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Capital adequacy

Capital adequacy

In order to solve the first problem and protect its clients from possible losses, a bank has to have sufficient capital. This requirement is imposed by special government agencies – regulators and is referred to as capital adequacy ratio. In many countries, the role of a banking regulator and the CB is performed by the same organization, which makes sense if one remembers that banking supervision in the modern economy is a direct extension of the control over money emission.

Capital adequacy can be viewed from two points:

  • quantitative, when the amount of a bank’s capital base is compared to the amount of its liabilities, and
  • qualitative, when both the amount of capital and the risk level of bank transactions are taken into account.

 

The simplest way to limit the risks would be to require maintaining the capital base amount in a certain proportion to the amount of clients’ deposits. In this case, the buffer protecting clients’ money from loss would be greater and the banks would be more sustainable.

Thus, let us consider an example in which a bank that attracted 100 units of clients’ money also has its own capital base of to the same amount. If the Bank places 170 units in loans, leaving 30 units in cash, its balance will look as follows:

 

Money in the CB

30

Clients’ money

100

Investment

 

 

170

Capital base

100

 

 

What happens if a part of granted loans to the amount of 40 units is lost? The losses will primarily “eat up” the capital base:

 

Money in the CB

30

Clients’ money

 

100

Investment

Original 170

Written off (40)

 

Remaining investment 130

Capital base

Original 100

Losses (40)

Remaining capital 60

There are several subordination levels, but for the sake of simplicity we will discuss only two of them, i.e., that all the losses are referred to the capital, i.e., bank shareholders, while all creditors have the advantage of being more insured since they only lose their share in the bank’s assets after the share owned by the shareholders is completely lost. And only if the losses are so great that the capital base is inadequate, the clients’ money will be at risk:

Money in the CB

30

Clients’ money

100

Investment

Original 170

Written off (120)

Remaining investment 50

Capital base

Original 100

Losses (120)

Remaining capital (20)

 

Please note that even in this case, banks do not decrease the clients’ money; instead, they show negative capital. Formally, the clients’ money remains untouched—this is one of the features of the modern banking system. If the clients’ money were depreciated due to the increased amount of bad debts, the systemic bank crisis would not occur in principle, and the situation would be resolved naturally.

As you can see, the amount of capital does matter: the greater it is in relation to the clients’ money, the higher the bank’s reliability. However, this straightforward approach has its drawbacks since it does not take the bank’s asset profile into account.

The amount of loss that may be referred to clients not only depends on the amount of capital that primarily absorbs the losses, but also on the risk of investments made by the bank. While the capital may be a big amount, the bank’s investments may be so risky that there is a high probability that they will “eat it up” should the conjuncture slightly deteriorate. On the contrary, a bank may have a small amount of capital but act very responsibly, and its clients’ money will be protected.

Thus, if banks were required to have at least thirty cents of their own capital base for every client dollar, then two different banks equally meeting this requirement could look as follows:

Bank A

 

Money in the CB

30

Clients’ money

100

Investment

 

100

Capital base

30

 

Bank B

Money in the CB

110

Clients’ money

 

100

Investment

 

 

 

20

Capital base

30

Bank A actively uses its clients’ money to make investments, trying to extract maximum profits. Bank B has a different business model designed to provide cash-management services and receive income from banking commission. Apparently, money at Bank B is protected much better, despite the fact that both banks have the same leverage ratio.

In order to make the capital adequacy ratio more accurate, Basel Committee on Banking Supervision introduced a capital adequacy standard in 1988 that takes into account the risks taken by banks. While the rules of calculating the standard have been improved and made more sophisticated since then, its essence has remained the same: the higher the risks taken by a bank, the greater the amount of capital that the bank must maintain to protect its clients’ money.

The 1988 Basel requirements set the capital adequacy standard at 8 percent, and this ratio was calculated as the correlation between the capital and the amount of risk-weighted assets.

In order to illustrate this, let us see what the risk-based capital adequacy standard would look like for Banks A and B from the example above:

As you remember, both banks had the same 30 percent correlation between their capitals and their clients’ money. However, the Basel technique also requires the capital adequacy ratio to take into account the risks taken by the banks. For this reason, both banks’ structures are significantly different, despite the fact that they have the same amount of assets (130 units). Bank B has a much greater share of CB money that does not involve any nonrepayment risk. According to the Basel agreement, the CB money would be assigned the risk ratio of 0 percent, i.e., as if those assets were absent for the purpose of determining capital adequacy. In this situation, these banks would have the following capital adequacy ratios:

Bank A

Money in the CB

30

30*0% = 0 risk

Clients’ money

 

100

Investment

100

 

Capital base

30

For Bank A, the value of the capital adequacy ratio would be the relationship between its capital (30 units) and the amount of assets factored for the risk (100 units, since the money in the CB is not taken into account) and would equal 30 percent.

Bank B

Money in the CB

110

110*0% = 0 risk

Clients’ money

 

100

Investment

 

 

 

20

Capital base

30

 

For Bank B, the value of the capital adequacy ratio would be the relationship between its capital (30 units) and the amount of assets factored for the risk (20 units, since the money in the CB is not taken into account) and would equal 150 percent.

As you can see, the capital adequacy ratio calculated based on the Basel agreement requirements ensures more accurate determination of clients’ money protection. Bank B is more reliable due to the specific nature of its business, and the Basel capital adequacy ratio shows it quantitatively.

In addition to the two options with risk absence for CB money (0 percent) and full risk for ordinary investment (100 percent), the Basel agreement also provided for intermediate options, for example, a 10 percent ratio for investment in government securities, 20 percent for investment in other banks, etc.

The Basel regulation further developed towards increasing the accuracy of bank risk calculation. Later on, the technique came to taking market risks into account. An opportunity to assign risk ratios based on the borrower’s rating emerged, and the applied methods and techniques became increasingly complicated. However, the basic rule has remained unchanged: the amount of a banks’ capital base is compared to the amount of risk taken by the bank.

Therefore, banking capital is inherently an insurance fund: by using various statistical methods, one can calculate the probability of loss for any bank’s operations and, correspondingly, the amount of capital sufficient to cover the estimated loss. This calculation may be more or less accurate, but it never guarantees banks a 100 percent protection against bankruptcy, which can only be attained by an opportunity to allocate unexpected losses to customers’ accounts.

Bearing in mind that bank shareholders view the bank’s capital as their investment, rather than an insurance fund designed to protect somebody’s money, their expectations differ dramatically from regulators’ viewpoints, causing a serious conflict of interests. Shareholders expect their capital to be profitable—i.e., they seek to generate maximum return from the least possible amount of capital. Regulators expect capital to be able to protect customers against losses. That is, they want bank transactions to be as risk-free as possible (and therefore low-yielding) and the capital to be as big as possible.

This specificity of bank capital makes bank stocks one of the most unconventional types of investment. Banks use equity in order to be able to attract more clients’ funds and obtain the right to create money because any bank cares about the scale and its role in the economy. At the same time, commercial profit of banks is quite an amorphous concept since it depends, to a much greater degree, on the estimated repayment of loans granted by a bank rather than on its revenues and expenses. Let us illustrate this as follows:

A bank having a 100 unit capital attracts 900 units of clients’ funds with an average annual interest rate of 3 percent and grants loans for 800 units with an average return of 13 percent,

The bank management can report a large net annual interest return of 77 units by showing 1) revenues in the form of interest return of 104 units (800×13 percent) less and 2) expenses in the form of interest return equal to 27 (900×3 percent).

However, in order to estimate profitability of these bank transactions, the main issue is whether the 800 units of loans are collectable. If, for example, every tenth loan is not returned, the net interest margin will become negative (77 minus 80 estimated loss on the loans).

Such an estimate always has a subjective component in it, and, taking into account banks’ asset sizes, a small change in an estimate can lead to a dramatic change in values of both the profit and the capital, from profitability to loss-making, from being a big, stable bank to bankruptcy and vice versa.

In actual practice, this subjectivity leads to a situation in which banks deliberately level up capital fluctuations, reporting profits that artificially fit into some expected profitability. So the current market capitalization of many banks is smaller than their capital. This discrepancy shows that the market does not trust official estimates and includes in the share prices greater risks than those acknowledged by the banks themselves. This way of reporting results in continuous accumulation of bank asset problems that “unexpectedly” become evident during “crises.” Banks’ tendency to showing unjustified optimism in good times always results in crises that dramatically bring the manipulators back to reality. The starting point of a crisis is usually the time when banks actively drawing positive pictures start lacking funds to discharge their current liabilities on their clients’ funds. In this case, no manipulations are capable of replenishing the missing funds to make current payments and solve the liquidity problem.

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