Concluding Section of Capital Adequacy

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Offline Deanfbe

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Concluding Section of Capital Adequacy
« on: July 07, 2013, 02:14:03 PM »
Concluding Section of Capital Adequacy

Although the capital of commercial banks have increased over the years, the more rapid increase in total assets and deposits continues to focus attention on the adequacy (or inadequacy) of bank capital. Regulatory authorities are especially concerned with this matter since they have been charged with responsibility of bank safety.

While it may be difficult to determine precisely the amount of capital that a bank or the banking system should have, the capital should be sufficient to fulfill the basic functions: financing the operation of a bank, providing protection to depositors and supervisory authorities.

Sometimes there are attempts to establish a set of standards that can be employed to test the adequacy of capital funds of a particulars bank or banking system. Although a ratio may be helpful as a starting point in analyzing the capital adequacy of an individual bank, it should not be considered as an end in itself. Is it beyond criticism just because a bank meets some ratio? The inquiry must go beyond the ratio to an examination of the bank’s operations and the risks it assumes in its loan and investment portfolio.
Capital funds have been measured in relation to various balance sheet items such as total deposits, total assets or risk assets. The ratio of a bank’s capital funds to these balance sheet items has been thought to indicate the extent to which a bank could suffer losses of one kind or another and still have enough capital to assure the safety of depositors’ fund. Various levels of these ratios have been used by supervisory authorities and others as standards of capital adequacy; the bank whose capital ratio were not at least equal to current standards at that time has often been considered undercapitalized for the volume of business it was doing or for the volume of assets or the volume of assets or deposits it held. The ratio of capital funds to total deposits has enjoyed the longest use of any ratio devised to measure and determine capital adequacy. The ratio of capital funds to total assets came into use by some supervisory authorities in the late 1940s. It was argued that the amount of capital the bank needs is not related to deposits, but to assets. Because a measure of capital adequacy purports to indicate the extent that a bank’s capital can absorb loss and still protect the depositors, a valid measure would have to be related to all items in the balance sheet that might be subject to loss. Losses are reflected in the bank’s balance sheet by reduced values of assets; therefore, a measure of capital adequacy should logically relate capital funds to those assets and not to deposits. Until very recently, the ratio of capital to total assets was in vogue.

But regulatory agencies did not seem to be completely satisfied with the above capital adequacy guidelines, and for that reason proposed revision that takes into account the risks of a bank’s assets. This would mean that banks with high proportion of risky assets would be required to maintain more capital than if assets possessed lower risk. This risk-adjusted capital requirement is given more attention at present. A variety of reasons prompted the introduction of the risk-adjusted ratio, including the growth of off-balance sheet item and the decline in the quality of loan portfolios of many banks, including loans to third world countries. Off-balance sheet items, such as letters of credit, loan commitments and promises to guarantee loans, are not considered to be assets; consequently, they do not presently require capital backing. The objective of the risk-adjusted ratio is to alter a bank’s assets mix and thus contribute to a safer banking system. For the purpose of this analysis, bank assets are divided into some rough groupings. These do not, of course, accurately reflect all the various shades or degrees of risk, but they appear to be the fundamental categories into which bank assets normally fall, and they provide a more selective basis than the simple distinction between risk and non-risk assets used in the risk-asset approach.

The ratios as stated above have been judged, at one time or another, to fall short of the requirements necessary for a valid standard of the adequacy of a bank’s capital funds. To the extent that adequate capital means enough to absorb losses and prevent failure, all have been poor predictors of bank failures and thus poor measures of capital adequacy.
It may be relevant to state U.S comptroller’s manual which provided official guidelines for the determination of capital adequacy that specifically denied reliance on capital ratios. Instead, its following eight factors are considered to be very important in assessing the adequacy of capital:
1.   The quality of management
2.   The liquidity of assets
3.   The history of earnings and of the retention thereof
4.   The quality and character of ownership
5.   The burden of meeting occupancy expenses
6.   The potential volatility of deposit structure
7.   The quality of operating procedures
8.   The bank’s capacity to meet present and future financial needs of its trade area, considering the competition it faces.

Each of these factors related in some way to the various kinds of risk that commercial bank faces. In addition to these qualitative factors, the regulatory agencies assess the growth rate in earnings and assets when attempting to judge the adequacy of bank capital. If a bank is not growing in earnings and assets, it obviously has more risk than does one that is enjoying a healthy growth. The existence of more risk indicates a need for more capital, other things being equal, than is necessary for a bank with less risk.
Bank management owes to itself, to the depositors, and to the economy as a whole. A careful appraisal of all the risks facing the bank is required when ascertaining the adequacy of bank capital. Bank management should not be lulled into a sense of false security by good times. It should not be forgotten that bank failures result in losses to depositors and stockholders, bring inability for banks to meet the legitimate demands of borrowers and reduces public’s confidence in the financial structure of the nation. Therefore, the banks must maintain adequate capital. But adequate capital is not, of course, a substitute for sound lending and investing policies; it cannot take the place of experienced and progressive management of a well-conceived programme of planning and control. However, adequate capital can provide assurance to the public, the stockholders, and the supervisor that the strength and the wherewithal to survive circumstances and conditions that even the best management can never foresee.

Professor Rafiqul Islam
Faculty of Business & Economics (FBE)

Offline Rozina Akter

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Re: Concluding Section of Capital Adequacy
« Reply #1 on: July 30, 2013, 03:44:28 PM »

Good post sir

Rozina Akter
Rozina Akter
Assistant Professor
Department Of Business Administration