“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.
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.