Capital adequacy and the finance of micro financiers

Capital is very important, not only in banking but also in other commercial sectors of the economy. For a bank, capital is simply the difference between assets (what it owns) and liabilities (what it owes). It is the networth of the institution; its value or worth to the investors. Capital is the strength behind any bank, irrespective of the kind of buildings, cars and other outward façade one may see. And this applies to both small and big banks, including microfinance banks. Generally, a strong capital base is very important to all businesses but it is more so for institutions in the banking business. This is because of the devastation that capital inadequacy in the banking sector, or even a single large banking institution, could cause to the institution and the wider economy.

A bank’s capital serves as a defence against future losses in the value of its other assets. This loss may arise from loan delinquency or other events that diminish the value of its assets. Such events are legion in good times to say nothing about an economy in retreat and assaulted by every imaginable bad. Capital therefore serves as a kind of cushion, a back stopper or defensive wall on which a bank can lean in times of need. Capital adequacy does even more for a bank. A good capital base helps to restore a bank, as much as possible, to its original strength after a financial challenge that impairs the value of its assets. This role of capital is even more relevant in the more risky sector of microfinancing, particularly at times like these.

Given the ease with which asset values can be eroded by simple policy action (market risk), such as the recent foreign exchange policy change, a strong capital base becomes an imperative. A bank is in business essentially to take risks because risk and reward are naturally intertwined. The rapid growth of the banking sector and the associated turbulence it has faced both in Nigeria (including the microfinance subsector), and elsewhere has thinned out experience and heightened the probability of occurrence of many risks. This is why the issue of capital adequacy has occupied regulators the world-wide over in the past several years.

The need for stability in the financial sector informed the different Basle arrangements and the establishment of standard Capital Adequacy Ratios (CAR) for international banks around the world. This CAR is a ratio relating a bank’s capital strength to its risk-weighted assets. A strong capital base is therefore not only a source of strength; it is a motivation and a driver of opportunities. Furthermore, a strong capital base increases the risk appetite of a bank, which makes it more aggressive and ready to take advantage of investment opportunities – a quality that may be good or bad depending on its application. This aggressiveness reinforces the risk profile of a bank thereby warranting an even stricter capital adequacy consideration.

Capital adequacy should be viewed as a principle, which simply states that a bank’s capital must match its risks. Indeed, this should be a truism. The philosophy of capital adequacy requirement is to relate a bank’s capital base that is not committed to any repayments, to its risk appetite – reflected in its risk-weighted assets. Essentially, its philosophical underpinnings are rooted in risk management. To make it effective therefore, the capital available to a banking institution has been divided into two categories or Tiers. Tier 1 Capital is essentially equity funds – more concrete and more tangible, and Tier 2 Capital, which contains some hybrid capital items and other weaker asset forms. The objective of this categorization is to ensure that real tangible capital funds or items are given greater weight in the computation of a bank’s capital. The CAR is then determined as the ratio of a bank’s Tier 1 and 2 capital to the value of its risk-weighted assets. It is a critical mark of strength or the lack of it.

The idea is that if a bank has made loans from its deposits, it should have enough flesh in its capital funds to accommodate any part of the loans that will not come back, because the depositors will surely come back. If a bank for example, has created risk assets, which are weighted to the value of N100 billion and has computed its qualifying capital assets to be a total of N30 billion, then its Capital Adequacy Ratio will be 30 per cent. There is a world standard for this ratio and all countries, including Nigeria, try to groom their institutions to play within safety margins of it.

In June 2006, the Bank for International Settlement (BIS) – a banker to central banks – introduced a new framework for the computation of capital adequacy for banks. This framework relates essentially to internationally active banks and was aimed at the stability of the international banking sector, as part of an on-going effort to improve the risk management strategies of banks. This new framework set the CAR for deposit money banks at 8 per cent. The Central Bank and the Nigerian Deposit Insurance Corporation have taken a rather proactive step by maintaining a higher ratio of 10 percent for regular banks and 15 percent for the big banks considered as Systemically Important.

It is encouraging to note that that this strong capital requirement was extended to microfinance and primary mortgage banks in the country also at 10 per cent – no kid gloves here. The regulatory authorities should be commended for painstakingly administering this vital stability pill to the lower end of the financial services spectrum – microfinance and primary mortgage banks. It is in their own interest and the benefit of their investors, as well as the general public. However, there is need to ensure consistent implementation, especially in view of the impact of the recession and new exchange rate realities on the capital funds of these institutions. Once a bank knows that it has enough room to accommodate much of the diminution of its assets that happen in the course of time, it gets emboldened to take on more transactions and make more money. Infact, there is ample research evidence that bank profitability is significantly driven by CAR in many parts of the world, including Europe, Japan and Turkey. It was found to be the most important driver of profitability in Jordan. Microfinance institutions, as financiers, should therefore endure they are properly financed, in terms of capitalization, because of its impact on their own ability to finance their clients.

In my view, the regulatory authorities have shown empathy and tactfulness in the implementation of this and similar policies without compromising standards. I think they should continue the humane approach they have adopted in the implementation of this and some other policies, which I would characterise as guided by consistency with empathy. This approach will not only ensure that regulated institutions are not unduly penalised for infractions exogenously induced, it will enhance voluntary compliance. Above all , I believe the market will be better served if operators do what is right, not because the law says so but because they understand it to be right. This kind of environment is always the best for microfinance banking.

Emeka Osuji