Capital Adequacy Chapter 20

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Capital AdequacyChapter 20

• Financial Institutions Management, 3/e
• By Anthony Saunders

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Importance of Capital Adequacy

• Preserve confidence in the FI
• Protect uninsured depositors
• Protect FI insurance funds and taxpayers
• 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

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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
• Credit risk
• Interest rate risk

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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 Banking and Thrifts

• Actual capital rules
• Capital-assets ratio (Leverage ratio)
• L Core capital/Assets
• 5 categories 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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Risk-based Capital Ratios

• Basle 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, Tier I (core) capital ratio
• Core capital (Tier I) / Risk-adjusted
  assets must meet minimum of 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

• 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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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.
• 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
• 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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Criticisms of Risk-based Capital Ratio

• Risk weight categories may not closely reflect
  true credit risk.
• Balance sheet incentive problems.
• Portfolio aspects Ignores credit risk portfolio
  diversification opportunities.
• Reduces incentives for banks to make loans.

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Criticisms (continued)

• All commercial loans have equal weight.
• Ignores other risks such as FX risk, asset
  concentration and operating risk.
• Adversely affects competitiveness.

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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 (continued)

• Life insurance
• C1 Asset risk
• C2 insurance risk
• C3 interest rate risk
• C4 Business risk

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Capital Requirements (continued)

• 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 (continued)

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