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Capital Adequacy Ratio - A comparative analysis
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Introduction CAPITAL ADEQUACY RATIO (CAR) CAR is a measure of the bank’s capital expressed as a percentage of its risk weighted credit exposures. A minimum CAR ensures that the bank can absorb certain amount of losses before becoming insolvent. Thus minimum CAR ensures the stability and efficiency of the financial system. Minimum CAR also gives some protection to the depositors. In the event of a winding-up, depositors’ funds rank in priority before capital, so depositors would only lose money if the bank makes a loss which exceeds the amount of capital it has. The higher the CAR, the higher is the level of protection available to depositors. One of the most important principles of BIS formulated “Core principles of Effective Banking Supervision” is that the banks should never be allowed to fail and for that it is essential that corrective action should be taken while the bank still has a manageable cushion of capital. This can be effectively tracked through the CAR requirements for the banks. The timely corrective actions can be taken when a bank fails to achieve a min. CAR. In case of foreign countries the supervision framework focuses only on one ratio i.e. CAR whereas in India, along with CAR, Net NPA and ROA are also taken a trigger points. If a bank fails to meet CAR, corrective actions like recapitalization, limits on deposit raising, prohibitions on extension of new credit, acquisitions of new securities are taken according to the level of seriousness. The current norm set by RBI in India for CAR is 9%. Once BIS II gets implemented, this will be raised to 10%. Three-tiered capital The Basle Capital Accord I, 1988 specifies three levels of capital to be taken for CAR calculation: 1. Tier 1 – This capital is permanently and freely available to absorb losses without the bank being obliged to cease trading. Tier-1 capital safeguards both the survival of the bank as well as the stability of the financial system. 2. Tier 2 – This capital absorbs losses only in the event of a winding-up and so is a lower level of protection. Tier-2 capital absorbs losses only after Tier-1 capital has been exhausted. Upper Tier-2 capital has no fixed maturity, while lower tier-2 has a fixed maturity. Thus upper tier-2 capital is more effective in absorbing losses. 3. Tier 3 – It consists of short term subordinated debt. It can be used as a buffer against market risks (losses on forex and interest rate contracts) if the upper tiers are not sufficient to do so. It is not mandatory to hold tier-3 capital. Credit Exposures Credit risk arises out of two factors, the counterparty risk and the market risk. Counterparty risk depends on the financial strength of the debtor while the market risk is the systematic factor in asset pricing. While calculating credit exposure, it is kept in mind that more capital would be held against riskier assets. The degree of riskiness is defined by the central bank for each broad category of assets. However, Basle II emphasizes on asset risk evaluation on case by case basis. Though costlier and more tedious, this approach would make banks more financially viable. Off balance sheet exposures are first converted to their “credit equivalent amounts” which are then assessed for their riskiness. CEA is obtained by evaluating the contingency and estimating the outcome. Under CAD2 (International banking norms), banking operations are categorized as either trading book (broadly, marked-to-market activities) or banking book (all other activities) and risk-weighted assets are determined accordingly. Banking book risk-weighted assets are measured by means of a hierarchy of risk weightings classified according to the nature of each asset and counter party, taking into account any eligible collateral or guarantees. Banking book off-balance sheet items giving rise to credit, foreign exchange or interest rate risk are assigned weights appropriate to the category of the counter party, taking into account any eligible collateral or guarantees. Trading book risk-weighted assets are determined by taking into account market-related risks, such as foreign exchange, interest rate and equity position risks, as well as counter party risk. This method seems to be a better method as it takes the various market risks into account. However, in India the banking book method is followed. Limitations of CAR Some of the limitations of CAR are: 1. It does not consider operational risk at all. 2. If provisions are inadequate, CAR overstates the bank’s viability. Thus for a reliable study of a bank’s financial study, CAR should be used in conjunction with other indicators of the bank’s financial health such as Net NPA and ROA. The Key Financials HSBC 1998 1999 2000 2001 2002 Dividend per share (US $) 0.308 0.34 0.435 0.48 0.53 Dividend payout ratio (%) 57 51.5 54.4 76.2 69.7 Retained Earnings per Share (US $) 0.23 0.32 0.36 0.15 0.23 US$0.50 ordinary shares in issue (Mn) 8067 8458 9268 9355 9481 Retained Earnings (Mn $) 1874.37 2708.20 3379.41 1402.51 2184.44 Capital Ratios Tier 1 capital 9.70% 8.50% 9.00% 9.00% 9.00% Tier 2 capital 3.90% 4.70% 4.30% 4.00% 4.30% Total Capital 13.60% 13.20% 13.30% 13.00% 13.30% Average CAR 13.28% (US $ Mn) Share capital 3443 4230 4,634 4,678 4,741 Shareholders’ funds 27,402 34,402 46,393 46,388 52,406 Undated subordinated loan capital 3,247 3,235 3,546 3,479 3,540 Dated subordinated loan capital 7,597 12,188 12,676 12,001 14,831 % Equity 24.10% 21.52% 22.22% 23.21% 20.51% % Borrowed Liabilities 75.90% 78.48% 77.78% 76.79% 79.49% Tier 1 (US $ Mn) 2001 2002 (% Change) Shareholders' Funds 45979 52406 13.98% Minority Interests 3515 3306 -5.95% Innovative tier 1 securities 3467 3647 5.19% Less: Property revaluation reserves -2271 -1954 -13.96% Goodwill capitalized and intangible assets -14989 -17855 19.12% Owner Shares Held -628 -601 -4.30% Total Qualifying Tier 1 Capital 35073 38949 11.05% Tier 2 (US $ Mn) 2001 2002 (% Change) Property Revaluation Reserves 2271 1954 -13.96% General provision 2091 2348 12.29% Perpetual Subordinated debt 3338 3542 6.11% Term Subordianted Debt 9912 12875 29.89% Minority and other interests 693 775 11.83% Total Qualifying Tier 2 Capital 18305 21494 17.42% Subordinated debt raised as Tier 2 cap 72.38% 76.38% 5.52% Unconsolidated Investments -1781 -2231 25.27% Investments in other banks -627 -638 1.75% Other deductions -116 -144 24.14% Total Capital 50854 57430 12.93% Sources of capital: 2001 2002 (% Change) Internal Funds (%) 78.91% 76.66% -2.85% External Funds (%) 21.09% 23.34% 10.66% Assets (US $ Mn) 2001 % 2002 % % Change Loans and Advances to customers 308649 44.90% 352344 47.10% 14.16% Loans and Advances to banks 104641 15.20% 95496 12.70% -8.74% Debt Securities 160579 23.40% 175730 23.40% 9.44% Treasury Bills and other eligible bills 17971 2.60% 18141 2.40% 0.95% Equity Shares 8057 1.20% 8213 1.10% 1.94% Intangible Fixed Assets 14564 2.10% 17163 2.30% 17.85% Others 73147 10.60% 82714 11.00% 13.08% 687608 100.00% 749801 100.00% 9.04% HK SAR Govt certificates of indebtedness 8637 9445 9.36% Total Assets 696245 759246 9.05% Total RWA 391478 56.23% 430551 56.71% 9.98% RWA of Contingent liabilities and commitments Contingent Liabilities 27501 30785 11.94% Commitments 17528 21003 19.83% Total 45029 6.47% 51788 6.82% 15.01% 2001 2002 (% Change) Gross NPAs as a % of total loans 2.90% 2.00% -31.03% Loan Loss Provision as a % of total loan 2.80% 2.70% -3.57% Loan restructured as a % of total loans 0.70% 1.10% 57.14% HSBC The amount of qualifying tier2 capital cannot exceed that of tier 1 capital.
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