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Capital adequacy ratio (CAR) was introduced as an anti-dote to bank failures and a stress signal to determine the volume of capital that will be sufficient to absorb any shock that may affect the going concern objectives of banks world-wide and other financial institutions (OFIs).
Many banks and OFIs caught in the web of inadequate capital became inexistent thereafter (45 was closed between 1994 and 2006 in Nigeria according to NDIC). About 10 years ago, Intercontinental Bank Plc, Oceanic Bank Plc and Bank PHB Plc were all well-branded banks in Nigeria with branch expansion goals, big balance sheet size and profitability at the centre of their corporate objectives. The banks with 5 others were declared illiquid later in 2009 by CBN as they lacked adequate capital to absorb credit risk losses. They needed to be merged, acquired or nationalized. In the case of Union Bank PLC, the bank opted for investment by a core investor African Capital Alliance (ACA) who invested $500 million and there were plans to further invest additional $250 million into the bank .
Similarly, big global banks such as Lehman Brothers, Fortis Bank, RBS, Lloyds and Northern Rock also ran into troubled waters and all became bankrupt. The collapse of these banks affected many other banks worldwide and caused fear and distrust in the banking sector. This ultimately led banks to exercise utmost caution in granting credits, reluctant to create investment outlets and generally losing their risk appetite.
On 26 March 2008, the Financial Services Authority, UK released an internal report into the failings over handling the problems at Northern Rock. "They found that their supervision of the bank had not been carried out to a standard that is acceptable".
The overall effect was call for stricter regulation and supervision of banks to ensure their long term stability. This informed the emphasis on CAR to support supervisory functions of regulators.
Reaction of Central Banks world-wide
To avoid re-occurrence of bank failures, Central Banks introduced Risk management frameworks (Basel I of 1974, Basel II of 2004 and most recently Basel III with implementation in 2019) to ensure that bank’s assets were covered from global shocks and local risks. They were also introduced to standardize risk management rules in central banks worldwide in their capital adequacy supervisory practices.
In paper 42 published in the ECB Journal of December 2005 on the new Basel Capital framework and its implementation in the European Union by Frank Dierick , Fatima Pires , Martin Scheicher and Kai Gereon Spitzer.
‘Basel II is based on three mutually reinforcing pillars: minimum capital requirements (Pillar I), the supervisory review process (Pillar II) and market discipline (Pillar III). A main innovation is that a set of increasingly sophisticated approaches is now available to banks to calculate their minimum capital requirements. Although the simplest method to calculate capital for credit risk is based on assessments by rating agencies, under the most advanced approaches, banks are allowed to use their own estimated risk parameters. Moreover, for the first time, banks are required to hold capital for operational risk.’
An index called CAR (Risk weighted assets ratio or capital adequacy ratio) is measured in determining compliance with Basel II which is presently being implemented in many countries and to monitor the health status of banks by central banks. It is the ratio of core capital (tier 1 and tier 2 capital) of a bank against risk weighted assets including contingent assets. In Nigeria, CAR is 10% for banks without foreign subsidiaries while it is 15% for banks with foreign subsidiaries. In most foreign countries, CAR is between 6% and 8%. Basel III asked for ratios as: 7–9.5% (4.5% + 2.5% (conservation buffer) + 0–2.5% (seasonal buffer)) forcommon equityand 8.5–11% for Tier 1 capitaland 10.5–13% for total capital.
The CBN reviewed the risk weights of some asset types upwards to ensure that banks adequately provide for any eventualities on some highly volatile sectors like the public sector where default on loans can crystallize immediately due to political reasons. Highlights of the circular released by the CBN are: increased risk weight on direct lending to government from 100 per cent to 200 per cent; and where a bank’s exposure to a particular sector of the economy exceeds 20 per cent of its total lending, the bank in question will be required to apply a risk weight of 150 per cent to its entire portfolio.
Where banks exceed the CBN stipulated large exposure limits, to prevent over-exposure to a client or group of connected clients, the CBN will, henceforth, treat such infractions as impairments to the respective bank’s capital; and the CBN tightened the circumstances under which credit transactions may take place between bank-related parties within a holding company structure.
The Central Bank of Nigeria also jacked up the Capital Adequacy Ratio for Nigerian banks with offshore subsidiaries to a minimum of 15 per cent from 10 per cent, which is the industry minimum. Though the CBN had taken other steps to ensure that the affected banks are inoculated from pressures from their offshore outlets, industry watchers believed that the CBN took this measure as an extra precaution against the pressures for additional capital from these subsidiaries.
Besides, some of the offshore subsidiaries, particularly those inherited from the acquired banks, are not doing well. This directive by the banking sector regulator has sent almost all the affected banks into the market sourcing for additional capital, to keep them clear of the new CAR requirement.
Zambia, became the latest African country to hike capital requirements to $100 million for foreign banks from $2 million, after Ghana and Kenya, as it tries to insulate its banking sectors from the effects of a weak global economy.
The new CBN’s directive affects six Nigerian banks that currently have foreign subsidiaries. They include United Bank for Africa Plc which leads with 18 subsidiaries on the continent; Access Bank Plc – nine subsidiaries; Guaranty Trust Bank Plc – five; Skye Bank Plc – four; Keystone Bank Limited – four; Diamond Bank Plc and Zenith Bank Plc – three respectively.
An international rating agency Fitch Ratings have said that the higher risk weights introduced by CBN might increase pressure on banks’ capital ratios. It, however, said that if the banks are successful in reducing sector concentrations, the changes could benefit asset quality and risk management.
A paper on New Zealand Banks’ Vulnerabilities and Capital Adequacy prepared by Byung Kyoon Jang and Masahiko Kataoka in January 2013 IMF Working Paper WP/13/7, finds that, given New Zealand’s conservative approach in implementing the Basel II framework, New Zealand banks’ headline capital ratios underestimate their capital strength.The soundness of the New Zealand banking sector was crucial to the resilience of the economy during the global financial crisis. The banking sector is dominated by four large subsidiaries of Australian banks that have proved resilient to the recent turbulence in the global financial markets. Their combined assets are close to 90 percent of total banking sector assets and about 160 percent of GDP. Bank profits are strong and nonperforming loans are less than 2 percent of total loans, low by advanced country standards. Sound regulation and supervision helped maintain stability. This can be said of French banks too such as BNP Paribas.
Computation of CAR
Concerns with high CAR
As much as CAR is good for the banks, there are some concerns of its implications if it is too high, non-uniformised or risk assets not properly defined by central banks the world over.
1. Contraction of the economy
Adequacy of capital in the contemporary banking system focuses two major issues. One is the function of provision of a buffer to absorb losses that can potentially crystallize if risk assets go bad or if currency trading results in huge losses, the other issue is that it regulates the amount of credits a bank can create and give to its customers. This requirement (CAR) for a bank is in addition to other reserve requirements of the central bank such as liquidity ratio, cash reserve ratio etc.
This latter function indirectly regulates money supply activities and also gives direction on the expansion of an entire economy. Therefore the macro-economic stability of a country will be compromised as high capital requirements act to suffocate monetary and lending expansion and could in fact work against real growth of credits and stimulate labour cuts in the broader sense.
Analysts have raised concerns that high CAR implies that large amount of money is stuck in provisions or reserves , meaning that there will be fewer money left for investment or for the smooth running or creation of bank’s credits. This is a major concern which will stifle the economy completely and ultimately lead to closure of companies and loss of jobs in a fragile environment.
2. Need for improvement in uniformity and pace of implementation of CAR / Basel III accord framework
There are also concerns that the Banks are not actually ready to implement fully the provisions of the Basel III accord as changes made on January 7, 2013 pushed implementation in some countries till 2019 and further amendments in 2021 like the USA. Basel III is to strengthen bank capital requirements by increasing bank liquidity and leverage ratios.
Leverage ratio
Basel III introduced a minimum "leverage ratio". The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total consolidated assets; the banks were expected to maintain the leverage ratio in excess of 3%.
Liquidity requirements
Basel III also introduced two required liquidity ratios.
(i) The "Liquidity Coverage Ratio" require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days;
(ii) The net stable funding ratio require the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
Dr Moghalu , formerly of CBN while fielding some media questions explained:
“Basel III, which is a response to the recent global financial crisis and will be implemented between 2013 and 2019, raises the level, quality and consistency of bank capital,” he explained. He added: “Basically, Basel III requires important global banks to hold core Tier I capital of a minimum of 7 per cent plus an additional buffer of 2.5 per cent of core tier one capital in order to counter macro shocks from economic cycles. It is important to note that some Nigerian banks are already operating above the capital thresholds established by Basel III, but there needs to be a more uniform approach to bank capital and risk management, especially by banks with national and international authorisations."
Chart from Sloman Economics New site: Rebuilding UK banks, not easy to do, March 2013
3. Inconsistencies in risk assets definition:
It is well-known that to make the CAR move above the benchmark set by central banks in different climates, banks up till recently place securitized loans as off balance sheet items and as such these items are discounted from the ratio. This practice is said to be common in many European banks to escape inclusion in the risk assets computation and increase CAR.
It is also noted that some banks classify commercial papers (CP) as off balance sheet items and exclude them as contingent assets in the risk assets computation. CAR of such banks which in actual sense is suppose to be very much below benchmark ratio of 10% will wrongly be above it because a heavily discounted risk weighted assets portfolio will result in a higher CAR.The treatment of Inter-bank placements under the definition of risk assets should also be properly clarified though in most EU countries it is included in their banks’ CAR computation.
The limitations of consistency in the definitions of risk assets can result in the problems of getting a true and accurate CAR. It should be noted that some of these banks which had to be bailed out, during the last economic crisis, had capital in excess of 20% of risk assets, yet were found to be short of capital when losses materialised. The implication is that the distortions in the computation of their CAR gave a false impression that they were adequately covered when in actual sense they were poorly capitalized, unstable and vulnerable to shocks.
The summary is that CAR is good for the banks to absorb shocks and facilitate their stability in the long run; the only concerns are that when it is high, there are implications on the overall economy as huge amount of money are tied down in provisions and reserves and not allowed to stimulate productivity through credit growth.
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