Contracts

(i) Foreign exchange contracts include  the following :
(a) Cross currency interest rate swaps
(b) Forward foreign exchange contracts
(c) Currency futures
(d) Currency options purchased
(e) Other contracts of a similar nature

(ii)         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 allotted to the relevant counter - party as given in I -A above.

2. Interest Rate Contracts

(iii) Interest rate contracts include the following  :
(a) Single currency interest rate swaps
(b) Basic swaps
(c) Forward rate agreements
(d) Interest rate futures
(e) Interest rate options purchased
(f) Other contracts of a similar nature

(iv) 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 percentage 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   I -A above.

Note : At present, most of the UCBs are not carrying out forex transactions. However, those who have been given A.D's licence may undertake transactions mentioned above. In the event of any uncertainly in assigning risk weight against a specific transaction, RBI clarification may be sought for.

Annex II

(Proforma for Returns)
( Vide  Para No. 9)

Name of the Bank:

Statement of Capital Funds, Risk Assets /

Exposures and Risk Asset Ratio

1. Part A - Capital Fund and Risk Assets Ratio

2.Part B – Weighed Assets i.e. On-Balance Sheet Items

3. Part C - Weighed Non-funded Exposures / Off-Balance Sheet Items

Each off-Balance Sheet item may be submitted in the format indicated below :

Note : Netting may be done only for advances collateralised by cash margins or deposits and in respect of assets where provisions for depreciation or for bad and doubtful debts.

Appendix

List of Circulars consolidated in the Master Circular.