One fine morning, our friend Johnny was lost in his own world. He had read about “Basel II” in Mint a few weeks ago, but was not sure what was it all about. At one point, he thought Basel II, like Dhoom II, must be a sequel of some movie. The confusion was getting worse. Luckily at this point, Jinny appeared. Johnny had a sigh of relief. “Now I would know everything I wish to know about this new worm that is troubling me,” he thought. He straightaway started the talk:
Johnny: Hi Jinny! I hope you had a nice weekend. It’s always good to see you back on Monday morning.
Jinny: I spent my weekend washing clothes and seeing Dhoom II on DVD. I hope you had better things to do.
Johnny: Well, I couldn’t see any new movie; I kept wondering which one is better to watch: Dhoom II or Basel II?
Jinny: What? Basel II? You think Basel II is a movie? Well, that’s not your fault. Different people confuse it for different things. I think it’s time for you to learn about banking prudential norms.
Johnny: Nice thought! But give me the basics first.
Jinny: I think you are already aware about how banks operate. A bank, like any other company, requires capital to start functioning. Suppose I start a bank with a capital of Rs100 crore. I set up an office and start working. What do I do? I accept deposits from one section of society and lend to another. A typical 3-6-3 banking implies that I take deposit at 3% interest, lend it at 6% and in the process I earn a cool interest of 3%. This business model looks so simple but in actual practice it is not so. All deposits that the banks mobilize are their liabilities, which they have to pay back. But there is a risk. The banks would be able to repay their depositors only when they in turn get back the money from their borrowers. Default by the borrower means that the banker will have to pay back the depositor from his own pocket. But this is possible only if the banker himself has a deep pocket. The size of the capital of the bank determines how deep the bank’s pocket is. The whole approach of prudential norms is to keep banks’ pockets safe and sound to meet any unforeseen risk.
Johnny: But how do the Basel norms fit in this kind of risk management? Do they make it compulsory for bankers to wear six-pocket cargo jeans?
Jinny: You may not see a banker in cargos, but all banks have to maintain a two-tier capital structure—tier I and tier II—in terms of prudential guidelines. Tier I capital of a bank is a pocket where you keep all your solid money.?Tier II capital is a pocket where you keep your loose change along with borrowed money. Basel I norms provide guidelines for sound capital structure of banks commensurate with the risk associated with their assets. These norms were accepted by various countries’ central banks including our Reserve Bank of India (RBI). Basel I talks about safe capital adequacy ratio (CAR) for banks. CAR is a ratio of capital to risk-weighted assets of the bank. It tells how deep a bank’s pocket is for absorbing the risk of default associated with different borrowers.
Johnny: Now you are confusing me. How can an asset be risky?
Jinny: Understand it this way. All the lending of a bank is its asset. But lending to different entities has different risk of default associated with it. So there are different risk weights for different assets. For instance, lending to government is considered less risky. So a very small risk weight of 2.5% is applied. Suppose you lend Rs100 to the government. The risk-weighted value of this asset would be 2.5% of 100, which turns out to be Rs2.50. Similarly, lending to commercial real estate is considered highly risky and hence RBI prescribes a risk weight of 150% to any loan to this sector. So the risk-weighted value of any loan of Rs100 to this sector would be Rs150. The ratio of capital to risk-weighted assets tells you how far the capital of the bank is able to cover the value of its risk-weighted assets. A bank having a CAR of 10% means that for every Rs100 of risk-weighted assets, the bank is keeping Rs10 as its capital.
(The rest of the talk on prudential norms will continue next week.)
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org