FIN416ppt_Capital_Adequacy.ppt

INTERNATIONAL BANKING
AND FINANCE
BANKING REGULATION –
CAPITAL ADEQUACY

INTRODUCTION
 Substantial decline in banks earnings and
increased numbers of bank failure between
1980s highlighted the interest in capital
management.
 Capital is a fundamental building block of the
banking business that is essential to survival and
growth
 Bankers – to use less capital to magnify asset
earnings and earn higher equity rates return
 Regulators – banks should increase their capital
to ensure safety and soundness in the event
earnings become negative

SUMMARY
This chapter covers:
o Definition of bank capital
o Important of bank capital
o Role of bank capital in managing bank
operation and financial risks
o Issues of capital adequacy from the view
points of regulators and bank shareholders
o International (IBS) risk base capital
requirements applicable to today’s bank.

Bank Capital – Definition
 Capital = equity + long term debts.
 Bank capital
o includes reserves that are set aside to meet
anticipated bank operating losses
o subject to regulatory requirements that attempt
to endure adequate capital to absorb losses on
investment to protect depositors and deposit
insurer.

(i) Accounting Approach
 Capital = difference between the accounting
book value of assets and liabilities.
(ii) Economist Approach
 Capital / Owners’ Equity / Net Worth = difference
between the market value of assets and
liabilities
(iii) Regulators Approach
 Capital and Required Leverage ratio (i.e. the
Core Capital / Asset ratio) are based partly on
book value accounting concept.

 Regulators: two types of capital i.e. core capital
(Tier-I) and supplementary capital (Tier II)
 Core Capital: constituent of core capital funds
should possess following features:
Fully paid-up and permanently available;
Freely available and not earmarked to particular assets
of banking activities;
Ability to absorb losses occurring in the curse of an on-
going business; and
Represents no fixed charged on the earnings of an
institution.

 Core Capital – represent resources that can be
used to meet current losses while enabling the
financial institution to continue operation as a
going concern.
 Types of Core Capital
Paid-up ordinary shares
Non-repayable share premium account
General reserves
Retained earnings
Non-cumulative irredeemable preference shares
Minority interests in subsidiaries consistent with foregoing
components.

 Supplementary Capital – Capital comprises
elements which are available to meet losses, but
which have certain drawbacks compared with
the Core Capital
 Types of Supplementary Capital
General provisions for doubtful debts.
Asset revaluation reserves.
Cumulative irredeemable preference shares
Perpetual subordinated debt
Limited-life redeemable preference shares
Term subordinated debt.

Supplementary Capital
Goodwill, which cannot be used to support
losses on an on-going basis, is deducted from
this core capital.
Investment in subsidiaries and other financial
institutions’ capital are also deducted in
assessing capital adequacy.
Net Future income tax benefits should be
excluded from the computing of core capital and
total capital.

Types of Capital – Equity
 Common Stock
It has a residual claim on income and assets behind
deposits, other liabilities, debt and preference shares.
 Preferred Stock
The dividend and asset claims of the shareholders are
fixed in amount but are subordinated to the claims of
depositors and to all indebtedness of the bank.
 Surplus
Amount of paid up capital in excess of par value realized
by the bank on the initial sale of stock (i.e. IPO)
 Undivided Profit
Retained earnings / cumulative net profits that are not
distributed as dividends to shareholders.

Capital – Debts
Subordinated notes and debentures are
sources of long-term debt that banks can
utilize to raise additional external funds.
Regulatory requirements allow notes and
debentures to be used to meet capital
standards. However, in the context of
regulatory capital, long-term debt only
serves to absorb operating losses in the
event of failure.

Capital – Reserves
 Banks set aside earnings for loan (and lease)
loss reserves.
 When a loan defaults, the loss does not
necessarily reduce current earnings because it
can be deducted from the reserve account.
 Bank establishes “Provision for Loan Loss”
(PLL) as an expense account in the income
statement bank to reduce tax burden.
 Reserves for loan losses account is reported on
the asset side of balance sheet.

Role of Bank Capital
(1) Source of Fund
 New bank requires funds to finance startup costs
of capital investment in land, plant and
equipment.
 Established banks require capital to finance their
growth and to maintain and modernize
operation. Example: branch operation and real
investment.
 External capital is often used to finance major
structural changes such as acquisition and
mergers.

Role of Capital
(2) To Serve as Cushion to Absorb Unexpected
Operation Losses
 Bank’s capital is the primary means of protection
against the risk of insolvency and failure.
 Insufficient large capital could lead to inability to
cushion unexpected losses and hence force the
bank to declare insolvent.
 Long term debt instruments are capital source of
funds that cannot be used to absorb losses except in
a liquidation of a failed bank.
 Therefore long term debt only weakly satisfies the
role of capital as a cushion to absorb losses.

 Example:
o The dept of economic downturn in 1997 in
many Asian countries caused many banks
loss substantially. These losses surpassed
the loan loss provisio0ns of many banks,
causing them to use capital to absorb
unanticipated losses. Banks with insufficient
capital to absorb losses are declared
insolvent by their regulatory agency. The
consequences: many banks are forced to
merge or being acquired by other banks or
financial institutions.

The third function of bank capital bears on
the question of Adequate Capital.
Bank generally has less than 10% of
assets funded by capital. Therefore
relatively small percentage of asset losses
can significantly affect bank capital and
threaten bank solvency.

 Bank regulator establishes minimum
requirements (Adequate Capital)
(i) To promote safety and soundness in the banking
system.
(ii) To protect uninsured depositors, bondholders and
creditors in the event of insolvency and liquidation.
(iii) To protect the shareholder of banks against increase
in insurance premium. Insurance premiums are paid out
of the net profit of the bank. Adequate capital will reduce
the risk of insolvency. This protects the banking industry
from paying larger insurance premiums.

(iv) Market confidence is another factor in
evaluating adequate capital. If market perceives
a shortage of bank capital, bank stock prices
will be affected.
(v) To protect Taxpayers and Bank Insurance
Funds. (For the U.S.) When banks insolvent,
the regulator would intervene to protect
depositors and insured claimants. Adequate
capital offers protection to taxpayers who bear
cost of bailing-out insolvent bank and insurance
funds. (For the U.S.)

Market Value of Capital
In market value terms, bank assets and
liabilities are valued at current prices on a
mark-to-market basis.
On market value basis, the bank is
economically solvent and imposes no
failure costs on depositors or regulators if
it were liquidated today.

 Market Value of Capital and Credit Risk
 Inability of borrowers to keep up their promised
loan repayment Decline in the current and
expected future cash flows would lower the
market value of the loan portfolio held by the
bank.
 Market Value of Capital and Interest Rate Risk
 Increase in interest rates reduce the market
value of bank’s long term fixed income securities
and loans while floating rate instruments, if
instantaneously re-priced, find their market
values largely unaffected.

 Market Value and Credit and Interest Rate Risk
o Credit risk and interest rate risk shocks that
result in losses in the market value of assets are
borne directly by the equity holders in the sense
that such losses are charges against the value
of their ownership claims in the bank.
o Market valuation of the balance sheet produces
an economically accurate picture of the net
worth, and thus, the solvency position of a bank.

Book Value of Capital
 Book value capital and capital rules based on
book values are most commonly used by banks
regulators.
 Under this valuation method of capital, both
assets and liabilities are valued at their historical
book values.
 Book value of capital, (assets less liabilities)
comprises the following four components
Par value of shares
Surplus value of shares
Retained earnings and,
Loan loss reserve.

 Book Value of Capital and Credit Risk
o Book value accounting systems do recognize credit risk
problems, but only partially and usually with a long and
discretionary time lag.
o There is a tendency for the bank to defer write-downs.
o When the loan customers having difficulty regarding
repayment schedules, the revaluation of cash flows
leads to an immediate downward adjustment of the loan
portfolio’s market value. By contrast, under historic book
value accounting methods, banks have greater
discretion in regulating or timing problem loan loss
recognition on their balance sheets and thus in the
impact of such losses on capital

 Book Value of Capital and Interest Rate Risk
o The effects of interest rate change are not
recognized in book value accounting method.
o The failure of book value accounting method to
recognize the impact of interest rate risk is even
more extreme.
o In the book value accounting method, all assets
and liabilities reflect their original cost of
purchase. The rise in interest rates has no effect
on the value of assets, liabilities, or book value
of equity. That is the balance sheet remains
unchanged.

 Discrepancy between Market and Book value of
equity
 Degree of difference between book value and
true economic market value depends on the
following factors:
o Interest Rate Volatility: The higher the interest
volatility, the greater the discrepancy.
o Examination and Enforcement: The more
frequent the on-site and off-site examinations
and the stiffer the examiner / regulator standards
regarding charging off problem loans, the
smaller the discrepancy

Capital Adequacy in Commercial Bank
Actual Capital Rules
o Commercial Banks faced two different
capital requirements: a capital-assets
(leverage) ratio and a risk-based capital
ratio.
o Risk-based capital ratio is in turn
subdivided into a Tier I capital risk-based
ratio and a total capital. (Tier I + Tier II
capital) risk-based ratio.

 This ratio measures the ratio of a bank’s book
value of primary or core capital to the book value
of its assets.
 The lower this ratio is, the more highly leveraged
the bank is.
 Primary or core capital is a bank’s common
equity plus qualifying cumulative perpetual
preferred stock plus minority interests in equity
accounts or consolidated subsidiaries.
 L = core capital / assets

Zone Total risk-
based ratio
Tier I risk-
based ratio
Leverage
ratio
Capital
directive /other
Well
capitalized
≥10% &/or ≥6% And ≥5% Not subject to a
capital directive
to meet a
specific level
for any capital
Adequately
capitalized
≥8% And ≥4% ≥4% Does not meet
the definition of
well capitalized
Significantly <8% Or <4% Or <4%
Under-
capitalized
<6% Or <3% Or <3%
Critically
under
capitalized
≤2% ≤2% ≤2%

 Problems of leverage ratio
Market value: There is no assurance that depositors
and regulators (include taxpayers) is adequately
protected against losses. This is because even if a bank
is closed when the leverage ratio falls below 2%, a 2%
book capital-asset ratio could be consistent with a
massive negative market value net worth.
Asset Risk – the leverage ratio fails to take into account
the different credit, interest rate and other risks of the
assets.
Off-balance-sheet activities: no capital is required to
meet the potential insolvency risks involving contingent
assets and liabilities.

CAR – Risk Base Capital Ratio
This section will examine
(i) how capital is used as a cushion against
credit using the BIS approach (Basel I)
(ii) capital as a cushion against credit risk using
Basel II
(iii) the required add-on to capital under Basel II
that cushion a bank against market and
operational risk.

CAR – Risk Base Capital Ratio
 The Basel Agreement
 Basel Agreement: The requirement to impose
risk-based capital ratios on banks in major
industrialized countries.
 1993 Basel Agreement (Basel I) explicitly
incorporated the different credit risks of assets
(both on- and off-balance sheet) into Capital
Adequacy measures.
 Basel I was revised in 1998: Market risk was
incorporated into risk-based capital.

CAR- Risk Base Capital Ratio (Basel II)
(a) Pillar I: Credit, Market and Operational Risks
Measurement
 Credit Risk:
Standardized approach: Similar to Basel except it is
more risk sensitive.
Internal Rating Based (IRB): Banks are allowed to use
their internal estimates of borrower creditworthiness to
assess credit risk in their portfolios.
 Operational risk:
Three approaches: Basic indicator, Standardized and
Advanced Measurement Approaches.
 Market Risk: Same as Basel I proposal.

Risk Base Capital Ratio (Basel II)
(b) Pillar II: Regulatory Review Process on
Minimum Capital Requirements
BIS recommended review procedures for
Regulator to ensure that
Bank has sound internal processes to assess
capital adequacy
Bank has set targets for capital that are
commensurate with the bank’s specific risk
profile and control environment.

(c) Pillar III: Detailed Guidance on Disclosure
 Basel II proposal provides detailed guidance on
the disclosure of capital structure, risk
exposures, and capital adequacy.
 These disclosure requirements allow market
participants to assess critical information
describing the risk profile and capital adequacy
of banks.

 The calculation of risk-based capital adequacy
measures
Distinguish among the different credit risks of assts on
the balance sheet and,
Identify the credit risk inherent in instruments off the
balance sheet by using a risk-adjusted assets
denominator in these capital adequacy ratios.
 In these measurements, bank’s capital is the
standard by which each of credit risk,
operational risk and market risk is measured.

Enforced alongside traditional leverage
ratio
Minimum requirement of 8% total capital
(Tier I core plus Tier II supplementary
capital) to risk-adjusted assets ratio and,
Tier (core) capital ratio = Core Capital
(Tier I) / Risk-adjusted ≥ 4%.
It is crudely mark to market on- and off-
balance sheet positions.

Calculating CAR
 Capital: Bank’s capital is divided into Tier-I and
Tier II
 Tier I Capital:
Book value of common equity plus
Perpetual (non-maturing) preferred stock plus
Minority interests of the bank held in subsidiaries
Less goodwill
 Tier II Capital
loan loss reserves (up to maximum of 1.25% of risk-
adjusted assets) plus
various convertible plus
Subordinated debt instruments with maximum caps.

Calculating CAR
Credit Risk-Adjusted Assets
Two components
o Credit risk-adjusted on-balance-sheet
assets
o Credit risk-adjusted off-balance-sheet
assets.

Calculating CAR –
Risk Based Capital Standards (Basel I)
Risk Categories
Category 1 (0% weight)
Cash, Central bank balances, securities of the Treasury,
OECD governments and government agencies
Category 2 (20% weight)
Cash items in the process of collection, domestic and OECD
Inter-bank deposits and guarantee claims, some non-OECD bank and
government deposits and securities, general obligation municipal bonds
Some mortgage-backed securities, claims collateralized by the Treasury and
some other government securities

Calculating CAR
 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 risks category.
To be adequately capitalized, a bank must hold a
minimum of Total Risk Based Ratio [Total capital (Tier I
+ Tier II) to credit risk-adjusted assets] of 8% and
minimum of Tier I Capital Ratio (Core Capital to credit
risk-adjusted assets) of 4%.

Calculating CAR
Limitation of Basel I Method
Individual risk weights depend on broad
categories of borrowers (i.e. sovereign, bankers
or corporate)
Example: All corporate loans have a risk weight
of 100% regardless of borrowing firm’s credit
risk.

Calculating CAR (On-Balance Sheet)
Credit Risk-Adjusted On-Balance-Sheet
Assets Under Basel II
It introduces a wider differentiation of credit risk
weights.
Risk weights are refined by reference to a rating
provided by external credit rating agency (S&P).
Therefore Basel II should produce Capital Ratio
more in line with actual economic risk that
depository institutions / banks are facing.

Calculating CAR (Off-Balance-Sheet)
Credit Risk Adjusted (CRA) Off-
Balance-Sheet Activities
The calculation CRA values of OBS
involves Two Steps
Step I– Derive the Credit Equivalent Amounts:
Find the risk-adjusted asset value for these OBS
items and multiply the amount outstanding of these
items with the conversion factors.
Step II – Multiply these Credit Equivalent amounts by
their appropriate risk weights.

Off-balance-sheet continent guaranty
contracts
Conversion factors used to convert into
credit equivalent amounts – amounts
equivalent to an on-balance-sheet item.
Conversion factors used depend on the
guaranty type.

 For example:
 Direct credit substitute SLC issues by banks –
100% conversion factor rating.
 Performance-related SLC and unused loan
commitments of more than 1 year – 50%
conversion factor.
 Other loan commitments, those with one year or
less to maturity – 0% credit conversion factor.
(Basel II: this conversion factor will increase to
20%)

Risk weights assigned to OBS contingent
guaranty contracts are the same as if the
bank had entered into the transactions as
a principal.
For Example:
o The credit rating used to assign a credit
risk weight for in-balance-sheet assets are
also used to assign credit risk weights on
these OBS activities.

The CRA Asset Value of OBS Market
Contracts or Derivative Instruments
o Banks engage in buying and selling OBS
futures, options, forward, caps and other
derivative securities are exposes to
counter party credit risk.
o Counterparty Credit Risk: The risk that the
other side of a contract will default on
payment obligations.

 The calculation of Risk-adjusted asset values of
OBS market contracts involves two steps:
o Step I: Calculate a conversion factor to create
credit equivalent amounts.
o Step II: Multiply the credit equivalent amounts by
the appropriate risk weights.
The Credit Equivalent (CE) amount is divided into a
potential exposure element and a Current exposure
element
That is CE = potential exposure ($) + current exposure ($)

Potential Exposure: The risk of
counterparty to a derivative securities
contract defaulting in the future. (Refer to
Table 20-15, page 534 for potential
exposure conversion factor)

 Current Exposure: The cost of replacing a
derivative securities contract at today’s prices.
The calculation is 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 bee generated under current rate or price
terms.
o Risk-adjusted asset value of OBS market contracts =
Total credit equivalent amount X risk weight.
o Limitation: This method ignores the netting of exposure.

 Risk-Adjusted Asset Value of OBS
Derivatives with Netting
o With netting, the bank requires to estimate the
net current exposure and net potential exposure
of bilateral netting contracts.
o Total credit equivalent amount = Net Current
exposure + Net potential exposure
o 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.

 The net potential exposure is defined by the following
formula:
o A net = (0.4 X A gross ) + (0.6 X NGR X A gross )
o A net = the net potential exposure
o A gross = the sum of the potential exposures of each
contract
o NGR = the ratio of net current exposure to gross current
exposure
o 0.6 = the amount of potential exposure that is
reduced as a result of netting.

Calculating CAR
Interest Rate Risk, Market Risk, and
Risk-Based Capital
From a regulatory perspective, a credit risk-based
capital ratio adequate only as long as a bank is not
exposed to undue interest rate or market risk.
This is because the risk-based capital ratio takes into
account only the adequacy of a bank’s capital to
meet both its on- and off-balance-sheet credit risks.
This method does not explicitly accounted for the
insolvency risk resulted from interest rate risk
(duration mismatches) and market (trading) risk.

Calculating CAR –
Operational Risk & Risk-Based Capital
Operational Risk and Risk-Based
Capital
Basel II on amendments to capital adequacy rules:
BIS proposed an additional add-on to capital for
operational risk.
Basel committee proposed 3 methods to Capital to
protect against operational risk: Basic Indicator
Approach, the Standardized Approach, and the
Advanced Measurement Approach.

Calculating CAR
 Basic Indicator Approach
o Gross Income = Net Interest Income + Non-
interest Income
o Operational Capital = α X gross income
o Limitation: It is too aggregative or “top-down”
and does not differentiate at all among different
areas where operational risks may differ
o For example: payment and settlement may have
a very different operational risk profile from
Retail Brokerage.

Calculating CAR –
 Standardized Approach
o This approach divides activities into eight major
business units and lines
o The capital charge computed by multiplying a
weight, β, for each line, by the indicator set for
each line, then summing.
o β = {[12% of current total regulatory capital of all
banks in the sample] X [-Average business line
weighting] }/ (Sum of financial indicator form
bank sample)

Calculating CAR –
Advanced Measurement Approach:
This model allows individual banks to rely
on internal data for regulatory capital
purposes.

Calculating CAR –
3 broadly categories are currently under
development:
(a) Internal Measurement Approach (IMA):
based on a framework that separates a
bank’s operational risk exposures into
lines of business and operational risk
event types.

Calculating CAR –
(b) Loss Distribution Approach (LDA):
Similar to IMA except that this method
assesses unexpected losses at the 99.9
percentile directly rather than via an
assumption about the relationship
between expected loss and unexpected
loss.

Calculating CAR –
(c) Scorecard Approach (SA):
Under this method, banks determine an
initial level of operational risk capital at the
firm or business line level, and then modify
these amounts over time on the basis of
scorecards that attempt to capture the
underlying risk profile and risk control
environment of the various lines of
business.

Risk-Based Capital Ratio – Criticisms
 The risk-based capital requirement seeks to
improve on the simple leverage ratio by
Incorporating credit, market, and operational risks
into the determination of capital adequacy
More systematically accounting ofr credit risk
differences among assets
Incorporating off-balance-sheet exposures, and
Applying a similar capital requirement across the
entire major DI in the world.

Limitation: The requirements have a
number of conceptual and applicability
weaknesses in achieving these objectives:
Risk Weights – The four (five) weight
categories may not reflect true credit risk.
For example: relative weight does not
imply the exact additional risk of one type
of loan on the other type of loan

 Risk Weights based on external credit rating
agencies – Measuring of credit risk depend on
external credit rating. It is unclear whether the
risk weights accurately measure the relative (or
absolute) risk exposures of individual borrowers.
Moreover S&P and Moody’s rating are ofthen
accused of lagging rather than leading the
business. As a result, “required” capital may
peak during a recession when banks are least
able to meet the requirements.

Portfolio Aspects: BIS plans largely ignore
credit risk portfolio diversification
opportunities.
Bank Specialness: Private sector’s
commercial loans have moderate and
highest risk weighting. This may reduce
incentives for banks to make loans to
these businesses.

Other Risks: BIS plan does not account for
other risks, such as interest rate risk,
foreign exchange risk, and liquidity risk.
Competition: Tax and accounting standard
differences across banking systems and in
safety net coverage, the risk-base capital
requirement has not created competition
among banks.

FIN416ppt_Capital_Adequacy.ppt

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