Capital Adequacy and Basel III Norms in Indian Banking

A bank is a leveraged institution by design. It funds a large book of risky assets with a small amount of its own money and a great deal of other people's, and it is that gearing which makes banking both useful and fragile. Capital regulation is the answer to the fragility. It does not stop a bank losing money; it requires the bank to hold enough of its own money that the loss falls on the shareholder before it falls on the depositor. Everything in the Basel framework, from risk weights to buffers to the leverage ratio, is an attempt to measure how much of its own money is enough.

1. What capital is for

Two misunderstandings are worth clearing first.

1. Capital is not cash. It is not money set aside in a vault. It is a claim ranking behind every other claim, which means that when an asset turns bad the loss is absorbed by the shareholder rather than by the depositor. A bank with ample capital may still be unable to pay tomorrow, which is a liquidity problem, and the liquidity standards address that separately.
2. Capital is measured against risk, not against size. A bank holding government securities is not exposed in the way a bank holding unsecured retail loans is, and so the denominator of the ratio is risk weighted assets rather than total assets. That insight is what distinguishes the Basel framework from a simple gearing limit, and the leverage ratio was later added precisely because the insight can be gamed.

2. The Basel accords

Figure 1: Four accords and their arrival in India

• Basel I, 1988. A single ratio of eight per cent of capital to risk weighted assets, with assets placed in five risk buckets and weighted at nought, ten, twenty, fifty or one hundred per cent. It addressed credit risk alone, and a 1996 amendment added market risk. Its virtue was simplicity; its defect was that it treated every corporate borrower alike.
• Basel II, 2004. The three pillars. Pillar One kept the minimum requirement but made risk weights sensitive to credit quality, offering a standardised approach based on external ratings and internal ratings based approaches for banks with the systems to use them, and it added a charge for operational risk. Pillar Two introduced supervisory review, under which a bank assesses its own capital needs and the supervisor may require more than the minimum. Pillar Three required disclosure, so that the market could judge.
• Basel III, 2010 and 2011. The response to the crisis of 2008. It improved the quality of capital by insisting on common equity, raised the quantity by adding buffers, introduced a non-risk-based leverage ratio, and for the first time set liquidity standards.
• The final reforms, December 2017. Often called Basel IV, though the Committee does not use the name. They revise the standardised approaches to credit, market and operational risk, constrain the use of internal models, and impose an output floor so that a bank using internal models cannot compute risk weighted assets below a fixed proportion of the standardised figure.

Figure 2: The three pillars, and what India added

3. The Indian minimum

The Reserve Bank has consistently applied a higher minimum than the Basel text requires, on the view that an emerging market banking system should carry a margin.

Two distinctions are worth holding on to before the figures. The first is between a minimum and a buffer. A minimum is a hard floor, and a bank that falls below it is in breach and faces supervisory action. A buffer sits above the minimum and is designed to be consumed in a downturn, the consequence being not breach but restriction. The second is between the quality of capital and its quantity. A requirement expressed in Common Equity Tier 1 cannot be met with subordinated debt however much of it the bank issues, which is why the three ratios below rise in steps rather than forming a single number.

4. What counts as capital

• Common Equity Tier 1 is paid up equity, share premium, statutory reserves, capital reserves and retained earnings, less the prescribed deductions such as goodwill, deferred tax assets and investments in the capital of other financial entities. It absorbs loss first and continuously, and it is the measure the whole framework turns on.
• Additional Tier 1 is perpetual instruments with no maturity, with discretionary and non-cumulative coupons, which are written down or converted into equity when a trigger is reached. They count as going concern capital because the write down happens while the bank is still operating.
• Tier 2 is subordinated debt of at least five years' original maturity, revaluation reserves at a discount, general provisions within a limit, and similar items. It is gone concern capital, absorbing loss only in liquidation or resolution.

Additional Tier 1 and the write down question

The whole purpose of an Additional Tier 1 instrument is that it stops being a debt when the bank is in difficulty. The investor is paid a higher coupon for accepting that. The difficulty is that the instruments were sold widely, including to retail investors, and the moment of write down arrives without warning.

5. Leverage, liquidity and the systemic surcharge

Each of these addresses a weakness that the risk weighted ratio alone could not catch.

1. The leverage ratio ignores risk weights entirely, measuring Tier 1 capital against total exposure including off balance sheet items. It is a backstop against a bank assembling a very large book of assets that happen to carry low risk weights. The Reserve Bank's circular of 28 June 2019 fixed it at four per cent for a domestic systemically important bank and three and a half per cent for other banks, from the quarter beginning 1 October 2019.
2. The liquidity coverage ratio requires enough high quality liquid assets to survive thirty days of acute stress, which is the problem capital does not solve: a solvent bank can fail because its funding runs before its assets mature.
3. The net stable funding ratio addresses the same mismatch over a one year horizon, requiring stable funding against assets that cannot be liquidated quickly.
4. The systemic surcharge requires a domestic systemically important bank to hold additional Common Equity Tier 1, from 0.20 per cent in the first bucket to 1.00 per cent in the fifth, under a framework issued on 22 July 2014 and fully effective from 1 April 2019. The list is published annually, and the logic is that a bank whose failure would damage the system should be harder to fail.

6. Prompt corrective action

Capital requirements are useless if nothing happens when they are breached. The prompt corrective action framework, revised on 2 November 2021 and effective from 1 January 2022, supplies the consequence. It applies to scheduled commercial banks other than small finance banks, payments banks and regional rural banks.

• The parameters are capital, measured by the capital to risk weighted assets ratio and the Common Equity Tier 1 ratio; asset quality, measured by the net non-performing assets ratio; and leverage, measured by the Tier 1 leverage ratio. Each has three risk thresholds, and the threshold breached determines the action taken.
• The return on assets trigger of the earlier framework, which brought a bank into the net for negative returns over consecutive years, was removed, on the view that profitability is an outcome rather than a measure of soundness.
• Mandatory actions at the first threshold include restrictions on dividend distribution and remittance of profits, and a requirement that promoters bring in capital. Higher thresholds bring restrictions on branch expansion, on capital expenditure other than board approved technology upgrades, and on variable operating costs.
• Discretionary actions extend to restrictions on lending, on management compensation and directors' fees, on the entities a bank may deal with, and ultimately to resolution by amalgamation or reconstruction under Section 45 of the Banking Regulation Act, 1949.
• Exit requires that no risk threshold be breached on any parameter for four consecutive quarterly statements, of which one must be the audited annual statement, and that the Reserve Bank be satisfied that the improvement is sustainable.

7. Where the framework is going

The Reserve Bank has been reissuing the Basel framework as Directions rather than circulars, and implementing the final reforms of 2017 in stages.

• The Prudential Norms on Capital Adequacy Directions consolidate the capital framework for commercial banks and are amended periodically. The amendments of 2026 removed the condition that tied the inclusion of quarterly profits in Common Equity Tier 1 to the bank's non-performing asset provisioning pattern, extended counterparty credit risk measurement to the trading exposures of all consolidated entities, revised the add on factors used to estimate future exposure on derivatives, and fixed a two per cent risk weight for trades cleared through a qualifying central counterparty.
• The Capital Charge for Credit Risk, Standardised Approach Directions, 2026, issued on 27 April 2026, replace the existing standardised credit risk framework from 1 April 2027, with more granular risk weights, an external rating based approach for exposures to banks, finer distinctions within commercial and residential real estate, an incremental charge for unhedged foreign currency exposures, and differential treatment for micro, small and medium enterprises and regulatory retail exposures.
• The Minimum Capital Requirements for Market Risk Directions, 2026, issued on 21 September 2026 and effective from 1 April 2027, prescribe a simplified standardised approach for market risk, define the boundary between the banking book and the trading book, deal with internal risk transfers, and prescribe the disclosures.
• Small finance banks, payments banks and local area banks are outside these Directions and continue under the existing framework.

8. Quick Revision

1. Capital is a claim ranking last, not a reserve of cash.
2. The denominator is risk weighted assets, which is why a leverage backstop was needed.
3. Common Equity Tier 1 absorbs loss first; Additional Tier 1 is written down or converted on a trigger; Tier 2 absorbs loss only on liquidation.
4. The conservation buffer is usable, at the price of restrictions on distribution.
5. A domestic systemically important bank carries an extra common equity requirement by bucket.
6. The return on assets trigger was removed from the prompt corrective action framework in 2021.
7. Breach of the third threshold can lead to resolution under Section 45.
8. The final Basel reforms reach India for credit and market risk from 1 April 2027.

9. Frequently Asked Questions

Why does India require nine per cent when Basel requires eight?

Partly history and partly judgement. The additional percentage point was introduced when Indian banks were emerging from a period in which their accounts had not disclosed their condition, and it has been retained on the view that an emerging market banking system faces greater volatility in asset quality, has thinner capital markets to raise fresh equity from, and carries a large share of exposures that are not externally rated. The Basel minimums are a floor and not a ceiling, and a national supervisor is expressly free to require more. India also applies the full conservation buffer on top, so the effective requirement is eleven and a half per cent against ten and a half.

Why was a leverage ratio added when the capital ratio already existed?

Because the risk weighted ratio can be satisfied by a bank that is enormously geared. If a bank assembles a very large book of assets that carry low risk weights, sovereign exposures, highly rated counterparties, or positions whose risk its own model assesses as small, the denominator of the ratio stays low while the balance sheet grows. That is exactly what happened before 2008. The leverage ratio takes no account of risk weights at all, measuring Tier 1 capital against total exposure including off balance sheet items, and acts as a simple backstop that cannot be engineered around.

If Additional Tier 1 bonds can be written down, why does anyone buy them?

For the coupon. The instruments pay materially more than senior debt precisely because the investor is accepting that the instrument converts or disappears when the bank is in difficulty. That is the bargain, and in institutional hands it is an intelligible one. The difficulty exposed by the Yes Bank episode was that the instruments had been sold to investors who did not understand it, in some cases as substitutes for fixed deposits, and the regulatory response has been to restrict their sale to retail investors, to raise the minimum investment size and to tighten the disclosure required at the point of sale.

What is the difference between capital adequacy and prompt corrective action?

Capital adequacy states the requirement; prompt corrective action states the consequence of falling short. Without the second, a breach would be dealt with case by case, which in practice means late and under pressure from the bank and its owners. The framework removes that discretion by linking defined thresholds on capital, net non-performing assets and leverage to defined mandatory actions, beginning with restrictions on dividends and rising through limits on branch expansion and capital expenditure to the possibility of resolution. Its purpose is to force intervention while intervention can still work.

Does a higher capital ratio always mean a safer bank?

Not by itself, and the reasons are structural. The ratio depends on the denominator, and the denominator depends on risk weights which are either prescribed or, where internal models are permitted, estimated by the bank. A bank may show a comfortable ratio while holding assets whose risk is understated, and the final Basel reforms exist precisely because that happened. The ratio also says nothing about liquidity, so a well capitalised bank can still fail if its funding runs, which is why the liquidity coverage and net stable funding ratios were added. The ratio is therefore a necessary measure and not a sufficient one, and it must be read with asset quality, provisioning coverage, leverage and the liquidity standards together.

What is the output floor, and why was it the hardest part of the final reforms to agree?

The output floor requires a bank using internal models to compute risk weighted assets that are not less than a fixed proportion of what the standardised approach would produce. Without it, a bank with sophisticated models can report far lower risk weights than a bank holding identical assets under the standardised approach, and the comparison between the two becomes meaningless. It was the most contested element of the 2017 package because its effect falls unevenly: jurisdictions whose large banks rely heavily on internal models face a substantial increase in required capital, while jurisdictions such as India, where the standardised approach predominates, are affected far less. That is also why the Indian implementation has concentrated on making the standardised approaches themselves more risk sensitive rather than on constraining models.

Why are small finance banks and payments banks outside the new Directions?

Because the final Basel reforms are calibrated for institutions with large and complex books, and the cost of applying them to a small institution would exceed any gain in precision. A payments bank takes no credit risk at all, since it may not lend, and a small finance bank's book is concentrated in small ticket exposures for which the existing standardised treatment is adequate. Both nonetheless remain subject to the minimum capital ratios, the cash reserve and statutory liquidity requirements and the ordinary prudential framework; what they are spared is the revised standardised approach for credit risk and the market risk Directions, both of which take effect for commercial banks from 1 April 2027.

10. Related Topics and Provisions

• Capital, reserve fund and shareholding under the Banking Regulation Act, 1949
• Non-performing assets: classification and provisioning
• Financial stability, systemically important banks and the resolution gap
• Moratorium, reconstruction and amalgamation under Section 45
• Banking sector reform and the Narasimham Committees
• Cyber security, outsourcing and operational risk in banks