WHAT IS CAPITAL ADEQUACY OF BANKS AND FINANCIAL INSTITUTIONS?

Introduction

Over the last months, we have been looking at banking and other financial institutions and how the microfinance institutions operate. Today, we shall look at the capital of these institutions and how the regulators assess them. We shall look at the historical development starting from 1974 till date.

Historical development

Basel is a city in Switzerland. In 1974, all G-10 countries’ Central Bank Governors met in Basel in order to see how banking could be improved through a common guidance. Various policies were developed since then, but the most important one became operational in 1988 which is called Basel I Capital Accord. Basel II Capital Accord was later developed in 2006 after series of revisions. Basel II is actually the basis of Capital Adequacy for all banks. Later, improvements were added and Basel III came up in 2010 and all Central (Reserve) Banks around the world are expected to implement the changes between 2013 and 2015 in their respective countries. However, an extension was granted for full convergence till 31st March 2019.

What is Capital Adequacy?

Capital adequacy is the statutory minimum reserves of capital which a bank or other financial institution must have availableInvestopedia

Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%. The capital adequacy ratio measures a bank’s capital in relation to its risk-weighted assets. The capital to risk-weighted assets ratio promotes financial stability and efficiency in economic systems throughout the world.

Capital Adequacy Ratio(CAR) is defined as:

CAR =   Tier 1 Capital + Tier 2 Capital

                Risk Weighted Assets (RWA)

Where:

  1. TIER 1 CAPITAL = (paid up capital + statutory reserves + disclosed free reserves) – (equity investments in subsidiary + intangible assets + current & brought-forward losses)
  2. TIER 2 CAPITAL = a) Undisclosed Reserves + b) General Loss reserves + c) hybrid debt capital instruments and subordinated debts
  3. The Risk Weighted Assets (RWA) refer to the fund based assets such as Cash, Loans, Investments and other assets. They are the total assets owned by the Banks, however, the value of each asset is assigned a risk weight (for example 100% for corporate loans, 70% for mortgage loans and 60% non-collateral loans) and the credit equivalent amount of all off-balance sheet activities. Each credit equivalent amount is also assigned a risk weight.

Off-balance sheet items could be described as the transactions done outside the books of accounts like operating lease, guarantees, options and hedging of some financial instruments.

Further Reading on ‘Basel III’

(Only for those who are still interested in the topic, otherwise, jump to “Why do banks fail or collapse”)

Basel III is part of the continuous effort to enhance the banking regulatory framework. It builds on the Basel I and Basel II documents and seeks to improve the banking sector’s ability to deal with financial stress, improve risk management, and strengthen the banks’ transparency. A focus of Basel III is to foster greater resilience at the individual bank level in order to reduce the risk of system-wide shocks.

  • Minimum Capital Requirements

Basel III introduced tighter capital requirements in comparison to Basel I and Basel II. Banks’ regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity, and their dividends can be canceled at any time. Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.

Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Risk-weighted assets represent a bank’s assets weighted by coefficients of risk set forth by Basel III. The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of certain assets to establish their risk coefficients.

In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at 8%.

  • Countercyclical Measures

Basel III introduced new requirements with respect to regulatory capital for large banks to cushion against cyclical changes on their balance sheets. During credit expansion, banks have to set aside additional capital, while during the credit contraction, capital requirements can be loosened. The new guidelines also introduced the bucketing method, in which banks are grouped according to their size, complexity, and importance to the overall economy. Systematically important banks are subject to higher capital requirements.

  • Leverage and Liquidity Measures

Additionally, Basel III introduced leverage and liquidity requirements to safeguard against excessive borrowings and ensure that banks have sufficient liquidity during financial stress. In particular, the leverage ratio, computed as Tier 1 capital divided by the total of on and off-balance assets less intangible assets, was capped at 3%.

In the United States, the minimum capital adequacy ratio is applied based on the tier assigned to the bank. The tier one capital of a bank to its total risk weighted exposure shouldn’t go under 4 percent. The total capital, which comprises tier one capital plus tier two minus specific deductions, so the total risk-weighted credit exposure should stay above 8 percent. (Source: Investopedia)

Why Do Banks Fail or Collapse?

From the aforementioned, you will see that for the bank to fail, its capital will be less than the 8% set. In other words, the following could lead to the results of its CAR being less than 8%: –

  1. High defaults on its loans: many banks take more than expected risk by lending to clients and sectors that are considered risky. In other words, they are not able to recover their loans leading to higher provision for loan losses and later write off of those loans. When this happens, its capital adequacy drops to a lower level as its capital has eroded by these write offs.
  2. Diversion of clients deposits: the majority of the financial institutions are in the habit of diverting clients’ deposits into other long term fixed assets. You will see that most of the financial institutions have a construction or property development subsidiaries. Clients deposits are used to finance those projects. Now when the clients come to demand their deposits, they do not have the cash available since it is locked up in the property development project.
  3. High Operating Costs: the majority of the financial institutions hire a number of staffs that are not productive. To demonstrate that they are doing well, much money is invested into advertising, uniforms, branding and image building. At long last, these all lead to high operating costs that eat up the profit and later eats up clients’ deposits as in 2 above.
  4. High staff turnover: most experienced hands often resign and go to other financial institutions. There is a loss of institutional memory and procedures and policies are not followed as it should be.

What will the Central Bank do if the financial institution is under distress?

The central bank would come with a number of suggestions to the financial institutions. It shall actually give it a deadline to address its capital adequacy issues or face revocation of its banking license.

The following are done by the Central Bank: –

  1. Ask the Board of Directors of the bank to increase its capital base in order to absorb the losses quickly. This could be done with injection of fresh capital which may mean taking a new strategic partner(s) if the existing shareholders cannot inject more capital.
  2. Without 1 above, the smoothest process is to allow another bank, which is more liquid and is of good standing, to take over the bank which is in distress. An example is what happened in Ghana in early August 2017 where two banks were taken over by the oldest commercial bank in that country.
  3. The bank could also be liquidated completely by appointing an official liquidator. The liquidator will sell the liquidating banks’ assets in order to defray the losses incurred. This last option normally causes hardships to depositors who will have to wait for all assets of the bank to be sold before they get their deposits back.

Conclusion

Banks should concentrate on their core mandate instead of diverting clients’ deposits into constructions, property developments, and fixed assets acquisitions. They should also stop the flamboyant lifestyles as displayed by many of the Banks and Savings & Loans in countries I was permitted to work. By this, they will be able to maintain a good capital adequacy ratio and continue to be in business.

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