Why capital adequacy requirement is important for banks

Why capital adequacy requirement is important for banks
The Central Bank of South Sudan outer view (photo credit: courtesy)

Bank capital risk should not be treated lightly because it may affect the whole economy. In other words, excess credit, interest risk, and operational risk could result in a bank’s having insufficient capital to meet losses resulting from loan losses. It may even run short of cash in some cases.

The important reason why the Central Bank imposes capital adequacy is simply to safeguard the economy and the customer’s deposits, prevent panic withdrawals that may cause a lack of confidence in the banking industry in the country, and influence the functions of a discount window where banks can borrow money from and safeguard confidence in the banking system.

This article addresses the proposal that we need the central banking system to function independently. Banks need to have several reserves for prudential purposes. If a bank fails to meet its minimum desired level of reserve assets, it may have to turn away customers and loan seekers and other obligations that fall due.

In this case, the bank has to seek additional reserve assets, and that is why the Central Bank sometimes imposes capital adequacy on banks. A wise bank may try to control its operations by raising or decreasing interest rates on loans. That is to say, high interest rates would scare the borrowers away while the lower rates may attract borrowers.

The purpose of officially imposing reserve or capital requirements is to effectively safeguard customers’ money in the case of a bank run. Therefore, the regulatory bank has the authority and responsibility to set policies to regulate the operations of the commercial banks in the country.

This is by imposing a capital requirement to a certain limit to safeguard the interests of the depositors in the case of insolvency, foreseeing the performance of every bank in the country and ensuring that all contracts in any form are honoured.

This is to mean that there is a payment of dividends to shareholders, a payment of interest on savings deposits to customers, and regulation of the charge imposed on customers. The other crucial area is the bank tariff.

It is prudent to ensure that the banks state clearly their dividend policy because this will influence investors to invest in these banks as long as the price for that investment is paid. 

There is also the Bank Run, a situation where there are roamers that the bank has run out of money, and as a result, everyone who has money in the bank will only run to ask for his or her money at a go. This is important to be prevented for confidence purposes or to build economic confidence.

In Some cases, if the bank cannot meet the capital requirement imposed by the Central Bank, that bank has a number of options to choose from and they include the following: borrowing from a discount window, requesting the un-paid shares from shareholders if any or issuing new shares and seeking the Lender of the Last Resort facility from the central bank and retained profits if any.

If all these failed, the Central Bank may advise the bank to take one of these options: seeking a merger with another sister bank.

The problem with this option includes the importation of corrupt practices and incompetence from one of these banks, inheritance of nepotism from one of the banks merged, and the liquidation of the entire bank. 

This option is not advisable because it sends a wrong signal to the whole economy about the financial institutions in the country and that will scare the investors.

Of course, it is the prerogative of any Central Bank to make sure that its decisions do not affect or create panic in the financial economy. Hence, in financial markets, words influence changes either negatively or positively.

– Dr Moyi Harry Ruben is an acting Managing Director at Ivory Trading and Investment Company