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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