Master Circular DBOD No.BP.BC.2/21.01.002/2002- 2003 date 5 July 2002

Prudential norms on Capital Adequacy
Chief Executives of all Scheduled Commercial Banks
(excluding RRBs and LABs)

Dear Sir,

Please refer to the Master Circular No. DBOD. BP. BC. 21/ 21.01.002/ 2001- 2002 dated 31 August 2001 consolidating instructions/ guidelines issued to banks till 30 June 2001 on matters relating to prudential norms on capital adequacy. The Master Circular has been suitably updated by incorporating instructions issued upto 30 June 2002 and has also been placed on the RBI web-site (http: // www.rbi.org.in).

This Master Circular is a compilation of all the instructions contained in the circulars issued by RBI on the above subject, which are operational as on the date of this circular.

Yours faithfully,

( M. R. Srinivasan )
Chief General Manager-in-Charge

PRUDENTIAL NORMS ON CAPITAL ADEQUACY1. General

1.1 With a view to adopting the Basle Committee framework on capital adequacy norms which takes into account the elements of risk in various types of assets in the balance sheet as well as off-balance sheet business and also to strengthen the capital base of banks, Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks (including foreign banks) in India as a capital adequacy measure.

1.2 Essentially, under the above system the balance sheet assets, non-funded items and other off-balance sheet exposures are assigned weights according to the prescribed risk weights and banks have to maintain unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of the risk weighted assets and other exposures on an ongoing basis. The broad details of the capital adequacy framework are detailed below.

2. Capital funds

2.1 Capital funds of Indian banks

For Indian banks, 'capital funds' would include the following elements:

2.1.1 Elements of Tier I capital

Paid-up capital, statutory reserves, and other disclosed free reserves, if any.

Capital reserves representing surplus arising out of sale proceeds of assets.

2.1.2 Equity investments in subsidiaries, intangible assets and losses in the current period and those brought forward from previous periods, should be deducted from Tier I capital.

2.1.3 In the case of public sector banks which have introduced Voluntary Retirement Scheme (VRS), in view of the extra-ordinary nature of the event, the VRS related Deferred Revenue Expenditure would not be reduced from Tier I capital.

2.1.4 Elements of Tier II capital

i) Undisclosed reserves and cumulative perpetual preference shares

These often have characteristics similar to equity and disclosed reserves. These elements have the capacity to absorb unexpected losses and can be included in capital, if they represent accumulations of post-tax profits and not encumbered by any known liability and should not be routinely used for absorbing normal loss or operating losses. Cumulative perpetual preference shares should be fully paid-up and should not contain clauses which permit redemption by the holder.

ii) Revaluation reserves

These reserves often serve as a cushion against unexpected losses, but they are less permanent in nature and cannot be considered as ‘Core Capital’. Revaluation reserves arise from revaluation of assets that are undervalued on the bank’s books, typically bank premises and marketable securities. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets, the subsequent deterioration in values under difficult market conditions or in a forced sale, potential for actual liquidation at those values, tax consequences of revaluation, etc. Therefore, it would be prudent to consider revaluation reserves at a discount of 55 percent while determining their value for inclusion in Tier II capital. Such reserves will have to be reflected on the face of the Balance Sheet as revaluation reserves.

iii) General provisions and loss reserves

Such reserves, if they are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, can be included in Tier II capital. Adequate care must be taken to see that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering general provisions and loss reserves to be part of Tier II capital. General provisions/loss reserves will be admitted up to a maximum of 1.25 percent of total risk weighted assets.

iv) Hybrid debt capital instruments

In this category, fall a number of capital instruments which combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital.

v) Subordinated debt

a) To be eligible for inclusion in Tier II capital, the instrument should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India. They often carry a fixed maturity, and as they approach maturity, they should be subjected to progressive discount, for inclusion in Tier II capital. Instruments with an initial maturity of less than 5 years or with a remaining maturity of one year should not be included as part of Tier II capital. Subordinated debt instruments eligible to be reckoned as Tier II capital will be limited to 50 percent of Tier I capital.

b) In the case of public sector banks, the bonds issued to the VRS employees as a part of the compensation package, net of the unamortised VRS Deferred Revenue Expenditure, could be treated as Tier II capital, subject to compliance with the terms and conditions stipulated in para 2.4 below.

c) The subordinated debt instruments included in Tier II capital may be subjected to discount at the rates shown below:

Remaining Maturity of Instruments	Rate of Discount (%)
Less than one year	100
One year and more but less than two years	80
Two years and more but less than three years	60
Three years and more but less than four years	40
Four years and more but less than five years	20

d) Banks should indicate the amount of subordinated debt raised as Tier II capital by way of explanatory notes/ remarks in the Balance Sheet as well as in Schedule 5 under 'Other Liabilities & Provisions'.

vi) The Investment Fluctuation Reserve would be eligible for inclusion in Tier II capital.

vii) Banks are allowed to include the ‘General Provisions on Standard Assets’ and 'Investment Fluctuation Reserve' in Tier II capital. However, the provisions on standard assets and 'Investment Fluctuation Reserve' together with other ‘general provisions/ loss reserves’ will be admitted as Tier II capital up to a maximum of 1.25 per cent of the total risk-weighted assets.

2.1.5 Tier II elements should be limited to a maximum of 100 percent of total Tier I elements for the purpose of compliance with the norms.

2.1.6 A bank’s aggregate investment in Tier II bonds issued by other banks and financial institutions shall be permitted upto 10 percent of the investing banks total capital. The total capital for this purpose will be the same as reckoned for the purpose of Capital Adequacy.

2.2 Capital funds of foreign banks operating in India

For foreign banks, 'capital funds' would include the following elements:

2.2.1 Elements of Tier I capital

i. Interest-free funds from Head Office kept in a separate account in Indian books specifically for the purpose of meeting the capital adequacy norms.

ii. Statutory reserves kept in Indian books.

iii. Remittable surplus retained in Indian books which is not repatriable so long as the bank functions in India.

Notes:

a. The foreign banks are required to furnish to Reserve Bank, (if not already done), an undertaking to the effect that the banks will not remit abroad the remittable surplus retained in India and included in Tier I capital as long as the banks function in India.

b. These funds may be retained in a separate account titled as 'Amount Retained in India for Meeting Capital to Risk-weighted Asset Ratio (CRAR) Requirements' under 'Capital Funds'.

c. An auditor's certificate to the effect that these funds represent surplus remittable to Head Office once tax assessments are completed or tax appeals are decided and do not include funds in the nature of provisions towards tax or for any other contingency may also be furnished to Reserve Bank.

d. It should be noted that once the banks treat any part of the remittable profits as capital funds for capital adequacy purposes, these funds cannot be hedged.

iv. Capital reserve representing surplus arising out of sale of assets in India held in a separate account and which is not eligible for repatriation so long as the bank functions in India.

v. Interest-free funds remitted from abroad for the purpose of acquisition of property and held in a separate account in Indian books.

vi. The net credit balance, if any, in the inter-office account with Head Office/overseas branches will not be reckoned as capital funds. However, any debit balance in Head Office account will have to be set-off against the capital.

2.2.2 Elements of Tier II capital

To the extent relevant, elements of Tier II capital as indicated above in paragraph 2.1.4 in respect of Indian banks will be eligible.

2.2.3 The elements of Tier I & Tier II capital do not include foreign currency loans granted to Indian parties.

2.3 Minimum requirement of capital funds

Banks were required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) norm of 8 percent on an ongoing basis up to the year ending 31 March 1999. With effect from the year ending 31 March 2000, banks are required to maintain a minimum CRAR of 9 percent on an ongoing basis.

2.4 Issue of subordinated debt for raising Tier II capital

2.4.1 The Reserve Bank has given autonomy to Indian banks to raise rupee subordinated debt as Tier II capital, subject to the terms and conditions given in the Annexure 1. It should be ensured that the terms & conditions are strictly adhered to.

2.4.2 Foreign banks also would not require prior approval of RBI for raising subordinated debt in foreign currency through borrowings from Head Office for inclusion in Tier II capital. To ensure transparency and uniformity, detailed guidelines in this regard are given at Annexure1A.

2.4.3 The banks should submit a report to Reserve Bank of India giving details of the Subordinated debt issued for raising Tier II capital, such as, amount raised, maturity of the instrument, rate of interest together with a copy of the offer document, soon after the issue is completed.

3. Risk adjusted assets and off-balance sheet items

3.1 Risk adjusted assets would mean weighted aggregate of funded and non-funded items. Degrees of credit risk expressed as percentage weightings, have been assigned to balance sheet assets and conversion factors to off-balance sheet items.

3.2 Banks’ investments in all securities should be assigned a risk weight of 2.5 percent for market risk. This will be in addition to the risk weights assigned towards credit risk since, in line with best practices, some capital cushion should also be provided for market risk in addition to credit risk.

3.3 The value of each asset/ item shall be multiplied by the relevant weights to produce risk adjusted values of assets and off-balance sheet items. The aggregate will be taken into account for reckoning the minimum capital ratio.

3.4 The risk-weights allotted to each of the items of assets and off-balance sheet items are furnished in the Annexure 2.

4. Reporting requirements

4.1 Banks should furnish an annual return indicating -

i. capital funds,

ii. conversion of off-Balance Sheet/non-funded exposures,

iii. calculation of risk weighted assets, and

iv. calculations of capital to risk assets ratio.

4.2 The format of the return is given in Annexure 3. In the case of Indian banks having branches abroad, the break-up and aggregate in respect of domestic and overseas operations will have to be furnished. Two officials who are authorised to sign the statutory returns submitted to Reserve Bank should sign the returns.

5. Capital Adequacy for Subsidiaries

5.1 The Basel Committee on Banking Supervision has proposed that the New Capital Adequacy Framework should be extended to include, on a consolidated basis, holding companies that are parents of banking groups. On prudential considerations, it is necessary to adopt best practices in line with international standards, while duly reflecting local conditions.

5.2 Accordingly, banks may voluntarily build-in the risk weighted components of their subsidiaries into their own balance sheet on notional basis, at par with the risk weights applicable to the bank's own assets. Banks should earmark additional capital in their books over a period of time so as to obviate the possibility of impairment to their net worth when switchover to unified balance sheet for the group as a whole is adopted after sometime. The additional capital required may be provided in the bank's books in phases, beginning from the year ending March 2001.

ANNEXURE 1

Master Circular

PRUDENTIAL NORMS ON CAPITAL ADEQUACY

Issue of unsecured bonds as
Subordinated Debt by banks for raising Tier II capital
(Vide paragraph 2.4.1)
I. Rupee Subordinated Debt

1. Terms of Issue of Bond

To be eligible for inclusion in Tier - II Capital, terms of issue of the bonds as subordinated debt instruments should be in conformity with the following:

(i) Amount

The amount of subordinated debt to be raised may be decided by the Board of Directors of the banks.

(ii) Maturity period

(a) Subordinated debt instruments with an initial maturity period of less than 5 years, or with a remaining maturity of one year should not be included as part of Tier-II Capital. Further, they should be subjected to progressive discount as they approach maturity at the rates shown below:

Remaining Maturity of Instruments	Rate of Discount (%)
Less than one year	100
More than One year and less than Two years	80
More than Two years and less than Three years	60
More than Three years and less than Four years	40
More than Four years and less than Five years	20

(b) The bonds should have a minimum maturity of 5 years. However if the bonds are issued in the last quarter of the year i.e. from 1st January to 31st March, they should have a minimum tenure of sixty three months.

(iii) Rate of interest

The interest rate should not be more than 200 basis points above the yield on Government of India securities of equal residual maturity at the time of issuing bonds. The instruments should be 'vanila' with no special features like options etc.

(iv) Other conditions

The instruments should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India.

Necessary permission from Exchange Control Department should be obtained for issuing the instruments to NRIs/OCBs/FIIs.

Banks should comply with the terms and conditions, if any, set by SEBI/other regulatory authorities in regard to issue of the instruments.

Nationalised banks should obtain permission from the Government for issuing the instruments.

In the case of foreign banks rupee subordinated debt should be issued by the Head Office of the bank, through the Indian branch after obtaining specific approval from Exchange Control Department.

2. Inclusion in Tier II capital

Subordinated debt instruments will be limited to 50 per cent of Tier-I Capital of the bank. These instruments, together with other components of Tier II capital, should not exceed 100% of Tier I capital.

3. Grant of advances against bonds

Banks should not grant advances against the security of their own bonds.

4. Compliance with Reserve Requirements

The funds collected by various branches of the bank or other banks for the issue, and held pending finalisation of allotment will have to be taken into account for the purpose of calculating reserve requirements.

To the extent the instruments are treated as Tier II Capital [after discount at the rates mentioned at item 1(ii)(a)] they will be exempted from reserve requirements. However, in view of the multiple prescriptions on different categories of liabilities, including prescription of a zero reserve requirement on certain liabilities, as stipulated under the law, effective CRR and SLR maintained by the bank on total demand and time liabilities, including the total amount raised under subordinated debt, should not be less than 3% and 25% respectively.

5. Treatment of Investment in subordinated debt

Investments by banks in subordinated debt of other banks will be assigned 100% risk weight for capital adequacy purpose. Also, the bank's aggregate investment in Tier II bonds issued by other banks and financial institutions shall be permitted upto 10 percent of the investing bank's total capital. The capital for this purpose will be the same as that reckoned for the purpose of capital adequacy. In case any bank has already exceeded this limit of 10 percent, a reference may be made to Reserve Bank indicating the period within which the exposure would be brought within the stipulated limit. (cf para 2(ii) of circular listed at item 8 part ‘B’ of Appendix)

II. Subordinated Debt in foreign currency and Subordinated Debt in the form of Foreign Currency Borrowings from Head Office by foreign banks

Banks may take approval of RBI on a case-by-case basis.

III. Reporting Requirements

The banks should submit a report to Reserve Bank of India giving details of the capital raised, such as, amount raised, maturity of the instrument, rate of interest together with a copy of the offer document, soon after the issue is completed.

ANNEXURE 1A

Master Circular

PRUDENTIAL NORMS ON CAPITAL ADEQUACY

Tier II capital - Subordinated debt - Head Office borrowings
in foreign currency raised by foreign banks operating
in India for inclusion in Tier II capital
(Vide paragraph 2.4.2)
In terms of para II (b) of RBI circular No. DBOD. BP. BC. 5/21.01.002/98-99 dated February 8, 1999 foreign banks are required to obtain the approval of RBI, for raising subordinated debt in the form of foreign currency borrowings from Head Office. The requests are presently examined on a case-by-case approach. Detailed guidelines on the standard requirements and conditions for inclusion of such Head Office borrowings in foreign currency, as subordinated debt in Tier II capital are as indicated below:-

Amount of borrowing

2. The total amount of HO borrowing in foreign currency will be at the discretion of the foreign bank. However, the amount eligible for inclusion in Tier II capital as subordinated debt will be subject to a maximum ceiling of 50% of the Tier I capital maintained in India, and the applicable discount rate mentioned in para 5 below. Further as per extant instructions, the total of Tier II capital should not exceed 100% of Tier I capital.

Maturity period

3. Head Office borrowings should have a minimum initial maturity of 5 years. If the borrowing is in tranches, each tranche will have to be retained in India for a minimum period of five years. HO borrowings in the nature of perpetual subordinated debt, where there may be no final maturity date, will not be permitted.

Features

4. The HO borrowings should be fully paid up, i.e. the entire borrowing or each tranche of the borrowing should be available in full to the branch in India. It should be unsecured, subordinated to the claims of other creditors of the foreign bank in India, free of restrictive clauses and should not redeemable at the instance of the HO.

Rate of discount

5. The HO borrowings will be subjected to progressive discount as they approach maturity at the rates indicated below:

Remaining maturity of borrowing	Rate of discount
More than 5 years	Not Applicable ( the entire amount can be included as subordinated debt in Tier II capital subject to the ceiling mentioned in para 2)
More than 4 years and less than 5 years	20%
More than 3 years and less than 4 years	40%
More than 2 years and less than 3 years	60%
More than 1 year and less than 2 years	80%
Less than 1 year	100% (No amount can be treated as subordinated debt for Tier II capital)

Rate of interest

6. The rate of interest on HO borrowings should not exceed the on-going market rate. Interest should be paid at half yearly rests.

Withholding tax

7. The interest payments to the HO will be subject to applicable withholding tax.

Repayment

8. All repayments of the principal amount will be subject to prior approval of Reserve Bank of India, Department of Banking Operations and Development.

Documentation

9. The bank should obtain a letter from its HO agreeing to give the loan for supplementing the capital base for the Indian operations of the foreign bank. The loan documentation should confirm that the loan given by Head Office would be subordinated to the claims of all other creditors of the foreign bank in India. The loan agreement will be governed by, and construed in accordance with the Indian law. Prior approval of the RBI should be obtained in case of any material changes in the original terms of issue.

Disclosure

10. The total amount of HO borrowings may be disclosed in the balance sheet under the head `Subordinated loan in the nature of long term borrowings in foreign currency from Head Office’.

Reserve requirements

11. The total amount of HO borrowings is to be reckoned as liability for the calculation of net demand and time liabilities for the purpose of reserve requirements and, as such, will attract CRR/SLR requirements.

Hedging

12. The entire amount of HO borrowing should remain fully swapped with banks at all times. The swap should be in Indian rupees.

Reporting & Certification

13. Such borrowings done in compliance with the guidelines set out above, would not require prior approval of Reserve Bank of India. However, information regarding the total amount of borrowing raised from Head Office under this circular, along with a certification to the effect that the borrowing is as per the guidelines, should be advised to the Chief General Managers-in-Charge of the Department of Banking Operations & Development (International Banking Section), Department of External Investments & Operations and Exchange Control Department (Forex Markets Division), Reserve Bank of India, Mumbai.

ANNEXURE 2

Master Circular

PRUDENTIAL NORMS ON CAPITAL ADEQUACY

Risk Weights for Calculation of CRAR
(Vide paragraph 3.3)
I. Domestic Operations

A. Funded Risk Assets