Chapter 11 – Management of Banking and Financial Services, 2nd Edition

Chapter Eleven


1. Jose A. C. Santos, ‘Bank Capital Regulation in Contemporary Banking Theory: A review of literature’, BIS Working Papers no. 90 (September 2000), Bank for International Settlements, Switzerland.

2. This portion is patterned on the discussion by Timothy, W Koch and S Scott, MacDonald in their book titled ‘Bank Management’, Chapter 13, pages 501–544, 4th edition, the Dryden Press, USA.

3. Source: RBI, ‘Trend and Progress of Banking in India—2007–2008’ and ‘Report on Currency and Finance, 2006-2008’, Chapter V titled ‘Managing Capital and Risk’, both accessed at

4. Shubhashis Gangopadhyay and Gurbachan Singh ‘Bank Runs, Capital Adequacy and Line of Credit’, revised version of discussion paper presented at the Indian Statistical Institute (IST), Delhi Chapter (December 2003): 2.

5. Various documents of the Bank of International Settlements from the Web site

6. Basel Committee on Banking Supervision, ‘International Convergence of Capital Measurement and Capital Standards—A Revised Framework’ (June 2006).

7. The banking book represents assets and liabilities of the bank, contracted with the intention of building a relationship or for steady income or statutory obligations and are generally held till maturity. In contrast, the trading book assets are primarily held for generating profits on short-term differences between prices/yields. Thus, while price risk is of prime concern to banks on the trading book, earnings or economic value changes are the main focus of the banking book.

8. The notations used by the Committee follow those used by Standard and Poor's (S&P). The use of S&P ratings is indicative and the ratings of other accredited rating agencies could also be used.

9. MDBs currently eligible for 0 per cent risk-weight are: the World Bank group which comprises the International bank for Reconstruction and Development (IBRD), the International Finance Corporation (IFC), the Asian Development Bank (ADB), the African Development Bank (AfDB), the European Bank for Reconstruction and Development (EBRD), the Inter American Development Bank (IADB), the European Investment Bank (EIB), the European Investment Fund (ElF), the Nordic Investment Bank (NIB), the Caribbean Development Bank (CDB), the Islamic Development Bank (IDB) and the Council of Europe Development Banks (CEDB).

10. See chapters on ‘Credit Risk’ for a detailed discussion on CRM.

11. Basel Committee on Banking Supervision, ‘Enhancements to the Basel II Framework’, Bank for International Settlements, accessed at (July 2009).

12. The Basel II document proposing enhancements to the framework defines resecuritization as ‘A resecuritisation exposure is a securitization exposure in which the risk associated with an underlying pool of exposures is trenched and at least one of the underlying exposures is a securitisation exposure. In addition, an exposure to one or more resecuritisation exposures is a resecuritisation exposure’ (July 2009): 2, para 541(i).

13. A financial instrument is defined as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include both primary financial instruments (and cash instruments) and derivative financial instruments. A financial asset is any asset that is cash, the right to receive cash or another financial asset or the contractual right to exchange financial assets on potentially favourable terms or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or to exchange financial liabilities under conditions that are potentially unfavourable.

14. Basel Committee on Banking Supervision, ‘Revisions to the Basel II Market Risk Framework’ Bank for International Settlements, accessed at (July 2009).

15. Basel Committee on Banking Supervision, ‘Guidelines for Computing Capital for Incremental Risk in the Trading Book’, Bank for International settlements, accessed at (July 2009).

16. Tier 3 capital will be limited to 250 per cent of a bank's Tier 1 capital that is required to support market risks. This means that a minimum of about 28.5 per cent of market risks needs to be supported by Tier 1 capital that is not required to support risks in the remainder of the trading book. Further, Tier 2 elements may be substituted for Tier 3 up to the same limit of 250 per cent in so far as the overall limits in the 1988 Accord are not breached, that is, eligible Tier 2 capital may not exceed total Tier 1 capital and long-term subordinated debt may not exceed 50 per cent of Tier 1 capital. For short-term subordinated debt to be eligible as Tier 3 capital, it has to be capable of becoming part of a bank's permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum:

  1. be unsecured, subordinated and fully paid up,
  2. have an original maturity of at least 2 years,
  3. not be repayable before the agreed repayment date unless the supervisory authority agrees,
  4. be subject to a lock-in clause, which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement.

17. ‘International Convergence of Capital Measurement and Capital Standards—A Revised Framework,’ Basel Committee on Banking Supervision, Bank for International Settlements, updated (June 2006).

18. Basel Committee on Banking Supervision, ‘Principles for Sound Stress Testing Practices and Supervision’, Bank for International Settlements (May 2009).

19. This Section is based primarily on RBI's Master circular—'Prudential guidelines on Capital Adequacy and Market Discipline–Implementation of new capital adequacy framework (NCAF)’ dated 1 July 2009.

20. A consolidated bank is defined by the RBI in the above circular as ‘a group of entities where a licensed bank is the controlling entity’. The RBI guidelines on consolidated banks issued in 2003 exclude group companies engaged in Insurance business and those not engaged in financial services.

21. RBI, Circular—'Introduction of Advanced Approaches of Basel II Framework in India-Time Schedule’ (July 7 2009).

22. RBI guidelines permit banks to amortize the profit on sale of securitized assets over the period of the securities issued by the SPV For more on securitization of standard assets, please refer RBI circular ‘Guidelines for Securitisation of Standard Assets’ and the chapter titled ‘Managing Credit Risk—An Overview’ (1 February 2006).

23. Minority interest is used to signify the equity capital of outsiders in consolidated subsidiaries.

24. Typically, the nomenclature ‘Upper Tier 2’ is applicable to those hybrid instruments that have greater affinity to equity. ‘Lower Tier 2’ is popularly known as subordinated debt in India.

25. The amount of subordinated debt raised as Tier 2 capital should be indicated in banks’ balance sheets under Schedule 5 ‘Other Liabilities and Provisions’ as well as in the explanatory notes/remarks in the balance sheet.

26. No part of the amount can be included in Tier 2 capital.

27. Compiled from Annexure 6 of the RBI Master Circular-'Prudential Guidelines on Capital Adequacy and Market Discipline—Implementation of the New Capital Adequacy Framework’ (1 July 2009).

28. Note that this definition of capital funds is not the same as the items of ‘capital’ found in Schedule 1 of the banks’ balance sheet. According to RBI's directive dated 30 March 2010, only PNCPS will be shown under Schedule 1—Capital–in banks’ balance sheets for the financial year ending 31 March 2010. All other instruments reckoned as ‘capital’ under the regulations, such as IPDI, RCPS, RNCPS, PCPS, hybrid debt capital instruments and subordinated debt – will be shown as ‘Borrowings’ under Schedule 4.

29. These are recorded as on balance sheet exposures by the originating bank, representing valuation of future cash flows related to margin income to be derived from the underlying exposures and is subordinated to the claims of other parties to the transaction in terms of priority of repayment. (RBI circular): 30.

30. Section 7 of the RBI Master Circular describes the guidelines to be followed by banks seeking capital relief for use of CRM techniques. An illustrative example for calculation of ‘exposure’ for calculating risk-weighted assets (RWA) is provided in Annexure 8, Part A.

31. Short positions not permitted in India except in the case of derivatives.

32. ‘Duration’ is not to be confused with the security's maturity. It is the measure of the price sensitivity of a fixed-income security to an interest rate change of 100 bps. It represents the time period within which the investment can be recouped and is calculated as the weighted average of the present values of all cash flows over the life of the instrument or asset. Duration is measured in years. However, this is not to be confused with the security's maturity. For all securities, duration is shorter than maturity except in the case of zero coupon bonds.

33. “Duration’ as defined above is also called ‘Macaulay's duration’. However, to assess the effect of a 1 per cent change in interest rate on the price of the security, ‘modified duration’ is used. ‘Modified duration’ follows the concept that interest rates and bond prices move in opposite directions. It is used to determine the effect that a 1 per cent change in interest rate will have on the price of a bond. The concepts of ‘duration’ and ‘modified duration’ have been discussed in more detail in the chapter on ‘Risk Management.’

34. Page 68 of RBI Master Circular (1 July, 2009).

35. The illustrations have been adapted from Annexure II of the RBI's ‘Master Circular—Prudential Norms on Capital Adequacy—Basel I Framework’ (1 July 2009).

36. For more discussion on interest rate derivatives, please refer to chapter on ‘Risk Management’.

37. Any deal which has not been settled by physical payment or reversed by an equal and opposite deal for the same date.

38. Capital charge for general market risk for equities is 9 per cent. (Thus, general market risk capital charge on equities would work out to Rs. 27 crores).

39. Capital charge on forex/gold position would be computed at 9 per cent. (Thus, the capital charge works out to Rs. 9 crores).

40. Detailed discussions on Pillar 2 and Pillar 3 can be found in pages 204–225 and 226–242, respectively of the Basel Committee document ‘International Convergence of Capital Measurement and Capital Standards—A Revised Framework, Comprehensive Version’, can be accessed at (July 2006).

41. RBI Master Circular—'Prudential Guidelines on Capital Adequacy and Market Discipline—Implementation of the New Capital Adequacy Framework (NCAF)’ (1 July 2009).

42. Observation made in RBI's ‘Report on Currency and Finance—2006–2008,’ Chapter V: 189