Capital Adequancy

11 Dec


Capital adequancy

Banks safe-keep money for depositors and operate by investing the pool of money by lending credits to borrowers. Thus, banks have to ensure that they do not lose the depositors’ trust in them, or it will result in widespread panic withdrawals that lead to the banks’ collapse. As such, banks are vulnerable and need regulation to compensate for the tendency of instability. Regulators are especially cautious that a major bank’s collapse might lead to a contagion of financial crisis (Young, 1986).

“Risk” is exposure to danger; a probability of deviation from expectations. Lending depositors’ money to borrowers is risky because there is a possibility of debt defaults (credit risk). The volatility of the market, interest rates and other factors are also not within the banks’ jurisdictions.

Hence, it is crucial that banks hold a buffer of capital to absorb unexpected losses and protect themselves, especially their depositors. This is the basis of capital adequacy (Gallanti, 2003). The purpose of the risk ratios, as advocated by Basel frameworks, serves to help banks calculate the amount of capital to hold (Young, 1986).

Prudential regulation ensures that financial institutions have the solvency to repay money owed to their depositors, through having the discipline of holding adequate capital (Thompson, 1996). This determines the amount a bank can lend out as loans

This has forced banks to draw up plans to raise money either from their shareholders or borrowing by issuing bonds at the stock market in 2012 these banks include. Kenyan banks are seeking to raise extra funds for expansion for example SCB rights issue, NIC, DTB,CFC stanbic bank, Family is expected to go the market to raise funds in 2013 This is to support their growing loan book.

However, the growth came at a cost. Stanchart’s ratio of total capital to total risk weighted assets stood at 13 per cent, just one percentage point above the statutory requirement of 12 per cent. This is the capital adequacy ratio which banks have to meet. For every kes 100 dollars a Kenyan bank lends out, it is required by law to have kes 12 dollars of its own as capital. The more capital a bank has the more it can lend out or even expand its branch network. majority of the listed banks have $14 dollars in capital for every $100 dollars they have lent out. In the same period last year most of the listed banks had at least $17 dollars in capital for each $100 dollars lent to customers or the government.

Basel accord

Under the Auspices of the Bank for International Settlements, the Basle Committee (which consists of the G-10 countries’ central bank governors), have agreed upon a scheme of regulation which will be applied to international banks. The key element of this scheme is a set of requirements relating a minimum amount of bank capital relative to a risk based measure of assets. Bankers have always been torn between reduction of Risks and increase of profitability . The equity multiplier magnifies the effect of profits on returns which gives bank owners an incentive to increase leverage.

Bank capital absorbs losses before depositors or creditors absorb losses. So bank depositors and creditors prefer capital.

Risky banks may pay higher interest rates so banks may internalize depositors preferences… But regulators have adopted a preference toward capital requirements institutionalized by Basel.

Capital and moral hazard

  • Consider a bank with 0 capital, full financed with deposits of $100 (which for convenience pay 0 interest rate).
  • Bank managers face two loan projects with differing payoff profiles.

Which will the bank choose? Which is socially optimal?

  Prob. of Good Outcome Prob. of Bad Outcome Interest Recovery %


Project A-RISKY .5 .5 .2 0
Project B-SAFE 1 0 .05 N/A



Expected Payoffs to depositors and bankers

The safe project creates value in excess of customers demand for funds. The expected value of the risky project is just $60, less than what was put in the project.

Assume that in the event of bankruptcy, depositors claim all remaining assets.

The depositors have an expected payoff of 100 under the safe scheme and only 50 under the risky lending scheme. They prefer safety. Under the safe scheme, the bankers will get a payoff of 5. Under the risky scheme the bankers will get an expected payoff of 10. They will prefer the destructive, risky scheme. Why?

Bankers get upside pay-off of risky scheme but put downsize risk on depositors. Let us Compare with bank finance by 80% deposits and 20% equity. Under safe scheme, bank gets an expected payoff of 25 for a 25% ROE. Under risky scheme, the bank owners receives 40 back in a good outcome and 0 back in a bad outcome for an expected payoff of 20.  Bank owners share the downside risk and avoid the risky scheme

Capital Measurement

Chief measures are Tier 1 leverage ratio and CAR (capital adequacy) ratio

Tier 1 capital/Total Asset      This equals CAR=Tier 1 Capital + Tier 2 Capital /Risk adjusted Assets

Types of capital

  • Tier 1 capital is thought to be more stable and more aligned with the concept of capital as the funds that owners have invested in the banks (i.e. equity capital, perpetual preferred stock and retained earnings)
  • Tier 2 capital are funds that protect depositors but may be withdrawn (subordinated debt) or is already somewhat committed to other purposes (reserves).

To determine how much capital is adequate

Depends on risk appetite of the bank, regulatory requirements, maintaining a good debt rating, limits of internal growth, relative cost of debt and equity financing.

  • Capital adequacy limitations can act as brake on bank growth.
  • Consider a bank that can achieve 10% growth on the asset side of its balance sheets and also can borrow freely to achieve that growth.

An adequately capitalized bank must achieve 10% capital growth or fall below the adequacy standard


Achieving Capital growth


  • Reduce dividend payout ratios
  • Earn higher ROA to increase cash flow (may increase risk)
  • Change mix of assets to those with smaller capital charges
  • Move assets off balance sheet
  • Issue more stock/subordinated debt


In modern capital requirement management

  • Instead of evaluating how much capital the bank needs, modern banks will evaluate lines of business and how much capital should be allocated for the assets needed to generate income in that line.

Different businesses require different quantities of capital. Capital is more expensive than debt, so business requiring heavy capitalization must earn higher returns






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Posted by on December 11, 2012 in Uncategorized


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