Making banks reliable and trustworthy

Banks have to make decisions about the amount of capital they need to hold mainly for three reasons. Firstly, capital helps prevent a crash, a situation in which the bank cannot meet its obligations to pay its depositors and other creditors and so it goes out of business. Secondly, the amount of capital affects returns for the owners (equity holders) of the bank, and thirdly, a minimum amount of bank capital is required by the regulatory authorities.
The rapid increase in total assets and deposits of banks continues to draw attention to the adequacy or inadequacy of bank capital. The regulatory authorities have been especially concerned about these since they are charged with the responsibility of bank safety. The adequacy is influenced by the prevailing and expected economic conditions of the entire economy and of the specific area served by the bank, by the quality and liquidity of the bank's assets, and by the quality of bank management. For example, assume that a bank operates in a prosperous economy with assets of excellent quality, possessing adequate liquidity in relation to deposit volatility and economic conditions, and that the management is sound. In these favourable conditions, a small amount of capital would be adequate for maintenance of solvency. An unfavourable change in any of these factors would increase the possibility of insolvency and would necessitate additional capital.   
While it may be difficult to determine precisely the amount of capital that a bank or a banking system should have, the capital should be sufficient to fulfill the basic functions such as financing the organisation and operation of a bank, providing protection to depositors and other creditors, and instilling confidence into depositors and supervisory authorities. In this context, the protective function is most important. Sufficient funds to absorb losses and assure depositors of safety of their funds often may prevent the failure of a particular bank. The amount of funds a bank needs is also related to the risks it assumes. If a bank assumes a great risk in its loan portfolio, it should have more capital funds if it is more conservative in its lending policy. Basically, a bank has two choices while establishing the size of its capital. It can increase its capital as the risks it assumes increase, or it can invest in assets that are relatively free of risk. This is not to say that the bank would follow an ultraconservative loan and investment policy. Such a policy might not result in a bank serving its trade area properly.
However, regulations aimed at ensuring stability of the banking system have been reduced almost entirely to rules regarding the capital adequacy of banks-rules specifying the proportion of bank assets which a bank capital must comprise. These rules, in turn, have been complicated by the need to cope with both globalisation of financial markets and with financial innovation.
THE BASEL ACCORD: The increased integration of financial markets across the countries and the need to make level-playing field for banks from different countries led to the June 1988 Basel accord by industrialised nations under the auspices of the International Bank for Settlements in Basel, Switzerland. Under this agreement, a proposal for a risk-based capital requirement was discussed. The risk weights currently given to different classes of assets were proposed by the Basel Committee. These were adopted as a basis for a common system of prudential banking control in all industrial countries in 1993.
The assets are divided into five categories on the basis of risks with lower weights given to less risky assets. Thus, cash has a weight of zero, loans to the discount market are weighted at 0.1, local authority bonds 0.2, mortgage loans 0.5, while commercial loans have a full weight of 1. The method of assessment, broadly speaking, is to multiply the market value of each asset and then to aggregate the risk-adjusted value. This is then compared with the banks' capital base. This involves a two-tier classification of capital.
Tier-1 or core capital consists essentially of shareholders' equity, disclosed reserves and the current year's retained profits, which are readily available to cushion the losses. These must be verified by the bank's auditors.
Tier-2 or supplementary capital comprises funds available but not fully owned or controlled by the institution, such as general provisions that the bank has set aside against unidentified future losses and medium and long-term subordinated debts issued by the bank. Tier 2 elements are not permitted to account for more than 50 per cent of an institution's own fund.
The Basel Committee recommended a lower limit of 8 per cent for the ratio of total capital to risk adjusted assets, though national bank supervisers had some discretion in applying this to different types of banks. The basic principle of such a ratio was that the risk of carrying on a banking business should be borne by the shareholders, rather than the bank's clients, and that the bank's capital should be sufficient to absorb any loss that could not be met out of current profits. Adjustments were later made to the Basel system, in particular to measure the market risk-the risk of movements in the prices of financial instruments that lead to losses. It is alleged that one of the crucial flaws in the existing framework called Basel I is that it is too simple. Banks lending to a blue chip client have to set aside the same amount of capital to cover the possibility of risks as they would have to with a much lower quality borrower. One consequence is that the more sophisticated banks have securitised some of their best loans, selling them to other investors. That has left them with a riskier loan which pays higher returns to match the higher risk.
Therefore, the existing framework, brought in during the 1980s, is already regarded as inadequate. The top central bankers have been trying for some years to finalise a new framework governing the amount of capital which commercial banks must put aside to meet any individual or industrial crisis. Now the Basel II is aimed at providing a more flexible approach, matching the amount of capital that needs to be put aside more closely to the risks attached to different types of loans and different borrowers. It will take, for example, a different approach towards commercial lending, credit card lending, mortgage lending and between big and small companies.
The Basel II proposals elicited a great deal of comments. Each of the issues covered affected some banks in one way or other banks in another way, and many were expected to have unintended consequences. So, the Basel II comment-period was extended, and the definitive application of Basel II capital adequacy rules was deferred. Complicating matters further is the fact that the Basel II proposals cover 'operational risks', risks associated with compliance failure, system failure, civil litigation and the like. Nobody knows how to measure these things, much less about how to price them in order to provide adequate capital. So the initial Basel II proposals suggested a 20 per cent capital charge-a simple heads-up, galvanising banks into getting to work on the issue.
BB REQUIREMENTS UNDER BASEL-II : At present, banks in Bangladesh follow revised guidelines in the case of risk-based capital adequacy in line with the Basel II, as per instruction of the Bangladesh Bank (BB). The BB has revised guidelines allowing the capital market investments as supplementary capital of the banks to meet overall capital requirement under the Basel-II framework. Under the revised guidelines, 10 per cent of revaluation reserves for equity instruments are eligible for Tier-2 capital, generally known as supplementary capital.
Under the amended guidelines, the banks were required to comply with the minimum capital required (MCR) at 8 per cent from January 1, 2010 to June 30, 2010 while a rate of 9 per cent was supposed to be maintained from July 1, 2010 to June 30, 2011. The banks, however, complied with the MCR at 10 per cent from July 1, 2011 and onwards. The MCR had been set at 9 per cent with the risk-weighted assets of the banks or Tk 4.0 billion of the total capital. Whichever of the two was higher would be treated as MCR of the banks under the Basel-II accord. The Basel-II accord came into force in Bangladesh on January 1, 2010 to consolidate the capital base of banks in line with the international standard. The new Basel accord has been prepared on the basis of three pillars: minimum capital requirement, supervisory review process and market discipline. Three types of risks-credit risk, market risk and operational risk-have to be considered under the minimum capital requirement.
BASEL III: After witnessing the numerous flaws in the global regulatory framework and banks' risk management practices, the global regulatory authorities introduced the global capital and liquidity rules, the third Basel accord or Basel III, with a view to improving and strengthening the banking sector to absorb any sort of shock arising from any financial or economic crisis. A stricter Basel III framework is supposed to strengthen the banking sector as it includes the higher capital and liquidity requirements. As a result of this, loans and advances will be more expensive and harder to find, which may result in slower economic growth. Some Basel III proposals, if implemented, would hurt the world's small banks more rapidly as their capital holdings increase dramatically. The OECD estimated, on an average, the annual GDP growth would decrease by 0.05-0.15 per cent as a consequence of the Basel III implementation. The Basel III new regime of capital adequacy needs a separate discussion.  
Sometimes there are attempts to establish a set of standards that can be employed to test the adequacy of capital funds of a particular bank or banking system. Although a ratio may be helpful as a starting point in analysing the capital adequacy of an individual bank, it should not be considered as an end in itself. Is it beyond criticism just because a bank meets some ratios? The inquiry must go beyond the ratio to an examination of the bank's operations and the risks it assumes in its loan and investment portfolio. Capital funds have been measured in relation to various balance sheet items such as total deposits, total assets or risk assets. The ratio of a bank's capital funds to these balance sheet items has been thought to indicate the extent to which a bank could suffer losses of one kind or another and still have enough capital to assure the safety of depositors' fund. Various levels of these ratios have been used by supervisory authorities and others as standards of capital adequacy. The bank whose capital ratio was not at least equal to current standards at that time has often been considered under-capitalised for the volume of business it was doing or for the volume of assets or the volume of assets or deposits it held. The ratio of capital funds to total deposits has enjoyed the longest use of any ratio devised to measure and determine capital adequacy. The ratio of capital funds to total assets came into use by some supervisory authorities in the late 1940s. It was argued that the amount of capital the bank needs is not related to deposits, but to assets. Because, a measure of capital adequacy purports to indicate the extent a bank's capital can absorb loss and still protect the depositors, a valid measure that would have to be related to all items in the balance sheet that might be subject to loss. Losses are reflected in the bank's balance sheet by reduced values of assets. Therefore, a measure of capital adequacy should logically relate capital funds to those assets and not to deposits. Until very recently, the ratio of capital to total assets was in vogue.
But regulatory agencies did not seem to be completely satisfied with the above capital adequacy guidelines, and for that reason proposed revision that took into account the risks of a bank's assets. This would mean that banks with a high proportion of risky assets would be required to maintain more capital. This risk-adjusted capital requirement deserves more attention at present. A variety of reasons prompted introduction of the risk-adjusted ratio, including the growth of off-balance sheet items and the decline in the quality of loan portfolios of many banks, including loans to third world countries. Off-balance sheet items such as letters of credit, loan commitments and promises to guarantee loans are not considered to be assets. Consequently they do not presently require capital backing. The objective of the risk-adjusted ratio is to alter a bank's asset mix and thus contribute to a safer banking system. For the purpose of this analysis, bank assets are divided into some rough groupings. These do not, of course, accurately reflect all the various shades or degrees of risk, but they appear to be the fundamental categories into which bank assets normally fall. They provide a more selective basis than the simple distinction between risk and non-risk assets used in the risk-asset approach. The ratios as stated above have been judged, at one time or another, to fall short of the requirements necessary for a valid standard of the adequacy of a bank's capital funds.
It may be relevant to state the US Comptroller's Manual which provides official guidelines for determination of capital adequacy that specifically denied reliance on capital ratios. Instead, its following eight factors are considered to be very important in assessing the adequacy of capital:
1. The quality of management
2. The liquidity of assets
3. The history of earnings and of the retention thereof
4. The quality and character of ownership
5. The burden of meeting occupancy expenses
6. The potential volatility of deposit structure
7. The quality of operating procedures
8. The bank's capacity to meet present and future financial needs of its trade area, considering the competition it faces.
Each of these factors is related in some way to the various kinds of risks that a commercial bank faces. In addition to these qualitative factors, the regulatory agencies assess the growth rate in earnings and assets when attempting to judge the adequacy of bank capital. If a bank is not achieving any growth in earnings and assets, it obviously has more risks than the other that is enjoying a healthy growth. The existence of more risks indicates a need for more capital than is necessary for a bank with any less risk.
Bank management owes accountability to itself, to the depositors, and to the economy as a whole. A careful appraisal of all the risks facing a bank is required when ascertaining its capital adequacy. Bank management should not be lulled into a sense of false security by good times. It should not be forgotten that bank failures result in losses to depositors and stakeholders, bring inability for banks to meet the legitimate demands of borrowers and reduce the public confidence in the financial structure of the nation. Therefore, the banks must maintain adequate capital. But adequate capital is not, of course, a substitute for sound lending and investing policies. It cannot take the place of experienced and progressive management of a well-conceived programme on planning and control. However, adequate capital can provide assurance to the public, the stakeholders, and the supervisor about the strength and the wherewithal to survive circumstances and conditions that even the best management can never foresee.
The writer is Professor of Economics at the Daffodil International University. [email protected]