1. Capital Adequacy Chapter 20 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

2. -220-2 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.

3. -320-3 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

4. -420-4 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

5. -520-5 Capital and Insolvency Risk (continued) Book value of capital  par value of shares  surplus value of shares  retained earnings  loan loss reserve

6. -620-6 Book Value of Capital  Credit risk tendency to defer write-downs  Interest rate risk Effects not recognized in book value accounting method

7. -720-7 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  Contention that it is difficult to implement  Increase in volatility of earnings  Bias against long term assets

8. -820-8 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

9. -920-9 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

10. -1020-10 New Basel Accord (Basel II)  Pillar 1: Credit, market, and operational risks  Credit risk: Standardized approach Internal Rating Based (IRB)  Market Risk --Unchanged

11. -1120-11 Basel II continued  Operational: Basic Indicator Standardized Advanced Measurement Approaches

12. -1220-12 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

13. -1320-13 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.

14. -1420-14 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

15. -1520-15 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.

16. -1620-16 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

17. -1720-17 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.

18. -1820-18 Risk-adjusted OBS Activities Off-balance-sheet market contracts or derivative instruments:  Issue is counterparty credit risk

19. -1920-19 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. -2020-20 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.

21. -2120-21 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

22. -2220-22 Operational Risk and Risk-Based Capital  Basel II implemented Add-on for operational risk  Basic Indicator Approach Gross income = Net interest Income + Noninterest income Operational capital =  × Gross income Top-down. Too aggregative.

23. -2320-23 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.

24. -2420-24 Operational Risk and Risk-Based Capital  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

25. -2520-25 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: Interest Rate, Foreign Exchange, Liquidity Impact on capital requirements Competition and differences in standards Pillar 2 demands on regulators

26. -2620-26 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.

27. -2720-27 Capital Requirements (cont’d)  Life insurance C1 = Asset risk C2 = Insurance risk C3 = Interest rate risk C4 = Business risk

28. -2820-28 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.

29. -2920-29 Capital Requirements (cont’d)  Property and Casualty insurance companies similar to life insurance capital requirements. Six (instead of four) risk categories

30. -3020-30 BIS www.bis.orgwww.bis.org Federal Reserve www.federalreserve.govwww.federalreserve.gov Federal Deposit Insurance Corporation www.fdic.gov www.fdic.gov National Association of Insurance Commissioners www.naic.orgwww.naic.org Securities and Exchange Commission www.sec.gov www.sec.gov Pertinent Websites