Capital Adequacy Standards: Are They Sufficient?

During the last two decades many countries have liberalised their financial markets. They have attempted to eliminate government intervention in setting interest rate ceilings, erecting entry barriers, interfering in credit allocation decisions, and have begun to privatise their financial institutions (FIs). However, recent banking crises have indicated a link between liberalisation and financial fragility and the subsequent trade-off between the benefits of liberalisation and the costs of increasing financial fragility in developing markets. Recent experiences in Asia have highlighted the importance of the soundness of domestic financial systems especially the need for a prudential regulatory, supervisory, and accounting framework before undertaking financial sector liberalisation. The object of the paper is to provide a link between the relative level of an individual bank's adequacy and its effects on the fragility of the banking system. Specifically, the probability of a banking crisis is modelled using the characteristics of individual banks - namely, their capital adequacy ratios. The paper concentrates on the importance of distinguishing between cosmetic and effective changes to capital adequacy ratios to avoid the systemic threats which can grow out of microeconomic weaknesses in domestic banking systems as witnessed in Asia.