Capital Adequacy Chapter 20

1. Capital AdequacyChapter 20 Financial Institutions Management, 3/e By Anthony Saunders

2. 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

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

4. Capital and Insolvency Risk • Capital • net worth • book value • Market value of capital • credit risk • interest rate risk

5. 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

6. 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

7. 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

8. 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

9. 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.

10. 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

11. 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.

12. Risk-adjusted Off-balance-sheet Activities • Off-balance-sheet contingent 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. • 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)

13. 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.

14. 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 today’s prices. • Risk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight.

15. 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 )

16. 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

17. 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.

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

19. 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.

20. Capital Requirements (continued) • Life insurance • C1 = Asset risk • C2 = insurance risk • C3 = interest rate risk • C4 = Business risk

21. 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) < 1.0, then subject to regulatory scrutiny.

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