BUS FINANCE 826

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BUS FINANCE 826
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Overview

• The functions of capital, different measures of
  capital adequacy, current and proposed capital
  adequacy requirements and advanced approaches
  used to calculate adequate capital according to
  internal rating based models of credit risk.

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Importance of Capital Adequacy

• Absorb unanticipated losses and preserve
  confidence in the FI
• Protect uninsured depositors and other
  stakeholders
• Protect FI insurance funds and taxpayers
• Protect DI owners against increases in insurance
  premiums
• To acquire real investments in order to provide
  financial services

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Cost of Equity

• P0 D1/(1k) D2/(1k)2
• Or if growth is constant,
• P0 D0(1g)/(k-g)
• May be expressed in terms of P/E ratio as
• P0 /E0 (D0/E0)(1g)/(k-g)

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Capital and Insolvency Risk

• Capital
• net worth
• book value
• Market value of capital
• credit risk
• interest rate risk
• exemption from mark-to-market for banks
  securities losses

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Capital and Insolvency Risk (continued)

• Book value of capital
• par value of shares
• surplus value of shares
• retained earnings
• loan loss reserve

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Book Value of Capital

• Credit risk
• tendency to defer write-downs
• Interest rate risk
• Effects not recognized in book value accounting
  method

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Discrepancy Between Market and Book Values

• Factors underlying discrepancies
• interest rate volatility
• examination and enforcement
• Market value accounting
• market to book
• arguments against market value accounting

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Capital Adequacy in Commercial Banks and Thrifts

• Actual capital rules
• Capital-assets ratio (Leverage ratio)
• L Core capital/Assets
• 5 target zones associated with set of mandatory
  and discretionary actions
• Prompt corrective action

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Leverage Ratio

• Problems with leverage ratio
• Market value may not be adequately reflected by
  leverage ratio
• Asset risk ratio fails to reflect differences in
  credit and interest rate risks
• Off-balance-sheet activities escape capital
  requirements in spite of attendant risks

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New Basel Accord (Basel II)

• Pillar 1 Credit, market, and operational risks
• Credit risk
• Standardized approach
• Internal Rating Based (IRB)
• Market Risk --Unchanged

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Basel II continued

• Operational
• Basic Indicator
• Standardized
• Advanced Measurement Approaches

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Basel II continued

• Pillar 2
• Specifies importance of regulatory review
• Pillar 3
• Specifies detailed guidance on disclosure of
  capital structure, risk exposure and capital
  adequacy of banks

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Risk-based Capital Ratios

• Basle I Agreement
• Enforced alongside traditional leverage ratio
• Minimum requirement of 8 total capital (Tier I
  core plus Tier II supplementary capital) to
  risk-adjusted assets ratio.
• Also requires, Tier I (core) capital ratio
• Core capital (Tier I) / Risk-adjusted ?
  4.
• Crudely mark to market on- and off-balance sheet
  positions.

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Calculating Risk-based Capital Ratios

• Tier I includes
• book value of common equity, plus perpetual
  preferred stock, plus minority interests of the
  bank held in subsidiaries, minus goodwill.
• Tier II includes
• loan loss reserves (up to maximum of 1.25 of
  risk-adjusted assets) plus various convertible
  and subordinated debt instruments with maximum
  caps

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Calculating Risk-based Capital Ratios

• Credit risk-adjusted assets
• Risk-adjusted assets Risk-adjusted
  on-balance-sheet assets Risk-adjusted
  off-balance-sheet assets
• Risk-adjusted on-balance-sheet assets
• Assets assigned to one of four categories of
  credit risk exposure.
• Risk-adjusted value of on-balance-sheet assets
  equals the weighted sum of the book values of the
  assets, where weights correspond to the risk
  category.

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Calculating Risk-based Capital Ratios under
Basel II

• Basel I criticized since individual risk weights
  depend on broad borrower categories
• All corporate borrowers in 100 risk category
• Basle II widens differentiation of credit risks
• Refined to incorporate credit rating agency
  assessments

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Risk-adjusted Off-balance-sheet Activities

• Off-balance-sheet contingent guaranty contracts
• Conversion factors used to convert into credit
  equivalent amountsamounts equivalent to an
  on-balance-sheet item. Conversion factors used
  depend on the guaranty type.

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Risk-adjusted Off-balance-sheet Activities

• Two-step process
• Derive credit equivalent amounts as product of
  face value and conversion factor.
• Multiply credit equivalent amounts by appropriate
  risk weights (dependent on underlying
  counterparty)

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Risk-adjusted Off-balance-sheet Activities

• Off-balance-sheet market contracts or derivative
  instruments
• Issue is counterparty credit risk

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Risk-adjusted Off-balance-sheet Activities

• Basically a two-step process
• Conversion factor used to convert to credit
  equivalent amounts.
• Second, multiply credit equivalent amounts by
  appropriate risk weights.
• Credit equivalent amount divided into potential
  and current exposure elements.

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Credit Equivalent Amounts of Derivative
Instruments

• Credit equivalent amount of OBS derivative
  security items Potential exposure Current
  exposure
• Potential exposure credit risk if counterparty
  defaults in the future.
• Current exposure Cost of replacing a derivative
  securities contract at todays prices.
• Risk-adjusted asset value of OBS market contracts
  Total credit equivalent amount risk weight.

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Risk-adjusted Asset Value of OBS Derivatives
With Netting

• With netting, total credit equivalent amount
  equals net current exposure net potential
  exposure.
• Net current exposure sum of all positive and
  negative replacement costs.
• If the sum is positive, then net current exposure
  equals the sum.
• If negative, net current exposure equals zero.
• Anet (0.4 Agross ) (0.6 NGR Agross )

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Interest Rate Risk, Market Risk, and Risk-based
Capital

• Risk-based capital ratio is adequate as long as
  the bank is not exposed to
• undue interest rate risk
• market risk

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Operational Risk and Risk-Based Capital

• 2001 Proposed amendments
• Add-on for operational risk
• Basic Indicator Approach
• Gross income Net interest Income Noninterest
  income
• Operational capital ? Gross income
• Top-down.
• Too aggregative.

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Operational Risk and Risk-Based Capital

• Standardized Approach
• Eight major business units and lines of business
• Capital charge computed by multiplying a weight,
  ?, for each line, by the indicator set for each
  line, then summing.

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Operational Risk and Risk-Based Capital

• Advanced Measurement Approaches
• Three broad categories
• Internal Measurement Approach (IMA)
• Loss Distribution Approach (LDA)
• Scorecard Approach (SA).

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Criticisms of Risk-based Capital Ratio

• Risk weight categories versus true credit risk.
• Risk weights based on rating agencies
• Portfolio aspects Ignores credit risk portfolio
  diversification opportunities.
• DI Specialness
• May reduce incentives for banks to make loans.
• Other risks Interest Rate, Foreign Exchange,
  Liquidity
• Competition and differences in standards

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Capital Requirements for Other FIs

• Securities firms
• Broker-dealers
• Net worth / total assets ratio must be no less
  than 2 calculated on a day-to-day market value
  basis.

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Capital Requirements (contd)

• Life insurance
• C1 Asset risk
• C2 Insurance risk
• C3 Interest rate risk
• C4 Business risk

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Capital Requirements (contd)

• Risk-based capital measure for life insurance
  companies
• RBC (C1 C3)2 C22 1/2 C4
• If
• (Total surplus and capital) / (RBC) lt 1.0,
• then subject to regulatory scrutiny.

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Capital Requirements (contd)

• Property and Casualty insurance companies
• similar to life insurance capital requirements.
• Six (instead of four) risk categories

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Pertinent Websites

• BIS www.bis.org
• Federal Reserve www.federalreserve.gov
• National Association of Insurance Commissioners
  www.naic.org
• U.S. Treasury Department www.ustreas.gov

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