We come across the term “Capital adequacy Ratio” (CAR) in relation to solvency of banks very frequently. Let us examine what it precisely implies. Capital Adequacy Ratio is a measure of the intrinsic strength of a bank to absorb loss that may be occasioned on certain advances which may turn out to be irrecoverably bad. It is calculated as a proportion of capital to assets which are weighted according to the risk of default attached to them.
Capital of banks consists of two tiers which are known as Tier I and Tier II.
The Tier I capital of a bank consists of the following:
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Paid-up Capital:
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Statutory Reserves;
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Disclosed Free Reserves:
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Capital Reserves representing surplus arising out of the sale proceeds of assets;
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Equity investments in subsidiaries.
It is important to note in this regard that intangible assets and losses in the current year and that of the past years would be deducted from Tier I capital and the total of Tier II capital would restricted to 100% of the Tier I capital. Banks are also directed to maintain on an on-going basis an additional Tier I capital of 5% on foreign currency position limit approved by the RBI and the same is case with regard to open position in gold.
Tier II Capital would consist of the following items:
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Undisclosed reserves and cumulative preference shares: The undisclosed reserves should represent accumulation of post tax profits not committed to meeting specific liability and not generally accessed for absorbing normal loan or operating losses and cumulative preference shares should be fully paid and should not contain clauses which permit redemption by the holder;
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Revaluation Reserves: these arise from revaluation of assets which are undervalued in the books of the bank and such revaluation should discounted to the extent 55% for the purpose of consideration for tier II capital;
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General Provisions and Loss Reserves: If these are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, they can be included in tier II capital. General provisions or loss reserves would admitted upto a maximum of 1.25% of weighted risk assets:
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Hybrid Debt capital Instruments; Capital instruments which combine certain characteristics of equity and debt both come in this category. Where these instruments have close similarities to equity , these would be eligible for inclusion in tier II capital;
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Subordinated Debt: Banks including foreign banks operating in India, are given autonomy to raise rupee subordinate debt as tier II capital. For issue of subordinated debt instruments prior approval of RBI is necessary.