Page 198 - DCOM208_BANKING_THEORY_AND_PRACTICE

Unit 12: Capital Adequacy

Ratio Approaches to Capital Adequacy Notes

Ratio approaches are among the oldest methods of capital adequacy analysis and are still widely
used by both managers and regulators. Ratio standards are generally expressed in terms of the
ratio to total assets. Ratio standards may be developed for equity capital, primary capital or
total capital.
A traditional approach to developing ratio is to use judgments in light of experience. Judgment
may be supplemented by studies of past failure.

Example: We might look at the failure percentage over a number of five-year periods
and study the relationship between failure clearing each five-year period and capital ratios at
the beginning of that five-year period.
When regulators are developing ratio standards, they are more interested in the solvency of
whole banking system than in single financial institutions. Furthermore, they want rules that
are simple to explain and that provide usable standards for monitoring performance. Regulators
may study past failure experience of banks to determine capital ratios that will keep failure at an
acceptable level.

Risk-based Capital Asset Approaches

Proposals for risk-based capital standards have been around for years and are getting increased
attention.

Notes Regulators in the United States and Great Britain worked jointly to develop a
standard in 1987.
Under the proposal being developed, off balance sheet claims such as credit guarantees would
also be given a weight and added to actual assets. A risk-weighted asset base would be developed
in this way, and capital requirements would then be a percentage of that risk-weighted asset
base.
The appeal of the risk-based approach is that it is a step forward from simply looking at total
assets in terms of riskiness. The risk-based approach also has the advantage of requiring capital
to support off balance sheet source of risk such, as loan guarantees.

Task Take an appointment with the branch manager of a bank and make a list of the
various capital adequacy guidelines he is aware of.

Portfolio Approaches to Capital Adequacy

Portfolio approaches to capital adequacy are based on recognition of the complex set of
intersections involved in a financial institution. These approaches specifically recognize the fact
that two independent risky actions may be combined to create a position that is less risky than
either of the independent positions.

Example: Suppose one institution specializes in commercial loans while the other
specializes in consumer loans. If these two institutions merge, total risk goes down, particularly
from the viewpoint of insurance age.

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