Capital adequacy: Basel I to Basel III

Detail

1. Why banks need capital

• Capital is the owners' own money in the bank. It is not money the bank has borrowed.
• If loans go bad, capital takes the loss first.

• Depositors lose money only after all the capital is used up.

• Net worth = Assets − Liabilities (Class 12). A bank's capital is the same idea. It is what is left for the owners after the bank pays everyone it owes.

• Leverage means buying assets with borrowed money. For a bank, the borrowed money is mostly deposits.
• Leverage makes profits bigger when things go well.

• It makes losses bigger when things go badly.

• Worked example of leverage:

• A bank has Rs 100 of assets (loans, bonds).
• It funds them with Rs 92 of deposits and Rs 8 of its own capital.
• If 8% of its assets go bad (a loss of Rs 8), all the capital is gone. The bank is insolvent (it owes more than it owns).

• With Rs 12 of capital, the same loss would leave Rs 4, and the bank would survive.

• The lesson: less capital means more leverage, so a smaller loss can bring the bank down.

2. Who sets the rules: BCBS and the Basel norms

• Basel norms are international standards for bank capital, liquidity (having enough cash to pay depositors on time) and risk management.
• They are set by the Basel Committee on Banking Supervision (BCBS).
• BCBS was set up in 1974, after the Herstatt Bank (West Germany) failed.
• Its office is at the Bank for International Settlements (BIS) in Basel, Switzerland.

• India has been a member since 2009.

• The Basel norms are not a treaty. They are not legally binding. Each country makes them law through its own regulator. In India that regulator is the RBI, and it often sets stricter levels than Basel.

3. Basel I (1988): the first global capital rule

• Banks must hold capital of at least 8% of risk-weighted assets (RWA).
• It covered credit risk only, meaning the risk that a borrower does not repay.
• Assets were put into a few risk-weight buckets from 0% to 100%. For example, government debt was 0% and most corporate loans were 100%.
• India:
• Adopted Basel I in 1992, as part of the financial sector reforms after 1991 (Narasimham Committee-I era; Class 11 LPG chapter).

• Raised the minimum to 9% CRAR from 2000, 1 point above the Basel level.

• Weaknesses:

• The buckets were too rough. A strong company and a weak company both got 100%.
• It ignored market and operational risk.

4. Basel II (2004; India 2008-09): the three pillars

• Basel II added market risk and operational risk:
• Market risk: losses when bond prices, share prices, exchange rates or interest rates move.

• Operational risk: losses from fraud, system failure or human error.

• Pillar 1: minimum capital

• Covers credit, market and operational risk.

• Banks can use the standardised approach (weights set by the regulator, based on external credit ratings) or the internal ratings-based approach (the bank's own models).

• Pillar 2: supervisory review

• The bank checks its own risks and capital needs through ICAAP (Internal Capital Adequacy Assessment Process).

• The RBI checks that work through its SREP (Supervisory Review and Evaluation Process).

• Pillar 3: market discipline

• Banks must publish their capital and risk data.

• Depositors, investors and analysts can then punish risky banks, for example by charging them more to borrow.

• Weakness shown in 2008: banks' own models showed low risk weights, so they held too little capital. The capital they did hold was often of poor quality.

5. Measuring capital: CRAR and RWA

• Capital to Risk-weighted Assets Ratio (CRAR), also called the Capital Adequacy Ratio (CAR):

CRAR = (Tier 1 capital + Tier 2 capital) ÷ Risk-weighted assets × 100

• Risk-weighted assets (RWA) = each asset × its risk weight, added together. Safer assets need less capital.
• Government securities (G-secs): 0%, because the government is not expected to default in its own currency
• Home loans: the weight depends on the LTV band (LTV, or loan-to-value, is the loan amount as a share of the house's value). A smaller loan against the house gets a lower weight.

• Unsecured consumer credit (personal loans, credit cards): higher weights

• Worked example:

Asset	Amount (Rs)	Risk weight	RWA (Rs)
G-secs	300	0%	0
Home loans	400	35%	140
Corporate loans	300	100%	300
Total	1,000		440

• Capital = Rs 50, so CRAR = 50 ÷ 440 ≈ 11.4%.
• This is above India's 9% minimum.
• It is just below 11.5%, the minimum once the conservation buffer is added. So the bank would face limits on paying dividends.
• Trap: capital ÷ total assets = 50 ÷ 1,000 = 5%. That is a different ratio, close to the leverage ratio (section 8). The CRAR divides by risk-weighted assets.

6. Quality of capital: Tier 1 and Tier 2

• Tier 1 capital is "going-concern" capital. It absorbs losses while the bank keeps running.
• Common Equity Tier 1 (CET1) is the best-quality capital. It includes:
  • common shares
  • share premium (money paid above the face value of shares)
  • retained earnings (past profits kept in the bank)
  • disclosed reserves

• Additional Tier 1 (AT1) instruments:

  • They are perpetual (no maturity date) and non-cumulative (interest that is skipped is never paid later).
  • They are written down or converted into equity if CET1 falls below a set trigger, or at the point of non-viability (PONV), when the regulator decides the bank cannot survive without help.
  • Instrument details are in financial-markets-instruments.

• Tier 2 capital is "gone-concern" capital. It absorbs losses mainly when the bank is wound up (liquidation). It includes:

• Subordinated debt (paid back only after depositors and other creditors)
• General provisions, counted only up to 1.25% of credit RWA

• Revaluation reserves (gains from revaluing property), counted at a discount because their value is uncertain

• The RBI's definition of CET1 does not include the capital conservation buffer or the countercyclical capital buffer. The buffers are held on top of the minimum CET1. [2]

7. Basel III (2010): the post-2008 overhaul

• Why: in the 2008 global financial crisis, banks had too little capital, poor-quality capital, too much leverage and too few liquid assets.
• Timeline in India:
• Basel III capital regulations took effect from 1 April 2013. Banks must meet the limits and minimums on an ongoing basis. [2]
• Full phase-in: October 2021, after several extensions, including during COVID-19.

Ratio	Basel III	India (RBI)
CET1	4.5%	5.5%
Tier 1	6%	7%
Total CRAR	8%	9%
Capital conservation buffer (in CET1)	2.5%	2.5%
CET1 + CCB	7%	8%
Total + CCB	10.5%	11.5%
Leverage ratio	3%	4% (D-SIBs), 3.5% (others)

• In the RBI's rules:
• Tier 1 capital must be at least 7% of RWA on an ongoing basis. [2]

• The minimum Pillar 1 CRAR is 9%, not counting the CCB and CCyB. [2]

• Why India sets stricter levels:

• PSBs have a history of high NPAs.
• Borrowers can be concentrated in a few sectors or companies.
• Stricter levels give an extra safety margin.

8. Buffers and the leverage ratio

• Capital conservation buffer (CCB): 2.5% of RWA, held in CET1.
• It sits on top of the minimum. Banks can use it up in bad times.
• A bank that falls into the buffer faces limits on dividends (and on bonuses and share buybacks). This keeps profits inside the bank to rebuild capital.

• Example: RWA = Rs 440. CET1 + CCB must be at least 8% = Rs 35.2. If CET1 is Rs 30 (6.8%), the bank meets the 5.5% minimum but is inside its buffer, so dividends are limited.

• Countercyclical capital buffer (CCyB): 0-2.5% of RWA.

• "Countercyclical" means working against the business cycle.
• It goes up in credit booms and is released in downturns:
  • In a boom, extra capital makes lending costlier, which slows risky lending.
  • In a slump, the RBI releases the buffer. Banks can then keep lending instead of cutting loans.
• Main indicator: the credit-to-GDP gap, meaning how far the credit-to-GDP ratio is above its long-term trend. Other indicators are used alongside it. [3]
• The RBI framework is from 2015. In April 2022 the RBI said it was not necessary to activate the CCyB at that time. [3] (NCERT: "not yet activated — verify current")

• Both buffers are Basel III's macroprudential tools. Macroprudential means protecting the whole financial system, not just one bank. They guard banks against periods of excess credit growth. [2]

• Leverage ratio = Tier 1 capital ÷ total exposure (no risk weights).

• Total exposure includes on-balance-sheet and off-balance-sheet items.
• It is a simple backstop. It still works if banks game risk weights, that is, show assets as safer than they are.

• Example: Tier 1 = Rs 40 and total exposure = Rs 1,000, so the leverage ratio is 4%. That just meets the D-SIB minimum of 4% and is above the 3.5% needed by other banks.

• D-SIB surcharge: Domestic Systemically Important Banks (banks "too big to fail") hold extra CET1 on top of all these minimums (Section 9).

9. Basel III final reforms ("Basel IV", 2017)

• Output floor: RWA from a bank's own models cannot fall below a set share of RWA under the standardised approach. This limits "model gaming".
• Revised standardised approaches for credit, market and operational risk make the rules more sensitive to risk.
• RBI implementation timelines: verify current.

10. Where Indian banks stand

• CRAR of scheduled commercial banks (SCBs): 12.94% (March 2015) → 17.36% (March 2025). [5]
• CET1: 9.98% → 14.81% over the same period. [5]

• Both are well above the 11.5% and 8% minimums that include the CCB.

• Stress tests (the RBI's simulations of a bad economy): SCBs' total capital stays above the regulatory minimum even in adverse scenarios. The banking sector has adequate capital and liquidity buffers (Financial Stability Report, June 2026). [4]

• Why capital improved:
• Government recapitalisation of PSBs (the government putting new capital into public sector banks)
• NPA clean-up after the Asset Quality Review (2015) and the IBC (2016)
• Higher profits kept in the banks

11. The trade-off

• Higher capital makes banks safer:
• There is more cushion before depositors are hurt.
• Depositors trust banks more.

• There is less need for taxpayer bailouts.

• But it can slow credit growth:

• Equity costs a bank more than deposits.
• Loans with high risk weights, such as MSME and unsecured loans, need more capital.
• PSBs that are short of capital may cut lending, which hurts growth.
• This was the case in 2017-18, when several PSBs were under Prompt Corrective Action (PCA), the RBI's framework of restrictions on weak banks.

Prelims Hooks

• CRAR = (Tier 1 + Tier 2) ÷ Risk-weighted assets. The leverage ratio uses Tier 1 ÷ total exposure with no risk weights.
• BCBS: set up 1974 after the Herstatt Bank failure. Housed at the BIS, Basel. India a member since 2009. Basel norms are not legally binding.
• Basel I (1988): 8% of RWA, credit risk only. India adopted it 1992 and moved to 9% from 2000.
• Basel II's three pillars: minimum capital, supervisory review (ICAAP/SREP), market discipline (disclosure). Operational risk first came with Basel II.
• India's Basel III minimums: CET1 5.5%, Tier 1 7%, CRAR 9%. With the CCB: 8% / 11.5%. Basel III took effect in India from 1 April 2013. [2]
• The CCB (2.5%) must be met with CET1 only. Breaching it limits dividends. It does not shut the bank.
• CCyB: 0-2.5%, main indicator the credit-to-GDP gap. Not activated (RBI review, April 2022). [3]
• Leverage ratio (India): 4% for D-SIBs, 3.5% for other banks (Basel minimum: 3%).
• Trap: general provisions count in Tier 2 (up to 1.25% of credit RWA), not Tier 1. AT1 bonds are Tier 1, not Tier 2.
• SCB CRAR 17.36%, CET1 14.81% (March 2025). [5]

Mains Points

• Safety vs growth: India's stricter-than-Basel norms (9% vs 8%, CET1 5.5% vs 4.5%) protect depositors in a system with a history of NPAs.
• They also raise the cost of lending.
• When PSBs were short of capital (the PCA years), credit to MSMEs was squeezed.

• A good answer should weigh the fiscal cost of recapitalisation against the growth cost of tight credit.

• Risk weights vs simple rules: gaming of internal models led to the leverage ratio and the output floor.

• A good answer can argue that no single ratio is enough.

• It needs capital, liquidity (LCR/NSFR), supervision (Pillar 2) and disclosure (Pillar 3) together.

• Macroprudential policy: the CCyB is designed to work against the credit cycle. The RBI has not activated it. [3]

• A good answer can debate whether the credit-to-GDP gap suits a fast-growing, under-banked economy.

• In such an economy, credit rises naturally as more people and firms get access to banks.

• Capital + resolution = stability: strong capital buffers (CRAR 17.36%, March 2025) [5] and good stress test results [4] are linked to NPA recognition (AQR 2015) and resolution (IBC 2016).

• Capital absorbs losses.
• Resolution removes the bad assets.
• Neither works alone.