Understanding Capital Adequacy and Capital Liquidity - Assignment Example

?Report on Financial and Market Risks in Banking sector and the ways to minimize the systematic risks. d 01 June Understanding capital adequacy and capital liquidity: Financial risks are inevitable while performing banking activities. Hence, liquidity and capital needed to be well maintained by the banks and the other financial institutions. It ensures a continuous process of daily operations and the ability to meet future capital requirements. As an example, absence of sufficient amount of capital in reserves due to excessive lending to customers might cause the cause cash crunch in the banks. It hinders the daily operations and outflows for settlement of balance account. Due to severe cash crunch withdrawals also get affected. Owing to non-liquidity and non-adequacy of reserves the bank turns to be insolvent. They are the measures of financial and market strength of a bank or a financial institution. Capital adequacy is the ratio between the capital and risk weighted assets. So, strength in capital base instills confidence within the depositors. This shows that there is a minimum possibility of insolvency due to systematic risks. It helps to attain stability during economic stress. It also helps to reduce the knock on effect of the stress that comes from the financial environment to the real economy. It helps to measure the financial stability and strength. Bank of International Settlement (BIS) provided a standard for capital adequacy i.e. primary capital base of a bank should be at least 8% of their assets. The regulators generally try to ensure that the banks and the other financial institutions have enough reserve to sustain themselves in an event of crisis. It helps to protect depositors as well as protects the wider economy from collapsing. It has been historically true that failure of big banks affect the wider economy. Financial risk from such economic downturn is termed as systematic risk. (All Banking Solutons, n.d.; Liquidity and capital, n.d.; Michael Hutchison, 1999) Capital liquidity is the cash being maintained by the other financial institutions and the banks and the balances with the central bank. Generally, the banks with large amount of liquid assets are in a lot safer position regarding meeting of any unexpected withdrawals. There are liquidity management measures, which manage liquidity positions that ensure the funding requirements. It also helps in meeting payment obligations under normal or stressful situations. In simpler words, liquidity for bank means the ability of meeting its financial obligations as they arrive in due course of time. They lend financial investments in relatively non-liquid assets. They generally fund loan in short-term liabilities. So, one of the challenge to a bank is to ensure its liquidity in any condition. Different Commercial banks manage their liquidity in different ways. Customer deposits are the main source of fund for small banks. Its assets mostly comprise of loans to the small firms and individuals. Small banks generally have more deposits in respect to borrowers with strong credit position. These excess funds are turned into assets with high liquidity. This type of banking operation is known as asset management banking. In contrast, large banks lack reserves to sponsor their major business. When needed, they borrow funds from the major lenders as short-term liabilities. This type of banking is termed as liability management, which is riskier than asset management banking. In this way the banks maintain the liquidity for daily operations and cash outflows. (All Banking Solutions , n.d.; Liquidity and capital, n.d.) Methods of liquidity management in commercial banks: Liquidity management is a vital process for the financial soundness of a bank or for any other financial organizations. It is one of the demanding elements, not just in terms of managing and optimization of cash reserve in multiple locations and currencies. But it also helps in prediction of the available liquidity accurately and tallying those calculations against different possibilities over numerous time frames. Mainly the constraints rise from the three sources: the corporation itself, banks and the fiscal or regulatory environment. First of all it is needful to determine the scale or degree of potential liquidity needs that depends on the daily activities of the banks in numerous dimensions. The important reasons are: to ensure cash adequacy at branches and ATMs to meet withdrawals, to have sufficient fund for settlement of overnight account balances, projection of the likely withdrawals in future and inflows to ensure adequate liquidity availability for the approaching dates. There are three levels for managing liquidity. Those are: Operational liquidity management that is the handling of intra-day and next or near day positions. It includes cash flows and account positions in central bank. This process also manages inter-bank markets and central bank access. Then comes the systems for aggregating information and limits on mismatch positions for future days are also taken care of. On the other hand, tactical liquidity management deals with the short-term asset liquidity and unsecured funding. The strategic liquidity management emphasizes upon the funding or capital market access. The tools generally used for managing liquidity are: Quantitative forecasting: It includes the tracking of regular alterations in central bank’s balance sheet and currency circulation. Predicting the future changes in central bank’s financial statement and currency circulation. It also helps to forecast changes in the demand for bank reserves. Early warning indicators: Hutchison and McDill (1999) focused on the banking sectors of big promising or developing market and industrial economies. They considered economic distress introduces an inherent bias towards the banking sector. Clues and information were derived, observed and scrutinized from the distressed environment. So that an onset of distress can be avoided by the countries, which have similar condition but still not in distress. In this way, other countries not undergoing distress can also isolate the problems and predict the forthcoming banking problems. The two important early warning indicators, which cause distress, are macroeconomic and institutional features. Among the macroeconomic side factors connected to banking problems, inflation might be considered as the foremost one followed by exchange rate changes and changes in real interest rates. Any abnormal or negative changes; in asset prices, real credit growth, real output growth, and the ratio of international money stock to that of its domestic counterpart also enhances banking problems. Among all the indicators Hutchison and McDill sorted out that two macro-variable factors are playing the main role in onset of banking distress. These are decline in real output and reduction in asset values. During recession generally the banking problem rises and asset price falls i.e. the real estate market declines. The institutional characteristics like regulatory and administrative frameworks, and deposit insurance, do not change much. This leads to cross-country difference in the institutional culture, which leads to banking problems. (Hutchison, 1999) Stress testing: It is a technique to measure liquidity of a bank. It helps to demonstrate the bank is able to survive when the primary source of fund dries up for a number of days. The assumptions taken during screen testing are asset market illiquidity and the decrement in value of liquid assets, retail funding dries off, availability or unavailability of funding sources for both secured and unsecured. Contingent claim, additional marginal calls, collateral requirements, liquidity drains related to complex products or transactions, operational ability of bank to monetize asset etc. are also some techniques of screen testing. (Davis, 2008; Hutchison, 1999) Contingency funding plan: The importance of daily operation is crucial in addressing the times of crisis. Liquidity can take place from either internal or external events. So, the plan should address both contingencies for short as well as long term effect. The crisis event may be short-term scenario like natural calamities, act of war and public relation situations. These factors affect leaves bad effects on the institution leading to large withdrawal of deposit or the same for large funding source. Long-term crisis imparts severe impact on the institution and often leads to insolvency. (Davis, 2008; Contingency Funding Plan, n.d.) Some elements are also being incorporated in liquidity management process. Those are: maintaining a large liquidity buffer sufficient to manage day-to-day operational and future funding needs. This ensures the balance sheet is structurally sound to gain confidence of depositors. Maintenance of long and short-term cash flow management also helps in contingency planning. This strengthens through management for foreign currency liquidity and preserving a well diversified funding base. (Liquidity and capital, n.d.) Asset management banking: As mentioned earlier, small bank derives its fund primarily from customer deposits. Mostly its assets are credit extended to the small companies and individuals. Generally they have more deposits than creditworthy borrowers. So, these excess funds are turned into assets with high liquidity. Liability management banking: As stated previously, large banks generally lack in reserve to fund their main business. They borrow capital when required, from the major lenders as short-term liabilities. It is riskier than asset management. In this way the banks maintain the liquidity for daily operations and cash outflows. Cash-Flow Approach: Taking the Basel Capital Accord and RBI guidelines as base Cash Flow Approach is coined to control the liquidity risk. To achieve the purpose the following objectives are formed, those are identification of the liquidity risks, classification of the liabilities and assets into different time frames. For efficient liquidity management bank needs to undertake the previous fund flow projections considering the movement of accounts in non-treasury assets and liabilities i.e. fresh and maturing deposits, new term loans, etc. This helps in forward planning of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). All banks have to maintain a certain part of their deposits as SLR and have to invest that amount in Government securities, in lieu of the borrowing program of Central Government. After all this, analysis of liquidity risk comes in the scenario. Actually, liquidity risk refers to the inability to satisfy the liabilities of the bank which lie pending or due. Liquidity risk in financial institutions arises from different dimensions those are funding, time and call risk. In funding risk there is a need to substitute the cash flowing out owing to unexpected non-renewal of deposits or their withdrawal. Compensate for non-receipt of fund inflows which are expected mostly arises from time risk. Call risk occur due to accumulation of contingent liabilities and the inability to grab profitable business opportunities proactively. The liquidity risk analysis incorporates liquidity position on a continuous basis and also examines how funding requirements are going to be affected under stress scenario of a crisis. Net funding required are identified by analyzing the future cash flows based on assumptions about the behavior of the assets and liabilities in the future under specified time frames, then calculating the cumulative net cash flows over time for assessment of liquidity. (Hutchison, 1999; Kodakkal, 2010) Significance of Basel Accord: Soundness of banking system is an issue of importance for regulatory authorities. It is defined as probability of a bank becoming insolvent; with lower probability the bank achieves higher soundness. This also depends on the bank capital as higher bank capital enables higher solvency, which in turn provides higher soundness. Till 1990 regulators estimated the capital adequacy on simple leveraged ratio i.e. ratio of capital to total assets, higher ratio provided larger cushion against failure. Distinction between the assets bearing different risk factor was absent in this accord. Higher asset risk can increase the chances of insolvency though the capital remaining the same (Money Terms, n.d.). To eliminate this weakness in the leverage ratio Basel committee introduced Basel Accord 1. In Basel Accord 1 refers to capital adequacy as a single numeric, which represents the ratio of capital to the assets of a bank. Two categories of capital exist. They may be referred as tier one and tier two. Tier one represents primarily the share capital and tier two the subordinated debts and preference shares. Here the key requirement was the share capital requires being minimum 8% of the assets. Assets are categorized into classes and they have an assigned weight between 0-1. Safe government assets weighing 0, where as high-risk assets like unsecured loan as 1 and others having between 0-1. Here Risk-Based Capital Ratio is considered instead of leverage ratio and calculated by the formula: Risk-Based Capital Ratio= Capital / (Risk – Adjusted assets) But afterwards the committee largely reformed the Basel 1 Accord and formed a new accord Basel Accord 2. Basel 2 is grounded upon three stands. These include market forces, administrative review process and least capital requirements. The first pillar is quite similar to the Basel Accord 1; second one is the use of advanced risk models to ascertain there is necessity of additional capital. Third pillar needs further secrecy about the risks, capital and policies of risk management. This encourages market to take high risks. In addition to capital adequacy specification most of the countries have guaranteed fund managed by regulators to pay depositors their owed money. Regulators usually mediate to avoid absolute bank defaults. The objectives of this accord are to promote reliability as well as safety in financial system, competitive equality enhancement and developing approaches for capital adequacy. Laying focus on internationally active banks and more inclusive method for dealing with risk were also objectives of the accord. To achieve these above-mentioned objectives, a new relation measures the risk-based capital ratio: Risk-based Capital Ratio= Capital / (Credit Risk + Market Risk + Operational Risk) Here the capital remains unchanged; the credit risk is measured by a combination of standardization approach, foundation internal rating approach and advanced internal rating approach. Techniques to measure the market risk are more or less similar as of in Basel Accord 1. Operational risk was brought in for the first time in this accord. So, these two accords laid a solid foundation for the capital adequacy in the banks and financial institutions. The main issue in which regulatory authorities stressed was dependability of the bank for the financial system stability and to construct a better measure for the insolvency probability. It is evident that for reaching the prior objective of capital adequacy and providing a better measure for insolvency probability the accords neglected the important issue concerning adequate capital liquidity. It is just a measure to obtain capital adequacy and soundness than achieving higher degree of capital liquidity. The financial market chaos in the sub-prime credit market of U.S. also exposed the weaknesses of the regulation and supervision of the financial sector. This resulted to Spring Meetings at 2008 by IMF-World Bank where top financial leaders endorsed new measures to strengthen the global supervisory and regulatory framework. It included a proposal from the Financial Stability forum calling for more vigilant watch of capital and liquidity at financial institutions. At that time bank regulators were implementing Basel 2 accords, but this financial crisis calls to make rules much tougher. Bank for International Settlements announced new rules and stricter regulatory capital structure-collectively known as Basel 3, which previously Basel Committee proposed during the credit crisis. Its directive requires bank to possess capital “against all of their securitization transaction, investments in asset-backed securities, retention of a subordinated tranche, and extension of a liquidity facility or credit enhancement.” (Tough capital requirements from Basel III, 2011) These attempts towards regulation and management had made the liquidity aspect more stringent. The outcome will be; local banks will face the heat, as they will have to comply with the new funds and liquidity needs as per the Basel 3 regulation. This also complies that the liquidity coverage ratio of the banks should comprise of valuable liquid assets equal to net cash outflows for 30 days. Since the financial crisis of last 2-3 years the regulators genuinely stressing on the capital adequacy issue and capital liquidity aspect is in the back seat, and this is creating displeasure to other financial institutions and banks. Though there is least probability for turn up of scenario as Basel 3 accords is going to stay and International banks have to comply with it for a long period from now. (Hasan, 2002, pp.2-8; Basel III Hit to local lenders in 2013, 2011) References 1 All Banking Solutions (n.d.), Camels, available at: http://www.allbankingsolutions.com/camels.htm (accessed on June 11, 2011) 2 Liquidity and capital (n.d) Standard Bank, available at: https://sustainability.standardbank.com/economic-performance/liquidity-and-capital/ (accessed on June 8 0211) 3 Davis, K. (2008), Managing Liquidity Risks(p.2-8), APEC, available at: http://www.apec.org.au/docs/08_TP_BRM/5.1_Davis.pdf (accessed on June 11, 2011) 4 Money Terms (n.d.), Capital adequacy, available at: http://moneyterms.co.uk/capital-adequacy/ (accessed on June 11, 2011) 5 Hutchison, M. (1999), Economic Research and Data, available at:: http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-28.html (accessed on June 11, 2011) 6 Contingency Funding Plan (n.d.), WIB, available at: http://www.wib.org/conferences__education/past_programs/09_liq_handouts/CFP_%20handout.doc (Accessed on June 11, 2011) 7 Kodakkal, S. (2010), LIQUIDITY MANAGEMENT IN BANKS, available at: http://kodakkal.ning.com/forum/topics/liquidity-management-in-banks (accessed on June 11, 2011) 8 Hasan, M. (2002), The Significance of Basel 1 and Basel 2 for the Future of The Banking Industry with Special Emphasis on Credit Information, available at: http://www.abj.org.jo/AOB_Images/633621457790666090.pdf (accessed on June 11, 2011) 9 Tough capital requirements from Basel III (2011), Cityam, available at: http://www.cityam.com/business-features/tough-capital-requirements-basel-iii (accessed on June 11, 2011) 10 Basel III Hit to local lenders in 2013 (2011), The Standard, available at: http://www.thestandard.com.hk/news_detail.asp?pp_cat=1&art_id=111754&sid=32598066&con_type=1 (accessed on June 11, 2011) Read More