Commercial banks are major players in the banking system. They are the largest and most important suppliers of funds in the banking system. Commercial banks initially placed under supervision of the BNM in 1959. Prior to the inception of BNM, commercial banks had only to comply the companies Ordinance 1948. The Banking Act 1973 was subsequently replaced in 1989, banking and financial Institutions Act 1989 (BAFIA), which combines the Banking Act 1973 and Finance Companies Act 1969 in a single law (BNM, 1999).

The main function of commercial banks is to provide retail banking services, such as accepting deposits, granting loans and advances, and financial guarantees. Apart from that, commercial banks provide trade financing facilities such as trust receipts, Banker’s Acceptance, shipping guarantees and letter of credit. Commercial banks are also authorized. Risks are usually defined as the negative impact on the profitability of many various sources of uncertainty. Although the types and degree of risks an organization may being depends on several factors, such as size, complexity of business activity level, it is believed that in general most banks are faced with Credit, Market, Liquidity, Operational, Compliance, Legal and Reputational Risks. Because there are many risks of involvement in banking, risk management is now becoming a discipline at the midpoint of each financial institution. (BNM, 1999).

At the end of September 2001, there were twelve domestic commercial banking institutions and 14 foreign banks, with a total of 1,719 bank branches. With completion of the merger of banks, a number of domestic commercial banks reduced by 10 banking groups. Banking institutions provide payment services via their own propriety network, and through their clearing accounts with BNM for interbank transfer of funds to pay a third party. In carrying out banking operations banks in Malaysia are required to comply with local and international regulations, such as the regulations issued by the Banks International Standards (BIS).

The Development of BIS

Yu.W (2005) explains that according to Pillar I of the New Capital Accord Basel II, banks must meet with certain criteria for the calculation of regulatory capital. Banks should have a certain level of solvency. Solvency is a measure of the extent to which the bank may satisfy their financial obligations. The higher the pay, the better the bank can meet its financial obligations. Such a calculation of solvency referred to as BIS II – ratio. Ratio shows the attitude of capacity and capability of banks capital reserved to cover all risks (Credit, market and operational risks).

BIS 11 – ratio is calculated as in formula 1. In the numerator, we can see that at tier 1, tier 2 and tier 3 capitals. In the denominator we can see several components, which represent the requirements to lower market risk and operational risks.

(1)

The components, which are included in the BIS II – ratio are generally described as following:

RWA = Risk Weighted Assets. These are the added up assets, weighed with the associated risk percentage. The RWA are stipulated at calculating the capital seizure for credit risk.

Tier I = A term used to describe the capital adequacy of a bank. Tier I capital is core capital; this includes equity capital and disclosed reserves.

Tier2 = A term used to describe the capital adequacy of a bank. Tier I1 capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated debt of five years.

Tier3 = A term used to describe the capital adequacy of a bank. This is the subordinated term debt of a maximum of two years.

Cmr = Capital requirements for market risk.

Cor = Capital requirements for operational risk.

BIS II-ratio was developed based on the ratio of BIS. This ratio was first introduced in the Basel Accord in 1988, it will be called as BIS I (1988)-ratio. Initially this ratio only took the credit risk into account. Claims that the capital was to capture at least 8% of the assets of the risk of weight. To calculate the risk weights assets, banks multiply several assets with the associated risk percentages, which are prescribed by Basel Committee. Capital exemptions should be included in Tier 1 and Tier 2 capital. BIS I (1988) – ratio is calculated with formula 2:

(2)

In 1996, another ratio was applied; it was called as I BIS (1996) – the ratio. Because the market risk was not taken into account in the old Basel Accord of 1988, so that additional element in the formula was adopted. As a result of the seizure of the capital for market risk included in the denominator of BIS I (1988) ratio. The numerator was extended with the Tier 3 capital to cover the market risk. For more information, one will be referred in formula 3.

(3)

The development of BIS II-ratio (see formula 1) is a step by step process through many years. Many adjustments were made for many years. Such as, the risk weight assets (RWA) should also be calculated differently. The Basel Committee has new interest for the calculation of RWA. But the most important change in the ratio that seizure of the capital of operational risk has been included in the denominator. Infliction denominator to be more or (less depends also on other credit and market risks), and the criterion is 8% of total capital. In addition, banks should be able to allocate fewer capitals to stronger loans, while more capital is needed for weak credit. A side effect of this new agreement is that it will affect the banks return on individual relationships, and is expected to lead to a change in their behavior for some clients and objects. Typically, the most difficult task in risk management operational risk management, due to lack of experience in dealing with this issue. Beside this, the operational risk is not clearly defined concept, and therefore it makes the task more difficult for the risk managers.

Capital adequacy ratios are a measure of the amount of the bank’s capital expressed a percentage of its risk weighted credit exposures. An international standard which recommends minimum capital adequacy ratios has been developed to ensure that banks can absorb an acceptable level of losses before becoming insolvent. The minimal capital adequacy in order to protect depositors and promote stability and effectiveness of the financial system. Two types of capital is measured – tier 1 capital that can absorb the losses, not the bank, which needed to stop trafficking, for example, ordinary share capital, as well as tier 2 of capital that can absorb losses in the event of liquidation and so provides a lesser degree of protection of depositors, such as subordinated debt.

Measuring the impact of the credit requires adjustments to be made to the amount of assets shown on the balance sheet. The loans a bank has made are weighted, in a broad-brush way, depending on the degree of riskiness, such as government loans are 0 per cent weighting whereas loans to individuals are weighed at 100 percent. Off balance sheet contracts, such as guarantees and foreign exchange contracts, as well as carry credit risks. These exposures are converted into credit equivalent amounts, which are also weighted in the same manner as on the balance sheet impact of the credit. On-balance sheet and off-balance sheet credit exposures are added to get the total risk weighted credit exposures.

Minimum capital adequacy ratios, which are used as follows:

Tier 1 capital to total risk weighted credit exposures is not less than 4 percent;

Total capital (Tier 1 plus Tier 2 less certain deductions) in relation to risk-weighted credit risk to be not less than 8 percent. (Reserve Bank of New Zealand)

Stephanou.C and Mendoza.CJ (2005) identified credit risk has traditionally been defined default risk, i.e. risk of loss from borrower / counterparty default on the amount of debt (principal or interest) in the bank in a timely manner on the basis of previously agreed payment schedule. A broader definition actually include the cost of risk, i.e. risk of loss in value of the borrower to switch to a lower credit rating (opportunity cost of not pricing the loan correctly for its new level of risk), without having a default. In order to protect itself from fluctuations in the level of default / value losses (as well as other risks), banks have adopted methodologies that allow them to quantify such risks, and thereby obtain the amount of capital required to support their business what is referred to as economic capital.

At BIS (2003a), “Operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems or external events. This definition includes legal risk but excludes strategic and reputational risk. “A new agreement presents three approaches to assessing operational risk: benchmark approach, standardized approach and advanced measurement approaches (AMA).

Terrence. F and Martell found the amendment to the Capital Accord provides distinct levels of capital at the expense of the price risk associated with positions in gold and other commodity markets. The BCBS is particularly concerned about market risk emerging from trading activities of the bank. Market risk is defined as the risk of loss for both on and off-balance sheet items related to the change in market prices. The Committee classifies the market risks in four areas: interest rate, equities, foreign exchange (including gold), and commodities risks. With regard to interest rates and risk in equity prices, recommendations relate to positions in the trading book only. Foreign exchange and commodities risk refers to any position carried by the bank.

The BCBS report allows two general methodologies to be employed. The standardized measurement method is a building block approach in which each position is treated individually. Necessary capital from standardized method of measurement will be the amount of capital required for each position in the portfolio. The internal model approach allows the bank to use its value at risk model (VaR) based certain minimum requirements. Thus, the internal models methodology for more portfolio approach, with each of the 4 product categories defined above considered as separate portfolio.

Risk and Capital

Frank Knight (1921) definition of objective and subjective probabilities aside, risk can be considered as uncertainty around the return of assets or investment strategy. A subset of this definition would be downside risk, or the risk of loss. Continuing in this direction, we can determine the risk of solvency as the risk of heavy losses in question survival of the company and determine how capital amount set aside to help mitigate this risk. We begin our analysis with any distribution of possible gains or distribution of possible losses, but we examine the extreme tail of either one to consider solvency. Economic and regulatory capital measurements aim to determine, given a pre-specified degree of statistical confidence, how much capital should be held in order to prevent insolvency. Economic measures are considered more suitable for institution in question, as well as more complex, realistic, etc., as compared with Formula approaches will be implemented in existing and proposed regulatory capital rules.

Smithson (2003) review of both top down and bottom-up approach to measuring economic capital. In the former, one measure of the uncertainty of cash flows, studying historical cash flows of the company or division. Using the standard deviation of cash flows one, we can evaluate the potential downside cash flow measure, given the distribution Assumption the level of trust, and then use the risk-free rate, to convert this amount in the rate of risk capital. For example, if my 99% confidence level changes in the annual income loss of $ 300 million, how much capital I should set aside to invest in risk-free assets to produce an offsetting flow in a given year. Dividing the annual risk free rate creates a risk of the amount of capital that is invested in the perpetuity, will produce $ 300 million each year. The advantage of this approach is that it is a comprehensive, total risk measures for the business unit or company (assuming that cash flows indeed cover all the company’s risk phenomenon). The disadvantage is that a significant amount of historical data of cash flows required. Any changes in business strategy over time should be taken into account for. For example, if a company enters into a new business or shuts down operations, historical aggregate cash flows are no longer the same current risk profile and require adjustments. In addition, the new case has no historical cash flow data for consideration to assess its uncertainty and should be a proxy for data from a similar business.

This leaves us bottom-up, the most common method currently used to measure the economic and regulatory capital. In this approach, categories risks are evaluated separately. The most frequently used categories are credit risk, market risk and operational risk. Based on the author’s experience, the typical total risk breakouts of large commercial banks represented at industry conferences 70% of credit risk, 10% market risk, and 20% of operational risk. Note that this approach can be in a position use historical market and industry data for risk assessment, but we must now determine what sort of individual risks within the business entity at an overall assessment of risk.

There is a little research data on the behavior of such interactions between risk and naYve addition implies perfect correlation. The experience of the author, credit risk can be defined as the risk of loss resulting from default events or changes in the probability of such events by default. Market risk is the risk of loss from changes in the market movement of traded instruments. It also encapsulates the changes in fair value when document in question may not be traded, but traded aspects of its value to do. For example will the over-the-counter derivatives, such as the difference between the two market interest rates. One can determine the fair value of this instrument, as well as its cost uncertainty or risk watching the market movement of its main indicators. Operational Risk has a number of potential definitions, the broadest being any risk that is not market or credit risk.

Problem Statement

In addition, as noted earlier in this chapter of this study is conducted on relation to commercial banks in Malaysia only. This study will address the question that is the level of capital adequacy ratio of commercial banks in Malaysia on the basis of Basel II Accord. In addition, the following statement of the problem in that we do not know which banks have or do not comply with Basel II Accord. To date, few studies have identified the factors that affecting the basis of CAR Basel II Accord interpretation.

Research Objectives

The objectives of the study are:

• To calculate the CAR of each bank in the sample based on Basel II
• To determine its compliance to the 8% CAR requirements.
• To analyze the trend of credit risk, market risk, operational risk, size, loan loss provision, loans, GDP over 2001 to 2005.
• To investigate the factors of affecting CAR of commercial banks in Malaysia.

Significance of the study

This study will make a valuable contribution to the assessment of the level of Capital adequacy ratio of commercial banks’ base Basel II Accord. Besides that, in this research can be found authority of public example, they may know effectiveness and efficiency of commercial bank in Malaysia. Then Banking Committee, they can manage their risks profile. In addition, this study contributes to a richer set of information, an academician with the best theoretical understanding and future applications for capital adequacy ratio Basel II Accord. The study serves as a guide to provide a report document or proof of where the problem as finds out.

CHAPTER 2

LITERATURE REVIEW

Introduction

Chapter 2 contains by examining the relevant literature for this study including comprehensive reading of books, magazines, periodicals and many more publications. This chapter also explains and describes the identification of related concepts and theory of capital adequacy and relationships with credit risk, operational risk and Liquidity risk framework in Basel II Accord.

In addition, the required capital adequacy ratio as may be used to determine the threshold at which the regulator intervenes in the management of the bank failing. Since payoff function of shareholders is convex with respect to equity of the bank, their incentive to take risks increases its equity decreases. While this would hurt interests of the bank’s depositors, they may not intervene if they are too small and uninformed about the management of the bank. Thus, in order to protect the depositors against shareholder moral hazard, it is optimal to transfer the bank’s control rights from its shareholders to the regulator who represent the interests of the bank’s depositors, before its capital is depleted (Dewatripont and Tirole, 1994).

Review of the theoretical literature and evidences

The main justification for regulating bank capital is the need to avoid the risk of transition incentives generated by the incorrect price deposit insurance. In fact, although it may ensure financial stability in the short term, risk-insensitive deposit insurance, as a rule, reduce incentives for banks to maintain adequate capital and can thus jeopardize the stability of the term. The ability of capital standards successfully eliminate this moral hazard problem was in the center of theoretical debate for more than 20 years. A first strand of the literature focuses on utility-maximizing banks using the portfolio approach of Pyle (1971) and Hart and Jaffee (1974). In this framework, Koehn and Santomero (1980) show that the introduction of higher capital ratios will lead banks to shift their portfolio to riskier assets and that the reshuffling effect will be larger for institutions which initially held relatively more risky assets per unit of capital. This effect occurs because flat requirements restrict the banks’ risk-return frontier, which leads them to compensate the loss in utility from the upper limit on leverage with the choice of a riskier portfolio. One way to eliminate the risk-shifting incentive is to require banks to meet risk-related capital ratios, as suggested by Kim and Santomero (1988).

These conclusions have been questioned on several grounds. Using alternative models Furlong and Keeley (1989) and Keeley and Furlong (1990) argue that higher capital ratio does not lead banks to increase asset risk. They argue that the utility maximization structure, which reaches the opposite conclusion, is inappropriate because it is not adequate description of the investment opportunities of the bank, ignoring the set value deposit insurance system, as well as the possibility of bank failure. In the same simulation framework, Gennotte and Pyle (1991) relax the assumption that banks invest in zero net present value assets and find that there are now plausible situations in which an increase in capital requirements results in an increase of asset risk. The portfolio approach is used again by Rochet (1992) who shows that when the objective of banks is to maximize the market value of their future profits, risk-related capital ratios cannot prevent them from choosing very specialized and very risky portfolios.

In this case, risk-based insurance premia are in fact the relevant instrument to limit banks’ risk-taking. Most recently, Blum (1999) also finds that capital regulation may increase banks’ risk-taking but in a dynamic framework. Using a two period model, he shows that the effect of inter temporal should be considered in addition to the standard negative impact on the capital management of credit risk. If banks find it too expensive to raise additional equity to meet new capital requirements tomorrow or unable to do so, they increase the risk today. The second effect of strengthening the known risk-shifting incentives by reducing profits. In short, economic theory does not clearly indicate whether introduction of more stringent capital requirements on banks leads to an increased risk structure of their portfolio of assets. Ultimately, the question of capital adequacy rules limiting banks incentives to engage in “moral hazard” is an empirical question. Next subsection attempts to clarify the debate on the impact of risk capital management briefly repeat the basic rules of 1988 Basel Accord and watching how the banks can carry them.

Currently, banks with international operations are regulated by the capital adequacy regulation set in 1988 Basel Capital Accord, under which they are obliged to maintain a minimum 8 percent capital to risk weighted asset ratio. The numerator of this regulatory ratio consists of the Tier I and Tier II capital former consists of equity Capital and disclosed reserves, while the latter may include items like equity, such as subordinated debt, and capital gains. Given the risk of assets that constitute denominator, and include out of balance, weighted appropriately depending on which of the four risk categories (0 per cent, 20 per cent, 50 per cent and 100 per cent), that particular asset belongs to. Although the original 1988 Accord only took the credit risk into account, the subsequent amendments in 1996 and including market risk. The main purpose of capital adequacy regulation is to limit the risk-taking by banks. Most industrial countries now have a deposit insurance scheme to pre-yield bank runs and protect small depositors and ignorance. Banks that are subject to a flat insurance premium, however, may have excessive incentives to take risks, since their payoff functions are convex with respect to their net worth. Capital adequacy requirement may mitigate this problem, since the marginal value of deposit insurance option with respect to asset risk falls with declining leverage (Furlong and Keeley, 1989).

The Basel II Accord has been criticized extensively because of its implications from its first conception. Altman and Saunders (2001) found, among other things, that relying on traditional agency ratings may produce cyclically lagging rather than leading capital requirements and that the risk based bucketing proposal lacks a sufficient degree of granularity. Instead they advised to use a risk weighting system that more closely resembles the actual loss experience on loans. Criticism like this has spurred subsequent research by authors such as Carling et al. (2004), Dietsch and Petey (2002), Estrella (2004), Calem and LaCour-Little (2001), and Hamerle et al. (2003). Their work employs credit risk models for the ultimate goal of calculating capital requirements under a variety of alternative systems and makes clear, among other things, how the proposed internal ratings based (IRB) approach relates to general Value-at-Risk (VaR) models of credit risk and state-of-the-art risk rating and how the technical specification of the final IRB design will affect banks’ policies. The extent to which different treatment of retail lending to small and medium business credit is justified will depend on at least two factors: the ability of domestic bank’s internal risk rating systems to adequately take into account the differences between loans and various types of assets, as well as the methods used to calculate the relevant measurement of risk. Several authors have investigated the ability of banks’ internal ratings systems to overcome differences between (portfolios) of assets and the implications for credit risk assessment and the possible operation of Basel II.

Cole (1998), for example, finds empirical support for the theory that banking relationships generate valuable private information about borrower quality. In more recent work, Degryse and Ongena (2005) report evidence that confirms the importance of geographical distance for monitoring (costs). Petersen and Rajan (2002) find that firms with long distances to their lenders, typically SMEs, no longer need to be the highest quality counterparts, indicating that they have obtained greater access to credit. In response to the work of the Base1 Committee, a number of authors have looked more explicitly into the differences in risk properties between credit types. A range of currently available methods to measure retail credit risk is surveyed by Allen et al. (2004).

Schmit (2003) studies retail lease portfolios by means of a Monte Carlo resampling method and finds that the Base1 I1 framework insufficiently recognizes collateral. Perli and Nayda (2003) model hture margin income and show that the capital ratios generated by the Basel formula best matches those generated by their model for low risk portfolio segments. Their results indicate some shortcomings in the Basel framework. Capital ratio for high-risk segments, such as, sometimes is lower than for low-risk segments. They also show that in Basel’s assumptions about the interaction between asset correlation and the probability of default may be inaccurate, especially in extreme ends of the spectrum of risks. With respect to SME loan portfolios, Dietsch and Petey (2002) propose two parametric methods for estimating credit risk. They establish, when applying these methods, which actual capital requirements are significantly lower than those derived under Basel 11. Dietsch and Petey (2004) also find that SMEs are riskier than large businesses and that PDs and asset correlations are not negatively, as assumed by Basel 11, but positively related to each other.

Angbazo (1997) look at the relationship between bank net interest margins and interest rate risk. To measure that relationship net interest margin and interest rate risk based on the annual Federal Reserve System’s Reported of Condition an Income (Call Report) for commercial Banks for 1989 to 1993. The sample consists of 1400 observations 286 commercial banks with assets of $ 1 billion or more by using of regression models. He checked the net interest margin and a variable as follows: the risk of default (NCO), the interest rate risk (SHORT), liquidity risk (LIQ), leverage (LEV), the implicit interest payment (IMPLICIT), opportunity cost of non-interest bearing reserves (NIBR), the management efficiency (MGMT) and branching regulation (LIMIT). From this research he discovered that assumption that the bank interest reflects both the default and premium interest rates. Net interest margins positively related to fixed assets, which proxy for operational risks based on the recommendations of the Basel II Accord, non-interest bearing reserves, management quality. But the result shows, the net interest margin is negatively associated with liquidity. Then the net interest Margin money center banks are important for banks first. Nevertheless, interest rate risk not important for many of the bank. Interest margin of the super-regional, and regional banks are sensitive to interest rate risks, but not the risk of default.

According to the Hendricks.D and Hirtle-B, while the original Basle Accord and U.S. risk based capital guidelines primarily addressed banks7 exposure to credit risk, the new requirements set minimum capital standards for banks’ market risk exposure. Generally speaking, market risk is the risk of losses from adverse changes in the market value of assets and liabilities, or off balance sheet positions. Market risk generally arises from changes in the underlying risk factors interest rate, exchange rates, equity prices or commodity prices, which affect the cost of those in and off balance-sheet items. Thus, the bank’s market risk exposure is defined as the volatility the major risk factors and the sensitivity of portfolio to movements in these risk factors.

Hendricks. D and Hirtle. B found that Banks face market risk from the full range of positions held in their portfolios, but the capital standards focus largely on the market risks arising from banks’ trading activities. This focus reflects the idea that the market risk is the main component of the risks associated with trading activities, and, moreover, that the market risk exposure are more visible and easily measured in the trading portfolio because these positions are marked to market daily. Thus, in accordance with the amended capital standards, positions in a bank’s trading book are subject to the market risk capital requirements but exempt from the initial risk-based capital charge for credit risk exposure. In addition, commodity and foreign exchange positions held organizations (both inside and outside the trading account) are subject to market risk capital requirements. As the capital standards are primarily directed and beyond trading account) are subject to market risk capital requirements.

Review of the empirical studies

With the exception of Ediz et al. (1998), all use the simultaneous equations approach. This modeling framework allows us to compare the behavior of undercapitalized and adequately capitalized banks in relation to changes in capital and risk, and whether these changes related. These studies surveyed generally support the idea that the undercapitalized banks (for example, those who do not achieve the requirements of Basel) increased its capital in the ratio of assets in the first half of 1990. Similar phenomenon is observed for adequately capitalized institutions, although to a lesser extent. In addition, little consensus among the documents reviewed that adequate capitalization of banks or not involved in risky activities. Finally, changes in equity and credit risk seem largely unrelated. Results of US studies are difficult to interpret as the implementation of the second stage of the Base1 Accord, between the end of 1990 and the end of 1992 coincides with the adoption of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in December 1991. Section 131 FDICIA, prompt corrective action (PCA), goes one step further than the Basel Accord by defining three regulatory ratios (Basle capital standards and use requirements) and five categories, on which banks are classified depending on their compliance with the three ratio. Thus, it is hard to ascribe the findings of the two papers by Aggarwal and Jacques (1997, 2001) to FDICIA or the Basel Accord, as US banks’ behavior is likely to have been affected by both regulations over the period that they consider. Jacques and Nigro (1 997) avoid this problem by focusing on the years 1990-91, i.e. the period before FDICIA was passed. However, the very small number of undercapitalized institutions in their sample – less than 2% of the total number of banks -may reduce the reliability of some of their estimates. Three papers present some non-US evidence regarding the relationship between, capital and credit risk: Ediz et al. (1998) base their study on confidential UK data whereas Rime (2001) uses Swiss data and Heid et al. (2004) employ German data. Like other studies listed in Table 1, the first of these papers uses a partial adjustment framework but, unlike them, treats changes in capital and risk-taking as two separate decisions. Surprisingly, Ediz et al.’s model leads to the result that banks adjust their capital levels each year by more than the difference between the current level and the target they have in mind, which means that banks overshoot the target (and by a higher amount each year). The study by Rime (2001) is interesting because it provides the first application of the simultaneous-equations model reviewed in section 4 to non-US banks. However, Rime adopts the PCA regulatory classification to measure regulatory pressure on Swiss banks, which might be inappropriate given that the additional requirements set by PCA have not been adopted formally by any other country besides the US. The paper by Heid et al. (2004) investigates the relation between capital and risk levels by looking at a sample