Capital Adequacy Ratio is a bank’s level of capital for its inherent risks, and capital under the requirement serves a loss-absorbing purpose for banks. It is stated as a percentage of an institution’s risk-weighted assets.
Capital of a bank is segregated into two parts, namely Tier 1 and Tier 2 Capital. Both the tiers are intended to save the bank in the event of a crisis, which may lead to a threat to the bank’s going concern. However, each tier of capital has its purpose when a bank incurs losses or risks to the going concern increases.
To calculate CAR for an institution, the sum of Tier 1 and Tier 2 capital of the banks is divided by risk-weighted assets.
Tier 1 capital consists of Common Equity Tier 1 (CET1) and Additional Tier 1 Capital (AT1). Under Basel III, the Basel Committee requires banks to have over 4.5% CET1 capital, and after including AT1, the level of Tier 1 Capital should be over 6%.
Also, the sum of capital instruments held by banks, including Tier 1 and Tier 2 capital should be minimum 8%. AT1 capital of the institutions could include perpetual contingent convertible instruments, but CET1 capital is pure common equity.
How Capital Adequacy Ratio Arrived In Banking Regulations?
Money has sometimes been mankind’s problem. In the Great Depression of the 1930s, there was a dramatic imbalance between fiscal policy and monetary policy, reflecting the inability of policymakers to strike a balance since interest-rates were raised at the outset of an economic crisis.
This was also partly responsible for the development of Keynesian Economics, which laid the foundations for monetary policy.
Capital Adequacy Ratio is administered by the banking regulator in a country, which could be the Central Bank, like in the US or a separate body like the Australian Prudential Regulation Authority (APRA) in Australia.
The growing internationalisation of banks led to the creation of Committee on Banking Regulation and Supervisory Practices in 1974. Also known as Basel Committee, it was headquartered in Basel at the Bank for International Settlements.
After the failure of Bankhaus Herstatt in West Germany, the Basel Committee was formed to oversee the international supervisory standards, improve resilience in the financial system worldwide, and to co-operate on banking supervision with member nations.
Since 1975, the Basel Committee on Bank Supervision (BCBS) has published landmark supervision protocols for national regulators and global standards, including Basel I, Basel II, Basel III capital adequacy accords.
The need for Capital Adequacy Ratio was felt after the Latin American crisis in the early 1980s. Over the past two decades into the 1980s, the Latin American nations borrowed heavily to fund industrialisation, but a global recession and interest rate hikes in 1970s and 1980s led to the Latin American Debt crisis.
It was the time when global policy thinktanks stressed on the need for capital reserves; commercial banks held a large amount of capital invested in Latin American bonds, which were then presented with looming risks of default.
The Basel Committee was concerned with the deteriorating capital ratios of international banks, resulting in the need for measurement of capital adequacy and abolishment of erosion of capital standards. Now banks started measuring capital adequacy based on weighted risks, including on and off-balance sheet risks.
How Is the Origin And Evolution Of Basel Accord Mapped?
In July 1988, the G10 Governors approved Basel I, which required banks to maintain a minimum ratio of capital to risk-weighted assets of 8%. Banks were given until 1992 to implement Basel I Accord, which was also adopted by members outside the Committee.
Additional amendments to Basel I continued until the proposal of Basel II, which was a new capital framework. The new accord led to a revised capital framework in 2004. It sought to develop and expand the rules for minimum capital requirements enacted in 1988.
Basel II also focused on the supervision of capital adequacy and internal assessment process by institutions, and disclosure requirements to bolster ethical practices and market discipline. As a result of financial innovation, there was a need for a framework to better reflect the underlying risks.
It also set the tone for continued improvement in efficiency of risk measurement and control. But the Committee realised the need of further improving capital framework before the collapse of Lehmann Brothers in 2008.
The Global Financial Crisis during 2007-09 reinforced the need for an improved capital framework in the wake of the banking crisis. Initially, the Committee released guidelines on liquidity risk management in the month when Lehmann Brothers failed.
BCB extended the approach of Basel II and released guidelines on the treatment of trading book exposure, off-balance sheet vehicles, and securitisation. In September 2010, the body introduced higher minimum capital guidelines.
During the same year, Basel III was endorsed by the Committee, which has amended the accord several times since 2010, including implementation dates. This accord included a range of areas for efficient risk management and control in the banking system.
ASX Banks And Capital Requirements
Australian major banks include Commonwealth Bank of Australia (ASX:CBA), National Australia Bank Limited (ASX:NAB), Westpac Banking Corporation (ASX:WBC), and Australia and New Zealand Bank Limited (ASX:ANZ).
Over the past years, the banking regulations in Australia galloped forward in contrast to the global developments. Financial System Inquiry 2014, under the leadership of David Murray AO, also recommended increasing the bank’s capital requirements to over 10%. As a result of these recommendations, the banks now have large capital reserves in Australia.
Basel III implementation pushed further ahead to 2023
In the wake of COVID-19, the implementation of Basel III standards has been further postponed to one year later to 1 January 2023. It was understood that the deferral of implementation would provide the banking sector the necessary capacity in response to COVID-19 economic deterioration.
In addition to meeting the Basel III requirements, global systemically important financial institutions (SIFIs) must have higher loss absorbency capacity to reflect the greater risks that they pose to the financial system. The Committee has developed a methodology that includes both quantitative indicators and qualitative elements to identify global systemically important banks (SIBs). The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance.
What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others. The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors. For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel. How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages. Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage. Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade. Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries. What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another. The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services. Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour. Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television. It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured. Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power. The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play. It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability. What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects. The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers. Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.
Gain or loss as a percentage of the initial capital invested. For example – If we gain $10 on investing $100, our Absolute return would be 10% ($10/$100*100)
What are accounts payable? Accounts payable is the amount of cash a company is liable to pay to its suppliers and clear dues. As current liabilities of the company, accounts payable is required to be settled over the next twelve months. It also shows the obligations of the business over the next year. Accounts payable is required to be repaid in a short period, depending on the relationship with suppliers. It is essentially a kind of short term debt, which is necessary to honour to prevent default. As a part of the company’s working capital, it is widely used in analysing the cash flow of the business and cash flow trends over a period. Accounts payable may also depict the bargaining power of the company with its vendor and suppliers. A vendor or supplier may give the customer longer credit period to settle the cash compared to other customers. The customer here is the company, which will incur accounts payable after buying goods on credit from the vendor. There could be many reasons why the vendor is providing a more extended credit period to the firm such as long term relationship, bargaining power of the firm, strategic needs of the vendor, the scale of goods or services. By maintaining a more extended repayment period to supplier and shorter cash realisation period from the customer, the company would be able to improve the working capital cycle and need funds to support the business-as-usual. However, prudent working capital management calls for not overtly stretching the payable days as it might lead to dissatisfaction of supplier. Also, investors tend to closely watch the payable days cycle to determine the financial health of the business. When the financial conditions of a firm deteriorate, the management tend to delay the payment to their suppliers. What is accounts payable turnover ratio? Accounts payable turnover ratio shows the capability of a firm to pay cash to its customer after credit purchases. It is counted as an essential ratio to analyse the cash management attribute of the firm and its relationship with vendors or suppliers. It is calculated by dividing purchases by average accounts payable. Purchases by the company are calculated as the sum of the cost of sales and net inventory in a given period: Now let’s understand this the help of an example. Let us suppose, Cost of sales of Company XYZ for the period was $60,000, and XYZ began with inventories worth $21000 and ended at $15000. Accounts payable at the beginning was $20000, and $15000 at the end. Now the purchases will be $66000 (60000+21000-15000). The average accounts payable will be $17500. Therefore, the accounts payable turnover ratio will be 3.77x. Dividing the number of weeks in a year by the accounts payable turnover ratio will give the number of weeks the company takes on average to settle its payables. In this case, it will be around 13.8 weeks (52/3.77).
What is Data Analytics? Data Analytics involves a set of quantitative and qualitative approaches and processes that can be used to determine useful information for business decision-making. The process involves various patterns and techniques, including: extracting a raw database, and categorising it to identify and analyse the behaviour, relation and connection of the results. The ultimate goal is to acquire valuable information in order to make decisions for businesses’ benefit and productivity. In today's competitive times, most companies chalk out their business plan with the help of data analytics. With organisations becoming customer-service oriented, data analytics has become a critical tool to reach the target audience in an effective manner while understanding their requirements. Once data is collected, it is analysed and stored according to organisations’ requirements. The data analysis process has multiple layers involved, and its diverse modules are not just used in businesses but also in science and social science fields. Rather than making decisions based on just available information, one can utilise data analytics in examining the data in standard ways and churning out the results from it. It has been observed that companies generally make decisions based on past references and future outcomes. Data analytics appears advantageous in providing useful information towards this end. Why do Businesses Need to Use Data Analytics? Many data analytics’ tools and softwares are readily available these days. These systems use resources, such as machine learning algorithms and automation. Data scientists and analysts are counted amongst the leading career options as well. These professionals use data analytics techniques while researching and presenting useful information for businesses to increase productivity and gain. The process helps companies understand their target audience and determine effective ways to cater to their needs. Data analytics can further be used to design strategies in marketing campaigns and promotions and also evaluate its results. Data analytics is primarily used in business-to-consumer (B2C) processes to boost business performance and improve the bottom line. There are data collection firms which gather consumer information and provide it to the businesses so that the companies can effectively influence the market. The collected data is not only used to understand and impact consumer behaviour but also determine market economics and its practical implementation. The data used in the process can be either be data collected in the past or newly updated data. There are various methods to manage consumer and market information. It may come directly from the customers or potential customers or can be purchased from the data collection vendors. The data primarily includes audience demographics, behavioural patterns and expense threshold. How Can Data Analytics be Effectively Used in Business Processes? Data analytics is an ever-evolving technique. Earlier, the data was collected manually, but with the rise of internet and technology, data is now collected online with the help of search engines and social media platforms. Subsequently, the information is analysed through available software. Here is a list of some key steps businesses can follow to leverage the benefits of data analytics: Set up crucial metrics: This step reduces the guesswork and provide data-based insights to the businesses. Before embarking on the data analytics process, it is vital to determine the goal for your business. Analysing customer data helps in understanding conversion rate, consumer spending ability, demographics etc. The results of the analysis can support the businesses while making decisions in launching an advertising or marketing campaign. Similarly, the unwanted data can be erased from the database so that the brands can focus on their right target audience. The relevant metrics will change the course of the company and push it in the right direction. Moreover, once your key metrics are set, even when the market conditions change in the future, you can adjust the metrics according to the requirement and achieve the results. Set a clear module: It is important to examine the data correctly by avoiding common mistakes. An ambiguous path can produce confusing insights while wasting time and energy of businesses. Therefore, it is recommended to draw a clear goal in order to achieve actionable insights. The data, when collected from different sources, need to be merged accurately in the analytics model. Businesses can modulate their data analytics systems either manually or through automation. There are various data modelling practices available in the market. The best use of these techniques can simplify the process of modelling complex data. Data visualisation: Once the relevant data is collected, and the modules are set to analysis, visualisation of that data will assist in understanding the information correctly. When the businesses have an acute knowledge of what their target audience wants, they can then focus on strategising advertisement and content, which matches the consumers' interest. It is the critical step in the data analytics process to distinguish insights from information. Not everyone is comfortable dealing with numbers. Hence, ensuring that key stakeholders understand essential points and information can be displayed in a visually appealing format seem crucial to capitalise on data effectively. Right tools to implement insights:Having access to data and insights can get overwhelming. However, the information is worthless if the businesses are unable to implement it successfully. While it is important to collect the data and set critical metrics and modules to analyse it, it is also imperative to translate the data into practical actions. The eventual goal is to improve sales or grow profits. It is ultimately in the marketers' hands to transform the gained insights into a successful implementation. The consumers' insights should be incorporated while establishing a marketing plan and at all decision-making steps.