Capital adequacy refers to the percentage ratio of any financial institution primary capital to its assets Gallanti, 2003). These include loans and investments. Capital adequacy is used as a measure of an institution’s financial strength and stability. It is a significantly respected and controversial issue in banking. In many years, there has been a lot of discussion on the importance of capital adequacy. The recent rates of financial crisis globally have raised greater awareness of the importance of capital adequacy. Bank regulators have considered evaluation of capital adequacy by placing particular attention on its role in preventing bank failures. For markets to function efficiently, it is necessary for stakeholders to have confidence in the stability of all participants (BIS, 2006). Therefore, capital adequacy evaluation is an extremely powerful tool in fostering this confidence. It is necessary for all stakeholders in a financial community to be equipped with adequate capital. This capital adequacy must be sufficient to protect creditors and other parties from risks that a financial institution may face, and related impacts in the balance sheet.
According to the Bank of International Settlements (BIS), Capital Adequacy Standard requires financial institutions to be equipped with primary capital base that is equal to at least of percent of the total assets (BIS, 2006). This amount of capital is related to loans and other assets of financial institutions; hence, it is a requirement that all bank regulators should aim at making the financial institutions hold a certain equity minimum capital against a risk-weighted asset. Hence, the capital standards should allow firms to be able to absorb losses, or in case of dissolution, the firms can wind up without any loss to customers, the counter parties, hence preventing any disruption on the orderly functioning of the financial markets. Therefore, capital adequacy standards are extremely valuable tools in reducing systemic risk. Capital adequacy also plays a significant role in the way regulators supervise financial institutions in order to minimize risks (Gallanti, 2003).
Risk is the probability of deviation from expectations. In a business cycle, lending depositors money to borrowers may be risky if there is a possibility of debt defaults. Therefore, it is essential if banks hold a capital buffer to absorb unexpected losses, and protect their depositors and themselves. This is the basis if capital adequacy (Gallanti, 2003). As stated by Young (2006), the purpose of the risk ratios serves to help financial institutions calculate the amount of capital to hold.
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A prudent financial regulation should ensure that financial institutions have adequate minimum capital. This helps to ensure that financial institutions can repay what they owe their depositors. This can be achieved if banks have the discipline of holding to adequate capital (Gallanti, 2003). When financial institutions are under pressure to offer more impalpable financial products to their consumers in order to gain competitive advantage, they are in a position of creating more financial losses in future. A phenomenon growth of banks is depending on haphazard loans. However, most banks face inadequate capital to weather a crisis in liquidity if they possess a poor credit culture (Olger, 2007). This illustrates the importance of capital adequacy, since bankers should have a guiding principle through that provides for anticipated losses, as well as, discretion for all gains, through becoming vigilant against uncertainties, and risks to the market environment, and their fallible behaviors, as well. This became the underlying principle of capital adequacy.
Banks should aim at striking a balance between risks and the availability of capital to support such a risk. There are tradeoffs that match too much capital to a risk; this may be a less attractive return to shareholders. Hence, the opportunity costs of doing the opposite would pose threats to the banks. Therefore, banks should be equipped with capital resources towards risks and capital management. This can be achieved through capital adequacy calculations. The complexity of a minimum capital is a better reflection of banks actual risks including operational, functional, interest rates risk, reputational, compared to credit use only. However, capital requirements have become clear mechanical rules in place of application of sophisticated risk- adjusted models. In addition, there are differences in capital requirements of financial institutions and security houses. This can have negative implications in market completion in the end between types of financial institutions. Banks and their subsidiaries should be subjected regulations with respect to capital adequacy requirements. Thus, capital adequacy is an indispensable tool, as well as, an indicator of financial stability and performance of banks. The risk based capital ratios are used to evaluate capital as a measure and a percentage of combination risk factors. These factors include weighted balance sheet and other related off-balance sheet risks that are determined according to risk factors (Olger, 2007).
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Since the policies, governing the evaluation of capital adequacy applies to capital assets and equity, these factors may be overvalued since they are not always reflected in the current market conditions. Therefore, they cannot adequately assess the risk associated with every trading position. According to Bank of International Settlement, capital adequacy standards require that a capital ratio to asset ratio of central banks should be above a set minimum international standard to ensure protection from risks of all the central banks involved. This was the main role of BIS in setting capital adequacy standards (BIS, 2006).
In conclusion, implementation of capital adequacy standards is a fundamental problem faced by financial institutions, as speculative lending based on an inadequate underlying capital, which has caused a widely varying liability rules that cause economic crisis.