LITERATURE REVIEW OF MINIMUM CAPITAL

REQUIREMENT

The concept of interest and profits in Islamic economies is different from

the ones in the conventional economies. In Islamic literature interest is
defined both in the narrow sense of consumption loans and in the wider
sense of "an increase as a result of exchange of goods. Such an excess
can come from two sources.

• Confirm return on assets without any regards to the income

being earned on the usage.
• Excess predetermined profit arising from the monopoly in the
market.
In Islamic mode profit is derived from the capital being utilized in the
business and the price is determined by the free market forces in the
economy. All other modes of profits or the prices determined in the non
competitive market are declared riba. Although Iran and Pakistan have
attempted to transform the interest based economy to an Islamic one yet
this action can lead to the disintermediation.[1]

Banks serve as intermediaries between savers and investors and also use
their liabilities as a transaction medium. Open ended mutual funds can
also serve as means of payment; however they are not prone to runs
therefore are not much regulated as commercial banks. The ideal Islamic
banking system can act like these open ended mutual funds with shares as
the primary transaction mediums. Monetary policy can be conducted
through open market operations however under such a system firms and
investments that are difficult to monitor could be starved of funds and
thus resources can be misallocated.
Equity markets thus play an important role in an interest free system.
Without a well functioning equity market the ban on interest payment
could greatly increase government involvement in the running of banks.
Ultimately banks may have to be effectively nationalized.[2]

Supervisors have always demanded more capital for large commercial

banks. One standard set was one dollar of capital for every 10 dollars in
deposits. During the growth period this standard was forgotten which was
again stressed upon when problems started to appear. The relationship of
bank’s capital to the risk premium required on bank debt concluded that
the market did not consider variations in the traditional capital adequacy
ratios of the bank to be a significant factor in the determination of the risk
premium. Additionally market has no clear difference between the capital
and the capital notes.

The beta model and the P / E model showed that while bank capital is
mostly regarded significant the tests applied did not find investors very
sensitive to risks. Why would then the supervisors ask for more capital if
investors are satisfied? Prior to 1974 market was not sensitive to the
variations in the bank capital however after that time when banks stock
prices decreased sharply both of them got worried. Therefore the need is
that both the investors and the regulators should be aware of the capital
needs of the bank keeping in mind the risks associated and the externality
factor. If these extra levels of capital demanded are much higher than the
normal level it will reduce the efficiency of the banks and can make the
operations of the banks more costly.[3]
Restructuring of the bank’s capital should not be a process of haste,
rather due consideration should be given to all the factors. An integrated
scheme should be on the basis of the following guide lines.

• A commercial banking system which even includes poverty

reduction lending can be successful if it is socially responsible and
professional.

• The bank’s capital should be converted into marketable bonds at

market rates of interest and eligible for SLR but repayable in
installments.

• The government capital should be repaid at a premium which is

fixed as a percentage of the premium to be paid to the public on shares.

• There should be no cancellation of government capital for

partially privatized banks.

• The primary requirement from weaker banks with sufficient

losses should be the strengthening of management.

• While assessing the banks turn round the provisions against NPL
should be excluded.

• Cancellation of capital against losses and plough back of profits

will demonstrate the strength of the bank. Once it is capable of doing it
should then be allowed access to the capital market for equity.

• As all banks will not be allowed to meet the minimum

requirement of capital sufficient time should be given depending upon the
individual circumstances.

• Extremely weak banks should be provided with tier 2 capital help

by the government for interim period.[4]
Over the past two decades most of the regulations regarding banking has
been focused on capital adequacy, however these discussions failed to
focus on the rationale of the matter, and not much attention was paid to
answering the question, whether this capital adequacy regulation actually
have the capability of saving the banks in the time of crises, as it is
generally believed. In short the mechanism linking the capital adequacy
and the systematic risk remain unexplained. Most of the previous
available models focused on the single bank which lacked the capability
of describing the two crucial aspects of systematic risk; the correlated
portfolio and the domino effect in case of interbank exposures. The
research now shows that the effects of capital adequacy regulations on
banks financial stability are very ambiguous. Although the capital
constraints may limit the exposures of banks with weak capital position,
however the risk exposure of other banks in the system may increase
through high risk as a result of interbank exposures. Allocations of
aggregate funds in the economy are indirectly affected by these capital
requirements. It is therefore not sure whether regulations of such kind
.will lower the risk exposure of the banks in the economy

[5]

The history of capital adequacy ratio has been characterized by

regulations that are of good intentions but ill advised. Although they
managed to unify every one on one platform yet there were many flaws.
New frameworks were proposed in 1999 but they also failed to repair the
defects of the 1988 accord. An alternative was thus proposed which took
into account the quality of the subordinated loans as a standard of
determining the ratio. The policy makers keep on denying the fact that
very little information is known about the solvency problem of banks.
Although research has proved that there is no correlation between bank’s
capital level and its failure, still the policy makers are stressing the need
of capital requirement for the banks. However changes in the approach of
the regulators is evident now because both the new framework and the
shadow proposal has shown the incompetency of the policy makers is
correctly calculating the market risk. If the banks maintain capital only on
the basis of regulation and not considering the market conditions its
.effects on banks performance can be felt in the following ways

• There will be misallocation of capital resources within in the

banking industry.

• It can cause distortion in bank’s pricing and business decisions.

• This may cause a global credit crunch.

• It can also induce banks to increase portfolio risk.

• These regulations can also cause banks to move from regulated

sector to an unregulated one.

There is therefore a need of integration of the regulations and the market

process which could be the main theme of next Basel accord. One thing
however is sure that no matter what happens banks would always be
.under tight rules and requirements of the minimum capital

[6]

In order to regulate the banking industry on the global basis the basal
committee on banking prescribes the capital adequacy standard to fallow
by the bank all over the world.

The basal committee on banking regulation and supervisory practice

appointed by the bank for international settlement has prescribe 8% of
capital adequacy standard to fallowed by the banks.
There are two tire capital prescribed to banks.

Tier 1 capital(core capital ) , which provides the most permanent and

readily available support against the un expected losses

And tier 2 capital which consist of elements that are temporary in nature
or readily available

The lull in the capital market as well as the persistent liquidity crunch in
the money market have made it difficult for banks to rise funds via
capital or tier 1 capital as well as bond or tier 2 capital . there fore banks
try to drawn up plane to rise subordinate debt through issue of long term
bond in order to meet the stringent the the adequacy level. Although the
banks are offer through offering coupon rates of around 16 to 16.5% , the
response to the bonds issues of even the stronger banks is doubtful . this
indicate that it is unlikely that the public sector well be able to meet this.[7]

One traditional and important objective of capital regulation has been to

reduce bank frailer and prompts banking stability . another important
objective is to reduce losses to depositor and the deposit insurer when
the bank fails.

But capital requirement seem to affect the behaviors of banks for the
generating the capital target. Banks may respond to capital regulation in a
number of different ways. Banks may increase its capital ratio as
measured under the regulatory standard, with out reducing either the
probability that the bank will fail or the losses to depositor and the
deposit insurance agency in the event of banks frailer . this response well
is referring as cosmetic changes in the capital ratio.

One way for banks to improve cosmetic improvement would be to reduce

total assets.
In view that the bank may response to capital in number of different ways
the regulatory authority need to consider what response they want to
elicit when formulating new regulation.[8]

Capital is seen as a cushion against unforeseen losses, capital adequacy is

thus the measure of a bank's internal strength to absorb credit risks which
may result in losses on account of its advances going bad

The objective of the capital adequacy is to strengthen the capital

resources of international bank , in order to improve the sustainability of
international banking system , another important aspect of the capital
adequacy is to reduce competitive inequalities arising from the difference
in capital requirement across the nation .

but the question arises that whether nationalized banks are able to sustain
it, it does not seem likely due the following reason .

most of the present boost to capital come from the government funds,
since the government will not provides further funds in the form of
recapitalization, this source will be no longer available , therefore the
bank will have to go for capital to market or generate resources internally
and for both these the bank will have to be more efficient therefore it is
necessary to look beyond capital and focus on the hard option to
restructure and turnaround the banking system.[9]

Bank capital is a source of fund enabling the bank to purchase earning

assets , and as cushion absorbing fluctuation in assets value. As a source
of fund bank capital is seem as yielding benefit primarily to shareholder .
Like deposit or any other source of fund equity allow the bank to
purchase earning assets , and if these are excepted to yielded more then
the cost of capital , the net benefit will accrue to the shareholder and
since the capital has indefinite term to maturity it can reduce the bank
exposure to high borrowing cost , and disinter mediate during the period
of tight money, and moreover the capital does not requires the reserve
requirement .[10]

Capital adequacy norm as per Basle accord 1988 has become one of the
prudential regulatory instruments being adopted increasingly regulatory
and or supervisory authorities of banking system all over the world . as
part of liberalization and global integration process of the economy of
which ban k is an important sub system the government and reserve bank
have chosen to adopt the same as recommended by the Narasimham
committee

capital regulation has been one of the main policy tools used by central
bankers to control financial instability. There are two main functions of
bank capital. The first is the incentives function. Because of the debt-like
nature of their liabilities, banks have an incentive to engage in risk
shifting or asset substitution, that is, to take on excessive risk knowing
that the downside risk is born by their creditors (depositors). Requiring
banks to hold a minimum ratio of capital to assets reduces the bank's
incentive to take risk. The second function of bank capital is the risk-
sharing function. Capital acts like a buffer that may offset the losses of
the creditors (depositors) and allows for the orderly liquidation and
disposal of assets in the event of financial distress.[11]
Capital of the bank should be enlarged to make a bank more risk
sensitive. The excess capital standard may be due to market failure or in
adequate regulation. According to BASEL II regulation is made that bank
have to hold minimum capital against their risk based assets. Bank capital
requirement are based on that the bank has a privilege that it can under
price its financial risk to allocation a large pie of it in financial markets.
Urge for minimum capital requirement was started by USA and UK in
1970s and early 80s. Some countries increase their capital above the
regulatory requirement to act as buffer to avoid fluctuations in the MCR.
BASEL II comprise three principals to for assessing capital adequacy
that are standardized and advance approach, focused on the process of
regulatory review and the market discipline . Hence the regulatory
authorities should be more and more efficient.[12]

The identification of the net capital ratio as the explanatory variable is the
most important empirical result of the study. It shows the simple financial
variables that are calculated from the bank statement are of little use in
predicting recoveries from failed banks. It raises some doubt on the
widespread use of bank financial statement. Since the assumption on data
was of the failed bank, this is valid assumption to estimate the valid
assumption when the purpose is to estimate the possible outcome of
bankruptcy. Although there is possibility of bank showing higher loss
remain solvent this us quiet unlikely since the net capital ratio, which is
the independent variable, is much higher for the solvent banks then the
failed banks [13]

An understanding of the bank responses to the capital requirement is the

main issue that helps the regulators to make their policies. Bank`s
financial ratio have become is the basic source to the analyze the bank`s
financial position, which is achieved after long efforts on international
level to achieve basic or common capital requirement for the banks on
international level. If these efforts for the bank`s harmony in the capital
requirement continue then the better understanding of the bank regulatory
policies responses would be valuable. At the best option the pricing result
can be regarded as mitigating factor in conclusion of positive association
of risk and regulatory capital. In Indian context the writer`s finding was
reassuring in capital requirement do affect the influence over and above
the bank`s own internally generated profit. In view of the fact that bank
will respond to the capital regulations in variety of ways, regulator need
to know what kind of respond they want to get when formulating new
regulations. Presuming the regulations is made to minimize the risk
problems. In recent contribution the regulation must seem evolutionary
struggle and regulatory innovation will remain a constant change[14]

Islamic economies, where profit sharing schemes, are replacing interest

payment. The effect of change is far reaching and some potentially
dangerous results especially in financial intermediation and banking
regulations. When Islamic bank will interact with other non Islamic bank
their will create a problem of their transaction without interest. Recent
financial innovations and emergence of non bank`s bank is far
threatening the stability of financial system and create panic in the
system. The ideal Islamic bank who never deals with interest will be like
open ended mutual funds with shares as its primary source of transaction
medium. Under such system funds and resources are difficult to handle
and are misallocated. Equity market plays a particularly important role in
such interest free system. The interest free banking can be greatly
handled by the government of the particular country. In such system the
government can interfere to preserve the rights of all. Bank and interest
bearing security are often thought to be the central to the conduct of
monitory policy.[15]

The financial stability concern has led America to the rescheduling of

interest in the financial markets of the bank capital, however current
knowledge suggest no strong directives about how to set the standard for
the bank capital which will move towards social optimality. Further
explanation of the banking sector`s current financial soundness suggest
that recent concern is not founded in fact. The financial institutions seems
sound at that time of the paper as in past, even if the casual symptoms
does not indicate similar results[16]

The role of capital for the prevention of bank failure and use of capital
adequacy measures are the major part of this literature. The prime
objective of the study is to analyze the predictive performance of the
bank adequacy and recoveries from the failed banks. It is concluded that
the simple financial ratios calculated by the bank and other financial
statements prepared by the banks are of little use in analyzing its
performance because of limitation of accounting information and
adjustment of low quality assets. There is also possibility of the loss of
highly productive bank and vice versa the highly risky situation of the
bank can also help it to prosper with time and to regenerate its capital[17]

There are similarities in the banking system of Pakistan and Iran but the
path towards its progress by two countries are selected differently. The
progress toward Islamic banking in Pakistan faced a lot of problems by
interrelated network of regulations. The roots of which, are disputed, and
lack to operate in the Islamic norms. It follows that the financial sector
must be very free to access to the market so that it receive proper rate of
return, similarly it provide opportunities for the depositors too. Islamic
banking in Pakistan are facing too much problems by policy makers and
the real banking sector because of its features of medium along term
profit and loss sharing basis business. The only way where banks are less
reluctant is the short term financing through profit and loss sharing basis.
In Iran the Islamic banking has different set of objectives and has off
course different rate [18]

The intent of regulator that at least all banks must have a capital up to a
certain limit. The rationale behind this is to protect the depositors,
maximize the banking sector. To select the bad banks from the industry,
and when the more transparent investment plans the easy is for the
regulator to predict their future. The last is that capital is used to solve the
bank problems. The last stage is the crises stage where the optimist
approach banker does not intend with the capital requirement despite the
pessimist does it in order to tighten the policy and improve the quality of
banking sector. How ever regardless of the two approaches the regulators
with less reputation require it an on high repute holder do not.[19]

The capital structure of the large and small banks in the sense of capital
contributed items different. Debenture and preferred stocks are
considered important in small banks, also the capital ratio of the small
banks is higher then larger one. A very little number of large banks
should a higher capital adequacy ratio. As this survey is conducted in the
us therefore the statistics showed the capital variation among the different
states because these states are different in their progress similarly
therefore capital ratio is to be calculated against capital account, risk
assets gross and current because the ability of banks to absorb losses
depend on its total net worth. How ever to have a pessimist or optimist
view the problem of the capital adequacy would still remains unless and
until the banks address high rate of return, reduction in liability regardless
of the regions and location also followed by the minimum taxation.[20]

The purpose of the bank capital is to provide sound ground to the

banking sector against failure. The capitalization concept has passed
through phases the significant point phase is the BASEL ACCORD in the
year 1988 when the member of G-10 formulate a three step formula of
capitalization. Indeed the purpose is to secure the banking sector, a sound
monetary system and ensure the stakeholders and stockholders
confidence. The system is adopted in the whole world by as considering
it the only solution of against the failure. Howe ever different country
formulated it according to their own requirement. There for sufficient
capitalization is necessary for banking sector not only as tool against
failure.[21]

There is a mathematical model that moves around a situation were large

intermediaries are provided with the tools demonstrate the intermediaries
course of action when the risk is non-diversified one. if then it will go for
equity issue as will as debt because equity will reduce its failure. While
when it is diversified one it can then only meet the claims by issuing the
debts means it can cover the risk with debt.[22]
The BASEL ACCORD one identifies the bank assets portfolio. When
Basel 2 take placed it added the market and credit risk also the minimum
capital requirement in order to mitigate the bank risk failure. A survey is
conducted on the Canadian bank on the cyclicality of the BASEL 2 which
reflects the volatility of capital different to different banks, the Basel 2 is
updated in order to make the capital as strong tool against losses also to
emphasize the relation between the capital and credit risk. Credit risk is
more closely connected to business cycle. Therefore credit risk should be
particularly modified by the banks when calculating the capital for it. The
Basel 2 is considered the first pillar for its calculation. However after its
inclusion it is accompanied by volatility. The updated Basel was adopted
now in most of the countries.[23]

The Islamic banking system was started in the year 1950 from our
country. Since it has passed through phases and still it is considered an
emerging field. The full fledged Islamic financial institution and the
commercial banks with Islamic branches have done well by showing the
benchmark of 8%. The capital adequacy ratio for full fledged Islamic
banks has gone up to 20.8%. [24]
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