Regulatory authorities in India have been implementing Ind AS in phased manner since 2016. The Ministry of Corporate Affairs had issued two notifications – first, for phase-wise implementation of Ind AS among non-banking non-financial companies (NBNC) and second, for phase-wise implementation of Ind AS among non-banking financial companies (NBFC). While the phase-wise implementation among NBNCs started from 1st April, 2016, those for NBFCs started from 1st April, 2018. However, for banking companies, the implementation schedule was notified by the Reserve Bank of India, as per which the implementation among banks will commence from 1st April, 2019.
Upon implementation, several portions of sector specific regulations require modifications, however, none of the regulatory authorities have modified their existing regulatory frameworks or clarified positions wherever required.
One such aspect which requires immediate attention is computation of capital risk adequacy ratio by financial sector entities, especially treatment of other comprehensive income (OCI) (computed as per Ind AS 109) while computing Tier 1 capital.
In this write up we intend to examine, at length, whether OCI should form part Tier 1 capital for the purpose of CRAR.
Other Comprehensive Income (OCI)
Before we delve into specifics, it is pertinent to understand the meaning of OCI. Under Ind AS, the statement of profit or loss gives us Total Comprehensive Income which consists of a) profit or loss for the period and b) OCI. While the first component represents the profit or loss earned by the reporting entity during the financial year, OCI represents unrealized gains or losses from financial assets of the reporting entity.
One of the main reasons for OCI is that it protects the gains/losses of companies from oscillation. As the fair values of assets and liabilities fluctuate with the market, parking the unrealized gains in the OCI and not in the P/L account provides stability. In addition to investment and pension plan gains and losses, OCI includes hedging transactions a company performs to limit losses. By segregating OCI transactions from operating income, a financial statement reader can compare income between years and have more clarity about the sources of income.
While profit or loss earned during the year forms part of the surplus or other reserves in the balance sheet, OCI is shown separately under the Equity segment of the balance sheet.
Capital Risk Adequacy Ratio
Moving on to the meaning of capital risk adequacy ratio (CRAR), it is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. The CRAR is used to protect creditors and promote the stability and efficiency of financial institutions. This in turn results in providing protection against insolvency. Two types of capital are measured: tier-1 capital, which can absorb losses without a bank being required to cease trading, and tier-2 capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
The concept of CRAR comes from the Basel framework laid down by the Basel Committee on Banking Supervision (BCBS), a division of Bank of International Settlement. The latest framework being followed worldwide is Basel III framework.
RBI has also adopted the Basel framework, however, with modifications to suit the economic environment in the country. The CRAR requirements have been made applicable to banks as well as NBFCs, however, the requirements vary. While banks are required to maintain 9% as CRAR, NBFCs are required to maintain 15% CRAR.
To understand whether OCI should form part of CRAR, it is important to understand the components of CRAR.
Components of Tier 1 and 2 Capital as per RBI Master Directions for NBFCs
For the purpose of this write-up, requirements have been examined only from the point of view of NBFCs, as Ind AS is yet to be implemented for banking companies.
CRAR comprises of two parts – Tier I capital and Tier II capital. Each of the two have been defined in the Master Directions issued by the RBI, in the following manner:
(xxxii) “Tier I Capital” means owned fund as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;
The term “owned funds” have been defined as:
“owned fund” means paid up equity capital, preference shares which are 9 compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any;
Tier II capital has been defined as:
(xxxiii) “Tier II capital” includes the following:
- preference shares other than those which are compulsorily convertible into equity;
- revaluation reserves at discounted rate of fifty five percent;
- General provisions (including that for Standard Assets) and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth percent of risk weighted assets;
- hybrid debt capital instruments;
- subordinated debt; and
- perpetual debt instruments issued by a non-deposit taking non-banking financial company which is in excess of what qualifies for Tier I Capital, to the extent the aggregate does not exceed Tier I capital.
The above definition of Tier I and II capital does not talk about OCI. However, the directions were prepared before the implementation of Ind AS 109 and no clarity on the subject has come from RBI post implementation of Ind AS 109.
In this regard, we can draw reference from Basel framework.
Components of Tier I capital as per Basel III framework
As per Para 52 of the framework, he Tier 1 capital consists of:
Common Equity Tier 1 capital consists of the sum of the following elements:
- Common shares issued by the bank that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies);
- Stock surplus (share premium) resulting from the issue of instruments included Common Equity Tier 1;
- Retained earnings;
- Accumulated other comprehensive income and other disclosed reserves;
- Common shares issued by consolidated subsidiaries of the bank and held by third parties (ie minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital. See section 4 for the relevant criteria; and
- Regulatory adjustments applied in the calculation of Common Equity Tier 1
Retained earnings and other comprehensive income include interim profit or loss. National authorities may consider appropriate audit, verification or review procedures. Dividends are removed from Common Equity Tier 1 in accordance with applicable accounting standards. The treatment of minority interest and the regulatory adjustments applied in the calculation of Common Equity Tier 1 are addressed in separate sections.
The Basel III norms clearly states that accumulated other comprehensive income forms a part of the Tier I capital.
It is very interesting to note that RBI had also adopted Basel III framework on July 1, 2015, however, the framework adopted and introduced is silent on the treatment of the OCI, unlike the original Basel III framework. The reason for omission of the concept of OCI is that the framework was adopted in India way before Ind AS implementation and under the erstwhile IGAAP, there was no concept of OCI or booking of unrealized gains or losses in the books of accounts.
It is well understood that due to the very recent implementation of IndAS 109, the guidelines have not been revised in line with the IndAS. However, going by the spirit of Basel III regulation, this leaves us very little doubt what the treatment of OCI for the purpose of CRAR computation. Therefore, one can safely conclude that the OCI should form part of Tier I capital, unless, anything contrary is issued by the RBI subsequently.