mcf 304: bank management
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MCF 304: Bank Management. Lecture 3.2 Capital Adequacy. Capital Adequacy. One of the critical issues in today’s commercial bank management involves issuing and sustaining adequate capital - PowerPoint PPT PresentationTRANSCRIPT
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MCF 304: Bank Management
Lecture 3.2
Capital Adequacy
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Capital Adequacy
• One of the critical issues in today’s commercial bank management involves issuing and sustaining adequate capital
• This is because many people are of the view that capital inadequacy is the main contributing factor to bank failure & closure
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Capital Adequacy
• Capital adequacy can be measured quantitatively as well as qualitatively with several methods
• Important issues;
i. The concept of capital adequacy
ii. Capital adequacy measurement method
iii. Bank stability
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The Concept of Capital Adequacy
• Definition: Any level of capital that allows a bank to absorb or accommodate any losses and at the same time equips the bank with sufficient funds to sustain and carry on its businesses as a continuing entity
• The main question “how much capital base does a bank need?”
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Capital Adequacy
• In general a bank must have enough capital to;
i. Balance the interest of depositors, creditors, share-holders and borrowers
ii. Protect depositors and creditors from losses
iii. Maintain general public confidence in the stability of the bank
iv. Provide funds for lending purposes
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Capital Adequacy
• The regulatory bodies expect banks to have enough capital because;
i. A large capital base can ensure the security and stability of the country’s financial system
ii. A large capital base can safeguard the banks as it allows then to absorb losses
iii. A large capital base can increase the bank’s liquidity
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Capital Adequacy & Bank’s Security
• The endeavors to protect the interest of the banking regulatory body, the depositors and borrowers specifically, and the interest of the general public
• Capital adequacy and banks security can be explain from four perspectives
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Capital Adequacy & Bank’s Security
Regulatory body of banks- Capital adequacy is vital
to ensure the stability of the banking system
- Without a sound banking system, the economy & business will suffer without proper payment & credit mechanism
Depositors- The safety of their
deposits is of the utmost importance
- Should a depositor’s withdrawal demand cannot be fulfill, the negative news will spread quickly and may lead to “bank runs”
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Capital Adequacy & Bank’s Security
Borrowers- Only secure & stable
banks can continue to provide loans during tough times
- It is important for the banking system to continue supporting businesses in economic downturn
General Public- Bank security is a vital
factor in their dealings with banks
- The general public desire for efficient & secure banking services can only be fulfill if the wellbeing of the banking system is intact
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Structure of Bank Capital: Non-Banks
Assets %Cash 4
Accounts receivables 26
Inventory 30
Total 60
Fixed assets 40
Total 100
Liabilities %Accounts payable 20
Short terms notes10
Total 30
Long term debts 30
Shareholder’s equity 40
Total 100
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Structure of Bank Capital: Banks
Assets %Cash 8Short term securities 17Short term loans 50
75Long term securities 5Long term loans 18
98Fixed assets 2Total 100
Liabilities %
Short term deposits 60Short term debts 20
80Long term debts 12
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Shareholder’s equity 8Total 100
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Structure of Bank Capital
• Shareholders equity of bank’s is 8% while non-bank 40%
• Banks have higher percentage of assets 60% - 70%
• Current assets & fixed assets of non-banks are split by 60:40 and are financed by debts & equities by 60:40
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Structure of Bank Capital
• Banks normally have 75% of their assets in current assets.
• 92% of their assets are financed by debts, 80% by short term & 20% by long term liabilities
• Banks maximize the usage of their capital to generate higher return on assets to maximized shareholders wealth
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Capital Adequacy Measurement Method
• Capital adequacy measurement are used to measure how much capital is considered as adequate for a bank
• Four capital ratios normally used;i. Capital to total depositsii. Capital to total assetsiii. Capital to risk weighted assetsiv. Capital to loans
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Capital Ratios
Capital to Total Deposits- A ratio of 10% is
considered as sufficient to protect depositors
- Does not take into consideration that risk mostly come from loans, not deposits
Capital to Total Assets
- A ratio of no less than 7% is consider adequate
- Take no account of assets structure even though each assets class has different risk level
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Capital Ratios
Capital to Risk Weighted Assets
- Net total assets of liquid assets comprising cash, bank balances and government securities
- 8% of RWCR is considered as safe
Capital to Loans- Loans & advances have
the highest risk. This is called credit risk
- Any bank with a gross loan base exceeding 7x its capital is considered as dangerous
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Capital Adequacy Ratio (CAR)
Minimum CAR= Free Capital
Total Assets- Free capital consist of
shareholder’s fund net of investment in the long term assets
- The minimum ratio for local banks are 4% while foreigh banks 6%
RWCR= Capital
total risks weighted assets
Where;Total risk weighted assets =Balance sheets items x (off
balance sheet items x credit conversion factor) x risk weighting
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RWCR Categories
0 %
- bank assets which have either minimal or zero credit risk
- Eg. Treasury bonds
10 %
- Investment in money market instruments
- Eg. NCD’s
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RWCR Categories
20 %
- Loans that are guaranteed by other financial institutions
50 %
- Housing loans- Even though they are
backed by collateral because the collateral value depends on the economic conditions
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RWCR Categories
100 %
- Other loans and advances
- All other banks assets
- When a bank guaranteed is issued, the amount is not recorded in the balance sheet of the bank. The bank however may have a commitment against the guarantee in the future
- These off balance sheet items are valued based on conversion factor
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Conversion Factor
0 %
- Formal standby & non-standby credit facilities with a maturity period of no more than 1 year or which can be unconditionally revoke at any time
20 %- Short term, self
liquidating trade related contingencies
- Eg. Letter of credits & shipping guarantees
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Conversion Factor
50 %- Trade related
contingencies not influenced by the integrity of the counter party
- Eg. Performance bonds & warranties
100 %- Direct credit substitutes
such as bank acceptance & letters of credit
- Assets sales with recourse. Eg. When the credit risk is still borne by the selling institutions
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Why RWCR?
• The old CAR does not take into consideration the risk portfolio of assets
• Also did not take into account the potential risk of off-balance sheet items
• The need for a standard measurement that is applicable to all major financial institutions
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Banks Five Primary Risk
Credit Risk- The potential loss of net
income & the market value of equity due to customer’s non / late payment of loan installments
Liquidity Risk
- Risk to net income or capital arising from a bank’s inability to procure funds by selling assets or borrowing without incurring unacceptable losses
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Banks Five Primary Risk
Interest Rate Risk
- The potential loss in the bank’s net income & the market’s value of its equity resulting from any change in the market interest rates
Capital / Bankruptcy Risk- The potential that a
change in a bank’s capital may disrupt its capital adequacy
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Banks Five Primary Risk
Operational Risk- The risk to a bank’s
net income & the market value of its equity arising from the changes of operating expenditure which are related to ;
i. Direct cost
ii. Staff error
iii. Fraud by customers
iv. Technology- Market risk refer to the
impact of interest rates on the net asset portfolio
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Qualitative Measurement
i. Quality of bank measurement
ii. Quality of bank asset
iii. Bank earnings history
iv. Quality of bank ownership
v. Accommodation cost
vi. Quality of operational activities
vii. Volatility of depositors
viii. Local market conditions
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Capital Adequacy & Bank Stability: Bank M
Assets
Cash 60
Treasury bills 120
Long term invest 120
Loans & advances 140
Total 440
Liabilities
Current deposits 120
Savings deposits 100
Fixed deposits 140
NCDs 30
REPOs 30
Equity 20
Total 440
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Capital Adequacy & Bank Stability: Bank N
Assets
Cash 40
Treasury bills 20
Long term invt100
Loans & advances 290
Total 440
Liabilities
Current deposits 320
Savings deposits 10
Fixed deposits 10
NCDs 50
REPOs 10
Equity 40
Total 440
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Thank You!Izdihar Baharin @ Md Daud
Post Graduate CentreHP: 006019-5170817
Email: [email protected]