Page 204 - DCOM208_BANKING_THEORY_AND_PRACTICE

Unit 12: Capital Adequacy

12.3 Summary Notes

Capital Adequacy is the test of a financial business’s ability to meet its financial obligation.
Capital adequacy rules mean that a bank/financial institution have to have enough money
to conduct its business.
The fundamental objective behind CAR is to strengthen the soundness and stability of the
banking system.
An annual return has to be submitted by each bank indicating capital funds, conversion of
off-balance sheet/non-funded exposures, calculation of risk-weighted assets, and
calculations of capital to risk assets ratio.

The higher the CAR, the lower the financial risk of the company.
The various approaches to capital adequacy are: Ratio approach, Risk-based capital asset
approach and Portfolio approach.

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.
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.
Portfolio approaches to capital adequacy are based on recognition of the complex set of
intersections involved in a financial institution.
A traditional approach to developing ratio is to use judgments in light of experience.
Judgment may be supplemented by studies of past failure.
The Basel Capital Accord was replaced with a new capital adequacy framework (Basel II),
published in June 2004.

12.4 Keywords

Basel Committee: an institution created by the central bank Governors of the Group of Ten
nations. It was created in 1974 and meets regularly four times a year.
Basel accord: The principle purpose of Basel accord is to ensure an adequate level of capital in
the international banking system and to create a more level playing field so that banks could no
longer build business volume without adequate capital backing.
Basel II Norms: The Basel Capital Accord was replaced with a new capital adequacy framework
known as Basel II and was published in June 2004.
Capital Adequacy Ratio (CAR): A measure of a bank’s capital. It is expressed as a percentage of
a bank’s risk weighted credit exposures.
Credit Risk: The risk of loss of principal or loss of a financial reward stemming from a borrower’s
failure to repay a loan.
Leverage: Use borrowed capital for an investment, expecting the profits made to be greater than
the interest payable.

Net Worth: It is the amount by which assets exceed liabilities. Net worth is a concept applicable
to individuals and businesses as a key measure of how much an entity is worth.
Operational Risk: A form of risk that summarizes the risks a company or firm undertakes when
it attempts to operate within a given field or industry.

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