WHAT IS CAPITAL ADEQUACY OF BANKS

AND FINANCIAL INSTITUTIONS?

Introduction

What is Capital Adequacy?

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

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.

‘Basel III’

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 cancelled 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.
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.