Capital Requirements

Abstract

A feature of provision calculation, as discussed in Chapter 10, is that it covers expected loss. To put it another way, an organization will make a provision for bad and doubtful debts based on its ‘best guess’ as to the losses that it will incur in future. Provision estimates are not perfect. The actual amount written-off at the end of the financial year will always be different from the estimate that was made at the start of the year. In some years the provision estimate will be too high. This is fine, because it means that profits will be higher than originally forecast. However, if losses are higher than predicted, then this could be a problem. Consider a bank that makes a provision of say $100 million against bad and doubtful debts at the start of the financial year when the economy is booming. During the year the economy unexpectedly takes a downturn. At the end of the year the actual losses are $150 million because many of the bank’s customers lose their jobs and are unable to meet their loan repayments. If the bank does not have sufficient funds (capital) to cover the $50 million shortfall in its provisions then it could face financial difficulty and become insolvent. A prudent strategy against such risks is to put some extra capital aside, in addition to provision, to cover any unexpected losses that might be incurred. This is especially important for deposit taking institutions that provide current accounts and savings accounts, to ensure that depositors don’t lose their funds and to maintain the stability of the banking system.