Chapter Three

CAPITAL ADEQUACY IN BANKS

Learning Objectives
• Functions of Capital Funds In Commercial Banks
• Capital Adequacy
• Basle Norms on Capital Adequacy
• Measurement of Capital Adequacy
Introduction.
• Banks play a distinct role in the economy. Unlike other business
enterprises, they are therefore subject to extensive regulation,
including capital requirements as an important element.
• The capital requirements for banks are based on international
standards laid down by the Basel Committee.
• he special role of capital in banks is explained in the following,
including its significance to the banks' role as credit providers, and
why special capital requirements for the banks are necessary
The role of capital in banks
• The conventional role of capital is to ensure the survival of business
enterprises when they encounter unexpected losses.
• The banks' capital reserves in excess of the 8 per cent and their
current earnings ensure their independence and survival in case of
unexpected losses.
• n practice, the losses will probably follow another
distribution, as indicated by the broken curve. Banks hold
capital in excess of the minimum capital requirement to
ensure that unexpected losses do not lead to non-
compliance with the minimum capital requirement, in
which case the shareholders would have to transfer
control of the bank to the authorities.
Functions of Capital Funds In Commercial Banks

• A bank's capital also known as equity is the margin by

which creditors are covered if the bank's assets were
liquidated. A bank must hold enough capital to protect
lenders and depositors from losses and also allow the
bank to meet its customer requirements. Banks must
maintain capital levels equal with the amount of risks
• In general the main functions of capital funds of financial
institutions is to absorb losses and to build and maintain
confidence in a bank.
Capital Adequacy

• Regulators endeavor to ensure that financial institutions, banks and

investment firms have enough capital to ensure their businesses
remain stable. This measure not only protects depositors within the
industry but also the larger economy as failures of institutions, such
as banks, can have wider-scale repercussions.
• Commonly used in financial regulation. An estimate of the capital
(loosely shareholders' funds plus subordinated debt) required to
absorb the maximum potential losses inherent in the business,
especially in a bank or insurance firm. May also be determined by
regulatory methods.
Capital Adequacy also known as
Regulatory Capital Requirement
• Capital Adequacy’ is therefore the statutory minimum
capital reserve that a financial institution or investment
firm must have available and regulatory capital adequacy
provisions thus require relevant firms to maintain these
minimum levels of capital, calculated as a percentage of
its risk weighted assets. Often Capital Adequacy is
referred to as the required Regulatory Capital of a firm.
Basle Norms on Capital Adequacy

• Basel I
• Recommended for implementation in 1974, for addressing the issue
of risk involved in recovery of loans lent
• Covered only Credit Risk, and ignored Market Risk, Operational Risk,
and Liquidity Risk
• Assets of banks were classified and grouped in five categories to
credit risk weights of 0,10,20,50 and up to 100%
• Assets like cash and coins usually have zero risk weight, while
unsecured loans might have a risk weight of 100%
Basel II
• Introduced in 2004
• Laid down guidelines for capital adequacy, risk management, and
disclosure requirements.
• Use of external rating agencies to set the risk weights for corporate,
bank and sovereign claims.
 Basel III
• Widely felt that the shortcoming in Basel II norms led to the global
financial  crisis of 2008
• Basel II did not have any regulation on the debt that banks could take
on their books
• Focused  more on individual financial institutions, while ignoring
systemic risk
• Formed in 2010, to ensure that banks don’t take on excessive debt, and
don’t rely too much on short term funds.
• Being implemented since April 1, 2013 in India, in a phased manner.
Transitional period for full implementation is extended up to March 31,
2019.
Regulatory & Economic Capital

Regulator Economic
y Capital To cover unexpected
Capital To cover unexpected
loss from credit + loss from the credit
market + + market + or +
Operational risk other risks

Minimum 8% Usually higher than

Tier 1 capital =6% Regulatory capital
Tier 2 capital = 2%
Determination of Risk-weights (RW) of
banking exposures
RW = PD x EAGD X LGD X N
1. PD: The likelihood that the debtor will default
2. EAGD: the amount of the facility that is outstanding
3. LRGD: proportion of the exposure that will be lost if a default occur
4. N: Maturity, measures the remaining economic maturity of the exposure
Higher PD, Higher RW
Higher EAGD, Higher RW
Higher LGD, Higher RW
Longer N, higher RW
The Banking Business
Risk-Weight
Assets - to
reflect risk-
profile of
business units
Capital
To absorb
Adequacy ratio =
potential losses
8%

Bank
Capital
 Risk-taking and Capital Allocation
• Financing Risk weights
Capital
• $100m 150%

CAR = K/RWA
0.08 = K/ ($100 x 1.5)
K = $12m
(to make $100m loan without collateral at 150%
RW, the bank needs to hold $12m)
Risky Financing and Capital Stress

Higher
Risky Higher
Risk-
positions capital
weights
 Conventional risk-weights
• Financing • Risk-weights

• Loans with collateral • 50%

• Personal loan • 100%
• Government bonds • 20%
• Corporate bonds • 80%
• Equities • 150%
 Risk-weights: Islamic products
• Financing • Risk-weights
• Murabaha with collateral 50%
• AITAB (financial lease 50%
with collateral) 50%
• Government Sukuk 20%
• Corporate sukuks 150%
150%
• Equities
150%
• Istisna
150%
• Bona fide Murabaha
 Conventional Bank Under Basel 2
Assets Amount Riskweights RWassets
Loans $600m 50% $300
Hire-Purchase $300m 50% $150
Personal Loans $200m 100% $200
Bond $100m 50% $ 50
TOTAL $1200 $700

Capital ratio = (Regulated Capital / RWA)

8% = RC / $700
RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)]
= $300m + $150m +$200m + $50m = $700

RC = $700 x 0.08 = $56m

Note Risk weight also known as conversion factor.
 Islamic Bank Under Basel 2: Higher Capital Requirement
• Assets Amount Riskweights RWassets
• Murabaha $600m 50% $300
• AITAB $300m 50% $150
• Personal F $200m 100% $200
• Sukuk $100m 50% $ 50
•
• TOTAL $1200 $700
• Capital ratio = (Regulated Capital / RWA)
• 8% = RC / $700
• RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)]
• = $300m + $150m +$200m + $50m = $700
• RC = $700 x 0.08 = $56m
• Note Risk weight also known as conversion factor.