RISK-BASED CAPITAL AND ITS APPLICATION TO THE BANKING SYSTEM IN SINGAPORE

Abstract

The hypothesis that bank capital affords a sense of financial stability to the firm by providing (I) a buffer against bankruptcy costs, (2) a direct source of funds, and (3) an indirect source of funds (Gart, 1994) while at the same time protecting against the external social costs of bank failure has brought about a proliferation of concern about the capital adequacy of banks. In fact, regulators have come up with numerous ways to evaluate banks. The publication of seminal works on risk-based measures such as the risk-based capital and the value at risk measures have motivated a number of empirical and theoretical research mainly in the United States of America and Europe to assess their adequacies. However, a comprehensive study using data from Singapore is still lacking despite the fact that some form of risk-based capital has recently been implemented locally. Therefore, the aim of this thesis is to evaluate Singapore banks standing with regards to the new regulation, gauge the probable impact and weaknesses of the risk-based capital measure and recommend the implementation of a new measure, namely the Value At Risk (VAR) measure to complement the existing regulation. The risk-based capital measure of three local banks were computed and compared for four consecutive years and the VAR was computed through stochastic simulation for all seven local stock option counters on the market to illustrate the higher risk faced with derivative instruments and to suggest the incorporation of the VAR measure for off-balance sheet derivative trading instruments. Conceivably, the risk-based capital measure has its inherent weaknesses. Alternatively, we recommend the incorporation of some measure of VAR which would help counteract the weaknesses until more sophisticated regulatory measures can be implemented empirically.