Banking Tutorial 6 – Capital and Capital Adequacy Pavel Hrbek Institute of Economic Studies, Faculty of Social Science, Charles University in Prague, Czech Republic November 7, 2012

Slide 2 Contents 1.Types of capital - recap 2. Basel I, II, III - recap 3. Case study – operational risk 4. Examples and tasks from the textbook

Slide 3 Capital The basic aim of banking is asset-liability management (ALM) in order to keep the liquidity, solvency and profitability of a bank in the sense of: 1.Capital management of the equity-liabilities relationship, i.e. managing the capital structure under risk conditions; 2.Assets management, their liquidity, profitability and risk; 3.ALM, liability and off-balance sheet management.

Slide 4 Capital definitions a)accounting capital b)regulatory capital c)economic capital b) and c) more used in the sense of „capital requirement“ a) Accounting capital Equity = Assets – Liabilities

Regulatory capital Defined by Prudential rules - Decree No. 123/2007 Coll., stipulating the prudential rules for banks, credit unions and investment firms Tier 1 – Core capital - the most important component of bank’s capital and consists primarily of paid-up equity capital, share premium and retained earnings Tier 2 – Supplementary capital - loan loss reserves, convertible bonds or subordinate debt with a maturity of at least five years Total Capital (CAP) = Tier 1 + Tier 2 – Deductibles Slide 5

Slide 6 Capital adequacy ratio b) Regulatory capital is used for the computation of capital adequacy, the ratio of capital to the risks undertaken by a given bank CAD – capital adequancy CAPITAL – total capital RWA – risk–weighted assets Capital adequacy ratio is one of the measures regulated by the prudential rules and must be at least 8%.

Slide 7 c) Economic capital - is a buffer against future unexpected losses brought about by credit, market, and operational risks inherent in the business of lending money. Economic capital Source: Chalupka, R., Teplý, P. (2008). “ Operational Risk Management and Implications for Bank’s Economic Capital – A Case Study ” IES Working Paper 17/2008. IES FSV

Regulatory vs. Economic capital The goal of regulation is to set the regulatory requirements in the way, that most reflects the real risk the bank is facing. => This shall lead to convergence of regulatory and economic capital Slide 8

Slide 9 Economic capital allocation of individual banks (2007 vs. 2010) Source: DP Vejdovec (2011)

Economic capital allocation ( ) Slide 10 Source: DP Vejdovec (2011)

Czech banking sector capital structure Slide 11 Source: CNB (2012): Financial Market Supervision Report 2011

Slide 12 Contents 1.Types of capital - recap 2. Basel I, II, III - recap 3. Case study – operational risk 4. Examples and tasks from the textbook

„Basel“ Bank for International Settlement (BIS) Basle Committee on Banking Supervision (BCBS) 1988 – Basel I (credit risk) 1996 – Basel I (credit and market risk) 2007 – Basel II (credit, market and operational risk, 3 Pillars) 2010 – Basel III (credit, market and operational risk, liquidity risk) Slide 13

Slide 14 Basel II The overall objective to increase the safety and soundness of the international financial system by: making capital requirements for banks more risk sensitive while maintaining the same level of overall average regulatory capital in the banking system (BIS,2006) Improvements in Basel II vs. Basel I (a more “menu- like” approach, different risk-weights, operational risk, own internal rating models etc.)

Slide 15 Basel II Three pillars Source: Teplý, Černohorská, Diviš (2007)

Slide 16 Basel II Pillar I - Capital Requirements Source: Teplý, Černohorská, Diviš (2007)

Basel II – summary of approaches for calculation of capital requirements Credit risk Standardized Approach Foundation IRB Approach (transformation of PD into RW) Advanced IRB Approach Market risk Standardized Approach Internal Models Operational risk Basic Indicator Approach (BIA) Standardized Approach (STA) Advanced Measurement Approach (AMA) Slide 17

Capital requirements and capital ratio of the Czech banking sector Slide 18 Source: CNB (2012): Financial Market Supervision Report 2011

Slide 19 Basel II Breakdown of capital requirements by type of risk of EU banks (2008) Source: DB Research (2007)

Basel III A new regulatory framework issued by the Basel Committee on Banking Supervision in 2010 which sets standards for capital adequacy of banks and now also for their liquidity. Overall, Basel III introduces stricter rules than the previous framework and came into existence mainly as a reaction to the financial crisis. Slide 20

Basel III According to the BCBS, Basel III has the following goals: "Basel III" is a comprehensive set of reform measures, developed … to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to: improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, improve risk management and governance, strengthen banks' transparency and disclosures. The reforms target: bank-level, or micro-prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress. Macro-prudential, system-wide risks that can build up across the banking sector, as well as the pro-cyclical amplification of these risks over time. Slide 21

Basel III Quality of capital shall be raised (strong focus on common equity, a move away from complex hybrid instruments (core Tier 1 > 4 %, Tier 1 > 7 %) Introduction of liquidity standards (Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR)) Promoting building up capital buffers in good times, that can be drawn down in periods of stress) Significat increase in risk coverage, with a focus on areas that were most problematic during the crisis - trading book and securitisation activities Slide 22

Slide 23 Contents 1.Types of capital - recap 2. Basel I, II, III - recap 3. Case study – operational risk 4. Examples and tasks from the textbook

Slide 24 Operational risk (OR) Basic terms Basel II: OR = the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events failures this definition encompasses a relatively broad area of risks, with the inclusion of legal risk (but reputation risk and strategic risk excluded) Jerome Kervile ($7.3 billion), Mr. Bernard Madoff ($65 billion swindle), Sir Allen Stanford ($8 billion fraud) non-existence of $1 billion in a balance sheet of Indian company Satyam CSOB Bank in 2000 (USD 53m)

Slide 25 Operational risk Heavy-tailed data distribution/Black swans Source: Chernobai et al. (2007)

Slide 26 Operational risk Modelling of OR losses – BIG CHALLENGE! Source: Chernobai et al. (2007)

Slide 27 Operational risk Modelling of OR losses Two parts of data simulations – body and tail Source: Chernobai et al. (2007)

Basel II Operational risk – Research results by P.Teplý and R. Chalupka Source: Teplý (2009) simple parametric distributions significantly underpredict losses in the tail focusing on the tail seems more reasonable – EVT fits statistically and brings reasonable capital estimates block maxima model (max. dozen) fits the best, hence 7.2% capital estimate (compared to 15% of banking income as required by the SA) appears as the most reasonable Slide 28

Basel II Operational risk – Methodology applied by P.Teplý and R. Chalupka Extreme value theory losses of low frequency and high severity – upper tail of distribution block maxima model o considers largest losses over a particular period of time o the limiting distribution of such normalised maxima is the generalised extreme value (GEV) distribution o x refers to the maxima, μ is the location parameter, β is the scale parameter, and ξ is the shape parameter, additional constrains on parameters (see e.g. Chernobai 2007) Loss amount X Time 0 Block maxima model Slide 29

Slide 30 Contents 1.Types of capital - recap 2. Basel I, II, III - recap 3. Case study – operational risk 4. Examples and tasks from the textbook

Slide 31 Balance sheet of Mikeska & Co Calculate: a) Tier 1 b) total capital c) on-balance sheet risk-weighted assets (RWA) d) total capital adequacy (CAD) Examples

Slide 32 Off-balance sheet of Mikeska & Co Calculate: e) off-balance sheet risk-adjusted asset amounts (RAAA) f ) Tier 1 ratio g) credit risk-adjusted assets (CRAA) h) total capital adequacy (CAD) Examples Off-balance sheet (OBS) exposure = Notional amount × Conversion factor RAAA = OBS exposure × risk weight

Slide 33 Source

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