Revised Capital Adequacy Requirements
by Michael Deasy 1.
Extract from
Central Bank of Ireland, Quarterly Bulletin, Winter 1990.
Introduction
One of the main issues exercising the minds of banking supervisors over the past decade or more has been the question of capital adequacy for credit institutions2. In particular, attention has focused on what constitutes capital, what criteria should be used in measuring its adequacy and, assuming agreement on an appropriate measure, how this should relate to individual credit institutions. Concern by regulatory bodies has been reflected at international level with the issue being considered at some length in a number of international fora -most notably by the Basle Committee on Banking Regulations and Supervisory Practices (Basle Committee)3 and by the Council of European Communities.
In the case of the Basle Committee these discussions have culminated in the publication in July 1988 of its paper 'International Convergence of Capital Measurement and Capital Standards' which seeks to secure international convergence of supervisory requirements governing the capital adequacy of international banks. It has set down a minimum solvency ratio of 8 per cent. to be observed by all international banks.
At EC level, the discussions have resulted in the adoption of two related Council Directives 'Own Funds of Credit Institutions' which was adopted in April 1989 and 'Solvency Ratio for Credit Institutions', adopted in December 1989. The Own Funds Directive defines the constituents of own funds (i.e. capital) of credit institutions and forms the numerator of the solvency ratio. The Solvency Ratio Directive establishes the denominator of the ratio and sets down a minimum ratio - also 8 per cent. - which will be required to be observed by all credit institutions incorporated in the Community. These two Directives together with the Second Banking Coordination Directive, which was adopted in December 1989, form the basic framework for the establishment of a single market for banks and other deposit-taking institutions in the Community after 1992.
As a result of close cooperation between the two bodies - several countries are members of both - their respective capital adequacy requirements are very similar in content. Both have opted for a risk based approach to capital adequacy, that is, the level of capital required is determined by reference to the perceived risk associated with both on- and off-balance sheet business, and both have set 1 January 1993 as the date from which their respective requirements are to be implemented in full. While similar in content, however, they differ significantly in the area of implementation. The EC requirements will be obligatory and will apply to all incorporated banks in the Community, whereas the Basle requirements are in the form of a Recommendation and are aimed primarily at international banks.
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1. The author is a Deputy Manager in the Credit Institutions Supervision Department. Any views expressed in the article are not necessarily those of the Bank and are the personal responsibility of the author.
2. Credit institutions for the purposes of this article may be taken to mean deposit-taking institutions. The terms 'credit institutionÕ and 'bank' have been used interchangeably throughout.
3. The Basle Committee comprises representatives of the Central Banks and Banking Supervisory Authorities of the Group of Ten countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom, United States) and Luxembourg.
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Notwithstanding the fact that the full implementation date for the Basle Agreement is 1 January 1993 and that it is aimed at international banks, G-10 countries in general have commenced implementation and are applying the requirements to all banks in their respective jurisdictions. Moreover, many non-Basle members have or are in the process of implementing the Agreement.
With a view to protecting the international position of Irish credit institutions, the Central Bank decided in mid-1989 to be guided in practice by the Basle requirements pending the implementation of the relevant EC Directives. Accordingly, it revised its capital adequacy standards for credit institutions with effect from early 1990 to conform to the Basle requirements. These requirements are discussed in greater detail in subsequent paragraphs. Initially, however, there is a brief discussion on why it is considered necessary for banks and other credit institutions to maintain a minimum level of capital in the first instance.
Banks and other credit institutions occupy a unique position in the nation's economy. They play a central role in providing an efficient and effective payments system, and, being the main providers of credit, their impact on users of credit can be considerable. Side by side with this role, they are the main repository for the nation's savings, with the largest portion of their funding taking the form of repayable deposits from the general public.
Confidence in the stability of banks and other deposit-taking institutions is therefore essential if major disruptions to the economy are to be avoided. In order to achieve this stability supervisors expect credit institutions to observe certain prudential standards designed to minimise the risk to which such institutions may be exposed. The maintenance of minimum capital adequacy ratios is a central feature of these requirements which also entail, inter alia, setting minimum ratios as regards liquidity, and lending and borrowing concentrations.
The primary function of capital in the first instance is to cover the costs involved in establishing banks - this is common to all enterprises setting up. In addition to this requirement, however, credit institutions must have sufficient capital to earn the trust and confidence of depositors and would-be depositors. Moreover, a credit institution must always be in a position to absorb unexpected losses generated from within the institution itself or as a result of an upheaval to the financial system as a whole, in such a way as to leave deposits unimpaired. Capital fulfills this buffer role in that the loss of assets will be offset against it in the first instance.
In the 1970s supervisors became concerned about the general weakening in the capital position of credit institutions. This led to a reassessment of the nature and role of capital. Increasingly, subordinated debt capital (that is subordinated to the claims of depositors) became recognised as forming part of the capital base of banks, subject to certain limitations (e.g. it could not account for more than a given percentage of total capital). At the same time supervisors were moving away from the traditional gearing method of assessing capital adequacy to the more sophisticated risk asset measurement approach. The gearing ratio which relates capital to total assets - liabilities takes no account of the relative riskiness of a bank's assets whereas, in contrast, the risk asset ratio is based on the perceived risk in holding certain types of assets.
Supervisors also became conscious of the need to harmonise supervisory standards, particularly given the increasing internationalisation of banking business. This led to the establishment of the Basle Committee in 1974 and in the following year to the publication of the Basle Concordat which was subsequently amended in 1983. As a result general guidelines designed to achieve international cooperation in the area of banking supervision have been put in place. In dealing with solvency the above document sought to allocate responsibility between the home and the host country supervisors. Beyond that, it did not seek to define capital or specify minimum requirements. Apart from the ongoing discussions at EC Community level, the first significant attempt to promote the convergence of supervisory policies on capital adequacy assessment came with the publication in January 1987 of the Anglo-American Accord. Under this Accord the supervisory authorities in both the United States and United Kingdom agreed to apply a common risk asset ratio to credit institutions under their respective supervision. Discussion on the Accord subsequently widened to include all G-10 countries and resulted in the publication in July 1988 of the Basle Capital Convergence Agreement which the Bank is currently implementing.
The Basle Committee and, indeed, the European Community have two main objectives in seeking to arrive at capital convergence. The first is that the new approach should seek to strengthen the soundness and stability of national and international banking systems; secondly it should be fair and have a high degree of consistency in its application to banks in different countries, with a view to diminishing a source of competitive inequality among international banks.
As already indicated, the Basle Committee, like the EC, has opted for a risk-based approach to capital adequacy which has three distinguishing features. Firstly it defines capital; secondly it applies risk weightings to on- and off-balance sheet assets and engagements and thirdly it sets the minimum ratio of 8 per cent.
Capital is divided into two tiers - tier I represents capital in its purest form and comprises paid-up share capital and disclosed reserves. Tier ll comprises undisclosed reserves, asset revaluation reserves, general provisions, perpetual capital instruments and subordinated term debt. The total of tier ll elements is limited to a maximum of 100 per cent. of the total of the tier I elements. Furthermore, subordinated term debt is limited to a maximum of 50 per cent. of the tier I elements. Finally, the amount of general provisions to be included in tier ll is limited to a maximum of 1.25 per cent. of risk assets.
Four basic weightings are applied to the different assets: O, 20, 50 and 100 per cent. They are applied to the on- and off-balance sheet business and in broad terms are classified as follows:
Cash and claims on Zone A governments and central banks4.....0%
Claims on Zone A banks ..........20%
Loans fully secured by mortgages on residential property ..... 50%
Claims on the private sector and all other assets........100%
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4. Zone A comprises countries which are full members of the OECD or which have concluded special lending arrangements with the IMF associated with the Fund's General Arrangements to Borrow.
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The different weightings were agreed after careful consideration and much consultation with interested parties. They are felt to represent the best estimates of the underlying risk for the purposes of assessing adequate levels of capital for credit institutions. Each category of asset is multiplied by its allocated weighting and the capital is then expressed as a percentage of the sum of the weighted assets. The resultant ratio must be at least 8 per cent.
Both Basle and EC stress that the figure of 8 per cent. is designed to represent the minimum level of capital for credit institutions and individual countries are free to adopt arrangements that set higher levels. Accordingly, the Bank has applied a range of ratios between 8 and 12 per cent. to the various credit institutions incorporated in Ireland that are under its supervision, namely banks, building societies and the trustee savings banks. These revised ratios replace a system under which the Bank employed a combination of risk-asset ratio measurement and gearing ratio measurement (capital to gross assets). Differing risk asset ratios (7 per cent. to 12 per cent.) and a gearing ratio (4 per cent.) were applied to the non-Associated Banks. In the case of the Associated Banks a gearing ratio of 6.5 per cent. was applied. Neither the Basle nor the EC requirements impose a gearing ratio, although individual supervisory authorities are free to apply one if they so wish. The Bank, in common with other supervisory authorities, has dispensed with its gearing ratio requirement, reserving, however, the right to reintroduce one should that become desirable.
The revised requirements concentrate almost exclusively on credit risk, that is the risk of counterparty failure. This represents the major source of risk for credit institutions. However, these institutions face other forms of risk, for example, interest rate risk, exchange rate risk and settlement risk. It is generally accepted among supervisors that these risks, although difficult to account for in terms of capital backing, should also be captured in the capital ratio requirement. Both the EC and the Basle Committee, together with national supervisors, are currently considering proposals designed to incorporate these risks within the overall assessment of capital adequacy. It is expected that revised proposals to take account of at least some of these additional risks, will be introduced in the not too distant future. In the meantime, the Bank, as a proxy measure for foreign exchange risk, currently applies a weighting of 100 per cent. to the aggregate net short open foreign exchange position. Similarly, weightings of up to 20 per cent. are applied to the nominal value of holdings of fixed rate securities as a proxy measure for interest rate risk.