Capital Adequacy Norms for Local Area Banks 2021

RBI/DOR/2021-22/87 DOR.CAP.REC.No.61/21.01.002/2021-22 October 26, 2021 ( Updated as on April 08, 2024 ) ( Updated as on August 11, 2022 ) ( Updated as on March 31, 2022 ) All Local Area Banks Dear Sir / Madam, Master Direction – Prudential Norms on Capital Adequacy for Local Area Banks (Directions), 2021 The Reserve Bank of India has, from time to time, issued several guidelines / instructions / directives to Local Area Banks on Prudential Norms on Capital Adequacy. 2. To enable Local Area Banks to have current instructions at one place, a Master Direction , incorporating all the existing guidelines / instructions / directives on the subject, has been prepared for reference of the banks. 3. This Direction has been issued by RBI in exercise of its powers conferred under Section 35A of the Banking Regulation Act 1949 and in exercise of all the powers enabling it in this behalf. Yours faithfully, (Usha Janakiraman) Chief General Manager RBI/DOR/2021-22/ DOR.CAP.REC.No.61 /21.01.002/2021-22 October 26, 2021 Reserve Bank of India - Prudential Norms on Capital Adequacy for Local Area Banks, Directions, 2021 In exercise of the powers conferred by Section 35A of the Banking Regulation Act, 1949, the Reserve Bank of India, being satisfied that it is necessary and expedient in the public interest so to do, hereby, issues the Directions hereinafter specified. CHAPTER – I PRELIMINARY 1. Short Title and Commencement. (a) These Directions shall be called the Reserve Bank of India (Prudential Norms on Capital Adequacy for Local Area Banks) Directions, 2021. (b) These directions shall come into effect from October 26, 2021. 2. Applicability The provisions of these Directions shall apply to all Local Area Banks, licensed to operate in India by the Reserve Bank of India. 3. Purpose This Master Direction covers instructions regarding the components of capital and the capital required to be provided for by banks for credit and market risks. These Directions serve to specify the prudential norms from the point of view of capital adequacy. Permission for LABs to undertake transactions in specific instruments/products shall be guided by the regulations, instructions and guidelines on the same issued by Reserve Bank from time to time. 4. Definitions (a) In these Directions, unless the context otherwise requires, the terms herein shall bear the meanings assigned to them below — i. “Basis Risk” is the risk that the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude. ii. “Credit risk” is defined as the potential that a bank's borrower or counterparty may fail to meet its obligations in accordance with agreed terms. It is also the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. iii. “Deferred Tax Assets” shall have the same meaning as assigned under the extant Accounting Standards. iv. “Derivative” shall have the same meaning as assigned to it in section 45U(a) of the RBI Act, 1934. v. “Duration” (Macaulay duration) measures the price volatility of fixed income securities. It is often used in the comparison of the interest rate risk between securities with different coupons and different maturities. It is the weighted average of the present value of all the cash flows associated with a fixed income security. It is expressed in years. The duration of a fixed income security is always shorter than its term to maturity, except in the case of zero coupon securities where they are the same. vi. “Hedging” is taking action to eliminate or reduce exposure to risk vii. “Horizontal Disallowance” is a disallowance of offsets to required capital used in the BIS (Bank of International Settlements) Method 1 for assessing market risk for regulatory capital in order to calculate the capital required for interest rate risk of a trading portfolio. The BIS Method allows offsets of long and short positions. However, interest rate risks of instruments at different horizontal points of the yield curve are not perfectly correlated. Hence, the BIS Method requires that a portion of these offsets be disallowed. viii. “Interest rate risk” is the risk that the financial value of assets or liabilities (or inflows/outflows) will be altered because of fluctuations in interest rates. ix. “Long Position” refers to a position where gains arise from a rise in the value of the underlying. x. “Market risk” is the risk of losses in on-and off-balfance sheet positions arising from movements in market prices. xi. “Modified Duration” or volatility of an interest-bearing security is its Macaulay Duration divided by one plus the coupon rate of the security. It represents the percentage change in the securities' price for a 100 basis points change in yield. It is generally accurate for only small changes in the yield. MD = - dP /dY x 1/P Where, MD= Modified Duration P= Gross price (i.e. clean price plus accrued interest) dP= Corresponding small change in price dY = Small change in yield compounded with the frequency of the coupon payment. xii. “Mortgage-backed security” is a bond-type security in which the collateral is provided by a pool of mortgages. Income from the underlying mortgages is used to meet interest and principal repayments. xiii. “Open position” is the net difference between the amounts payable and amounts receivable in a particular instrument or commodity. It results from the existence of a net long or net short position in the particular instrument or commodity. xiv. “Short position” refers to a position where gains arise from a decline in the value of the underlying. It also refers to the sale of a security in which the seller does not have a long position. xv. “Vertical Disallowance” in the method for determining regulatory capital necessary to cushion market risk is a reversal of the offsets of a general risk charge of a long position by a short position in two or more securities in the same time band in the yield curve where the securities have differing credit risks. CHAPTER – II COMPOSITION OF REGULATORY CAPITAL 5. Banks are required to maintain a minimum Capital to Risk Weighted Assets Ratio (CRAR) of 9 per cent on an ongoing basis. 6. Components of Capital The capital funds shall consist of the sum of Tier I Capital and Tier II Capital. 7. Elements of Tier I Capital: Tier I capital shall consist: Paid-up capital (ordinary shares), statutory reserves, AFS reserve 2 , and other disclosed free reserves, if any; Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion as Tier I capital; Perpetual Debt Instruments (PDI) eligible for inclusion as Tier I capital; and Capital reserves representing surplus arising out of sale proceeds of assets. 8. Perpetual Non-Cumulative Preference Shares (PNCPS) shall be eligible for inclusion as Tier I capital subject to compliance with the minimum regulatory requirements specified in Annex 1 . Perpetual Debt Instruments (PDI) shall be eligible for inclusion as Tier I capital subject to compliance with the minimum regulatory requirements specified in Annex 2 . 9. Banks may include quarterly / half yearly profits for computation of Tier I capital only if the quarterly / half yearly results are audited by statutory auditors and not when the results are subjected to limited review. 10. Elements of Tier II Capital Tier II capital shall consist of undisclosed reserves, revaluation reserves, general provisions and loss reserves, hybrid debt capital instruments, subordinated debt and investment reserve account as explained hereunder: (a) Undisclosed Reserves Undisclosed Reserves shall be included in Tier II capital, if they represent accumulations of post-tax profits and are not encumbered by any known liability and shall not be routinely used for absorbing normal loss or operating losses. (b) Revaluation Reserves Revaluation Reserves shall be subject to a discount of 55 per cent while determining their value for inclusion in Tier II capital. Such reserves shall be reflected on the face of the Balance Sheet as Revaluation Reserves. (c) General Provisions and Loss Reserves General Provisions and Loss Reserves shall be included in Tier II capital provided 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. Adequate care shall be taken to ensure 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 and loss reserves shall be admitted up to a maximum of 1.25 percent of total risk weighted assets. General provisions/loss reserves shall include:- (a) 'Floating Provisions' held by the banks, which is general in nature and not made against any identified assets. (b) Excess provisions which arise on sale of NPAs (c) General provisions on standard assets (d) Investment Reserve Account as disclosed in Schedule 2- Reserves & Surplus under the head “Revenue and Other Reserves” in the Balance Sheet (e) Incremental provisions in respect of unhedged foreign currency exposures 3 (d) Hybrid Debt Capital Instruments The following instruments shall be eligible for inclusion in Upper Tier II capital: (i) Debt capital instruments subject to compliance with minimum regulatory requirements specified in Annex 3 . (ii) Perpetual Cumulative Preference Shares (PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative Preference Shares (RCPS) subject to compliance with minimum regulatory requirements specified in Annex 4 . (e) Subordinated Debt Rupee-subordinated debt shall be eligible for inclusion in Tier II capital, subject to the terms and conditions specified in the Annex 5 . 11. Swap Transactions Banks shall not enter into swap transactions involving conversion of fixed rate rupee liabilities in respect of Tier I/Tier II bonds into floating rate foreign currency liabilities. 12. Deductions from computation of Capital funds (i) Deductions from Tier I Capital The following deductions shall be made from Tier I capital: (a) Intangible assets and losses in the current period and those brought forward from previous periods (b) Deferred tax assets (DTA) (c) The net unrealised gains arising on fair valuation of Level 3 financial instruments recognised in the Profit and Loss Account or in the AFS-Reserve 4 (ii) Deductions from Tier I and Tier II Capital Equity/non-equity investments in subsidiaries: The investments of a bank in the equity as well as non-equity capital instruments issued by a subsidiary, which are reckoned towards its regulatory capital as per norms prescribed by the respective regulator, shall be deducted at 50 per cent each, from Tier I and Tier II capital of the parent bank, while assessing the capital adequacy of the bank on standalone basis. 13. Limit for Tier II elements Tier II elements shall be limited to a maximum of 100 per cent of total Tier I elements for the purpose of compliance with the norms. 14. Norms on cross holdings (i) A bank’s / Financial Institution’s (FI’s) investments in all types of instruments listed at paragraph 14(ii) below, which are issued by other banks / FIs and are eligible for capital status for the investee bank / FI, shall be limited to 10 per cent of the investing bank's capital funds (Tier I plus Tier II capital). (ii) Banks' / FIs' investment in the following instruments shall be included in the prudential limit of 10 per cent referred to at paragraph 14(i) above. Equity shares; Preference shares eligible for capital status; Perpetual Debt Instruments eligible as Tier I capital; Subordinated debt instruments; Debt capital Instruments qualifying for Upper Tier II status ; and Any other instrument approved as in the nature of capital. (iii) Banks / FIs shall not acquire any fresh stake in a bank's equity shares, if by such acquisition, the investing bank's / FI's holding exceeds 10 per cent of the investee bank's equity capital. (iv) Investments in the instruments issued by banks / FIs which are listed at paragraph 14(ii) above, which are not deducted from capital of the investing bank/ FI, shall attract 100 per cent risk weight for credit risk for capital adequacy purposes. (v) An indicative list of institutions which may be deemed to be financial institutions for capital adequacy purposes is as under: Banks, Mutual funds, Insurance companies, Non-banking financial companies, Housing finance companies, Merchant banking companies, Primary dealers (vi) The following investments shall be excluded from the purview of the ceiling of 10 per cent prudential norm prescribed in paragraph 14(i) above: a) Investments in equity shares of other banks /FIs in India held under the provisions of a statute. b) Strategic investments in equity shares of other banks/FIs incorporated outside India as promoters/significant shareholders (i.e., Foreign Subsidiaries / Joint Ventures / Associates). c) Equity holdings outside India in other banks / FIs incorporated outside India. 15. Capital Charge for Subsidiaries A consolidated bank defined as a group of entities which include a licensed bank shall maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) as applicable to the parent bank on an ongoing basis. The parent bank shall consider the following points while computing capital funds: i. Banks shall maintain a minimum capital to risk weighted assets ratio of 9%. Non-bank subsidiaries shall maintain the capital adequacy ratio prescribed by their respective regulators. In case of any shortfall in the capital adequacy ratio of any of the subsidiaries, the parent shall maintain capital in addition to its own regulatory requirements to cover the shortfall. ii. Risks inherent in deconsolidated entities in the group shall be assessed and any shortfall in the regulatory capital in the deconsolidated entities shall be deducted (in equal proportion from Tier I and Tier II capital) from the consolidated bank's capital in the proportion of its equity stake in the entity. CHAPTER – III Capital Charge for Credit Risk 16. Banks shall manage the credit risks in their books on an ongoing basis and ensure that the capital requirements for credit risks are maintained on a continuous basis, at the close of each business day. The applicable risk weights for calculation of CRAR for credit risk are specified in Annex 6 . CHAPTER – IV Capital Charge for Market Risk 17. Scope and Coverage of Capital Charge for Market Risks The capital charge for market risk shall cover the capital charges for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and other precious metals) in both trading and banking books. Trading book for the purpose of capital adequacy shall include all instruments 5 that are classified as "Held for Trading" as per Master Direction - Classification, Valuation and Operation of Investment Portfolio of Commercial Banks (Directions), 2023 dated September 12, 2023 . All other instruments 6 shall be included in the banking book and attract corresponding capital charge for credit risk (or counterparty credit risk, where applicable). 18. Banks shall manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are maintained on a continuous basis, at the close of each business day. Banks shall also maintain strict risk management systems to monitor and control intra-day exposures to market risks. 19. Measurement of Capital Charge for Interest Rate Risk in Trading Book other than Derivatives The capital charge for interest rate related instruments shall apply to the fair value of these items in bank’s trading book. The fair value shall be determined as per the extant RBI guidelines on valuation of investments. The minimum capital requirement is expressed in terms of two separate capital charges:- (i) Specific risk charge for each security both for short and long positions (ii) General market risk charge towards interest rate risk in the portfolio where long and short positions in different securities or instruments can be offset. In India short position is not allowed except in case of derivatives and Central Government Securities. Banks shall follow the framework specified hereunder for capital charge for both specific risk and general market risk for interest rate risk in the trading book other than derivatives. 20. Specific Risk The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. The specific risk charge is graduated for various exposures under three heads: (a) claims on Government, (b) claims on banks, (c) claims on others as specified in Annex 7 . 21. General Market Risk (a) The capital charge for general market risk is designed to capture the risk of loss arising from changes in market interest rates. The capital charge shall be the sum of three components: the net short ( short position is not allowed in India except in derivatives and Central Government Securities) or long position in the whole trading book; a small proportion of the matched positions in each time-band (the “vertical disallowance”); and a larger proportion of the matched positions across different time-bands (the “horizontal disallowance”). (b) Banks shall adopt the standardized duration method for computation of capital charge for market risk. Banks shall be required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately. The mechanics shall be as follows: first calculate the price sensitivity (modified duration) of each instrument; next apply the assumed change in yield to the modified duration of each instrument between 0.6 and 1.0 percentage points depending on the maturity of the instrument as specified in Annex 8 ; slot the resulting capital charge measures into a maturity ladder with the fifteen time bands as specified in Annex 8 ; subject long and short positions in each time band to a 5 per cent vertical disallowance designed to capture basis risk; and carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances specified in Annex 9 . 22. Capital Charge for Interest Rate Derivatives The measurement of capital charge for market risk shall include all interest rate derivatives and off-balance sheet instruments in the trading book, which react to changes in interest rates (eg. Forward rate agreements, other forward contracts, etc.) and derivatives entered into for hedging trading book exposures. The details of measurement of capital charge for interest rate derivatives are specified in Annex 10 . 23. Measurement of Capital Charge for equities in the trading book (a) Capital charge for equities in the trading book shall be applied to all instruments that exhibit market behavior similar to equities but not to non-convertible preference shares (which are covered by the interest rate risk requirements). The instruments covered include equity shares, whether voting or non-voting, convertible securities that behave like equities, such as units of mutual funds, and commitments to buy or sell equity. The capital charge for equities shall apply to the fair value of these items in the bank’s trading book. Capital charge for specific risk (akin to credit risk) shall be 11.25%. Specific risk shall be computed on the banks’ gross equity positions (the sum of all long equity positions and of all short equity positions-short equity position is, however, not allowed for banks in India). The general market risk charge shall be 9% on the gross equity positions. (b) Investments in shares and units of Venture Capital Funds (VCFs) shall be assigned 150% risk weight for measuring the credit risk when these are held under banking book. When these are held under or transferred to trading book, the capital charge for specific risk component of the market risk shall be fixed at 13.5% to reflect the risk weight of 150%. The charge for general market risk component shall be at 9% as in the case of other equities. 24. Measurement of Capital Charge for Foreign Exchange and Gold Open Positions Foreign exchange open positions and gold open positions shall be risk weighted at 100%. Capital charge for foreign exchange and gold open positions (limits or actual whichever is higher) shall attract capital charge at 9%. 25. Aggregation of Capital Charge for Market Risks The capital charges for specific risk and general market risk shall be computed separately before aggregation. For computing the total capital charge for market risks, the calculations shall be plotted in the proforma as per Table 1 below. Table-1: Total Capital Charge for Market Risk

Reproduced for reference with acknowledgment — Source: Reserve Bank of India · RBI/DOR/2021-22/87 · issued 26 Oct 2021. The plain-English explanation above is BankPulse’s own independent summary.

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