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"Financial stability 2002"

The Banks' Capital Adequacy and Earnings

Excess capital reserves and a good earnings capacity both help to safeguard banks and thus contribute to financial stability. Several large Danish banks have implemented capital allocation models to optimise the relationship between earnings capacity, capital base and risk profile. Such models can be good strategic tools which can enhance the banks' risk management when combined with traditional credit rating.

The banks' capital adequacy

In recent years the focus on corporate governance has increased. The desire for good governance stems from the fact that ownership and management are segregated^[1]. The management might in such case choose to pursue objectives which are not – or are only partly – shared by the owners.

Banks are mostly operated as limited companies on a par with other companies in the corporate sector. This means that owners demand the same return on invested capital as from other companies with a similar risk profile.

However, the financial sector has a special position in a macroeconomic context, and special rules and regulations apply to its companies. The most important requirement as regards banks is the capital-adequacy requirement. The current capital-adequacy requirements are based on the Basle Accord of 1988, which has been incorporated into EC directives and thus implemented in Danish law. The capital requirement sets a lower limit for the banks' ratio of capital to the sum of risk-weighted assets. The capital-adequacy rules and a number of other statutory requirements for banks have been set out to meet society's need for a stable financial sector, including the wish to protect depositors trusting commercial banks with their funds. This makes banking business unique in relation to other business. The stakeholders safeguarding the interests of society and its citizens are referred to as authorities in the following.

There may be a conflict of interests between authorities and owners, which can pose a dilemma for a bank when optimising the capital structure and risk profile.

The authorities determine the capital requirements which the bank must meet as minimum. In addition, the authorities define limits for the risks the bank may assume.

The owners set targets for the return on the invested capital and thus encourage the bank to take risks which can ensure a satisfactory return. 

Capital adequacy and profitability

The increased focus on corporate governance has accentuated the owners' interests, i.e. shareholder value. One result of this has been that a number of banks have reduced their core capital via increased dividend payments or share buy-backs. Reduction of the core capital increases the return for the owners, since it is assumed that they can obtain a better return by investing their excess capital elsewhere. By buying back shares the bank also signals to the market its adherence to the principle of shareholder value, which is expected to boost the price of its shares and thus increase its value. However, a number of Danish banks also have limits on voting rights and ownership, which does not support the target of maximising the return on capital.

It is in the interest of owners that banks are operated as efficiently as possible in order to maximise the earnings capacity. An improved earnings capacity will have a positive effect on profitability. Profitability can be a measure of the extent to which the bank is capable of generating earnings on the basis of the use of capital and the risks assumed. A good earnings capacity can act as a buffer against unexpected losses.

Since the bank's authorisation to carry out credit-institution activities may be revoked if the capital adequacy falls below the authorities' capital-adequacy requirement of 8 per cent, it is in fact the capital reserves exceeding 8 per cent which enables the bank to withstand unexpected losses.

Good earnings capacity and excess capital reserves therefore both help to safeguard the banks and thus contribute to financial stability. These are not independent sources, since the excess capital reserves may have been generated via good earnings in previous years. An improved earnings capacity may, all other things being equal, reduce the need for excess capital reserves.

On the other hand, it requires considerable resources to keep the excess capital level as close as possible to the statutory requirement. This may be one reason why small banks in particular often opt for greater excess capital reserves.

Based on 50 banks'^[2] financial statements, Chart 42 defines a measure for the banks' average earnings and capital buffers^[3] in the period 1996-2001. The earnings and capital buffers can be seen as simple indicators of earnings capacity and excess capital reserves. Considered over the whole period the Danish banks' earnings and capital buffers declined marginally. In 2001 they increased compared to 2000.

Capital allocation

The major Nordic financial groups and the largest Danish banks have implemented capital-allocation models to optimise capital utilisation in the various business areas by focusing on earnings capacity and risks.

The return in relation to the risk and thus the allocated capital can basically be improved via three parameters. Firstly, revenue can be increased, depending on the competition environment among other things. Secondly, costs can be reduced, but only to the extent that the earnings capacity is maintained. Thirdly, the risk can be adjusted, with focus on whether the risk-to-earnings ratio is appropriate. When attempting to optimise all three parameters, the bank must still take into account the statutory capital-adequacy requirement.

RAROC models^[4] constitute one type of capital-allocation model. In the following RAROC is used as a generic term for capital-allocation models where the risk-adjusted return is seen as a ratio of economic capital. Risk-adjustment of the net income can be based on several principles, and likewise there are several methods for calculating capital. The risk-adjusted return differs from the accounting return as it reflects the annual loss the bank expects to suffer on average over a longer period, e.g. a complete business cycle. The term economic capital covers the estimated capital required to cover the anticipated maximum loss within a period with a certain probability. The calculation takes into account unexpected losses in relation to various risk types, e.g. market risks, credit risks^[5] and operational risks. Economic capital is thus the bank's own assessment of the necessary capital base.

RAROC models enable calculations and comparison of the risk-adjusted return on economic capital within the individual business areas. For each business area the risk-adjusted return on economic capital must at least match the requirements set. If this is not the case for a business area, the activity may be subject to strategic review. RAROC models may help to ensure an appropriate relationship between earnings capacity, capital and risk profile within the individual business areas. In addition, RAROC models can be used for pricing products and services.

Some Nordic financial groups and Danish banks apply capital allocation models which are less sophisticated than the RAROC models, e.g. models which allocate the statutory capital.

The Basle Committee is reviewing the capital requirements for banks, and published a new consultative document to this effect in January 2001^[6]. The philosophy behind the proposed new capital-adequacy requirements is that the banks' knowledge and overview of their own risk profiles should be exploited further to improve the coherence between statutory capital reserves and economic capital. The proposed capital-adequacy requirements take greater account of the financial innovation within risk assessment and management. According to the Basle Committee's present time schedule the proposal should be finalised by the end of 2002 with implementation by 2005. It is uncertain whether this can be achieved, since a number of key elements in the proposed set of rules still need to be negotiated and settled. Judging from the present proposal, there will be many similarities between the RAROC models and the principles for determining future capital requirements.

The existing capital allocation models were implemented at a time when the economy had seen sustained high growth for some years, which may have affected the parameters used and thus yielded a too optimistic risk picture. However, the models are good strategic tools which can enhance the banks' risk management when combined with traditional credit rating.

Footnotes

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Version 1.0 Maj 2002 Nationalbanken.
Published by Danmarks Nationalbank Maj 2002, http://www.nationalbanken.dk/