Reining in bank's capital shortfall

Although capital shortfall of any bank is a bad indication for the whole industry, it has different implications for two major stakeholders. Government is the owner of state-owned commercial banks, so profit generated by these banks goes to government exchequer, while deficit, if any, will be reimbursed from the government exchequer. On the other hand, private commercial banks are owned by businessmen and general people through ordinary shares. So, lion's share of profit generated by private commercial banks goes to the businessmen and general shareholders whereas capital deficit is not easily reimbursed by the owners' group and general shareholders. Although there is a provision of injecting capital through issuance of additional shares and declaring stock dividend instead of cash dividend, still this is a completely different approach that may have other implications.    

Consequence of capital shortfall: Capital shortfall has both short term and long-term impact for the bank and the industry as a whole. Because of capital shortfall, bank may be treated as noncompliant and as such will remain under strong regulatory watch. Banks with capital shortfall will not be able to declare dividend which will have very negative impact on its share price and thus will adversely affect country's stock market. Even, banks will not be able to pay incentive bonus to its employees who will then be frustrated and demoralised. Frustrated and demoralised employees cannot render good services to the customers. So, bank's capital shortfall finally becomes a vicious cycle affecting the entire banking operations.

Banks with capital shortfall confront tremendous difficulty in carrying out international trade as foreign banks are reluctant to maintain correspondent relationship and allows counterparty limit with the banks facing capital shortfall. In modern banking, full-fledged competitive banking service cannot be provided to the customers without maintaining correspondent relationship with foreign banks. So, bank's capital shortfall will also adversely affect our country's export-import business because opportunity of international trade will be restricted to few banks which will be able to maintain strong capital base. Although only nine banks out of more than 50 banks operating in the country are facing this problem, this bears wrong signal to the whole industry as other peer groups may undergo defensive approach being extra careful that might slowdown  business growth.

REMEDY OF CAPITAL SHORTFALL: In our country's banking industry, capital shortfall means provision shortfall, so building up adequate provision can resolve this problem. However, if banks do not have enough reserve or are not in a position to generate substantial profit to build up required amount of provision, this solution may not apply. Under this situation, there is no alternative to injecting additional capital. It may be mentioned here that injecting additional capital is known as the appropriate solution to capital shortfall. However, this kind of solution is not easy and practical in the context of our country's economic environment. Those banks which have already fallen into this problem must manage additional capital by issuing additional capital. Practice of periodical assessment of bank's assets, i.e. loans and advance will have to be carried out so that risk level of asset can be ascertained well ahead and accordingly adequate provision can be built up. The banks which will not be able to build enough reserve and provision against loans, will not be allowed to declare dividend. True, this measure will have very negative impact in country's share market as general investors will most likely be frustrated and as such try to offload their holdings which may contribute in declining share price. In order to avoid this situation and with a view to giving protection to the general shareholders, special arrangement may be introduced allowing banks to issue stock dividend instead of cash dividend only for the general shareholders. Owners group and members of the Board of Directors will be kept out of that stock dividend. This practice may be continued until bank builds up substantial reserve. 

INTRODUCING RISK-BASED LOAN PRICING & LOAN TRADING: Time has come to introduce risk-based loan pricing which will resolve many problems associated with bank's loan operations. This technique of determining lending rate ensures lower rate for the good borrower while higher rate for the bad borrower. In our country there is common criticism of high lending rate which can be addressed by introducing risk-based loan pricing. At the same time, borrowers who are not very sound economically will also have access to bank lending but they will have to be ready to pay higher price which will help the bank outweigh the risk undertaken and as such required amount of provision can easily be created. Loan trading is another appropriate measure for addressing the problem of bank's capital shortfall. Capital shortfall originates from overtrading, i.e. acquiring excessive assets comprising loans and advances which are not supported by bank's capital base. Similarly, when the quality of asset deteriorates, bank falls into capital shortfall. If bank can offload its excess assets and deteriorating assets as well, its capital shortfall problem will be automatically resolved. Under the present banking system, there is no institutional facility allowing banks to maneuver its asset volume, whereas by introducing loan trading facility, banks may be allowed to maneuver their loan portfolio. Under this system, banks experiencing capital shortfall may sell out a portion of their loans to the banks which has capital surplus. Under secondary loan trading arrangement, both accrual and non-accrual loans can be traded among the banks and financial institutions. Almost all developed countries and many developing countries have already introduced this loan trading platform allowing banks and financial institutions to play around with their loan portfolio having consistency with its capital base. 

Capital shortfall has not been created overnight. It is the cumulative impact of many important issues not properly addressed in a timely manner in the past.

Keeping pace with the developed world, we have been successful in implementing BASEL III but many other relevant modern approaches, such as -- risk-based loan pricing, secondary loan trading have not been introduced yet and as such there is the critical need of streamlining banking operations in keeping with these modern and proven approches.  

Nironjan Roy is a banker based in Toronto, Canada. [email protected]