Capital adequacy
Also written Capital adequacy requirement
The minimum net worth an intermediary must have to be registered and must keep while registered — e.g. Rs 50 crore for a Category I merchant banker, Rs 75 crore for a custodian, Rs 10 crore for a debenture trustee.
In plain language
A client may hand money, shares or a mandate to an intermediary. If that intermediary goes bust, the client is at risk.
Capital adequacy is how the regulator deals with this. Some intermediaries must show a minimum net worth before SEBI registers them. They must keep it for as long as they stay registered. Net worth here is their own money. It stands between their mistakes and their clients.
The amount is not the same for every activity, because the risk is not the same. A custodian holds the assets of big institutions for safekeeping. It needs far more than an intermediary that mainly does research.
For some intermediaries, the rules go further. They test how much capital there is. They also test how much of it is liquid, which means how much can be turned into cash quickly.
How it works
Figures across the workbook.
| Intermediary | Requirement | Notes | Chapter |
|---|---|---|---|
| Merchant banker, Category I | Net worth Rs 50 crore; liquid net worth Rs 12.5 crore | Failing either: no fresh permitted activity until complied with | 13 |
| Merchant banker, Category II | Net worth Rs 10 crore; liquid net worth Rs 2.5 crore | As above | 13 |
| Custodian | Net worth Rs 75 crore | Separately and independently of capital adequacy for other activities; existing custodians get three years from the 2025 amendment | 22 |
| Debenture trustee | Net worth Rs 10 crore | Existing trustees got three years from the 2019 amendment | 20 |
| Credit rating agency | Net worth Rs 25 crore | To be maintained at all times | 21 |
| KYC registration agency | Net worth Rs 25 crore | On a continuous basis | 10 |
| Portfolio manager | Net worth Rs 5 crore | Maintained at all times; not applicable to a co-investment portfolio manager | 12 |
| Stock broker becoming a depository participant | Rs 3 crore, rising to Rs 5 crore | Phased under the 2022 amendment | 16 |
| Corporate stock broker offering margin trading | Rs 3 crore | Auditor's half-yearly net worth certificate as on 31 March / 30 September, due by 30 April / 31 October | 12 |
Definitions. For a merchant banker, net worth of a body corporate has the meaning in section 2(57) of the Companies Act, 2013; for an LLP it is the partners' fixed contributions plus reserves and surplus. "Liquid assets" are low-risk assets convertible to cash quickly — cash, fixed deposits, government securities, money market instruments, treasury bills, repo on government securities and acceptable marketable securities with haircuts.
Capital also limits activity. In margin trading, a broker's total indebtedness for MTF may not exceed 5 times net worth; its maximum MTF exposure may not exceed borrowed funds plus 50% of net worth; and exposure to a single client may not exceed 10% of that maximum.
Enforcement. Failure to meet minimum net worth or liquid net worth is one of the grounds on which SEBI may use the special procedure under the Intermediaries Regulations, without a designated authority enquiry.
A worked example
Illustrative figures. Kaveri Financial Services Ltd holds three registrations and wants a fourth.
1. Can it be a custodian as well as a debenture trustee?
Custodian requirement = Rs 75 crore, separately and independently
Debenture trustee = Rs 10 crore
Net worth needed = Rs 85 crore — not Rs 75 crore
Its audited net worth is Rs 80 crore. It meets each figure on its own, but not the custodian figure "separately and independently" of the trustee business. It needs Rs 5 crore more.
2. How much margin trading can its broking arm do? The broking subsidiary has net worth of Rs 12 crore and has borrowed Rs 40 crore from banks for MTF.
| Limit | Computation | Amount |
|---|---|---|
| Total MTF indebtedness | 5 × Rs 12 crore | Rs 60 crore — Rs 40 crore is within it |
| Maximum MTF exposure | Rs 40 crore + 50% × Rs 12 crore | Rs 46 crore |
| Exposure to any single client | 10% × Rs 46 crore | Rs 4.6 crore |
A high-net-worth client asking for Rs 7 crore of funding gets Rs 4.6 crore.
3. Its merchant banking arm (Category II). Net worth Rs 11 crore, liquid net worth Rs 2.1 crore. It meets Rs 10 crore but misses the Rs 2.5 crore liquid test by Rs 0.4 crore — so it may take no fresh permitted activity until the shortfall is cured, although its existing mandates continue.
Why NISM asks about it
Capital adequacy is a registration condition in almost every activity chapter of the III-A paper — Chapters 10, 12, 13, 16, 20, 21 and 22 — and Chapter 20 (SEBI (Debenture Trustees) Regulations, 1993) names "capital adequacy requirements for debenture trustee" as a learning objective. Chapter 6 lists failure to meet net worth among the grounds for the special procedure.
The paper tests the figures directly. A one-page table of every intermediary's net worth is worth building for revision.
Common exam traps
- Merchant bankers have two tests — net worth and liquid net worth. Meeting one is not enough.
- Custodian: Rs 75 crore "separately and independently" of capital needed for any other regulated activity.
- Credit rating agency: Rs 25 crore for the agency — but a corporate promoter of a CRA needs a continuous Rs 100 crore net worth for five years.
- Portfolio manager: Rs 5 crore, which does not apply to a co-investment portfolio manager.
- MTF exposure is borrowed funds plus 50% of net worth, and a single client is capped at 10% of that — not 10% of net worth.
- Transition periods differ: three years from the 2019 amendment for debenture trustees; three years from the 2025 amendment for custodians.
- Consequence for a merchant banker is prospective: no fresh permitted activity — not automatic cancellation.
Check yourself
1.What is the capital adequacy requirement for a debenture trustee?
- a)Net worth of not less than ten crore rupees
- b)Net worth of not less than one crore rupees
- c)Net worth of not less than five crore rupees
- d)There is no net worth requirement
Show the answer
Answer: (a) Net worth of not less than ten crore rupees
The capital adequacy requirement shall not be less than the net worth of ten crore rupees, provided that a debenture trustee holding certificate of registration as on the date of commencement of the Securities and Exchange Board of India (Debenture Trustees) (Amendment) Regulations, 2019 shall fulfil the net worth requirements within three years from the date of such commencement.
Rs. 10 crore, with a three-year transition for existing trustees.
Option C states the portfolio manager's figure — the net worth requirement shall be not less than Rs.5 crores under those Regulations.
The obligation is continuous, not merely at entry. A debenture trustee shall maintain the net worth requirements as specified in the regulations continuously and shall inform SEBI immediately in respect of any shortfall in the net worth and such a case it shall not be entitled to undertake new assignments until it restores the net worth to the level of specified requirement within the time specified by SEBI.
A shortfall stops new business — existing trusteeships continue, since no debenture trustee shall relinquish its assignments... unless and until another debenture trustee is appointed in its place.
And the net worth must be protected from the trustee's other lines of business. Where it undertakes permitted activities beyond trusteeship, a debenture trustee shall ensure that the net worth specified under these regulations is ring-fenced from any adverse impact that may arise from undertaking the activities specified, those activities being fee-based, non-fund based and conducted on an arms-length basis through separate business units.
Capital adequacy is also one of the registration criteria, alongside infrastructure, experienced personnel, at least one person who possesses the professional qualification in law, clean records and fit and proper status.
2.Which of the following may apply for registration as a debenture trustee?
- a)All of the above — a scheduled bank, a public financial institution and an insurance company
- b)A scheduled bank only
- c)A public financial institution only
- d)An insurance company only
Show the answer
Answer: (a) All of the above — a scheduled bank, a public financial institution and an insurance company
No person shall be entitled to act as a debenture trustee unless he is either – a) a scheduled bank carrying on commercial activity; or b) a public financial institution within the meaning of section 2(72) of the Companies Act, 2013; or c) an insurance company; or d) body corporate as defined under sub-section (11) of section 2 of the Companies Act, 2013.
Four eligible classes — the three named in the options, plus a body corporate.
Eligibility is only the first hurdle. SEBI also requires the necessary infrastructure like adequate office space, equipment's and manpower; any experience as a debenture trustee or... a minimum of two persons who had the experience in matters which are relevant to a debenture trustee; that no connected person has been refused registration; at least one person who possesses the professional qualification in law from an institution recognised by the Government; no director or principal officer convicted for any offence involving moral turpitude or... found guilty of any economic offence; fit and proper status under the SEBI (Intermediaries) Regulations, 2008; and fulfilment of the capital adequacy requirements — net worth of ten crore rupees.
The legal qualification is distinctive. A trustee must read and enforce a trust deed, so at least one lawyer is required in-house.
Fees: fifty thousand rupees with the application, twenty lakh rupees on grant paid within fifteen days from the date of receipt of intimation from SEBI, and nine lakh rupees every three years from the sixth year paid three months before the expiry of the block.
And note that eligibility as an institution does not guarantee eligibility for a particular issue. A bank may not be appointed where it has lent and the loan is not yet fully repaid or is proposing to lend money to the body corporate.
3."The applicant for merchant banker should necessarily fulfil the capital adequacy requirement as specified in the SEBI (Merchant Bankers) Regulation." True or False?
- a)True
- b)False
Show the answer
Answer: (a) True
It is an express eligibility condition and a continuing one.
Regulation 6(i) requires that the applicant satisfies the capital adequacy requirements and is a fit and proper person.
And Regulation 7 sets the figures: a net worth of not less than– 1. fifty crore rupees for Category I merchant banker, and 2. ten crore rupees for Category II merchant banker.
Regulation 7A adds liquid net worth: twelve crore fifty lakh rupees for Category I merchant banker, and two crore fifty lakh rupees for Category II merchant banker — liquid assets meaning low risk assets that can be converted into cash in a short period of time such as cash, fixed deposits, government securities, money markets instruments, treasury bills, repo on government securities and acceptable marketable securities with applicable haircut.
The obligation does not end at registration. Among the conditions of registration, the merchant banker shall maintain capital adequacy requirements at all times during the period of the certificate.
And the consequence of a shortfall is immediate and automatic. On either test, a merchant banker that fails shall not undertake any fresh permitted activity, till such time it complies with the requirement — without prejudice to any action that may be taken by the Board.
Not a fine, but a stop on new business.
Breach must also be reported. Among the disclosures to SEBI is the particulars relating to the breach of the capital adequacy requirements as mentioned in the regulation.
Net worth is defined — for a body corporate as in sub-section (57) of section 2 of the Companies Act, 2013, and for an LLP as the sum of the partners' contributions (fixed) plus reserves and surplus.
One narrow exemption exists: merchant bankers handling only debt/hybrid issues are exempt from revenue requirements.
Where this is taught
Free preparation for NISM Series III-ARelated terms
- Liquid Net WorthThe part of a merchant banker's net worth deployed in unencumbered liquid assets, counted after a prescribed haircut on each asset type — a second capital test that net worth alone cannot satisfy.
- Margin trading facilityA SEBI-regulated facility in which a stock broker lends part of the purchase price of eligible shares or equity ETFs to a client, holds the bought stock as pledged collateral and charges interest.
- CustodianThe SEBI-registered entity that holds a fund's securities in accounts of its own and settles its trades, so the assets sit somewhere other than with the manager who decides what to buy.
- Debenture trusteeThe SEBI-registered trustee of the trust deed securing an issue of debentures — the debenture holders' agent, standing between them and the issuer for the life of the paper.
- Eligible promotersThe promoter categories SEBI requires before considering a credit rating agency application — PFIs, scheduled commercial banks, foreign banks, eligible foreign CRAs, or companies with Rs 100 crore net worth.
- Merchant bankerA SEBI-registered body corporate engaged in the business of issue management — arranging the selling, buying or subscribing of securities, or acting as manager, consultant or adviser in relation to an issue.
- Net worthEverything you own minus everything you owe — the one number that says where a household actually stands, and the starting point of any financial plan.
- Early warning signalsIndicators that stock exchanges, depositories and clearing corporations monitor to catch a stock broker's deteriorating finances or diversion of client securities early, triggering joint preventive action.