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Capital adequacy

Capital adequacy. Class 12, Chap 20. Lecture outline. Introduction to capital adequacy What is it and why is it important What are the costs and benefits to regulation How to measure capital Calculation of Capital Ratios Leverage Risk-based Tier I capital ratio Total capital ratio.

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Capital adequacy

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  1. Capital adequacy Class 12, Chap 20

  2. Lecture outline • Introduction to capital adequacy • What is it and why is it important • What are the costs and benefits to regulation • How to measure capital • Calculation of Capital Ratios • Leverage • Risk-based • Tier I capital ratio • Total capital ratio Purpose: Gain a general understanding of why equity capital is important, how it is measured and how it is regulated

  3. Why is Capital Adequacy Important? • What happens when banks are under capitalized? • Should banks be forced to hold more capital?

  4. Cost/Benefit of Regulating Capital Increasing Capital Capital Requirements Lowers Insolvency Risk • Absorbs unanticipated losses – equity capital acts as a buffer between the value of assets and liabilities. Losses in asset values decrease the value of equity. At zero equity value the firm is insolvent. • Protects unsecured creditors against losses in the event of liquidation. • Proceeds from the sale of assets will more likely cover creditor claims for firms with high equity capital • Protects FDIC insurance fund DIF and tax payers • Lower insolvency risk means fewer payouts from the FDIC insurance fund and lower likelihood of a tax-payer bailout of the FDIC Economic Growth Economic Stability

  5. Cost Benefit of Regulating Capital Economic Growth Economic Stability Increasing capital requirements decreases the credit supply • Banks are required to hold more capital on their balance sheet which decreases the lending capacity of banks • Decreased credit supply reduces corporate investment activity, which slows economic growth. Increasing capital requirements can promote economic growth • Increased stability increases consumer confidence which can promote growth • More capital reduces FDIC Premiums which increases lending capacity

  6. Measuring Equity Capital

  7. Book Value of Equity Definition • The historic value of assets/ liabilities. Reflects total purchase price of all assets on the balance sheet less the face value of liabilities Main Advantages • Easy to measure • Easy to observe (regulate) Main Disadvantages • The book value may not reflect the current value of the asset i.e. What you could buy/sell it for • Gives managers more discretion on when they report (realize) losses • Does not consider off-balance sheet items

  8. Market Value of Equity Definition: • Difference between the market value of assets and liabilities. • Market value of equity is the remaining value after assets have been liquidated at market price and all liabilities have been repaid (or repurchased in the market) Main Advantages: • More current measure of liquidation value • Quick to adjust Main Disadvantage: • Hard to measure especially for assets that do not have secondary markets • Market prices do not always reflect the true (fundamental) asset value due to market imperfections – crisis

  9. Types of Capital (Basel III) • Common Equity Tier I (CET1) • Tier I Capital • Tier II Capital

  10. Common Equity Tier I (CET1) • Strict definition of capital, closely related to book value of common stock • The contribution of DI owner’s available to absorb losses Minority interest in consolidated subsidiaries Accumulated income and disclosure reserves + + (6) (5) (4) (3) (1) (2) – Goodwill • Common shares issued and stock surplus that meets regulatory requirements • Undistributed earnings • Ex: losses on defined benefits pension obligations • Shares issued by subsidiaries and held by a 3rd party (50% ownership <) • Technical adjustments made to CET1 • Amount paid for acquisitions above Market value Regulatory adjustments to common equity Tier 1 Common stock Retained earnings = CET1 + +

  11. Tier I Capital • Broader definition of capital: includes options other than common equity for absorbing losses Noncumulative perpetual preferred stock Tier I minority Interests + + (6) (3) Regulatory adjustments (4) (5) (2) + (1) • Common stock Tier 1 (CET1) • Instruments with no maturities date or incentive to redeem (may be called within 5 years of issue if replaced with better capital) • Perpetual prefer stock that does not cumulate • Tier I capital of minority interest not included in CET1 • Securities issued under small business jobs act 2008 that qualify as Tier 1 equity capital • Technical adjustments made to additional Tier I capital Other Tier I securities Other perpetual securities + CET1 = Tier I +

  12. Tier II Capital • The broadest definition of capital including all equity-like resources not accounted for else where Loan loss reserves Total capital of minority interest + + (6) Regulatory adjustments (4) (5) + (2) (1) (3) • Subordinate bonds and preferred stock • Instrument subordinate to deposits and general creditor claims • Tier II capital of minority interest not included in minority Tier I capital • Reserve account to absorb losses on loans and leases • Securities issued under small business jobs act 2008 that qualify as Tier II equity capital • Technical adjustments made to additional Tier II capital Other Tier II securities Other subordinate securities Subordinate debt = Tier II + +

  13. CET1, Tier I, & Total Capital • CET1 = CET1 • Tier I capital = CET1 + additional Tier I • Total capital = Tier I + Tier II

  14. Equity Capital Ratios

  15. Capital Ratios • Leverage Ratio • Tier I risk-based capital ratio • Total risk-based capital ratio Book Value Measure Book & Market Value – includes OBS Risk-Based Ratios are defined in the Basel Accord Book & Market Value – includes OBS

  16. Leverage Ratio(s)

  17. Leverage Ratio (Capital-to-Asset) Standard approach Advanced approach Guarantee contracts: • Conversion factor = 100% • 10% if contract is immediately cancelable Derivatives: Potential + Current Exposure

  18. Working with Capital ratios Equity = 100M Assets = 400M Liabilities =300M

  19. Working with Capital ratios Equity = 25M Assets = 325M Liabilities =300M Lower ratio = higher leverage, more risk – regulator want high L ratios

  20. Given the following balance sheet calculate the leverage ratio

  21. Draw-backs of leverage ratio • Does not consider off-balance sheet risks • Measures asset values using book value • Assumes that all assets are equally risky Is there a difference in risk? 100 Billion in Greek bonds (purchased in 2005) 100 Billion in cash

  22. Risk Based Capital Ratios The Basel Accord

  23. Basel Accord • Banking regulation recommended by the Basel Committee on Banking Supervision (BCBS) a division of the Bank of International Settlement (BIS) • US DI regulators agreed, with other BIS member countries, to enforce regulation outlined in the Basel Accord • Three main versions • Basel I • Basel II • Basel II.5 • Basel III

  24. Basel Accords I & II • Basel I (1993) • Introduced risk-based capital ratios • Credit-risk adjust assets • Include off-balance sheet items • Set capital requirement thresholds 8% adequately capitalized • Prompt corrective action • Market risk (1998) revision to include market risk as an add-on to the 8% capital requirement • Basel II (2006) • Increased option to account for credit risk • Standard approach • Internal Ratings Based (IRB) • Recommended holding capital against operational risk

  25. Basel Accords II.5 & III • Basel II.5 (2009 passed, 2013 effective) • Updated capital requirements on market risk for banks’ trading operations • Basel III (2010 passed, 2019 effective) • Raised quality consistency and transparency of capital base at banks • Redefined capital to emphasize common equity • Refined risk weight categories • Introduced conservation buffer • Introduced countercyclical capital buffer • Introduced global systemically important bank (G-SIB) surcharge • Also has provisions for supervision (Pillar 2) and disclosure (Pillar 3)

  26. Risk-Based Capital Ratio Calculation

  27. Risk Adjustment Overview • The Basel III proposed 3 risk-adjusted capital ratios • Common Equity Tier I capital ratio • Tier 1 risk-adjusted capital ratio • Total risk-adjusted capital ratio • There are 2 components of risk adjusted asset value • Credit risk-adjustment of on-balance sheet asset values • Credit risk adjustment of off-balance sheet asset values

  28. CET1, Tier I & Total Capital Ratios • CET1 Capital Ratio: • Tier I Capital Ratio: • Tier II Capital Ratio:

  29. Calculating Risk-Adjusted Assets Procedure • Calculate credit-risk adjusted asset value of on-balance-sheet assets • Calculate credit risk adjusted asset value of off-balance-sheet assets

  30. 1 . Calculate credit-risk adjusted asset value of on-balance-sheet assets

  31. Calculating Risk-Adjusted Assets - On Balance-Sheet Items – Procedure 2 steps to risk-adjusting on-balance sheet asset values • Classify assets into 1 of 9 risk categories to obtain the risk weight • Risk-adjust asset values: multiply risk weights by balance sheet asset values and sum Risk-adjusted asset value Weight = Asset Value Σ

  32. Calculating Risk-Adjusted Assets - On Balance-Sheet Items – Risk Weights Step 1:Under Basel III assets are assigned to 1 of 9 categories

  33. Calculating Risk-Adjusted Assets - On Balance-Sheet Items – Example Step 2: Convert to credit equivalent amounts and sum Risk-adjusted asset value Weight = Asset Value Category 1: Category 2: Category 3: On Balance-sheet risk adjusted asset value Category 4: Category 5: 764.5 Mill Consumer Loans Risk Weights #1 Risk Weights #2

  34. Back

  35. High Quality • Traditional, First lien, and prudentially underwritten • Low Quality • Junior liens • Non-traditional Back

  36. 2 . Calculate credit-risk adjusted asset value of off-balance-sheet assets

  37. Calculating Risk-Adjusted Assets - Off Balance-Sheet Items - Procedure • Convert to on-balance sheet credit equivalent amounts using Basel conversion factors • Classify off-balance sheet items into 1 of 9 risk categories to determine risk weights • Risk-adjust asset values: multiply risk weights by balance sheet asset values and sum New Contingent or guaranty contracts Market & Derivatives contracts

  38. Step #1 Contingent or guaranty contracts

  39. Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents Step 1 Convert to credit equivalent amounts (CEA) using the Basel conversion factors Contingent or guaranty contracts: Off-balance sheet value (notional) Basel Factor CEA =

  40. Step #1 Market contracts or derivatives (FX, interest rate forwards, options and swaps)

  41. Calculating Risk-Adjusted Assets- Off Balance-Sheet Items – Convert to Credit Equivalents Step 1 Convert to credit equivalent amounts (CEA) using the Basel conversion factors Potential Exposure: Captures expected losses from future counterparty default. Current Exposure Potential Exposure Credit Equivalent Amount + = Market contracts or derivatives: Potential Exposure = [Off-balance sheet value (notional)] × [Basel Factor]

  42. Calculating Risk-Adjusted Assets- Off Balance-Sheet Items – Convert to Credit Equivalents Step 1 Convert to credit equivalent amounts (CEA) using the Basel conversion factors Current Exposure: Replacement cost of the contract if counter party defaults today Current Exposure Potential Exposure Credit Equivalent Amount + = Market contracts or derivatives: • Positive value (in the money): The FI would have to pay out-of-pocket to reestablish the contract – regulators will recognize this (market) value as the replacement cost • Negative value (out of the money): The FI would not likely actively seek to reestablish a negative position – regulators require that the FI sets replacement costs equal to zero.

  43. Calculating Risk-Adjusted Assets- Off Balance-Sheet Items – Risk adjustment Step 2 Classify Credit Equivalent Amountsinto 1 of 9 categories using Basel tables Step 3 Sum risk adjusted Credit Equivalent Amounts Risk-adjusted asset value = Weight CEA Σ

  44. Example Off Balance Sheet Adjustment

  45. Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents Example Step 1Contingent or guaranty contracts: Example Total = $60M Conversions

  46. Guarantee Contract Conversions Back

  47. Calculating Risk-Adjusted Assets- Off Balance-Sheet Items – Convert to Credit Equivalents Example Step 1Market contracts or derivatives: Example Suppose an FI has the following off-balance-sheet items: • 4-year Fixed for floating Interest rate swap with notional amount of $100 mill and current market value of 3 Mill • 2-year forward foreign exchange contract with $40 mill In notional value and calculated value of -1Mill to the FI Convert OBS items to on-balance-sheet credit equivalent amounts by adding potential and current exposures: Replacement cost • 4-year Fixed for floating Interest rate swaps Credit Equivalent Amount = $3,500,000 Conversions

  48. Calculating Risk-Adjusted Assets- Off Balance-Sheet Items – Convert to Credit Equivalents Example Step 1Market contracts or derivatives: Example Suppose an FI has the following off-balance-sheet items: • 4-year Fixed for floating Interest rate swap with notional amount of $100 mill and current market value of 3 Mill • 2-year forward foreign exchange contract with $40 mill In notional value and calculated value of -1Mill to the FI Convert OBS items to on-balance-sheet credit equivalent amounts by adding potential and current exposures: Replacement cost • 2-year forward foreign exchange contract Credit Equivalent Amount = $2,000,000 Conversions

  49. Market & Derivative Contract Conversions Back

  50. Example Calculating Risk-Adjusted Assets Step #2 Adjust for credit risk

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