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Bank's capital shortfall—causes and consequences

Nironjan Roy from Toronto, Canada | Published: January 14, 2019 21:23:28 | Updated: February 15, 2019 21:28:40


It has been learnt from a media report that our banking sector is facing a crisis as nine banks are identified with capital shortfall. The report further states that six state owned banks and three private banks have failed to meet the minimum capital requirement. By any standard, bank's capital shortfall is considered a serious concern because this problem weakens bank's resilience. Depositors trust and confidence get eroded, and many partners and stakeholders feel insecure in continuing their business relationship with such banks.

Banks with capital shortage cannot operate with efficiency, and as a result, operating cost rises and profitability declines. If this problem is not resolved and capital shortfall persists, bank's existence will be at stake as this problem may lead to bankruptcy.

BASEL III & MINIMUM CAPITAL REQUIREMENT: Banking industry in our country has implemented BASEL III entailing that each bank  maintains minimum capital requirement which is calculated using the formula recommended in BASEL III. Minimum capital requirement as per BASEL III recommendation is calculated based on risk weighted asset which includes bank's loan and advances as major components. So, bank's minimum capital requirement is mostly governed by its asset quality. In fact, there is a linier relationship between bank's minimum capital requirement and its asset quality. If bank can mobilise and maintain quality assets, i.e. less risky loans and advances, its minimum capital requirement will be comparatively less. On the other hand, if bank procures and maintains inferior asset, i.e. risky loans and advances, its minimum capital requirement will be relatively higher. So, technically, bank loans and advances govern the minimum capital requirement. Unfortunately, asset quality in our banks is not satisfactory with more than 15 per cent NPL (Non-performing loan) and much higher percentage of disguised NPL. It is obvious that our banks will remain under constant pressure of meeting minimum capital requirement and this pressure will intensify if NPL problem is not resolved. 

CAPITAL SHORTFALL & CAPITAL DOLE-OUT: News of bank's capital shortfall may give wrong impression to the common people because they may think that owners have taken away bank's capital which is not the case. In fact, ratio between minimum capital requirement and bank's risk weighted assets decline resulting in capital shortfall. Banks and financial institutions are growing companies and this growth is a continuous process. Persistently procuring assets i.e. loans and advances are a regular activity of banks, so it is obvious that minimum capital requirement will constantly rise commensurate with bank's growth of lending. In order to meet this rising capital requirement or to avoid any capital shortfall, banks are required to maintain very conducive capital structure. Issuing additional shares at the right time, maintaining favourable dividend payout ratio from bank's perspective, i.e. adequately retaining profit as reserve, paying out stock dividend instead of cash dividend can help construct strong capital base of the bank. While calculating and maintaining minimum capital requirement, bank must keep some buffer so that any unforeseen situation arising out of sudden deterioration of asset quality can easily be avoided. This standard practice is hardly followed in our banking industry and as a result, capital shortfall is not an unlikely situation in our country.   

REASONS FOR CAPITAL SHORTFALL: There may be various reasons behind capital shortfall. Drastically increasing loans and advances, deterioration of asset quality, rescheduling of NPL without required amount of down payment, interest accrued on NPL but retained in suspense account and taken into income after rescheduling of NPL, retention of inadequate provision, no protection against disguised NPL, paying out of cash dividend are identified as common reasons behind bank's capital shortfall. In our country, there is no practice of creating full provision against NPL, instead, obsolete CL (Classifications of Loans) is applied to categorise NPL and retain provisioning. As per CL, impaired loans are classified into substandard, doubtful and bad-loss. There is the requirement of creating 100 per cent provision only for loans and advances categorised as bad & loss whereas partial i.e. certain percentage of provision is created against other classified loans, so provision shortfall is always there exposing the bank to capital shortfall risk. Standard practice states that as soon as loan seems to be heading towards NPL, full provision is created in order to protect bank's capital but unfortunately, our banking sector is far behind this standard practice. We have to keep in mind that when provision is understated, profit is overstated. Similarly, good profit means good dividend, so in the form of dividend, substantial amount of profit which was supposed to be retained as provision is taken out of the bank. This is one of the root causes of capital shortfall in Bangladesh. 

Moreover, loans and advances are not periodically assessed by the lending banks and consequently, actual status of the loans remains unascertained, so entire loan portfolio is flatly treated as good loans requiring no provision retention. Because according to the current practice, provision is not required to build up against good loans. Subsequently, when substantial amount of loan deteriorates, bank's capital requirement abruptly rises-a situation bank can hardly manage within short time. Whereas, if the practice of periodical assessment of loans is meticulously followed and actual status of loans are properly ascertained, bank will be able to gradually build up adequate provision, and this will help avoid capital shortfall.

Our banking industry is still following traditional loan pricing which is determined by adding flat spread to the deposit rate or average cost of fund. Of course, a brand set by country's central bank is maintained while determining traditional loan pricing. It is ironic that our banking sector has already implemented modern strategy BASEL III and minimum capital requirement is being calculated based on weighted risk assets as recommended in BASEL III but risk-based loan pricing is far away from our country's banking practice. In the developed world's banking, risk-based pricing has been introduced so as to substantiate risk weighted capital requirement. Our banking sector has implemented risk weighted capital requirement as per BASEL III recommendation but has not yet introduced risk-based loan pricing. Using traditional loan pricing, it is very difficult for banks to meet minimum capital requirement using BASEL III formula as under this loan pricing, risk associated with asset is not properly compensated and as such bank does not earn enough to retain provision against risky assets. So, following traditional loan pricing always leaves the bank in adverse situation to meet capital requirement. Under risk-based loan pricing, higher spread is added to the risky asset to compensate bank's assuming higher risk of default and this higher portion is always retained as provision against risk assets. We have to keep in mind that traditional loan pricing and minimum capital requirement as per BASEL III should not go together because the former concept ignores risk associated with bank's asset while the latter takes risk factor associated with bank's asset into active consideration.  

Nironjan Roy is a banker based in Toronto, Canada.

nironjankumar_roy@yahoo.com

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