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.
Components of CET1: The Common Equity component of Tier 1 (CET1) capital is bank’s core equity capital compared with its total risk-weighted assets. The Tier 1 common equity ratio excludes any preferred shares or non-controlling interests while determining the calculation. Thus CET1 ratio differs from the Tier 1 capital ratio which is based on the sum of its equity capital and disclosed reserves, and sometimes non-redeemable, non-cumulative preferred stock. It is expected that all banks should meet the minimum required CET1 ratio of 4.50% by 2019.
Formula for calculation of Common Equity ratio:
Common Equity Tier 1 ratio = Common Tier 1 capital ÷ Risk weighted assets
The following are components of CET 1 capital:
1. Common shares (paid-up equity capital) issued by the bank which meet the criteria for classification as common shares for regulatory purposes.
2. Stock surplus (share premium) resulting from the issue of common shares;
3. Statutory reserves;
4. Capital reserves representing surplus arising out of sale proceeds of assets;
5. Other disclosed free reserves, if any;
6. Balance in Profit & Loss Account at the end of the previous financial year;
7. Revaluation Reserve*
8. While calculating capital adequacy at the consolidated level, common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority Interest), which meet the criteria for inclusion in Common Equity Tier 1 capital .
* Revaluation reserves
On a review of the existing capital adequacy guidelines, the Reserve Bank of India made some amendments to the treatment of certain balance sheet items for the purposes of determining banks’ regulatory capital. Accordingly Revaluation reserves arising from change in the carrying amount of a bank’s property consequent upon its revaluation would be considered as common equity tier 1 capital (CET1) instead of Tier 2 capital as hitherto. These would continue to be reckoned at a discount of 55 per cent. The above treatment is subject to a condition that the revaluation of property should be realistic in accordance with Indian Accounting Standard and the determination of banks’ regulatory capital is subject to the conditions that the external auditors of the bank have not expressed any qualified opinion on them.
Standard.2.Treatment of foreign currency translation reserve (FCTR):
Foreign currency translation reserve arising due to the translation of financial statements of bank’s foreign operations in terms of Accounting Standard (AS) 11 as CET1 capital which is reckoned at a discount of 25%. 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;.
3.Treatment of 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 recognised in the CET1 capital up to 10% Bank’s CET1 capital instead of the full deduction.
The treatment of items mentioned is subject to the conditions that the external auditors of the bank have not expressed any qualified opinion on them. This is for the purposes of determining banks’ regulatory capital. The review was carried out with a view to further aligning the definition of regulatory capital with the internationally adopted Basel III capital standards, issued by the Basel Committee on Banking Supervision (BCBS).
Related article: What is Tier 1 capital in banks?
