A key concept in banking regulation is the provision of standards or guidelines by regulators to prevent financial institutions from incurring risk-weighted assets (loans) beyond their respective risk management capacity and capital adequacy. Simply put, a capital adequacy ratio ('CAR') is expressed as a ratio of a bank's equity to its credit exposures. According to the Central Bank of Nigeria (CBN) Guidance Notes on Regulatory Capital, (herein referred to as "CBN Guidance Note") CAR refers to the proportion of the bank's qualifying capital or Equity in relation to its risk weighted assets. It is used by financial regulators to ensure that banks have sufficient capital to absorb losses in order to avoid insolvency, loss of depositors' fund and bolster confidence in the financial system.
According to CBN Guidance Note, to determine a bank's CAR, the CBN (being the financial regulator), must first ascertain, from its balance sheet, the bank's total capital. This is derived by a summation of the bank's Tier 1 Capital (comprising of its paid-up share capital, stocks, retained profits, share premiums, etc.) and Tier 2 Capital (comprising of its revaluated debts [recently valued tangible assets], general loan-loss reserve [sum set aside to service outstanding debts], capital instruments, subordinated debts etc.,). Thereafter, the ascertained capital is divided by the bank's total credit exposures (its loans, performance bonds, losses carried forward from the previous financial year, etc.,). A percentage of the ascertained figure, which is currently pegged at 10%/15% depending on whether the Bank is a Systematically Important bank or not, is referred to as the Bank's CAR.
The CBN also takes into account relevant risk factors and the internal capital adequacy assessments of each bank to ensure that the capital held by banks are sufficient to absorb its overall risk profile. Thus, where a bank's capital (summation of tier 1&2 less risk-weighted assets) fails to meet its CAR, the CBN is at liberty to take definite measures to ensure the bank shores up its capital to comply with the required prudential ratios. Such measure includes prohibiting the bank from advertising, accepting new deposits, or making new investments. It can also, in extreme cases lead to the revocation of the Bank's license.
Whilst it remains the case that a failure to meet CBN's CAR does not presuppose that a bank is unable to meet its long term financial obligation to its creditors when it falls due (insolvency), it is important to say that such failure entails that the affected bank is currently unable to meet its short-term financial obligations (liquidity risk); thereby putting depositor's funds at risk. Where such inability persists over a long period of time, it could ultimately lead to bank runs as most depositor's may decide to withdraw funds en masse upon suspicion that the said bank is in distress. The effect of this would mean that such bank will ultimately loose its major source of funding (depositor's funds) and consequently become insolvent at the long run. This in itself may invariably lead to a contagion and consequently have a ripple effect on the economy.
To avoid such occurrence, the CBN may beyond issuing statements of comfort to the public, consider proactive ways in which banks can conveniently trade their risk-weighted assets to generate capital.
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