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As I am new to the banking risk management, I need some clarity on the concept of provisioning and capital adequacy with respect to banking industry. As the banks make loans and some of these loans will go wrong. I understand that whenever the bank lend any loan to any customer, bank calculates the capital based on the riskiness of the customer and bank set aside the capital to cover up the unexpected loss over the expected loss. Also, I understand that bank also calculate the provision amount based on the accounting standards like ifrs9 along with the capital. My queries are,

  1. Do the bank invest that calculated capital or provision amount in any of the govt securities until the bank realise the actual losses?
  2. How does the bank use that capital or provision amount calculated during loan sanctioning or in the event of loss or non loss account closure. Thanks,
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    $\begingroup$ I’m voting to close this question because (although interesting) it is about basic bank accounting and not about Quantitative Finance. $\endgroup$
    – nbbo2
    Jan 17 at 12:59
  • $\begingroup$ @noob2, May I ask you not to vote to close this question as this is a good introductory question related to credit risk and risk models and will attract good responses from the various perspective for beginners to learn the basics. Moreover, this is the site to ask credit risk and risk models related questions as these are falls under banking and finance. I feel it should be opened to receive very good answers with a better explanation. $\endgroup$ Jan 18 at 15:52
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    $\begingroup$ OK, I am willing to leave it open. Hoping for a more technical answer. $\endgroup$
    – nbbo2
    Jan 18 at 16:07

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Q1 does not make sense. Bank capital is not "invested" in a specific asset such govt securities. Bank Capital is concerned with the Sources (not the Uses) of the bank's funds and is the amount that is attributable to Shareholders as opposed to Bank Bondholders or Bank Depositors. Hypothetically if all the assets of the bank could be liquidated, they could be used to pay back the Depositors, then the Bondholders and if anything is left the Shareholders. So Bank Capital is calculated as a residual amount in a (theoretical) liquidation.

Bank Capital is not bags of money stored in the bank which can be used to buy assets such as govt bonds or to pay bonuses, etc. Rather Bank Capital is the result of a calculation done by accountants following an agreed upon and regulated procedure. Do not think of it as a physical amount of money or you will get very confused; is it just a number, but a very important number.

Banks have made very risky loans for a long time (starting with the Medici, Bardi and Peruzzi in the Renaissance, and perhaps even earlier in China). Suppose the Medici Bank has a capital of 100000 scudi and they have lent 20000 to the king of England. The 100000 is on the RHS of the balance sheet as Capital and the 20000 is on the LHS as Loans. Suppose the king dies in battle and England defaults on its loan. The accountants recognize the loss by setting the loan value to 0 and (to keep the two sides of the balance sheet equal) setting the capital to 80000. The bank has less capital than before due to the loan loss. The reduction is a mathematical operation that occurs on the books of the bank as a result of the loan default.

That is the way it used to be done. The modern world is trying to take a more forward looking, statistical approach. Suppose we think the loans have a 5% chance of not being paid back. Then under a provisioning approach we would assume that 5% of the loans have already defaulted. So at the moment we lend to the king the capital would be reduced to 100000-0.05*20000 = 99000 scudi. The provision is 1000. Later if the king defaults completely we will take the remaining write down and the capital will go to 80000 as before. Or if the default is very minor (less than 5%) or none at all we may adjust the capital upward.

The idea is the same as before but we are tracking the amount of capital more accurately and dynamically by using estimates of the probability of default rather than the old yes/no default/no-default approach.

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Imagine the bank has given loans of total face value 100 to several borrowers 5% of which are very likely to default. A typical bank funds this with 100 of deposits that other customers have in their savings accounts, or with 100 of bonds that the bank has issued. This does not really matter. What matters is that from the loan borrowers the bank will receive back only 95 but is due the full 100 to its other customers/bond holders. The setting aside of enough capital has the purpose to finance the missing 5. It is very important that this capital is owned by the bank, and not borrowed yet again from another source.

Does this answer your second question? My answer to your first question is:

As long as the government securities are 100% safe and liquid that should be fine.

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Every bank seeks protection against future loan losses. The Basel bank regulation defines two types of losses (Expected and Unexpected losses). The capital is the buffer banks maintain to protect themselves against Unexpected Losses(UL), capital is a compliment to the loan loss provision which protect the banks against the expected losses(EL).

The loan loss provision for EL is a part of the bank's liabilities, the capital is financed through equity.

The more capital is more stable the institution is. A high capital buffer against unexpected losses is translated into a higher rating. Even though there may not be covered from the capital against the losses from the tail risk for 100% protection, so set some confidence level(based on bank stress appetite and expected rating, say for example 95%) to calculate the capital for unexpected losses.

The bank can deploy this capital(initial funding) in short term assets(government securities are 100% safe and liquid) or overnight deposits this way it also produces the return(from overnight rate). The reduction in the capital that occurs on the books of the bank as a result of the loan default (you can check the example from the above answers).

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