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

1. Capital adequacy provides protection to depositors & creditors.2. Capital adequacy relates to the firm’s overall use of financial leverage.3. 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 loan 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.