RBI – Central Banking Glossary: Capital Funds

Economic capital:

There are three types of capital viz. Regulatory capital, Book capital and Economic capital. Regulatory capital is the amount of capital a bank is required to hold as per the stipulations prescribed by the banking regulator of the country. Book Capital is the actual capital that the bank has, which includes equity capital, loans and advances extended by the bank. Economic capital (EC) also known as risk capital refers to the amount of capital that a bank estimates to run the business and remain solvent at a given confidence level and time horizon.

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What is economic capital?

Capital adequacy framework:

Capital contribution/Equity contribution is a contribution of capital, in the form of money or property, to a business by an owner, partner, or shareholder. The sufficient capital contribution in the business provides stable resources to help the owner to absorb any losses arising from the risks in his business. The capital adequacy frame work in banking business emphasizes adequate resource to absorb any losses arising from the risks in its business. The Capital is divided into different tiers according to the characteristics / qualities of each qualifying instrument. For supervisory purposes capital is split into two categories viz. Tier I and Tier II.

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Capital Management:

Capital Management indicates that the sufficient capital contribution in the business provides stable resources to help the owner to absorb any losses arising from the risks in a business. The objective of Capital management as well as its risk appetite is to reach solvency ratio adequate for its lending activities during a period of difficult business conditions.

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CET 1 capital:

Sufficient capital is required by banks to absorb any losses that arise during the normal course of the bank’s operations. The Capital of a bank is divided into different tiers according to the characteristics / qualities of each qualifying instrument. The Basel III framework tightens the capital requirements by limiting the type of capital into two categories viz. Tier I and Tier II for supervisory purposes of capital.  Basel III accord also recommends for the Common Equity component in Tier 1 (CET1) capital.

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Tier I Capital in Banks:

Adequate capital is required by banks to absorb any losses that arise during the normal course of the bank’s operations. As per recommendations of Basel III capital requirements banks’ capital is split into two categories viz. Tier I and Tier II for supervisory purposes. The Tier 1 capital is the term used to refer core component of capital from a regulator’s point of view.

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Tier II Capital:

Tier 2 capital is the secondary component of bank capital, in addition to Tier 1 capital, that makes up a bank’s required reserves. Tier II items qualify as regulatory capital to the extent that they can be used to absorb losses arising from a bank’s activities. Tier II’s capital loss absorption capacity is lower than that of Tier I capital.

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Capital reserves:

The term capital reserve is sometimes used for the capital buffers that banks have to establish to meet regulatory requirements which are different from cash reserves that banks to maintain as per Central Bank (RBI) regulations. In general terms, a capital reserve is an account on the balance sheet of a company that can be used for a sum earmarked for specific purposes or long-term projects or mitigating capital losses or any other long-term contingencies or to offset capital losses.

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Risk Weighted Assets (RWA): The Risk Weighted Asset (RWA) is a measurement designed to evaluate the element of risk involved in each asset held by the bank. For example Cash held by bank is an asset with zero risk, where as other assets of the bank such as loans and advances, guarantees etc., are vulnerable to risk of default. Thus, such assets are called risk weighted assets. Banks make provisions on those risk weighted assets to meet future unforeseen losses.

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Basel III rule on capital requirement:

The Basel III rule is common set of global standards to be implemented by banks across countries.  Basel III introduced several measures to strengthen the capital requirement and presented more capital buffers to supplement the risk-based minimum capital requirements. This is to ensure that adequate funding is maintained in case there are other severe banking crises.

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Revaluation reserves:

A business usually owns capital assets like Plant and machinery, land and building, equipment etc. The values of these assets are periodically depreciated over their useful life span both for accounting and tax purposes. The revaluation of assets is stark opposite to planned depreciation where the recorded decline in value of these assets tied down to their ages. The revaluation of assets is the action taken by the business to show the true market value of the assets which have considerably appreciated since their purchase such as land and buildings. Increase in the value of fixed assets because of revaluation is credited to ‘Revaluation Reserve’

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FCTR or Foreign currency translation reserve:

In terms of Accounting Standard (AS) 11 FCTR or foreign currency translation reserve arises due to the translation of financial statements of bank’s foreign operations. FCTR is reckoned at a discount of 25% for the purpose of determining bank’s regulatory capital. The above treatment is subject to a condition that the FCTR are shown as ‘Reserves & Surplus’ in the Balance Sheet of the bank under schedule 2 and the external auditors of the bank have not expressed any qualified opinion on them.

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Deferred tax assets (DTAs):

The DTAs are associated with accumulated losses and other such assets. Such losses should be deducted in full from CET1 capital. However, the DTAs other than accumulated losses due to the timing difference may be recognized in the CET1 capital up to 10% Bank’s CET1 capital instead of the full deduction. (Unabsorbed depreciation and carry forward of losses which can be set-off against future taxable income which is considered as timing differences result in deferred tax assets).

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Deferred Tax Liabilities (DTL):

Deferred Tax Liability (DTL) can be defined as Provision for Future Taxation or an obligation to pay taxes in the future. In the other words, DTL reported on an organization’s balance sheet represents the net difference between the taxes that are paid in the current accounting period and the tax that is assessed or is due for the current period that will be paid in the next accounting period. The tax effect on the timing differences is thus termed as deferred tax which literally means taxes which are deferred.

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Subordinated debt:

Subordinated debt refers to the debt owed to an unsecured creditor. In the event of the bankruptcy or liquidation of the debtor, the court will prioritize the outstanding loans which the liquidated assets shall repay. Therefore, subordinated debt can only be paid if any assets left after the claims of secured creditors have been met. Hence, these types of debt with lesser priority make the grade as subordinated debt. In financial parlance, subordinated debt is also known as subordinated loan, subordinated bond, subordinated debenture or junior debt.

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Hybrid debt capital instruments:

Hybrid securities, often referred to as “hybrids,” generally combine both debt and equity characteristics. The instruments in this category fall a number of capital instruments, which combine certain characteristics of equity and certain characteristics of debt. Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options, including converting the securities into the underlying share. The most common type of hybrid security is a convertible bond that has features of an ordinary bond but is heavily influenced by the price movements of the stock into which it is convertible. Other common examples include convertible and converting preference shares.

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Mortgage Backed Security

Mortgage-backed security (MBS) is a bond type security in which the collateral is provided by a pool of mortgages. For example, A borrows money from Bank ‘B’ mortgaging his house to Bank ‘B’. The Bank ‘B’ sells the mortgage to a company ‘C’ (which may be a government agency or investment bank or private entity). The company ‘C’ groups similar mortgages ((i.e., similar interest rates, maturities, etc.) already bought by it. This system of grouping mortgages is known as pooling the mortgages. This way the companies like ‘C’ can purchase more mortgages and create MBS which will be sold to investors in a package similar to bonds in the open market. For investors an MBS is much like a bond which offers monthly, quarterly or half yearly income along with the principal.

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Asset-Backed security:

Both Asset-backed securities (ABS) and mortgage-backed securities (MBS) are fixed income financial securities collateralized (backed) by a pool of assets such as Auto loans, Education Loans, Housing Loan, credit card debts, and receivables etc.the MBS are created from the pooling of mortgages that are sold to interested investors, whereas an ABS is similar to a mortgage-backed security, except that the underlying securities are not mortgage-based.

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