CAPITAL ADEQUACY

Capital adequacy affects all corporate entities, but as a term it is most often used in discussing the position of firms in the financial sectors of the economy, and in particular whether firms have adequate capital to guard against the risks that they face. A balance needs to be struck between the often conflicting perspectives of the various stake-holders; lenders require capital to ensure that there is a cushion against possible losses at the borrowing firm, while shareholders often focus upon return on capital. For firms operating in the financial sector, the general public also has a stake in the firm as failure may have implications for the financial stability of the system as a whole.

The focus of financial stability is primarily upon banks because of the functions that they perform. Banks not only provide a significant proportion of the financing required by the economy, but they also act as a conduit for payments. Further, the financial sector is used by central banks as a mechanism for transmitting changes in monetary policy through to the real economy. The focus of financial stability is the financial system itself, rather than an individual institution, but the means by which financial stability is achieved is through the review of individual institutions. (See George (1994) for a policy speech on supervision and financial stability).

Users of the financial sector of the economy benefit from the competition within this sector, and in response banks, and other firms, seek to optimize their business mix. In order to allow competition within the financial sector those agents responsible for monitoring capital adequacy need to give firms the freedom to take risks. On occasions, this means that firms in the financial sector will fail. If this never happened either the costs to the users of banking services would be prohibitive (and/or the range of services themselves extremely limited) or the lender of last resort would effectively be taking all of the risks, but have no influence over which risks it acquired.

Permitting banks to fail indicates a possible conflict between capital adequacy, deposit protection (see Stone and Zissu, 1994a), and the perspective of other stakeholders such as shareholders. Deposit protection schemes are operational in many countries, but most do not protect the full value of every depositor’s claim. The intention is usually to ensure that depositors bear some responsibility for their actions when a bank is liquidated. If the deposits were entirely risk free then a significant group of stakeholders would have no interest in the risks being taken and banks might be tempted into acquiring inappropriate types and levels of risk.

Capital adequacy is intended to aid financial stability and, as a result, the role of an individual institution in the system is the overriding concern, rather than individual institutions per se.

As the relationship between banking activities and other parts of the financial sector is increasing in breadth and depth, there is the possibility of financial stability being disrupted by non-banking activities. It is also the case that some sources of disruption could originate from international activities. These developments have encouraged greater discussion among supervisors of different financial sectors, both domestically and internationally.

 

Risk and Capital Adequacy

Banks, by virtue of their role in the economy, transform risks. The commonest risks transformed are those of credit and liquidity, which are also the risks that banks have been assuming for the longest periods of time. Hall (1993) provides a list of statutes relating to the financial sector of the economy for Japan, UK, and USA, including some legislation still in place from the 1930s. Many banks have extended their financial intermediation role and risk taking from traditional activities to include many forms of market risk; this is an indication of the continuing evolution of banks and their role in the economy.

Risks are often described as “qualitative” when it is difficult to provide an accurate value as to their impact. This is in contrast to those risks seen as quantitative. An example of a qualitative risk is settlement risk where, although the amounts at risk can be measured, the probability of loss is difficult to assess. An illustration of settlement risk was provided by the demise of the Herstatt Bank in Germany during 1974. In order to alleviate this particular risk there has been a concerted effort to promote real-time payment settlement systems and a general reduction in settlement times. In this case the interested parties have not only been the supervisors, but also industry bodies and individual firms in the financial sector. Another example of a qualitative risk is reputation risk, affecting either one particular bank or an entire sector of the banking community. Other risks in this category involve various management and systems issues, including valuation methods and risk management for complex products, as well as acts that are potentially criminal.

Some commentators would suggest that there are no new risks in the system, but it would appear that certain types of products and activities amplify the impact of a given risk; an example would be some forms of derivative contracts. While derivatives may be a relatively recent tool by which banks intermediate risk, capital adequacy standards have also evolved to reflect their development. Some of the standards are based upon holding given quantities of capital for a given risk, while other standards may be qualitative. The Basle Supervisors Committee issues statements on qualitative standards, such as the paper on risk management guidelines for derivatives, as well as minimum quantitative standards, such as the Basle Accord.

Banks and securities firms are required to hold capital against their quantitative and qualitative risks. Until recently the main capital requirements, for banks, have addressed credit and counterparty risk. For securities firms the focus has been upon market risk.

However, with the implementation of the Capital Adequacy Directive (which applies to banks and securities firms in the EU) and proposed amendments to the Basle Accord, banks will be required to hold capital against some of their market risks (see Stone and Zissu, 1994a). Both the Basle Accord and the Capital Adequacy Directive represent minimum standards and local supervisors have the ability to impose higher requirements. For example: the Basle Accord has 8 percent as the minimum ratio between capital- and risk-weighted assets, but some supervisors impose higher ratios which typically reflect qualitative risks at individual banks.

Capital may be in the form of equity, tier 1 capital, and various forms of subordinated debt, upper and lower tier 2 capitals, and must be capable of absorbing losses either on a continuing basis or at least in the event of a bank’s liquidation. Supervisors normally impose limits on the contribution that different forms of capital can make to the composition of the capital base.

It should be noted that the quantitative capital standards are based upon the values of the positions held by the firms in the financial sector. Often national bodies produce guidelines and recommendations on the application of accounting principles to banks and financial firms, such as the British Bankers’ Association statements of recommended practice. Differences can occur between countries, in the capital required for an exposure, or position, due to different accounting standards. This is a feature of on- and off-balance sheet items; however, the International Accounting Standards Committee is in the process of producing international guidance.

 

Capital Adequacy Agents

Agents and agencies responsible for monitoring capital adequacy vary from country to country, and on occasions within countries; Hall (1993) describes the banking regulation and supervisory framework for Japan, the UK, and the USA. In some countries a single agency is responsible for capital adequacy of all participants in the financial sector of the economy; in other countries several agencies may be responsible for a given constituency. The lender of last resort is not necessarily the same as the agency responsible for the monitoring of the capital adequacy of banks or other parts of the financial sector.

Although capital adequacy frameworks operate in, and are shaped by, the national environment, they may also be influenced by international foray. The Basle Supervisors Committee, with representatives from the G10 countries plus Luxembourg and Switzerland, has been meeting at the Bank of International Settlements since 1975 to address international banking issues. Some countries that are not members of the Basle Committee nevertheless adopt their standards. The European Union (EU) also has an interest in developments in capital adequacy standards, setting common minimum standards to enable the free flow of services and capital within the Community (the Single Market initiative). However, while the standards issued by the Basle Supervisors Committee may be considered as “guidance,” the EU initiatives are in the form of directives which are legal in nature and as a result influence the balance between supervision and regulation. The International Organization of Securities Commissions (IOSCO) through its technical committee, which has been meeting since 1987, also has convergence of capital standards as one of its aims.

Both the Basle Committee and the EU have significantly altered the capital adequacy standards that apply to banks in the past fifteen years. The Basle Committee issued the Basle Accord in July 1988 and this was followed by the EU Directive on the Solvency Ratio for Credit Institutions (89/647/EEC) in 1989. These two comparable initiatives led to an eight percent minimum capital requirement to support credit risk at banks being adopted by the members of G10, the EU and more widely. The list of EU directives (below) provides a perspective of the range of quantitative and qualitative issues that comprise current capital adequacy standards for banks; some also apply to securities firms, while others describe the roles and responsibilities among the supervisors of a global banking or securities group.

Broader descriptions of some of these issues are contained in Maisel (1981), and Stone and Zissu (1994b).

Modernizing capital adequacy standards tends to create step changes in requirements. Very often the changes in capital requirements are derived or generated in international foray, such as Basle or the EU, and negotiations and consensus building take time and resources. When the Basle Accord was released in July 1988, it was recognized that market risk also needed to be addressed; it is likely that the Accord will be amended to encompass market risk during 1996.

The process of updating capital adequacy standards is made more complex as the techniques used by banks to manage particular risks may evolve during the discussion of the requirements to address that particular risk. The step changes in capital adequacy standards often arise due to the time taken to build the necessary consensus not just among the supervisors, but also between the banks and the supervisors. The occasionally abrupt changes are in contrast to the more evenly paced evolution of developments within individual banks and the financial sector as a whole. Although capital standards may lag behind market developments and the activities of banks, it does not necessarily mean that the supervisors are unaware of developments, or have not devised interim treatments until the developments are formally addressed in revised standards.

While the revisions to capital adequacy standards may not always be at the cutting edge, in contrast to the position of some individual banks, the standards apply to a diverse range of banks. As a result they need to be capable of being applied to the majority of banks, even if they are less technically advanced than methods used by a small minority of banks.

As the purpose of capital adequacy is not necessarily to protect a bank from failure, but to promote financial stability in the system, supervisors consider losses in that context. Significant losses published by firms in the financial sector serve to remind everybody that risks need to be actively managed and the response to these losses by the marketplace often reinforces the qualitative aspects of capital adequacy standards.

As a generalization there is probably a trend towards the greater use of qualitative standards for capital adequacy. This brings with it the ability to adjust the demands and expectations of those responsible for monitoring capital adequacy to the activity and needs of individual banks. No two banks are exactly the same. These qualitative standards are underpinned by the quantitative standards which require specific amounts of capital to support a given volume of a particular form of risk, or provide outright limits on certain activities and exposures.

 

European Union Directives Influencing Capital Adequacy Standards

  1. 77/780/EEC First Banking Coordination Directive
  2. 89/646/EEC Second Banking Coordination Directive (home versus host supervisors, branching within the EU and who is the lead supervisor for a banking group)
  3. 86/635/EEC Bank Accounts Directive (accounting standards for banks)
  4. 87/62/EEC Monitoring and Controlling Large Exposures of Credit Institutions
  5. 89/647/EEC Solvency Ratio for Credit Institutions
  6. 91/31/EEC Amendments to the Solvency Ratio for Credit Institutions (credit risk oriented capital requirements)
  7. 89/299/EEC Own Funds of Credit Institutions
  8. 91/633/EEC Amendments to the Own Funds of Credit Institutions
  9. 92/16/EEC Amendments to the Own Funds of Credit Institutions (forms and volumes of capital)
  10. 92/30/EEC Consolidated Supervision Directive
  11. 93/6/EEC Capital Adequacy of Investment Firms and Credit Institutions (market risk based capital requirements)
  12. 93/22/EEC Investment Services Directive

 

Resources For Capital Adequacy:

George, E. A. J. (1994). The pursuit of financial stability. Bank of England Quarterly Bulletin, 34, 60–6.

Hall, M. J. B. (1993). Banking regulation and supervision: A comparative study of the UK, USA and Japan. 1st edn, Brookfield, VT: Edward Elgar.

Maisel, S. J. (1981). Risk and capital adequacy in commercial banks. 1st edn, Chicago, IL: University of Chicago Press.

Quinn, B. (1993). The Bank of England’s role in prudential supervision. Bank of England Quarterly Bulletin, 33, 260–4.

Richardson, G. W. H. (1974). Speech to the Institute of Bankers. Bank of England Quarterly Bulletin, 14, 54–5.

Stone, C. A. & Zissu, A. (1994). Global risk based capital regulations. Vol. I: Capital adequacy. 1st edn, New York: Irwin Professional Publishing.

The Basle Committee on Banking Regulations and Supervisory Practices (1988). International convergence of capital measurement and capital standards. Basle.

The Basle Committee on Banking Regulations and Supervisory Practices (1994). Risk
management guidelines for derivatives
. Basle.