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Wanted to understand how Basel arrived at the figure of 8% for capital adequacy .

Is it fair to say that if banks maintain CAR, then even if their loan portfolio goes bad, they have enough capital to provide for it? And does that also mean that banks cannot go bust if they maintain their CAR?

Thanks

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I honestly wouldn't read too much into the 8% figure. It's just a historical ballpark figure for minimum adequacy to weather all but the biggest shocks (in which case, it would be sensible and appropriate for the central banks to step in and play their lender-of-last resort role).

Most banks after their post-GFC workouts run much higher than this these days. Running 8% equity:CoreTier1 ratios these days would be seen by regulators and the market as "flashing some ankle", if not a full-on Janet Jackson "nipplegate". The effective minimum is well above 8% these days!

Plus the 8% is based on equally subjective risk-weightings for different kinds of loans. Back in the EUrozone Crisis, a bank owning PIIGS (even French at times) govvie bonds yielding 10% was Basel "safer" than a bank lending to German students at 4%. The market CDS of those Banks was obviously not consistent with the regulatory measures ;-)

What the CAR tries to guage is how much loans can go bad before the bank runs out of equity (rather than they cannot ever go bust thus). It's more of a "margin of safety" thing. How much equity do they have to cover potential losses?

Note that this does NOT mean that lending is immune to losses that the banks can cover without failing. Say I have 100 loans, 10 equity with 1 provisions booked for bad/doubtful debts (BDD) = 10% CAR. 2 loans go bad, and I recover 25% = 1.5 losses. Less the 1 provision for these already booked, that's a 0.5 hit to profits and equity. So I now have 98 loans, 9.5 equity, 0 BDD = 9.7% CAR. But I now have no provisions for BDDs on the rest of my book. Provisioning for the same 1% of assets, that's a 0.98 hit to profits and equity. So I end up 98 loans, 8.52 equity with 0.98 provisions = 8.7% CAR.

I'm not bust, or even "underwater" from a regulatory perspective - but my capital cushion has been wiped out if I expected 1% of loans to sour and 2% did. So I will curtail my lending (even start calling in riskier debts) long before my solvency ever becomes a pertinent question. This is the real (and still unresolved) issue with banks!

hope this helps

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  • $\begingroup$ thanks. But what is still not clear to me is that while banks may proactively call back riskier debts, if we have a GFC, things will spiral out of control too fast for the bank to react, in which case their CAR will go down and they won't be able to lend. But won't it wipe out their networth and bring the solvency issue back to the table? Is this addressed by Basel? Also any idea from where I can understand how this figure of 8% and requirement for other buffers have been arrived at. $\endgroup$ – Shyam Jan 28 at 2:28
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    $\begingroup$ Hi, no capital adequacy regime can prevent a solvency issue in something like the GFC. All any CAR tries to do is “raise the bar” to make a GFC-like spiral ever less likely. This raises the bar at which the central bank needs to step in and play lender or last resort. In that regard, Basel3 is significantly tougher than Basel2. But the 8% figure is still finger-in-wind, especially given that the actual risk of any loan may not necessarily correlate with its Basel risk-weighting. But then risk-weight any govvie <100% and you”re officially classifying some governments as dodgy credits! $\endgroup$ – demully Jan 29 at 3:06
  • $\begingroup$ I suppose the simple point here is that the CAR is set by the central bank/regulator, for its purposes. They set the bar at the point which they think sets the likelihood they have to step in and play the last-resort-lend game. They don't want that probability at zero... given the obvious trade-offs against the benefits of a well-functioning financial system.That's the nub of it, methinks. $\endgroup$ – demully Jan 30 at 0:10

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