Capital Adequacy

1

• Chapter 20
• Capital Adequacy

2
Overview

• This chapter discusses 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.

3
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 FI owners against increases in insurance
  premiums
• To acquire real investments in order to provide
  financial services

4
Capital and Insolvency Risk

• Capital
• net worth
• The economic definition of capital is the
  difference between the market value of assets and
  the market value of liabilities.
• book value
• The book value definition of capital is the value
  of assets minus liabilities as found on the
  balance sheet. This amount often is referred to
  as accounting net worth.
• Market value of capital
• credit risk
• interest rate risk
• mark-to-market for banks securities losses

5
Capital and Insolvency Risk

• How does economic value accounting recognize the
  adverse effects of credit and interest rate risk?
  
• The loss in value caused by credit risk and
  interest rate risk is borne first by the equity
  holders, and then by the liability holders. In
  market value accounting, the adjustments to
  equity value are made simultaneously as the
  losses due to these risk elements occur. Thus
  economic insolvency may be revealed before
  accounting value insolvency occurs.
• How does book value accounting recognize the
  adverse effects of credit and interest rate risk?
  
• Because book value accounting recognizes the
  value of assets and liabilities at the time they
  were placed on the books or incurred by the firm,
  losses are not recognized until the assets are
  sold or regulatory requirements force the firm to
  make balance sheet accounting adjustments. In
  the case of credit risk, these adjustments
  usually occur after all attempts to collect or
  restructure the loans have occurred. In the case
  of interest rate risk, the change in interest
  rates will not affect the recognized accounting
  value of the assets or the liabilities.

6
Example (P. 547 8)

• State Bank has the following year-end balance
  sheet (in millions)
•  
• Assets Liabilities and Equity
• Cash 10 Deposits 90
• Loans 90 Equity 10
• Total Assets100 Total Liabilities
  Equity 100
•  
• The loans primarily are fixed-rate, medium-term
  loans, while the deposits are either short-term
  or variable-rate. Rising interest rates have
  caused the failure of a key industrial company,
  and as a result, three percent of the loans are
  considered to be uncollectable and thus have no
  economic value. One-third of these uncollectable
  loans will be charged off. Further, the increase
  in interest rates has caused a 5 percent decrease
  in the market value of the remaining loans. What
  is the impact on the balance sheet after the
  necessary adjustments are made according to?

7
Example (P. 547 8)

• Under book value accounting, the only adjustment
  is to charge off 1 percent of the loans. Thus
  the loan portfolio will decrease by 0.90 and a
  corresponding adjustment will occur in the equity
  account. The new book value of equity will be
  9.10. We assume no tax affects since the tax
  rate is not given.
• Under market value accounting, the 3 percent
  decrease in loan value will be recognized, as
  will the 5 percent decrease in market value of
  the remaining loans. Thus equity will decrease
  by 0.03 x 90 0.05 x 90(1 0.03) 7.065.
  The new market value of equity will be 2.935.
• The new market to book value ratio is
  2.935/9.10 0.3225.

8
Capital and Insolvency Risk (continued)

• Book value of capital
• par value of shares
• surplus value of shares
• retained earnings
• loan loss reserve
• A special reserve set aside out of retained
  earnings to meet expected and actual losses on
  the portfolio.
• Loan loss reserve reflect an estimate by the FIs
  management of the losses in the loan portfolio.

9
Discrepancy Between Market and Book Values

• Factors underlying discrepancies
• interest rate volatility
• examination and enforcement
• Market value accounting
• market to book
• Market values produce a more accurate picture of
  the banks current financial position for both
  stockholders and regulators. Stockholders can
  more easily see the effects of changes in
  interest rates on the banks equity, and they can
  evaluate more clearly the liquidation value of a
  distressed bank.
• arguments against market value accounting
• Among the arguments against market value
  accounting are that market values sometimes are
  difficult to estimate, particularly for small
  banks with non-traded assets. This argument is
  countered by the increasing use of asset
  securitization as a means to determine value of
  even thinly traded assets.
• In addition, some argue that market value
  accounting can produce higher volatility in the
  earnings of banks.
• Unrealized capital gains and losses
• A significant issue in this regard is that
  regulators may close a bank too quickly under the
  prompt corrective action requirements of FDICIA.

10
Arguments against Market Value Accounting

• Among the arguments against market value
  accounting are that market values sometimes are
  difficult to estimate, particularly for small
  banks with non-traded assets.
• This argument is countered by the increasing use
  of asset securitization as a means to determine
  value of even thinly traded assets.
• In addition, some argue that market value
  accounting can produce higher volatility in the
  earnings of banks.
• Unrealized capital gains and losses
• A significant issue in this regard is that
  regulators may close a bank too quickly under the
  prompt corrective action requirements of FDICIA.
• FIs are less willing to accept longer-term asset
  exposure.
• Interfere with FIs special functions.

11
Capital Adequacy in Commercial Banks and Thrifts

• Actual capital rules
• Capital-assets ratio (Leverage ratio)
• L Core capital/Assets
• Where core capital is book value of equity plus
  qualifying cumulative perpetual preferred stock
  plus minority interests in equity accounts of
  consolidated subsidiaries.
• 5 target zones associated with set of mandatory
  and discretionary actions
• Prompt corrective action
• The prompt corrective action provision requires
  regulators to appoint a receiver for the bank
  when the leverage ratio falls below 2 percent.
  Thus even though the bank is technically not
  insolvent in terms of book value of equity, the
  institution can be placed into receivorship.

12
Leverage Ratio

• Problems with leverage ratio
• Market value may not be adequately reflected by
  leverage ratio
• closing a bank when the leverage ratio falls
  below 2 percent does not guarantee that the
  depositors are adequately protected. In many
  cases of financial distress, the actual market
  value of equity is significantly negative by the
  time the leverage ratio reaches 2 percent.
• 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

13
Basel Agreement

• The Basel Agreement identifies the risk-based
  capital ratios agreed upon by the member
  countries of the Bank for International
  Settlements.
• The major feature of the 1988 Basle Agreement is
  that the capital of banks must be measured as an
  average of credit-risk-adjusted total assets both
  on and off the balance sheet.
• The 1993 Basel Agreement explicitly incorporated
  the different credit risks of assets into capital
  adequacy measures.
• This was followed with a revision in 1998 in
  which market risk was incorporated into
  risk-based capital.
• In 2001, the BIS issued a Consultative Document,
  The New Basel Capital Accord, that proposed the
  incorporation (effective in2006) of operational
  risk into capital requirements and updated the
  credit risk assessments in the 1993 agreement.

14
New Basel Accord (Basel II)

• Pillar 1 Credit, market, and operational risks
• Credit risk
• Standardized approach
• Internal Rating Based (IRB)
• Market Risk Unchanged
• Operational
• Basic Indicator
• Standardized
• Advanced Measurement Approaches

15
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

16
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.

17
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

18
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.
• Category 1(0 weight) includes cash, United
  States Treasury bills, notes and bonds,
  mortgage-backed securities, and Federal Reserve
  Bank balances.
• Category 2 (20 weight) includes U.S.
  agency-backed securities, municipal issued
  general obligation bonds, FHLMC and FNMA
  mortgage-backed securities, and interbank
  deposits.
• Category 3 (50 weight) includes other municipal
  revenue bonds and regular residential mortgage
  loans.
• All other commercial, consumer, and credit card
  loans, real assets and any other asset not
  included above are included in category 4 (100
  weight).
• 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.

19
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
• Basel II widens differentiation of credit risks
• Refined to incorporate credit rating agency
  assessments

20
Risk Categories (Table 20-12)

• Basel II attempts to align capital requirements
  more closely with the banking risk of the FI. In
  addition to the above classifications, the Basel
  II categories include the following
• Category 1 (0 weight) Loans to sovereigns with
  an SP rating of AA- or better.
• Category 2 (20 weight) Loans to sovereigns with
  an SP rating between A- and A inclusive, and
  loans to banks and corporates with an SP rating
  of AA- or better.
• Category 3 (50 weight) Loans to sovereigns with
  an SP rating between BBB- and BBB inclusive,
  and loans to banks and corporates with an SP
  rating between AA- and A inclusive.
• Category 4 (100 weight) Loans to sovereigns
  with an SP rating of B- to BB. Loans to banks
  with an SP rating of B- to BBB. Loans to
  corporates with a credit rating of BB- to BBB.
• Category 5 (150 weight) This is a new category
  introduced by Basel II. Loans to sovereigns,
  banks, and securities firms with an SP credit
  rating below B-. Loans to corporates with a
  credit rating below BB-.

21
Example (P.548, 20)

• National Bank has the following balance sheet (in
  millions) and has no off-balance-sheet
  activities
• Assets Liabilities and Equity
• Cash 20 Deposits 980
• Treasury bills 40 Subordinated debentures 40
• Residential mortgages 600 Common stock 40
• Other loans 430 Retained earnings 30
• Total Assets 1,090 Total Liabilities and
  Equity1,090
• The leverage ratio is (40 30)/1,090
  0.06422 or 6.422 percent
• Risk-adjusted assets 20x0.0 40x0.0
  600x0.5 430x1.0 730.
• Tier I capital ratio (40 30)/730 0.09589
  or 9.59 percent
• The total risk-based capital ratio (40 40
  30)/730 0.150685 or 15.07 percent.
• The bank would be place in the well-capitalized
  category.

22
Risk-adjusted Off-balance-sheet Activities

• Two-step process
• The first step is to convert the
  off-balance-sheet items to credit equivalent
  amounts of an on-balance-sheet item by
  multiplying the notional amounts by an
  appropriate conversion factor as given in Table
  20-14.
• Conversion factors used depend on the guaranty
  type.
• Sale and repurchase agreements and assets sold
  with recourse(100)
• Direct credit substitute Standby LC (100)
• Performance-related standby LC (50)
• Unused portion of loan commitments with maturity
  of more than one year (50)
• Commercial LC (20)
• Banker acceptance conveyed (20)
• Other loan commitment with one year or less to
  maturity(0) (20 in2006)
• Multiply credit equivalent amounts by appropriate
  risk weights (dependent on underlying
  counterparty), see table 20-12.

23
Risk-adjusted Off-balance-sheet Activities

• Off-balance-sheet market contracts or derivative
  instruments
• Issue is counterparty credit risk
• Counterparty credit risk is the risk that the
  other party in a contract may default on their
  payment obligations.
• Basically a two-step process
• Conversion factor used to convert to credit
  equivalent amounts.
• Credit equivalent amount of OBS derivative
  security items Potential exposure Current
  exposure
• The potential exposure is the portion of the
  credit equivalent amount that would be at risk if
  the counterparty to the contract defaulted in the
  future. The current exposure is the cost of
  replacing the contract if the counterparty
  defaulted today.
• Second, multiply credit equivalent amounts by
  appropriate risk weights.
• Risk-adjusted asset value of OBS market contracts
  Total credit equivalent amount risk
  weight(0.5 in Basel I 1.0 in Basel II).

24
Potential Exposure

• Remaining Maturity Interest Rate
  Contracts Exchange Rate Contracts
• Less than one year 0 1.0
• One to five years 0.5 5.0
• Over five years 1.5 7.5
• The credit conversion factors for the potential
  exposure of foreign exchange contracts are
  greater than they are for interest rate contracts
  because research indicates that foreign exchange
  rates are more volatile than interest rates.

25
Current Exposure

• This reflects the cost of replacing a contract if
  a counterparty defaults today.
• The bank calculates this replacement cost or
  current exposure by replacing the rate or price
  initially in the contract with the current rate
  or price for a similar contract and recalculates
  all the current and future cash flows that would
  have been generated under current rate or price
  terms. The bank discounts any future cash flows
  to give a current present value measure of the
  contracts replacement cost.
• If the contracts replacement cost is negative,
  regulations require the replacement cost to be
  set to zero.
• If the replacement cost is positive, this value
  is used as the measure of current exposure.

26
Risk-adjusted Asset Value of OBS Derivatives With
Netting

• A large commercial bank may have exposure from
  many derivative contracts at any given time, and
  thus it may be desirable to net or combine the
  various positive and negative exposures to
  determine one total net exposure. The Fed allows
  this netting or combining of exposures under the
  condition that the bank has a bilateral netting
  contract that clearly establishes a legal
  obligation by the counterparty to pay or receive
  a single net amount on the contracts. The bank
  must estimate the net current exposure and the
  net potential exposure of the positions included
  in the bilateral netting contract.
•  

27
Risk-adjusted Asset Value of OBS Derivatives With
Netting

• The net current exposure is the net 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.
• The net potential exposure is determined by
  calculating a weighted average of the sum of the
  potential exposures of each contract and the
  product of the sum of the potential exposures
  multiplied times the ratio of the net current
  exposure to gross current exposure (NGR). The
  weights are 0.4 and 0.6 respectively.
• Anet (0.4 Agross ) (0.6 NGR Agross )

28
Example 20-4

• Amount Conversion Potential
  Replace Current Credit
• factor exposure cost Exposure Equivalent
• Amount
• 4-year fixed
• Floating interest
• Rate swap 100m .005 .5m 3m 3m 3.5m
• Two-year forward
• Foreign exchange
• Contract 40m .05 2m -1m 0 2m
• Credit risk-adjusted asset value of OBS
  derivatives5.5 million0.52.75million
• Agross2.5m Net current exposure2m Current
  exposure3m
• Anet (0.4 Agross ) (0.6 NGR Agross )
• NGRNet current exposure/current exposure2/3
• Anet (0.4 2.5m) (0.6 2/3 2.5m )2m
• Total credit equivalentnet potential
  exposurenet current exposure
• 2m2m4 million
• Credit risk-adjusted asset value of OBS
  derivatives4 million0.52 million
• Netting reduces the credit risk-adjusted asset
  value from 2.75 m to 2 m.

29
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
• No formal add-on has been required for
  interest-rate risk.
• market risk
• To calculate an add-on to the 8 percent
  risk-based capital ratio to reflect their
  exposure to market risk.

30
Operational Risk and Risk-Based Capital

• 2001 Proposed amendments
• Add-on for operational risk
• Increased visibility of operational risks in
  recent years has induced regulators to propose a
  separate capital requirement for credit and
  operational risks.
• Basic Indicator Approach
• Gross income Net interest Income Noninterest
  income
• Operational capital ? Gross income
• is set between 17 and 20 percent
• Problems
• Top-down.
• Too aggregative and doest not differentiate at
  all among different areas.

31
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.
• The ?s reflect the importance of each activity in
  the average bank.
• The ?s are set by regulators and are calculated
  from average industry figures from a selected
  sample of banks.
• The bank would add up the eight different
  operational capital requirements to get its total
  operational capital requirement.

32
BIS Standardized Approach Business Units and Lines

• Business Line Indicator Capital Factors
• Corporate finance Gross income ?1
• Trading and sales Gross income ?2
• Retail banking Gross income ?3
• Commercial banking Gross income ?4
• Payment and settlement Gross income ?5
• Agency services and custody Gross income ?6
• Retail brokerage Gross income ?7
• Asset management Gross income ?8

33
Operational Risk and Risk-Based Capital

• Advanced Measurement Approaches
• To allow individual banks to rely on internal
  data for regulatory capital purposes. Three broad
  categories
• Internal Measurement Approach (IMA)
• Loss Distribution Approach (LDA)
• Scorecard Approach (SA).

34
Criticisms of Risk-based Capital Ratio

• Risk weight categories versus true credit risk.
• Risk weights based on rating agencies
• It is unclear whether the risk weights accurately
  measure the relative risk exposure of individual
  borrowers.
• Rating agencies are often accused of lagging
  rather than leading the business cycles.
• Portfolio aspects Ignores credit risk portfolio
  diversification opportunities.
• No account is taken of the covariances among
  asset risks between different counterparties.
• DI Specialness
• May reduce incentives for banks to make loans.
• Other risks Interest Rate, Foreign Exchange,
  Liquidity
• Competition and differences in standards