Sample Law Paper on Banking Capitalization Requirements

Introduction

With the increased number of banks filing for bankruptcy, it became necessary to develop solutions for detecting financial problems before they finally collapse. In most jurisdictions, regulatory authority or authorities are mandated with the responsibility of monitoring the performance of banks and installing corrective actions where necessary. In the light of this development, this paper discusses the PCA Framework, CAMELS rating, and cease-and-desist order as a mechanism for regulating financial institutions.

Prompt Corrective Action (PCA) Framework

Under the U.S. Federal law, banks that show deteriorating capital ratios are faced with progressive penalties. The law seeks to ensure that institutions do not go bankrupt without being detected early enough. Essentially, banks’ financial health is monitored by different agencies with the Federal Deposit Insurance Corporation (FDIC) being a major one. Other countries such as India have their own bodies to undertake the same mandate. These agencies have installed mechanisms that control, monitor, access, and take the necessary corrective action on troubled and weak banks[1]. The process under which these actions are undertaken is referred to as the Prompt Corrective Action (PCA).

The PCA Framework was necessitated by a period of distress and turmoil that saw numerous banks receiving financial assistance, and others being closed. More than 1600 banks in the U.S experienced such difficulties in the 1980s and 1990s. To avoid a repeat of such cases, it became important to develop strategies that can detect bank failures and take corrective actions before they actually collapse. Once a bank is detected to be worsening, the law allows the regulatory authority to impose some restrictions and place it on a special watch. The financial institution has to follow prescribed corrective action plan until it stabilizes. During this period, improvements on various areas are demanded.

For the regulatory authority to impose a corrective action on banks, a number of factors are considered. Parameters such as Returns on Asset (ROA), Leverage ratio, Capital to Risk Weighted Asset Ratio (CRAR), and Net Non-performing assets (NPA) usually invite corrective action[2]. NPA ratio determines the bank’s asset quality. Good performing banks have a lower NPA. ROA is used to calculate a bank’s profitability. The higher the ROA, the better the bank’s performance. Capital adequacy ratio is used to establish whether banks have adequate capital to facilitate smooth running. If the capital falls beyond a certain limit, corrective action is initiated.

Consequences of Undercapitalization

Less than Undercapitalized: These institutions cannot pay management fees or dividends to their shareholders. Further, such banks are prohibited from accepting, rolling over, or renewing any brokered deposit. Undercapitalized financial institutions are also required by the law to file a capital restoration plan. The plan must be acceptable and reasonable in the eyes of the law and from the regulatory agencies’ standpoint.

Significantly Undercapitalized Institutions: Such banks face the similar repercussions just as the less than undercapitalized banks. However, further corrective actions are imposed. For instance, such banks are barred from paying bonuses or increasing the salary of executives without any prior approval. Additionally, significantly undercapitalized banks are subjected to more restrictions by the FDIC.

Critically Undercapitalized Banks: All restrictions imposed on both less than capitalized and undercapitalized banks are applicable to critically undercapitalized financial institutions. However, further consequences follow. For instance, such banks are not allowed to pay either the principal or interest on any subordinated debts without FDIC waiver within 60 days of turning critically undercapitalized. Further, a receiver must be appointed by the chartering authority within the first 90 days[3]. Any other action necessary for the purposes of PCA can be taken.

The CAMELS Rating System

Originally developed in the U.S., the CAMELS is a financial rating system used as a supervisory tool for evaluating the financial soundness of banks[4]. Through this evaluation, supervisory agencies are able to identify the financial systems that require special concern and attention. CAMELS Rating has developed to become an indispensable and critical tool for regulators. The system assesses the overall condition of the financial institution. All banks and credit unions in the U.S. are subjected to the rating. The system is also applied in other jurisdictions across the world. To avoid cases of bank-run, the ratings are not shared with the public.

CAMELS system is an acronym of the six bank’s conditions assessed by regulators when rating the financial institutions. The factors accessed are Capital adequacy, Asset Quality, Management Capability, Earnings, Liquidity, and Sensitivity to market risks. In each of the categories, ratings range from 1 to 5, with 1 representing the best while 5 denotes the worst performing banks. 1 is the most desirable rating in each category.

Capital Adequacy

Capital adequacy focuses on the amount of capital that financial institutions are required to keep by the regulator. Financial institutions should maintain capital levels necessary to guarantee absorption of credit, operational and market risks. Key components considered when evaluating the capital adequacy of banks include the overall financial condition, quality of capital, composition of the balance sheet, and dividend reasonableness among others. Capital adequacy is measured using two major rations, the capital Adequacy ratio (CAR) and CRAR. A rating of 1 shows strong capital levels while a rating of 5 indicates deficient capital levels. A bank with a capital adequacy rating of 4 and 5 should be subjected to supervisory watch and scrutiny.

Asset Quality

Key assets owned by banks include real estate investments, loans, cash, and government securities. Loans are the largest components of many financial institutions. Loans carry a very high risk, hence determining the quality of such assets is vital. Asset quality ratios used to evaluate banks include Non-Performing Loan ratio (NPL) and provision for loan loss ratio. Key items measured when determining bank’s asset quality include loan diversification, adequate internal controls, underwriting standards, and credit risks. A rating of 1 shows minimal risks and strong asset quality. A rating of 5 indicates deficient asset quality.

Management Quality

Management quality evaluates the ability of bank’s management to diagnose problems and handle financial distress. Good management should identify and measure risks and implement the necessary corrective actions. Similarly, the management should be able to foster sound, efficient, and safe organizational operations while ensuring compliance with all applicable laws. Key factors considered when evaluating the management quality of financial institutions include management depth, internal controls, compensation policies, and the overall experiences of the top management. A rating of 1 indicates capable management while 5 indicates deficient management.

Earning

The ability of a financial institution to create returns on the investments made is also measured under the CAMELS rating system. Earning ensures that banks remain competitive, foster expansion, and most importantly, maintain adequate capital levels. Key rations used to determine a bank’s earning ability are Return on Assets (ROA), Return on Equity (ROE), and Net Interest Margin (NIM)[5].  Similar to the other components, a rating of 1 shows that a bank has a higher and desirable ability to create earnings. A rating of 5 is undesirable as it represents a threat to solvency and capital erosion.

Liquidity

Liquidity is the ability of financial institutions to meet their present and future financial obligations without negatively impacting the daily operations. Banks should have enough cash to cater for customer withdrawals and meet other obligations. Key items considered when evaluating the liquidity risk of banks include the availability of readily convertible assets, diversification of funding, and stability of deposits. Liquidity ratios used when rating banks are Loan to customer Deposits (LTD), and deposits to the total assets. A rating of 1 reflects a strong liquidity position while 5 indicates a deficiency.

Sensitivity to Market Risks

As a key factor in evaluating banks, sensitivity refers to the ability of financial institutions to respond to market risks. Such risks include changes in foreign exchange rates, cost of commodities, and interest rates. A rating of 1 indicates that a bank can respond to market risks with ease. On the other hand, 5 reflects a deficiency in sensitivity to risks.

Cease-and-Desist Order

A cease-and-desist order is a document sent to an individual or institution warning it to stop doing an illegal activity, ‘cease’, and not to perform it again, ‘desist’[6]. The latter should adhere to all applicable laws. The document may outline that failure to stop performing the underlined activity by the stipulated date will lead to a legal suit. Although a cease-and-desist order is not a guarantee of a legal suit, failure to comply can be costly and punishable by the courts. The order is not a legally binding document as it represents one’s opinion, usually an attorney.

Although cease-and-desist orders can be used in many situations, there are four key topics covered. These include harassment, intellectual property (trademark and copyright) infringement, contract violations, and defamation and libel[7]. A person issuing threats can be sent a cease-and-desist order as a warning. Debt collectors are barred from oppressing, abusing, or harassing others in their efforts to collect debts. Duplicating or copying intellectual property such as copyrights and trademarks can attract cease-and-desist order.  A person who spreads untruthful information regarding others can be supplied with a cease-and-desist order.

From a bank’s standpoint, a consent order may not be preferable. Such orders prevent banks from harassing their debtors in a bid to collect money advanced. In some cases, people may not be willing to repay the loans advanced to them by financial institutions. In such cases, banks would want to ‘threaten’ such debtors as a way of encouraging them to repay the loan. The law, however, prohibits this from happening. Banks may view the cease-and-desist order and memorandum of understanding as a way of limiting their powers when recovering their loans. As a result, such orders may not be desirable to financial institutions.

Conclusion

To avoid more cases of bank failures, regulatory authorities monitor and evaluate banks. Mechanisms that control, monitor, access, and take the necessary corrective action on troubled and weak banks are undertaken through a process called Prompt Corrective Action (PCA). The CAMELS rating accesses banks’ Capital adequacy, Asset Quality, Management Capability, Earnings, Liquidity, and Sensitivity to market risks. A cease-and-desist order is a document sent to an individual or institution warning it to stop doing an illegal activity.

 

 

Bibliography

Aspal P. Kumar, and Sanjeev Dhawan. Camels Rating Model For Evaluating Financial Performance of Banking Sector: A Theoretical Perspective. 3 IJSMS. 10, 10-15. (2016)

Grinvald L. Chan. Policing the Cease-and-Desist Letter.49 USFL. 411 Rev.  (2015)

Kupiec, Paul. Fixing prompt corrective action. 3 JRMFI, 207, 207-223 (2016):

 

[1]Kupiec Paul. Fixing prompt corrective action. 3 JRMFI, 207, 207-223 (2016).

[2]Kupiec Paul. Fixing prompt corrective action.

[3]Kupiec Paul. Ibid.

[4]Aspal P. Kumar, & Sanjeev Dhawan. Camels Rating Model For Evaluating Financial Performance of Banking Sector: A Theoretical Perspective. 3 IJSMS. 10, 10-15. (2016)

 

 

[5]Aspal P. Kumar, & Sanjeev Dhawan. Camels Rating Model For Evaluating Financial Performance of Banking Sector

 

[6]Grinvald L. Chan. Policing the Cease-and-Desist Letter. 49 USFL. 411 Rev.  (2015)

 

[7]Grinvald L. Chan. Policing the Cease-and-Desist Letter.