Meaning of Capital charge and calculation of capital requirement

In banking parlance ‘Capital charge’ refers to capital requirement (also known as regulatory capital or capital adequacy). The capital charge is usually articulated as a capital adequacy ratio (CAR) of equity that must be held as a percentage of risk-weighted assets. The banking regulator of a country tracks a bank’s CAR to ensure that the bank can absorb a reasonable amount of loss and complies with statutory Capital requirements. Higher CRAR indicates a bank is better capitalized.

Quite a few aspects of the Indian framework are more conservative than the Basel framework in respect of capital requirement. This includes higher minimum capital requirements and risk weightings for certain types of exposures as well as higher minimum capital ratios. Indian banks as per RBI direction are required to maintain 5.5 per cent Common Equity Tier 1 (CET 1) as against 4.5 per cent required under the Basel III framework. As per prudential norms commercial banks operating in India shall maintain a minimum total capital (MTC) of 9% of total risk weighted assets (RWAs) i.e. capital to risk weighted assets (CRAR) which will be further divided into different components as described below.

Regulatory Capital as percentage to Risk weighted assets (RWAs)

(i)  Minimum Common Equity Tier 1 Ratio= 5.5%

(ii) Capital Conservation Buffer (comprised of Common Equity)= 2.5%

(iii) Minimum Common Equity Tier 1 Ratio plus Capital Conservation Buffer (i) +(ii)=8.0%

(iv) Additional Tier 1 Capital= 1.5%

(v) Minimum Tier 1 Capital Ratio [(i) +(iv)]= 7.0%

(vi) Tier 2 Capital= 2.0%

(vii) Minimum Total Capital Ratio (MTC) [(v)+(vi)]= 9.0%

(viii) Minimum Total Capital Ratio plus Capital Conservation Buffer [(vii)+(ii)]=11.5

Minimum Common Equity Tier 1 (CET1) capital must be at least 5.5% of risk-weighted assets i.e. for credit risk + market risk + operational risk on an ongoing basis.  Tier 1 capital must be at least 7% of RWAs on an ongoing basis. Thus, within the minimum Tier 1 capital, Additional Tier 1 capital can be admitted maximum at 1.5% of RWAs.

Illustration 1:

The details of XYZ Bank Repo transactions are as under. Find the total capital required to XYZ Bank.

Type of the Security – GOI security, Residual Maturity -4.5 years,Coupon – 7%,Current Market Value – Rs.6000 Million

Cash borrowed – Rs.4000 Million,Modified Duration of the security – 3.5 years,Assumed frequency of margining – Daily

Haircut for security (adjusted for minimum holding period) -1.5 %,Haircut on cash – Zero,Minimum holding period – 5 business days

Change in yield for computing the capital charge for general market risk – 0.8 % p.a.

Solution:

Step 1:

Exposure:  6000 Million , Credit Conversion Factor (CCF) for Exposure: 100 %

iOn-Balance Sheet Credit Equivalent: 6000 * 100 % = 6000.00 Million

Haircut : 1.5 % therefore exposure adjusted for haircut: 6000 * 1.015 = 6090.00 Million

Collateral for the security lent – Cash = 4000.00 Million

Haircut for  collateral exposure: 0 % (because cash)

Therefore Collateral adjusted for haircut: 4000 * 1.00 = 4000.00 Mill

Net Exposure: 6090 – 4000 = 2090.00 Million

Risk weight (for a Scheduled CRAR complaint bank*) = 20 %

Risk weighted assets for CCR (ix)× (x): 2090 * 20 % = 418 Million

Capital Charge for CCR [(xi) x 11.5 %] – 418 * 0.115 = 48.07 Million

Hence Capital charge for CCR is 48.07 Million

(* The Risk Weights for different categories of exposure of banks ranging from 0 % to 150 % depending upon the riskiness of the assets. While commercial loan assets had a risk weight of 100%, inter-bank assets were assigned 20% risk weight; sovereign paper carried 0 % risk weight)

Step 2:  Calculate Capital Charge for credit risk

Capital for credit risk (if the security is held under HTM) = Zero (Being Govt. security)

Step 3.  Calculate Capital Charge for market (specific) risk

            For  Govt. security Capital for market (specific) risk is zero)

Step 4.  Calculate Capital Charge for market (General) risk:

Capital for market (General) risk = (Modified duration * Assumed yield change (%) * market value of security)

= 3.5 * 0.8% * 6000=168

          Hence Capital Charge for market (General) risk is 168 Million

Step 5.  Calculate Total capital required:

Total capital required = Capital charge for (CCR + credit risk + specific risk + general market risk)

= 48.07+0+0+168= 216.07

          HenceTotal capital required to XYZ bank is Rs.216.07 Million

Illustration 2:

XYZ Bank’s balance sheet as on 31.03.2019 provides following information.

1st year (Rs. In crores)

Net profits: 1050, Provisions: 1500,Staff expenses: 1850,Other operating expenses:  2100, Other income: 1300

2^nd  year (Rs. In crores)

Net profits: 1300,Provisions: 1700,Staff expenses: 2050,Other operating expenses:  2450, Other income: 1500,

Beta factor:  15% (denoted beta) assigned to that of banking business line. Answer the following questions, based on the information provided.

2.01.      What is the amount of capital charge for operational risk, on the basis of 1st year results alone as per Basic indicator approach?

Solution:  Capital charge = Gross income × 15%

Gross income = net profit + provisions + staff expenses + other operating expenses.

= 1050+ 1500 +1850 + 2100 = Rs.  6500 Cr

Capital charge for operational risk for 1st year = 6500 x 15% = Rs.975 Cr

2.02.      What is the amount of capital charge for operational risk, on the basis of 2nd year results alone as per Basic indicator approach?

Solution:  Capital charge = Gross income x 15%

Gross income = net profit + provisions + staff expenses + other operating expenses.

= 1300 + 1700 +2050 +2450 = 7500 cr

Capital charge for operational risk, on 2nd year = 7500 x 15% = 1125 cr

2.03.      What is the amount of capital charge for operational risk, on the basis of 1st and 2nd year results as per Basic indicator approach?

Solution:  Capital charge Gross income  x l5%.

Gross income for 1st year = 6500 cr

Gross income for 2nd year = 7500 cr

Average gross income = (6500 + 7500) / 2 = 7000 cr

Capital charge for operational risk, on the basis of 1st and 2nd year results = 7000 x 15% = 1050 cr

2.04.      What is the amount of risk weighted assets for operational risks in India as per Basel III recommendations, on the basis of 1st year results alone?

Solution: Amount of Risk weighted assets=Capital charge / 11.5 % = 975 / 11.5 % = Rs.8478 cr

2.05.      What is the amount of risk weighted assets for operational risks in India as per Basel III recommendations, on the basis of 2nd year results alone?

Solution: Amount of Risk weighted assets=Capital charge / 11.5 % =1125 / 11.5 % = Rs.9783 Cr

2.06.      What is the amount of risk weighted assets for operational risks in India as per Basel III recommendations, on the basis of 1st year and 2nd year results?

Solution: Capital charge / 11.5 % = 1050 / 11.5 % = Rs. 9130 cr