Credit Risk and Capital Adequacy of Banks

Abstract

Prudential regulation of banks and financial institutions, especially the stipulation of risk weighted capital adequacy ratio, has brought into sharp focus their inherent weaknesses. The real licence to expand banking is no more a nod from the regulator than the adequacy of capital backup. The situation is getting complex with deregulation and globalisation wherein the inherent risks especially the credit risk and market risk, need to be covered by proper capital adequacy ratio. Asset managers have to be always alert about the inherent risk and return embedded in any proposed asset accretion. Even before stabilising with an adequate CAR, banks are required to gear up with the proposed and more rigorous new capital adequacy framework of Basle Committee. Instead of confining to centralised approach, the banks can plan and monitor continuously asset expansion at zonal/regional and branch levels with a notional concept of capital adequacy. While pricing the assets, especially in a decentralised process of decision making in the form of both fund based and non-fund based exposures, cost of capital for any additional exposure needs to be taken care in the relevant computations. Ultimately the scope for healthy and sustainable growth of any bank depends upon its competitiveness to attract capital which in turn depends upon the economic value added, i.e., return on capital net of opportunity cost of such capital. Now that the government has almost stopped further infusion of capital into (public sector) banks, are the banks capital market fit?