Afzalul Haq in the first of a three-part article on bank capital standard

There has been an apparent dimensional change in the recent times between the capital standards of banks in two paradigms. These two paradigms may be categorised: firstly, as the paradigm before, and secondly, as the paradigm after (or since) the international convergence of the measurement and standard of capital of banks. That is, we are talking about the pre-Basel and post-Basel standards of banks' capital requirement.

In the realm of financial management, capital-structure ratios, indicating the proportion of funds provided by the 'owners and creditors', have been recognised as very important statistics for many purposes. Among such different ratios, debt-equity ratio, as an indicator of the capital financing structure of a company, has got a significant role. It is also an important element for credit risk grading (CRG) of a company. The CRG is conducted in respect of a company, which seeks finance from the external sources, specially from any bank or non-banking financial institution.

Bankers now, among other peripheries of scrutiny, conduct the CRG while checking for the eligibility of a potential borrower, whether he qualifies to get finance from the bank. The CRG has got five principal risk components encompassing 20 parameters, where leverage or debt equity ratio has been listed the top. This ratio is calculated as a measure of the financial risk involved and the fund-seeking firms' ability to use the debt.

In broad statistical terms, debt-equity ratio is nothing but the proportion of sources of fund of a company between internal (equity) and external (debt) sources. So debt-equity ratio of 0.4 or 40 per cent would indicate that the company concerned has got debt of Taka 40 against every Taka 100 from the sources of the owners i.e. the share-capital, as talked about a joint stock company.

The prudent use of debt plays the role of leverage or 'gear to lift' in magnifying earning per share (EPS) of a company. This is why the debt-equity ratio is also termed as gearing ratio or leverage, meaning an accelerator. Thus literally the term leverage as the nomenclature denotes, indicates something positive, a magnifier of shareholders' return as already stated.

Financial risk: But in this write-up, we will focus how debt-equity ratio is rather treated as one of the indicators of a significant risk factor, the financial risk. Debt-equity is a risk factor. Because when a company takes excessive fund in the form of debt, the fate of recovery/repayment of debt becomes uncertain. Such an uncertainty accentuates if the borrower company unfortunately fails in business.

Let us think of a business of Taka 100m (hundred million), consisting of bank debt of Taka 30m and own capital or equity of Taka 70m. Say the business of the company fails and the residual fetches the company 50 per cent i.e. Taka 50m only. In this case, the bank, which has lent the debt of Taka 30m, is supposed to get back full amount it lent, although the borrower company has suffered loss of Taka 50m. This is the 'rule' that the creditor (in this case, the bank) will have the first claim over the recovered money. The owner will have claim on residual, if any, after meeting claim of the creditors as the externals pre-emption right.

In the other instance, let Taka 100m business fund is conversely composed of Taka 70m as bank debt and only Taka 30m as equity. If the business faces the same fate of 50 per cent decay, then the scenery would be terrible for the lender bank. The bank would not be able to recover more than the amount the company could realise i.e. Taka 50m only, incurring a loss of Taka 20m (70m minus 50m). The entrepreneur company (i.e. its shareholders), according to law, is not supposed to bear any loss beyond its share capital i.e. Taka 30m in this case.

So the shrinkage of the company's asset at a higher rate than the proportion of the equity in the total source of its fund would cause loss to the creditor bank, the lender. As such a lender or an external provider of fund must take care, so that it/he need not incur any loss. In other words, the lender must expect that the loss, if any, is to be covered by the owners money. The higher is the debt equity ratio, the higher is the risk of the external financier or the lender to incur loss.

The above scenario assumes a case where a joint stock company, other than a bank or a non-banking financial institution (NBFI), is approaching a bank or NBFI to avail of external finance. For simplicity, we have also assumed to limit component of finance between the owners capital and bank loan only i.e. in the above example, bank is the external financier or provider of debt or a lender / creditor.

Now let us conversely think of a bank as a business (borrower) unit or entrepreneur, forgetting its earlier role as loan provider. For simplification like in the earlier, case we assume that sources of fund are limited between paid-up capital (as internal) and depositors (outsiders or external source of) money. Thinking in the similar way of two liquidition scenarios as stated, we must talk of the safeguard of the outsiders i.e. the depositors. The more the depositors fund is in relation to equity, the more will be the risk or uncertainty of recovery of their (depositors) fund.

So there had been a concern vis-à-vis maintaining a balance between internal and external finance of any venture, be it banking or any other business organisation. This is to control debt or external finance (in relation to internal finance) so that it does not touch the danger point, which may ultimately land the external financiers in a situation to suffer loss. For the creditors, it reaches the danger point when the concerned company incurs an amount of loss, surpassing the contribution of the owners or equity capital.

Once upon a time, until the Basel accord, such a ratio or proportion-like debt-equity was also applicable for the banking companies. The ratio had been in the use, to determine and control the maximum limit, which a bank can collect from the depositors in relation to its share capital. That was the ratio between deposit (debt) and bank's equity or capital.

At that time, say for every Taka 6.0 capital, a bank could collect an amount of Taka 94 from the depositors to equate a Taka 100 as sources of fund. The purpose of this ratio was obviously to contain a bank so that it cannot take excessive money from depositors. Excess money from the depositors might cause them suffer loss. Because, where the actual loss of a bank exceeds the amount of its capital, depositors might be compelled to share a part of that loss.

So the above proportion at that time played the role of a controlling device, a limit or cap to safeguard the interest of the depositors of the bank. This was simply to maintain such a capital structure of financing, so that external liability (as opposed to internal liability or equity) does not become reckless. As a regulation it was not unfair to control external finance from the public in connection with the bank's capital (deposit versus capital, liability versus liability).

A 'same-side' case: But such a ratio, as a proportion between those two figures, was subsequently considered inadequate or irrelevant. The rationale shown for this negation was that the debt and equity both stay under the same umbrella. Both of them belong to liability group as opposed to asset group (or sources of fund as opposed to application of fund) of the balance sheet. So the ratio between two liability items was regarded as irrelevant to fixing the limit or floor of volume of deposit. Such an equation was rather regarded as a 'same-side' case.

It was then thought that the ratio must not be the quotient of two items from the similar group of the balance sheet items, as stated above. This realisation gave birth to Basel Accord, the most talked about and important issue in the banking and finance industry across the globe.

The Basel accord is a global standard designed in the Bank for International Settlements (BIS). This accord is known as International Convergence of Capital Measurement and Capital Standards. The standard, as was born in Basel of Switzerland, it has got a nickname as Basel accord or simply Basel.

As a control device, the suggestion in the Basel came to find out a ratio, where the components, numerator and denominator must be from the reversal part. That is, if one of these items is from the group of sources of fund, another is to be from that of application of fund. Therefore, the BIS agreed that the new control device shall be the proportion of capital on one side, and loans & advances, on the other side (liability vs asset).

Loans and advances, in banking, are termed as the asset item. Such asset figures, for the purpose of calculation of sufficiency of capital, under Basel accord, are however adjusted in amount, multiplying them by their respective risk-weights. Risk-weights are expressed in terms of a fixed percentage of a few options determined by the Basel Committee on Banking Supervision (BCBS). The risk-adjusted amount of asset is then termed as risk-weighted asset (RWA) or risk weighted amount as the basis on which a bank's minimum capital amount is to be decided.

A new ratio: The BCBS therefore advised rather to contain the RWA in relation to capital. In other words the Basel accord discovered a new ratio to find out the minimum capital that a banking company must have in relation to its corresponding risk weighted asset, not in relation to the amount of collected deposit, unlike the provision of the pre-Basel paradigm.

According to the new formula, if a quotient (Capital ÷ RWA) of 0.10 or 10 per cent is set as the required minimum capital, it would mean that to book risk weighted asset of Taka 100, a bank must have its own capital of Taka 10. In other words, a capital of Taka 10 would enable a bank to extend its weight adjusted loans (RWA) upto Taka 100 and not more. To extend credit or loans beyond this limit, the bank must increase its capital proportionately. Here the required amount of capital (a liability item) is determined in relation to an asset item and not related to the depositors fund (another liability item).

The initial Basel accord was subsequently updated. A revised standard known as Basel-II has now been prevailing. For further updating, particularly in the backdrop of the latest financial meltdown, resulting in fall of many ' too big to fall' like Lehman Brothers & AIG and subsequent many a bailout programme to save the drowning ones, the Basel-III is cooked with more stringent regulations to come into force in the near future. To accommodate the lessons of the financial crisis, the revision extended the purview of recognition of risk factors and some other new factors. Those will be discussed in the subsequent parts of the article.

The writer is Vice President & Head of Islamic Banking, Bank Asia Limited at its Corporate Office at Rangs Tower,

Purana Palton.

afzal@bankasia.com.bd

Financial Express/ Bangladesh/ 10th May 2012