Prudential ratios. Risk cover and division ratios. Liquidity ratio
Category: Bank Management
If the above-mentioned risks materialise they can have serious consequences on a credit institution alone but also on the whole banking system.
When risks materialise they have a direct impact on the financial results through write offs; if there write offs amount significarry, they will have an impact on results which might become negative. If the capital stock is in sufficient, customers’ deposits may have to be utilised which is not economically correct.
The existing links between credit institutions increase the risk due to a snowball effect, specially when interbank operations represent a high percentage: this is called the systemic risk.
Unfortunately, these risks are real and many banks have become insolvert during the last ten years for different reasons (treasury crisis, failure of a major industrial customer, counterpart international risks, fall in the interest rates, Market operations, etc.).
To face these various risks, and especially to protect deposit, holders, public authorities have reinforced control bodies
(1-3) and set up Prudential regulations
Minimum capital stock
In every country, the authorities decide upon a minimum capital stock.
Risk cover and division ratios
The ratios covering the counterparty risks to keep banks solvent.
Risk cover ratios
In Europe, two different ratios are used: the European Solvency Ratio applies to all banks and the Cooke Ratio to those having an international activity.
These ratios oblige banks to keep a certain amount of capital stock equivalent to a % of the credits granted.
All liabilities have to be registered (credits, securities, etc.)
These liabilities are weighted with regard to the evaluation of risk (0 % to 100 %)
The total of these liabilities is the denominator of the ratio.
Liquidity ratio
This is to prevent a bank from being unable to face large withdrawals from its customers; the bank must have a certain amount of liquid assets.
The amount of liquid assets (those union less than one months maintainly) must be larger than resources of the same duration.
Liquidity notion > 100 %
Exchange rate Position Ratio
There is a ratio to be respected between the positions (short or long) in a currency and the capital stock (< 15 %).
The total of the positions should be kept under 40 % of the capital stock.
Shareholding participation in Non-banking enterprises
Individual participation should be under 15 % of capital stock
Total participation should be under 60 % of capital stock
So it appears that most prudential ratios issued by Public Authorities try to limit the risks due to Banking activities.
Counterpart risk ==> Cooke Ratio
Interest rate risk ==> Ratio on capital stock and Permanent Resources
Liquidity risk ==> Liquidity ratio
Foreign exchange risk ==> Exchange Position Limitations