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Swasti Lankabangla Swasti Lankabangla

Purpose of capital adequacy in banking: A critical view

| Updated: August 13, 2020 22:23:09

Purpose of capital adequacy in banking: A critical view

The banking industry is a highly regulated sector all over the world. Since 1970s, banking regulations have been born not only in the country but also outside the country i.e., at Basel, Switzerland. As per the Basel Committee Charter, Basel Committee on Banking Supervision (BCBS) primarily frames prudential regulations for compliance by banks worldwide. Besides regulations, its mandate is also to strengthen  supervision and practices of the banks. BCBS has so far established a series of bank regulations; most prominent ones relating to capital adequacy are commonly known as Basel I, Basel II and Basel III. Present discussion aims to critically look at the main purpose of maintaining capital adequacy as intended by BCBS.

BCBS considers that the key element of capital on which the main emphasis should be placed is equity capital and disclosed reserves. Total regulatory capital consists of the sum of elements: 1. Tier 1 Capital (going-concern capital) a. Common Equity Tier 1 b. Additional Tier 1 2. Tier 2 Capital (gone-concern capital). All elements are net of the associated regulatory adjustments and are subject to some restrictions. From regulatory capital perspective, going-concern capital is the capital which can absorb losses without triggering bankruptcy of the bank. Gone-concern capital is the capital which will absorb losses only in a situation of liquidation of the bank.

What is the real purpose of minimum capital ratios? It appears from several documents released on Basel standards and guidelines that the utility of Capital to Risk-weighted Assets Ratio (CRAR) is nowhere illustrated with a few case studies. However, it is shortly described in BCBS' Discussion Paper on The regulatory framework: balancing risk sensitivity, simplicity and comparability (July 2013) that a bank must have sufficient capital to meet the losses that it might incur. Thus it is clear that minimum capital ratios are to be maintained to absorb losses. Global Financial Development Report 2019/2020 (World Bank Group) suggests that equity capital is the most secure and liquid form of capital to absorb losses in the event of a financial emergency. Bank for International Settlements ( BIS) which houses BCBS, World Bank, and IMF echo the same voices on the Basel Framework prepared for both member  and non-member countries.

The Basel Framework 2020 states that capital would  absorb losses (Principle 16).This purpose of  capital adequacy may be  questioned as under:

i) Capital ratio is expressed as percentage of risk-weighted assets (RWA). Capital ( total with buffer) is to be maintained at 10.5-12.5 per cent minimally. Would that ratio ( ? 100 per cent) cover total risky assets ? Besides, the risk weights assigned differ from case to case, bank to bank, region to region, country to country, and so on. Is risk measured truly in probability method ?

ii) It is strongly argued that capital absorbs loss. If capital thus disappears in part or in whole, shareholders lose their capital. How are they compensated for? Frequent explicit regulations for minimum capital are incentivising defaulters. Is it a real solution to credit loss? Is it not just clipping the bad asset and correcting the equity-liability side with equal amount? It is actually a balance sheet adjustment, nothing else. How often can capital absorb losses? Is it ethical and justifiable for owners and employees to suffer the losses caused by defaulters?

iii) It is also argued that adequacy of minimum capital averts bankruptcy. Will not disappearance of equity capital be visible to the public? Can the company conceal the fact adjusting the balance sheet?

iv) Common equity Tier 1 includes not only equity capital but also retained earnings and other reserves created out of profit. Besides shareholders, employees do have interest in profit that turns into reserves. If common equity is exhausted, how is the right of employees protected? The Basel Framework gives maximum priority to this category of capital to absorb losses.

v) Maximum possible equity capital is highly desirable in publicly held banking companies. Its capital ratio needs to be calculated based on total sources of fund ( i.e. equity-liabilities side total) or on total assets and aims to indicate how much of the asset is financed by shareholders' equity. Why is bank capital not viewed from shareholders' perspective?

It appears that the amount of regulatory capital has been treated as scapegoat in banking firms. Big international banks back the Basel Framework to avert bankruptcy since they are much more engaged in financial market investment. They want to stay alert to escape the event of ill-fated banks like Lehman Brothers during the global financial crisis of 2007-2009.

It is observed that the legal remedies of the cases of bad assets are not emphasised upon. BCBS sets regulations paying attention to accounting solutions. Mounting risk-weighted assets are a non-performing loan (NPL) problem and should not be linked to owners and employees' resources. It is better not to highlight capital to bad assets relationship. The base for capital ratios should be chosen from the equity-liability side of the balance sheet.

Haradhan Sarker, PhD, is ex-Financial Analyst, Sonali  Bank & retired Professor of Management.


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