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BASEL I and II

Fulbright Scholar at XIMB Dr. Sunil Mohanty. BASEL I and II. CAPITAL ADEQUACY. Role Of Capital. The primary role of capital is to protect a FI against the risk of insolvency/failure. Several Functions of Capital To absorb unanticipated loss.

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BASEL I and II

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  1. Fulbright Scholar at XIMB Dr. Sunil Mohanty BASEL I and II CAPITAL ADEQUACY

  2. Role Of Capital • The primary role of capital is to protect a FI against the risk of insolvency/failure. • Several Functions of Capital • To absorb unanticipated loss. • To protect uninsured depositors, bondholders, and creditors in the event of insolvency and liquidation. • To protect FI insurance funds and the tax payers. • To protect FI against increases in insurance premium • To acquire the plant and other real investments necessary to provide financial services.

  3. Capital and Insolvency Risk • To see how capital protects an FI against insolvency risk,we define the market value versus book value of capital. • Market Value of an FI’s Capital = Net Worth A measure of an FI’s capital which is equal to the difference between the market value of its assets and the market value of its liabilities. • Book Value of Capital The difference between the asset and liability values based on their historical costs.

  4. Assets Liabilities Long-term securities $80 Liabilities (short-term, floating-rate deposits) $90 Long-term loans 20 Net worth 10 $100 $100 • Table 1 An FI’s Market Value Balance Sheet(in millions of dollars) • Table 2 An FI’s Market Value Balance Sheet after a Decline in the Value of Loans ( in millions of dollars) Assets Liabilities Long-term securities $80 Liabilities $90 Long-term loans 12 Net worth 2 $92 $92

  5. Table 3 Assets Liabilities Long-term securities $80 Liabilities (short-term, floating-rate deposits)$90 Long-term loans 8 Net worth -2 $88 $88 An FI’s Balance sheet after a Major Decline in the Value of the Loan Portfolio(in millions of dollars) • Table 4 Assets Liabilities Long-term securities $75 Liabilities (short-term, floating-rate deposits)$90 Long-term loans 17 Net worth 2 $92 $92 An FI’s Market Value Balance Sheet after a rise in Interest Rates (in millions of dollars)

  6. Table 5 Assets Liabilities Long-term securities $80 Liabilities (short-term, floating-rate deposits)$90 Long-term loans 20 Net worth 10 $100 $100 Book Value of an FI’s Assets and Liabilities (in millions of dollars) • Table 6 Assets Liabilities Long-term securities $80 Liabilities (short-term, floating-rate deposits)$90 Long-term loans 17 Net worth 7 $97 $97 The effect of a Loan Loss Charge-Off against the Book Value of an FI’s Equity (in millions of dollars).

  7. The Discrepancy Between the Market and Book Values Of Equity • Interest rate volatility: The higher the interest rate volatility, the greater the discrepancy. • Examination and Enforcement: The more frequent the on-site and off-site examination and the stiffer the examiner/regulator standards regarding changing of problem loans, the smaller the discrepancy.

  8. Market To Book RatioThe Ratio MV/BV For publicly traded FI’s MV = Market value of equity ownership outstanding Number of shares BV = Par value of equity + surplus value +retained earnings + loan loss reserves Number of Shares The lower the ratio (MV/BV) , book value of capital overstate the economic net worth of an FI.

  9. Table 7 FDICIA and Capital Regulations (1) (2) (3) Total Risk- Tier I Risk- Leverage Zone Based Ratio Based Ratio Ratio 1.Well capitalized 10% or above & 6% or above & 5% or above 2.Adequately capitalized 8% or above & 4% or above & 4% or above 3.Undercapitalized Under 8% or Under 4% or Under 4% 4.Significantly Undercapitalized Under 6% or Under3% or Under 3% 5.Critically Undercapitalized 2% or Under or 2% or Under or 2% or Under Specifications of Capital Categories for Prompt Corrective Action (in present)

  10. FDICIA and Capital Regulations • Table 8A Zone Mandatory Provisions Discretionary Provisions 1.Well capitalized 2.Adequately capitalized 1.No brokered deposits except with FDIC 3.Undercapitalized 1. Suspend dividend & Management 1. Order restriction. Fees. 2. Require capital restoration plan. 2. Restrict interaffiliate transactions. 3. Restrict Asset growth. 3. Restrict deposit interest rates. 4. Approval required for acquisitions, 4. Restrict certain other branching, and new activities. activities. 5. No brokered deposits. 5. Any other action that would better carry out prompt corrective action. Summary of prompt Corrective Action Provisions of the Federal Deposit Insurance

  11. Table 8B FDICIA and Capital Regulations Zone Mandatory Provisions Discretionary Provisions 4.Significantly Undercapitalized 1.Same as for Zone 3 1. Any Zone 3 discretionary actions. 2. Order recapitalization 2. Conservatorship or receivership if fails to submit or implement plan or recapitalize pursuant to order. 3. Restrict interaffiliate 3. Any other Zone 5 transactions. provisions if such action is necessary to carry out prompt corrective action. 4. Restrict deposit interest rate. 5. Pay of officers restricted. 5.Critically Undercapitalized 1.Same as for Zone 3. 2.Receiver/Conservator within 90 days. 3. Receiver if still in Zone 5 four quarters after becoming critically undercapitalized. 4. Suspend payments on subordinated debt. 5. Restrict certain other activities.

  12. Risk-based Capital Standards • The 1988 Based Accord (Basel I) or the New Basel II Capital Accord (Basel II) is applicable to Banks only • Basel Accords are Regulatory frameworks • Basel Committee on Banking Supervision (BCBS) of the Bank for International Settlements (BIS)

  13. Brief History of Basel I • 1988, the G-10 central banks agreed to apply a common minimum capital standards to all internationally active banks • Basel I is not applicable directly, but through national regulatory authorities or through transnational rules (EU Directive: Capital Adequacy Directive) • A huge success for Basel I, which is applied to all internationally active banks in most countries (Approx, 100 countries)

  14. Minimum Capital Requirements Under Basel I Assets = Liability + Equity Loan Assets ($100) = Debt ($92) + Equity ($8) Minimum Capital Requirements: 8% * Loan Amount * Risk Weight • Basel I Risk Weightings (OECD) Sovereigns: 0% (OECD) Banks: 20% Mortgage Loans: 50% Other Loans : 100%

  15. Risk Categories • Table 9 Basel I Category 1 (0% weight) Cash, Federal Reserve Bank balances, securities of the U.S. Treasury, QECD governments, some U.S. agencies. Category 2 (20% weight) Cash items in the process of collection. U.S. and OECD interbank deposits and guaranteed deposits and guaranteed claims. Some non-OECD bank and government deposits and securities. General obligation municipal bonds. Some mortgage backed securities. Claims collateralized by the U.S. Treasury and some other government securities. Category 3 (50% weight) Loans fully secured by first liens on the one-to four-family residential properties. Other (revenue) municipal bonds. Category 4 (100% weight) All other on-balance-sheet assets not listed above, including loans to private entities and individuals, some claims on non-OECD governments and banks, real assets, and investments in subsidiaries. Summary of the Risk-based Capital Standards for On-Balance-Sheet Items under Basel I

  16. Table 10 Off-Balance-Sheet Items (Basel I) Sale and repurchase agreements and assets sold with recourse that are not included on the balance sheet (100%). Direct credit substitute standby letters of credit (100%). Performance-related standby letters of credit (50%). Unused portion of loan commitments with original maturity of more than one year (50%). Commercial letters of credit (20%). Bankers acceptances conveyed (20%). Other loan commitments (10%). Conversion factors for Off-Balance-Sheet Contingent or Guaranty Contracts, Basel I

  17. Capital Adequacy Rules ( Basel I) Under the Risk-based Capital Plan, banks must meet three minimum capital requirements simultaneously. Tier I (core) Capital Ratio = Core Capital (Tier1)> 4% Risk-adjusted assets Core capital is primarily the book value of stockholders’ equity. Total Risk-based Capital Ratio = Total Capital (Tier1+Tier 2)> 8% Risk-adjusted assets

  18. Capital Adequacy Rules (cont.) • Tier II capital is supplementary capital which includes subordinate debt, convertible debt instruments, and loan loss reserve. Leverage Ratio = Core capital = Tier1 > 3% Assets Assets • Risk-adjusted Assets = Risk-adjusted on-balance-sheet assets + Risk-adjusted off-balance-sheet assets

  19. Bank’s Balance Sheet (in million $)Basel I • An example – See Appendix A

  20. Risk Adjusted On-Balance-Sheet Assets (Basel I) = 0 ( 8m +13m + 60 m + 50m + 42m) + 0.2 ( 10m + 10m + 20) + 0.5 (34m + 308m) + 1.0 (10m + 55m + 75m + 390m + 10m + 108m + 22 ) = $849 million Note: Book value of On-Balance-Sheet Assets = $1,215 million

  21. Risk-adjusted Asset Value of OBS Contingent Guaranty Contracts • Credit Equivalent Amount OBS Item Face Conversion Credit Value Factor Equivalent Amount Two-year loan commitment $80 .5 = $40 Standby letter of credit 10 1.0 = 10 Commercial letter of credit 50 .2 = 10 • Note: See Table 1 Conversion Factor

  22. Risk-adjusted Assets for OBS Guaranty Contracts OBS Item Credit Equivalent Risk Weight Risk-adjusted Asset Amount, $ mil (wi) Amount, $millions Two-year loan commitment $40 X 1.0 = $40 Standby letter of credit 10 X 1.0 = 10 Commercial letter of credit 10 X 1.0 = 10 $60 Note: The bank’s risk-adjusted asset value of its OBS contingent/ guaranty contracts is $60.

  23. Calculating the Overall Risk-based Capital Position of a Bank (Basel I) • Tier I capital = Common stock + perpetual preferred Stock + Retained earnings = 30 + 10 + 10 = 50 million • Tier II capital = Convertible bonds +Subordinate bonds +Perpetual Preferred Stock (nonqualifying) + Reserve for Loan losses = 15 + 15 + 5 + 10 = 45 million.

  24. Risk-based Capital Ratios • Total Risk-adjusted Assets = Risk-adjusted On-Balance-Sheet assets + Risk-adjusted assets for OBS items = 849m + 60m = 909 million. • Total Risk-based capital Ratio = Tier I + Tier II capital Total Risk-adjusted assets = (50 + 45) 909 = 10.45% > 8% • Tier I Capital Ratio = Tier I Capital Total Risk-adjusted Asset = 50 909 = 5.1 % > 4%

  25. Leverage Ratio = Tier I Capital Total Assets = 50 1,215 = 4.11% < 5% Note: The bank meets risk –based capital requirements under Basel I. The Bank is adequately capitalized.

  26. Why New Capital Standards ?(Basel II) • Basel II aims to better align regulatory capital with underlying risk • Basel II explicitly accounts for credit risk, market risk and operational risk • Better address capital requirements for banking innovation such as asset securitization • Basel II will be implemented by year end 2006

  27. Deficiencies of Basel I • While simple in application, it is easy to achieve significant capital reduction with little or no risk transfer • Did not sufficiently discriminate between different levels of risks • Encouraged excessive risky lending and investing in certain areas [Subprime loans, asset-backed securities (ABS)]

  28. The New Capital Standards (Basel II) • Risk sensitivity of capital requirements for credit risk • New capital charges for operational risk • No more “one-size-fits-all” approach • More flexible approach through a menu options • New incentives for sound risk management practices

  29. Three Pillars of Basel II Basel II Minimum Capital Supervisory Disclosure & Requirement Review Process Market (Pillar 1) (Pillar 2) Discipline (Pillar 3)

  30. Flexible Approach to Determine Regulatory Capital under Basel II • Basel II offers many different approaches to compute regulatory capital against credit risk and operational risk • Banks opt for one approach for all for some segments of activities or some asset classes • Banks opting for the most advanced approaches must be authorized by their supervisors • Basel II incorporates minimum capital requirements into a three pillar structure that includes supervisory review and market discipline

  31. Calculating Risk Weighted Assets Risk Weighted Assets Market Risk Credit Risk Op Risk Standardized Approach Basic Indication Approach Standardized Approach Foundation IRB Approach Standardized Approach Internal Model Approach Advanced IRB Approach Advanced Measurement Approach

  32. Standardized Approach to Credit Risk • Use fixed risk weights based on external credit ratings • Least sophisticated capital calculation with highest capital burden • Except for the largest 20 banks, most US banks will use standardized approach

  33. Internal Ratings-Based (IRB) Approaches to Credit Risk Substantially differ from the standardized approach • Banks internal assessments of key risk drivers serve as primary inputs to the capital calculation • The risk weights and capital changes are determined through the combination of quantitative inputs provided by banks and formulas specified by the committee • Banks have strong incentive to move to IRB status and reduce capital changes by improving risk management system.

  34. Foundation IRB VS. Advanced IRB Data Input Foundation IRB Advanced IRB -Probability of -Provided by bank based - Provided by bank Default (PD) on ownestimatesbased on own estimates -Loss Given -Supervisory Values set - Provided by bank based on Default (LGD) by the committeeown estimates -Exposure at -Supervisory values set - Provided by bank based on Default (EAD) by the committeeown estimates -Maturity (M) -Supervisory values - Provided by bank based on provided by the own estimates committee

  35. Table 11A Risk Categories under Basel II Category 1 (0% weight) Cash, Federal Reserve Bank balances, securities of the U.S. Treasury, QECD governments, some U.S. agencies, and loans to sovereigns with an S&P credit rating of AA – or better. Category 2 (20% weight) Cash items in the process of collection. U.S. and OECD interbank deposits and guaranteed deposits and guaranteed claims. Some non-OECD bank and government deposits and securities. General obligation municipal bonds. Some mortgage backed securities. Claims collateralized by the U.S. Treasury and some other government securities. Loans to Sovereigns with an S&P credit rating of A+ or A-. Loans to banks and corporates with an S&P credit rating of AA- or better. Summary of the Risk-Based Capital Standards for On-Balance Sheet Items Under Basel II effective 2006

  36. CONTINUED from Table 11A • Table 11B Category 3 (50% weight) Loans fully secured by first liens on the one-to four-family residential properties. Other (revenue) municipal bonds. Loans to Sovereign with an S&P credit rating of BBB+ to BBB-. Loans to banks and corporates with an S&P credit rating of A+ to A-. Category 4 (100% weight) Loans to Sovereigns with an S&P credit rating of BB+ to B-. Loans to banks with a credit rating of BBB+ to B-. Loans to corporates with a credit rating of BBB+ to BB-. All other on-balance-sheet assets not listed above, including loans to private entities and individuals, some claims on non-OECD governments and banks, real assets, and investments in subsidiaries. Category 5 (150% weight) Loans to sovereigns, banks and securities firm with an S&P credit rating below B-. Loans to corporates with a credit rating below BB-.

  37. Table 12 Conversion Factors for OBS items Sale and repurchase agreements and assets sold with recourse that are not included on the balance sheet (100%). Direct credit substitute standby letters of credit (100%). Performance-related standby letters of credit (50%). **Unused portion of loan commitments with original maturity of more than one year (50%). Commercial letters of credit (20%). Bankers acceptances conveyed (20%). Other loan commitments (10%). ** Loan commitments with original maturity < 1year (Conversion factor is zero based on Basel I and 20 percent based on Basel II) Conversion factors for Off-Balance-Sheet Contingent or Guaranty Contracts, Basel II (Same as Basel I)

  38. Bank’s Balance-Sheet under Basel II • An example = See Appendix B

  39. Risk-adjusted On-Balance-Sheet Assets = 0 ( 8m +13m + 60 m + 50m + 42m) + 0.2 ( 10m + 10m + 20 + 10m + 55m) + 0.5 (34m + 308m + 75m) + 1.0 (390m + 108m + 22m ) + 1.5 (10) = $764.5 million Risk-Adjusted assets for Off-Balance-Sheet items = 60 million (same as before) Total Risk-adjustment assets = 764.5 million + 60 = 824.5 million

  40. Risk-based Capital Ratios under Basel II • Tier I (Core) Capital Ratio = Core Capital Total Risk-adjusted Assets = $50 million 824.5 million = 6.06% > 4% • Total Risk-based Capital Ratio = Tier I + Tier II Capital Total Risk-adjusted Assets = (50 m + 45) m 824.5 = 11.52% > 8% • Leverage Ratio = Tier I Capital Total Assets = 50 mil 1,215 mil = 4.11 % < 5%

  41. Comparison of Basel I & Basel II Basel I Basel II • Tier 1 (core) capital Ratio = 5.5% 6.06% • Total risk-based Capital Ratio= 10.45% 11.52% • Leverage Ratio = 4.11% 4.11%

  42. Bank Book Capital Ratios Table 13 Asset Size Bucket 1996(in $bn) 0.5-1 1-2 2-5 5-10 10-30 > 30 Number of Banks 203 112 65 33 32 29 Tier 1 capital/Avg Assets (in %) 8.58 8.57 7.80 8.46 7.50 7.14 Total Capital (Tier 1+Tier2)/ Risk-Weighted Assets 14.47 14.23 13.46 13.75 13.25 12.80 Source: Adapted from Davis and Lee (1997) Observation #1: Smaller banks hold (relatively) more capital. Why?

  43. Capital serves as substitute for Risk Management to ensure bank safety • Smaller banks tend to have following characteristics: • Concentrated ownership and owner-managers, thus prefer more risk management to less. • Limited access to sophisticated risk management. • More operating risk due to the lack of management depth. • Lack of fee-based income might lead to more earnings volatility. • Lack of diversification of their credit portfolios (with geographical and/or industry concentrations). • The capital structure choice in banks is closely related to the underlying risks held on the books of a bank.

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