Capital adequacy of banks and Basel II framework
Wednesday, 10 March 2010
Md. Saidur Rahman
ONE of the most vital issues of all the banking companies in recent years has been raising and maintaining adequate capital in accordance with the framework of capital adequacy as prescribed under Basel II accord.
In the mid 80s, the central bank governors of some developed countries established the Basel Committee on Banking Supervision following the collapse of a small German bank in 1974 which was active in the international banking.
The committee felt that a level playing field in the matters of banking capital was necessary. Accordingly, in 1987 an agreement was reached among the central bank governors and members of the Basel Committee.
In the following year i.e. in July 1988, the Basel Committee published its first landmark accord in the name 'International Convergence of Capital Measurement and Capital Standards', which was shortly known as Basel-I Accord and became fully enforceable on January 1, 1993.
In Bangladesh, Basel-I accord was adopted in 1996 through the guidance and BRPD circular of the Bangladesh Bank. After practising few years of Basel I, the Basel Committee published the first draft of Basel-II in a very comprehensive and amended form in June, 1999. The second consultative paper on Basel-II was published in January, 2001 and the final Accord was published in June, 2004.
Our banking sector started parallel run of Basel-II on January 01, 2009 and a full-fledged run of Basel-II is going on from January 01, 2010.
Basel-II accord describes three-tier concept with a view to complying with the requirements which are designed to encourage the banks to strengthen their capital positions considering their risk, supervisory review process and market discipline. In Basel II accord, the total capital of a banking company has been segregated as tier-one capital, tier-two capital and tier-three capital.
Tier-one capital, also considered as core capital, mainly comprises of highest quality capital elements which include the amount of funds contributed by the owners of the banking company in exchange for shares or stock as paid-up capital, share premium account that represents the excess value of a share of stock above its par (face) value and which is non-repayable in nature, statutory reserve which is kept at least 20% of pre-tax profit as per sec.24 of BCA, 1991 until the reserve along with share premium account becomes equal to bank's paid-up capital, the balance of general reserve, the amount of earnings which has been retained in the bank as undistributable portion of profit or retained earnings after making payment of appropriation items including dividend, the bank's minority interest in subsidiaries that represents the bank's ownership shares in the related business, non-cumulative irredeemable preference shares which pay a fixed rate of dividend and dividend equalization account which is maintained to insure payment of dividend each year at a certain rate.
Tier-two capital, also called supplementary capital, covers some items which fall short of some of the features of the core capital in terms of readiness and supporting quality of the capital. Tier-two capital includes general provision of unclassified loans and advances, special mention account and off-balance exposures, 50% of asset revaluation reserves which represent the difference between the book value and the re-valued amount of land and buildings of the bank, all other preference shares except ones listed under core capital, subordinated debt that does not have liquidity date or is perpetual in nature and limited to use up to 30% of tier-one capital, exchange equalization account which arises from exchange gain due to devaluation of local currency with foreign currencies and up to 50% of revaluation reserve of securities which holds for transaction motive.
Tier-three capital, another sort of supplementary capital, is essential for meeting partial capital requirements of market risk of a banking company which may arise from trading book. This sort of capital consists of short term subordinated debt. Subordinated debt means an unsecured debt mainly extended to the borrowers by its sponsors subordinated to the claim against the borrowers and documented by a formal subordination agreement between the providers and the borrowers. Subordinated debt-holders have a prior claim over common and preference shareholders against the bank's earnings and assets.
The sum of the above mentioned three tiers of capital shall be at least 10 per cent of risk weighted assets of on-balance sheet and off-balance sheet items of a bank. This amount of capital is termed as adequate capital of a bank.
In addition, to manage adequate capital, a banking company is to follow a number of constraints in its capital structure. First, the ratio of core capital (Tier-one) to risk weighted assets must be at least 5.0 per cent. Second, the total of tier-two and tier-three capital shall not exceed the total of tier-one capital. Third, a minimum of about 20% of market risk needs to be supported by tier-one capital. Fourth, supporting of market risk from tier-three capital shall be limited up to a maximum of 250% of a bank's tier-one capital that is available after meeting credit risk capital requirements.
However, to determine each bank's total eligible regulatory capital, banks are required to make deductions from Tier-1 capital some additional items including book value of goodwill, shortfall in provisions required against classified assets, and remaining deficit on account of revaluation of investments in securities after netting off any other surplus on the securities.
The banks must meet minimum capital requirements because capital plays some important roles in supporting the daily operations and ensuring the long-term viability of a financial institution. Capital provides a cushion against the risk of failure by absorbing financial and operating losses until management can address the bank's problems and restore the bank's profitability.
Capital provides the funds needed to get the bank chartered, organised and operating before deposits come flowing in. A new bank needs start-up funding to acquire land, build a new structure, and equip its facilities etc., even before opening day.
Capital promotes public confidence in a bank and reassures its creditors/depositors of its financial strength. So, it must be strong enough to reassure borrowers that the bank will be able to meet their needs. Capital provides funds for the organisation's growth and development of new services and facilities as well as serving as a regulator. It limits the extent of risk that a bank can accept. It protects the deposit insurance system from serious losses.
(The author is a trainer in finance and banking. He can be reached at E-mail: saidur08gmail.com)
ONE of the most vital issues of all the banking companies in recent years has been raising and maintaining adequate capital in accordance with the framework of capital adequacy as prescribed under Basel II accord.
In the mid 80s, the central bank governors of some developed countries established the Basel Committee on Banking Supervision following the collapse of a small German bank in 1974 which was active in the international banking.
The committee felt that a level playing field in the matters of banking capital was necessary. Accordingly, in 1987 an agreement was reached among the central bank governors and members of the Basel Committee.
In the following year i.e. in July 1988, the Basel Committee published its first landmark accord in the name 'International Convergence of Capital Measurement and Capital Standards', which was shortly known as Basel-I Accord and became fully enforceable on January 1, 1993.
In Bangladesh, Basel-I accord was adopted in 1996 through the guidance and BRPD circular of the Bangladesh Bank. After practising few years of Basel I, the Basel Committee published the first draft of Basel-II in a very comprehensive and amended form in June, 1999. The second consultative paper on Basel-II was published in January, 2001 and the final Accord was published in June, 2004.
Our banking sector started parallel run of Basel-II on January 01, 2009 and a full-fledged run of Basel-II is going on from January 01, 2010.
Basel-II accord describes three-tier concept with a view to complying with the requirements which are designed to encourage the banks to strengthen their capital positions considering their risk, supervisory review process and market discipline. In Basel II accord, the total capital of a banking company has been segregated as tier-one capital, tier-two capital and tier-three capital.
Tier-one capital, also considered as core capital, mainly comprises of highest quality capital elements which include the amount of funds contributed by the owners of the banking company in exchange for shares or stock as paid-up capital, share premium account that represents the excess value of a share of stock above its par (face) value and which is non-repayable in nature, statutory reserve which is kept at least 20% of pre-tax profit as per sec.24 of BCA, 1991 until the reserve along with share premium account becomes equal to bank's paid-up capital, the balance of general reserve, the amount of earnings which has been retained in the bank as undistributable portion of profit or retained earnings after making payment of appropriation items including dividend, the bank's minority interest in subsidiaries that represents the bank's ownership shares in the related business, non-cumulative irredeemable preference shares which pay a fixed rate of dividend and dividend equalization account which is maintained to insure payment of dividend each year at a certain rate.
Tier-two capital, also called supplementary capital, covers some items which fall short of some of the features of the core capital in terms of readiness and supporting quality of the capital. Tier-two capital includes general provision of unclassified loans and advances, special mention account and off-balance exposures, 50% of asset revaluation reserves which represent the difference between the book value and the re-valued amount of land and buildings of the bank, all other preference shares except ones listed under core capital, subordinated debt that does not have liquidity date or is perpetual in nature and limited to use up to 30% of tier-one capital, exchange equalization account which arises from exchange gain due to devaluation of local currency with foreign currencies and up to 50% of revaluation reserve of securities which holds for transaction motive.
Tier-three capital, another sort of supplementary capital, is essential for meeting partial capital requirements of market risk of a banking company which may arise from trading book. This sort of capital consists of short term subordinated debt. Subordinated debt means an unsecured debt mainly extended to the borrowers by its sponsors subordinated to the claim against the borrowers and documented by a formal subordination agreement between the providers and the borrowers. Subordinated debt-holders have a prior claim over common and preference shareholders against the bank's earnings and assets.
The sum of the above mentioned three tiers of capital shall be at least 10 per cent of risk weighted assets of on-balance sheet and off-balance sheet items of a bank. This amount of capital is termed as adequate capital of a bank.
In addition, to manage adequate capital, a banking company is to follow a number of constraints in its capital structure. First, the ratio of core capital (Tier-one) to risk weighted assets must be at least 5.0 per cent. Second, the total of tier-two and tier-three capital shall not exceed the total of tier-one capital. Third, a minimum of about 20% of market risk needs to be supported by tier-one capital. Fourth, supporting of market risk from tier-three capital shall be limited up to a maximum of 250% of a bank's tier-one capital that is available after meeting credit risk capital requirements.
However, to determine each bank's total eligible regulatory capital, banks are required to make deductions from Tier-1 capital some additional items including book value of goodwill, shortfall in provisions required against classified assets, and remaining deficit on account of revaluation of investments in securities after netting off any other surplus on the securities.
The banks must meet minimum capital requirements because capital plays some important roles in supporting the daily operations and ensuring the long-term viability of a financial institution. Capital provides a cushion against the risk of failure by absorbing financial and operating losses until management can address the bank's problems and restore the bank's profitability.
Capital provides the funds needed to get the bank chartered, organised and operating before deposits come flowing in. A new bank needs start-up funding to acquire land, build a new structure, and equip its facilities etc., even before opening day.
Capital promotes public confidence in a bank and reassures its creditors/depositors of its financial strength. So, it must be strong enough to reassure borrowers that the bank will be able to meet their needs. Capital provides funds for the organisation's growth and development of new services and facilities as well as serving as a regulator. It limits the extent of risk that a bank can accept. It protects the deposit insurance system from serious losses.
(The author is a trainer in finance and banking. He can be reached at E-mail: saidur08gmail.com)