CAPITAL ADEQUACY

&
CAPITAL PLANNING
Meaning Of Capital & Capital
Adequacy
 Capital is the investment in, or
contribution to, the business of an
institution that ranks behind depositors and
other creditors as to entitlement to
repayment or return on investment.
 Capital adequacy is a ratio that can
indicate a banks ability to maintain the
equity capital sufficient to pay the
depositors whenever they demand the
money & still have enough funds to
increase the banks assets through
additional lending.
FEATURES OF CAPITAL ADEQUACY
 Capital adequacy provides protection
to depositors & creditors.
 Capital adequacy relates to the firm’s
overall use of financial leverage.
 It measures the relationship between
firm’s market value of assets &
liabilities with the corresponding book
value.
NEED OF CAPITAL ADEQUACY
 Adequate capital is required:
 To support the growth
 To absorb losses not covered by
earnings
 To provide protection to fiduciary
accounts.
 To ensure the public confidence in
trust company system.
NEED FOR CAPITAL PLANNING
 A capital plan needs to :
 See section for adjustments;
 Identify the underlying assumptions
supporting the projection;
 Identify the quantity, quality and sources of
additional capital required, if any;
 Assess the availability of any external
sources identified; and
 Estimate the financial impact of raising
additional capital
THE COST OF EQUITY CAPITAL
 Financial institution compete in the
market for equity capital . The value
of the bank’s stock or equities sold in
the capital market reflects the current
& the expected future dividend to be
paid by the financial institutions from
these earnings, as for all firms.
CAPITAL & INSOLVENCY RISK
THE MARKET VALUE OF CAPITAL
 On a market value basis, the financial
institution is economically solvent and
would impose no failure costs on
depositors or regulators if it were to
be liquidated today.
The financial institution’s net
worth is being affected by :
 Credit risk & interest rate risk
 Market value of capital & credit risk:
A decline in the current & expected future
cash flows on loans lowers the market
value of loans portfolios held by the FI.the
loss of the value in M.V of loans appears on
liability side of the B/sheet as loss to FI’s
net worth, but libility holders are fully
protected in total MV of the claim.
 Market value of capital & interest
rate risk:
The rising interest rate reduce the
market value of the bank’s long term
fixed income securities and loans
while floating rate instruments, but th
e M.V of the short term liabilities
remain unchanged.
THE BOOK VALUE OF CAPITAL
 The FI regulators most commonly use
book value capital & capital rules
based on book values. The book
value of capital comprises four
components:
 Par value of shares
 surplus value of shares
 Retained earnings
 Loan loss reserve
APPROACHES TO CAPITAL
ADEQUACY
 Ratio Approach to Capital
adequacy:
When the regulators are developing
the ratio standards, they are more
interested in the solvency of banking
system than in single financial
institutions. Regulators may study
past failure experience of banks to
determine capital ratios.
 Risk based capital Asset
Approach:
This approach follows the following
criteria:
 credit guarantee would be given
weight & added to actual asset.
 It is step forward from simply
looking at total assets in terms of
risk.
PORTFOLIO APPROACHES TO
CAPITAL ADEQUACY
 This Approach is based on :

 Recognition of the complex set of

intersections involved in a FI.
 The fact that two independent risky
actions may be combined to create a
position that is less risky than either
of the independent positions.
THE CAPITAL ADEQUACY RATIO
(LEVERAGE RATIO)
 The capital assets or leverage ratio
measures the ratio of a bank’s book
value of primary or core capital to it’s
assets. The lower this ratio, the more
leveraged it is. Primary or core capital
is a bank’s common equity plus
qualifying cumulative perpetual
preferred stock plus minority interest
equity account of consolidated
subsidiaries.
 Formula:

CAR= Tier one capital + Tier two capital

Risk weighted Assets

 Risk weighted assets means fund
based assets such as cash, loans,
investments & other assets.
 Tier one capital includes:
*paid-up capital
*statutory reserves
*other disclosed free reserves
*capital reserves representing surplus
arising out of sale proceeds of assets.
Minus
*equity investments in subsidiaries,
*intangible assets, and
*losses in the current period and those
brought forward from previous periods
to work out the Tier I capital.
 Tier two capital includes:
*Un-disclosed reserves and cumulative perpetual
preference shares:
*Revaluation Reserves (at a discount of 55 percent
while determining their value for inclusion in Tier II
capital)
*General Provisions and Loss Reserves upto a
maximum of 1.25% of weighted risk assets:
*Investment fluctuation reserve not subject to 1.25%
restriction
*Hybrid debt capital Instruments (say bonds):
*Subordinated debt (long term unsecured loans:
CAPITAL ADEQUACY RATIO OF
COMMERCIAL BANKS
 The calculation of capital adequacy ratio of a commercial bank
shall be on the basis that full account has been taken of the
reserves to compensate losses in loans and various other
losses.
 Article 5. The capital of commercial banks shall be able to
withstand credit risks and market risks.
 Article 6. Commercial banks shall calculate the capital adequacy
ratio on the basis of consolidated operations as well as
separated operations at the same time.
 . The capital adequacy ratio of commercial banks shall not be
lower than 8% and the core capital adequacy ratio shall not be
lower than 4%.
GUIDELINES OF RBI
 RBI has been prescribing prudential norms
for banksconsistent with international
practice.
 To meet the minimum capital adequacy
norms set by RBI & to enable the banks to
expand operations.
 Public sector banks need more capital,such
capital be raised with reduction in govt.
shareholdings.2
Problems using Capital Adequacy
 Differences in credit risk for most loans are not taken
into account.
 Book values are used rather than market values for
most of the assets in the risk-adjusted assets
calculations.
 Regulatory requirements may change banks’ behavior
in terms of allocation of loanable funds and
investment decisions and possibly channel savings to
less than the best uses.
 Some kinds of bank risk are excluded, including
operating risk and legal risk.
 Portfolio diversification is not taken into account.