Capital Adequacy

Basel II Accords Proposed 2004, Implemented Soon Three Pillars Minimum capital requirements, New methodology for calculating required capital for credit risk. Charges for operational risk Supervisory review - regulators use more comprehensive tools for assessing risk. Market discipline – banks expected to increase reporting to financial markets.

Basel Accords Under the Auspices of the Bank for International Settlements, the Basle Committee (which consists of the G-10 countries’ central bank governors), have agreed upon a scheme of regulation which will be applied to international banks. (What is the BIS?) The key element of this scheme is a set of requirements relating a minimum amount of bank capital relative to a risk based measure of assets. Why capital?

Capital: Tension between profits and risk The equity multiplier magnifies the effect of profits on returns which gives bank owners an incentive to increase leverage. Bank capital absorbs losses before depositors or creditors absorb losses. So bank depositors and creditors prefer capital. Risky banks may pay higher interest rates so banks may internalize depositors preferences… But regulators have adopted a preference toward capital requirements institutionalized by Basel.

Capital and Moral Hazard Consider a bank with 0 capital, full financed with deposits of $100 (which for convenience pay 0 interest rate). Bank managers face two loan projects with differing payoff profiles. Which will the bank choose? Which is socially optimal? Prob. of Good Outcome Prob. of Bad Outcome Interest Recovery % Project A (Risky) .5 .2 Project B (Safe) 1 .05 N/A

Expected Payoffs to depositors and bankers The safe project creates value in excess of customers demand for funds. The expected value of the risky project is just $60, less than what was put in the project. Assume that in the event of bankruptcy, depositors claim all remaining assets. The depositors have an expected payoff of 100 under the safe scheme and only 50 under the risky lending scheme. They prefer safety.

Bankers payoffs Under the safe scheme, the bankers will get a payoff of 5. Under the risky scheme the bankers will get an expected payoff of 10. They will prefer the destructive, risky scheme. Why? Bankers get upside pay-off of risky scheme but put downsize risk on depositors.

Well capitalized banks? Compare with bank finance by 80% deposits and 20% equity. Under safe scheme, bank gets an expected payoff of 25 for a 25% ROE. Under risky scheme, the bank owners receives 40 back in a good outcome and 0 back in a bad outcome for an expected payoff of 20. Bank owners share the downside risk and avoid the risky scheme.

Measures of Capital Risk Chief measures are Tier 1 leverage ratio and CAR (capital adequacy) ratio. CAMELS rating system

Recent rise in US capital ratios as well FDIC Historical Banking Statistics http://www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=10

Rising Capitalization Ratios in Hong Kong Source: CEIC/HKMA

Capital Adequacy Ratio Main regulatory requirement of HK banks is the CAR: Capital Adequacy Ratio. CAR is Since 1987, the Basel Accords imposed in HK and CAR > .08. What is regulatory capital? How do you adjust for risk?

Historical Capital Adequacy for HK Source:

Types of Capital Tier 1 capital is thought to be more stable and more aligned with the concept of capital as the funds that owners have invested in the banks (i.e. equity capital, perpetual preferred stock and retained earnings) Tier 2 capital are funds that protect depositors but may be withdrawn (subordinated debt) or is already somewhat committed to other purposes (reserves).

Measuring Capital For regulatory purposes, capital is divided into two tiers. Tier 2 Subordinated Debt General Loan Reserves (LLA) Other Reserves (similar to undivided profits) Tier 1 Common Stock at Par + Surplus Undivided Profits/Retained Earnings Minority Interests Minus Intangible Assets, Goodwill

Risk Adjusted Assets Loans & securities are placed in a number of buckets AjOn with associated risk weights based on the identity of the borrower Off-balance sheet items are converted to credit equivalents with credit conversion factor, ccfk, based on type of item. AjOff = ccf1∙ Aj,1Off + ….. Aj = AjOn + AjOff Risk Adjusted Assets: w1A1 + w2A2 + …w4A4

Risk adjustment of assets: Standardized Approach Different assets are differentiated into buckets which have different risk weights. Risk Bucket Loans Risk Weights 1. Domestic Central Govt. 0% 2. Public Entities, Foreign Governments (OECD), Banking. 20% 3. Secured Residential Lending. 50% 4. Commercial and consumer loans 100%

Timeline Basel Accords signed in 1987 imposed risk-based capital requirements Basel Market Risk Amendment in 1996. Impose market risk requirement Problems with Basel I Risk weights too broad Does not account for new risk management techniques.

Standardized Approach Basel II Meant for smaller, less sophisticated banks. New risk weights (0%; 20%; 50%; 100%, 150%) used for assessing capital required based on credit rating and type of assets. Uses External Ratings (where available) Unrated (most SMEs) weighted at 100% 35% weight for claims secured by Residential Mortgage 100% weight for claims secured by Commercial Mortgage

Set of risk weights (ranging from 0 to 150%) for different types of assets with different credit ratings claims on Sovereign Public Entities MDB Banks Securities Firms Corporates Residential Lending Cash Regulatory Retail Other Assets Past Due

Credit Conversion Factors Off Balanced Sheet Type ccf 1. Standby LOC, Guarantees, Securitization w/ Recourse 100% 2. LT Loan Commitments 50% 3. Commercial LOC 20% 4. Finanical Derivatives (depends on type & maturity) 0-15% 5. ST Loan Commitments 0%

Market Risk Banks with significant trading activity (trading assets+liabilities > 10% of total assets) must have additional capital beyond 8% of credit risk adjusted assets. Banks should calculate VAR of foreign exchange and securities positions and allocate some capital equal to 8% of VAR.

IRB Approach Internal Ratings Based: Foundation Approach Only banks that can demonstrate competence can use IRB approach Internal Ratings Based: Foundation Approach Banks examine lending and associated assets and calculate probability of default for loans. Regulators provide formulas for associated capital requirement. Internal Ratings Based: Advanced Approach Bank constructs own (supervisor approved) formulas to calculate. PD: probability of default, EAD: exposure of bank to default LAD: Loss at default M: remaining maturity and uses these to determine required capital.

Operations Risk Loss of funds through operating circumstances may be a source of risk for banks. Standardized Approach: Allocate capital to equal 15% of 3year lagged moving average of revenues. Subject to regulatory approval, most sophisticated banks may design their own systems for operations risk.

How much capital? Depends on risk appetite of the bank, regulatory requirements, maintaining a good debt rating, limits of internal growth, relative cost of debt and equity financing. Use statistical ratios to describe the risk appetite of banks.

Capital and Growth Capital adequacy limitations can act as brake on bank growth. Consider a bank that can achieve 10% growth on the asset side of its balance sheets and also can borrow freely to achieve that growth. An adequately capitalized bank must achieve 10% capital growth or fall below the adequacy standard.

Achieving Capital Growth Reduce dividend payout ratios Earn higher ROA to increase cash flow (may increase risk) Change mix of assets to those with smaller capital charges Move assets off balance sheet Issue more stock/subordinated debt.

Internal Growth Rate The change in the capital of the bank that can be obtained from internal sources is:

Modern Capital Management Instead of evaluating how much capital the bank needs, modern banks will evaluate lines of business and how much capital should be allocated for the assets needed to generate income in that line. Different businesses require different quantities of capital. Capital is more expensive than debt, so business requiring heavy capitalization must earn higher returns.

Basel II Accords In what ways have recent events challenged the Basel Accords?

Reading List Bank for International Settlements – Basel II Overview International Convergence of Capital Standards KPMG Canada, 2006, -Basel II: A Worldwide Challenge for the Banking Business