Question

Capital adequacy was a major concern of bankers during the financial crisis. Give three ways that a bank can improve its capital adequacy. Then briefly explain why a “credit crunch” resulted from one of these ways.    

Answer 1

Capital adequacy is one of the major parameters in which the stability liquidity and risk metrics of a bank is measured. As per the BASEL norms all the Banks and banking institutions are required to maintain a minimum Capital adequacy as per regulatory norms in order to function properly.

Improving Capital adequacy:

1. Managing the exposure and limiting the Risk weighted Asset -

capital adequacy is mainly Tier 1 capital + tier 2 capital of the bank measured as a ratio to the risk weighed Assets in the portfolio of the bank. Managing the risky lendings in the portfolio and reducing the subsequent risk will help in improving the Capital adequacy requirements of the bank.

2. Maintaining and improving the CCB Capital conversion buffer

CCOB is an additional capital requirements which adds on to the basic Capital adequacy requirements and its a major component of Total capital managed by the bank. Maintaining a healthy ccob will help the bank to improve the CAR ratio of the reporting period and will also prevent and adverse drop in the ratio below regulatory requirements in times of uncertainty.

3.​​​​​3.Issuing additional AT1 Bonds which are Quasi equity instrument-

instead of issuing traditional debt instruments , the bank or fi may consider issuing AT1 bonds or additional tier 1 bonds which are quasi equity instruments and the investment in such can be accounted as direct injection in banks total capital in the numerator of capital adequacy ratio. Thus the capital adequacy of the banks improve.

Credit crunch.

Banks generally issue credit or cash lendings to clients based on their maximum ability to lend out the funds of the investors. When the banks runs out of enough liquidity , they need to pack the collateral debt and securitize these securities in secondary market and sell these to Investors in order to fulfill their requirements of cash. Credit Crunch occurred when the debt bubble collapsed and these secrutized assets and cdos values have sharply dropped in the secondary market leaving the banks in a highly exposed situation . The same thing happened with the largest investment banks in wall st as the value of the mortgage collateral fell , the Risk weighted Assets skyrocketed and capital adequacy ratio declined.