Question

What is the relationship between a bank’s capital ratio and the risks and returns faced by (i) its depositors and (ii) its shareholders? Explain your answers

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Answer 1

The bank's capital ratio also known as capital adequacy ratio (CAR) measures the amount of capital a bank retains compared to its risk.It is the ratio of a bank’s capital in relation to its risk-weighted assets and current liabilities. It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process. It measures how much capital does a bank has with it as a percentage of its total credit exposure. Bank regulators enforce this ratio to ensure credit discipline in order to protect depositors and promote stability and efficiency in the financial system.The formula used to measure Capital Adequacy Ratio is = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets)
Two types of capital are measured with the CAR. The first, tier 1 capital, can absorb a reasonable amount of loss without forcing the bank to cease its trading. The second type, tier 2 capital, can sustain a loss in the event of a liquidation. Tier 2 capital provides less protection to its depositors.

(i)An individual depositor cannot know if a bank has taken risks beyond what it can absorb. Thus, depositors receive a level of assurance from shareholder equity, along with regulations, audits, and credit ratings also for depositors it can be assumed that if the bank is maintaining higher capital adequacy it means that bank is not going to fail and is more likely to pay principal of deposits along with interests while on the other hand if bank's capital adequacy ratio is lower than it means banks can go in trouble and may fail to pay depositors their money as well interest so higher CAPITAL RATIO is assumed safe for depositors.

(ii) The relation between a bank's capital ratio and its shareholders is that a higher bank capital ratio is viewed as a safe asset that is ready to meet its budgetary needs whereas a fall in the ratio implies the portion of the benefit of investors fall.The amount of equity a bank receives from shareholders sets the limit on the value of deposits it can attract. This also limits the extent to which the bank can lend money. If a bank sustains large losses through credit or trading, eroding the bank’s net worth, this causes a decreased fund base through which a bank can offer loans.The CAR provides shareholders with a better understanding of the risks a bank is taking with the equity they provide. A bank that continually takes more risks than it can reasonably sustain leaves potential shareholders with a sense their equity investments are more at risk. A bank must maintain a professional level of risk management and sound lending practice to attract the capital that acts as its first line of defense against loss, both expected and unforeseen.

In a nutshell, higher capital ratio maintained by the bank is assumed to be safe for both depositors as well as equity shareholders...