Capital Adequacy & Bank Regulation: Basel Norms, CRAR, Risk Weights

TAKEAWAYS:

• Banks must hold Tier 1 + Tier 2 capital ≥ 8% of risk-weighted assets to meet the Capital Adequacy Ratio (CAR).
• Risk-weighted assets (RWA) classify loans, securities, and cash based on their credit risk (e.g., government securities = 0%, corporate loans = 100%).
• NRB enforces CAR via Basel III norms, penalizing banks below 8% with restrictions on dividends or lending.
• Tier 1 capital (core capital) includes paid-up equity and retained earnings, while Tier 2 (supplementary) includes subordinated debt and revaluation reserves.
• Liquidity risk (e.g., Sirjana Finance’s cash crunch) triggers NRB interventions like repurchase agreements (repos).
• Exam focus: Calculate CAR, RWA, and interpret NRB’s regulatory tools (e.g., reserve requirements, stress tests).

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1. Capital Adequacy Ratio (CAR): The Bank’s Financial Shield

Banks operate on leverage—borrowing to lend—but must prove they can absorb losses. The Capital Adequacy Ratio (CAR) ensures this by comparing a bank’s capital to its risk-weighted assets (RWA).

Formula:

$$\text{CAR}=\frac{\text{Total Capital}}{\text{Risk-Weighted Assets (RWA)}}\times 100\%$$ Minimum CAR: 8% (Basel III standard; NRB enforces this in Nepal).

Why 8%?

• Tier 1 Capital (core capital) must be ≥ 4.5% of RWA.
• Total Capital (Tier 1 + Tier 2) must be ≥ 8% of RWA.
• Buffer: Banks must hold 2.5% above 8% for unexpected losses (capital conservation buffer).

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Example Calculation: For ABC Bank Ltd. (given in past exams):

• Tier 1: Rs 2,400M (paid-up) + Rs 120M (retained earnings) = Rs 2,520M
• Tier 2: Rs 120M (capital redemption) + Rs 220M (capital adjustment) = Rs 340M
• Total Capital = Rs 2,520M + Rs 340M = Rs 2,860M
• RWA = Assume Rs 3,500M (from exam context)
• CAR = (2,860 / 3,500) × 100 = 81.7% (passes Basel III).

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Visual: Tier 1 vs. Tier 2 Capital

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2. Risk-Weighted Assets (RWA): Not All Assets Are Equal

Banks classify assets by credit risk and assign weights (0%–100%) to calculate RWA. Lower risk = lower weight.

Worked Example (Past Exam): A bank has:

• Loans: Rs 1,100M (weight = 100%)
• Govt. securities: Rs 200M (weight = 0%)
• Cash-in-transit: Rs 50M (weight = 0%) RWA Calculation: $$\text{RWA}=(1,100\times 100\%)+(200\times 0\%)+(50\times 0\%)=\text{Rs 1,100M}$$

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3. How NRB Regulates Banks: Tools in Nepal

NRB (Nepal Rastra Bank) uses carrots and sticks to enforce CAR:

1. Minimum CAR Requirement: Banks below 8% face restrictions (e.g., no dividend payouts).
2. Stress Tests: NRB simulates crises (e.g., 20% loan defaults) to check if banks survive.
3. Liquidity Crackdowns: If a bank like Sirjana Finance faces liquidity risk, NRB may:
   • Repurchase Agreements (Repos): Lend cash temporarily (e.g., Rs 20M to Sirjana).
   • Higher Reserve Requirements: Force banks to hold more cash (e.g., 10% of deposits).
4. Prompt Corrective Action (PCA): For banks with CAR < 6%, NRB can:
   • Appoint a board of directors.
   • Restrict new lending.

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Mermaid Flowchart: NRB’s Regulatory Process

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4. Tier 1 vs. Tier 2 Capital: The Core vs. Supplementary Shield

Why Tier 2 Exists:

• Tier 1 is permanent (equity).
• Tier 2 provides flexibility (e.g., banks can issue subordinated debt to raise capital quickly).

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Tier 1 Capital (Core)
│
├── Paid-up Share Capital (Rs 2,400M)
├── Retained Earnings (Rs 120M)
└── Minority Interests (if any)
│
Tier 2 Capital (Supplementary)
│
├── Subordinated Debt (Rs 120M)
├── Capital Redemption Reserve (Rs 220M)
└── Revaluation Reserves (if any)

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5. Real-World Applications: How Banks Use CAR in Nepal

In the Real World

1. NMB Bank’s Loan Approvals:

   • Before approving a Rs 50M loan to a Kathmandu retail shop, NMB checks its CAR.
   • If NMB’s CAR drops below 8% due to high loans, it restricts new lending to maintain stability.

2. NRB’s Stress Test on Global IME:

   • During the 2020 COVID-19 crisis, NRB ran stress tests on banks.
   • Global IME had a CAR of 9% but faced Rs 200M in loan defaults.
   • NRB increased reserve requirements to 5% (from 4%) to force banks to hold more cash.

3. Pathao’s Supplier Financing:

   • Pathao partners with Nepal Investment Bank for working capital loans to drivers.
   • NIB assigns a 35% risk weight to these loans (since they’re collateralized by Pathao’s revenue share).
   • NIB ensures its CAR stays above 8% by diversifying loans across low-risk (govt. securities) and high-risk (Pathao loans).

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Worked Example: Kathmandu Retail Shop’s Loan Impact Scenario: ABC Retail (Kathmandu) takes a Rs 10M loan from Nepal Bank Ltd. with a 100% risk weight.

• Before Loan:
  • NBL’s RWA = Rs 500M
  • CAR = (Rs 45M capital / Rs 500M RWA) × 100 = 9%
• After Loan:
  • New RWA = Rs 500M + Rs 10M = Rs 510M
  • CAR = (Rs 45M / Rs 510M) × 100 = 8.82% (still above 8%, but NRB may monitor closely).
• If ABC Retail defaults:
  • NBL’s capital erodes → CAR drops below 8% → NRB freezes new loans until recapitalized.

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6. Exam Tip: How to Score Full Marks

1. Memorize the CAR Formula:

   • Always show Tier 1 + Tier 2 = Total Capital and CAR = (Total Capital / RWA) × 100.
   • Example: If RWA = Rs 3,000M and Tier 1 = Rs 1,500M, Tier 2 = Rs 600M → CAR = 70% (passes).

2. Risk Weight Assignment:

   • Government securities = 0%, loans = 100% (unless specified otherwise).
   • Past Exam Trick: If a question gives mixed weights (e.g., 35% for mortgages), apply them directly.

3. NRB’s Regulatory Tools:

   • Know the hierarchy:
     • Warning (CAR < 8%) → PCA (CAR < 6%) → Bailout (CAR < 4.5%).
   • Repo Agreements: NRB lends cash to banks like Sirjana Finance to boost liquidity.

4. Numerical Problems:

   • Step 1: Calculate Total Capital (Tier 1 + Tier 2).
   • Step 2: Calculate RWA (sum of assets × their weights).
   • Step 3: Divide Total Capital / RWA × 100 for CAR.
   • Example:

     Given:
     - Tier 1 = Rs 2,000M
     - Tier 2 = Rs 500M
     - Loans (100% weight) = Rs 2,500M
     - Govt. Securities (0%) = Rs 500M
     Solution:
     RWA = (2,500 × 100%) + (500 × 0%) = Rs 2,500M
     CAR = (2,000 + 500) / 2,500 × 100 = **100%** (exceeds Basel III)
     

5. Compare Basel I vs. Basel II vs. Basel III:

   • Basel I (1988): Simple 8% CAR (no risk differentiation).
   • Basel II (2004): Introduced risk weights (0%–100%).
   • Basel III (2010): Added liquidity coverage ratio (LCR) and capital conservation buffer (2.5%).

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Mermaid Table: Basel Norms Evolution

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7. Common Mistakes to Avoid

1. Ignoring Tier 1 Minimum:

   • Tier 1 must be ≥ 4.5% (not total capital). If Tier 1 = Rs 2,000M and RWA = Rs 5,000M → Tier 1 CAR = 40% (but total CAR = 80%—still passes).

2. Misapplying Risk Weights:

   • Mortgages = 35%, corporate loans = 100%. Mixing them up leads to wrong RWA.

3. Forgetting Liquidity Tools:

   • NRB doesn’t just check CAR—it also uses repo agreements and reserve requirements to manage liquidity.

4. Overlooking Supplementary Capital:

   • Tier 2 (subordinated debt) counts but must not exceed 50% of Tier 1. If Tier 2 > Tier 1, NRB flags the bank.

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Final Exam Tip:

• For numericals, always label your steps (e.g., "Step 1: Calculate RWA").
• For definitions, include Nepal’s NRB context (e.g., "Basel III is enforced by NRB via stress tests").
• For comparisons, use a table (like the Basel norms above).

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Practice Question (From Past Exams): A bank has:

• Assets: Rs 10M (0% weight), Rs 350M (20% weight), Rs 680M (50% weight), Rs 1,010M (100% weight).
• Capital: Rs 200M (Tier 1), Rs 100M (Tier 2). Calculate its CAR.

Solution:

1. RWA = (10×0) + (350×0.2) + (680×0.5) + (1,010×1) = Rs 1,380M.
2. Total Capital = Rs 200M + Rs 100M = Rs 300M.
3. CAR = (300 / 1,380) × 100 = 21.7% (passes easily).

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Key Takeaway for Exam:

• CAR is the bank’s "financial armor"—higher CAR = safer bank.
• NRB’s job is to ensure no bank’s armor is too thin (CAR < 8% = red flag).
• Real banks (NMB, Global IME) live by this rule—your exam questions will too!