Role of capital quality in risk management

Capital is critical for banks to be in business. In banks and financial sector, it is meant to meet unexpected losses arising out of normal course of banking business like any other commercial enterprise. 

Unlike other business enterprises, banks are more sensitive entities dealing with public savings and they need to return them back safely with interest commitments. Hence, they must be adequately capitalized to meet any kinds of risks. 

Globally all Central Banks focus on the stability and financial soundness of financial sector by prescribing stringent capital adequacy standards. They are therefore subject to extensive regulation, including capital requirements as an important element. 

Capital requirements relate to the size and composition of assets, their inherent riskiness and bank’s exposure to sensitive sectors of the economy. The capital requirements for banks are based on international standards prescribed by Central Banks. But they normally take cue from the global benchmarks set by Bank for International settlement (BIS) formed in 1930 and working relentlessly to protect the global financial system by innovating better standards and benchmarks. 

Reinventing risk 
Inherent risks of banking and financial system are well recognized, identified, measured and mitigated on an ongoing basis. But despite such advanced sophisticated risk governance in place, the Global Financial Crisis (GFC) engulfed the financial sector in 2008. GFC came much to the disappointment of risk managers and risk governing bodies who believed that they could ring fence organizations against risks but they were still vulnerable open to emerging risks which could not be detected with the systemic controls put in place. 

Learning from the GFC when Lehman Brothers had collapsed and many small and big financial entities became bankrupt, BIS began to reinvent financial risk and worked towards better models of risk management. A protracted understanding of causes for eruption of GFC led to development of a new capital adequacy framework in 2013 known as Basel III that laid more stress on aligning capital with the types of risks inherent in banking business. Thus GFC led to reinventing risk in its changing form, characteristic and emancipation. 

Missing early alerts 
Years before GFC – 2008, the signs of irrational exuberance in the conduct of business were ticking in banking system but they could not be captured by the risk governance group. Some of the globally renowned economists such as Dr. Nouriel Roubini, Dr. Ann Pettifor, Dr. Steve Keen, Dean Baker, to mention a few and many more have expressed apprehensions about the impending GFC before it struck but there was lack of sensitivity to act upon such early alerts. 

Banks must therefore be watchful that the dimensions and intensity of risks undergo seminal transformation with change in customer base and business mix. It is affirmed that modulation of not only capital but composition of capital will be important to tackle the risks transcending the business environment. Therefore, radar of risk management group in banks has to be well aligned to capture any incipient signs of adverse behavior of business indicators that can prevent episodes like Subprime crisis or profligacy in lending practices. 

Minimum Capital adequacy Ratio  
BIS had prescribed a minimum standard of capital set at eight per cent way back in 1988 when Basel – I framework was prescribed to manage risks. But since it is minimum and there could be better capital composition, various central banks across the globe had prescribed minimum capital adequacy greater than 8 per cent depending upon their capabilities to implement it. Minimum Capital adequacy Ratio (CAR) prescribed by different countries are according to their business composition and risk management strategies. Minimum CAR prescribed by China is 9.5 per cent, India – 9 per cent, Bangladesh 10 percent, Sri Lanka – 10 percent. But now it is prescribed at 11.875 percent for Sri Lankan banks having asset size of less than Rs.500 billion and 12.875 percent for banks with asset size of Rs.500 billion and above with effect from 1.1.2018. In Sri Lanka banks have a size based division in terms of need to maintain CAR. Banks across the globe prescribe CAR on aggregate basis and then stipulate quality of capital divided between core capital (equity) and subordinate capital. These differentiation improves the fall back mechanism on application of capital to meet the risks in banks. 

Quality of capital
In addition to maintaining minimum CAR, it is also necessary for Central Bank to monitor quality of capital. In order to facilitate it, BIS stipulates two distinct class of capital composition. Capital mix is bifurcated into (a) Common Equity Tier –1 (CET– 1) comprising of core capital and (b) CET – 2 subordinate capital – Tier 2. CET-1 is a superior capital and CET – 2 is a subordinate or supplementing capital. Both are important means in risk management. 

Following the GFC – 2008, Basel Committee formulated a reformed set of international standards to review and monitor the capital adequacy of banks. These standards have been collectively fitted into Basel III framework. It needs to compare a bank’s assets with its quality of capital to determine if the bank could stand the test of a crisis. 

Since, capital is required by banks to absorb unexpected losses that arise during the normal course of the bank’s operations, banks should be adequately capitalized in terms of quality too. Thus, Basel III framework tightens the capital requirements by limiting the type of capital that a bank may include in its different capital tiers and structures.  Thus a bank’s capital structure consists of Tier 1 common equity and Tier 2 capital. 

Common equity Tier 1 comprises of a bank’s core capital that includes common shares, stock surpluses resulting from the issue of common shares, retained earnings, common shares issued by subsidiaries and held by third parties, and accumulated other comprehensive income. The Tier 2 capital is defined as instruments that are not common equity but are eligible to be included in this tier. 
An example of Tier 2 capital is a contingent convertible or hybrid capital which has a perpetual term and can be converted into equity when a trigger event occurs. An event that causes a security to be converted to equity occurs when CET1 capital falls below a certain threshold and calls for such conversion in such eventualities. Tier-1 capital gauzes the solvency of the bank whereas Tier 2 explains the supportive capital. In the event of a loss to the bank, Tier 2 capital is used which needs to be replenished at the earliest to fall in line with minimum needs before Tier – 1 capital is accessed. 

Capital conservation buffer 
On the basis of banks increasing exposure to markets open to greater volatility, Basel III brought out a new form of additional capital requirement of up to 2.5 per cent of risk weighted assets in addition to minimum capital needs forming part of Tier – I  capital known as Capital Conservation Buffer (CCB). This brought to surface new prescription of capital thus taking the global minimum capital needs to 10.5 per cent (8 plus 2.5 per cent now added) increasing the capital needs. 

As a result, all Central Banks have brought out a matrix to progressively increase CCB spaced in 3-4 years to reach 2.5 per cent of additional capital. Sri Lanka needs its banks having asset base of less than Rs. 500 billion to increase Tier – I capital by 100 basis point to reach 7.875 per cent of risk weighted assets and large banks having asset base of Rs. 500 billion or more to raise Tier – I capital to 8.875 by 2019. Similarly Central Banks across the world have panned out a capital up-gradation plan in sync with emerging risks. 

Way forward, not only the CAR but more important will be the granular composition and quality of capital assessed in terms of share of Tier-1 core capital (including CCB) and Tier -2, the subordinate capital. Itwill thus be important for banking system to fall in line with more sophisticated risk management systems enunciated in the Basel III framework. 

 (The author is Director, National Institute of Banking Studies and Corporate Management – NIBSCOM, Noida, National Capital Region, Delhi, India. The views are his own)