Question

How do bank managers calculate minimum capital requirements and how do banks classify off‑balance sheet?

Answer 1

How do managers calculate minimum capital requirements?

Basel III is an international regulatory that is formed for proper regulation and risk management in Banking sector.

Concept of Adequate requirement of capital became important after 2008 economic crisis. Thus capital adequacy ratio became an important ratio which need to be maintained to meet the future uncertainities.

Basel III has bifurcated tier 1 and tier 2 capital. Where Tier 1 capital is the core capital of business which includes Equity capital and Reserve. This capital is useful during losses and uncertainities without affecting the norma operation of business And Tier 2 capital is useful at the time of Liquidation.

As per 2019, bank’s tier 1 and tier 2 capital must be atleaset 8% of its risk weighted assets. Thus the minimum capital adequacy ratio is 10.5% and this ratio maintains the capital buffering.

So, for an example if Bank has $2 million as tier 1 capital and $4 million as tier 2 capital. Bank has given loan to ABC of $40 million has risk of 25% and another loan given to XYZ is of $4 million which has risk of 50%.

Calculation of capital adequacy ratio in this case would be :

Risk weighted assets :millions ($40 * 0.25) + ($4 * 0.5) = $12 million.

Total capital = Tier 1 + Tier 2 = $6 million

Capital adequacy = ($6 million / $12 million)* 100 = 50% capital adequacy is required in this case.

Classification of capital off Balance Sheet :

Tier 1 capital is reflected on Liability side as Equity and Retained Earnings.

Tier 2 capital is also reflected on liability side as various types of reserves such as Revaluation reserve, unclosed deserve, hybrid instruments and subordinated term debt.

whereas loan advanced are shown on asset side. And risk associated to it is based on prior payment by those debtors. This is asset is thus known as risk weighted assets.