Move from Capital Adequacy to Capital Efficiency

The Need – Why move?

Requirement of capital adequacy for banks has been well understood. Till very late, capital adequacy was seen as adhering to norms set by regulatory authorities. Regulatory authorities are motivated primarily by depositors’ interests. They also need to ensure that there is minimal systemic risk. Maintaining a high regulatory capital means lesser business for the banks, which conflicts with the interests of the investors, who seek high return on capital. Now, there is a trade off and no body knows where to draw a line and what is the accurate adequacy ratio for banks. The point to be noted here is that technically, adequacy ratio has to be different for different banks depending on the quality of their assets. So, the norm is set taking into account weak as well as best run banks. Now, when capital adequacy is there, i.e. capital to be used is given, in order to increase the shareholders’ value, banks need to employ this capital at minimum risk or at least take an informed decision and employ capital at a known and calculated risk i.e. move towards capital efficiency.

Building the case.

The Basel Capital Accord – II framework is based on three pillars of ‘Minimum Capital Requirement’, ‘Supervisory Review’ and ‘Market Discipline’. Minimum capital requirement sets regulatory norms to meet credit risks, market risks and operational risks. Supervisory review tries to capture the risks not taken care by meeting the minimum capital requirements, e.g. concentration risk and liquidity risk. Market discipline is all about disclosures. If banks adequately disclose their risks in their annual reports, analysts would be able to compare and rate them, which would keep management of banks in discipline.

Basel II does not talk about capital efficiency, but its adoption by banks is inevitable. We can expect modified version of the accord (Basel) in future, but as of now capital efficiency is not an adopted regulatory norm. Hence, the movement towards capital efficiency has to be voluntary. The capital efficiency thus, requires adequacy in economic capital. Economic capital reflects the true market value differential between assets and liabilities. Economic capital requirement is bank specific and captures the capital requirement to support all the assumed risks, up to a given level of confidence. It thus helps in manage the risk within the risk appetite specified by the board. It also helps in taking capital allocation decisions among competing business units, ensuring that capital is allocated to most efficient business units. Thus the move towards capital efficiency will help increasing the shareholders’ wealth, adhering to the regulatory norms at the same time.

How to move - Implications for managers

Risk management is only an understanding and not actions based on sure shot prediction. Risk management relies heavily on building data to predict future trends. And based on these predictions and targeted confidence levels, amount of capital adequate to support risks is calculated. Mathematical and probability distribution techniques are used to calculate value at risk (VaR). Further, risk adjusted performance measurement (RAPM) acts as an efficient tool in assessing risk and helping in taking business decisions. RAPM takes into account varying risks on different class of assets and also accounts for impact of financial leverage. One such metric is Risk Adjuste Return On Capital (RAROC). RAPM thus acts as a consistent metric for all asset and risk classes, thereby helping to evaluate alternative business propositions. Managers can thus effectively use RAPM in conjunction with VaR based on risk appetite of the board to take important business decisions.