Banking Regulation, Capital Adequacy & Risk Management
This is the most technically precise chapter in Finance & Management, and it is graded accordingly — a vague answer about "banks needing enough capital" scores far below one that cites the exact CRAR percentage, the exact day-count for NPA classification, or the exact risk category being tested.
1. Capital adequacy — India holds banks to a higher bar than Basel III's minimum
The Basel III global minimum Capital-to-Risk-weighted-Assets Ratio (CRAR) is 8%, but RBI requires Indian banks to hold a minimum CRAR of 9% — a stricter domestic requirement reflecting the sector's historical exposure to stressed assets.
Layered on top of the 9% minimum is a 2.5% Capital Conservation Buffer, making the effective well-capitalised threshold 11.5% — a bank operating below this combined threshold faces restrictions on discretionary distributions (like dividends and bonuses) even if it remains technically solvent, since the buffer exists specifically to ensure banks retain capital during good times to absorb losses during stress.
Within total capital, RBI additionally requires a minimum Common Equity Tier 1 (CET1) ratio of 5.5% of risk-weighted assets — higher than Basel III's own 4.5% CET1 minimum — and a minimum Tier 1 capital ratio of 7%. CET1 (predominantly common equity and retained earnings) is capital's highest-quality, most loss-absorbing layer, which is why regulators set its minimum above and beyond the overall CRAR figure rather than trusting banks to self-allocate quality within the total.
Small Finance Banks (SFBs) face a materially higher CRAR requirement of 15%, reflecting the higher credit risk inherent in lending to the underserved borrower segments SFBs specifically target.
2. Asset classification — the 90-day rule and its categories
An asset becomes a Non-Performing Asset (NPA) the moment interest or principal remains overdue for more than 90 days — a strict, date-based rule with no discretion for a bank to classify a genuinely-overdue account as still performing based on its own judgment of the borrower's prospects.
Once classified as an NPA, an asset moves through three further sub-categories based on how long it has remained non-performing: Sub-standard (NPA for up to 12 months), Doubtful (NPA for more than 12 months), and Loss (an asset identified as virtually uncollectible, where continuing to carry it as a bankable asset is not warranted even though some recovery value may remain).
Each sub-category carries a progressively higher mandatory provisioning requirement, since deeper-aged NPAs are judged progressively less likely to be recovered.
3. Resolution and the Prompt Corrective Action framework
Prompt Corrective Action (PCA) is RBI's structured early-intervention framework, triggered automatically when a bank's key financial-health metrics — CRAR, net NPA ratio, or return on assets — breach specified thresholds, rather than waiting for a full-blown crisis to force intervention.
Once a bank is placed under PCA, RBI can impose graduated restrictions: limits on branch expansion, restrictions or prohibitions on dividend payments, curbs on certain categories of lending, and management-related restrictions in more severe cases — the explicit design goal being to correct a weakening bank's trajectory before deposit-taking or systemic stability is actually threatened.
4. The four risk types every bank manages
Banks manage four analytically distinct risk categories, and F&M questions frequently ask a candidate to correctly identify which risk type a given scenario illustrates.
| Risk type | What it captures | Example trigger |
|---|---|---|
| Credit risk | Risk a borrower fails to repay | Loan default, NPA formation |
| Market risk | Risk from adverse movements in market prices | Interest-rate change, equity/forex price swing on a held position |
| Operational risk | Risk from failed internal processes, people, systems, or external events | System outage, fraud, process failure |
| Liquidity risk | Risk of being unable to meet short-term obligations despite being solvent | A sudden deposit outflow the bank cannot fund without a distressed asset sale |
A bank can be fully solvent (assets exceed liabilities) and still fail from a liquidity crisis — solvency and liquidity are genuinely different conditions, and this distinction is a recurring source of confusion in risk-management answers: a solvency problem means the bank's true net worth is negative, while a liquidity problem means the bank cannot convert assets to cash fast enough to meet an immediate obligation, even though its underlying net worth may still be positive.
Worked Examples
Example 1. What is RBI's minimum CRAR requirement for Indian banks, and how does it compare to the global Basel III minimum?
9%, compared to Basel III's global minimum of 8% — RBI's requirement is stricter than the international floor.
Example 2. What is the effective well-capitalised CRAR threshold once the Capital Conservation Buffer is included?
11.5% (9% minimum CRAR + 2.5% Capital Conservation Buffer).
Example 3. A borrower's loan account has interest overdue for 95 days. Is this account an NPA?
Yes — an asset becomes an NPA once interest or principal remains overdue for more than 90 days, and 95 days exceeds that threshold.
Example 4. An NPA has remained non-performing for 14 months. Which asset-classification sub-category does it fall into?
Doubtful (NPA for more than 12 months).
Example 5. A bank's CRAR falls below RBI's required threshold. What kind of RBI action is triggered, and name two possible restrictions.
Prompt Corrective Action (PCA) — possible restrictions include limits on branch expansion and restrictions on dividend payments.
Example 6. A bank is fully solvent but cannot meet a sudden, large deposit withdrawal request without selling assets at a loss. Which risk type does this illustrate?
Liquidity risk — the bank's underlying net worth may remain positive (it is solvent), but it cannot convert assets to cash quickly enough to meet the immediate obligation.
Example 7. Classify the risk type in each scenario: (a) a core banking system outage prevents transactions for six hours, (b) a sharp rise in interest rates reduces the market value of the bank's bond holdings.
(a) Operational risk. (b) Market risk.
Summary
RBI holds Indian banks to a stricter capital-adequacy bar than the global Basel III minimum: 9% CRAR (vs. 8% globally), 11.5% effective threshold once the 2.5% Capital Conservation Buffer is added, 5.5% minimum CET1 (vs. 4.5% globally), and 15% CRAR for Small Finance Banks specifically.
Asset classification follows a strict 90-day overdue rule for NPA status, with Sub-standard, Doubtful and Loss as the three progressively-aged sub-categories carrying progressively higher provisioning requirements — and PCA is RBI's automatic, threshold-triggered early-intervention framework for banks whose CRAR, NPA ratio or ROA breaches specified limits.
The four risk types — credit, market, operational and liquidity — are analytically distinct, and the solvency-versus-liquidity distinction in particular (a bank can be solvent yet still fail from a liquidity crisis) is a frequently tested conceptual anchor across this entire risk-management topic.
