In the aftermath of the sub-prime mortgage crisis and the consequent financial market meltdown, there has been considerable debate about the failure of banking regulators to accurately assess institutional and systemic risks. There have been demands to identify and use more representative and accurate parameters that adjust for the inherent solvency risks and toxic assets that are present in the banking sector.
The conventional parameters for evaluating the soundness and strength of banks have been Capital Adequacy Ratios (CAR) and Non Performing Assets (NPAs). The former, also called Capital to Risk Weighted Assets Ratio (CRAR), is the ratio of a bank's capital (equity plus reserves) to its risk weighted credit exposures or risk weighted assets, and is a measure of the "ability of the bank to withstand losses before its ability to pay off its liabilities starts getting compromised" or how much the bank's "assets could fall in value by upto and still it would be able to pay back its depositors". The latter is measured as the percentage of its assets (lendings) which are classified as sub-standard or doubtful of repayment.
However, as Madan Sabanvis writes in a Mint op-ed, looked independently, these two ratios alone can provide misleading indications - a bank with low CAR can show a low NPA ratio and a bank with high CAR may have built up toxic assets. He therefore proposes a "knockout ratio" ("how much of capital would be erased by NPAs", measured as ratio of gross NPAs to capital), by juxtaposing the contaminated part of the portfolio (or NPAs) with the available capital that belongs to the bank. The objective is to arrive at the true extent of capital, or free capital, that the banks actually own, after adjusting for the NPAs. As he writes, "This gives the extent to which the bank’s own capital is being blocked by its impaired assets."
The adjusted CARs for 39 major Indian banks for the fiscal 2009, by extrapolating how the CAR would look like in case NPAs were deducted from the capital of the bank, reveals serious concerns about the capitalization of our banks.
The average "knockout ratios" for these 27 public sector and 12 private banks was quite high at 20.4%; under the concept of adjusted CAR, six banks now slide below the 9% mark that Basel II stipulates; whereas while only one bank had a single-digit conventional CAR, there are now 17 with adjusted CAR less than 10%; the median decline from conventional to adjusted CAR was 2.42 and the average decline was 2.6. The balance sheets of some of the public sector majors like SBI, Syndicate Bank, Union Bank of India, and Indian Overseas Bank, suddenly becomes less flattering. In a further confirmation of the widely held fears about the strength of the ICICI Bank, it emerges with the largest "knockout ratio" among the major private sector banks. Axis Bank, Indian Bank, HDFC, Bank of Baroda, Andhra Bank are among those who emerge with low knockout ratios.