Philippine Regulatory Capital

Basel Capital Accord

It has long been recognized that risks and banking goes hand in hand together. While other companies such as those in manufacturing, trading and other industrial firms are head over heels in avoiding risks, it's a different scenario for the banking sector. Banks earn money (in the form of interest earnings) by seeking risks (e.g., looking for borrower), understanding those risks (assessing the borrower) and taking them (lending to the borrower).

With risks (possibility that unexpected events will result in losses to the bank) being an inherent part of banking, one can only wonder if banks are protected from the possible adverse effects of risks taking. Is there a forcefield that shields banks from unexpected turn of events?

Frankly, there is no forcefield that can shield banks from risks the way forcefield shielded Camp Big Falcon from attacks of the Bolzanian (oh, how I miss Voltez V!). But when it's raining and we want to go out, we either use a jacket, an umbrella, or at best a raincoat to protect ourselves. Oh yes, in the banking industry, we also have something similar to those things. I'll call it CAPITAL.

Capital, Defined

For an entrepreneur, capital will simply mean the money invested in the business. An accountant layman's definition of capital would be stockholder's equity computed by summing up all of the company's assets and deducting the total of the company's liabilities. While these definitions are right, capital for banks is defined in a different way. Banks' capital is the amount held or required to be held by a financial institution to underpin the risk of loss in value of exposures, businesses etc., so as to protect the depositors and general creditors against loss.

The phrase "required to be held" emphasizes the regulated environment in which most banks all over the world operate in. While "risk of loss in value" underscores what I have discussed in the preceding

paragraph - that banks earn money by seeking risks, and taking them. While most of the time their risk taking is successful, the reality is, losses will be incurred along the way.

I mentioned earlier about jackets, umbrellas, raincoats and how the banking industry wear protective gears similar to these. The above definition of capital simply means that capital is indeed a protective gear against possible losses. Of course, in the Philippine banking system, capital is one of those protective gears that Bangko Sentral ng Pilipinas (BSP) requires banks to wear all the time. That protective gear is best described as regulatory capital or the minimum capital requirement which Philippine banks are required to hold vis-Ðo-vis its risk assets. But how do we determine which gear to wear? How do we know if banks are adequately protected? What does BSP require banks to wear - a jacket, an umbrella, or a raincoat?

BASEL Capital Accord of 1988

The approval of Republic Act No. 8791, otherwise known as the General Banking Law of 2000 (GBL 2000), paved the way for the adoption of an internationally accepted standard for capital requirements of Philippine banks. With its objective of promoting world-class banking standards and practices in the Philippine banking system, the Monetary Board (MB) in its resolution no. 285 dated February 16, 2001, approved the guidelines on the adoption in the Philippines of the BIS risk-based capital adequacy framework - the internationally accepted standard for measuring capital adequacy for G-10 member countries, and as recent events will show, for almost all developing countries.

The guidelines, which was published by the Basel Committee for Banking Supervision (Basel Committee), is more popularly known as the Basel Capital Accord of 1988 (Basel Accord). The Basel Committee for is a rule-setting institution composed of the banking supervisory authorities of the Group of 10 industrialized countries. (The G-10 countries are the United States, Germany, France, Canada, Japan, Belgium, Switzerland, Netherlands, Italy and the United Kingdom).

The guidelines, which were issued locally through Circular No. 280 dated March 29, 2001, initially covered only capital requirements for credit risks (or the risk of losses from counterparty failure). Following the major amendment made on the Basle Accord in January 1996, the MB approved the guidelines to incorporate market risk (risk of losses in on and off balance sheet positions arising from movements in market prices) in the risk-based capital adequacy framework for universal banks and commercial banks starting March 2003.

In its introductory comments, Basle Committee emphasized the two fundamental objectives that lie at the heart of the Committee's work on regulatory convergence. These are:

1) firstly, that the new framework should serve to strengthen the soundness and stability of the international banking system; and,

2) secondly, that the framework should be in fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks.

The Basel Capital Adequacy Framework

The Basel Accord requires banks to hold capital equal to at least 8% of the basket of assets measured in different ways according to their riskiness (risk weights). While 8% is the recommended ratio, the BSP opted to adopt a more conservative policy and required banks to maintain a capital ratio of 10% to total risk-weighted assets.

There are basically four basic steps in the calculation of risk-based capital adequacy ratio:

1. Compute for the Qualifying Capital or Eligible Capital

2. Convert all off-balance sheet credit exposures into credit equivalent "assets".

3. Calculate the market risk requirement and convert this into a risk-weighted asset equivalent.

4. Multiply the sum of all of the RWA in no. 3 above by 10% (the minimum capital requirement), and compare with the computed qualifying capital or eligible capital in no. 1

Qualifying Capital

Under the Basle Accord, there are two types of qualifying capital - tier 1 capital (core capital) and tier 2 capital (supplementary capital). Tier 1 comprises the highest quality capital elements being mostly shareholders' equity and retained earnings.