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Capital Adequacy

(Chapter 20)
FIN544 SPRING 2017
Five Functions of Capital
1. To absorb unanticipated losses with enough margin to
inspire confidence, and enable the FI to continue as a
going concern.
2. To protect uninsured depositors, bondholders, and
creditors in the event of insolvency and liquidation.
3. To protect FI insurance funds and the taxpayers.
4. To protect FI owners against increases in insurance
5. To fund the branch and other real investments
necessary to provide financial services.
Capital and Insolvency Risk
How does capital protect an FI against insolvency?
To answer this question, we first look at the economic
and accounting definitions of capital.
The economic definition of an FIs capital or owners
equity stake in an FI is the difference between the
market values of its assets and its liabilities. This is also
called the Economic Net Worth of an FI, which is
calculated through a market value accounting concept.
The book value concept of capital is the difference
between the book values of assets and liabilities.
The Market Value of Capital
To calculate market value of capital, balance sheet assets and liabilities must be converted from
book value to market value at current prices on a mark-to-market basis. Thus, if market value
of its long term securities (80) and long term loans (20) total 100, and market value of its
liabilities are 90, then its economic net worth is 10. On a market value basis, this FI is
economically solvent and imposes no failure costs on depositors or regulators if it were
liquidated today.
Now, suppose that a number of these borrowers get into cash flow problems and are unable to
keep up their promised loan repayment schedules. The market value of the loan portfolio goes
down to 8. Now, market value of the assets (80+8) is less than market value of liabilities (90)
and the FI becomes insolvent, as the owners net worth stake is completely wiped out (10-12)
making the net worth negative. The first 10 of the 12 in loss is borne by equity holders. Then
the liability holders begin to loose as they get only (88/90) 97.78 poisha per Taka of deposits.
This example shows that the economic net worth is an insurance fund protecting liability
holders, such as depositors, against insolvency risk. The larger the economic net worth the
more the insolvency protection.
If an FI is closed by regulators before its economic net worth becomes zero, neither liability
holders nor deposit insurers stand to lose.
The Book Value of Capital
The Book Value of Capital is the difference between the book value of its assets and the
book value of its liabilities. It is comprised of the following four components:
1. Par value of shares
2. Surplus value of shares
3. Retained earnings
4. Loan loss reserves
Using the same balance sheet as before, we see that under the book value accounting
method, the reduction in the value of the loan portfolio due to non-repayment of principal
or interest need not be reflected in the balance sheet immediately. The loan classification
guidelines issued by BB requires a loan to be classified as Substandard (20% write-down)
after three months of default and as Doubtful (50% write-down) after six months and as
Bad/Loss (100% write-down) after 12 months. Thus, FIs get a longer period of time to
write down their bad loans in the balance sheet.
Therefore, after 3 moths the FI would charge only 2.4 against the equity of 10, and the
balance sheet would show long-term securities of 80, long-term loans of 17.60, liabilities
of 90 and equity of 7.60.
Discrepancy between Market and
Book Values of Equity
In actual practice, for large publicly traded banks and FIs, discrepancy between
book value (BV) and market value (MV) of equity becomes evident from market
price of their shares in the stock exchange even though the FI does not mark its
balance sheet to market. As the share price is calculated on the basis of present
value of current and expected future net earnings or dividend flows, the market
value of its shares outstanding is calculated as:
MV = Number of shares outstanding x market price per share.
By contrast, the historical or book value of the FIs equity per share (BV) is
calculated as:
BV = Par value + surplus + RE + loan loss reserves.
The ratio of MV/BV is called the market to book ratio and shows the degree of
discrepancy between market value of an FIs equity capital as perceived by
investors in stock market and book value of capital on its balance sheet. The
lower this ratio, the more the book value overstates true equity or economic net
worth of an FI as perceived by investors in the capital market.
Problem Solving
Bangla Bank has 6 million shares outstanding in the
market at a face value of Tk10 each, which is selling at
Tk15 per share in the Dhaka Stock Exchange. The
banks balance sheet shows Retained Earnings of Tk7.5
million, Surplus value of shares of Tk5 million, and Loan
Loss Reserves of Tk2.2 million. What is the market to
book ratio of this bank?
Capital Adequacy in Commercial
Banking Industry
The new Basel Accord or Agreement (Basel II) of 2006 consists of three
mutually reinforcing pillars, which together contribute to the safety and
soundness of the financial system.
Pillar 1 covers regulatory minimum capital requirements for credit,
market, and operational risk.
In Pillar 2, the BIS stresses the importance of the regulatory supervisory
review process as a critical complement to minimum capital
In Pillar 3, the BIS sought to encourage market discipline by developing
a set of requirements on the disclosure of capital structure, risk
exposures, and capital adequacy. Such disclosure requirements allow
market participants to assess critical information describing the risk
profile and capital adequacy of DIs.
Risk-Weighted Capital Ratios
A DIs capital is divided into Tier I and Tier II. Tier I capital is primary
or core capital; Tier II capital is supplementary capital. The sum of
Tier I and Tier II gives the total capital of a DI. Under Basel II, a DI
must hold a minimum ratio of 8% of risk weighted assets.
Tier I is closely related to a DIs book value of equity, and includes the
book value of common equity plus an amount of perpetual preferred
stock plus minority equity interests held by the DI in subsidiaries
minus goodwill. The minimum amount of Tier I capital is 4% or more
of risk weighted assets.
Tier II is a broad array of secondary capital resources. It includes loan
loss reserves upto a maximum of 1.25 percent of risk-weighted assets
plus various convertible and subordinated debt instruments with
minimum caps.
Risk Weights for Assets
Category I : 0% weight; includes Cash and Balances with BB, government
securities; loans to sovereigns with an S&P rating of AA-
Category II: 20% weight; includes interbank deposits, cheques under
collection, municipal bonds, loans to sovereigns with an S&P rating of A+ to A-
Category III: 50% weight; includes loans fully secured by first lien on
mortgages, loans to banks and corporates with an S&P rating of A+ to A-,
loans to sovereigns with an S&P rating of BBB+ to BBB-
Category IV: 100 weight; includes all other loans including consumer loans,
loans to banks and corporates with an S&P rating of BBB+ to B-, loans to
sovereigns with an S&P rating of BB+ to B-
Category V: 150% weight; includes loans to sovereigns, banks, and securities
firms with an S&P rating of below B-, and loans to corporates with an S&P
rating below BB-.