Management of the Banking Sector Finance Essay

The reason for having minimum capital adequacy ratios is to make sure that banks can bare a certain level of losses before it becomes insolvent, and before depositors funds are lost. The "Basle Committee", established in 1974 (centred in the Bank for International Settlements), represents central banks and financial supervisory authorities of the major industrialised countries (the G10 countries). The committee ensures effective supervision of banks by setting and promoting international standards on a global basis. Its principal interest is in the area of capital adequacy ratios. Basel III

What are the Major Features of Basel III ? (a) Better Capital Quality : Basel 3 introduced much stricter definition of capital that has higher loss-absorbing capacity. . Better quality capital means that the banks will be stronger to withstand periods of stress. (b) Capital Conservation Buffer: As per Basel iii banks are required to hold a capital conservation buffer of 2.5% that ensure that banks maintain a cushion of capital that can absorb losses during periods of economic and financial stress. (c) Countercyclical Buffer: The countercyclical buffer is introduced in basel III with the objective to rise capital requirements in good times and reduce the same in bad times. When the buffer overheats it slows down the banking activity and will encourage lending when times are tough i.e. in bad times. The buffer will be between 0% to 2.5%, (d) Minimum Common Equity and Tier 1 Capital Requirements : Under the Basel III The minimum common equity required which is the highest form of loss-absorbing capital, is increased from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement has also been increased from 4% to 6%. (e) Leverage Ratio: Basel III includes a leverage ratio to work as a safety net. A leverage ratio is the comparative volume of capital to total assets (not risk-weighted).

(f) Liquidity Ratios: Under Basel III, a structure for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively. (g) Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential framework, systemically important banks is expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt. Capital Adequacy Ratio A measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures. Capital Adequacy Ratio (CAR) Also known as "Capital to Risk Weighted Assets Ratio (CRAR)." Investopedia explains 'Capital Adequacy Ratio - CAR' This ratio is used to protect depositors and promote the steadiness and competence of financial systems around the world. Two types of capital are measured: tier one capital, that absorbs losses without a bank being required to cease trading, and tier two capital, that absorbs losses at the time of winding-up and thus provides a lesser amount of protection to depositors. Tier 1 capital Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, that mainly consists of common stock and disclosed reserves (or retained earnings), and it may also include non-redeemable non-cumulative preferred stock.

The Basel Committee observed that banks have used innovative instruments over the years to create Tier 1 capital; these are subject to tough situations and are restricted to a maximum of 15% of total Tier 1 capital. Providing protection against unexpected losses is the theoretical reason for holding capital. The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country's central bank). Most central banks follow the Basel Committee on Banking Supervision (BCBS) procedures in setting formulae for asset risk weights. Assets like coins and cash generally have zero risk weight, while certain loans have a risk weight at 100% of their face value. The BCBS is a part of the Bank of International Settlements (BIS). Under BCBS strategies total RWA is not limited to Credit Risk. It has components for Market Risk (typically based on value at risk (VAR) and Operational Risk As an example, assume a bank with $2 of equity receives a client deposit of $10 and lends out all $10. Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk weighting of 90%, the bank now holds risk-weighted assets of $9 ($10*90%). Using the original equity of $2, the bank's Tier 1 ratio is calculated to be $2/$9 or 22%. There are two different conventions for calculating and quoting the Tier 1 capital ratio: Tier 1 common capital ratio and Tier 1 total capital ratio Preferred shares and non-controlling interests are included in the Tier 1 total capital ratio but not the Tier 1 common ratio. Thus the common ratio will always be less than or equal to the total capital ratio. In the example above, the two ratios are the same. Tier 2 capital Tier 2 capital, or supplementary capital, include numerous important and legitimate constituents of a bank's capital base. These forms of banking capital were largely standardized in the Basel I accord but left untouched by the Basel II accord. National regulators of most countries have applied these standards in local legislation. While calculating regulatory capital, Tier 2 is limited to 100% of Tier 1 capital.

Subordinated debt is debt which ranks lower than ordinary depositors of the bank. In calculation of this form of capital only those with a minimum original term to maturity of five years can b included. Risk weighted assets Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. This type of asset calculation is used in the determination of the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. In the Basel I, the Basel Committee explains the reason for preferring risk-weight approach for capital calculation. it provides an easier approach to compare banks across different geographies off-balance-sheet exposures can be easily included in capital adequacy calculations banks are not deterred from carrying low risk liquid assets in their books Generally, different classes of assets have different risk weights connected with them. The calculation of risk weights is dependent on whether the bank has adopted the standardized or IRB approach under the Basel II framework. Certain assets like debentures are allotted a higher risk than others like cash or government securities/bonds. Since different types of assets have different risk profiles, weighing assets based on the level of risk associated with them primarily adjusts for assets that are less risky by allowing banks to discount lower-risk assets. In the most basic application, government debt is allowed a 0% "risk weighting"- that is, they are subtracted from total assets for purposes of calculating the CAR. A document was written in 1988 by the Basel Committee on Banking Supervision which recommends certain standards and regulations for banks. This was called Basel I, and the Committee came out with a revised framework known as Basel II. More recently, the committee has published another revised framework known as Basel III. The main recommendation of this document is that banks should hold enough capital to equal at least 8% of its risk-weighted assets. The calculation of the amount of risk-weighted assets depends on which revision of the Basel Accord is being followed by the financial institution. Most countries have implemented some version of this regulation.

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