TCA # 6: Is Capital Adequacy Ratio (CAR) an effective tool to measure capital strength?
Leverage Ratio could be an effective primary tool to judge relative capital strength of a bank as compared to Capital Adequacy Ratio (CAR)
Thomas Hoening, a former President of Federal Reserve Bank of Kansas City and a Senior Fellow at Mercatus Center, George Mason University recently testified at the US House of Representatives regarding ‘risk weighted capital standards and their role in assuring bank resilience through the business cycle’. In the last three decades, the Basel framework for banks has been adopted by all advanced economies and most emerging economies and have come to be seen as the gold standard for bank stability. If there is one measure that epitomizes the Basel framework, it is the the Capital Adequacy Ratio (CAR) of bank capital to risk-weighted assets (of credit risk, market risk and operational risk). The CAR is the starting point of any discussion on bank stability and solvency is routinely used to ascertain solvency of banks all over the world. Today the Basel framework epitomized by CAR is considered the only game in town and following the Basel framework is considered self-evident. However, this was not always the case.
History of Bank Capital Regulations in USA
An overview of the history of bank capital regulations in the US shows that in the nineteenth century, banks in the US were prescribed a minimum level of capital and there was a restriction that labilities may not exceed a certain multiple of that capital (In the modern times, the restriction is on level of assets, not liabilities). In the early years of the twentieth century, capital regulations started focusing on being risk-sensitive as opposed to an absolute minimum level. In the 1930s, capital adequacy in the US was defined as having an asset ratio of better than one-tenth capital to total assets. In the years following the Second World War, the US Comptroller of Currency (bank regulator of federally chartered banks in US) emphasized that capital ratios were one part of a suite of tools to assess bank health. The idea was to de-emphasize the sole reliance on capital ratios and to look at bank health in a more holistic manner.
Basel Regulations
The oil shock of the 1970s and the Latin American Debt Crisis of the 1980s along with rising capital flows between countries led to a situation where large banks in different jurisdictions were subject to different rules by their national authorities which could give an unfair advantage to some large banks. Due to these concerns, Basel capital regulations were introduced in the late 1980s, with the US adopted the Basel I regulations in 1989.
The major reform that came with Basel I was that bank capital was subject to risk weights. So after Basel I, a bank would have to apportion capital based on the riskiness of their loans and a bank with a riskier loan profile would have to keep more capital as opposed to a bank with a less riskier loan profile. Since, 1989 there have been two more reforms to the Basel capital framework, the Basel II framework was implemented in 2007, allowing smaller banks to use same Risk Weighted Assets (RWAs) in Basel I - dubbed as the ‘standardized approach’ while larger banks could use an ‘advanced approach’ to calculate capital based on their internal risk models. Since, Basel II was implemented around the time of the Global Financial Crisis (GFC), this framework was deficient at inception to safeguards banks from the crisis. Resultingly, Basel III capital standards were introduced in December 2010. Like many other developing countries, Pakistan has also implemented all Basel agreements starting from Basel I in the 1990s to Basel III by 2019.
CAR and the Leverage Ratio (LR)
Each successive Basel standard has made calculation of capital adequacy more complex with inclusion and exclusion of different tiers of capital and even inclusion of sub-ordinated debt as capital. Furthermore, it has become more costly and cumbersome for both the banks and the regulators to ascertain the riskiness of banks due to complexity and opaqueness of the rules. In this regard, Thomas Hoening and Andy Haldane (ex-central banker at Bank of England) have both proposed Leverage Ratio (LR) - the ratio of equity to total assets - as a simple, understandable and efficient way to measure the owners’ stake in a bank and the ability of the bank to absorb losses and remain solvent.
While Thomas Hoening makes the case that Leverage Ratio performs better than capital adequacy ratio in crisis situations, Haldane is of the view that the capital adequacy ratio and leverage ratio should be on an equal fitting as a regulatory measure rather than the Basel III modification of capital adequacy ratio being a front stop and the leverage ratio acting as a backstop. Haldane in particular makes the case that in complex environments such as the financial system there are too many variables at play and in such environments, simple rules perform better than complex ones.
Although the Basel framework along with its capital adequacy ratios is here to stay, it is important to acknowledge that this wasn’t always the case. There is a strong case to be made for other regulatory tools such as the Leverage Ratio which will reduce complexity in implementation and made bank equity owners more accountable for their performance.