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Capital Adequacy

Banks in the modern world face an inherent risk of insolvency. Hence, banks must
maintain adequate capital in their vaults if they want to survive. This is generally
measured in the form of a “capital adequacy ratio” and central banking institutions
all over the world prescribe the level of capital that needs to be maintained.
The capital adequacy ratio is important from the point of view of solvency of the
banks and their protection from uncertain events which arise as a result of liquidity
risk as well as the credit risk that banks are exposed to in the normal course of their
business.
Hence, if the banking system were to go bankrupt, the entire economy would
collapse within no time. Also, if the savings of the common people are lost, the
government will have to step in and pay the deposit insurance, so that, since the
government has a direct stake in the issue, regulatory bodies are involved in the
creation and enforcement of capital ratios. In addition to that capital ratios are also
influenced by international banking institutions.
Capital adequacy ratios mandate that a certain amount of the deposits be kept
aside whenever a loan is being made. These deposits are kept aside as provisions
to cover up the losses in case the loan goes bad. These provisions therefore limit
the amount of deposits that can be loaned out and hence limit creation of credit.
Changes to the capital adequacy ratio therefore can have a significant impact on
the inflation in the economy.

Credit Exposure
The capital adequacy ratios are laid based on the credit exposure that a particular
bank has. Credit exposure is different from the amount loaned out. The concept of
credit exposure and how to measure it in a standardized way across various banks
in different regions of the world is an important issue in formulating capital
adequacy ratios. There are two major types of credit exposures that banks have to
deal with.

 Balance Sheet Exposure: Balance sheet exposure is the amount of risk that
a bank is exposed to on account of the activities that are listed on its balance
sheet. This would include the credit exposure that result from the loans that
have been sanctioned. It would also result from the credit exposure that is the
result of the securities that have been purchased by the bank. Hence an analyst
can simply look at the balance sheet and come to an exact estimate of the
credit exposure of any bank.
 Off Balance Sheet Exposure: On the other hand, there are some risky
activities that a bank takes that are not listed on the balance sheet. For
instance, bank may issue guarantees to some parties on behalf of some other
parties. These guarantees are not financial transactions that can be listed on the
balance sheet.

In order to accurately calculate the credit exposure that arises due to such risks,
the analyst requires additional information from the banks.

 Multi-Tiered Capital
The capital is considered to have a multi-tiered structure. Therefore, some
part of the capital is considered to be more at risk than other parts. These
tiers represent the order in which the banks would write off this capital if the
situation to do so arises.
 Risk Weighting
Some of the liabilities of the bank i.e. demand liabilities and the loans that
have been financed by them are far more dangerous than other liabilities.
Hence, they need to be assigned appropriate risk weights. Using the system
of weighted risks, banks can be more prepared regarding the probability of
an adverse outcome and to meet the effects that such an outcome would have
on the profitability and solvency of the bank.
History of the Basel Norms
After the collapse of the gold standard in 1971 and in 1973, many banks were
concerned about the fact that banks with an international presence were not
holding sufficient capital. Since the international financial system had come to be
deeply integrated by this time, it became a source of great concern for the various
countries involved. A crisis that was born in one country could quickly spiral out
of control and affect the other countries as well.
It is for this reason that the central banks of the prominent G-10 nations created a
committee of experts. This committee came to be called as the Basel Committee
on Banking Supervision. As per the recommendations of this committee the Basel
norms were first formulated under the patronage of the Bank for International
Settlements (BIS).
The banking industry has undergone drastic change in the past three to four
decades. Hence, the Basel norms that were first formulated became obsolete and
Basel –II norms had to be introduced. At the present moment, even the Basel-II
norms seem inadequate and the major banks in the world are swiftly moving
towards a new accord called the Basel-III system.
The Third Basel Accord
The global banking crisis that ensued worldwide in 2008 exposed the weakness of
the industry. The third Basel accord should have ideally been implemented by
now. However, there have been certain delays in the process and worldwide
adoption of Basel norms is expected to occur by 2018.
The third Basel accord plans to aggressively increase the amount of money banks
hold on as capital. Although, the total amount of capital required may remain
unchanged, the third accord requires a considerably higher amount of tier-1 capital
to be maintained. For instance, the amount of equity capital to be maintained has
been increased to 4.5% from the erstwhile 2%.
Also, the third Basel accord has created the provision for capital buffers.
These capital buffers will act as the second layer of protection for the banks in the
event of a crisis. Provision has also been made for countercyclical buffers. These
buffers will help to regulate the volume of credit and prevent a credit boom from
occurring so that a bubble is not formed.
The Basel accords have therefore undergone a drastic change since their
introduction in 1988. The third Basel accord is expected to be able to provide the
banking industry with the much needed stability using which a period of growth
can be ushered in.
Assest Liability Management
Asset liability management is a step that assures banks and other financial
institutions with protection that helps them to manage these risks efficiently. The
model of asset liability management helps to measure, examine and monitor risks.
It ensures appropriate strategies for their management. Thus, it is suitable for
institutions like banks, finance companies, leasing companies, insurance
companies, and other financing bodies.
ALM is an integral part of the financial management process of any bank. Asset
liability management is an initial step to be taken towards the long term strategic
planning. Asset liability management is a strategic approach of managing the
balance sheet in such a way that the total earnings from interest are maximized
within the overall risk-preference of the institutions.
ALM is defined as, “the process of decision – making to control risks of existence, stability and
growth of a system through the dynamic balances of its assets and liabilities.”
The Reserve Bank of India announced its first set of ALM Guidelines in February
1999. These guidelines were effective from 1st April, 1999. These guidelines
enclosed, inter alia, interest rate risk and liquidity risk measurement, broadcasting
layout and prudential limits. Gap statements were necessary to be made by
scheduling all assets and liabilities according to the stated or anticipated re-pricing
date or maturity date.
At this stage the assets and liabilities were enforced to be divided into the
following 8 maturity buckets −

 1-14 days
 15-28 days
 29-90 days
 91-180 days
 181-365 days
 1-3 years
 3-5 years
 and above 5 years
On the basis of the remaining intervals to their maturity which are also referred as
residual maturity, all the liability records were to be studied as outflows while the
asset records were to be studied as inflows.
Later, the RBI made it compulsory for banks to form ALCO, that is, the Asset
Liability Committee as a Committee of the Board of Directors to track, control,
monitor and report ALM.
The Asset-Liability Committee (ALCO) is one of the top most committees to
overlook the execution of ALM system. This committee is led by the CMD/ED.
ALCO also acknowledges product pricing for the deposits as well as the advances.
The expected maturity profile of the incremental assets and liabilities along with
controlling, monitoring the risk levels of the bank. ALCO is the very important and
bone of the system so that’s why they need to focus on the current news,
information, laws, Government rules and market situation urgently so there
meeting are arranged on short interval basis to determine the exact accurate and
latest picture of the situation. By gathering this data they can make the strategy
according to the situation which is very helpful for the bank.
ALM objective
Liquidity Risk Management, Interest Rate Risk Management, Currency Risks
Management, Profit Planning and Growth Projection
ALM functions include the tools adopted to mitigate liquidly risk, management of
interest rate risk / market risk. It comprises of functions like identifying the risk
parameters, risk measurement and Risk management and laying out of Risk
policies and tolerance levels. In short, ALM is the sum of the financial risk
management of any financial institution. ALM sits between risk management and
strategic planning.
In other words, ALM handles the following three central risks −

 Interest Rate Risk


 Liquidity Risk
 Foreign currency risk
Banks which facilitate forex functions also handles one more central risk —
currency risk. With the support of ALM, banks try to meet the assets and
liabilities in terms of maturities and interest rates and reduce the interest rate risk
and liquidity risk.
Asset liability mismatches − The balance sheet of a bank’s assets and liabilities
are the future cash inflows & outflows. Under asset liability management, the cash
inflows & outflows are grouped into different time buckets. Further, each bucket of
assets is balanced with the matching bucket of liability. The differences obtained in
each bucket are known as mismatches.
The ALM Process
The ALM process rests on the following three pillars −

 ALM Information Systems


 Management Information System
 Information availability, accuracy, adequacy and expediency
ALM information systems
The key to the ALM process is information. The large network of branches and the
unavailability an adequate system to collect information necessary for ALM, which
examines information on the basis of residual maturity and behavioral pattern
makes it time-consuming for the banks in the current state to procure the necessary
information.
Measuring and handling liquidity requirements are important practices of
commercial banks. By persuading a bank’s ability to satisfy its liabilities as they
become due, the liquidity management can minimize the probability of an adverse
situation developing.

Measurement and Management of Risks


Risks have a negative effect on a bank’s future earnings, savings and on the market
value of its fairness because of the changes in interest rates. Handling assets invites
different types of risks. Risks cannot be avoided or neglected in bank management.
The bank has to analyze the type of risk and necessary steps need to be taken. With
respect to assets, risks can further be categorized into the following −
Currency Risk

Dealing in Different Currencies


It brings opportunities as also risks. If the liabilities in one currency exceed the
level of assets in the same currency, then the currency mismatch can add value or
erode value depending upon the currency movements. The simplest way to avoid
currency risk is to ensure that mismatches, if any, are reduced to zero or near zero.
Banks undertake operations in foreign exchange like accepting deposits, making
loans and advances and quoting prices for foreign exchange transactions.
Irrespective of the strategies adopted, it may not be possible to eliminate currency
mismatches altogether. Managing Currency Risk is one more dimension of Asset
Liability Management.
Interest Rate Risk (IRR)
Interest rate risk is the risk where changes in market interest rates might adversely
affect a bank’s financial condition. Changes in interest rates affect both the current
earnings (earnings perspective) as also the net worth of the bank (economic value
perspective). The risk from the earnings’ perspective can be measured as changes
in the Net Interest Income (Nil) or Net Interest Margin (NIM).
Therefore, ALM is a regular process and an everyday affair. This needs to be
handled carefully and preventive steps need to be taken to lighten the issues related
to it. It may lead to harm to the banks on regards of liquidity, profitability and
solvency, if not controlled properly.
In order to deal with the different types of risks involved in the management of
assets and liabilities, we need to manage the risks for efficient bank management.
There are various techniques used for measuring disclosure of banks to interest rate
risks –

Gap Analysis : Gap Analysis is a technique of Asset – Liability management. It is


used to assess interest rate risk or liquidity risk. It measures at a given point of time
the gaps between Rate Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA)
(including off balance sheet position) by grouping them into time buckets
according to residual maturity or next re-pricing period , whichever is earlier.
This model represents the total interest income disclosure of the bank, to variations
occurring in the interest rates in different maturity buckets. Repricing gaps are
estimated for assets and liabilities of varying maturities.
A positive gap reflects that assets are repriced before liabilities. Meanwhile, a
negative gap reflects that liabilities need to be repriced before assets.

Thus ;

GAP=RSA-RSL

GAP Ratio=RSAs/RSL

 Mismatches can be positive or negative


 Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch
 In case of +ve mismatch, excess liquidity can be deployed in money market
instruments, creating new assets & investment swaps etc.
 For –ve mismatch,it can be financed from market
borrowings(call/Term),Bills rediscounting,repos & deployment of foreign
currency converted into rupee.

Gap analysis was widely used by financial institutions during  late 1990s and early
years of present century in India.  The table below gives you idea who does a
positive or negative gap would impact on NII in case there is upward or downward
movement of interest rates:

Gap Interest rate Change Impact on NII

Positive Increases Positive

Positive Decreases Negative


Negative Increases Negative

Negative Decreases Positive


 The general formula that is used is as follows −
ΔNII = ΔRi×GAPi
In the above formula −

 NII is the total interest income.


 R is the interest rates influencing assets and liabilities in the relevant
maturity bucket.
 GAP is the difference between the book value of the rate sensitive assets and
the rate sensitive liabilities.
Hence, when there is a variation in the interest rate, we can easily analyze the
influence of the variation on the total interest income of the bank. A change in
interest rate has direct impact on their market value.
The main drawback of this model is that this method considers only the book value
of assets and liabilities and thus neglects their market value. So, this method is an
incomplete measure of the true interest rate exposure of a bank.

Duration Gap Analysis : Duration or interval is a critical measure for the interest
rate sensitivity of assets and liabilities. This is due to the fact that it considers the
time of arrival of cash flows and the maturity of assets and liabilities. It is the
measured average time to maturity of all the preset values of cash flows. This
model states the average life of the asset or the liability.

It is denoted by the following formula −


DPp = D (dR /1+R)
The above equation briefs the percentage fall in price of the agreement for a given
increase in the necessary interest rates or yields. The larger the value of the
interval, the more sensitive is the cost of that asset or liability to variations in
interest rates.
According to the above equation, the bank will be protected from interest rate risk
if the duration gap between assets and the liabilities is zero. The major advantage
of this model is that it uses the market value of assets and liabilities.
The larger the value of the duration, the more sensitive is the price of that asset or
liability to changes in interest rates. Duration analysis could address these in
theory, but implementing sufficiently sophisticated duration measures was
problematic.
Simulation Model
This model assists in introducing a dynamic element in the examination of interest
rate risk. The previous models — the Gap analysis and the duration analysis for
asset-liability management endure from their inefficiency to move across the static
analysis of current interest rate risk exposures. In short, the simulation models use
computer power to support “what if” scenarios. For example,
What if

 the total level of interest rates switches


 marketing plans are under-achieved or over-achieved
 balance sheets shrink or expand
This develops the information available for management in terms of precise
assessment of current exposures of asset and liability, portfolios to interest rate
risk, variations in distributive target variables like the total interest income capital
adequacy, and liquidity as well as the future gaps.
There are possibilities that this simulation model prevents the use to see all the
complex paper work because of the nature of massive paper results. In this type of
condition, it is very important to merge the technical expertise with proper
awareness of issues in the enterprise. These refer to accuracy of data and reliability
of the assumptions or hypothesis made.

Scenario Analysis : Under the scenario analysis of ALM several interest rate
scenarios are created during  next 5 to 10 years . Such scenarios  might specify
declining interest rates , rising interests rates,  a gradual decrease in rates followed
by sudden rise etc.   Different scenarios may specify the behavior of the entire
yield curve, so there could be scenarios with flattening yield curve, inverted yield
curves etc. Ten to twenty scenarios might be specified to have a view of the
scenario analysis. Next assumptions would be made about the performances of
assets and liabilities under each scenario. Assumptions might include prepayment
rates on mortgages and surrender rates on insurance products. Assumptions may
also be made about the firms performance. Based upon these assumptions the
performance of the firm’s balance sheet could be projected under each scenario. If
projected performance was poor under specific scenario the ALCO might adjust
assets or liabilities to address the indicated exposure . A short coming of scenario
analysis is the fact that it is highly dependent on the choice of scenario. It also
requires that many assumptions be made about how specific assets or liabilities
will perform under specific scenario.

Value at Risk

VaR or Value ar Risk refers to the maximum expected loss that a bank can suffer
over a target horizon, or interval. It enables one to calculate the net worth of the
organization at any particular point of time so that it is possible to focus on long
term risk implications of decisions that have already been taken or that are going to
be taken. It is used extensively for measuring the market risk of a portfolio of
assets and/or liabilities.

Conclusion:

We can conclude to say that ALM is an important tool for monitoring, measuring
and  managing the interest rate risk, liquidity risk and foreign currency risk of a
bank. With the deregulation of interest regime in India , the banking industry has
been exposed to interest rate risk / market risk . Hence to manage such risk, ALM
needs to be used so that the management is able to assess the risks and cover some
of these by taking appropriate decisions.