The Importance Of Capital Adequacy In Banking

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During the credit crisis of 2009, investors and banking institutions realized that adequacy of capital within a given bank was difficult to judge. Assets that were considered safe for lengthy periods of time suddenly were viewed as risky and worth a fraction of the initial investment. This realization came at a time shortly after banking regulators released new methods to judge capital adequacy. These new methods are more fluid in nature than the predecessors and employ formulas which take into account factors that must be estimated by banks and approved by regulators.

The document governing capital adequacy for banking institutions is referred to as the Basel Accord. Initially Basel utilized several fixed percentage weighting amounts for each asset of a bank. However, as assets became more complex, the Basel Accord was revised and set forth other methods to calculate various instruments using a variety of inputs. These inputs are often based on banks' internal forecasts and ratings and include items such as an asset's probability of default, loss given default, exposure at default, and time to maturity. Additionally, these formulas rely on or refer to grades given by credit rating agencies when determining various inputs to the formulas. Further, deductions from the capital components may be required following the risk weighting of the asset, as determined by the external ratine.

Credit rating agencies are often slow to alter ratings as they attempt to distinguish between short term trends versus longer term changes in market conditions. Often times, market participants have forecasted these credit rating changes prior to the actual occurrence. This speculation results in decreased share prices prior to the rating change and may result in further depression of price following the rating change. These rating changes will ultimately require banking institutions to raise additional regulatory capital, which often occurs through common stock equity issuance. However, the fluid nature of the revised inputs to the capital adequacy formula results in the need for this regulatory capital at a time when it is most expensive for the bank to raise the additional capital. Thus, banks will have a necessary, expensive capital raise if neither the bank nor the credit rating agencies timely forecast the change in risk of the underlying assets of a bank's portfolio.

This article reaches the above conclusion by first discussing the typical methods and cost of raising capital. The rating agency companies and their regulations are briefly discussed. Thirdly, the article discusses the Basel Accord's capital adequacy formula. Then, Basel II is discussed with a focus on the risk weighting of securitization assets. The impact of the fluid nature of rules governing asset weighting for securitization on instruments that were once viewed as safe and subsequently viewed as risky is analyzed. Concluding remarks are then provided.

Raising Capital

Corporations need capital to operate successfully. Capital needs may be for general liquidity purposes to cover cash flow shortfalls or may be for business investment in an effort to expand. Whatever the needs may be, corporations generally have two methods of raising capital - debt or equity issuances. Debt issuances may take the form of longer term bond offerings, short term commercial paper, or corporate credit facility arrangements. Equity capital raises predominantly take the form of an initial public offering (IPO) or a secondary offering of common stock. Unlike debt, this equity capital from common stock need not be paid back to the providers of the capital, as this money is an investment in the company expected to yield profits in the form of dividends and capital gains. Preferred stock is a quasi debt instrument, meaning that it possesses traits of both equity and debt. Rather than having no obligations attached to the investment, as in common stock, preferred stock has favored treatment
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