Generally capital adequacy is a measure of the financial strength of a bank or securities firm, usually expressed as a ratio of its capital to its assets. Capital is held by firms to absorb any possible business losses and thus protect the creditors. For banks, capital also provides the protection to government agencies that insure depositors, such as FDIC. From supervision point of view banks have an interest in maintaining adequate capital in the banking system and have used their authority to impose minimum capital requirements. Regulatory capital typically consists of equity and long-term subordinated debt. Capital adequacy has become important for bank regulations to avoid and minimise problems of moral hazard and adverse selection.
The following paper will provide an explanation for the rationale behind the new capital adequacy framework. Prior to starting the discussion, it is imperative the highlight the key features of the 1988 Basel Committee Accord and also the importance of bank regulation.
The idea behind bank regulations is to restrict banks from taking too much risk and therefore, stopping them from making ambitious lendings which if went wrong would lead to bank runs and eventually lead to a financial crisis in the country and then lead to an economic collapse. Besides controlling risk, bank regulation also promotes diversification, which reduces the risk by limiting the amount of loans in particular categories or to individual borrowers. Imposing requirements on banks to hold a certain level of capital is another way to change bank’s incentives to take on less risk. It must be noted that bank capital requirements take two forms namely; the first type is based on the leverage ratio, which is the amount of capital divided by the bank’s total assets. Thus for a bank to be classified as well capitalised, a banks’ leverage ratio must exceed 5%. Thus, a lower leverage ration would lead to increased regulatory restrictions on the bank.
In 1988 the Basel Committee on Banking Supervision adopted the Basel Capital Accord, which created capital requirements for the credit risk in banking assets. It established minimum capital requirements that were internationally comparable, paving the way for more uniform capital requirements across the countries. The Accord also created capital requirements for the credit risk in banking assets. Thus the Basel Accord was an agreement, which required that banks hold as capital at least 8% of their risk-weighted assets. This had been adopted by over 100 countries. Off-balance sheet activities were allocated into four categories, each with a different weight to reflect the degree of credit risk. The first category carried zero-weight and included items that had little default risk such as reserves and government securities in the OECD (Organisation for Economic Cooperation and Development) and industrialised countries. The second category had a 20% weight and included claims on banks in the OEC countries. The third category had a weight of 50% and included municipal bonds and residential mortgages. The fourth category had a maximum weight of 100% and included loans to consumers and corporations. As Mishkin (2005) highlighted that off-balance sheet activities were treated in a similar manner by assigning a credit-equivalent percentage that converts them to on-balance-sheet items to which the appropriate risk weight applied.
However, over a period of time the limitations associated with the Accord have become apparent. While the original Accord focussed mainly on credit risk, it has since been amended to include market risk. Interest rate risk in the banking book and others risks such as operational, liquidity, legal and reputational risks are not explicitly addresses. Implicitly however, the 1988 Accord took account of such risks by setting a minimum ratio that has an acknowledged buffer to cover unquantified risks. Besides, another related and an increasing problem with the 1988 Accord was the ability of the banks to arbitrage their regulatory capital requirement and exploit divergences between true economic risk and risk measured under the Accord. A second limitation indicated that the risk weighting system of the 1988 Accord was a crude measure of economic risk, mainly because degrees of credit risk exposure was not sufficiently standardised and regulated as to adequately differentiate between borrower’s differing default risks. For instance claims on corporations received the same 100% risk weight, regardless of whether the corporations are highly rated or lower rated and therefore, riskier. And, since the full 8% capital requirements applies to these claims, a bank would generally favour the riskier claims, which would provide greater returns on investment. Thus shifting to riskier assets could keep a banks’ required regulatory capital constant, even though the overall riskiness had increased. Thus, it was considered a crude measure of bank risk. Finally it was argued that for certain kinds of transactions, the Accord did not provide the appropriate incentives for risk mitigation techniques. For instance, there was only minimal capital relief for collateral, and in some cases, The Accord’s structure discouraged the use of credit risk mitigation techniques, which further meant that it was inappropriate for regulatory purposes.
Another limitation that was pointed out was that of loan securitisation. By selling loans to a third party, while retaining some exposure through credit enhancements, a bank could effectively remove loans from its portfolio and decrease its required capital without a commensurate reduction in its overall credit risk.
With the development and evolution of the financial during the past decade has highlighted that, to a certain extent, where a bank’s capital ratio, which was calculated using the 1988 Accord, was not always found to be a good indicator of its financial condition. As a result of which the framework was revised and amended to what is not termed as ‘Basel 2′. Thus, Basel 2 is a revision of the existing framework, which aims to make the framework more risk sensitive and representative of the modern bank’s risk management practices.
There were four key objectives of the new framework, namely:
There are four main components to the new framework; firstly, it is more sensitive to the risks that firms face: the new framework includes an explicit measure for operational risk and includes more risk sensitive risk weightings against credit risk, secondly, it reflects improvements in firms’ risk management practices; thirdly, it provides incentives for firms to improve their risk management practices, with more risk sensitive risk weights as firms adopt more sophisticated approaches to risk management and lastly, the new framework aims to leave the overall capital held by banks collectively broadly unchanged.
Each of the three pillars are complimentary to each other and are required for supervising both the overall financial health of the banking industry and that of the individual institution as well, though it must be highlighted that none can substitute for effective bank management. The rationale behind adopting the new Accord is that it is believed by the committee that the new framework has the potential to meet challenges of innovations in increasingly complex financial markets.
According to FSA, the revised capital adequacy framework will further reduce the probability of consumer loss or market disruption as a result of prudential failure. It will do so by seeking to ensure that the financial resources held by a firm are commensurate with the risks associated with the business profile and the control environment within the firm. The new framework is established on three pillars, whereby pillar 1 of the new standard sets out the minimum capital requirements firms will be required to meet for credit, market and operational risk. Under Pillar 2, firms and supervisors have to take a view on whether a firm should hold additional capital against risks not covered by pillar 1 and must take action accordingly. The aim of Pillar 3 would be improve market discipline by requiring firms to publish certain details of their risks, capital and risk management.
With the new approach, the Committee highlighted clearly that all internationally active banks must have effective internal processes for evaluating their own capital adequacy. Banks may utilise various techniques in this effort including subjective measures of risk, rigorous capital allocation methodologies, and internal models. In additions Supervisors would evaluate a bank’s capital adequacy through on-site examinations, off-site surveillance and review of the work of internal and external auditors. Besides, the supervisors would also have to consider various factors including bank’s risk appetite and its track record in managing risk; the nature of the markets on which the bank operates; the quality, reliability and volatility of its earnings; its adherence to sound valuation and accounting standards; the diversification of its activities; and its relative importance for the national and international financial markets.
Despite the various advantages associated with the New Accord, it has its own set of challenges to meet, namely, the number-crunching aspect of the framework contains lots of daunting ratios for credit risk (the chance that a debt might not be repaid or recovered) and operational risk (the chance that, say, a bank is clobbered with a large regulatory penalty). But these are less exact than they look: there is almost unlimited scope for these to be adjusted over the next few years.
It is further argues that regulators have been placing less weight on pillar 1 and more on pillar 2Basel-speak for supervisors’ discretionin order to overcome anomalies produced by the formulas in pillar 1. Each national banking system and each class of bank within it has a different track record of default and of recovering loan losses, and faces different operational and legal risks. Thus the only way to deal with these inconsistencies is to allow regulators to adjust the rules. The good thing with the framework is that it allows for adjustments to be made to the rules.
There is also a pillar 3: reliance on disclosure by banks and market reaction to it as a means of discipline. This too is already bearing an increasing weight. Banks have been under more pressure from rating agencies and from threats to their sources of funding than they have been from regulators to show that they are aligning themselves with Basel 2.
The original Basel Accord helped to strengthen the soundness and stability of the international banking system as a result of the higher capital ratios that it required. It also helped in enhancing the competitive equality among internationally active banks. In addition, it established minimum levels of capital for the internationally active banks, incorporating off-balance sheet exposures and a risk weighting system aimed in part at ensuring that banks were not deterred from holding low risk assets. From the preceding paragraphs it can be said that whilst Basel 1 (1988 Basel Accord) set up to provide an appropriate regulatory measure for banks, however, due to the presence of inherent weakness of inappropriate risk weighting it was not meeting its purpose. To provide a solution to the above problem Basel 2 came into being, which can be seen as the next step to managing risks and providing a more stable financial system internationally. Thus in conclusion it can be said Basel 1 has been the foundation of Basel 2 and the factors have contributed in providing a better framework for Banking Regulation and Supervision.
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Website: Finance Glossary [http://www.finance-glossary.com/terms/capital-adequacy.htm?id=1680&ginPtrCode=00000&PopupMode=false]
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