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well as off-balance sheet business and also to strengthen the capital base of banks, RBI decided in April 1992 to
introduce a risk asset ratio system for banks (including foreign banks) in India as a capital adequacy measure. This
requires us to maintain a minimum ratio of capital to risk adjusted assets and off-balance sheet items of 9.0%, at least
half of which must be Tier I capital.
The total capital of a banking company is classified into Tier I and Tier II capital. Tier I capital, i.e. the core capital,
provides the most permanent and readily available support against unexpected losses. It comprises paid-up capital and
reserves consisting of any statutory reserves, free reserves and capital reserve as reduced by equity investments in
subsidiaries, intangible assets, and losses in the current period and those brought forward from the previous period. A
bank’s deferred tax asset is to be treated as an intangible asset and deducted from its Tier I capital.
Tier II capital, i.e. the undisclosed reserves and cumulative perpetual preference shares, revaluation reserves (at a
discount of 55.0%), general provisions and loss reserves (allowed up to a maximum of 1.25% of risk weighted assets),
hybrid debt capital instruments (which combine certain features of both equity and debt securities) and subordinated debt.
Any subordinated debt is subject to progressive discounts each year for inclusion in Tier II capital and total subordinated
debt considered as Tier II capital cannot exceed 50.0% of Tier I capital. Tier II capital cannot exceed Tier I capital.
With a view to enable the building up of adequate reserves to guard against any possible reversal of the interest rate
environment in the future due to unexpected developments, the RBI has advised banks to build up an investment
fluctuation reserve of a minimum of 5.0% of the bank’s investment portfolio within a period of five years from fiscal 2001.
This reserve has to be computed with respect to investments in Held for Trading and Available for Sale categories.
Investment fluctuation reserve is included in Tier II capital. Though investment fluctuation reserve is also considered in the
general provision for Tier II but the same is not subjected to the ceiling of 1.25% of risk weighted assets.
Risk adjusted assets and off-balance sheet items considered for determining the capital adequacy ratio are the weighted
aggregate of specified funded and non-funded exposures. Degrees of credit risk expressed as percentage weights are
assigned to various balance sheet asset items and conversion factors to off-balance sheet items. The value of each item
is multiplied by the relevant weight or conversion factor to produce risk-adjusted values of assets and off-balance-sheet
items. Guarantees and letters of credit are treated as similar to funded exposure and are subject to similar risk weight. All
foreign exchange and gold open position limits carry a 100.0% risk weight. A risk weight of 2.5% to cover market risk has
to be assigned in respect of the entire investments portfolio over and above the risk weight for credit risk. Banks are
required to assign a 100.0% risk weight for all state government guaranteed securities issued by defaulting entities. The
aggregate risk weighted assets are taken into account for determining the capital adequacy ratio.
As per regulatory requirements, banks have to maintain a capital to risk asset ratio of 9.0%. However, as per RBI
guidelines issued in September, 2002, in addition to other conditions to be complied with for declaration of dividend
without approval of RBI, capital to risk asset ratio must also be maintained at 11.0%.
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