Capital Adequacy Chapter 20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

McGraw-Hill/Irwin 20-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview  This chapter discusses the functions of capital, different measures of capital adequacy, current and proposed capital adequacy requirements and advanced approaches used to calculate adequate capital according to internal rating based models of credit risk.

McGraw-Hill/Irwin 20-3 © 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 20-4 © 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

McGraw-Hill/Irwin 20-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital and Insolvency Risk (continued) Book value of capital  par value of shares  surplus value of shares  retained earnings  loan loss reserve

McGraw-Hill/Irwin 20-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Book Value of Capital  Credit risk tendency to defer write-downs  Interest rate risk Effects not recognized in book value accounting method

McGraw-Hill/Irwin 20-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Discrepancy: Market versus Book Values  Factors underlying discrepancies: interest rate volatility examination and enforcement  Market value accounting market to book arguments against market value accounting

McGraw-Hill/Irwin 20-8 © 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 20-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 and interest rate risks Off-balance-sheet activities: escape capital requirements in spite of attendant risks

McGraw-Hill/Irwin © 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 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Basel II continued  Operational: Basic Indicator Standardized Advanced Measurement Approaches

McGraw-Hill/Irwin © 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 © 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 © 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 © 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)

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risk-adjusted OBS Activities Off-balance-sheet market contracts or derivative instruments:  Issue is counterparty credit risk

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

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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risk-adjusted Asset Value of OBS Derivatives With Netting With netting, total credit equivalent amount equals net current exposure + net potential exposure. Net current exposure = sum of all positive and negative replacement costs.  If the sum is positive, then net current exposure equals the sum.  If negative, net current exposure equals zero. A net = (0.4 × A gross ) + (0.6 × NGR × A gross )

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. Operational Risk and Risk-Based Capital  2001 Proposed amendments Add-on for operational risk  Basic Indicator Approach Gross income = Net interest Income + Noninterest income Operational capital =  × Gross income Top-down. Too aggregative.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Operational Risk and Risk-Based Capital  Standardized Approach Eight major business units and lines of business Capital charge computed by multiplying a weight, , for each line, by the indicator set for each line, then summing.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Operational Risk and Risk-Based Capital  Advanced Measurement Approaches: Three broad categories: Internal Measurement Approach (IMA) Loss Distribution Approach (LDA) Scorecard Approach (SA).

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

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Requirements for Other FIs  Securities firms Broker-dealers: Net worth / total assets ratio must be no less than 2% calculated on a day-to-day market value basis.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Requirements (cont’d)  Life insurance C1 = Asset risk C2 = Insurance risk C3 = Interest rate risk C4 = Business risk

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Requirements (cont’d)  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.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Requirements (cont’d)  Property and Casualty insurance companies similar to life insurance capital requirements. Six (instead of four) risk categories

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. BIS Federal Reserve Federal Deposit Insurance Corporation National Association of Insurance Commissioners U.S. Treasury Department Pertinent Websites