My little essay on Capital Adequacy

Posted: 31 July 2008 in Education, My Muse
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I wrote this thesis on Capital Adequacy for my Finance Module. I thought it was a fascinating and interesting topic, although the research process of ploughing so many dry and technical books is rather dull. I wonder how well I fared, especially in my understanding and analysis of the situation, so I posted it on my blog. Hopefully, when any Finance “gurus” saw it, they might comment and help me improve my knowledge about it. Haha 8)

To any uni. students: NO COPYING or PLARGARISM OF MY WORK, Please. Thank You very much. Because I had put in much effort. How would you learn if you don’t do your own research as well? However, You may reference me if you like at :) 

” Tan, Y.W. (2008). WordPress. My Little Essay on Capital Adequacy. [Online]. Available from:  http://yingweitan.wordpress.com/2008/07/31/essay-on-capital-adequacy. (Accessed: ……)” :p

Introduction: Nature of Banking
Banks safe-keep money for depositors and operate by investing the pool of money by lending credits to borrowers. Thus, banks have to ensure that they do not lose the depositors’ trust in them, or it will result in widespread panic withdrawals that lead to the banks’ collapse. As such, banks are vulnerable and need regulation to compensate for the tendency of instability. Regulators are especially cautious that a major bank’s collapse might lead to a contagion of financial crisis (Young, 1986).

Capital and risk management
“Risk” is exposure to danger; a probability of deviation from expectations. Lending depositors’ money to borrowers is risky because there is a possibility of debt defaults (credit risk). The volatility of the market, interest rates and other factors are also not within the banks’ jurisdictions.

Hence, it is crucial that banks hold a buffer of capital to absorb unexpected losses and protect themselves, especially their depositors. This is the basis of capital adequacy (Gallanti, 2003). The purpose of the risk ratios, as advocated by Basel frameworks, serves to help banks calculate the amount of capital to hold (Young, 1986).

Prudential regulation ensures that financial institutions have the solvency to repay money owed to their depositors, through having the discipline of holding adequate capital (Thompson, 1996).

History of Change: Prudential Regulation in Australia (1980s – 1990s)

Thompson and Gray (1999) chronicled the evolution of attitudes towards capital management, along with reforms made to the Australian regulatory system over the past decades.

 

Australia commissions reviews of its financial systems periodically to study the ever changing financial scene and introduce reforms to the regulatory frameworks to keep pace with the change (Goldsworthy, Lewis & Shuetrim, 2000).

 

In line with the recommendation by the Australian Financial System Inquiry, led by the Campbell committee in 1981, the 1980s was an era of deregulation in the Australian financial system.

 

During the early 1980s, the management of risk and the risk management systems in the banking and financial sectors were too simplistic. In fact, most banks did not have effective measurement systems in place, nor systematized management of credit risk – the largest single risk facing a bank with the greatest likelihood of defaults (Thompson & Gray, 1999).

 

It was difficult for many financial institutions to determine aggregate exposures to counterparties, especially when different entities within the financial conglomerate were lending to the same borrower. Credit or loan grading systems, especially those based on the historical default characteristics of exposures, were uncommon. Only a handful of institutions had the expertise and technical tools to assess the credit worthiness of homogenous loans. Even then, such credit and other risk assessments were rarely accurate; relying upon an undesirably high degree of subjectivity. Thus, systematic identification, measurement and management of risk were not the concerns of the banking sector at this period (Thompson & Gray, 1999).

 

The eruption of the worldwide credit problems in the late 1980s to early 1990s revealed serious risk management flaws and problems. In response, banks began to pay greater attention to credit risk management, disclosing a substantial volume of risk-related information, as compared to before.

 

It was around this time, in 1988, the Basel Capital Accord, developed by the Basel Committee, was introduced, the onset of the risk-based capital adequacy regime. Although banks made passing mention about capital adequacy, descriptive information regarding issues of risk measurement or management within the respective institution was not given; the specific and general provisioning of credit related risks were the only information provided (Thompson & Gray, 1999).

 

The growth in financial markets and instrument in the late 1980s coincided with the increased attention to credit risk assessment, changing the focus of traded market risk management in banks and other financial institutions (Thompson & Gray, 1999).

 

By the early 1990s, the banks began to furbish more comprehensive and detailed quantitative data on their credit portfolios, such as having interest margins, in addition to information on credit risk (Thompson & Gray, 1999).

 

Even then, the information was still insufficient – references to operational risks, issues on traded market risks and information description the banks’ risk or risk management matters were hardly made. The growth in derivatives and derivatives risks that began in the early 1990s was of particular importance, adding another level of complexity towards understanding risks (Thompson & Gray, 1999).

 

By the latter half of the 1990s, the issue of risk management was regarded seriously. It became institutionalised within organisations. They were analysing risk with much greater precision than in the past and are revealing more details to the public about the benefits and limitations of their risk management practices in relation to many different dimensions of risks. However, these simplistic analyses were still not enough.

 

 

** Australia’s Current Regulatory Environment (1998 – 20xx)

 

The Financial System Inquiry, or Wallis Inquiry, was commissioned in 1996 and is notable for its impact on the current regulatory system (Goldsworthy et al., 2000).

 

It found that the regulatory framework of 1980s had not been effective — there were overlaps of duties, conflicts and confusion among the various agencies conducting prudential supervisions, especially as financial regulation got more complex.

 

Hence, the Wallis Inquiry recommended a major rearrangement of financial regulation, shifting from a regulatory structure organised around institutions types, to one based on functions (Goldsworthy et al., 2000).

 

This led to the formation of the Australian Prudential Regulation Authority (APRA) in July 1998, bringing an end to the Reserve Bank of Australia (RBA)’s role in bank supervision. Today, RBA oversees monetary policies, system stability and payment systems of banks; while APRA is the main prudential supervisor.

 

Around this time, the 1988 Basel Accord was becoming irrelevant in today’s banking environment. The new capital adequacy framework, Basel 2, was set to replace its predecessor in phrases.

 

Basel 2 is more comprehensive than the Basel Accord; its framework consists of three pillars – minimum capital requirements (Pillar 1), the supervisory review process (Pillar 2) and market discipline for increased disclosure requirements (Pillar 3). It aims to better align mandatory capital with the different risks of banks then its predecessor, whose sweeping risk approach was too arbitrary (APRA, 2002).

 

APRA studied the framework, making some discretion to tailor it to suit Australia’s local practices, before implementing Basel 2 in Australia in 2008.

 

Summary: Capital adequacy – From Past to Present

 

Comparing the financial institutions, as well as regulatory frameworks, in Australia today and twenty years ago would reveal some quite stark differences in the areas of capital-risk management and capital allocation. One of such changes is the dramatic development of modern prudential supervision in Australia. Based on the Wallis Inquiry, APRA was conceived to facilitate a more integrated regulatory framework and meet the challenges of maintaining a sound financial system, especially in the area of capital adequacy.

 

Over the years, there is increasing emphasis on the importance of capital adequacy. The recent spates of financial crisis worldwide have raised greater awareness of the importance for capital adequacy.

 

Banks has to strike a balance between the risks they are exposed and the capital to support that risks. The trade offs of matching too much capital to a risk, is a less attractive returns to its shareholders. The opportunity costs of doing the opposite would be perilous to the banks.

 

Hence, banks are devoting significant resources towards risk and capital management, using sophisticated tools and calculations. The complexity of this minimum capital adequacy model (Basel 2) is a better reflection of their actual risks – with the inclusion of operational, functional, reputation, traded market, interest rates risks – as compared to the use of credit risk only (Basel Accord) in the past. Besides, technology has made it somewhat easier for banks to keep track of their risk profiles, as compared to the 1980s.

** Critically Argue your opinion about the Effectiveness of the Current Regulations.
Due to the vulnerability of banks and the adverse impact on the entire financial system and economy caused by any major bank collapses, stringent banking regulations are in place to compensate for the tendency of instability (Young, 1986). Therefore, the effectiveness of regulations is measured by how best it can accomplish its purpose: protecting the interest of depositors and the entire financial market (Gallanti, 2003).

Although banking regulations have several facets, this essay is primarily concerned with the effectiveness in the area of prudential supervision of capital adequacy standards.

The rationale for having adequate capital allows a bank to buffer any unexpected losses stemming from its risk exposures and be able to continue its operations. This serves to bolster the people’s confidence in the banks.

Despite, the best intentions of such regulations, this essay believes that its effectiveness is to a limited extent. There are limitations how far regulators can watch over banks – who decide whether to flout the principles and objectives of regulations in favour of more profits and thus putting itself in peril.

Since introduced in 1988, banks in the fifty five member countries were significantly safer as compared to the pre-Basel days. There is heightened awareness to the importance to having capital buffer. The standardised methodology serves a benchmark for banks and regulators to adhere to (Coy, 2008).

However, the effectiveness of the Basel Accord can be judged by its lack lustre performance in the past decades. The current subprime-mortgage debacle shows how banks learnt to circumvent the restrictions regarding their mandatory 8% capital requirements. The infamous subprime meltdown stemmed from lending money to risky American home owners. Although such loans would rank poorly and require substantial amount of capital backing, banks got around by using Securitisation, Collaterals, Guarantees and Derivatives; repackaging these loans for sale to other banks. The staggering growth of such cheap credits eventually leads to a catastrophic meltdown worldwide in 2007 when the Americans defaulted on loans (Lim, 2008). It continues to deteriorate today and write-offs have reached exorbitant high levels. Another example is the 1997 Asian Financial crisis – when banks realised, too late, the capital they held was insufficient.

Many bankers attributed the crude “broad-brush” approach of Basel Accord, lumping different risk together, for its undoing. The Accord was unable to keep pace with financial innovation in the market. The effectiveness of Basel Accord had faltered to keep banks from taking such “kamikazes”.

Basel Accord, whose loopholes were exploited brazenly, will be phrased out by Basel 2. Basel 2 enhances protection of depositors and taxpayers: the riskiness of a loan is proportionate to the buffer shareholders are required to put up. It is touted to be better; a more comprehensive extension of its predecessor – assessing risks that are more reflective of Banks’ portfolios. Hopefully, the more stringent regulatory supervision and financial disclosure will keep banks in reins on overly rapid growth of banks through indiscriminate lending (Young, 1986).

Whether Basel 2 can fulfil its objectives, shall be seen in time to come. Yet, Basel 2 is already receiving a backlash from many critics (Coy, 2008). There are fears that Basel 2 may be too constrictive and may aggravate an economic decline: when banks are reluctant to lend money, to reduce risks, in a downturn, more defaults results.

The failure of the Basel Accord was due to complacency – bankers are lulled into thinking they have ample provisions for unexpected losses and took greater risks. No matter how stringent the requirements, how complex the capital-risk calculations assessments, bankers will inevitability find creative solutions to exploit the loopholes and outwit regulations. On the other hands, excessively dependent on Basel calculations will be counterproductive. Neither the regulators, nor the banks, can anticipate all the problems and hazards. Regulations and ratios can only guide the actions of the banks.

“A high degree of compliance with the (Basel) Principles should foster overall financial system stability; however, this will not guarantees it, nor will it prevent the failure of individual banks…” (BIS, 2006)

There will always be capital-risk imperfections using formulas: there will always be a high probability of error – using probabilities to forecast the unpredictable future. But it is a matter of behaviour rather than a measurement problem. This was already raised by Young in 1986, before the implementation of the 1988 Accord.

Therefore, the key to a robust financial system is not an overtly uptight with regulations, but on exemplary management practices. Banks should guard against complacency and other human flaws, which can undermine the solvency requirements and erode the purpose of having adequate capital. With billions of dollars being transacted through the financial system globally everyday, it is hard for bankers to remember that these are the culmination of the thousands of depositors’ hard earned money.

When bankers are pressured to offer more “impalpable” financial products, to stay ahead in the competition, they are only creating more financial bubbles to come. Their perception of the risk might decline and compensation for the risks becomes inadequate. Basel 2 may restrict the phenomenon growth of banks attributed to haphazard loans, but no amount of capital is adequate for the banks to weather a liquidity crisis if their credit culture is wrong (Young, 1986). Hence, bankers must be guided by the prudence concept: provision for all losses and discretion for all gains; and be vigilant against the uncertainty of the market environment and their own fallible behaviours. This is also the underlying principle of capital adequacy.

While banks in Singapore (Lee, 2008.) and Australia (APP, 2008.) are fortunate to remain “unscathed” by the sub-prime credit crunch, American Banks are struggling to stay afloat. Although these countries have similar Basel regulation regime in place, risk appetites and the discipline to exercise circumspection at all times, differ in different countries, thus the varying results.  

Banks have an onus to the public who placed their trust in them and ensure depositors’ money is safe; whereas regulators make sure the banks do that. Therefore, the effectiveness of current regulations based on solely on the Basel regime is limited, and will have to depend on how the banks behave and how the regulators moderate their rules accordingly.

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References

Glossary

  1. Derivatives:
    Derived: not original; secondary. A financial contract or investment whose value derives from another more fundamental investment, such as underlying stocks, bonds, currencies, commodities, etc, as a commitment to buy a bond for a certain sum on a certain date.
  2. Collateral: 
    Security pledged for the payment of a loan
    Additional; confirming: collateral evidence; collateral security
    Secured by collateral: a collateral loan.
  3. Securitisation:
    The use of such securities as Eurobondsto enable investors to lenddirectlyto borrowers with a minimum of risk, but without using banks as intermediaries.
    Process of creating a financial instrument by combining other financial assets and then marketing them to investors
  4. Solvency
    Solvent condition; ability to pay all just debts. 
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Comments
  1. ying.wei says:

    Someone commented on this blog entry, but I had accidentally removed it as spam.

    However, that person has this website which looks pretty well written: http://futures.morewrite.com/2008/06/17/immunizing-bond-portfolios-using-bond-futures. It is kinda of complicated to understand the person’s blog though as it has quite a bit of complex terminologies. It got “Genius” for its blog readibility test Nonetheless, it is manageable.

    On the bright side, mine is so much easy to understand, possibly because I am a Layman writing for other laymen. 8) Mine is only “High School” standards, or my “Fog index” is 12.05. Ha ha. Maybe I should like a another post on similar topic, and strive to make it much easier to understand. The lower my Fog Index, the better. :-P

  2. siyi says:

    mine is elementary school standard

  3. p s iyer says:

    Well written with original thoughts. No matter how stringent Basle norms are, as long as bankers are under pressure (from any source) to show profits quickly, they will always find ways to get around regulations.
    Good common sense and fundamental consciousness on how banks deal with public funds and have a trustee role cannot be nurtured by regulation.

  4. Meme says:

    This assignment has excellent description of the history of Australian banking environment. It is reflected in the ability to link history together and demonstrated sound understanding of the development of regulations since 1980s.

    It displayed exceptional ability in explaining the current regulatory environment. However, as regards to the specific details of the Basel II in Australia, it is felt that more could be elaborated on perhaps the risk management models, the asset risk weightage being recommended by APRA for adoption by the ADIs and the attitude of these banks towards risk and capital management.

    On the effectiveness of the current regulations, your synthesis of the sources is impressive and is follow-up by sound and logical argument. Essay did well to highlight banks circumventing the 8% mandatory CAR through assets securitization and the lesson learnt from US subprime meltdown as a result. Effective use of references and collection of excellent research materials noted.

    Overall, an excellent assignment – characterised by good analysis and research done, solid argument and effective conceptual ability to relate theories to real life situation.