CAPITAL ADEQUACY---CAMALS

CAPITAL ADEQUACY

Capital Adequacy Shortly:

The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted. Internationally, the Basel Committee on Banking Supervision housed at the Bank for International Settlements influence each country's banking capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Accord. This framework has been replaced by a significantly more complex capital adequacy framework commonly known as Basel II. After 2012 it will be replaced by Basel III.

Rating factors:

Capital is rated based on the following considerations:

·         Nature and volume of problem assets in relation to total capital and adequacy of LLR and other reserves.

·         Balance sheet structure including off balance sheet items, market and concentration risk.

·         Nature of business activities and risks to the bank.

·         Asset and capital growth experience and prospects.

·         Earnings performance and distribution of dividends.

·         Capital requirements and compliance with regulatory requirements.

·         Access to capital markets and sources of capital.

·         Ability of management to deal with above factors.

Capital rating 1:

Rating “1” is characterized by:

·         Capital levels and ratios exceed all regulatory requirements.

·         Strong earnings performance.

·         Well managed and controlled growth.

·         Competent management able to analyze the risks associated with the activities in determining appropriate capital levels.

·         Reasonable dividends and ability to raise new capital.

·         Low volume of problem assets.

Capital rating 2:

Rating “2” is characterized by similar criteria as “1”, but experiences weaknesses is one or more of the factors. For example:

·         Capital and solvency ratios exceed regulatory requirements, but:

1.   Problem assets relatively high

2.   Management inability to maintain sufficient capital to support risks

Capital rating 3:

Rating”3”indicates that the bank complies with capital adequacy and solvency regulatory requirements, but has major weaknesses in in one or more factors:

·         High level of problem assets in excess of 25% of total capital.

·         Bank fails to comply with regulatory regulations.

·         Poor earnings.

·         Inability to raise new capital to meet regulatory requirements and correct deficiencies.

·         It requires regulatory oversight to ensure management and shareholders address the issues of concern.

Capital rating 4:

Rating “4” means that the bank is experiencing severe problems resulting in inadequate capital to support risks associated with the business and operations:

·         High level of problems generating losses in all area of activities.

·         Problem loans in excess of 50% of total capital.

·         Insufficient capital.

·         Non compliance with regulatory requirements.

·         Management needs to take immediate action to correct deficiencies to avoid going into bankruptcy.

Capital rating 5:

Rating”5” indicates that the bank is insolvent:

·         Strong regulatory oversight is needed to mitigate the loss to depositors and creditors.

·         Very slight possibility that actions from management will prevent the demise of the bank.

·         Only shareholders may be able to prevent the failure.

Capital Adequacy Ratio – CAR:

What Does Capital Adequacy Ratio - CAR Mean?
A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.

Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."

Capital Adequacy Ratio - CAR
This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.

Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Capital Adequacy:

While Basel II significantly alters the calculation of the risk weights, it leaves alone the calculation of the capital. The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord.

Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework.

Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a bank’s capital eroded by the yearly inflation rate.

The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital, have been replaced by one single criterion. While the international standards of bank capital were laid down in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement.

Examples of national regulators implementing Basel II include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy.

In the United States, depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB). These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels.

Contents:

• 1 Regulatory capital
• 1.1 Tier 1 capital
• 1.2 Tier 2 (supplementary) capital
• 1.2.1 Undisclosed Reserves
• 1.2.2 Revaluation reserves
• 1.2.3 General provisions
• 1.2.4 Subordinated-term debt
• 2 Different International Implementations
• 3 Common capital ratios

Regulatory capital:

In the Basel I accord bank capital was divided into two "tiers", each with some subdivisions.

Tier 1 capital:

Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank, retained profits subtracting accumulated losses, and other qualifiable Tier 1 capital securities. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in retained earnings each year since, paid out no dividends, had no other forms of capital and made no losses, after 10 years the Bank's tier one capital would be $200.

Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. One of these instruments is referred to Tier 1 capital securities.

Apart from a few minor issues, these began to gain momentum from 1998 and usually consisted of a perpetual security with a fixed coupon for 10 years.. As with equity, their coupons were not guaranteed and usually could only be paid provided the bank had sufficient distributable reserves. If the coupon was not paid, the coupon would never be paid. They were also loss absorbing to provide a further buffer for depositors. Until the credit crunch of 2007-2009, 99% of all issues were called as they could be refinanced at cheaper levels to their post-step coupon. However, even though many issues were trading wider than their step level during the credit crunch most were still called much to the annoyance of the regulators. Holders of the argued that they needed these issues to be called and coupons paid as, unlike shareholders, they do not benefit in the upside of a bank's equity price. They also hold no voting rights.

Tier 2 (supplementary) capital:

There are several classifications of tier 2 capitals, which are composed of supplementary capital and are called temporary capital unlike tier 1 which is permanent capital. In the Basel I accord, these are categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results.

Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.

General provisions

A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.

Different International Implementations:

Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction.

For example, it has been reported that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Financial Services Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.

Common capital ratios:

• Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6%
• Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets >=10%
• Leverage ratio = Tier 1 capital / Average total consolidated assets >=5%
• Common stockholders’ equity ratio = Common stockholders’ equity / Balance sheet assets.