CHAPTER 20 Capital Adequacy Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

20-2 Overview  This chapter discusses the functions of capital, different measures of capital adequacy, current capital adequacy requirements, and advanced approaches used to calculate adequate capital according to internal rating based models of credit risk.

20-3 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

20-4 Capital Adequacy and TARP  Part of TARP : Capital Purchase Program –Encourage building of capital to increase flow of funds –Treasury purchase of $200 billion of senior preferred shares

20-5 Capital Adequacy and TARP  Required certain standards −No compensation incentives for senior management to take excessive risks −Required payback of bonuses based on inaccurate financial reports −Prohibition of golden parachutes −Agreement not to deduct more than $500,000 for each senior executive for tax purposes −Emergency funding to Citigroup ($25 billion), BOA ($20 billion) −August 2009: $250B allocated. $72.5B paid back, $9.5B in dividends and assessments

20-6 Capital and Insolvency Risk  Capital –Net worth –Book value  Market value of capital –Credit risk –Interest rate risk –During financial crisis, FASB clarified position on market value accounting and allowed management to exercise greater discretion for pricing illiquid assets

20-7 Capital and Insolvency Risk (continued)  Book value of capital −Par value of shares −Surplus value of shares −Retained earnings −Loan loss reserve

20-8 Book Value of Capital  Credit risk –Tendency to defer write-downs –May require pressure from regulators to actually write-down substandard loans –Only an outright loss requires 100 percent charge-off –Refer table 20-1 and 20-2 to compare BV and MV

20-9 Discrepancy: Market vs Book Values  Market value accounting –Market to book  Lower ratio indicates greater overstatement of true economic value  Arguments against market value accounting: –Contention that it is difficult to implement, especially for small banks –Increase in volatility of earnings  Could force premature closure under prompt corrective action –Bias against long term assets

20-10 Capital Adequacy: Commercial Banks and Thrifts  Actual capital rules  Capital - Assets ratio (Leverage ratio) L = Core capital/Assets table target zones associated with set of mandatory and discretionary actions. See table 20-3  : Regulators acted quickly –Stress tests of 19 largest DIs (February 2009) –By early June 2009, DIs had raised $149.45B of capital

20-11 Leverage Ratio  Problems with leverage ratio: –Market value may not be adequately reflected by leverage ratio –Asset risk ratio fails to reflect differences in credit & interest rate risks –Off-balance-sheet activities escape capital requirements

20-12 New Basel Accord (Basel II)  Pillar 1: Credit, market, and operational risks  Credit risk: –Standardized approach –Internal Rating Based (IRB)* (Appendix 20A)  Market risk unchanged (from 1998)

20-13 Basel II (continued)  Operational: –Basic indicator –Standardized –Advanced measurement approaches

20-14 Basel II (continued)  Pillar 2 –Specifies importance of regulatory review  Ensures sound internal processes to manage capital adequacy  Pillar 3 –Specifies detailed guidance on disclosure of capital structure, risk exposure, and capital adequacy of banks

20-15 Calculating Risk-based Capital Ratios  Tier I (Core Capital) includes: –Book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill  Tier II (Supplementary Capital)includes: –Loan loss reserves (up to maximum of 1.25% of risk-adjusted assets) plus various convertible and subordinated debt instruments with maximum caps

20-16 Risk-based Capital Measurement  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%  Enforced alongside traditional leverage ratio

20-17 Calculating Risk-based Capital Ratios  Credit risk-adjusted assets: table 20-7 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 five categories of credit risk exposure table 20-7 −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. Ex 20-1

20-18  Basel I criticized since individual risk weights depend on broad borrower categories –All corporate borrowers in 100% risk category  Basel II refines differentiation of credit risks –Incorporates credit rating agency assessments Calculating Risk-based Capital Ratios

20-19 Risk-adjusted OBS Activities  Off-balance-sheet contingent guaranty contracts table. table 20-9 −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

20-20 Risk-adjusted OBS Activities  Credit risk weights for OBS are the same as the weights assigned to on- balance-sheet items. Ex 20-2  Off-balance-sheet market contracts or derivative instruments: −Issue is counterparty credit risk −Distinction between market traded derivatives and over-the-counter in terms of counterparty risk

20-21 Risk-adjusted OBS Activities  Basically a two-step process: −Conversion factor used to convert to credit equivalent amounts −Second, multiply credit equivalent amounts by appropriate risk weights  Credit equivalent amount divided into potential and current exposure elements

20-22 Credit Equivalent Amounts of Derivative Instruments  Credit equivalent amount of OBS derivative security items = Potential exposure + Current exposure  Potential exposure: Credit risk if counterparty defaults in the future  Current exposure: Cost of replacing a derivative securities contract at today’s prices  Risk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight ex and ex. 20-4

20-23 Interest Rate Risk, Market Risk & Risk-based Capital  Risk-based capital ratio is adequate as long as the bank is not exposed to: –Undue interest rate risk –Market risk –Since 1998, DIs required to calculate an add on to 8% capital requirement to adjust for market risk  Standardized model  Internal model

20-24 Operational Risk and Risk-Based Capital  Basel II implemented –Add-on for operational risk under 3 headings  1. Basic Indicator Approach –Gross income = Net interest Income + Noninterest income –Operational capital =  (15%)× Gross income –Top-down –Too aggregative, because all operational risks are not the same

20-25  2. Standardized Approach –Eight major business units and lines of business see table –Capital charge computed by multiplying a weight, , for each line, by the indicator set for each line, then summing Operational Risk and Risk-Based Capital

20-26 Operational Risk and Risk-Based Capital  3. Advanced Measurement Approaches: –Regulatory capital requirement as sum of expected loss and unexpected loss for each type of event:  Internal fraud  External fraud  Employment practices and workplace safety  Clients, products, and business practices  Damage to physical assets  Business disruption and system failures  Execution, delivery, and process management

20-27 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  Excessive complexity  Other risks such as interest rate and liquidity  Impact on capital requirements  Competition and differences in standards  Pillar 2 demands on regulators may be too great

20-28 Capital Requirements for Other FIs  Securities firms regulated by SEC –Close to a market valuation approach –Broker-dealers  Net worth / total assets ratio must be no less than 2% calculated on a day-to-day market value basis. –Special treatment of illiquid assets

20-29 Capital Requirements (continued)  Life insurance –C1 = Asset risk –C2 = Insurance risk –C3 = Interest rate risk –C4 = Business risk

20-30  Risk-based capital measure for life insurance companies: RBC = [ (C1 + C3) 2 + C2 2 ] 1/2 + C4 If, (Total surplus and capital) / (RBC) < 1.0, then subject to regulatory scrutiny Capital Requirements (continued)

20-31  Property and casualty insurance companies –Similar to life insurance capital requirements, but some differences since risk exposures for P/C not identical to life insurance exposures –Six (instead of four) risk categories Capital Requirements (continued)

20-32 BIS Federal Reserve Federal Deposit Insurance Corp. National Association of Insurance Commissioners Securities and Exchange Commission Pertinent Websites