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What is capital Adequacy?

It is the ratio of the Regulatory Capital to the Total Risk Weighted Assets. It is also known as Capital to the Risk Weighted Assets Ratio (CRAR) or CAR in the Banking terminologies.

We need to understand that the Accounting Capital is not the same as the Regulatory Capital. The regulators in the respective regions or countries have instructed the Banks to include or exclude certain capital instruments. For example, the accounting capital includes “intangible assets” like Good will. However, the regulators do not consider as the available capital for a Bank. Therefore there is a difference between the regulatory capital and accounting capital.

What is the difference between an Asset and Risk Weighted Asset?

The Banks will have different types of assets. For example a bank may have the following assets in its Balance Sheet. Basically the Regulators / Basel – Committee classified the Bank’s assets into different categories. The following are some of the asset classes which are used for computing the capital adequacy of a Bank.

-          Housing Loans

-          Loans to Small and Medium Enterprises

-          Loans to Corporate Borrowers

-          Treasury Investments in Government Securities

-          Loans to Government Enterprises (without Government Guarantee)

-          Loans to Government Enterprises (With Government Guarantee)

-          Cash with their respective Central Bank (Reserve Bank / Federal Reserve)

-          Current Account Balances with other Banks in the country

-          Loans to Foreign Banks

-          Loans to Multi – lateral Banks like IMF / World Bank etc

-          Fixed assets

-          Any Other assets

What we need to understand from the above?

The Reserve Bank / Fed Reserve / Central Bank of a country does not view all the asset classes with equal risk category. The risk perception of the regulatory is different for all the above asset classes. For example the housing loans to individuals will be having a less risk as compared to the loans to corporate borrowers.

How can we understand which asset classes are with lower risk and assets with higher risk?

As mentioned above, the regulator’s risk perception is based on the capacity of the Bank to recover its dues, ability of the Bank to sell an asset and recover the dues, whether the loan is sanctioned to corporate borrowers or small finance customers and other parameters. Based on the risk perception of the Regulator, the Banks will be asked to keep certain amount of capital for each asset class.

How does a Bank keep the capital asset for each asset class?

The Regulators / BCBS guidelines mention that a Bank has to convert an asset as identified in the Balance Sheet to a Risk Weighted Asset and on the Risk Weighted Asset, the Bank needs to provide the capital. Therefore all the asset classes mentioned above are arrived at a particular risk weights. These risk weights are arrived by the Regulators or the Central Banks, based on the amounts of losses, the Banks suffered in the past. For example, in the Housing Loans, the losses to the Banks for every loan of USD100, the loss is around $4- $6. Again the losses are not unique for all geographies. They are different for different countries. There are certain countries where the Banks have the right of “Repossession” and in certain countries such rights are not available.

Is there any mathematical way to arrive at this loss of USD4 - USD6 in capital adequacy terms?

Yes! Absolutely. That is where the capital adequacy ratio comes into picture. For example if we look into the risk weights of housing loans, we can understand. Let us take a hypothetical example of a Bank which gave a housing loan of USD100000. The value of the asset as per the Balance Sheet is USD100000. However, the risk value of the loan as per the Basel Committee / Central Bank / Reserve Bank / Federal Reserve is not USD100000. Here the regulators prescribed certain risk weights for keeping the capital aside for the loan amount of USD100000. Let us assume that the risk weight is 50% (the risk weights are ranging from 35% to 75% for different geographical locations). This means the Risk Weighted Asset (RWA) value of the housing loan is: Loan value in Balance Sheet x Risk Weight of the asset class. Therefore, the risk weighted asset (RWA) of the housing loan is equal to: USD100000 x 50% = USD50000.

The Risk Weighted Asset (RWA) is then multiplied with the minimum capital adequacy ratio as prescribed by the concerned regulator. If we follow Basel Committee guidelines, the minimum capital on any risk weighted asset is 8%. This means for every USD100 of risk weighted asset value, the Bank has to provide USD8. Therefore, the capital required for a housing loan of USD100000 is equal to è USD50000 x 8% è USD 4000. In other words, the Bank has to keep aside a capital of USD4000 for creating an asset of USD100000 of housing loan.

 

 

This post is intended mainly for Bankers who are planning to work in the Risk Management Department. The performance monitoring of Basel is dependent on 3 pillars. You may ask me a question why it is not 4 pillars. Anyways, let us know how these pillars are expected to protect the Banking system from systematic risk.

 

Pillars	Their Descriptions and Importance
Pillar – I	Under Pillar – I, Banks need to identify the risks in their credit / lending portfolio, Investments portfolio and Operational areas. After identification of the risks, each type of risk is given certain weight. Then multiply each asset with the respective risk weight and arrive the risk weighted assets. These risk weighted assets are compared with available Regulatory Capital (Repeat the word – Regulatory Capital).
Pillar – II	Apart from the risks in their lending portfolio, Investment portfolio and operational areas, the Banks will also have risks in other areas. For example, the Bank may have a liquidity risk. Basically, any risks that are not identified in the Pillar – I, are to be identified and the Banks have to assess how much capital is required under this pillar. If any Bank has not identified or unable to identify those risks, the Central Bank of the country identifies those risk and instructs the Banks to keep certain amount of capital for those identified risk.
Pillar – III	Once all the risks are identified and capital assessment is done through Pillar – I and Pillar – II, the Banks are expected to disclose the relevant risks and the available regulatory capital to all the market participants like equity holders, regulatory bodies, or any other stakeholder.

We will learn about how these pillars work in practical manner in the coming weeks.

 

Regards..