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Opinions of Thursday, 19 May 2005

Columnist: Ampong, Kwabena Owusu

Capital Reserve Requirements in Banks. Part I

(Using the Value-at-Risk measure for the banking system in Ghana)

The Banking Act, 2004, which has passed through parliament indicates that: ?A bank shall at all times while in operation maintain a minimum capital adequacy ratio of ten per cent?The capital adequacy ratio shall be measured as a percentage of the adjusted capital base of the bank to its adjusted asset base in accordance with Regulations made by the Bank of Ghana.?

The central bank (Bank of Ghana) is concerned about the possibility of a banking crisis resulting from the lack of adequate foresight in the actions of an individual bank. A bank?s capital reserves can fall dangerously too low and thus fail to meet the operational requirements of its customers. The panicked customers will rush to the bank to cash their accounts. The bank will obviously not be able to meet this demand, since banks generally don?t keep customers? money lying idle in safes. This will create a ripple effect and reverberate the panic through the whole banking sector. With everybody rushing to the banks to cash their money, there will be a banking sector collapse which will fuel an economic recession. But this scenario is not likely at the moment, since the Bank of Ghana has adequate mechanisms to nib this kind of problem in the bud.

Prescribing the same type of medicine for all ailments (as is allegedly done by the IMF) can have considerable downsides. Some banks might need a higher capital adequacy requirement, whiles others might need something much lower. In nominal terms, 10% capital requirement for, say, Barclays Bank could be the market capitalization of about 5 Rural Banks combined. At this time, when funds are needed for investments to boost economic productivity, tying these funds unduly in ?untouchable? capital requirements will stifle the capacity of the private sector to source badly needed capital. If the risk of financial distress in, for example, Barclays is fairly low, then Barclays need not be required to lock up such a huge amount of money outside the reach of investors - their capital requirements can be much smaller. In such a situation, the Bank of Ghana can still maintain the objectives of its regulatory oversight responsibility whiles at the same time releasing more money into the system for investments.

It is exclusively imperative that a careful look is taken of the factors which go into the formulation of this capital requirement obligation. In any business environment, there are basically two types of risks; financial risk and business risk. In the banking system, financial risk is categorised into market risk, credit risk and liquidity risk, whiles the business risk is made up of operational risk, trade risk and strategic risk. Of course, risk is risk, but it is the financial risk, which is very significant for the decision making about capital requirements, since it has a market component. But then, financial risk is idiosyncratic or bank specific, due to the fact that bankruptcy costs are specific to a firm.

The magnitude of the impact of different risk factors, felt by different firms vary. For example if we look at credit risk, the profile of investors who borrow from small banks is likely to be very different from those who can borrow from large banks. Small banks might therefore face different levels of default risk than large well established banks. In much the same way, small banks can run into a liquidity crisis fairly easily by making just one or two misguided decisions than big banks.

It is quite obvious, that how much a bank should keep in capital reserves, must be determined by the specific risk conditions that the bank faces. It might therefore not be optimal to prescribe the same capital requirement ratios for all banks. Finding what the appropriate capital requirements should be for banks has never been easy. It is always difficult to make projections to deal with variables which are stochastic in nature, especially when you cannot model with certainty, how other underlying factors may affect your variable under consideration. For example, due the general drop in airlines passenger numbers after the September 11 attacks in the US, a lot of airlines run into steep debts and fuel prices dropped significantly in the wake of that event. No one could factor this into prior decision making.

In recent years, Value-at-Risk (VaR) has been acclaimed as the single most important risk measurement tool. VaR is a measure of the maximum loss on a portfolio, expected from ?normal? market movements, over a certain time interval, with a certain degree of confidence. VaR is particularly useful because it can be used to measure firm-wide risk. VaR is now widely used not just among banks, but by other financial and non-financial companies.

? to be continued

Kwabena Owusu Ampong
BSc Engineering, KNUST, Ghana
Master?s in International Business, NHH, Norway
Candidate for MSc in Financial Economics, BI NSM, Norway

Views expressed by the author(s) do not necessarily reflect those of GhanaHomePage.