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(Commercial & Investment Banking) TOPIC : Discuss the problems in the risk-based capital approach to measuring capital adequacy Introduction The risk-based capital rule(RBCR)，as a standard for international financial risk management, in line with the principles set out by the Bank for International Settlements[footnoteRef:1]. It means that the risk tests the capital adequacy of a bank and provides a criteria followed to governing bodies of the banking industry when proposing effective legislation relating to the management of bank capital. Starting from scientific principles, the effectiveness of capital management are all affirmed by scholars based on state preference model and option pricing model. Stricter capital management seems to reduce banks’ level of exposure to risk by these scholars. As such, the insolvency risk index is low(high) while capital adequacy is high(low). On the other hand, scholars based on portfolio theory have questioned the effectiveness of capital management. They believe that when capital adequacy ratios tend to be tightly regulated, it can lead to more riskier behavior by banks, which makes the bank more susceptible to failure and promote the banks’ level of exposure to risk[footnoteRef:2]. This report aims to illustrate the problems in the risk-based capital approach to measuring capital adequacy. Finally, the article will end with the critical thinking. [1: Saunders, A., Cornett, M. M., & Erhemjamts, O. (2021). Financial institutions management: A risk management approach. New York, NY: McGraw-Hill Education.] [2: Lin, S.2005. Risk-based capital adequacy in assessing on insolvency-risk and financial performances in Taiwan's banking industry. [online] Lin, Shu Ling. Available at: [Accessed 6 October 2004].] the problems in the risk-based capital approach to measuring capital adequacy As a tool employed by government regulators, risk-based capital adequacy requirements are widely used to secure the bank stability. Regulators in many countries adopt this method to regulate banks by restricting their exposure to risks[footnoteRef:3]. This approach also allows banks to select a number of alternative methods to calculate the required capital. In spite of this, there are several problems need to be considered. [3: Ronn, E. I. and Verma, A. K. (1989) ‘Risk-Based Capital Adequacy Standards for a Sample of 43 Major Banks’, Journal of Banking & Finance, 13(1), pp. 21–29. doi: 10.1016/0378-4266(89)90016-2.] According to the current regulatory framework, banks are allowed to choose between the standard incremental risk and tailored Value-at-risk (VaR) based approaches to risk management. Generally speaking, the VaR-based approach enables banks to reach capital adequacy requirement with capital reserves lower than the standard 8% determined by the Basel Accord. The main problem occurred by using this method is producing results with low precision[footnoteRef:4], since calculating value at risk is based on different assumptions. Banks may pay a high price for oversimplification and risk, and a regulatory surcharge on inaccurate internal models. Moreover, the risk-based capital approaches provide incentives for arbitrage opportunities. In such case, banks would distort investment portfolios in order to pursuit high yield and cover up the risk through capital market transactions. [4: Wiener, Z. (2012) ‘The value of Value-at-Risk: A theoretical approach to the pricing and performance of risk measurement systems’, Journal of Economics and Business, 64(3), pp. 199–213. doi: 10.1016/j.jeconbus.2012.02.002.] Another problem in the risk-based capital approach is that strong capital ratios could provide a false sense of security when the leverage being out of control. It found that, from different countries, the banking sectors with higher regulatory capital ratios would have more leverage when entering the crisis and as a result, they would lose more compared to those with worse capital adequacy positions. One good example is that Swiss, German and Belgian Banks showed off the best Tier 1 ratios among 12 countries from a study. However, because of the highest unweighted leverage, they suffered the worst losses in the end, 1.5% to 2.5% of total assets. On the contrast, although Italian banks had poor Tier 1 capital levels, with much less leverage they also lost much less in the crisis[footnoteRef:5]. [5: Horwitz, J. (2010) ‘Risk Lies in Risk-Based Capital Approach of Basel’, American Banker, 175(108), pp. 1–2. Available at: http://search.ebscohost.com.ezproxy.library.qmul.ac.uk/login.aspx?direct=true&db=bth&AN=52267000&site=eds-live (Accessed: 10 April 2021).] The regulation of capital adequacy ratio has been widely adopted by the banking industry. The important theoretical premise of this regulation is that capital can offset the losses of banks, thus improving the ability of banks to resist risks. Well-capitalised banks also boost depositors' confidence and prevent runs. Central bank digital currency. Design principles and balance sheet implications. Portfolio characteristics. Under the portfolio theory model, the increase of capital adequacy ratio leads to the increase of bank's capital level, and then affects the expected earnings of banks. Banks tend to increase the level of risk in their portfolios in order to achieve expected returns. Therefore, the increase of capital level will stimulate the increase of bank risk level. The increase of capital level will stimulate the increase of bank's risk level, while the reduction of capital level will reduce the bank's risk bearing capacity. With the continuous improvement of capital adequacy ratio, the risk sensitivity of regulation also tends to rise. An important prerequisite for the effectiveness of capital adequacy regulation is that the risk weight of assets can accurately reflect the actual market risk of assets. Impact on capital requirements. The active operation of Basel Accord in the operation mode of commercial banks makes the banking system have differences in taxation, accounting and security guarantee. A study by the Federal Deposit Insurance Corporation (FDIC) found that the new rules, far from preventing bigger losses, would reduce the capital that American banks have on hand. The study found that the first set of core capital requirements lowered pre-Basel standards and were even lower than what American regulators had agreed was safe. This adjustment is often painful for smaller banks, because operating under Basel standards means that more capital is likely to be needed to operate, widening the gap between deposits and loans at big and niche banks and making it harder for smaller banks to attract customers so they can raise more capital. Conclusion The primary purpose of this paper is to provide a critical assessment of the risk-weighted capital approach to capital adequacy. All in all, the above analysis of this article indicates that the risk-based capital approach is flawed either in its concept or in its application. The essence of the problems contained in the risk-based capital approach reveals that it provides a misleading in the measurement of the total bank risks. The approach is partial in its coverage, concerning with only credit or default risk almost exclusively. Consequently, because of multiple factors, including the absence of comprehensive portfolio approach to risk evaluation, reliance on historical-cost accounting techniques, and inaccurate in risk weights to credit risk exposure, the approach is likely to distort the allocation of credit. However, there worth mentioned an alternative way to approach the evaluation of bank risk exposure. The development in option pricing theory provides a means in bank risk measurement and pricing, or in gaining optimal capital and other regulatory requirements in a system of fix-rate deposit insurance[footnoteRef:6]. Different from the risk-based system, this alternative optional pricing system is conceptually valid, being developed from accurate market-based valuations and from risk measurements relating to the market activities of certain banks. [6: Hogan, W. P. and Sharpe, I. G. (1990) ‘Risk-Based Capital Adequacy of Australian Banks’, Australian Journal of Management, 15(1), pp. 177–201. doi: 10.1177/031289629001500108.]

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(Commercial & Investment Banking) 
TOPIC : Discuss the problems in the risk-based capital approach to measure capital adequacy
Introduction
Risk based capital is basically the measuring method for minimum capital amount that is appropriate to report entity for supporting the overall business operations while considering the size as well as risk profile. This tends to limit the risk amount that can be taken by an organization and it refers to rule establishing minimum regulatory capital for the financial institutions as such. Thus, this ensures adequate capital for the financial institution on hand in order to sustain the operating losses while maintaining the efficient as well as safe market. As a standard for international financial risk management, RBCR aligns with the principles set out by the Bank for the international Settlement[footnoteRef:2]. It means that the risk tests the capital adequacy of a bank and provides criteria followed by the governing bodies of the banking industry when proposing effective legislation relating to the management of bank capital. Starting from scientific principles, the effectiveness of capital management is all affirmed by scholars based on state preference model and option pricing model. It is being stated that more strict the capital management, lesser the bank’s exposure to risk. As such, the insolvency risk index is low (high) while capital adequacy is high (low).  On the other hand, scholars based on portfolio theory have questioned the effectiveness of capital management. They believe that when capital adequacy ratios tend to be tightly regulated, it can lead to more risky behavior by banks making the bank more susceptible to failure and even promote the banks’ level of exposure to risk[footnoteRef:3]. This report aims to illustrate the problems in the risk-based capital approach to measuring capital adequacy. Finally, the article will end with the critical thinking. [2:  Saunders, A., Cornett, M. M., & Erhemjamts, O. (2021). Financial institutions management: A risk management approach. New York, NY: McGraw-Hill Education.]  [3:  Lin, S.2005. Risk-based capital adequacy in assessing on insolvency-risk and financial performances in Taiwan's banking industry. [online] Lin, Shu Ling. Available at:  [Accessed 6 October 2004].] 
Capital measurement from the regulatory point varies much from the purposes of internal company management. A regulator measures the capital level so as to if it exceeds the minimum predetermined level in worst case scenario that is the liquidation state or not. Contrary to this,

(Commercial & Investment Banking) TOPIC : Discuss the problems in the risk-based capital approach to measuring capital adequacy Introduction The risk-based capital rule(RBCR)，as a standard for...

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