Banking supervisors in industrial countries seek in a variety of ways to ensure that commercial banks are prudent in their lending and balance sheet management.
(1). The assessment of capital adequacy. To ensure that banks have enough capital to meet potential losses, supervisors typically prescribe a ratio of capital to total assets. The ratio varies in its makeup and desired level from country to country, but the normal range is 4 to 6 percent-that is, $4 million to $6 million of capital can support $100 million of lending. In determining this ratio, some supervisors weight assets according to their riskiness: the riskier the loan, the more capital a bank must have to back it.
(2). Exposure limits. Supervisors pay close attention to how bank assets are diversified, aiming to avoid any undue concentration of risk. In recent years some of the adverse risks attached to international lending materialized simultaneously, which underlined the need to bolster banks' capital bases. Supervisors normally require that lending to a single borrower be limited to a fraction of the bank's capital, or a group of large exposures to a multiple of capital. In some countries, borrowers may be consolidated for the purpose of determining exposure limits, and lending to two or more subsidiaries owned by a single holding company may count as a single exposure. Typically borrowers within a country are not consolidated, so that banks can lend to a variety of enterprises within a country without meeting exposure limits. Tighter exposure limits have not generally been introduced. Increasingly, however, as developing-country debt is rolled over in new financing packages for the government and, as sometimes occurs, the government takes over private sector debt, these loans are accrued to a single borrower, and exposure limits may be reached.
(3). Loan-loss provisioning. Supervisors have been concerned in recent years that the quality of assets on banks' books are properly reflected in their balance sheets and so have encouraged banks to provision against losses. Policies regarding provisioning-that is, the setting aside of funds to cover potential general or specific losses-vary significantly among countries. The accounting and tax treatment of loan losses can have important implications for the profitability of banks' loans to some countries and therefore for their willingness to lend. The accounting issue revolves around whether provisions can be counted as part of a bank's capital base or not.