What are the components of Tier-1 and Tier-2 capital according to Basel Accord?

 

Capital requirement is categorized into three tiers:

 1. Tier-1 capital called "Core Capital comprises of highest quality of capital elements:

a) Paid-up capital

b) Non-repayable share premium account

c) Statutory reserve

d) General reserve

e) Retained earnings

f) Minority interest in subsidiaries

g) Non-cumulative irredeemable preference shares

h) Dividend equalization account

 2. Tier-2 capital called 'Supplementary Capital represents other elements, that fall short of some of the characteristics of the core capital but contribute to the overall strength of a bank:

a) General provision

b) Revaluation reserves - Fixed assets - Securities - Equity instrument

c) All other preference shares

d) Subordinated debt

 3. Tier-3 capital called Additional Supplementary Capital, consists of short-term subordinated debt (original maturity 2 to 5 years) would be solely to meet a proportion of the capital requirements for market risk.

 

Discuss the methods of measuring CAR (Capital adequacy ratio), ROA (Return on assets), and EPS (Earnings per share).

To calculate CAR, banks are required to calculate their Risk Weighted Assets (RWA) in respect of credit, market, and operational risks. Total RWA will be determined by multiplying capital charge for market risk and operational risk by the reciprocal of the minimum CAR and adding the resulting figures to the sum of risk weighted assets for credit risk. The CAR is calculated in the following ways:-

 CAR (Tier 1 Capital Tier 2 Capital)/Risk-Weighted Assets

 The Bank separates capital into Tier 1 and Tier 2 based on the function and quality of the capital. Such as: -

 ·        Tier 1 capital is the primary way to measure a bank's financial health. It includes shareholder's equity and retained earnings, which are disclosed on financial statements. As it is the core capital held in reserves, Tier 1 capital is capable of absorbing losses without impacting business operations.

 ·        On the other hand, Tier 2 capital includes revalued reserves, undisclosed reserves, and hybrid securities. Since this type of capital has lower quality, is less liquid, and is more difficult to measure, it is known as supplementary capital.

 The bottom half of the equation is risk-weighted assets. Risk-weighted assets are the sum of a bank's assets, weighted by risk Banks usually have different classes of assets, such as cash, debentures, and bonds, and each class of asset is associated with a different level of risk.

 Safe asset classes, such as government debt, have a risk weighting close to 0%. Other assets backed by little or no collateral, such as a debenture, have a higher risk weighting. This is because there is a higher likelihood the bank may not be able to collect the loan. Different risk weighting can also be applied to the same asset class.

 For example, if a bank has lent money to three different companies, the loans can have different risk weighting based on the ability of each company to pay back its loan.

 ROA is calculated by dividing a firm's net income by the average of its total assets. It is then expressed as a percentage. Net profit can be found at the bottom of a company's income statement and assets are found on its balance sheet. ROA can be used by management, analysts, and investors to determine whether a company uses its assets efficiently to generate a profit.

ROA is calculated by dividing a company's net income by its total assets. As a formula, it's expressed as:

ROA =  Average Total Assets/Net Income

 (ROA) helps investors measure how management is using its assets or resources to generate more income. It's important to compare companies of similar size and industry.

 Earnings per share (EPS), also called net income per share, is a market prospect ratio that measures the amount of net income earned per share of stock outstanding. In other words, this is the amount of money each share of stock would receive if all of the profits were distributed to the outstanding shares at the end of the year.

 Earnings per share or basic earnings per share is calculated by subtracting preferred dividends from net income and dividing by the weighted average common shares outstanding. The earnings per share formula looks like this.

 Earnings per Share= (Net Income- Preferred Dividends )/ End-of-Period Common Shares Outstanding

 Earnings per share is the same as any profitability or market prospect ratio. Higher earnings per share is always better than a lower ratio because this means the company is more profitable and the company has more profits to distribute to its shareholders.

 Although many investors don't pay much attention to the EPS, a higher earnings per share ratio often makes the stock price of a company rise. Since so many things can manipulate this ratio, investors tend to look at it but don't let it influence their decisions

What is the Capital Adequacy Ratio (CAR)? Do you think our banks are maintaining CAR as per Bangladesh Bank requirements?

 Capital Adequacy Ratio is also known as Capital to Risk Assets Ratio, It is the ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and comply with statutory Capital requirements. It is a measure of a bank's capital.

 ·        The Capital Adequacy Ratio (CAR) helps make sure banks have enough capital to protect depositor’s money 

·        The formula for CAR is: (Tier 1 Capital + Tier 2 Capital)/Risk-Weighted Assets 

·        Capital requirements set by the BB have become stricter in recent years.

 A bank that has a good CAR has enough capital to absorb potential losses. Thus, it has less risk of becoming insolvent and losing depositors' money.

 Basically, the Banking sector in Bangladesh has maintained the lowest capital adequacy ratio (CAR) than other South Asian countries-India, Pakistan and Sri Lanka. The stability report says the capital adequacy ratio (CAR) of the banking industry stood at 11.6% at the end of December 2020, which was 10.5% a year earlier.

 The low capital adequacy ratio is the direct consequence of the banks' default loans as the banks had to keep their provisioning against default loans.

 According to the BB guidelines on risk-based capital adequacy, banks have to maintain a minimum capital adequacy ratio (CAR)-which is a bank's capital reserve to cover their risk exposure of 12.50% by 2020, in line with the BASEL III requirement.

The overall capital adequacy ratio (CAR) in the overall banking sector was not bad at all but the state-run banks and some new banks capital adequacy ratio was not good owing to their high amount of non-performing loans.

The reason minimum capital adequacy ratios (CARs) are critical is to make sure that banks have enough cushion to absorb a reasonable amount of losses before they become insolvent and consequently lose depositors' funds. The capital adequacy ratios ensure the efficiency and stability of a nation's financial system by lowering the risk of banks becoming insolvent. Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations. Banks have to maintain CAR on a solo basis as well as on a consolidated basis as per instruction(s) given by BB from time to time. Banks can increase their regulatory capital ratios by either increasing their levels of regulatory capital (the numerator of the capital ratio) or by decreasing their levels of risk-weighted assets (the denominator of the capital ratio).

Describe the objectives of issuing Basel-III related documents by the Basel Committee on Banking Supervision (BCBS).

 The Basel Committee on Banking Supervision (BCBS) issued several documents related to Basel III, which is a set of international regulatory standards for banking institutions. The objectives of issuing these documents are as follows:

 1. Strengthening Bank Capital and Liquidity: One of the primary objectives of Basel III is to enhance the resilience of banks by strengthening their capital and liquidity positions. The documents issued by the BCBS outline the minimum capital requirements, including the common equity tier 1 (CET1) capital ratio, capital conservation buffer, and countercyclical buffer. These requirements aim to ensure that banks maintain an adequate level of capital to absorb losses during periods of financial stress and maintain liquidity to support their operations.

 2. Enhancing Risk Management and Governance: Basel III documents emphasize the importance of robust risk management and governance practices within banks. They provide guidelines for implementing effective risk management frameworks, including risk identification, measurement, monitoring, and control. The documents also highlight the need for strong corporate governance, risk committees, and independent risk oversight to ensure prudent and effective risk management practices.

 3. Introducing Leverage Ratio: Basel III introduced a leverage ratio as an additional measure to limit excessive leverage within banks. The BCBS documents define the leverage ratio and establish a minimum threshold to prevent banks from relying excessively on debt financing. The leverage ratio complements the risk-based capital requirements and serves as a backstop measure to capture risks not adequately captured by the risk-weighted approach.

 4. Addressing Systemic Risk and Too-Big-to-Fail Institutions: Basel III documents aim to address systemic risk and reduce the likelihood of bank failures with significant impacts on the overall financial system. They introduce additional requirements for systemically important banks, including higher capital buffers, enhanced liquidity standards, and recovery and resolution planning. These measures seek to mitigate the risks associated with "too-big-to-fail" institutions and promote financial stability.

5. Improving Risk Disclosure and Transparency: Basel III emphasizes the importance of transparent and consistent reporting of banks' risk profiles and capital adequacy. The BCBS documents provide guidance on risk disclosure requirements, including the disclosure of key risk metrics, risk management policies, and capital adequacy information. Improved risk disclosure enhances market discipline, facilitates informed decision-making by stakeholders, and promotes a more transparent and stable banking system.

 6. Promoting International Coordination and Consistency: The BCBS documents promote international coordination and consistency in banking regulations to avoid regulatory arbitrage and ensure a level playing field among banks globally. They provide a framework for aligning regulatory approaches across jurisdictions and fostering cooperation among supervisory authorities. This international harmonization enhances the effectiveness and efficiency of prudential supervision and contributes to the stability of the global banking system.

 Overall, the objectives of issuing Basel-III-related documents by the Basel Committee on Banking Supervision include strengthening banks' capital and liquidity positions, enhancing risk management practices, addressing systemic risk, promoting transparency and international coordination, and ultimately improving the stability and resilience of the global banking sector.

Explain the major guidelines of Bangladesh Bank's management of capital of BASEL III and BASEL-III. Or discuss the main features of BASEL III

 Basel II is a set of international banking regulations put forth by the Basel Committee on Bank Supervision, which leveled the international regulation field with uniform rules and guidelines.

Basel II provides guidelines for the calculation of minimum regulatory capital ratios and confirms the definition of regulatory capital and an 8% minimum coefficient for regulatory capital over risk-weighted assets. Basel II divides the eligible regulatory capital of a bank into three tiers.

The higher the tier, the less subordinated securities a bank is allowed to include in it. Each tier must be of a certain minimum percentage of the total regulatory capital and is used as a numerator in the calculation of regulatory capital ratios.

The major guidelines regarding capital management are as pointed out below:

1. Tier-1 Core Capital:

a) Paid up capital

b) Non-repayable share premium account

c) Statutory reserve

d) General reserve

e) Retained earnings

f) Minority interest in subsidiaries

g) Non-cumulative irredeemable preference shares

h) Dividend equalization account

2. Tier-2 Supplementary Capital:

a) General provision

b) Revaluation reserves - Fixed assets

c) All other preference shares

d) Subordinated debt

3. Tier-3 Additional Supplementary

Short-term subordinated debt that an original maturity of 2 to 5 years.

4. Foreign banks operating:

a) Tier-1 consists - Funds from head office - Remittable profit retained - Other items approved by BB

b) Tier-2 consists- General provision borrowing from head office in foreign currency Revaluation of securities - Other items approved by BB.

5. Conditions of maintaining capital:

a) Tier-2 will be limited to 100% of amount of Tier-1

b) 50% of revaluation reserves for fixed assets & securities eligible for Tier-2

c) 10% of revaluation reserves for equity instruments eligible for Tier-2

d) Subordinated debt should limited up to 30% of the amount of Tier-1

e) Limitation of Tier 3: 28.5% market risk needs to support by Tier-1. Market Risk support from Tier-3 should up to 250% of Tier-1

The Basel III accord is a set of financial reforms that was developed by the Basel Committee on Banking Supervision (BCBS), with the aim of strengthening regulation, supervision, and risk management within the banking industry.

Key Principles of Basel III

1. Minimum Capital Requirements: The Basel III accord raised the minimum capital requirements for banks from 2% in Basel II to 4.5% of common equity, as a percentage of the bank's risk-weighted assets. There is also an additional 2.5% buffer capital requirement that brings the total minimum requirement to 7%. Banks can use the buffer when faced with financial stress, but doing so can lead to even more financial constraints when paying dividends.

As of 2015, the Tier 1 capital requirement increased from 4% in Basel II to 6% in Basel III. The 6% includes 4.5% of Common Equity Tier 1 and an extra 1.5% of additional Tier 1 capital. The requirements were to be implemented starting in 2013, but the implementation date has been postponed several times, and banks now have until January 1, 2022, to implement the changes.

2. Leverage Ratio: Basel III introduced a non-risk-based leverage ratio to serve as a backstop to the risk-based capital requirements. Banks are required to hold a leverage ratio over 3%. The non-risk-based leverage ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of a bank.

To conform to the requirement, Central Bank fixed the leverage ratio at 5% for insured bank holding companies, and at 6% for Systematically Important Financial Institutions (SIFI).

3. Liquidity Requirements: Basel III introduced the usage of two liquidity ratios the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The Liquidity Coverage Ratio requires banks to hold sufficient highly liquid assets that can withstand a 30-day stressed funding scenario as specified by the supervisors. The Liquidity Coverage Ratio mandate was introduced in 2015 at only 60% of its stated requirements and is expected to increase by 10% each year till 2019 when it takes full effect.

On the other hand, the Net Stable Funding Ratio (NSFR) requires banks to maintain stable funding above the required amount of stable funding for a period of one year of extended stress. The NSFR was designed to address liquidity mismatches and will start becoming operational in 2018.

How can a commercial bank reconcile conflicting objectives in the case of asset management?

 Asset management is the practice of increasing total wealth over time by acquiring, maintaining, and trading investments that have the potential to grow in value. It is a practice meant to improve wealth over time by acquiring, maintaining, and trading investments that can potentially grow in value.

 Like every other business, the prime motive for commercial banks lies in profit through the mobilization of existing of asset management. Banks extend loans and buy securities to increase their profits as the loans and securities will help them earn interest payments, increasing their earnings.

 However, another goal for commercial banks is safety. Safety depends on the liquidity of the banks. The higher the liquid assets (cash and excess reserves), the stronger the security of the banks because it assures the public that the banking system is steady. There is no need for panic withdrawals.

 To maintain higher liquidity, banks will have to minimize the loans and purchase of securities which will sacrifice their profit.

 Deposits and withdrawals are not the goals of commercial banks. Also, both the processes go hand-in-hand. If deposits decline, it automatically means a decrease in withdrawals. Similarly, assets and liabilities also move together. An increase in assets implies a decline in the bank's liabilities as the two are seen in relative terms to each other.

 Banks have to make decisions on which proportion of these assets described above to choose to make profits and maintain liquidity. They do not have free choice, because a great part of their liabilities is controlled by Bangladesh Bank. On the other hand, if one bank gets into difficulties, other banks will help it, because the collapse of one bank will affect the trust of all the banking system.

 From the essay, it seems that it is quite hard to reconcile profitability and liquidity as part of asset management. It requires many predictions, but looking at the banks' buildings and the wealth of bank managers, it seems that they are managing very well.

 Therefore, liquidity and profitability of asset management are two contradictory goals for commercial banks

Discuss the relationship between liquidity and profitability of a commercial bank.

Profitability is the ability of a business to generate earnings as compared to its expenses and other relevant costs incurred for the period. For a firm to continue existing as a going concern, it will largely depend on its ability to generate profit or even attract equity capital and additional investors.

 Profitability means the ability to generate profit from all the business activities of an enterprise, firm, company, or organization. In banks, profitability is termed as the ability to generate revenue over costs, about the capital base.

 Liquidity is necessary in obtaining financial performance, maintaining and improving the market share of an entity.

·        There is an inverse relationship between profitability and liquidity. The higher the liquidity the lower will be the profitability and vice versa. Liquidity and profitability are competing goals for the Finance Manager.

·        By increasing profitability, there is the probability of reducing a firm's liquidity and an extensive interest on liquidity would tend to affect the profitability. A firm will not be able to fulfill its immediate obligations when it is making low profits due to the high liquidity that it gains. This will mean that funds are held in non-liquid assets and cannot be used for productive activities, hence lowering the profitability.

·        Financial expert indicates that a dilemma in liquidity management is finding a balance between liquidity and profitability since these two are inversely associated, and thus profits diminish with an increase in liquidity and vice versa.

 Moreover, holding liquid assets could improve a bank's profitability since this affects banks' profitability.

 

How do you manage liquidity risk in the banking sector?

Managing liquidity risk in the banking sector is crucial to ensure the bank's ability to meet its financial obligations and maintain stability. Here are some key practices and strategies employed by banks to manage liquidity risk:

 1. Liquidity Risk Assessment: Conduct regular and comprehensive assessments of liquidity risk by analyzing cash flow projections, funding sources, and potential liquidity needs under various scenarios. Identify liquidity gaps and stress test the bank's liquidity position to evaluate its resilience in adverse conditions.

 2. Liquidity Policies and Frameworks: Establish robust liquidity policies and frameworks that outline the bank's liquidity risk tolerance, funding strategies, liquidity contingency plans, and monitoring mechanisms. These policies should align with regulatory requirements and the bank's risk appetite.

 3. Diversification of Funding Sources: Maintain a diversified funding base to reduce reliance on a single source of funding. This includes attracting retail and corporate deposits, accessing interbank markets, issuing debt securities, and establishing committed credit lines with reputable counterparties. Diversification enhances the bank's ability to access funding in various market conditions.

4. Liquidity Buffer: Maintain an adequate liquidity buffer in the form of liquid assets that can be quickly converted into cash without significant loss. This buffer provides a cushion during times of liquidity stress or unexpected cash outflows. Commonly held liquid assets include government securities, highly rated corporate bonds, and cash reserves.

 5. Cash Flow Management: Implement effective cash flow management practices to optimize the timing of cash inflows and outflows. This involves closely monitoring cash flow projections, managing operational cash flows, and coordinating with business units to align funding needs with available resources.

 

6. Contingency Funding Plan (CFP): Develop a comprehensive CFP that outlines strategies and actions to be taken in the event of a liquidity crisis or disruption. The plan should identify potential sources of additional liquidity, including access to emergency borrowing facilities, asset sales, or central bank liquidity support.

 7. Stress Testing and Scenario Analysis: Conduct regular stress tests and scenario analyses to assess the impact of adverse events on the bank's liquidity position. This helps identify vulnerabilities, evaluate the adequacy of liquidity buffers, and refine liquidity management strategies.

 8. Regulatory Compliance: Stay updated with applicable liquidity risk regulations and ensure compliance with liquidity reporting requirements. Banks are typically required to maintain specified liquidity ratios, such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), which aim to ensure sufficient liquidity buffers and stable funding sources.

 Managing liquidity risk requires a proactive and comprehensive approach, integrating sound risk management practices, effective governance, and continuous monitoring. Banks must strike a balance between profitability, liquidity, and risk considerations to maintain financial stability and meet their obligations in different market conditions

Liquidity Management is a dilemma for the Treasury Manager of a bank. Do you agree? Explain

 Liquidity management is the process of ensuring that a bank has enough cash and liquid assets to meet its obligations and fund its operations. A treasury manager is responsible for managing the liquidity position of a bank, as well as its interest rate risk, foreign exchange risk, and capital adequacy.

Liquidity management can be a dilemma for a treasury manager of a bank because of the trade-off between profitability and liquidity. On one hand, a bank needs to maintain a high level of liquidity to avoid liquidity crises, meet regulatory requirements, and satisfy customer demand for withdrawals and loans. On the other hand, a bank wants to invest its excess liquidity in profitable assets, such as loans, securities, and derivatives that generate higher returns than holding cash or low-risk liquid assets.

Therefore, a treasury manager of a bank has to balance the liquidity risk and the opportunity cost of liquidity, while also considering the market conditions, the bank's strategy, and the expectations of the stakeholders. This can be a challenging task, especially in times of financial stress or uncertainty, when the liquidity demand and supply can fluctuate unpredictably.

Some possible ways to address this dilemma are:

Implementing a liquidity management framework that defines the liquidity objectives, policies, limits, and contingency plans for the bank.

Developing a liquidity forecasting system that monitors the cash inflows and outflows, and identifies the potential liquidity gaps and surpluses.

Diversifying the sources and maturities of funding, and maintaining a buffer of high-quality liquid assets that can be easily converted into cash in case of liquidity shocks.

Optimizing the asset-liability management, and aligning the interest rate and currency profiles of the assets and liabilities to reduce the liquidity mismatch and the exposure to market risk.

Enhancing the liquidity risk management, and conducting regular stress tests and scenario analyses to assess the impact of various liquidity events on the bank's liquidity position and performance.

 In summary, liquidity management presents a complex set of challenges for treasury managers, requiring a delicate balance between maintaining sufficient liquidity to meet short-term obligations, optimizing returns on excess funds, and complying with regulatory requirements. The ever-changing financial landscape and the need for swift decision-making add to the dilemmas faced by treasury managers in addressing liquidity-related concerns.

Why are financial institutions concerned with liquidity

 Liquidity risk occurs when an individual investor, business, or financial institution cannot meet its short-term debt obligations. The investor or entity might be unable to convert an asset into cash without giving up capital and income due to a lack of buyers or an inefficient market. Banks and financial institutions are particularly vulnerable to this kind of liquidity problem because much of their revenue is generated by lending long-term loans for home mortgages or capital investments and borrowing short-term from depositor's accounts.

 A liquidity crisis indicates a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM). It can affect the entire financial ecosystem and even the global economy.

Financial institutions faced the following threats during the liquidity crisis that's are given below:

· The liquidity risk of banks arises from funding long-term assets with short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.

·  The liquidity risk is closely linked to other dimensions of the financial structure of the financial institution, like the interest rate and market risks, its profitability, and solvency, for example.

·  Having a larger amount of liquid assets or improving the matching of asset and liability flows reduces the liquidity risk, but also its profitability. This relationship also operates in the opposite direction: loans in an irregular situation will impact jointly on profitability and liquidity, as the expected cash flows do not appear.

·  Liquidity spreads have an impact on banks' earnings. The degree of impact depends on the sensitivity of the client rates on deposits and loans towards the liquidity spread movements.

·        Excess Liquidity creates interest risk and vulnerable fund management

 

The General Objectives of Cash Management are to plan, Monitor & manage liquid resources-Discuss this comment in relation to the cash management policy of a commercial bank in bd.

 In Bangladesh, the general objectives of cash needs management, as mentioned in the comment, hold true for commercial banks' cash management policy. Cash management is a crucial aspect of banking operations in Bangladesh, and commercial banks must plan, monitor, and manage their liquid resources effectively to ensure operational efficiency and regulatory compliance. Let's explore this further:

1. Planning: Bangladesh's Commercial banks must develop a comprehensive cash management policy that aligns with their business goals its cash resources, including cash planning, forecasting, and determining optimal cash levels. Planning helps banks anticipate their cash needs, account for liquidity regulations, and establish guidelines for maintaining adequate reserves.

 2. Monitoring: Regular monitoring of cash flows and liquidity positions is vital for commercial banks in Bangladesh. Monitoring involves closely tracking cash inflows and outflows, analyzing cash forecasts, and evaluating the accuracy of projections. By monitoring their cash positions, banks can identify any liquidity gaps, manage cash outflows effectively, and address deviations or risks promptly. Monitoring also helps banks comply with the liquidity requirements imposed by the Bangladesh Bank, the central bank of Bangladesh.

 3. Managing Liquid Resources: Effective management of liquid resources is a core objective of cash management for commercial banks in Bangladesh. Banks need to maintain appropriate levels of cash reserves to meet their day-to-day operational needs, honor customer withdrawals, and fulfill regulatory obligations. Managing liquid resources also entails optimizing the utilization of available cash through prudent investment strategies, such as investing in short-term money market instruments or government securities. By managing their liquid resources efficiently, banks can strike a balance between liquidity and profitability.

 Commercial banks in Bangladesh operate within a regulated framework set by the Bangladesh Bank. They must comply with liquidity ratios, reserve requirements, and other directives to maintain stability in the banking sector. The cash management policy of commercial banks in Bangladesh needs to consider these regulatory guidelines and ensure adherence to them. Furthermore, technological advancements and the rise of digital banking in Bangladesh have introduced new dimensions to cash management. Banks need to embrace digital solutions for cash  management, including online banking platforms, mobile banking services, and real-time transaction monitoring. These technologies enable banks to improve their cash management processes, enhance operational efficiency, and provide customers with convenient cash management solutions.

 In conclusion, the general objectives of cash management mentioned in the comment hold significant relevance to the cash management policy of commercial banks in Bangladesh. Planning, monitoring, and managing liquid resources effectively enable banks to maintain liquidity, comply with regulatory requirements, and optimize cash flows to support their operational stability and growth. Embracing technology-driven solutions is also crucial for efficient cash management in the evolving banking landscape of Bangladesh.