Abstract
“How much capital should shareholders be required to invest 11 in their bank?” is a question that has been asked for a half century or more. This concern for the adequacy of bank capital is part of the broader regulation of banks to assure their solvency. The length of time that capital adequacy has been debated suggests the extreme difficulty, really the impossibility, of objectively deciding what is an adequate amount of capital, or what is the appropriate ratio of capital to assets, liabilities, deposits, or risk assets—whichever denominator is eventually chosen. Nevertheless, this does not diminish the importance of capital adequacy as an operational norm for assuring bank solvency.
“How much capital should shareholders be required to invest 11 in their bank?” is a question that has been asked for a half century or more. This concern for the adequacy of bank capital is part of the broader regulation of banks to assure their solvency. The length of time that capital adequacy has been debated suggests the extreme difficulty, really the impossibility, of objectively deciding what is an adequate amount of capital, or what is the appropriate ratio of capital to assets, liabilities, deposits, or risk assets—whichever denominator is eventually chosen. Nevertheless, this does not diminish the importance of capital adequacy as an operational norm for assuring bank solvency.
In highly industrialized countries, bank managers, regulators, financial reporters, and even political figures have for some years been expressing their concern over the decline in banks’ capital ratios, measured in one way or another. Usually these commentators have been able to reconcile the prevailing capital ratios with their personal standards of capital adequacy but have concluded that lower ones would be imprudent. If the capital ratios of the past were the minimum considered acceptable at the time, then—from the present perspective—banking is currently less risky; the former standards were too stringent; or the lower ratios of modern banks are unsafe.
Many commentators have suggested that banks are now better managed and therefore less risky. Moreover, since modern governments are committed to smoothing out business cycle fluctuations and preventing financial crises, banking is inherently less risky. On the other hand, banks have tended to get more involved in international dealings, quasi-banking activities (such as real estate ventures, computer services, factoring, and the leasing of fixed assets—such as ships and aircraft—to industrial companies), and complicated corporate structures (particularly variations of the bank holding company as a method of increasing leverage). In addition, the evolution of multinational banking—banks incorporated in one nation operating branches or subsidiary banks “offshore” and in many other countries—has blurred responsibility for their supervision and may have enabled them to slip free of normal restraints in order to engage in more profitable but riskier activities. Moreover, these banks’ deposits from oil producers and loans to finance less developed countries’ (LDCs) balance of payments deficits may have accentuated the risks of operating in international markets, of quasi-banking activities, and of complicated corporate structures. This concern that banking is no less risky and the secular decline in bank capital ratios have once again brought to the fore discussion of bank capital adequacy in developed countries.
The same problem of capital adequacy emerges in LDCs, even if banks there do not engage in all the high-risk activities of banks in developed countries. In LDCs, at the government’s behest, banks often take on business of high social priority that exposes them to high risks. Moreover, in LDCs that are starting to create a credit structure, it is important that they start from a strong base. Finally, in many LDCs and some developed countries as well, the central bank is unable, even if it is willing, to make good the foreign exchange losses incurred by banks over which it has jurisdiction. For these reasons, bank capital adequacy is just as important an issue in LDCs as in industrialized countries.
Although there is no agreement on what amount constitutes adequate capital or on what capital ratio is satisfactory, the issues in the discussions of capital adequacy are well recognized and can be assessed. This paper considers these issues—the definition of capital (Section I), the relation between liquidity and capital (Section II), the functions that bank capital performs (Section III), and the sources of risk to which a bank is exposed (Section IV). Section V develops a framework for putting in context the competing claims of bankers, regulators, and the whole economic society about capital adequacy, as well as for recognizing the potential conflicts between capital adequacy regulations and other policy objectives. The many criteria that have been suggested for assessing capital adequacy are considered in Section VI, and the criteria actually applied in a sample of countries are looked at in the next section. The last section is a brief conclusion.
I. Definition of Capital
The first consideration is what capital should encompass. Naturally, it includes paid-up capital (both in the form of common stock and preferred shares); any undivided profits, retained earnings, or surplus; and general reserves. The question is whether the definition of capital should be extended to include subordinated, long-term debt and reserves for loan losses and other specific contingencies. Another consideration is how assets and liabilities should be valued, because the manner in which they are valued can also influence the amount of capital.
The inclusion in capital of debt subordinated to deposits is found in several countries. During the 1930s, the authorities in the United States permitted capital notes and debentures, most of which had been sold to a government agency created specifically to hold such debt, to be considered as capital to maintain the solvency of many small banks. Thereafter, “debt capital” fell into disuse by banks until 1962, when federal regulators announced that some subordinated debt could again be counted as capital for regulatory purposes.2 The argument in favor of including subordinated debt in capital is that, if the bank fails, depositors will be paid before holders of subordinated debt, so that the latter affords depositors protection in the same way that paid-up capital, undivided profits, retained earnings, and general reserves do. However, unlike these four other forms of capital, subordinated debt cannot absorb losses and allow a bank to continue as a going concern. Rather, once losses have to be written off against subordinated debt, a bank is insolvent, since its assets no longer exceed its liabilities, and thus it must cease business. This is the most important difference between subordinated debt and paid-up capital, etc.—“debt capital” is only protection for depositors once the bank closes.
The advantage of subordinated debt from the bank shareholders’ perspective is that it does not dilute their own share of their bank’s earnings as would new issues of common stock. Instead of reducing the shareholders’ leverage,3 the subordinated debt increases it in the same way that an increase in any other bank liability does. Thus, another advantage of “debt capital” is that shareholders are not averse to issuing it because of the impact that it would have on their earnings. However, in addition to its inability to absorb losses for a going concern, subordinated debt has other disadvantages in serving as capital. First, subordinated debt’s interest charges impose a fixed charge on future income that reduces the capacity of the bank’s earnings to absorb losses. Second, subordinated debt, unlike paid-up capital, must ultimately be retired, although there is always the possibility of issuing new subordinated debt to refund the old.
The second consideration is how to treat reserves for loan losses and other specific contingencies. In many banks, determination of the amount to set aside annually for these reserves is made on the basis of provisions for reserves in the income tax code rather than the inherent risks that they are intended to protect against. Because such reserves are larger than necessary for absorbing the loan losses and other categories of losses indicated by their corresponding risks, the argument runs that these reserves should be treated as part of capital rather than as contra accounts to the corresponding assets. Moreover, when these reserves are considered to be capital rather than contra accounts, the resulting ratio of capital to total assets is considerably higher.4 So, there are two justifications for treating reserves for specific contingencies as capital. First, in many banks, because of the manner in which they are determined, reserves for specific contingencies exceed the amount that would be set aside just to cover losses. Second, for banks that are required to satisfy a ratio of capital to some other balance sheet magnitude (total assets, total liabilities, total deposits, or risk assets), the inclusion of reserves for specific contingencies in capital can substantially improve the ratio.
No matter what specific items are counted as capital, the way in which assets and liabilities are valued also has a bearing on the amount of capital. Any method of valuation that tends to lower asset values or raise the amount of liabilities thereby tends to reduce capital (as the difference between assets and liabilities). For instance, banks are well known for depreciating their premises to zero, for tax and other reasons, long before the structures need to be replaced and when their premises’ real estate value may be substantial. Even acknowledging the undesirability of using market value to appraise real property, the value in a liquidation sale would well exceed zero. Another way in which assets are often undervalued is by using “the lower of market value or acquisition cost” method when market values have long surpassed acquisition cost. In addition, many assets are valued at what it is estimated that they would sell for in a forced sale. Here, the question is what sort of forced liquidation is realistic.
A depression (such as the one in the United States during the early 1930s) in which every institution and person is selling financial assets for cash is no longer a justifiable scenario for valuing assets because the fiscal and monetary authorities in most countries would no longer accept such a catastrophe, not simply because of its repercussions on banks but also because of its impact on the whole economy. If bank assets do not have to be sold in a financial panic but instead in relatively normal conditions, then a bank has some choice not only of what assets to sell but also of when to sell them, even if the bank is under some pressure. So, the price that will be realized in a forced sale could approximate the prevailing market price of the asset. The question of asset and liability valuation cannot be solved definitively, but the fact that the valuation of bank assets and liabilities usually understates the amount of capital available in a liquidation can be accepted. In addition, it should be recognized that understating the amount of capital also reduces the amount of losses that capital is able to absorb before the bank becomes insolvent. In regulating bank capital, account must be taken of conservative accounting practices that undervalue assets and overvalue liabilities. While such practices do not necessarily maintain a bank’s solvency, they do increase the protection for depositors in case of bankruptcy.
II. The Relation Between Liquidity and Capital Adequacy
Liquidity and capital adequacy are often stated to be separate and distinct. What is usually meant is that high liquidity does not assure a bank’s solvency (i.e., a positive difference between assets and liabilities) and that liquidity is irrelevant once a bank is insolvent.5 This is a rather superficial view of the relation between liquidity and capital.
Revell has very carefully presented the ways in which liquidity and capital are related in modern banking.6 There are four forms of liquidity for a bank: (1) the currency, demand deposits, and other perfectly liquid assets held by it; (2) its assets that can be readily sold with little risk of loss; (3) its projected net cash inflow from ongoing business; and (4) its ability to acquire additional cash by borrowing.7 Items (1) and (2) are both connected to capital in the same two ways. On the one hand, a bank reduces its revenues and its net income by remaining highly liquid, ceteris paribus. By increasing its liquidity, a bank reduces the capacity of its current earnings to absorb losses without diminishing its previously accumulated capital and also decreases the amount of net earnings from which it can increase its capital through retained earnings. On the other hand, by decreasing its liquidity held in forms (1) and (2), a bank is increasing the chance that deposit withdrawals or the maturing of long-term liabilities will wipe out its liquidity and so force it to sell less liquid assets at a considerable loss. This loss will decrease its net income, from which new capital can be accumulated through retained earnings, and could even cause a net operating loss that would reduce the bank’s capital. Thus, there is an optimum liquidity position for the bank that balances lower expected revenue against lower risk of running out of liquid assets to meet withdrawals. Underlying this trade-off is the impact on the bank’s capital position. Too much or too little liquidity held in forms (1) and (2) can adversely affect the bank’s capital.
There is a limited similarity between net cash inflow (item (3) of bank liquidity) and liquid assets (items (1) and (2)). First, net cash inflows are able to cover unexpected deposit withdrawals without any reduction in liquid assets or any additional borrowing. Thus, high cash inflows, like high amounts of liquid assets, are a protective cushion. However, high net cash inflows, unlike high amounts of liquid assets, do not necessarily require a sacrifice in earnings. On the contrary, high net cash inflows suggest that a bank has high earnings. Although current net cash inflows might be sacrificed for higher future net cash inflows, this should not be a major consideration for a long-established bank whose ongoing business should provide a steady net cash inflow. A dramatic shift by an established bank from current income-producing assets to higher-yielding but postponed income-earning assets would be symptomatic of some fundamental problem in the bank. Thus, the similarity here between cash flow and liquid assets is not perfect. Both high cash flow and high amounts of liquid assets give a bank protection against deposit withdrawals, but high cash inflows do not require a compensating reduction in earning assets, as high amounts of liquid assets do.
A high rate of cash inflow suggests a high rate of net earnings and thus implies that a bank can absorb unexpected losses and will be able to augment its capital through retained earnings. There is certainly the likelihood that a bank with a net cash outflow will have to compensate by drawing down its liquid assets or by borrowing more. The negative cash flow itself suggests a very poor earnings position, and actions taken to compensate for reduced liquidity by running down liquid assets and resorting to liability management may lead to additional losses. Thus, low cash inflow may be a symptom of poor net earnings and may aggravate this situation.
The fourth form of bank liquidity is a bank’s ability to borrow additional funds to meet unexpected cash needs owing either to withdrawals of deposits and other short-term liabilities or to the identification of profitable new lending opportunities. Although the practice of borrowing to obtain additional funds is very old, the treatment of and reliance on the potential to borrow as a source of liquidity, which is referred to as “liability management,” is relatively new to banking. Liability management is generally thought of as a bank’s ability to borrow in a very short-term interbank market (such as the U. S. federal funds market) or a slightly longer-term market for notes (such as certificates of deposit), but it also encompasses deposits as a source of additional borrowing. The relevant markets need not be confined to domestic ones for large banks with international standing. The essence of liability management is that, when it is in a bank’s interest to do so, it can borrow additional funds instead of running down its liquid assets or reallocating its cash flow.
Liability management and capital adequacy are also related. First, a bank’s capacity to borrow partly depends on lenders’ assessments of its solvency. Of course, a bank that is believed to be virtually insolvent will be unable to borrow at all. The closer that a bank is believed to be to this state, the higher the risk premium it will have to pay in order to borrow. Thus, the availability of funds and the interest rate that will have to be paid for them will be a function of lenders’ evaluations of the adequacy of the bank’s capital as well as other determinants. In other words, a bank’s ability to practice liability management will partly depend on its capital position. Second, illiquidity that obliges a bank to borrow to satisfy its cash requirements, instead of choosing to do so as the profit-maximizing alternative, will reduce the bank’s net earnings and may even cause it to suffer a loss that will have to be charged to its capital. Moreover, if lenders know about the bank’s predicament, they may require the bank to bear an onerous interest rate. Rather than being an accommodating alternative, borrowing that is forced upon a bank can be destructive, by eroding its net earnings and capital.
The foregoing is intended to show the detailed, direct links between liquidity and capital. Although the liquidity requirements that are imposed on banks are now maintained for monetary policy purposes and to assist governments to finance their deficits, it should be remembered that cash reserve requirements were first designed to protect depositors, which (as we shall see in the next section) is one of the functions of bank capital. Not only are liquidity and capital connected through the losses that a bank may incur from having too little or too much liquidity; they are also conceptually related. Liquidity can be viewed as the availability of funds that ensure that a bank can pay its current obligations (including deposit withdrawals and maturing long-term liabilities), while capital can be regarded as funds that ensure that all liabilities could be repaid if the bank were to be liquidated. Considered in this manner, the only difference between liquidity and capital is the time perspective—liquidity referring to the present and capital to some indefinite period in the future.
III. Functions of Bank Capital
There are three functions that a bank’s capital does or should fulfill and an additional two functions that capital requirements imposed on banks by the regulatory authorities may perform. In addition, from individual banks’ point of view, capital has another function, as a source of funds. The first function of a bank’s capital, like that of any business, is to cover all the expenses incurred in setting it up and getting it into operation, and thereafter to finance additions to its fixed assets. The argument runs that no firm, especially a bank, should use borrowed funds to get established or to acquire fixed assets; rather, these should be financed directly by the shareholders or from funds accumulated within the business. However, a bank or, for that matter, any financial intermediary, is fundamentally different from a nonfinancial enterprise because fixed assets are a small proportion of its total assets. Accordingly, capital would only need to be a small fraction of a bank’s total assets or total liabilities if this were its only function.
In addition to financing its creation and the subsequent acquisition of any more fixed assets, a bank should also have capital to justify the trust placed in it by depositors and to protect the economy’s payments mechanism, of which its deposits are a part. Two more functions of bank capital arise from these considerations. The second role for a bank’s capital is to absorb unexpected losses, so that the bank can avoid bankruptcy and continue to operate as a bank. Where losses can be anticipated or predicted, the bank should insure against them, avoid that activity, or create a reserve from earnings to cover the losses. Although defining unexpected losses is important (and this will be considered presently in Section IV), the essential idea is that a bank’s capital should be a buffer to absorb these losses, so that it does not have to be liquidated. The third role for a bank’s capital is to minimize the losses that depositors and other creditors will have to bear if it does fail.
The second and third functions of bank capital are very similar, and the distinction between them is one of degree. In the second function, capital is designed to absorb losses, so that the bank can continue in business without impairing the payments mechanism or jeopardizing depositors’ funds. In the third function, once the bank has become insolvent (i.e., once its liabilities exceed its assets) and its deposits have thereby been frozen, at least temporarily, by the bankruptcy proceedings, capital is intended to reduce the losses that will necessarily fall upon depositors and any other creditors.
The fourth function of capital is controversial and is often passed over because whether it is an actual function or not depends on the attitude of the authorities who oversee bank regulation. If bank managers believe that their capital should be proportional to their deposits or if the regulatory authorities enforce a capital-to-deposits ratio to ensure that capital will adequately fulfill the first three functions, then capital may be used to restrain the growth of bank deposits. Of course, this is not a classical instrument of monetary policy and may even seem implausible. Nevertheless, there is some indication that capital requirements may have been employed in the United States to help slow the growth of the money supply.8 It appears that capital adequacy requirements, like cash reserve requirements that also were initially imposed to protect depositors, may be evolving into a monetary policy implement. Whether or not capital adequacy has actually been used yet for monetary policy purposes, the potential exists for it to be so employed. Consequently, the fourth function of bank capital is to restrain the growth of bank deposits, if the authorities choose to use a capital ratio as an instrument of monetary policy.
Finally, where some or all of the commercial banks in a country are branches or subsidiaries of foreign banks, capital requirements may be imposed on all banks to increase the foreign banks’ own funds in the host country, either because this is considered desirable per se or because it puts foreign banks on a more equal footing with domestically incorporated banks. Economies of scale in the provision of capital to the foreign banks’ branches or subsidiaries and other barriers to entry based on the foreign banks’ sizes and reputations may prevent a local bank from being organized or, once it is organized, from competing effectively with the foreign banks. In countries where the banking system is dominated by foreign banks, small, local banks often complain that they (the local banks) must operate with lower leverage (i.e., a lower multiple of deposits to capital) than the foreign banks in order to obtain the confidence of depositors and the necessary prestige in general to engage in banking. This, in turn, reduces local banks’ profitability because the foreign banks can earn the same rate of return on their equity as the domestic banks with a narrower spread between their lending and borrowing rates.
Where foreign banks tend to dominate the banking system, the host country may require that foreign banks allocate a specified amount of capital to be invested in local assets to ensure that the foreign banks do invest some of their own funds in their branches or subsidiaries. However, simply requiring that foreign banks invest some of their funds in their local operations may not always be effective, because individual assets cannot be identified as corresponding to specific items of liabilities or capital. For instance, a foreign bank faced with such a requirement could transfer some of its own funds into the country, then assign some of its existing local assets (which had previously been acquired from funds raised through local liabilities) to these funds, and finally lend or invest its own funds back outside the host country. This could only be prevented if the host country also imposed a ratio of local assets to the sum of capital and local liabilities or if it had foreign exchange controls. A uniform capital requirement (with a minimum ratio of local assets to total assets) for all banks can eliminate this element of inequality, but it may not equalize the cost of capital for local and foreign banks. Foreign banks may be able to raise capital—within their own organizations, in their own countries, or in international markets—at lower cost than the local banks can obtain capital in the host country, because the rate of return on capital is lower where the former get their capital.
So far in this discussion of bank capital’s functions, the vantage point of particular groups in the economy has not been considered explicitly. First, bank capital is a concern to depositors, since it serves not just to protect their deposits against loss but also to assure that their deposits will remain liquid and usable as money. Borrowers from banks have an interest in bank capital as protection against bank insolvency, because disruption of intermediation by the banking system would curtail the flow of credit to them.9 Moreover, there are externalities involved in the dislocation of the payments system and of financial intermediation by the banking system that would have repercussions on the whole economy. These externalities are what justify the imposition of bank capital requirements by the regulatory authorities. However, once the decision to foster bank solvency through capital requirements has been made, the regulatory authorities have placed their reputations on the line so that they, themselves, have a personal interest in assuring that bank capital is adequate to eliminate the possibility of bankruptcy.
From bank shareholders’ and managers’ points of view, the functions of capital are slightly different than the five set out previously. The first function discussed above is not particularly relevant to bank share-holders and managers. They see no reason why borrowed funds should not be used to acquire fixed assets if lenders are willing to let them do so. However, from a practical point of view, a bank’s capital must be sufficient to get it started, or otherwise it can never become a going concern. The second function of capital—to absorb losses so that the bank can continue in operation—is obviously extremely important to bank shareholders and management. Both the second and third functions are relevant to bank shareholders and management insofar as a bank’s capital position is considered by depositors and other bank customers before giving their business to a bank. In other words, depositor protection per se is not important to bank shareholders and managers, but they do view it as a means of increasing their bank’s business and earnings. Consequently, capital as protection against insolvency is only relevant to bank shareholders and management insofar as it can keep the bank operating by absorbing any unexpected losses and insofar as it is necessary to attract depositors and other lenders.
The discussion of the preceding paragraph leads into consideration of bank capital as a source of funds for the bank, a sixth function that has not been considered yet. A highly leveraged bank that fears that, if credit conditions tighten, it would have to borrow at unreasonably high interest rates, may hold back on loans and illiquid investments. By remaining more liquid than it would have had to if its leverage were lower, the bank reduces it earnings. This reduction is an incentive for the bank to increase the amount of its capital. Thus, another function of bank capital is as a source of funds. Another way of putting this is to consider capital as a bridge that finances the difference between the amount of funds demanded from a bank and the amount supplied to it.10 During periods of tight money, if the bank is “undercapitalized,” it will be locked into some loans at low interest rates when the rates that it has to pay for funds are rising. At these times, its profits will be squeezed. If the bank were not undercapitalized, it would not have to finance so much of its low-interest rate loans from short-term borrowings with relatively high interest rates. Conversely, in periods of easy money, an “overcapitalized” bank suffers losses, because it is unable to employ more low-interest rate, short-term borrowings because its capital funds are so large. Thus, there is an optimum amount of bank capital to bridge the difference between the bank’s uses and its other sources of funds.
The fourth function of capital—to act as an instrument of monetary policy—is of no concern to bank shareholders and managers. If anything, they will oppose the use of capital requirements to restrain the growth of bank deposits on the grounds that it will reduce the banks’ profitability. The fifth function of capital—to equalize competitive conditions among banks in a banking system dominated by large foreign banks—will only interest small local banks trying to expand in such a banking system and large foreign banks trying to suppress small local banks. Nevertheless, from the point of view of bank shareholders and management, there are essentially only three functions of bank capital: to absorb unexpected losses so that the bank is not forced into bankruptcy, to attract depositors and other lenders to the bank, and to bridge the difference between the demand for funds from the bank and the supply of funds by lenders to the bank.
IV. Sources of Risk that Give Rise to Unexpected Losses
1. sources of risk
The preceding section considered the functions of bank capital in terms of the interests of depositors, borrowers from banks, bank shareholders and managers, and the economic society as a whole. It showed that one important function—if not the most important—is for capital to absorb unexpected losses, so that the bank can continue as a going concern, or, if the bank becomes insolvent, so that minimal losses are forced upon depositors and other creditors. However, where losses are anticipated or predictable, the bank should insure against the risk (if possible), avoid the risky activity, make provision to cover the losses from corresponding revenue (by charging a risk premium), or set aside specific reserves for these losses. For unexpected losses, the traditional position has been that the bank’s capital should be relied on to absorb them.11 Given the importance of the distinction between unexpected and expected losses, as well as the premise that capital should be adequate to absorb unexpected losses, consideration of the sources and rough magnitudes of the risks that can cause unexpected losses is appropriate.
First, let us enumerate the different sources of unexpected bank losses and then explain precisely the nature of each risk. The following eight categories of risk are based on the classifications of Butler, Revell, and Vojta:12
(1) credit risks
(2) investment risks
(3) earnings risks
(4) liquidity risks
(5) operating risks
(6) fraud risks
(7) fiduciary risks
(8) spillover risks
Some of the risks from which unexpected losses result are also sources of losses that can be anticipated by statistical techniques. Credit risk, which is the risk of default or delay in payments owing to insolvency, is a good example. Every bank will naturally suffer losses on some proportion of its loan portfolio. Of course, the more receptive that a bank is to high-risk loans, the higher this proportion will be. Nevertheless, even though this proportion will vary from bank to bank, these normal losses can be predicted and provided for from current gross earnings. However, beyond normal losses there is the risk of unexpected loan losses, in the sense that losses could be greater than predicted. Where to draw the line between normal and unexpected losses a priori is difficult; once losses have occurred and have exceeded the provisions made for losses, they can be termed unexpected, but distinguishing more precisely between normal and unexpected losses cannot be done in advance. This point is raised to acknowledge the difficulty of separating normal from unexpected losses in many of the risk categories that will be discussed.
Although credit risk has already been defined as the risk that payment will not be received owing to the temporary or permanant insolvency of the payer, this definition should be expanded slightly. In the Anglo-American banking tradition, one usually thinks of these defaults or delays as arising from borrowers becoming insolvent. However, these defaults or delays could come from other sources besides loans. For instance, in banking systems where banks participate in the equity of nonbank companies, these equity positions are an obvious source of credit risk, although it may stretch the meaning of credit to include bank purchases of shares. Moreover, the purchase and lease arrangements13 in “modern” banking between banks (or their subsidiaries) and customers are another source of credit risk. Thus, credit risk is used here to include shares, other securities, leases, etc., as well as loans.
Investment risk is the risk of losses in the principal or the income stream of assets when these losses are not owing to default or delay by the payer but only to a drop in the value, or in the flow, of income from the bank’s assets. The most obvious example is a decrease in the market value of securities held by a bank owing to events in the securities market but not to a default by the company that issued them. Another is the risk of loss from an open foreign exchange position. In addition, there is the risk of losses on fixed assets, especially real estate. Moreover, investment risk can be extended to cover lower yields than were expected on securities and fixed assets—for example, shares that were purchased on the basis of an expected dividend rate that turns out to be higher than the actual rate or of fixed assets (like computers) that are expected to be leased at a higher price than the bank is actually able to lease them at. Unlike losses from credit risk, losses from investment risk usually allow the bank some discretion in choosing when to write down the value of the assets for its balance sheet.
Earnings risks arise from the possibility that changes in interest rates, asset prices, or operating expenses will narrow the margin between a bank’s lending and borrowing rates or otherwise eat into earnings. A long-term liability may be issued on the assumption that a higher interest rate than what is realized will be earned on shorter-term assets. Alternatively and perhaps more realistically for banks, a bank may lend long at a fixed interest rate in anticipation of being able to borrow through short-term liabilities at lower interest rates than the bank is actually able to negotiate. Both of these examples arise from the mismatching of the maturities of assets and liabilities. In addition, there is the possibility that inflation will push up a bank’s operating expenses for wages, salaries, materials, etc. without a proportional increase in earnings.
Liquidity risks have already been considered at some length—although not explicitly as risks—during the discussion of the relation between liquidity and capital adequacy in Section II. These are the risks that, in order to satisfy the demands on it for cash, a bank will be forced to borrow in short-term markets at such high interest rates that it will suffer a loss, or that a bank will be obliged to sell off some assets at a loss. Such risks arise not just from the mismatching of the maturities of a bank’s assets and liabilities but also from the lack of correspondence between all cash inflows and outflows.
The probability of unexpected losses from the preceding four categories of risk are likely to vary cyclically, increasing during recessions and decreasing during expansionary phases. If this is so, a bank’s capital, which is used for protection against unexpected losses, should not be required to vary contracyclically. In addition, this cyclical pattern of risk raises the question of how deep a recession should bank capital be able to withstand losses from. When the government of the country in which a bank operates is committed to eliminating major recessions and is able to do so, it is unreasonable to contemplate such conditions in appraising the adequacy of the bank’s capital in that country. Perhaps long before the government is compelled to act to save the banking system, the central bank, being aware of the wider ramifications of a financial crisis, will intervene, so that a bank will never have to face this situation.
Operating risks are those owing to errors and inefficiencies of bank management and staff, and owing to improper control over such errors and inefficiencies. One example is inadequate control over a bank’s currency traders to ensure that they adhere to the limits, which are set by senior management, on the amount of the open foreign exchange position that they may take at their own initiative.
Fraud risks are the well-known risks of dishonesty, fraud, forgery, misplacement, mysterious disappearance, etc. committed by bank staff or customers, and of burglary, larceny, and so on committed by third parties. In most countries, most forms of fraud risk can be insured. Thus, this risk only results in unexpected losses when the bank has failed to obtain insurance or to obtain sufficient insurance coverage.
Fiduciary risks encompass risks from a bank’s trustee business, letters of credit, underwriting, and other contingent liabilities that are often not found on the bank’s balance sheet. Revell claims that these risks are also insurable, but in most countries, banks probably find it more difficult to obtain insurance coverage for fiduciary risks than for fraud risks.
Spillover risks encompass many otherwise unrelated risks whose only common characteristic is that the bank bearing the risk has little or no control over the problem that forces losses upon the bank. The best-known sort of spillover risk is the chain risk from one bank to another through interbank deposits or foreign exchange contracts. For example, it is well known that one large New York bank, which was a correspondent of a foreign bank, incurred losses when the latter was closed without completing its half of current foreign exchange transactions. The New York bank suffered these losses not because it had an open foreign exchange position nor because it had imprudently dealt with a risky bank, but because an apparently viable foreign bank with a good reputation was suddenly found to be insolvent. Another type of spillover risk is the risk that a bank’s subsidiary will incur losses that fall back on the parent bank. Although there are legal limits to the liability of parent banks for their incorporated subsidiaries, most banks would not want their reputations to be impugned by the creditors of their insolvent subsidiary who would have to bear losses. Moreover, there has been some speculation that, in the case of a bank’s subsidiary, judges might rule that the bank’s liability was not limited to its investment in the subsidiary. Another spillover risk is the risk that a bank holding company’s difficulties will spill over to the subsidiary bank. As far-fetched as this may seem, a bank in California was forcibly merged by authorities with a larger bank when a run on it developed—although it was perfectly solvent until the run—because its parent holding company was dangerously close to being insolvent. Finally, there are the spillover risks from seizure of assets and nationalization of a bank’s foreign branches or subsidiaries and from repudiation of a bank’s international loans to the government of a country where the bank has no branches or subsidiaries.
2. economies of scale in risk taking
Whether a large bank needs proportionally less capital than a small bank depends on whether risks are proportionally lower for a large bank than a small one. There are economies of scale in risk bearing that are associated with several of the risk categories just considered in Section IV. 1 and the suggestion of diseconomies in one category.
It has long been argued that larger banks do experience economies of scale in credit risks, because their loans are spread over a wider geographic area, more industries, and more individual borrowers. Thus, if one loan goes bad, this will be a small proportion of its loan portfolio. Moreover, since its loans are spread so widely, there is less likelihood that a default on one loan will be accompanied by defaults on other loans in the portfolio. While this is analytically correct, there have been no tests of whether this or any other economies of scale in risk bearing exist in practice. If this contention is valid for credit risks, then there is a similar case for investment risks. Just as it spreads its loans more widely than a small bank, a large bank is able to spread its holdings of securities over more security issuers than a small bank.
In addition, it has long been a proposition of banking that large banks are relatively less exposed to liquidity risks than small ones. First, for a large bank, the probability is higher that any withdrawal will be a small proportion of its total deposits, because its deposits are spread over a wider area and are held by more depositors than a small bank’s deposits. While this is valid, ceteris paribus, a few large banks, which specialize in accepting deposits from large corporations, may not have as many depositors as many smaller banks. Second, simply because of their size, big banks usually have better access to interbank markets and at better interest rates and terms. Thus, big banks are more able than small ones to use liability management as a source of liquidity.
Several years ago, claims were made that big banks are able to attract better managers because they are able to pay higher salaries and to offer more prestige. It was argued that the better management of large banks reduces their exposure to operating risks relative to small banks. However, such claims have been heard less frequently in the United States since the recent failures of three large banks owing to allegedly poor management. Moreover, on a theoretical plane, if better managers in large banks do reduce their banks’ operating risks, they should be able to extract the pecuniary value of this for themselves through the competition among large banks for their presumably scarce talents.
Finally, there is the argument that large banks are proportionally more exposed to spillover risks because they are more engaged in nonbank activities through their subsidiaries or are more exposed to them through their parent holding companies, because they are more involved in interbank dealings and the chain risks associated with them, and because they are more deeply engaged in international business. Here the argument is not that spillover risks necessarily increase with size but that large banks choose to become involved in activities with high spillover risks that smaller banks shun.
Although it seems that, on balance, there are some economies of scale in risk bearing, regulatory authorities have resisted implementing capital requirements that favor large banks. There are two probable reasons for this. First, it is difficult to demonstrate that economies of scale exist in practice. Second, capital requirements that discriminate in favor of large banks decrease the opportunity for small banks to evolve sufficiently to bring about a more purely competitive banking system.
V. An Analytic Framework for Considering Capital Adequacy Requirements
Section III considered the functions of bank capital from the viewpoints of bank shareholders and managers, bank creditors, bank borrowers, regulatory authorities, and society more generally. With this previous discussion as background, this section presents an analytic framework for determining the optimum amount of capital from the differing perspectives of bank shareholders and managers, bank regulators, and the whole economic society (including depositors and borrowers).14
To bank shareholders and managers, capital is (i) a buffer for absorbing unexpected losses, so that a bank is not forced into liquidation; (ii) a means of attracting deposits through the safety offered by (i); and (iii) a source of funds. While these are the functions of capital itself, the returns to a bank from having more capital are not determined by the amount of capital alone but by the amount of capital in relation to the bank’s total assets, total liabilities, or even its total deposits. Having more capital will not afford a bank more protection against insolvency, etc., if the other balance sheet magnitudes have grown at a greater rate than capital has. Thus, this framework considers capital relative to one or all of the following: total assets, risk assets, total liabilities, and deposits. However, for expository simplicity, rather than choose among the ratios of capital to total assets, etc., hereafter we will use the phrase “capital ratio” to represent them, individually and collectively.
The higher a bank’s capital ratio, ceteris paribus, the greater is its protection against unexpected losses rendering it insolvent, the better able it is to attract deposits, and the better capital serves it as a source of funds. These benefits then generate the returns to banks from having a higher capital ratio. The higher the ratio, the greater will be the total return to banks, but each additional unit of capital adds successively less to the total return. Of course, this is simply a statement that the marginal returns to banks decrease as the capital ratio increases. This relation is depicted in Figure 1 by the line15 labeled “marginal private returns,” which slopes downward from left to right.
Private and Social costs of, and Returns from, Higher Bank Capital Ratios
Citation: IMF Staff Papers 1978, 003; 10.5089/9781451972559.024.A005
For the whole economy, the returns from a higher capital ratio are higher than the returns to banks alone. In addition to the returns to the banks, the returns to society are the various forms of protection: against losses for depositors and other creditors,16 against disruption of the economy’s payments system, against spillover of a banking crisis to other financial intermediaries and beyond, against loss of financial services, and against concentration of banking among the remaining banks. Once again, it is postulated that, as the capital ratio increases, the total returns to the economy through protection against these undesirable events increase and marginal returns decrease. To represent these facts, the marginal social returns line in Figure 1 lies above the marginal private returns line and slopes downward from left to right.
To bank shareholders and managers, there are costs as well as benefits from increasing the capital ratio. If the ratio is increased through retained earnings, the dividends foregone are a cost. Alternatively, if the ratio is increased by issuing new shares, the earnings per old share are reduced (unless the new shares are sold at a substantial premium over their par value),17 and this is the cost. The higher the capital ratio, the higher are both the total and marginal costs. Therefore, the additions to total costs of the banks, represented by the line labeled “marginal private costs,” are shown in Figure 1 as an increasing function of the capital ratio. To the whole economy, the costs of a higher capital ratio are the banks’ costs plus the costs external to the banks. The latter are the costs of capital diverted to banking from other uses. Alternatively, the costs of a higher capital ratio may be seen as the higher costs that are imposed on society by the banks’ efforts to earn a higher return on their assets (by charging more for loans or paying less for deposits) in order to try to prevent earnings per share from being diluted too much. In other words, by operating with a wider margin between their lending and borrowing rates, banks impose a higher cost on society to compensate for their higher capital ratio. Consequently, the marginal social costs line in Figure 1, which also slopes upward from left to right, lies above the marginal private costs line.
Having established these marginal costs and returns functions, the equilibria, from the banks’ and the economy’s points of view, are easily indicated. Of course, the banks’ equilibrium is at the intersection of marginal private costs and marginal private returns, and the economy’s equilibrium is where marginal social costs and marginal social returns cross. The next step is to postulate how bank regulators behave. Their view of the returns from a higher capital ratio is certainly that of the economic society whose interests they are intended to represent. Perhaps they even put a higher value on capital than society does, because they believe that even one bank failure would reflect adversely on themselves. Nevertheless, leaving aside this possibility, bank regulators’ view of the marginal returns on capital should coincide with society’s. On the other hand, regulators’ view of the marginal costs of capital may only take account of bank shareholders and managers’ costs, because these are more visible and measurable. If this is so, regulators look at the costs and returns of capital asymmetrically-viewing the returns from the whole economy’s perspective but the costs only from the bank shareholders and managers’ perspective. Thus, for regulators, the optimum capital ratio is determined by the intersection of marginal social returns and marginal private costs.
Figure 1 shows one set of optima in which bank shareholders and managers’ preference is for a lower ratio than the one that society wants, which, in turn, is lower than the ratio desired by regulators. However, this order of preferences is not unique. Society may prefer a lower ratio than bank shareholders and managers do.18 Nevertheless, using the previous paragraph’s assumptions about regulators’ views, bank regulators always desire the highest ratio.
The value of this analytic framework is as a means of putting into perspective the claims and counterclaims about capital adequacy made by various parties. Very clearly, capital regulations should be formulated and administered from the whole economy’s perspective. Equally clear is the probable divergence in opinion between society, on the one hand, and bank shareholders and investors, on the other. Moreover, if marginal social returns to capital external to the banks exceed the marginal social costs external to the banks, then banks will regard society’s optimum as too high. This divergence between private and social optima can explain the continuous disagreement between bank management and regulatory authorities over capital adequacy.
This framework can also explain why society’s capital requirements are unlikely to remain unchanged indefinitely. Society has other policy objectives besides assuring commercial banks’ solvency, some of which can conflict with capital requirements. When society places a higher value on any of these competing objectives, its marginal social cost function will shift upward and consequently its equilibrium capital ratio will decrease.
One potential conflict between capital adequacy and another social objective has already been alluded to. Section III mentioned the possibility of capital ratios being used as a monetary policy instrument to restrict the growth rate of deposits. In addition, if capital ratios are set immutably, they may also decrease deposits’ growth rates when the authorities do not want them restrained. Especially when bank deposits are counted on to mobilize savings, unchangeable capital ratios may have an adverse effect. In developed countries, they may only divert financial flows through other institutions at slightly higher costs of intermediation. However, in less developed countries, immutable capital ratios may depress the financialization of savings until alternative intermediaries emerge. This is one explanation of why society’s capital standards may shift downward over time.
This section has already discussed how bank earnings can be a direct source of capital and are necessary to attract new share subscriptions. Bank earnings are also important as a means of absorbing losses without having to resort to capital (See Section VI.3.) So, high bank earnings are desirable from the point of view of bank solvency. However, from the point of view of the microeconomic efficiency of the banking system, the goal is to have the banks behave as if they are pure competitors by narrowing the spread between their lending and borrowing rates. Consequently, if the authorities impose interest rate floors and ceilings, these controls and capital adequacy regulations—the objective of each of which is desirable by itself—can easily conflict, and this conflict may partly be resolved by revising the latter downward.
Capital requirements may also interfere with the microeconomic objective of reducing the concentration of the banking system. Regulations that are only intended to assure that new banks have sufficient capital may turn out to be obstacles that prevent new banks from being formed.
Programs to promote bank lending to priority borrowers also can decrease bank earnings and thereby interfere with efforts to increase bank capital. Portfolio requirements are often placed on banks so that they will hold government securities. If these requirements are exploited to furnish a captive market for low-interest rate government securities, bank earnings will suffer. Alternatively, portfolio requirements may force banks to grant a certain proportion of their loans to priority sectors (such as agriculture, housing, and small businesses). Although the nominal interest rate on these loans may appear very high, loss experience may substantially diminish the interest rate realized by the banks. Unless the risks of loans to priority sectors are directly or indirectly subsidized by the authorities, banks earn less on these than on other loans, so that banks’ capacity to increase their capital will be impaired.
Finally, capital regulations may inhibit domestic banks from engaging in international business. Authorities may desire domestic banks to enter international banking in order to finance trade and to serve as a conduit for capital inflows. However, margins are low in international banking, so that banks need to be highly leveraged to earn a satisfactory return. Capital regulations may prohibit high enough leverage to make international business attractive. Moreover, since risks appear to be higher in international banking, high capital requirements to cover these risks are all the more justified.
From the foregoing, it is clear that society may often have to compromise its capital standards for commercial banks in order to achieve other policy objectives. In terms of Figure 1, when society attaches higher priority to these other competing objectives, the marginal social costs line will shift upward, with the result that society’s desired capital ratio will decrease.
VI. Criteria for Assessing Capital Adequacy
1. minimum amounts of capital
Proposals for promoting capital adequacy fall into four different categories—proposals that capital exceed only a certain minimum amount, that capital be a specified ratio of some other balance sheet item, that bank earnings be the focus of attention, and that capital adequacy be left to depositors and other creditors to assess for themselves.
The simplest proposal is to require that banks have a certain minimum amount of subscribed capital to begin business and that thereafter this be supplemented by a general reserve fund. Obligatory transfers from profits must be made to the general reserve fund until it is a certain proportion of the amount of share capital.19
Requiring that capital exceed a minimum amount recognizes that capital should cover the expenses of starting up a new bank. Re veil has proposed that before a bank gets into full swing, a minimum capital requirement is able to cover losses, if any, from inexperienced management and other risks, such as legal suits, which are more probable at the time of start-up and the amount of which bears no relation to balance sheet items.20
This approach to capital adequacy implies either that solvency can be assured by a constant amount of capital, which does not have to increase as a bank’s deposits, total liabilities, and total assets grow, or that a bank will voluntarily furnish whatever additional capital is necessary to assure its solvency owing to self-interest or the insistence of depositors who would otherwise not increase the amount of their deposits with the bank. However, the discussion in Section V indicates that bankers’ preferences are not likely to coincide with society’s. In addition, even when a bank intends to keep its capital proportional to its liabilities by means of transfers to retained profits or general reserves from annual net profits, circumstances may prevent it from doing so. Specifically, when deposits and profits are growing equally fast, such as in a period of inflation, the amount of additional capital required to keep capital proportional to deposits may exceed the net profits available.21
2. capital ratios
A popular proposal is to relate the required amount of capital to another balance sheet item. This item may be total liabilities, or some component of liabilities (normally deposits), or total assets, or specific assets. The justification for requiring that capital be some percentage of total liabilities is that liabilities must be protected against losses. Therefore, capital should be related to liabilities. Another reason for connecting bank capital to liabilities is that there is a relation between the amount of liabilities and the risk of losses resulting from premature liquidation of assets to meet deposit withdrawals. However, since losses also result from default of bank assets, it has alternatively been suggested that required capital be proportional to total assets. Whether required capital is made a ratio of total liabilities or of total assets is immaterial because both totals are related by the balance sheet identity. However, requiring that banks maintain their capital in proportion to their total liabilities, or to their deposits, or to their total assets does not make them able to do so. Once again, the required increments in capital may exceed net profits, so that the required ratio can only be sustained by subscribing additional capital or by reducing liabilities or deposits.
The recognition that large, unforeseen, and unusual losses generally result from default on bank assets has led to more detailed ratios being proposed. Unexpected losses do not just depend upon the total amount of a bank’s assets but also depend upon the distribution of assets and the nature of the debtors. For example, two banks with the same amount of total assets would need different amounts of capital to absorb potential losses if one were holding more risky assets than the other. This consideration has prompted recommendations that required capital be related to the amount of risky assets held and to their degree of risk. One advantage of this proposal is that it permits banks to allow their deposits or total liabilities to increase without having to increase their capital proportionally, as long as they place the increase in risk-free assets. For instance, if deposits or total liabilities increase so rapidly that transfers from net profits could not keep capital proportional, this form of requirement relieves the pressure on the banks to reduce deposits or to increase subscribed capital by letting them hold risk-free assets to which capital is not required to be proportional. On the other hand, this takes less consideration of losses that may result from liquidity risks. The practical problem with this approach is that, to determine the degree of risk, either risk must be arbitrarily defined or a very large amount of work must go into determining the risk of each type of asset. At the latter extreme is a proposal that first requires that the risk of each type of asset should be determined. Then, for every type of asset, the degree of risk should be multiplied by the amount held of that asset. Finally, the resulting products should be added, and the amount of capital should be required to be at least equal to their sum.
Less detailed proposals are for required capital to be a proportion of risky assets defined in some arbitrary way, such as the amount of loans to the private sector. Another proposed definition of risky assets is deposits or total liabilities less risk-free assets, such as cash and government-issued and guaranteed securities. Such a definition arbitrarily treats all government securities as riskless when, in fact, there may be some risk of loss if the securities have to be sold before maturity. Moreover, some other assets may be as riskless as long-term government securities, especially from the point of view of premature liquidation.
There are two more difficulties with capital ratios. First, they do not take account of whatever economies of scale that there may be in risk taking. To the extent that such economies of scale exist (See Section IV.), big banks need proportionally less capital than small banks.
The second difficulty, which is regarded as more serious, is whether the evidence demonstrates that banks that go bankrupt have the lowest capital ratios. Comparisons of banks that failed in the United States during the depression of the 1930s with those that survived concluded that the level of capital ratios was not an important indicator for distinguishing between banks that failed and those that continued in operation. Subsequently, the research techniques of these studies were questioned,22 and more careful studies were undertaken of recent experience in the United States.
The first of the newer studies23 found no significant relation between failure/survival and conventional capital ratios, but it did discover a significant relation between failure/survival and the ratio of capital less fixed assets to deposits or risk assets (the latter being defined as total assets less cash and U.S. government securities). This numerator was justified on the grounds that capital invested in fixed assets is not available to absorb losses until the bank is liquidated, because U.S. regulatory authorities will not allow capital to be reduced below the balance sheet value of fixed assets. A subsequent study had less favorable results for this ratio.24 In a third study, there was a statistically significant relation between the author’s soundness index and various capital ratios.25 In addition, many “early warning” studies of bank soundness have found capital ratios, when included with other independent variables, to be useful predictors of bank supervisors’ evaluation of banks’ condition.26 Finally, a study of recoveries by receivers appointed to liquidate 40 banks that had failed was unable to uncover a significant relation between the ratios of capital to several other balance sheet magnitudes and the ratio of net recoveries to liabilities.27 Taken as a whole, these studies indicate that there is some evidence that banks with high capital ratios are most likely to avoid insolvency, but the evidence is not too strong. This should not be alarming, because the magnitude of losses that banks incur is not determined by the amount of their capital.28 After all, Section III only claimed that capital absorbs losses after they have happened, not that it prevents losses from happening or even limits their size. Moreover, in terms of the framework presented in Section V, the marginal social costs may exceed the marginal returns to society of imposing a capital ratio that is so high that no bank ever fails.
3. earnings
During the last decade, bank earnings have been thrust into the debate over bank capital adequacy.29 It has long been realized that bank earnings are an important source of new capital through retained earnings and additions to general reserves (if the latter are included as capital). In addition, high earnings relative to the amount of share capital or total assets can enhance a bank’s prospects for successfully issuing new shares (and subordinated debt, if this is accepted as capital) because the high returns encourage investors, and vice versa. Therefore, earnings are crucial in determining the amount of capital that a bank can mobilize from within and are very important for deciding the amount that it can raise from without. However, what has interjected bank earnings into the discussion of capital adequacy is recognition that they form a bank’s first line of defense against unexpected losses (as well as predicted losses).
Unexpected losses that are absorbed by earnings do not have to be absorbed by capital. Moreover, for a “wholesale” bank,30 earnings are vital, since they enable it to retain deposits and to be assured of access to funds in the short-term market. Without a good earnings record, a bank will be unable to practice liability management (See Section II.). When earnings fall, uninsured creditors (including uninsured depositors) will immediately and en masse transfer funds away from the bank, and its earnings record will prevent it from borrowing funds to replace those that have been withdrawn. Although its capital may be able easily to absorb the initial loss, this large and rapid reduction of the bank’s liabilities will force it to cash in assets at such substantial losses (liquidity risk losses—See Section IV.) that capital will be wiped out. While this scenario may seem fanciful or exaggerated, experience subsequent to the formulation of this hypothesis has proven that this sequence of events is realistic.31
In his path-breaking pamphlet, Vojta proposes that net current earnings should be at least twice bank management’s expectations of the amount of losses for the year.32 Alternatively, Keefe has suggested simply that pre-tax earnings plus provisions for losses be at least three times the actual amount of loans written off in the corresponding year.33
Clearly, if earnings are officially accepted as an indication of bank solvency, the multiple used to compute minimum acceptable earnings from losses is a crucial number. For example, on the one hand, Keefe’s standard appears too lenient because, in the United States in 1971 (the worst year for bank losses from 1939 to 1973), after-tax earnings of all banks insured by the Federal Deposit Insurance Corporation (FDIC) were five times net loan losses.34 On the other hand, his standard looks too stringent because, in the same year, the earnings of the big banks most involved in the Penn Central Railroad’s troubles were only one and a half times their loan losses.35 Moreover, if the multiple is set too high, banks will have to widen the margin between their lending and borrowing rates in order to attain the required level of earnings. The widening of banks’ margins will increase the social cost of financial intermediation by banks (See Section V.). The other question is how well do experiences with writeoffs in the recent past predict the magnitude of future writeoffs. First, banks sometimes can choose when to write off investment risk losses (See Section IV.). Second, perhaps low current loss realizations will embolden management to accept much greater risks, which will cause very large losses in the future. Nevertheless, recognition of earnings’ relevance to bank solvency is an important practical step. Most of the “early warning” studies have successfully employed some measure of earnings to forecast bank supervisors’ ratings of individual banks.
4. market evaluation of capital adequacy: laissez-faire
The difficulty of determining the correct capital ratio and the controversy between bankers and regulators over the appropriate measure and level of capital has led to proposals that capital adequacy be left up to banks and their clients.36 Unfortunately, although a laissez-faire approach to capital adequacy would simplify—indeed eliminate—regulation of bank capital, there are two problems with the underlying hypothesis that banks’ creditors assess bank leverage (among many factors) before lending to a bank and that bank managers react to creditors’ preferences by maintaining the soundness of their banks’ capital.
The first objection is based upon the analysis of Section V. Although creditors and depositors may be capable of looking after their own interests, there is no reason why they should bring the wider social ramifications of capital adequacy into their decision making. More specifically, a depositor may indeed weigh the loss to himself personally if his bank fails, but it is doubtful whether he considers the disruption of the economy’s payments mechanism and intermediation process. A regulatory authority is more appropriate for this task.
The second objection, which has several aspects, is that creditors may not really be able to look after their own interests. One form of this objection is that even uninsured depositors and creditors are not interested in how highly leveraged a bank is because they believe that the authorities provide de facto insurance of their loans to banks. They believe that when a bank becomes insolvent, regulators will keep the bank afloat long enough for them to liquidate their loans.37 Moreover, at least in the United States, experience indicates that once a bank is finally closed, regulators usually arrange for all the insolvent bank’s liabilities to be taken on by a healthy bank.38 In one way or another, all bank creditors are “insured” against the risk of bank failure.
Another form of this objection is that large corporate depositors, which should be most aware of banks’ leverages, are indifferent to the risk that this poses to their deposits because they are net debtors to their bank. If their bank fails, their loans will more than offset their deposits. Not only does this remove corporations’ incentive for examining banks’ leverage but it also eliminates the threat of deposit withdrawals as a means of persuading banks to reduce their leverage, because the corporations’ deposits are compensating balances or are otherwise necessary to maintain access to loans. In a survey done some time ago, only one third of the treasurers of large industrial corporations who replied to the questionnaire stated that they paid much attention to bank capital as protection for their deposits.39 In the United States, only 0.6 per cent of all deposits in failing banks has been permanently lost to depositors.40
The third form of this objection is that, even if depositors wanted to base their depositing upon banks’ solvency, additional disclosures of banks’ conditions would be necessary and that, even with better disclosure, depositors’ appraisals would have recently been unable to keep up with the new complexities in banking, specifically the bank holding company structure and the spread of banks into new lines of endeavor (such as international banking, real estate investment, factoring, leasing, and liability management).
Three studies have looked at the relation between the stock market prices of bank shares and the leverage of the corresponding banks.41 While two of these studies found that as leverage increased, ceteris paribus, the share price decreased, the third did not locate any significant relation. Although the latter result was interpreted to mean that the market considers all banks to have sufficient capital, it may mean instead that investors in bank shares are just not sensitive to capital ratios. More to the point, one of these three studies, and another study as well,42 have considered whether the interest rate on subordinated bank debt is a function of the issuing bank’s capital ratio. Both obtained rather poor results. Thus, in addition to the objections raised previously, empirical results do not show unequivocally that uninsured bank debtholders are sensitive to leverage. In conclusion, the grounds for a laissez-faire approach to capital are weak.
VII. Capital Requirements in Selected Countries
This section gives examples of capital requirements in 42 countries to illustrate the different types of capital requirements discussed in the previous section and the various possible definitions of capital considered in Section I.43 For instance, a limited amount of subordinated debt is permitted by the banking law or regulatory authorities in seven countries: Belgium, Denmark, Ireland, Luxembourg, the Netherlands, the United Kingdom, and the United States (by the Comptroller of the Currency and the Federal Deposit Insurance Corporation). In all of these, there is some limitation on the amount of subordinated debt that can qualify as capital, and additional conditions usually have to be met, such as prior notification to the authorities that subordinated debt is going to be issued.
The capital requirements in 15 countries (Cameroon, Canada, Hong Kong, Iran, Jordan, Kuwait, Lebanon, Madagascar, Malawi, Malta, Mauritius, Nigeria, Panama, Sierra Leone, and Uganda) simply specify that a bank must have a minimum amount of paid-up capital, although in seven countries (Jordan, Lebanon, Malawi, Malta, Mauritius, Sierra Leone, and Uganda), banks must also have a capital reserve into which they are obliged to pay a certain per cent of their annual net profits until the capital reserve is a specified proportion of their paid-up capital. It seems that in most of the countries that follow this approach to capital adequacy, the banking systems’ institutions have been influenced by British banking traditions. There are a large number of countries (Belgium, Botswana, Cyprus, Denmark, France, The Gambia, the Federal Republic of Germany, Ireland, Italy, Jamaica, Lesotho, Luxembourg, Malaysia, the Netherlands, Panama, Singapore, South Africa, Swaziland, Switzerland, Trinidad and Tobago, the United Kingdom—by agreement between the Bank of England and the larger banks—and the United States) whose laws or banking customs also provide—either specifically in the law or at the discretion of the authorities—for capital ratios as well as minimum amounts. In addition, the banking laws of the Philippines and Thailand impose capital ratios but do not require minimum amounts. Of the 24 countries that have some sort of capital ratio, the following are the different denominators:
Total liabilities—nine countries,
Deposits—two,
All or any liabilities that the authorities specify—one,
Total assets—one,
Total assets less liquid assets—six,
All or any assets chosen by the authorities—one, and
Various categories of assets, each of which has its own ratio, the required minimum amount being the sum of the products—four.44
Belgium is the only country where the capital ratio is adjusted to require proportionally less capital of large banks than small ones. In roughly one third of the countries (Botswana, the Republic of China, France, the Federal Republic of Germany, Ireland, Italy, Luxembourg, Madagascar, Malaysia, the Netherlands, Singapore, Thailand, and the United States), the capital requirement, whether a ratio or minimum amount, is set by the central bank, the finance minister, a banking commission, or similar regulatory authorities, allowing them scope to adjust the requirement to what they feel to be the socially optimum capital standard.
Finally, there are two interesting requirements that are found in a few countries. In the Republic of China, Turkey, and the United States (for banks that are members of the Federal Reserve System), the required minimum amounts of capital depend upon the population of the city in which a bank’s head office is located. Turkey’s law is unique among the selected countries in requiring banks to have additional capital for each city in which they have an office; the amount of capital required also varies according to the size of the city. Second, the capital requirements of France and Cameroon (as well, no doubt, as other countries influenced by French banking practices) differ according to the bank’s form of incorporation.
The one form of solvency requirement that was discussed in Section VI, for which no example could be found, is an earnings criterion. This relatively new approach has not yet worked its way into legislation or been added to formal regulations, although it has been used informally by regulators in the United States and other countries.
In enforcing capital standards in the United States, one controversy has been over the effectiveness of regulators and supervisors in imposing their criteria on banks.45 No matter how successful regulators have actually been in the United States, the source of their real or imagined problem is easy to see. In punishing a bank that violates the standard, the regulators only have a choice between closing the offending bank down and applying moral suasion. Any time that the penalties are so extreme, there will be poor compliance if the offending banks know that the authorities will not react by putting them out of business. However, where the banking law offers a choice of penalties or calibrates the penalty specifically to the magnitude and duration of the violation of the capital standard, compliance should be better. Consequently, it is noteworthy that the laws of seven countries (Belgium, Denmark, the Federal Republic of Germany, Italy, the Netherlands, the Philippines, and Singapore) do have specific penalties for having insufficient capital, although in some cases these may not be too flexible.
For the 42 selected countries, it is impossible to generalize about capital requirements. Perhaps the most remarkable thing is the diversity of requirements, which must reflect the underlying diversity of banking systems and legal traditions.
VIII. Conclusion
This paper has covered the many issues that have arisen in the course of the debate over capital adequacy during the last half century. Instead of immediately trying to determine the merits of the four essential approaches to assuring bank solvency, consideration was first given to setting out the preliminary and peripheral issues and then to establishing a framework from which to judge them. One of the preliminary issues, as trivial as it may seem, is the definition of capital itself. The choices range from paid-up capital alone to the sum of it and other items such as retained earnings, undivided profits, general reserves, reserves for specific contingencies, and subordinated debt. Another issue is establishment of the relation between bank liquidity and bank solvency, so that arguments for the one are not confused with those for the other. Although illiquidity can cause losses, measures for guaranteeing liquidity are not sufficient for assuring solvency.
This leads into the subject of the functions of bank capital. To bank owners and managers, capital is a means of attracting depositors and a source of funds, as well as protection for themselves against their banks’ failure. However, besides bank owners and managers, capital is a concern to bank depositors and creditors since it protects their funds, to bank borrowers since it protects the banking system as a source of credit, and to the whole economy since it protects the payments mechanism and financial intermediary network. Given this emphasis on the protective purpose of bank capital, the risks to which banks are exposed were discussed. These range from the risk that deposit withdrawals will all come at once, through the risks of losses on loans and investments, to the risk of criminal acts.
With this background established, the divergent interests in, and perspectives on, capital adequacy of bank shareholders and managers, bank creditors, and the whole economy can be determined and presented in an analytic framework. This framework enables the irreconcilable and continual divergence of opinion between the bank shareholders and managers, on the one hand, and bank regulators, on the other, to be seen. Over the last half century, there has been debate concerning whether a minimum amount of capital, a capital ratio, or no capital requirement at all should be imposed and concerning what an appropriate level for the requirement should be. The capital requirements in the 42 countries surveyed were not presented as norms, but as illustrations of the different proposals for regulating capital that have been suggested.
Within the past decade, two new concepts have emerged that promise to be prominent in future considerations of bank solvency. The first is the recognition that a bank’s earnings are its first line of defense against unexpected losses. The second is the recognition that multiple discriminant analysis and related statistical techniques can be used to identify problem banks that need more frequent inspections in banking systems where there are such a large number of banks that supervisors are spread thin.
The paper has previously noted the impossibility of objectively setting a standard of capital adequacy. Partly, this is impossible because capital is intended to protect against unexpected losses. Since these losses are unexpected, their magnitude and frequency are unknown and unpredictable, so that the amount of capital required to absorb them must also be unknown. Partly, the difficulty of determining capital standards is that society’s estimation of what is the optimum is bound to change. In terms of the framework set out in Section V, society’s marginal costs and returns are not constant over time, but shift with its economic priorities. Consequently, capital standards cannot be immutable, and bank regulatory authorities should not be embarrassed when their standards change from time to time.46 Moreover, as time goes on, unalterable capital standards are more and more likely to come into conflict with other social objectives. This is not to say that capital standards should not be established to protect society; however, they should be reviewed periodically to see that they are still appropriate. Even though it is impossible to set a definitive standard for bank capital that will be relevant indefinitely, a recognition of all the issues and alternatives—as well as a realization that regulators’ standards are not likely to please bank owners and managers—can make inevitably subjective decisions more appropriate to the circumstances.
Mr. Short, Senior Economist in the Central Banking Service, is a graduate of the University of Western Ontario and Cornell University. Before joining the Fund, he taught at the Universities of Guelph and Windsor (in Canada) and was a post-doctoral fellow at Macalester College (in the United States). His previous publications have been in the areas of bank concentration, demand for money, and empirical approaches to defining money.
This is a condensed version of a larger paper, which is available from the author on request, containing a 23-page table covering the 42 countries surveyed in Section VII.
There are several qualifications that must be satisfied for subordinated debt to count as capital. It must have a maturity of at least seven years from its issue date or, in the case of amortized debt, an average maturity of at least seven years. In addition, the issue of the debt must have the prior approval of the appropriate regulatory agency. Debt meeting these criteria may be counted as capital up to an amount equal to one half of the total of the other forms of the bank’s capital.
Leverage is the ratio of borrowed funds to shareholders’ own funds.
For example, let a bank’s liabilities be $80, its capital $20, its assets $110, and its reserves for loan losses $10. If the last item is treated as a contra account, the ratio of capital to total assets is only 0.20 whereas, if the reserves are included in capital, the ratio is 0.27.
An exaggerated example is usually used to demonstrate the first point. In this type of example, a bank always holds all of its assets in cash. Consequently, the bank is very liquid but its revenues are extremely low, if not zero. Since its expenses are still quite large, the bank continuously operates at a loss. Sooner or later, depending on the initial amount of capital, the bank’s capital is completely eroded, and it is insolvent. In such an illustration, the bank’s high liquidity actually leads to its bankruptcy.
In the second case, once a bank’s insolvency becomes known to the authorities, they will close the bank and wind up its affairs or perhaps merge it with another bank. The bank’s liquidity cannot save it from insolvency. If the authorities do not act and the bank’s insolvency becomes known to the public, they will withdraw their funds from the bank as fast as they can, so that the bank will be threatened with illiquidity as well as insolvency.
Jack R. S. Revell, Solvency and Regulation of Banks: Theoretical and Practical Implications, Bangor Occasional Papers in Economics, No. 5 (University of Wales Press, 1975), pp. 13-24.
This last item is referred to as “liability management” and is a relatively new concept.
Golembe (a bank industry consultant) and Carey (an officer of the First Pennsylvania Bank’s holding company) both suggest that capital adequacy requirements are becoming an instrument of monetary policy. Moreover, Carey asserts that the U.S. Federal Reserve used capital adequacy requirements to help to reduce the expansion of the money supply in 1974. Leavitt (director of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System) and LeMaistre (a director of the Federal Deposit Insurance Corporation (FDIQ) have both counted capital adequacy requirements as a monetary policy instrument. See Gerard V. Carey, “Reassessing the Role of Bank Capital,” Journal of Bank Research, Vol. 6 (Autumn 1975), p. 165; Carter H. Golembe, “Capital Adequacy and Bank Losses,” Journal of Commercial Bank Lending, Vol. 57 (August 1975), pp. 21-22; Brenton C. Leavitt, “Required Reading: Standard Needed for Judging Safe Level of Bank Capital,” American Banker (April 23, 1974), p. 4; and George A. LeMaistre, “Capital Adequacy,” an address to the Georgia Bankers’ Association’s Bank Study Conference, September 25, 1974, (unpublished, Federal Deposit Insurance Corporation), p. 3.
On first impression, one might think that borrowers would be pleased if their bank failed, because they would not have to repay the loans that they had obtained. However, they would have to repay their loans to the bank’s receiver and so would not gain in this way.
For example, suppose that the bank is a pure competitor in raising capital in the capital market, so that the supply of capital to the bank is perfectly elastic at the prevailing expected cost to the bank. In addition, assume that the amount of funds demanded from the bank by borrowers varies inversely with the bank’s expected earnings on these funds, and that the amount supplied to the bank by lenders is a positive function of the funds’ expected cost to the bank. Thus, the demand line slopes downward from left to right and the supply line slopes upward from left to right. To maximize profit, the bank will equate the expected cost rate of capital to the expected marginal cost of borrowed funds. For the profit-maximizing bank, capital makes up the difference between loans and borrowings.
A more recent view (presented in Section VI) is that earnings should be the first buffer aginst losses.
Larry B. Butler, “An Approach to the Analysis of Bank Capital Adequacy,” in Federal Reserve Bank of Chicago, Proceedings of a Conference on Bank Structure and Competition, May 1 and 2, 1975 (Federal Reserve Bank of Chicago, 1975), pp. 19-23. (Hereinafter this book is referred to as Federal Reserve Bank of Chicago, Proceedings.); Revell, op. cit., pp. 82-96; and George J. Vojta, “Bank Capital Adequacy,” a booklet prepared by First National City Bank (New York, 1973), pp. 16-17 and 22-29.
Purchase and lease arrangements are agreements whereby banks directly or through their subsidiaries purchase fixed assets in order to lease them to customers. There is a risk that the customer will be unable to fulfill the terms of the lease.
This framework is adapted from Anthony M. Santomero and Ronald D. Watson, “Optimal Capital Standards for the Banking Industry,” in Federal Reserve Bank of Chicago, Proceedings, op. cit., pp. 61-72.
Of course, this relationship need not be linear, but it and the other functions in Figure 1 are so represented for graphical simplicity.
Deposit insurance does not change this. It only transfers the loss from the insured to the insurer. If the premiums paid by banks are actuarily sound (given the risk of loss), then the cost is borne by the banks, which may, in turn, pass the charges along to customers.
Suppose, for example, that a bank earns 1 per cent on its total assets and that it raises its ratio of capital to total assets from 5 per cent to 10 per cent (by issuing new shares at their par value). As a result, earnings per dollar of share capital will fall from 20 per cent to 10 per cent.
The difference between the second case and the first one is that, in the former, the vertical distance between marginal social returns and marginal private returns exceeds the vertical distance between marginal social costs and marginal private costs at any one capital ratio, while in the latter, the inequality is reversed.
For example, subscribed capital might be required to be at least $100,000. In addition, a general reserve of at least $100,000 could also be required. This reserve fund would be formed by transferring a fixed per cent of net profits to the fund each year, until the fund reaches $100,000.
Revell, op. cit., p. 119.
To give a more concrete example, suppose that a bank has capital of $10, deposits of $100, and net profits of $2. Now let the latter two double to $200 and $4 owing to inflation. To maintain bank capital in proportion to deposits, capital would have to be increased by $10. But net profits are only $4, so that new capital would have to be subscribed. Stock exchange conditions and the reluctance of existing shareholders to dilute earnings could make new share issues an unattractive solution.
One problem was that these comparisons looked at the relation between solvency and the capital ratios without including additional explanatory variables. Another error was that they looked at failing banks’ capital ratios immediately before they failed. Since so many became insolvent because they suffered severe runs on their deposits, their capital ratios were actually improving as they were being wiped out. The appropriate procedure is to look at their capital ratios a year or two in advance of their failures.
Richard V. Cotter, “Capital Ratios and Capital Adequacy,” National Banking Review, Vol. 3 (March 1966), pp. 333-46.
Vincent P. Apilado and Thomas G. Gies, “Capital Adequacy and Commercial Bank Failure,” The Bankers’ Magazine, Vol. 155 (Summer 1972), pp. 24-30.
Benjamin Wolkowitz, “Measuring Bank Soundness,” in Federal Reserve Bank of Chicago, Proceedings, op. cit., pp. 73-84. The soundness index is a bank’s mean net earnings minus a coefficient (4 or 1.356) times the standard deviation of net earnings plus the amount of its capital (the latter defined to include and to exclude long-term subordinated debt).
Paul A. Meyer and Howard W. Pifer, “Prediction of Bank Failures, Journal of Finance, Vol. 25 (September 1970), pp. 853-68; Robert R. Dince and James C. Fortson, “The Use of Discriminant Analysis to Predict the Capital Adequacy of Commercial Banks,” Journal of Bank Research, Vol. 3 (Spring 1972), pp. 54-62; David P. Stuhr and Robert Van Wicklen, “Rating the Financial Condition of Banks: A Statistical Approach to Aid Bank Supervision,” Federal Reserve Bank of New York, Monthly Bulletin, Vol. 56 (September 1974), pp. 233-38; Joseph F. Sinkey, Jr., “A Multivariate Statistical Analysis of the Characteristics of Problem Banks,” Journal of Finance, Vol. 30 (March 1975), pp. 21-36, and “Early-Warning System: Some Preliminary Predictions of Problem Commercial Banks,” in Federal Reserve Bank of Chicago, Proceedings, op. cit., pp. 85-91; Leon Korobow and David P. Stuhr, “Toward Early Warning of Changes in Banks’ Financial Condition: A Progress Report,” Federal Reserve Bank of New York, Monthly Bulletin, Vol. 57 (July 1975), pp. 157-65; Leon Korobow and others, “A Probabilistic Approach to Early Warning of Changes in Bank Financial Condition,” Federal Reserve Bank of New York, Monthly Bulletin, Vol. 58 (July 1976), pp. 187-94; and “A Nation-wide Test of Early Warning Research in Banking,” Federal Reserve Bank of New York, Quarterly Review, Vol. 2 (Autumn 1977), pp. 37-52.
Instead of inspectors’ ratings, Meyer and Pifer use whether a bank failed or not as their measure of validity. Korobow and Stuhr (1975), and Korobow and others (1976) construct an index of each bank’s condition from financial data.
Yair E. Orgler, “Capital Adequacy and Recoveries from Failed Banks,” Journal of Finance, Vol. 30 (December 1975), pp. 1366-75.
Watson lists mismatching of asset and liability maturities, high loan losses, and low return on assets as the “three classic conditions” causing bank failure. Justin T. Watson, “A Regulatory View of Capital Adequacy,” Journal of Bank Research, Vol. 6 (Autumn 1975), p. 171.
Harry V. Keefe, Jr., “Capital Funds in the Banking System—No More Free Lunches for Borrowers,” address to the Association of Reserve City Bankers (New York, February 3, 1975) and to the American Bankers Association’s 1975 Bank Investments Conference (San Francisco, February 20, 1975); Leavitt, op. cit., pp. 4, 11, and 16; Revell, op. cit.; Vojta, “Bank Capital Adequacy” (cited in footnote 12); J. T. Watson, op. cit.; and Ronald D. Watson, “Insuring Some Progress in the Bank Capital Hassle,” Federal Reserve Bank of Philadelphia, Business Review (July-August 1974), pp. 3-18.
Banks that borrow substantially from other banks, other financial intermediaries, and large corporations (in the last case, through short-term instruments rather than deposits) are considered to be wholesale banks.
Franklin National Bank (FNB), which was the twentieth largest bank in the United States in 1974 and which was the largest bank ever to have failed in the United States, is the best example. See Keefe, op. cit,; Walter A. Varvel, “FDIC Policy Toward Bank Failures,” Federal Reserve Bank of Richmond, Economic Review, Vol. 62 (September/October 1976), pp. 3-12; and J. T. Watson, op. cit. FNB’s statements for the first quarter of 1974 showed that its earnings were down. From the end of March until the middle of May of that year, FNB lost about 9 per cent of its deposits (Keefe). After the large foreign exchange losses, which were the cause of these poor earnings, were made public on May 9, the bank lost 53 per cent of its remaining deposits (Varvel). Within two weeks of the announcement of these losses, FNB borrowed over $1.7 billion from the Federal Reserve Bank of New York (Watson). Sinkey’s data show that from December 31, 1973 to June 30, 1974, FNB’s deposits only fell by 40 per cent and that they only fell by 9 per cent from June 30 until the bank was closed on October 8, 1974. He claims that in the failure of the U.S. National Bank of San Diego, which is the second largest bank to go under in the United States, there was not such a running down of aggregate deposits only because state and various local governments added to their deposits. See Joseph F. Sinkey, Jr., “Adverse Publicity and Bank Deposit Flows; The Cases of Franklin National Bank of New York and United States National Bank of San Diego,” Journal of Bank Research, Vol. 6 (Summer 1975), pp. 109-112.
Although this is the first of three preconditions, Vojta devotes considerable space to this proposal. See Vojta, “Bank Capital Adequacy,” pp. 17-18.
Keefe, op. cit., p. 15.
R. D. Watson, op. cit.
Leavitt, op. cit.
Samuel B. Chase, “Regulation of Risk in Banking: Role of the Market,” address given at the 1976 annual meeting of the American Economic Association (Atlantic City, September 16, 1976); Golembe, op. cit.; Roland I. Robinson and Richard H. Pettway, Policies for Optimum Bank Capital, a study prepared for the Association of Reserve City Bankers (Chicago, 1967); and George J. Vojta, “A Dynamic View of Capital Adequacy,” Journal of Commercial Bank Lending, Vol. 57 (December 1974), pp. 15-21.
Whether or not Franklin National Bank was kept in operation until October 1974 for this reason, the FDIC and Federal Reserve’s actions can be interpreted in this way. See footnote 31.
In these situations, an equal amount of assets are also accepted by the healthy bank, but the regulatory authority promises to assume any losses from these assets. Of 125 insured banks that failed in the United States from 1946 to 1975, only 54 were placed in receivership. See Varvel, op. cit., p. 6.
William F. Staats, “Corporate Treasurers View Bank Capital,” Banking, Vol. 58 (June 1966), pp. 46-48. Staats sent his questionnaire to 150 treasurers of Fortune’s list of the 500 largest industrial companies. Forty-two responded. One third did not consider bank capital in choosing a bank in which to deposit and another third gave capital only a little consideration because they dealt only with the largest banks. Thus, size was often substituted for capital as an indication of protection. The treasurers more often admitted that bank capital was important to them as borrowers rather than as lenders, because a bank’s loans to any one borrower cannot exceed a certain proportion (which varies according to the jurisdiction in which it is chartered) of its capital.
Benjamin M. Friedman and Peter Formuzis, “Bank Capital: The Deposit-Protection Incentive,” Journal of Bank Research, Vol. 6 (Autumn 1975), p. 211.
H. Prescott Beighley and others, “Financial Structure and the Market Value of Bank Holding Company Equities,” in Federal Reserve Bank of Chicago, Proceedings, op. cit., pp. 61-72, and “Bank Equities and Investor Risk Perceptions: Some Entailments for Capital Adequacy Regulation,” Journal of Bank Research, Vol. 6 (Autumn 1975), pp. 190-201; and Richard H. Pettway, “Market Tests of Capital Adequacy of Large Commercial Banks,” Journal of Finance, Vol. 31 (June 1976), pp. 865-75.
Pettway, op. cit.; and H. Prescott Beighley, “The Risk Perceptions of Bank Holding Company Debtholders,” Journal of Bank Research, Vol. 8 (Summer 1977), pp. 85-93.
The 42 countries are Belgium, Botswana, Cameroon, Canada, the Republic of China, Cyprus, Denmark, France, The Gambia, the Federal Republic of Germany, Hong Kong, Indonesia, Iran, Ireland, Italy, Jamaica, Jordan, Kuwait, Lebanon, Lesotho, Luxembourg, Madagascar, Malawi, Malaysia, Malta, Mauritius, the Netherlands, Nigeria, Panama, the Philippines, Sierra Leone, Singapore, South Africa, Swaziland, Switzerland, Thailand, Trinidad and Tobago, Turkey, Uganda, the United Kingdom, the United States, and Zambia.
A table listing by country the source of information, the definition of capital, the capital requirements, and the penalty provisions is available in the larger paper (See footnote 1.).
The United States is counted twice, once for the Federal Reserve’s “Analyzing Bank Capital” (ABC) formula, and once for the FDIC’s and Comptroller of the Currency’s ratios.
Sam Peltzman, “Capital Investment in Commercial Banking and Its Relationship to Portfolio Regulation,” Journal of Political Economy, Vol. 78 (January/February 1970), pp. 1-26; Lucille S. Mayne, “Supervisory Influence on Bank Capital,” Journal of Finance, Vol. 27 (June 1972), pp. 637-51; John J. Mingo, “Regulatory Influence on Bank Capital Investment,” Journal of Finance, Vol. 30 (September 1975), pp. 1111-21.
Similarly, it can be anticipated that bankers’ standards will also shift over time.
