Why is capital adequacy so important?

Why is capital adequacy so important?

A lot of Czech politicians and businessmen are still calling for banks to make further (bad) loans. But since loaning money can in fact be just delayed government indebtment, these bad loans would hit taxpayers exactly the same way bad loans in the past have.
The Czech National Bank has been wrongly accused of tightening the limits of capital adequacy. But the truth is that these limits have been at the same level for the last two years, while some partly state-owned banks have been losing capital because of their own bad loans. There have also been calls to reduce the 8 percent capital adequacy limit set by the Central Bank. These are, however, just a pointless reaction to the fact that some banks have been having a difficult time staying within the limit.

Differences between capital and adequacy

At first glance, the term "capital adequacy" may seem to be redundant. Capital, it would seem, should be a sufficient indicator of the financial strength of a bank. But the two terms are actually quite different. Amount of capital represents the present value of a company, while adequacy is a measure of a bank's future.
The account value of a company shows its present value on the market, but a bank's capital is measured by the differnce between its assets and obligations. The economic term capital adequacy is a measure which analyzes a bank's risks in case of possible unfavorable developments in the external economic environment. Adequacy ensures that the bank is able to cover all future possible bank losses with stockholder equity. So, in the case of real troubles, losses would not be paid by shareholders nor by bank depositors.
The principle of capital adequacy was invented by the governors of the national banks of the G-10 countries at a conference in Basel in July 1988. The original Capital Accord set a requirement of creating capital intended for covering credit risks. This document says that the percentage of a bank's risky loans should be 8 percent of its capital. Since then, capital adequacy has become a worldwide standard used not only by G-10 countries but everywhere, including in developing countries.
In 1991, the Czech Central Bank used the Basel accord as the basis for its own capital adequacy measure. It made capital adequacy obligatory for all banks active in the Czech Republic. The majority of Czech banks were relatively weak at that time, so banks were not required to meet the 8 percent rate until as late as the end of 1996.

Consequences of reducing the limit

The Central Bank could reduce the limit of a bank's capital adequacy, but that would not help troubled Czech banks. Every bank whose capital adequacy drops below 8 percent is likely to face big problems anyway. The market views such a situation as a serious threat to a bank's financial stability and credibility. Investors would be willing to deposit money in such a bank only for the highest interest rate returns, and that would further worsen the bank's financial position.
No doubt that the public would understand that reducing the capital adequacy limit sends a bad signal to bank customers, in the end jeopardizing their deposits, too.

The simple solution

The capital adequacy of many Czech banks exceeds not only 8, but quite often even 10 percent. So the majority of banks have no problem staying over the limit. Only 10 Czech banks (most of them the big ones) operate with their capital adequacy between 8 and 10 percent.
The reason why some partially state-owned banks are losing money right now is the bad loans which they made in the past. If there are losses, they should be covered with stockholder equity. Since the state is the principal shareholder in these banks, it is responsible for the losses and therefore should pay for them. Many large loans have been granted by these partly state-owned banks, so it may be just a matter of time until the losses which originate from those bad loans are absorbed into the state budget to be covered by taxpayer money. Financing business through the banking sector is, in fact, just delayed financing using the country's budget.

Josef Jílek
Economics University in Prague
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