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Capital Adequacy of Financial Intermediaries (FI)

What is a Financial Intermediary (FI)

The term financial intermediary includes Banks, Investment Companies, Insurance Companies, Development Financial Institutions, Non-Banking Finance Companies, Mutual Funds, etc. All these financial institutions assist in the transfer of savings from economic units/individuals with excess money to those that need capital for investments.

Need for Capital:

Financial Intermediaries need capital for two reasons:

  • To run operations of their business.
  • To safeguard against the losses, that may arise.

Adequate capital helps financial intermediaries to survive even during substantial losses. It gives time to re-establish the business and avoid any break in operations.

To ensure the good performance of FIs the regulatory authority (RBI) has specified the minimum capital for the FI.

This requirement is called Capital Adequacy, and it is specified for Banks and Non Banking Financial Corporations (NBFCs).

Computation of capital adequacy ratio (CAR) of banks:

For computation of CAR, we need to calculate:

  • Tier I capital

  • Tier II capital

  • Risk Weighted Assets (RWA)

Step 1: Compute Tier I capital:

Tier I capital is the most permanent and readily available support against unexpected losses. It consists of-

1. Paid up equity capital
2. Statutory reserves
3. Capital reserves
4. Other disclosed free reserves


1. Equity investments in subsidiaries
2. Intangible assets
3. Current and Accumulated Losses, if any

Step 2: Compute Risk Weighted Assets click here...

Step 3: Compute tier II capital
These are not permanent in nature or, are not readily available.

Tier II capital consists of-
1. Undisclosed reserves and cumulative perpetual preference shares- Cumulative preference shares should be fully paid and should not contain clauses which permit redemption from shareholders.

2. Revaluation Reserves (RR)- 45% of RR is only taken in calculation of tier II capital

3. General Provisions and Loss Reserves (GPLR)- Actual GPLR or 1.25% of Risk Weighted Assets, whichever is lower, is taken.

4. Hybrid Debt Capital Instruments- These combine characteristics of both equity and debt. As they are more or less similar to equity, they are included in the Tier II capital

5. Subordinated Debts- These must be fully paid up, unsecured, subordinated to the claims of other creditors, also there should be no such clause which permits redemption. The amount of subordinate debts to be taken as Tier II capital depends upon the maturity of debt. Subordianate Debt Instruments will be limited to 50% of Tier I capital.

Remaining term to maturity Discount Rate(%) Amount to be taken in %
1.Where the date of maturity is above 5 years 0 100
2.Where the date of maturity is above 4 years but doesn't exceed 5 years 20 80
3.Where the date of maturity is above 3 years but doesn't exceed 4 years 40 60
4.Where the date of maturity is above 2 years but doesn't exceed 3 years 60 40
5.Where the date of maturity is above 1 year but doesn't exceed 2 years 80 20
6.Where the date of maturity does not exceed 1 year 100 0

Note: Tier II capital cannot be more than Tier I capital.

Capital Adequacy Ratio:
Capital Adequacy Ratio = (Tier I capital + Tier II capital) / RWA

According to the present norm, the Capital Adequacy Ratio of bank as defined earlier should be at least 10%.


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