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Importance of Capital Adequacy

Importance of Capital Adequacy. Absorb unanticipated losses and preserve confidence in the FI Protect uninsured depositors and other stakeholders Protect FI insurance funds and taxpayers Protect DI owners against increases in insurance premiums

timothy-barber
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Importance of Capital Adequacy

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  1. Importance of Capital Adequacy • Absorb unanticipated losses and preserve confidence in the FI • Protect uninsured depositors and other stakeholders • Protect FI insurance funds and taxpayers • Protect DI owners against increases in insurance premiums • To acquire real investments in order to provide financial services

  2. Capital and Insolvency Risk • Capital • net worth • book value • Market value of capital • credit risk • interest rate risk • exemption from mark-to-market for banks’ securities losses • Arguments against MVA

  3. Capital Adequacy: Commercial Banks and Thrifts • Actual capital rules • Capital-assets ratio (Leverage ratio) L = Core capital/Assets • 5 target zones associated with set of mandatory and discretionary actions • Prompt corrective action

  4. Balance Sheet Regulations • Liquidity • Fed gives minimum reserve requirements • reserve computation period • 2 weeks beginning on Tuesday and ending on Monday 14 days later • Capital Adequacy – minimum capital requirements to constrain leverage • capital-to-assets ratio • risk-based capital ratio • Tier I • Tier II

  5. Risk-based Capital Ratios • Basle I 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 requires, Tier I (core) capital ratio = Core capital (Tier I) / Risk-adjusted  4%. • Crudely mark to market on- and off-balance sheet positions.

  6. 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

  7. New Basel Accord (Basel II) • Pillar 1: Credit, market, and operational risks • Credit risk: • Standardized approach • Internal Rating Based (IRB) • Market Risk --Unchanged

  8. Basel II continued • Pillar 2 • Specifies importance of regulatory review • Pillar 3 • Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks

  9. Calculating Risk-based Capital Ratios • Credit 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.

  10. Calculating Risk-based Capital Ratios under Basel II • Basel I criticized since individual risk weights depend on broad borrower categories • All corporate borrowers in 100% risk category • Basle II widens differentiation of credit risks • Refined to incorporate credit rating agency assessments

  11. Risk-adjusted OBS 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.

  12. Risk-adjusted OBS Activities • 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) • Credit equivalent amount divided into potential and current exposure elements.

  13. 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

  14. Criticisms of Risk-based Capital Ratio • Risk weight categories versus true credit risk. • Risk weights based on rating agencies • Portfolio aspects: Ignores credit risk portfolio diversification opportunities. • DI Specialness • May reduce incentives for banks to make loans. • Other risks: Interest Rate, Foreign Exchange, Liquidity • Competition and differences in standards

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