Caerletti (2005) states that the role
of a bank is just like a bridge between borrowers/firms and depositors because
it is involved in taking money from depositors and lending it to
borrowers/firms. Banks rely upon depositors for their funding and they act as
the major source of funds for bank. The practice of banking makes banks expose
to severe risks because of their core functions (lending),the structure of
banking institutions (limited liability structure) permit them to take undue
risk without facing downside risk (risk of loss of investment), but depositors
have to face serious downside risk. Capital requirement standards obligate
banks to maintain a minimum capital level and thus protect depositors against
unnecessary risk taking decisions of management.

 

Basel committee on banking supervision (1988)
in their report (Basel
accord I) had taken the first major step towards capital regulations and had
linked standards of capital to risk of assets. The G-10 members of the
committee agreed upon 8% as the minimum capital standard which is known as
capital to risk weight asset ratio (CRAR). For their purpose they had explained
both capital and the risk weights. Capital is divided into (a) Core capital (b)
Supplementary capital. The core capital is mainly composed of equity and
announced reserves. Another name of core capital is tier I capital, the Basel Accord
I instructed that 50% of regulatory capital must be composed of tier I capital.
Supplementary capital is also known as tier II capital, it comprises of:

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(1)  
Undisclosed reserves: They include reserves which are not
eligible to be included in core capital; the main reason for their exclusion is
lack of transparency in the case.

(2)  
Revaluation reserves: It involves the revaluation of an
asset to bring it near to market value; in case of confirmation of fair
assessment of an asset the additional value is added to total capital under the
head of supplementary capital.

(3)  
General provisions: General provisions are meant to
cover future losses expected in particular assets. In case such assets (loans)
do not show any reduction in their worth, general provisions will become
eligible to be added in capital under the umbrella of supplementary capital.

(4)  
Hybrid debt capital instruments: This category includes
capital instruments which are enjoying the properties of both capital and debt.
All of them have special/specific qualities which decide their destiny upon
whether to be included or not in capital. In cases where these instruments have
close resemblance to capital, they are advised to be considered as capital and
are being added to capital under the umbrella of supplementary capital.

(5)  
Subordinated term debt: Subordinated debts are similar
to debt because of their feature to be unable to cover losses in positions other
than liquidation. Although subordinated loans are found to be similar to that
of debt but such a debt is eligible to be included in capital in case where its
duration/maturity is at least five years.

 

In
this regard following deductions are proposed from above mentioned categories
before considering them for CRAR:

(1)  
Goodwill (good impression in market) will be deducted
from tier 1 or core capital constituents.

Deduction from total capital (It accounts for both core
and supplementary capital) is instructed in case of investments in