Evaluating Capital Adequacy

Maintaining adequate capital requires developing plans for building capital resources needed by the bank. In order to assess your bank's capital needs, you need to know its current position and the adequacy of that position in protecting the bank, now and in the future. Accordingly, you need to be familiar with the level and trend of your bank's financial condition. To do this, you'll need:

  • the bank's financial statements or Call Reports,
  • risk management reports, and
  • the bank's plans for future expansion and growth.

A useful tool for evaluating capital is financial ratio analysis. Ratios can provide information that dollar values may not. For example, if your bank's equity capital doubled over a certain time period, you might think its capital is stronger. However, if over the same period the bank's assets tripled, you might conclude that capital support actually declined.

Ratios can be more meaningful if they are placed in context. For example, compare current period ratios to those of a previous period, as well as to ratios of similar, or peer, banks, which you can obtain from the Uniform Bank Performance Report (UBPR). The UBPR is a valuable source of peer information. UBPRs may be obtained from the FFIEC website at: http://www.ffiec.gov/ubpr.htm.

Should your bank need capital, here are some sources to consider:

  • External
    • sale of equity, e.g., common or certain preferred stock
    • sale of subordinated debt issues

Whether a bank can raise capital from external sources depends largely on the bank's financial condition and size. Financially sound banks generally can find purchasers for their equity or debt instruments. However, capital can be difficult to obtain during economic downturns regardless of a bank's condition. Size is a factor as larger banks typically have better access to capital markets and, therefore, more options than smaller institutions, which often have to rely on their current owners for capital injections.

  • Internal
    • earnings retention
    • selling assets
    • reducing risk

Earnings retention may require making hard choices. For example, bank dividends may have to be reduced or eliminated until capital is restored to sound levels, even though this may cause possible financial hardship for owners who rely on dividends as an income source. If your bank’s earnings power is low, you may have to reduce asset growth, abandon planned acquisitions, or put branch additions and other facilities improvements on hold.

An alternative to raising capital is to reduce the need for capital by selling assets or by redistributing asset holdings to those with less risk, thus requiring less capital support, e.g., reducing loans in favor of U.S. government securities.