Basel accords, capital requirements and bank risks

The balance sheet of a bank has two sides: assets and liabilities. The assets are financed by two sources of funds: debt capital (liabilities) and equity capital (owners' equity).

There was a long-standing debate regarding the amount of equity capital a bank should hold. In every country, a specific amount of capital is required to establish a bank. For example, in Bangladesh, it is Tk 500 crore. But with the passage of time, banks become involved in various risky businesses which call for increasing equity capital.

The Basel Committee on Banking Supervision developed the Basel Accords to focus on bank supervision and regulation. It mainly addressed the issue of capital regulation for the safety and soundness of banks.

In 1988, Basel I was developed to set minimum capital requirements for banks. Basel II was expanded with some new rules in 2004. Finally, Basel III was extended in response to the financial crisis of 2007-2008.

According to Basel I, the minimum capital requirement (MCR) was 8 percent of risk-weighted assets (RWA) with 4 percent of core capital. In 2002, the MCR was raised to 9 percent with an increase of core capital to 4.5 percent.

In 2011, the MCR was further raised to 10 percent with an increase of core capital to 5 percent which continued until 2015. The MCR was fixed to 12.5 percent in 2019.

Banks in Bangladesh used to maintain 6 percent of their demand and time liabilities as equity capital before adopting Basel I in 1996.

Bangladesh Bank data showed that there was a significant improvement in capital maintenance over the 1992-2022 period. The Capital Adequacy Ratio (CAR) was only 5.81 percent in 1992 and it rose to 7.5 percent in 2002.

It increased to 10.5 percent in 2012, 11.63 percent in 2020 and 11.83 percent in 2022. However, India, Pakistan and Sri Lanka maintained a ratio of 16 percent, 16.6 percent and 15.3 percent, respectively, in 2022. Among these countries, Bangladesh had the lowest capital.

Bank category-wise data indicated an outstanding improvement in the CAR of foreign commercial banks. For example, their CAR was 10.12 percent in 1992 and it reached 26.4 percent in 2022.

Private commercial banks also showed almost the same pattern. Their CAR was just 5 percent in 1992 and it jumped to 13 percent in 2022.

Although state-owned commercial banks failed almost every year to maintain the CAR, they were still improving marginally. Their CAR was 4.29 percent in 1992, 8.1 percent in 2012 and 6.4 percent in 2022.

The CAR of specialised banks stood at 6 percent in 1997 and rose to 9.10 percent in 2004. Since then, the CAR has been in negative territory except for 2009. It was negative 35.8 percent in 2022.

The Basel Committee's capital requirements are directly related to the riskiness of assets: the higher the risky assets, the higher the equity capital. However, banks should have other defences like quality management, portfolio diversification, and deposit insurance against risks at par.

Furthermore, they must disclose the riskiness of assets properly so that capital requirements become proportionate to risks. Misreporting of distressed assets may create serious equity capital risk.

The recent report shows that 11 Bangladeshi banks are suffering from capital shortfall. The number of such banks will undoubtedly increase if the volume of distressed assets reported lately by the central bank is considered.

The author is a professor and former chairman of the Department of Banking and Insurance at the University of Dhaka. He can be reached at mainuddin@du.ac.bd