Risk Management and Capital Adequacy Norms for Banks

Abstract

The overall banking scenario has undergone a dramatic change in the wake of liberalization of markets and advent of the concept of universal banking. Commercial banks can now operate as veritable financial supermarkets offering all kinds of services under one roof. The various regulatory requirements and the presence of NPAs in banks' balance sheets introduce certain rigidities in their operating parameters. Besides, the investment options expose them to market and project risks, and brings the issue of financial fragility to the foreground. In view of the new kinds of risk affecting banks and increasing global competition faced by them, their capitalization and the efficacy of the regulatory and supervisory norms assume a greater significance. The current article explores the impact of possible changes in CRR and SLR on a bank's cut-off risk, i.e. the maximum permissible risk without any default, as well as its dependence on interest rate and capital adequacy ratio. Basel II norms for taking market risk into account, the use of Value at Risk as its measure and the recent guideline by Reserve Bank of India to relate the overall market exposure to net worth, have been examined. A method towards selection of an appropriate capital adequacy ratio to cover market risks has also been proposed.