RBI/2009-10/96
UBD.PCB. MC. No.6/09.18.201 / 2009-10

July 1, 2009

The Chief Executive Officers of
All Primary (Urban) Co-operative Banks

Dear Sir/Madam,

Prudential Norms on  Capital Adequacy – Master Circular -UCBs

Please refer to our Master Circular UBD.PCB.MC.No. 6 / 09.18.201 / 2008-09 dated July 1, 2008 on the captioned subject (available on RBI website www.rbi.org.in).  The enclosed Master Circular consolidates and updates all the instructions / guidelines on the subject issued up to June 30, 2009

Yours faithfully,

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

Encl: As above

MASTER CIRCULAR ON CAPITAL ADEQUACY

Contents

CAPITAL ADEQUACY

1.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 Primary (Urban) Cooperative Bank.

3 Share linking to Borrowings

Traditionally, Primary (Urban) Cooperative Banks 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 above share linking norm may be applicable for member’s shareholdings upto the limit of 5% of the total paid up share capital of the bank.  Where a member is already holding 5% of the total paid up share capital of an UCB, it would not be necessary for him/her to subscribe to any additional share capital on account of the application of extant share linking norms.  In other words, a borrowing member may be required to hold shares for an amount that may be computed as per the extant share linking norms or for an amount that 5% of the total paid up share capital of the bank, whichever is lower.

4 Capital Adequacy Norms -

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.

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 are 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.

5 Capital 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) Primary Urban Cooperative Banking 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) Primary Urban Cooperative Banks 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:

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.

Primary Urban Cooperative Banks 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.

6 Capital 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 rights

(ii) Contributions received from associate / nominal members where the bye-laws permit allotment of shares to them and provided there are restrictions on withdrawal of such shares, as applicable to regular members

(iii) Contribution / non-refundable admission fees collected from the nominal and associate members which is held separately as ‘reserves’ under an appropriate head since these are not refundable.

(iv) Perpetual Non-Cumulative Preference Shares (PNCPS).

(v) 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. For example, 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.

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

(vii) Innovative Perpetual Debt Instruments*

(viii) 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.

* Guidelines on issue of Innovative Perpetual Debt Instruments are furnished in Annex of circular UCB.PCB.Cir.No. 39 / 09.16.900 / 2008-09 dated January 23, 2009.

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 should satisfy two criteria viz., the Fund should be created as an appropriation of net profit and should be a 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:

6.3.1 Undisclosed 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 : General provision for Standard Assets, excess provision on sale of NPAs 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: Additional specific provisions for NPAs may be used by banks for netting off from Gross NPAs to arrive at the Net NPAs and such provisions cannot be reckoned for Tier II capital. Additional general provisions (floating provisions) for bad debts i.e., provisions not earmarked for any specific loan impairments (NPAs) may be used either for netting off of gross NPAs or for inclusion in Tier II capital but cannot be used on both counts.

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 qualification 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.The instruments are as follows:

(i) Tier II Preference Shares

Primary (Urban) Cooperative Banks are permitted to issue Perpetual Cumulative Preference Shares (PCPS), Redeemable Non Cumulative Preference Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS) subject to extant instructions as per Annex III

(ii) Long Term Deposits (LTDs) would be treated as lower 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.

Other Conditions

(i) PNCPS should not exceed 20% of Tier I capital (excluding PNCPS).

(ii)Long Term Deposit being lower Tier II capital should not exceed 50% of Tier I capital and that total Tier II should not exceed Tier I capital.

(iii) All the components of Tier II capital mentioned above except Long Term Deposits are to be considered as upper Tier II capital.

(iv) 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.This restriction is kept in abeyance for five years i.e., upto March 31, 2013 for banks that are having CRAR less than the prescribed 9% in order to give time to the banks to raise Tier I capital.  In other words, Tier II capital would be reckoned as capital funds for capital adequacy purpose even if a bank does not have Tier I capital.  However, during this period, for the purpose of capital adequacy requirement, lower Tier II capital alone would be restricted to 50% of the prescribed CRAR and the progressive discount in respect of Tier II capital would be applicable.

7. Capital for Market Risk:

7.1 The Basel Committee on Banking Supervision (BCBS) had issued an amendment to the Capital Accord in1996 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 investments. It may, however, be noted that the additional risk weights are clubbed with the risk weight prescribed in the Annex and banks are not required to provide for the same separately.

8. Measures to augment capital funds

8.1 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.

8.2 Instruments for augmenting capital funds

Based on the recommendations of the Working Group constituted to examine the issues concerning raising of capital by Primary (Urban) Cooperative Banks, they have been permitted to issue the following financial instruments :

(A) Preference Shares

Preference shares may be of the following types

(i) Perpetual Non-Cumulative preference shares (PNCPS)

(ii) Perpetual Cumulative preference shares (PCPS)

(iii) Redeemable Non-Cumulative preference shares (RNCPS)

(iv) Redeemable Cumulative preference shares (RCPS)

The detailed guidelines are given in Annex-III. While Perpetual Non-Cumulative Preference Shares (PNCPS) would be eligible to be treated as Tier I capital, Perpetual Cumulative Preference Shares (PCPS), Redeemable Non-Cumulative Preference Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS) would be eligible to be treated as Tier II capital. UCBs, however, are not permitted to subscribe to the preference shares of other UCBs.

(B) Long Term Deposits

UCBs may be permitted to raise term deposits for a minimum period of not less than 5 years, which will be eligible to be treated as Tier II capital. The detailed guidelines are given in the Annex - IV.

Primary Urban Cooperative Banks may issue preference shares and Long Term Deposits subject to compliance with their bye-laws / provisions of the Co-operative Societies Act under which they are registered and with the approval of the concerned Registrar of Co-operative Societies / Central Registrar of Co-operative Societies, wherever applicable and the Reserve Bank of India. The Central / State Governments are being requested separately to make necessary amendments to Multi-State Cooperative Societies Act / Co-operative Societies Acts / Rules, wherever necessary.

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.