McGraw-Hill/Irwin 20-1 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin 20-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital and Insolvency Risk  Capital net worth book value  Market value of capital credit risk interest rate risk exemption from mark-to-market for banks’ securities losses  Arguments against MVA

McGraw-Hill/Irwin 20-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Adequacy: Commercial Banks and Thrifts  Actual capital rules  Capital-assets ratio (Leverage ratio) L = Core capital/Assets 5 target zones associated with set of mandatory and discretionary actions Prompt corrective action

McGraw-Hill/Irwin 20-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet Regulations  Liquidity Fed gives minimum reserve requirements  reserve computation period 2 weeks beginning on Tuesday and ending on Monday 14 days later  Capital Adequacy – minimum capital requirements to constrain leverage capital-to-assets ratio risk-based capital ratio  Tier I  Tier II

McGraw-Hill/Irwin 20-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risk-based Capital Ratios  Basle I Agreement Enforced alongside traditional leverage ratio 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%. Crudely mark to market on- and off-balance sheet positions.

McGraw-Hill/Irwin 20-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Risk-based Capital Ratios  Tier I includes: book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill.  Tier II includes: loan loss reserves (up to maximum of 1.25% of risk-adjusted assets) plus various convertible and subordinated debt instruments with maximum caps

McGraw-Hill/Irwin 20-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. New Basel Accord (Basel II)  Pillar 1: Credit, market, and operational risks  Credit risk: Standardized approach Internal Rating Based (IRB)  Market Risk --Unchanged

McGraw-Hill/Irwin 20-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Basel II continued  Pillar 2 Specifies importance of regulatory review  Pillar 3 Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks

McGraw-Hill/Irwin 20-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Risk-based Capital Ratios Credit risk-adjusted assets: 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 four categories of credit risk exposure.  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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Risk-based Capital Ratios under Basel II  Basel I criticized since individual risk weights depend on broad borrower categories All corporate borrowers in 100% risk category  Basle II widens differentiation of credit risks Refined to incorporate credit rating agency assessments

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risk-adjusted OBS Activities Off-balance-sheet contingent guaranty contracts  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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risk-adjusted OBS Activities 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) Credit equivalent amount divided into potential and current exposure elements.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Interest Rate Risk, Market Risk, and Risk- based Capital  Risk-based capital ratio is adequate as long as the bank is not exposed to: undue interest rate risk market risk

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. Other risks: Interest Rate, Foreign Exchange, Liquidity Competition and differences in standards