Separate capital for market risks

Domestic banks will have to provide separate capital exclusively for market risks under a proposed new capital structure "" tier III.

According to banking sources, tier III capital will be raised exclusively to provide for market risks as banks will have to provide a capital charge for these risks under Basle II.

The Reserve Bank of India (RBI) will issue directives to banks in this regard shortly so as to enable them to raise tier III capital.

Tier III capital will comprise short term debt instruments, primarily bonds with a minimum maturity period of two years. It is not as yet known how bank's capital will be structured.

However, it is expected that Tier II and Tier III will form 100 per cent of Tier I. Currently, banks can raise Tier II capital up to 100 per cent of Tier I. While tier I comprises of equity, reserves and surplus capital, tier II is made up of subordinated debt raised in the form of bonds with maturity ranging between one year to 15 years.

The central bank feels the need to segregate capital to meet market risk, which can arise from interest rate fluctuations, default in credit payment (credit risk). These risks can affect the investment portfolio of banks.

The Basle II norms require banks to put a capital charge on each and every investment in their respective portfolios. Under the current guidelines, banks have to uniformly provide capital at the rate of 2.5 per cent risk weightage irrespective of the nature of the asset or risk associated with the same.

Under Basle II, specific risks of each security be it long or short, have to be assessed. This means exposure to government bonds, foreign exchange-denominated investments, and metals like gold will have to be assessed at the current market value.

Capital will have to be provided on the combined risk emerging out of the same. This will reduce the capital adequacy of individual banks, and also bring down their respective profits to a large extent.

The need for additional capital to provide for risks as per Basle II explains why almost all the banks are accessing the capital markets. On an average, the capital adequacy ratio is expected to fall by 2-3 per cent once the Basle II norms are implemented.