MCF 304: Bank Management Lecture 3.2 Capital Adequacy

Capital Adequacy One of the critical issues in today’s commercial bank management involves issuing and sustaining adequate capital This is because many people are of the view that capital inadequacy is the main contributing factor to bank failure & closure

Capital Adequacy Capital adequacy can be measured quantitatively as well as qualitatively with several methods Important issues; The concept of capital adequacy Capital adequacy measurement method Bank stability

The Concept of Capital Adequacy Definition: Any level of capital that allows a bank to absorb or accommodate any losses and at the same time equips the bank with sufficient funds to sustain and carry on its businesses as a continuing entity The main question “how much capital base does a bank need?”

Capital Adequacy In general a bank must have enough capital to; Balance the interest of depositors, creditors, share-holders and borrowers Protect depositors and creditors from losses Maintain general public confidence in the stability of the bank Provide funds for lending purposes

Capital Adequacy The regulatory bodies expect banks to have enough capital because; A large capital base can ensure the security and stability of the country’s financial system A large capital base can safeguard the banks as it allows then to absorb losses A large capital base can increase the bank’s liquidity

Capital Adequacy & Bank’s Security The endeavors to protect the interest of the banking regulatory body, the depositors and borrowers specifically, and the interest of the general public Capital adequacy and banks security can be explain from four perspectives

Capital Adequacy & Bank’s Security Regulatory body of banks - Capital adequacy is vital to ensure the stability of the banking system - Without a sound banking system, the economy & business will suffer without proper payment & credit mechanism Depositors The safety of their deposits is of the utmost importance Should a depositor’s withdrawal demand cannot be fulfill, the negative news will spread quickly and may lead to “bank runs”

Capital Adequacy & Bank’s Security Borrowers Only secure & stable banks can continue to provide loans during tough times It is important for the banking system to continue supporting businesses in economic downturn General Public Bank security is a vital factor in their dealings with banks The general public desire for efficient & secure banking services can only be fulfill if the wellbeing of the banking system is intact

Structure of Bank Capital: Non-Banks Assets % Cash 4 Accounts receivables 26 Inventory 30 Total 60 Fixed assets 40 Total 100 Liabilities % Accounts payable 20 Short terms notes 10 Total 30 Long term debts 30 Shareholder’s equity 40 Total 100

Structure of Bank Capital: Banks Assets % Cash 8 Short term securities 17 Short term loans 50 75 Long term securities 5 Long term loans 18 98 Fixed assets 2 Total 100 Liabilities % Short term deposits 60 Short term debts 20 80 Long term debts 12 92 Shareholder’s equity 8 Total 100

Structure of Bank Capital Shareholders equity of bank’s is 8% while non-bank 40% Banks have higher percentage of assets 60% - 70% Current assets & fixed assets of non-banks are split by 60:40 and are financed by debts & equities by 60:40

Structure of Bank Capital Banks normally have 75% of their assets in current assets. 92% of their assets are financed by debts, 80% by short term & 20% by long term liabilities Banks maximize the usage of their capital to generate higher return on assets to maximized shareholders wealth

Capital Adequacy Measurement Method Capital adequacy measurement are used to measure how much capital is considered as adequate for a bank Four capital ratios normally used; Capital to total deposits Capital to total assets Capital to risk weighted assets Capital to loans

Capital Ratios Capital to Total Deposits A ratio of 10% is considered as sufficient to protect depositors Does not take into consideration that risk mostly come from loans, not deposits Capital to Total Assets - A ratio of no less than 7% is consider adequate - Take no account of assets structure even though each assets class has different risk level

Capital Ratios Capital to Risk Weighted Assets Capital to Loans Net total assets of liquid assets comprising cash, bank balances and government securities 8% of RWCR is considered as safe Capital to Loans Loans & advances have the highest risk. This is called credit risk Any bank with a gross loan base exceeding 7x its capital is considered as dangerous

Capital Adequacy Ratio (CAR) Minimum CAR = Free Capital Total Assets Free capital consist of shareholder’s fund net of investment in the long term assets The minimum ratio for local banks are 4% while foreigh banks 6% RWCR = Capital total risks weighted assets Where; Total risk weighted assets = Balance sheets items x (off balance sheet items x credit conversion factor) x risk weighting

RWCR Categories 0 % bank assets which have either minimal or zero credit risk Eg. Treasury bonds 10 % Investment in money market instruments Eg. NCD’s

RWCR Categories 20 % Loans that are guaranteed by other financial institutions 50 % Housing loans Even though they are backed by collateral because the collateral value depends on the economic conditions

RWCR Categories 100 % Other loans and advances All other banks assets When a bank guaranteed is issued, the amount is not recorded in the balance sheet of the bank. The bank however may have a commitment against the guarantee in the future These off balance sheet items are valued based on conversion factor

Conversion Factor 0 % - Formal standby & non-standby credit facilities with a maturity period of no more than 1 year or which can be unconditionally revoke at any time 20 % Short term, self liquidating trade related contingencies Eg. Letter of credits & shipping guarantees

Conversion Factor 50 % Trade related contingencies not influenced by the integrity of the counter party Eg. Performance bonds & warranties 100 % Direct credit substitutes such as bank acceptance & letters of credit Assets sales with recourse. Eg. When the credit risk is still borne by the selling institutions

Why RWCR? The old CAR does not take into consideration the risk portfolio of assets Also did not take into account the potential risk of off-balance sheet items The need for a standard measurement that is applicable to all major financial institutions

Banks Five Primary Risk Credit Risk The potential loss of net income & the market value of equity due to customer’s non / late payment of loan installments Liquidity Risk - Risk to net income or capital arising from a bank’s inability to procure funds by selling assets or borrowing without incurring unacceptable losses

Banks Five Primary Risk Interest Rate Risk - The potential loss in the bank’s net income & the market’s value of its equity resulting from any change in the market interest rates Capital / Bankruptcy Risk The potential that a change in a bank’s capital may disrupt its capital adequacy

Banks Five Primary Risk Operational Risk The risk to a bank’s net income & the market value of its equity arising from the changes of operating expenditure which are related to ; Direct cost Staff error Fraud by customers Technology Market risk refer to the impact of interest rates on the net asset portfolio

Qualitative Measurement Quality of bank measurement Quality of bank asset Bank earnings history Quality of bank ownership Accommodation cost Quality of operational activities Volatility of depositors Local market conditions

Capital Adequacy & Bank Stability: Bank M Assets Cash 60 Treasury bills 120 Long term invest 120 Loans & advances 140 Total 440 Liabilities Current deposits 120 Savings deposits 100 Fixed deposits 140 NCDs 30 REPOs 30 Equity 20 Total 440

Capital Adequacy & Bank Stability: Bank N Assets Cash 40 Treasury bills 20 Long term invt 100 Loans & advances 290 Total 440 Liabilities Current deposits 320 Savings deposits 10 Fixed deposits 10 NCDs 50 REPOs 10 Equity 40 Total 440

Izdihar Baharin @ Md Daud Thank You! Izdihar Baharin @ Md Daud Post Graduate Centre HP: 006019-5170817 Email: izdi@oum.edu.my