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 2008-2009: 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

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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 20-55 target zones associated with set of

mandatory and discretionary actions. See table 20-3

2008-2009: 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)

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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

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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 20-7Risk-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. 20-3 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 riskStandardized 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 20-11– 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

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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 fraudExternal fraudEmployment practices and workplace safetyClients, products, and business practicesDamage to physical assetsBusiness disruption and system failuresExecution, 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 + C22] 1/2 + C4If,(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 www.bis.orgFederal Reserve www.federalreserve.govFederal Deposit www.fdic.gov

Insurance Corp. National Association www.naic.org

of Insurance Commissioners

Securities and Exchange www.sec.govCommission

Pertinent Websites