Capital Structure of Banks in India
[By Ms. Sailashree, PG Student, IIT, Roork]

Preface

Module: 1 - Key Role of Capital in Corporate Finance

Subsequent to its incorporation and securing a legal status, the first task of a corporate entity is to proceed to mobilize its capital. The entity can receive public credibility and acceptance only after its capital is adequately subscribed. After contribution of promoters' quota and completion of all legal formalities, the offer to the public inviting them to subscribe to the capital of the company is made either through the IPO route or though private placement. Incorporation of the company gives it a legal status. Investing it with adequate capital transforms it as a business entity. Thus the first cash flow into the company is by way of the in-flows on account of capita subscriptions. The capital represents the ownership rights of the company. The Authorised Capital, Issued Capital, Subscribed Capital and Paid-up Capital are all to be disclosed in the company's balance sheet. Capital of the Company consists of different types like Equity Capital, Preference Capital, long-term Loan-Capital or Debt-capital (Debentures or Bonds) and short-term loan capital (Working Capital). The performance of the company is rated on the basis of the return it is able to generate on its capital through the process of its business or service activities.

The capital of a corporate body in the strict sense represents only the shareholders' equity and retained earnings. This is called the risk capital. The equity share capital contributed by shareholders is not returnable to them. The corporate body is also not bound by law to declare dividends. However as a measure of judicious financial policy corporates always strive towards maximization of equity shareholders wealth. This is accepted as the objective of prudent financial management. Capital of the firm represents the shareholders (owners) stake in the business. It is intended to provide for its stability and continuity and helps to cross over temporary periods of crisis. It also acts as a source of confidence to the other stakeholders of the business and motivates them to come forward and to play their respective roles effectively.

From a broader perspective the capital of the firm may include certain other types of long-term liabilities in addition to the shareholders stake. Thus it may include preference share capital, and, debentures, which may be irredeemable, or redeemable over the long term. Though these are repayable, unless the terms of issue specifically term them as irredeemable, their redemption is considered as normally being not met out of the assets of the company but out of current and future earnings. Where the corporate body is showing adequate profitability, they need not be considered as a direct burden on the assets of the company. These sources may be specified as Tier II Capital, to distinguish them from owners' equity.

'Banking' as defined under Section 5 (b) of the Banking Regulations Act, 1949 is the business of "accepting deposits of money from the public for the purpose of lending or investment". These deposits are "repayable on demand or otherwise, and withdrawable by a cheque, draft, order or otherwise". The deposits accepted by a Banking Company are different from those accepted by Non Banking Finance Companies or any other company in the nature in which these are repayable. Banks are the only financial institutes, which can accept demand deposits (Saving / Current), which can be withdrawn by a cheque. There is an explicit obligation for the banker to return the money to the depositor or to his order whenever demanded if accepted payable on demand, and on the expiry of the term, if accepted for a fixed tenure. There is on the other hand also a potential risk faced by the banker that his investments may depreciate in value or that he may face counterparty default in the recovery of his advances. Thus while the assets of the bank are risk-oriented and may not be forthcoming in full in times of need as a source to meet his payment obligations, the liabilities of the Bank exert a binding compulsion on it for prompt discharge without fail whenever demanded or due. Holding adequate capital is the only protection for the banker to ward against the potential hazards that he may have to face in meeting his payment obligations.

Since commercial banks, as financial intermediaries, mobilise huge savings from the public accumulating demand and short-term liabilities to deploy these funds in a portfolio of investment and credit products, it devolves a huge customer base and thrives on customer support. A commercial bank survives and sustains itself on account of the implicit trust and confidence reposed by the public in its solvency and creditworthiness. The adequacy of the capital of the Institution, guaranteeing its assured ability to discharge its payment obligation at any time, is the solid edifice on which this confidence and trustworthiness are built. It also has relevance in assessing the risk bearing capacity of the bank and its ability to absorb shocks and adverse developments in its business. By nature of its credit dispensation business a commercial bank faces diverse risks. The quality of its assets may deteriorate at any time resulting in an unexpected erosion of the intrinsic worth of such deteriorated assets. Holding of adequate capital is a source of strength to meet such contingencies. As per the recent norms of RBI a new private bank to be eligible for being given banking licence must have a minimum of Rs.500 Crore of Capital provided by the promoters. Obviously the quantum of capital requirement will increase proportionately as business develops and increases in size and volume. This is true for all businesses, and banks cannot be an exception. What then are the considerations that a banker should weigh in arriving at the optimum quantum of capital that he should hold to serve the best interest of his business and what should be its structure? Recent developments in the field international banking has crystallised thinking on this subject into definite norms on the questions of capital adequacy and capital structure of banks, bringing global standards into focus.

Capital adequacy is not only relevant in respect of Banks but also of all financial institutions. Capital has a decisive and significant role in the case of all financial intermediaries. The term financial intermediary includes Banks, Investment Companies, Insurance Companies, Development Financial Institutions, Non-Banking Finance Companies, Mutual Funds, etc. All these financial institutions assist in the transfer of savings from economic units/individuals with excess money to those that need capital for investments.

Financial Intermediaries need capital for two reasons:

1. To run operations of their business.

2. To safeguard against the losses, that may arise.

Holding adequate capital helps financial intermediaries to survive even during substantial losses. It gives time to re-establish the business and avoid any break in operations.

To ensure uninterrupted good performance of Financial Institutions the regulatory authorities have specified the minimum capital for them. This requirement is called Capital Adequacy. RBI has specified it for Banks and Non Banking Financial Corporations (NBFCs). SEBI in turn has prescribed Capital Adequacy for all financial intermediaries under its regulatory authority. IRDA similarly decides the capital requirement of Insurance Companies.

But traditionally the concept of capital adequacy linking capital to size and volume of financial operations was not realized. It was only in the 1980s the importance of possessing adequate capital was realized at the level of international banking. Recent developments in the field of international banking are brought in a debate in the Lok Sabha of Indian Parliament.

"Traditionally, deposit taking and lending or the interest payments has been the core business of the banks. But the greater financial deregulation in the world during the Eighties, coupled with revolutionary advances in the communications technology, has changed the very nature of banking. It has unleashed greater competitive pressures. Banks are now deriving an ever-increasing percentage of income from sources other than interest from merchant banking operations such as, trading in securities, brokerage, portfolio management services, underwriting, and providing back up liquidity.

"Greater portion of credit and liquidity exposure is being incurred by off balance sheet items and inter bank transactions, leading to reduced transparency. "There is a general agreement that the system needed reforms to better suit the needs of supplier and users of funds. The Bank of International Settlements (BIS) based in Basle, which is a Central Banker's bank, had set a Committee consisting of several Governors of the Central Banks- "the Committee on Banking Regulations and Supervisory Practice" in 1988. This Committee released a broad framework of standards, which are known as BIS standards. They are followed by all the banks in the world, particularly those operating in international fields."(Extract from a debate in the Lok Sabha dated 19.08.92)

The growing concern of commercial banks regarding international competitiveness and capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries, to be achieved by year-end 1992. The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The document consists of two broad sections, which cover:

1. The definition of capital and

2. The structure of risk weights.

The Basel Accord 1988 for the first time brought out the need that the capital of a bank should be directly in proportion not only to its risk-based assets, but also to the risk-weight age (quality) thereof. The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of the G10 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition. Capital is necessary for banks as a cushion against losses and it provides an incentive for the owners of the business to manage it in a prudent manner.

The 1988 Accord requires internationally active banks in the G10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their risk-content. The definition of capital is set (broadly) in two tiers, Tier 1 being shareholders' equity and retained earnings and Tier 2 being additional internal and external resources available to the bank. The bank has to hold at least half of its measured capital in Tier 1 form.

A portfolio approach is taken to the measure of risk, with assets classified into four buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that some assets (essentially bank holdings of government assets such as Treasury Bills and bonds) have no capital requirement, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claim. However, virtually all claims on the non-bank private sector receive the standard 8% capital requirement. There is also a scale of charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc. This is the only complex section of the 1988 Accord and requires a two-step approach whereby banks convert their off-balance-sheet positions into a credit equivalent amount through a scale of conversion factors, which then are weighted according to the counterparty's risk weighting.

The 1988 Accord has been supplemented a number of times, with most changes dealing with the treatment of off-balance-sheet activities. A significant amendment was enacted in 1996, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument.

The two principal purposes of the Accord were to ensure an adequate level of capital in the international banking system and to create a "more level playing field" in competitive terms so that banks could no longer build business volume without adequate capital backing. These two objectives have been achieved. The merits of the Accord were widely recognized and during the 1990s the Accord became an accepted world standard, with well over 100 countries applying the Basel framework to their banking system.

However, there also have been some less positive features. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. The simple bucket approach with a flat 8% charge for claims on the private sector has given banks an incentive to move high quality assets off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the 1988 Accord does not sufficiently recognize credit risk mitigation techniques, such as collateral and guarantees. These are the principal reasons why the Basel Committee decided to propose a more risk-sensitive framework in June 1999. The second accord is also finalised now and is to come into operation from the end of year 2006. Broad outlines of the second accord are given in Annexure I. We will study more about the 1988 Accord in Module No.2.