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“Capital Adequacy” sounds a very content scenario. The phrase gives an
impression of satisfaction and fulfillment; being adequate suggests that a major
issue is over. How adequate is capital adequacy? Does it really bring about the
results desired by the depositors, regulators and the bankers? Is there anything
called adequate capital ? Isn’t more better ? Wouldn’t less be enough? The purpose
of this article is to highlight the limitations of a single factor performance/strength
measurement that can give a misleading message, “Everything is alright !”.
The article looks at the role of capital, its relationship to bank failures, preventive
role and “cure” that capital can offer, matters “beyond capital” and related issues.
What role does capital play in a bank? The role of capital can be identified broadly
in the following lines:
1) Capital provides the funds required to set up (and expand) the bank by
meeting the fixed capital requirements.
2) Capital provides a means of absorbing temporary losses or set backs
encountered by the bank.
3) Capital provides solvency, i.e. ability to meet all the liabilities at the time of
dissolution / winding up of the bank.
Capital Adequacy of a bank has become an important topic in terms of the second
and third items listed above. The importance of capital in the banking system is
viewed with emphasis on its ability to absorb losses arising from undertaking a
variety of risks and also with regard to its role as a provider of solvency.
Banks take a variety of risks in running their day to day operations. These risks
can lead to gains or losses. Therefore the assumption of risks is followed by the
potential for gains or losses. If risks consistently provide gains only, then it is well
and good. However, if risks lead to losses, then the bank must have the ability to
meet the losses. The availability of capital meets losses in two ways :
a). When explicit losses are incurred, such losses may be partly or fully financed
by the earnings attributable to the equity holders. The result is a reduction of
profits. Should there be sufficient equity capital, there is likely to be adequate
profits attributable to shareholders prior to charging those losses arising from
crystallization of risks.
b). If the adverse effects of the risks are substantial and hence if the losses are
significant, then the losses might exceed the current year earnings. The result
is that there should be a source of funding of the losses. Capital performs
this role of meeting such losses.
A bank assumes a large variety of risks. Of all these, it is possible to identify three
broad categories of risks :
This is the risk of default by the borrowers of the bank. This probably is
the single most significant risk that a bank may assume if it is operating
under a typical banking model.
This is the risk of losses arising from changes in the market prices
including exchange rates and interest rates. The key types of risks that
may be classified under this heading are :
1) Interest Rate Risk
2) Foreign Currency Risk
3) Equity Risk
4) Commodity Price Risk (if applicable)
Operational Risk is defined in the document titled“ International
Convergence of Capital Measurement and Capital Standards; A Revised
Framework” more popularity known as Basel II, produced by the Basel
Committee on Banking Supervision, and published by the Bank for
International Settlements, in June 2004.
“Operational Risk is defined as the risk of loss resulting from inadequate
or failed internal processes, people and systems or from external events.
This definition includes legal risk but excludes strategic and reputational
risk”.
If a bank fails , despite all capital requirements, regulations, supervision etc., what
would be the fate of the depositor ? The answer to this question depends on two
aspects :
(1) The realisability of the assets and, in particular, the recoverability of the credit
facilities extended.
(2) The proportion of funding of such assets by the depositors and the providers
of capital.
The first is an issue of “asset quality” and, of course, higher the asset quality
- higher the ability to pay the depositors; hence higher the solvency.
The second item is the adequacy of capital in funding the assets. If, in a
hypothetical scenario, all the assets are funded by depositors, then it is obvious
that, as only a certain percentage of assets can be realized into cash, the depositors
will lose a portion of their deposits.
If, on the other hand, a certain portion of the funding comes by way of capital
funds which are subordinated to the depositors‘ claim, then it is likely that the
depositors will receive either full deposit value or at least a higher percentage of
the claim than in the previous scenario.
To illustrate this, let us take a bank that has assets of Rs. 100 Bn Suppose the bank
fails and only Rs.70 Bn can be realized in cash. Take two scenarios of the liability
side. First scenario is where 100% is funded by deposits. In this case, of the deposits
of Rs.100 Bn only, Rs. 70 Bn can be repaid i.e. 70% of deposits.
The second scenario is where, let us assume, the assets are funded by Rs.80 Bn of
deposits and Rs. 20 Bn of Capital funds. Since Capital funds are subordinated to
the depositors’ claim, depositors will be paid first. They will receive Rs.70 Bn
which is the total amount realized. This works out to Rs.70 Bn out of Rs.80 Bn
which is 87.5% of deposits; a big improvement.
It can be clearly seen that the asset quality as well as the proportion of capital
(capital adequacy) both play a vital role in providing solvency.
The illustration in the previous paragraph was on the basis of liquidation of
the bank concerned realizing the assets i.e. mainly recovering the loans granted,
after the failure of the bank.
However, liquidation or closing down is found to be the least effective way of
safeguarding the interest of the depositors. The most obvious reason is that the
credit facilities granted by a bank to an on going business cannot be demanded
for repayment simply because the bank has come to a standstill. While the bank
ceases to be a going concern, the borrowers are yet going concerns. They will
demand revolving banking facilities and longer repayment programmes as
previously scheduled. If not, alternative banking facilities should be arranged by
transfer of the facilities to some other bank/s, may be at discounted values. Instead,
if the facilities are called up for immediate repayment the recoverability will be
very poor. This is against the best interest of the depositors. On the other hand,
if a liquidator takes a long time & allows the repayment of debts over a period of
time, there will be heavy administrative overheads that will eat into the sums
recovered. In this case too, the amount available to the depositors will be adversely
affected.
Therefore, it is necessary that a regulatory authority, charged with the duty of
taking over a bank upon failure, acts fast and also acts in a restructuring approach
rather than resorting to liquidation.
There are different alternative methods / approaches available to an authority to
deal with a failed bank using a restructuring approach :
1) Permit another bank to take over the failed bank while retaining the identity
and license of the failed bank. This could probably be in a situation where
the failed bank is yet found to have potential to revive.
2) Permit another bank to absorb the failed bank. The deposit liabilities are
assumed by the acquiring bank and the assets are transferred. The transfer
value of the assets, i.e. the extent of discount, will depend on the asset quality.
If there is a gap between the discounted value of assets that are identified for
transfer and the amount of deposit liabilities, then somebody must bridge the
gap. Different options are available:
1) Capital funds would have already absorbed part of the loss & reduced the
gap.
2) A deposit insurance agency, if one had existed and covered the deposits,
would meet the difference.
3) A Government Authority will meet the difference on an exceptional basis,
through a grant. (Examples are available in the Japanese banking system).
4) The gap can be passed on to the depositors by compelling them to accept
the relevant percentage after reducing the gap as the new value of the deposits,
since depositors anyway have not much choice.
5) A part of the deposits can be converted into risk capital in either of a number
of forms such as :
1) Non interest bearing long term debt
2) Deep discount subordinated debentures
3) Preference Shares
4) Non Voting Shares or
5) Ordinary Shares
In either of the two approaches suggested above and under different options
in the second approach, it is likely that the depositors will receive a higher
percentage of their deposits than on an outright liquidation or winding up of the
failed bank.
This forms my first contention of Capital inadequacy. While capital adequacy
may reduce the extent of losses to depositors, the authorities can bring about a
major impact and thereby significant changes to the percentage of deposit funds
realized by the depositors, simply by using a forward looking and positive
restructuring approach instead of a backward looking negative approach of
winding up.
USA had encountered a large number of bank failures probably in line with the
large number of small banks operating as unit banks, with a single office or few
branches.
The Federal Deposit Insurance Corporation (FDIC) is the US Government agency
charged with the duty of promoting stability in the financial system and also
providing deposit insurance. It is an independent agency created by the US
Congress in 1933. FDIC supervises banks and insures deposits up to USD100,000/
- and helps maintain a stable and sound banking system. The deposit insurance
is voluntary. The FDIC insures banks and Savings Associations.
FDIC proudly claims that not a single depositor has lost a penny out of their
insured deposits up to USD 100,000/- since 1934.
FDIC has had 3596 insured bank failures to deal with since 1934. The depositors
are paid or assured payment almost immediately while FDIC will pursue different
approaches to resolve the failure. There are three broad categories and sub
categories defined within the three categories.
| Category I : |
In this category the FDIC attempts to revive the failed bank,
while FDIC will provide assistance to overcome the failures.
The License & identity of the failed bank remains. |
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| Category II : |
In this category the assets and liabilities are transferred to FDIC
or another bank. One method is to place the failed bank under
the control of a Government agency until it is revived. |
Both category I and II appear to be approaches to maintain the going concern
nature of the failed bank and to restructure and revive the business.
| Category III : |
This is to pay off the depositors and liquidate the bank. Of
the 3596 failures, FDIC, having paid the insured deposits, has
concluded 2011 transaction of finalizing the affairs of the failed
banks. The difference of 1585 instances relate to transaction
pending conclusion. |
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Please refer Annex 1 for a detailed schedule.
It should be noted that there were two eras of bank failures in the USA. The 1st
era was 1934 to 1942 where 402 banks had failed. (banks include savings
associations). The second era of a large number of failures was between 1980
and 1994. There were a massive 2936 bank failures during this 14 year period.
Therefore, of the 3596 failures, 3,338 failures belong to the two specified eras. In
other words, of the 70 years period between 1934 and 2004, 3338 out of 3596
failures had occurred during two eras totalling to 22 years. This is to say that
92.8% of the failures have occurred during 31.4% of the total time period.
Bank failure is not simply an internal matter. Bank failures are significantly affected
by the external economic environment. They could also be contagious. Did all
the 2936 banks that failed during the 14 years period of 1980 – 1994 fail because
of capital adequacy issues ? It is unlikely.
These lead to my second contention of “Capital inadequacy”. While capital does
play a vital role, the external economic shocks on a bank cannot be undermined.
An attempt was made to establish a relationship between bank failures and key
economic indicators such as GDP, GDP growth, Money supply, consumer price
indices and rate of inflation. It was found that it was difficult to establish a clear relationship between the level of GDP or GDP growth and the intensity of bank
failures in the USA.
However, there was a medium level negative correlation (r), (r = - 0.5041), between
the level of money supply (M3) and the intensity of bank failures, in the USA
during the period 1980 – 2004 (r = - 0.599 for the period 1986 to 2004). It is of
course pre-mature to come to a conclusion that contractionary monetary policy
where the growth of the money stock had been slowed down, had an adverse
impact on the banks leading to failures.
The following graphs indicating number of bank failures and the percentage
growth of money supply (M3) also show a somewhat strong negative relationship.
(It is left for further research to establish a relationship and also justify the causation
of one by the other). One could, of course, argue that slowing down of the
monetary growth affects both the main end products of a bank viz deposits and
advances. When growth of both these is restricted the banks will have to control
their own growth. With a restricted growth of business they invariably will have
to control the growth of overheads. If not, the bank will have poor or negative
earnings.
Controlling overhead costs is easier said than done. Hence, the banks will have to
service increasing overheads with restricted growth of business under a prolonged
period of low monetary growth. Would banks fail due to this reason?
Another possible reason is that under restricted growth of credit, the businesses
will find it difficult to grow and sustain financial performance. Could there be an
increase in default rates leading to poor asset quality and bank failures?
Can restrictive monetary policy create severe pressure particularly on the smaller
and weaker banks in maintaining liquidity; hence liquidity problems that lead to
failure? Attempting to grow credit portfolios at a rate higher than the overall
restricted growth rate will lead to liquidity constraints in the system.
Could the negative relationship between the growth rate of money supply and
the number of bank failures be as a result of the bank failures causing the slower
growth of money supply instead of the slower growth of money supply causing
the bank failures? Or is there no relationship at all but a co-incidental pattern?
More research will be necessary to address these issues.
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Graph (1) Number of Bank failures year by year, in USA, 1980 - 2004
Source: Federal Deposit Insurance Corporation, FDIC, USA |
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Graph (2) The percentage change in money supply (M3) in USA during the period
1981 - 2004 based on closest year end point to point figures.
Source: (M3 Values) Federeal Reserve Bank
http://research.stlouisfed.org/
publications/usfd/ |
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Basel II is the most authoritative source of confirmation that the role of capital as
the sole means of banking and financial system stability, has been challenged.
Basel II proposes a ‘three pillar’ approach.
 The First Pillar is the Minimum Capital Requirements
Under this, there are comprehensive guidelines on the methods to be adopted
in determining the minimum capital required to be held with particular
emphasis on credit risk and operational risk.
The Second Pillar is the Supervisory Review Process
Four key principles for supervisory review are proposed in the document.
The whole idea is to place much importance on the supervisory review
process, a step beyond capital adequacy.
The Third Pillar is the Market Discipline.
Under this pillar, emphasis is made on the disclosure requirements and need
to achieve adequate disclosure. It is presumed that adequate disclosures
will enable the public to make assessments on the strengths & stability of
banks. Further, improved disclosures will also compel the banks to address
the underlying issues, as matters of priority.
A common model used to identify a balanced set of factors that are important
for the stability of a bank is known by the acronym CAMEL.
C - Capital Adequacy
A - Asset Quality
M - Management
E - Earnings
L – Liquidity
A further analysis of these aspects, which are undisputed and well recognized as
factors that bring about stability and strength to a bank, is not being pursued.
Instead, the endeavour is to expand on the model to identify several internal and
external factors that are important for the soundness and stability of a bank. In
identifying these factors, it is proposed that it is not necessary to confine to the
economic and financial market inputs. Banks can be viewed as business
organizations and some of the factors that lead to the failure of business
organizations can equally lead to failure of banks.
Some of the important external factors that may trigger failures are broadly
identified below: The list is not, by any means, exhaustive.
Like in any other industry, severe competition must lead to some banks
being compelled to exit for the survival of the rest.
An exchange crisis (currency crisis) can trigger a banking crisis. Banks
are the gateway for economic crisis to enter and exit the economies. In
the process, the banks’ Balance Sheets get affected. Banks’ customers
too will get affected in a currency crisis and that in turn will lead to nonperforming
assets leading to eventual failures.
A banking crisis, per se, once triggered can lead to further failures.
Examples of banking failures in the United States were discussed in a
previous paragraph. Such failures were despite deposit insurance where
depositors (at least the large number of small depositors) would not have
any reason to panic. In an environment where the banks have not
subscribed to a deposit insurance scheme the sensitivity could be higher.
Rapidly rising property prices under an economic boom can plant time
bombs that explode after a delay. When property prices rise the potential borrowers get the ability to offer more collateral (same properties would
be worth more) and be able to borrow more. Further, there would be
increased borrowings to finance the real estate projects themselves. After
reaching a particular point the economy may have excess capacity in
properties and the property market could collapse. The property market
could also collapse due to a slowing down of the economy. The failure
of this segment will leave the banks with poor collateral on facilities
granted and hence, coupled with a economic recession, non recoverable
advances.
As discussed earlier, persistent contractionary monetary policy can lead
to instability in the banks. In addition to the effects on growth and
liquidity, there will also be adverse effects from rapidly rising interest
rates.
Banks typically carry long-term assets funded by short-term liabilities. It
is a fact. This is particularly so because most of the customer advances
tend to be for periods over 3 months whereas the most common deposits
in the form of current and savings accounts are payable on demand. It
is easy for a bank to benefit from a reduction of interest rates where
short-term liabilities get re-priced immediately while the long-term assets
tend to carry the same high rates until they are re-priced.
In contrast, a bank will have to meet an immediate increase in interest
cost without an increase in revenue, when interest rates go up while the
bank carries a long position.
A sudden increase in interest rates to a high level will also weaken the
financial performance of the borrowers, which in turn will affect the
banks.
Intervention of a regulatory authority without adequate legal backing
and a range of tools to overcome failure can in fact trigger failure. For
example, in the Sri Lankan legal framework, one of the first steps available
to the regulator is to “suspend the license” to carry on the banking
business. This is probably the last step in a comprehensive framework.
Different arrangement made by FDIC of USA under three categories were discussed earlier.
Banks engage in the business of lending money. If borrowers do not
repay, the banks suffer losses. There are willful defaulters who have the
ability to repay but not the willingness. Banks should be in a position to
pursue legal action and recover dues on the merit of the transactions
and not on the technical details that may be filed in a Court of Law. A
poor legal system with pro-longed court cases will weaken the debt
recovery process and hence the stability of the banks.
Let us identify some key internal factors, again the list not being exhaustive.
Like in the case of any business organization, Management plays a vital
role in a bank. It is the management that can decide the destiny and fate
of the bank in most instances. Failure on the part of the management
will invariably lead to failure of the bank.
Does the size of the bank matter ?
Rightly or wrongly, banks that have reached a certain qualifying size
seem to benefit from economies of scale, pooling of risk and diversification.
They also will have a bigger economic impact in the event of a failure
and hence tend to get more support to avoid failure rather than being
“pushed towards” failure.
As much as the capital base, the capital structure of a bank is important.
If the capital base comprises more of interest bearing ‘debt capital’ then
the bank would be of relatively higher gearing. This increases the financial
risk and reduces the financial strength.
Banks pool risk by lending to a large number of borrowers. It is a kind of an insurance. No one loan would be large enough to destabilize the
bank. If, however, a bank ignores this principle of “Pooling” and place
reliance on few large borrowers, then the failure of few borrowers can
lead to the failure of the bank.
A bank that concentrates on a couple of sectors in the economy may be
adversely affected by failure of such sectors. Having a well diversified
portfolio of advances will bring in stability to a bank.
One of the single most important contributory factors for bank failures
has been poor quality of advances. When advances are non recoverable,
the bank encounters failure.
Some banks fail because they engage in a growth process that cannot be
sustained. The overtrading problems that banks attribute to their
borrowers are equally applicable to the banks themselves. In a battle to
capture market share, a bank may expand its deposit base and the
advances base aggressively. In this process, it could lower/relax its lending
criteria. Further, the growth may not be supported by the internal
systems, procedures, human resources, organizational knowledge and
adequate financial resources. The result could be an eventual failure.
Banks tend to get into a dilemma in reconciling the growth objectives
and the need for the maintenance of asset quality. Further, once trapped
in a low quality asset portfolio, high growth tends to be the only way to
sustain earnings. Such high growth in turn could be through the
acquisition of low quality assets with a view to sustaining short-term
profitability. This creates a viscous cycle and the bank will find it difficult
to get out of the trap.
| Asset Quality – Growth Dilemma |
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Diagram (1): The Asset Quality - Growth Dilemma faced by a bank with poor
asset quality. |
The degree of operating leverage refers to the extent to which the bank
has relied on fixed overheads in its cost structure. Heavy reliance adds
to operating leverage while low reliance reduces such leverage. A bank
with high fixed overheads is more vulnerable to changes in the net
income arising from loss of margins or volumes. Hence, managing the
cost structure is important. Particularly, it is necessary to remove
unnecessary fixed overheads incurred in non-core banking activities.
Like in the case of any other business organization, sustained profitability
is an important aspect that leads to stability of a bank. Volatile earnings
affect the ability to grow and also will lead to loss of confidence and
hence a premium added to the cost of funds.
A bank ought to manage liquidity at the desired levels having satisfied
the regulatory minimum requirements. Loss of liquidity and the resultant
inability to meet the customer demand for withdrawals, even if it
happens only at a branch office, can lead to a severe loss of confidence
and the panic driven customers may rally round to get the deposits back
before the bank fails. This in turn leads to a “bank run”.
Similar to the scenario in the previous paragraph, loss of customer
confidence, due to factors such as adverse disclosures may lead to a ‘bank
run’ or a gradual shrinkage of the volumes.
A bank ought to place emphasis on proper systems and procedures for
managing risks. It should pay particular attention to credit risk and
liquidity risk. It should manage the interest rate risk and foreign exchange
risk as two other key risks that keep the bank exposed. In addition,
proper operational guidelines and procedures will ensure minimizing
the operational risk.
Capital Adequacy is an important aspect for the stability of a bank. However,
bank failures are not entirely attributed to this aspect. Hence there is a problem
i.e. “Inadequacy of capital adequacy” to prevent bank failures. Basel II recognizes
this by identifying three pillars of the framework where minimum capital
requirement is all but just one pillar out of the three. There are many important
aspects that are preconditions to prevent bank failures. Historical information
suggests that there have been concentrated periods of large numbers of bank
failures. This proves the impact of external influence on bank failures.
Having encountered a failure, the extent to which the depositors’ interest would
be safeguarded will depend on the approach used by the authorities to resolve
the issue. A forward looking restructuring based solution is more appropriate.
W A Wijewardena, Capital Market in Sri Lanka, Problems and Prospects,
Sri Lanka Economic Association, 1993
 Federal Reserve Statistical Release, web site
Federal Deposit Insurance Corporation, FDIC, USA, website
International Convergence of Capital Measurement and Capital Standards;
A Revised Framework” more popularity known as Basel II, produced by the
Basel Committee on Banking Supervision, and published by the Bank for
International Settlements, in June 2004.
Failing institutions have been resolved through several different types of
transactions. The transaction types outlined below can be grouped into three
general categories, based upon the method employed to protect insured depositors
and how each transaction affects a failed institution’s charter. In most assistance
transactions, insured and uninsured depositors are protected, the failed institution
remains open and its charter survives the resolution process. In purchase and
assumption transactions, the failed institution’s insured deposits are transferred
to a successor institution, and its charter is closed. In most of these transactions,
additional liabilities and assets are also transferred to the successor institution. In
payoff transactions, the deposit insurer - the FDIC or the former Federal Savings
and Loan Insurance Corporation - pays insured depositors, the failed institution’s
charter is closed, and there is no successor institution. For a more complete
description of resolution transactions and the FDIC’s receivership activities, see
Managing the Crisis: The FDIC and RTC Experience, an historical study prepared
by the FDIC’s Division of Resolutions and Receiverships. Copies are available
from the FDIC’s Public Information Center.
| Category 1 |
Failed institution’s charter survives
| A/A |
Assistance Transaction, includes 13(c) and FAM |
| REP |
Reprivatization |
| RO |
Institution closed and reopened |
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| Category 2 |
Failed institution’s charter is terminated, insured deposits plus some
assets and other liabilities are transferred to a successor charter
| P&A |
Purchase of assets and assumption of liabilities of a failed
institution |
| IDT |
Transfer or assumption of insured deposits of a failed
institution |
| MGR |
Failed institution was placed under government control
through FSLIC’s Management Consignment Program, then
transferred to the Resolution Trust Corporation’s
conservatorship program after creation of RTC in 1989 |
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| Category 3 |
| PO |
Payoff of insured deposits, remaining liabilities and assets
are liquidateSource: Federal Deposit Insurance Corporation,
USA |
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Sources: Federal Deposit Insurance Corporation, FDIC, USA, website
Federal Reserve Statistical Release, web site |
Ajantha Madurapperuma is the Deputy General Manger,
Foreign Currency and Corporate Banking at Seylan Bank Ltd.,
Director / CEO of Seylan Bank Asset Management Ltd. and
Finance Director of Ceylinco Seylan Developments Ltd.
He is a Chartered Financial Analyst (CFA) and a member of
the CFA Institute (Formerly Association for Investment Management and
Research), U.S.A. He holds a Masters Degree in Business Administration (MBA)
from the Postgraduate Institute of Management, University of Sri
Jayewardenepura. Ajantha is a Fellow of the Chartered Institute of Management
Accountants, (CIMA), U.K, and an Associate Member of the Institute of Bankers
of Sri Lanka (IBSL). Ajantha is a prizewinner at both CIMA and IBSL
Examinations. He had been a lecturer and a Chief Examiner of the IBSL and
conducts Lectures for CIMA and CFA examinations. He is a former President of the Association of Primary Dealers and Membership Chair of CFA Sri Lanka. He
is also a Board member of the Financial Services Ombudsman of Sri Lanka
(Guarantee) Ltd. and the Sri Lanka Association of Securities & Investment
Analysts (SLASIA).
He won “The CIMA Business Manager of the Year, 2004” Gold Award presented
at the CIMA Janashakthi Pinnacle Awards Ceremony
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