INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

CAPITAL ADEQUACY
(LEVERAGE)
IN BANKS

Typical Balance Sheet of a Bank

Assets

Liabilities& Equity

Loans and advances 200

Lease Financing

Deposits-Current,

Saving, Term etc 360

50

Share Capital

30

Investments in Shares 50

Bonds, etc.

Reserves

06

R/E

04

FAs.

100

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

WHAT IS RISK OF FAILURE

Probability that the Bank will fail.
Will not honour commitments
Commitments to whom
-

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

KEY FINANCIAL RISKS

Credit risk and counterparty risk

Liquidity or funding risk
Settlement/payments risk
Market or price risk
Interest rate risk
Capital or gearing risk
Operational risk
Sovereign and political risks.

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Liquidity or funding risk

liquidity for normal operating

to fund its day-to-day operations
Deposit with drawls
Loans disbursements
Investing opportunities
Liquid vs illiquid assets- effect on profitability
Maturity gaps vs Maturity matching
Maturity profile of a banks liabilities understates actual liquidity

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Capital or gearing risk

Principal function of capital is to act as a buffer to support /
absorb losses
Highly geared Banks must have reputation for sound RM
Thresh hold for tolerance is low
More risk more capital as warranted by Basel risk assets ratio
ROE = ROA*(gearing multiplier)
Minimum ratio prescribed to constrain the gearing of leverage to
manageable levels ---10% in Pakistan
Prompt corrective actions are taken by the regulator for violation

Typical Balance Sheet of a Bank

Assets

Liabilities& Equity

Loans and advances 180

Lease Financing

Deposits-Current,

Saving, Term etc 360

50

Share Capital

Investments in Shares 50

Bonds, etc.

Reserves

FAs.

100

R/E

30
06
(16)

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Capital /assets ratio

C =Core Capital / Assets

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Capital to assets ratio

or gearing
Core capital
Assets
C/As

40
400
10%

20
380
5.26%

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Need for redefining

Core capital- what is actually available to act as buffer for
meeting emergency or loss situation
real source is the risk associated with assets whose value may
depreciate due to a multitude of reasons
Therefore we must define risk adjusted assets

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Capital
Tier 1 capital PUC, share premium, reserve for bonus shares,
general reserves, R/E net of losses minus good will, shortfall in
provisions, remaining deficit on account of revaluation of AFS
securities. (details in SBP guidelines)
Tier 2 capitalProvisions for loan and lease losses, revaluation
reserves, exchange translation reserves, undisclosed reserves and
subordinated debt.
Tier 3 capital--- short-term subordinated debt solely for the
purpose of meeting a proportion of the capital requirements for
market risk.
Total capital is sum total of the 3 minus prescribed deductions

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Qualifying Conditions
Total of Tier 2 and Tier 3 capital should be less that or equal to
Tier 1 capital PUC, share premium, reserve for bonus shares,
general reserves, R/E net of losses. (details in SBP guidelines)
Provisions for loan and lease losses will not include specific
provisions against identified loans losses, and are freely available
to meet any loss
Revaluation Reserves created by revaluation of fixed assets and
equity instruments only and up to 45% of value.
Undisclosed Reserves should be unencumbered and certified by
auditors and accepted by SBP

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Qualifying Conditions
Subordinated debt will be limited to a maximum of 50% of the
amount of Tier 1 capital and will also include rated and listed
subordinated debt instruments4 (like TFCs/Bonds) raised in the
capital market. It should be fully paid up, unsecured, subordinated
as to payment of principal and profit, to all other indebtedness of
the bank including deposits, and should not be redeemable before
maturity without prior approval of SBP
The Tier 3 capital shall be solely for the purpose of meeting
capital requirement for market risk.

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Risk Adjusted Assets

On balance sheet
Off balance sheet

INSTITUTE OF BUSINESS FINANCE

AND INDUSTRY

Risk based Capital /assets ratio

Total risk based Capital ratio = Total capital (tier 1+tier 2)
Risk adjusted assets
Tier 1 (core ) ratio
=Core capital (tier 1)
Risk adjusted assets