Chapter 17 Capital Adequacy

Overview This chapter discusses the functions of capital in modern FIs. We learn that capital is not only a source of funds, but further protects an FI from insolvency. We discuss the various measures of capital in FIs. We also discuss the various measures of capital by accounting bodies and regulators, such as the Bank for International Settlements. We explore how regulators measure capital adequacy in FIs. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Introduction to Capital Adequacy The major functions of capital are: To absorb unanticipated losses. To protect uninsured depositors, bondholders and creditors in case of insolvency and liquidation. To protect FI insurance funds and the taxpayer. To protect the FI owners against increases in insurance premiums and lowering the cost of funds. To partially fund the FI’s investment activities. Sufficient capital levels inspire confidence in the FI. Sufficient capital levels enable the FI to continue as a going concern even in difficult times. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Cost of Equity Capital as a Funding Source The value of an FI’s share reflects the current and expected future dividends to be paid by the FI from its earnings. Where: P0 = current price of share, Di = dividends expected in year i = 1 …∞, k = discount rate (required return on the share). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Cost of Equity Capital as a Funding Source If dividends are growing at a constant rate g, we find that: Dividing both sides of the equation by current earnings per share (E): Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Cost of Equity Capital as a Funding Source Thus: P/E is greater, the higher D/E, P/E is greater, the higher g, P/E is higher, the lower k. The P/E of an FI influences the attractiveness of issuing additional equity. The higher the P/E, the more investors are willing to pay for a dollar of earnings. The higher the P/E, the cheaper for an FI to issue equity. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk Defining ‘capital’: Net worth: market value of assets minus market value of liabilities. Book value: asset and liability values based on historical cost Economists prefer the market value definition, while most regulators prefer the book value definition. The book value method can be misleading. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk The Market Value of Capital: The marking-to-market method allows balance sheet values to reflect current rather than historic prices. Consider the following market value balance sheet of an FI. Assets ($m) Liabilities ($m) Securities Loans 70 30 Deposits Net worth 95 5 TA = 100 TL + E = 100 In this example the FI is solvent on a market value basis. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk The Market Value of Capital and Credit Risk: Consider a fall in the market value of loans to $27. Assets ($m) Liabilities ($m) Securities Loans 70 27 Deposits Net worth 95 2 TA = 97 TL + E = 97 While the FI is still solvent, its net worth has declined from $5 to $2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk The Market Value of Capital and Credit Risk: Consider a further fall in the market value of loans of $5. Assets ($m) Liabilities ($m) Securities Loans 70 22 Deposits Net worth 95 -3 TA = 92 TL + E = 92 The FI is insolvent. After insolvency and the liquidation of the remaining $92 in assets, depositors would get only 92/95 in the dollar (96.84%). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk The Market Value of Capital and Interest Rate Risk: Losses in asset values due to adverse interest rate changes are borne first by equity holders. If losses exceed the value of equity, liability holders will be affected. Sufficient capital levels will protect liability holders from losses. Since new accounting rules introduced in Australia (1995): Fair market value of most assets and liabilities has to be disclosed. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk The Book Value of Capital: Components of the book value of capital for FIs: Par value of shares, Surplus value of shares, Retained earnings, Loan loss reserve. In Australia, accounting convention of par value has been replaced by the representation of book value of equity as price paid on shares when originally offered. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk The Book Value of Capital and Credit Risk: Tendency to defer write-downs. The Book Value of Capital and Interest Rate Risk: Effects not recognised in book value accounting method. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk The Discrepancy between the Market and Book Values of Equity: Factors underlying discrepancies: Interest rate volatility, Examination and enforcement. MV of equity per share: MV of equity ownership shares outstanding / numbers of shares. BV of equity per share: (Par value of equity + surplus value + retained earnings + loan reserves) / number of shares. Market to book ratio: MV / BV. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital and Insolvency Risk Arguments Against Market Value Accounting: Difficult to implement, Introduces unnecessary variability into an FI’s earnings, FIs are less willing to take longer-term asset exposures. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Risk-based capital ratio introduced in Australia in 1989. Capital ratio divided into: Tier 1 capital risk-based ratio, Total capital risk-based ratio. Total capital risk-based ratio consists of: Tier 1, plus Tier 2 capital. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions The Capital–Assets Ratio (L): Measures the ratio of an FI’s core capital to its assets. Leverage ratio. L = Core capital / assets Problems: Market value, Asset risk, Off-balance-sheet activities. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Risk-Based Capital Ratios: Proposed by the Bank for International Settlements (BIS): www.bis.org Full implementation in January 1993. Arrangement known as Basel Agreement (Basel I). Initially, capital requirements against credit risk exposures only. Since 1989: additional capital requirements for market risk exposures. 2001: publication of Basel II. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Risk-Based Capital Ratios: Basel II requirement: additional capital against operational risk exposures. Basel II consists of three mutually reinforcing pillars: Pillar I: regulatory capital requirements, Pillar 2: supervisory review process. Pillar 3: market discipline. In Australia, Basel I currently enforced by APRA. Basel II yet to be implemented. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Risk-Based Capital Ratios: Total capital = Tier 1 + Tier 2 capital – deductions. Tier 1 = core capital. Tier 2 = supplementary capital. Tier 1 capital must equal or exceed 4% of risk-weighted assets. Tier 2 capital is limited to 100% of Tier 1 capital. Total capital must equal or exceed 8% of risk-weighted assets. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Risk-Based Capital Ratios: Credit-risk adjusted assets: on- and off-balance-sheet assets whose values are adjusted for approximate credit risk. Total risk-based capital ratio = Total capital / credit risk adjusted assets ≥ 8%. Tier 1 (core) capital ratio = Core capital / credit risk adjusted assets ≥ 4%. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Calculating Risk-Based Capital Ratios – Basel I: Assets subdivided into four categories dependent on counterparty default risk: 0% risk-weight, such as notes and coins, 20% risk-weight, such as claims on international banking organisations, 50% risk-weight, such as loans fully secured by mortgage against eligible residential mortgages, 100% risk-weight, such as claims on commercial companies. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Calculating Risk-Based Capital Ratios – Basel I: Where: wi = risk-weight of ith asset, where i = 1 to n, ai = dollar (book) value of the ith asset on the balance sheet. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Calculating Risk-Based Capital Ratios – Basel I: Example: Suppose an FI holds the following assets: Notes and coins: $10 million Loans to Australian banks: $20 million, Loans fully secured by mortgages: $70 million, Commercial loans: $100 million. Total assets: $200 million. Risk-adjusted assets = 0%×10 + 20%×20 + 50%×70 + 100%×100 = $139 million. The FI needs to hold at a minimum $139 million × 8% = $11.12 million in capital. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Credit Risk Adjusted On-Balance-Sheet Assets under Basel II: Major criticisms of Basel I: risk-weights dependent on broad categories of borrowers. Basel II widens differentiation of credit risks: refined to incorporate external credit rating agency assessments. Risk-weight classes: 0%, 20%, 50%, 100%, 150%. Risk weights dependent on: Counterparty, Credit rating of counterparty. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Credit Risk Adjusted On-Balance-Sheet Assets under Basel II: Risk weightings for residential mortgage loans determined by relative risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Credit Risk Adjusted On-Balance-Sheet Assets under Basel II: Example: Suppose an FI holds the following assets: Notes and coins: $10 million, Loans to international banks with a credit rating of BBB: $20 million, Residential mortgage loans (LVR = 80%, no mortgage insurance): $70 million, Loans to international corporates with a credit rating of AA: $50 million, Loans to corporates with a credit rating of B: $50 million. Total assets: $200 million. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Credit Risk Adjusted On-Balance-Sheet Assets under Basel II: Example (continued): Risk-adjusted assets = 0%×10 + 50%×20 + 35%×70 + 20%×50 + 150%×50 = $119.5 million. The FI needs to hold at a minimum: $119.5 million × 8% = $9.56 million in capital. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Credit Risk Adjusted Off-Balance-Sheet Assets Under Basel I and II: Conversion factors used to convert into credit equivalent amounts – amounts equivalent to an on-balance-sheet item. Conversion factors used depend on the guarantee 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). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Credit Risk Adjusted Off-Balance-Sheet Assets Under Basel I and II: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions The Credit Risk Adjusted Asset Value of Off-Balance-Sheet Market Contracts or Derivative Instruments: Counterparty credit risk: The risk that the other side of a contract will default on payment obligations. Credit equivalent amount of OBS derivative security item ($) = potential exposure ($) + current exposure ($) Potential exposure: the risk of a counterparty to a derivative securities contract defaulting in the future. Current exposure: the cost of replacing a derivative securities contract at today’s prices. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions The Credit Risk Adjusted Asset Value of Off-Balance-Sheet Market Contracts or Derivative Instruments: Credit risk adjusted value of OBS market contracts = total credit equivalent amount × risk weight. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions The Credit Risk Adjusted Asset Value of Off-Balance-Sheet Derivative Instruments with Netting: Addresses the problem that netting of exposures is ignored. Approach adopted by APRA under the condition that an FI has a bilateral netting contract. Net potential exposure (PFCEadj): (0.4 × PCFEgross) + (0.6 × NGR × PCFEgross) Where: PCFEgross = sum of the potential future credit exposures of each contract, NGR = ratio of net current exposure to gross current exposure. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions The Credit Risk Adjusted Asset Value of Off-Balance-Sheet Derivative Instruments with Netting: Current exposure: net sum of all positive and negative replacement costs. If result is positive, then the net current exposure equals the sum. If result is negative, the net current exposure is zero. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Interest Rate Risk, Market Risk and Risk-Based Capital: Insolvency risk arising from duration mismatches and trading risk were not explicitly accounted for in the original capital framework. Since 1998: FIs have had to calculate an ‘add-on’ to cover market risk. Two different approaches: Standardised model (predetermined by regulators), FI’s own internal market risk model. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Operational Risk and Risk-Based Capital: Three increasingly sophisticated approaches to calculate operational risk capital: Basic Indicator Approach, Standardised Approach, Advanced Measurement Approach. Basic Indicator Approach: On average banks hold 12% of total regulatory capital against operational risk exposures, Operational capital = α × gross income. α = 17 – 20%. Gross income = net interest income + net non-interest income Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Operational Risk and Risk-Based Capital: Standardised Approach: Refinement to Basic Indicator Approach, FI’s activities divided into eight business units and lines, Risk indicator (β) in each business line reflects the business line’s riskiness. Operational capital in each business line = β × gross income. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Operational Risk and Risk-Based Capital: Standardised Approach: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Operational Risk and Risk-Based Capital: Advanced Measurement Approach: Internal Measurement Approach (IMA), Loss Distribution Approach (LDA), Scorecard Approach (SA). Requirements to be fulfilled by FIs to qualify for the Advanced Measurement Approach: Systematic and transparent operational risk management and measurement practices (capable of independent review and validation), Framework to manage, measure and monitor operational risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Operational Risk and Risk-Based Capital : Requirements to be fulfilled by FIs to qualify for the Advanced Measurement Approach (continued): Collection of operational risk data, Use of internal and relevant external operational risk data, scenario analysis, specific indicators of the FI’s current and future operational risk profile. Operational risk capital must cover expected and unexpected losses, Operational risk requirement must be comparable to a 99.9% confidence level and a one-year holding period. Risk mitigators might be allowed, subject to APRA’s approval (maximum: 20%). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Capital Adequacy: Australia’s Authorised Depository Institutions Criticisms of the Risk-Based Capital Ratio: Risk weights, Risk weights based on external credit rating agencies, Portfolio aspects, DI specialness, Other risks, e.g. credit crunches. Competition. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Internal Ratings Based Approach to Measuring Credit Risk Adjusted Assets Two Internal Ratings Based (IRB) Approaches: Foundation IRB Approach, Advanced IRB Approach. Foundations IRB Approach: Bank internally estimates the one-year probability of default (PD), Supervisor determines other risk determinants. Advanced IRB Approach: Bank determines PD, loss given default (LGD), exposure at default (EAD) and maturity (M). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Internal Ratings Based Approach to Measuring Credit Risk Adjusted Assets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher