drake drake university fin 129 capital adequacy. drake drake university fin 129 overview the...

DrakeDRAKE UNIVERSITY

Fin 129

Capital Adequacy

DrakeDrake University

Fin 129Overview

The underlying goal of analyzing risk has been to assure that the institution does not become insolvent.The primary insurance against failure is capital. 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.


Fin 129

Importance of Capital Adequacy

Absorb unanticipated losses and preserve confidence in the FIProtect uninsured depositors and other stakeholdersProtect FI insurance funds and taxpayersProtect FI owners against increases in insurance premiumsTo acquire real investments in order to provide financial services


Fin 129

Equity Capital as a Funding Source

The institution must compete for equity funds in the same manner that it competes for borrowed funds.The suppliers of equity will base the value of the equity on the discounted value of future cash flows expected to be received from the asset.


Fin 129Cost of Equity

The value of a share of stock can be found using the dividend discount modelP0 = D1/(1+k) + D2/(1+k)2 +…

Or if growth is constant,P0 = D0(1+g)/(k-g)

May be expressed in terms of P/E ratio as

P0 /E0 = (D0/E0)(1+g)/(k-g)


Fin 129Capital and Insolvency Risk

Capitalnet worth

= market value of assets – market value of liabilitiesbook value – values based o historical costs

Market Value of capitalcredit riskinterest rate riskexemption from mark-to-market for banks’ securities losses


Fin 129Credit Risk Example

Basic Balance Sheet

Assets LiabilitiesAssets80 Liabilities (ST, deposits)90L-T Loans 20 Net Worth 10Total 100 100

What happens if the loans default and the market value of loans decreases to 12?



Basic Balance Sheet


The equity holders bear the risk, what if the loss had been 12 instead of 8?



Basic Balance Sheet

Assets LiabilitiesAssets80 Liabilities (ST, deposits)90L-T Loans 8 Net Worth -

2Total 88 88

Insolvency would cause the liquidation of assets and liability holders would not receive full value of their claims


Fin 129Interest Rate Risk Example

Basic Balance Sheet

Assets LiabilitiesAssets80 Liabilities (ST, deposits)90L-T Loans 20 Net Worth

10Total 100 100

What happens if the loans the level of interest rates increases, decreasing the value of assets, but not liabilities?


Fin 129Interest Rate Risk Example

Basic Balance Sheet


The equity holders would be forced to take the loss in terms of net worth.


Fin 129Market vs Book Value

The previous examples assume that the market value is used in the balance sheet.However, banks are exempted from marking to market the asset side of the balance sheet to adjust their net worth. The fear was that volatility in interest rates could cause solvent institutions to appear insolvent and be closed.


Fin 129Capital and Insolvency Risk

(continued)

Book value of capital =par value of shares (the face value of stock usually $1 multiplied by # of shares)

+ surplus value of shares (difference between price paid by the public and face value at initial issuance multiplied by # of shares)

+ retained earnings (accumulated value of past profits not paid in dividends)

+ loan loss reserve


Fin 129

Credit Risk Example Revisited

Basic Balance SheetAssets Liabilities

Assets80 Liabilities (ST, deposits)90L-T Loans 20 Net Worth 10Total 100 100

What happens if the loans are in trouble? Previously the market value of loans decreases to 12. Now there is discretion in writing down the loans. Maybe only 3 is written down


Fin 129

Credit Risk Example Revisited

Basic Balance Sheet


The equity holders bear the risk, but it is not as large as it previously was.


Fin 129Book Value of Capital

Credit risktendency to defer write-downs

Interest rate riskEffects not recognized in book value accounting method


Fin 129Discrepancy Between Market and Book Values

Factors underlying discrepancies:interest rate volatility (increased volatility increased discrepancy)examination and enforcement (increased enforcement, decreased discrepancy)

Market value accountingmarket to book ratio


Fin 129

Arguments against market value accounting

Difficult to implementEspecially if the Institution has small loans and other nontraded assets Counter argument is that error from estimating value may be less than error from using book value

Introduces variability in net worthEspecially if assets are held to maturity and it is only a temporary paper lossCounter is that failure to report gain and loss misrepresent true value of institution


Fin 129

Arguments against market value accounting

FI’s may be less wiling to accept long term asset exposure if it is going to be marked to market

Since long term assets are more interest rate sensitive this increases fluctuations in net worth. May interfere with intermediary roles as lenders and monitors and also increase impact of credit crunch.


Fin 129

Capital Adequacy in Commercial Banks and Thrifts

Requirements for capital asset ratio and for risk based capital ratioCapital-assets ratio (Leverage ratio)

L = Core capital/Assets5 target zones associated with set of mandatory and discretionary actionsPrompt corrective action if outside of well capitalized levelReceivership if l fall s below 2%


Fin 129Capital Categories

ZoneTotal Risk

Based RatioTier 1 Risk

Based RatioLeverage

Ratio

Well Capitalized

10% or above 6% or above 5% or above

Adequately Capitalized

8% or above 4% or above 4% or above

Undercapitalized

Under 8% Under 4% Under 4%

Significantly undercapitaliz

edUnder 6% Under 3% Under 3%

Critically Undercapitaliz

ed2% or under 2% or under 2% or under


Fin 129Leverage Ratio

Problems with leverage ratio:Market value: may not be adequately reflected by leverage ratioAsset risk: ratio fails to reflect differences in credit and interest rate risksOff-balance-sheet activities: escape capital requirements in spite of attendant risks


Fin 129New Basel Accord (Basel II)

Basel Agreement – imposes risk based capital requirements on banks in major industrialized countriesPillar 1: Credit, market, and operational risksCredit risk:

Standardized approachInternal Rating Based (IRB)

Market Risk --Unchanged


Fin 129Basel II continued

Operational:Basic IndicatorStandardizedAdvanced Measurement Approaches


Fin 129Basel II continued

Pillar 2Specifies importance of regulatory review

Pillar 3Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks


Fin 129Capital

Divided into Tier I and Tier IITier I – closely linked to book value, represents the core contributions to banks owners. Includes common stockholders equity, some preferred stock, equity interests of subsidiaries Tier II – secondary capital. Includes loan and lease losses, hybrid capital (perpetual debt), subordinated debt, revaluation reserves


Fin 129Risk-based Capital Ratios

Basle I AgreementEnforced alongside traditional leverage ratioMinimum 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.


Fin 129Calculating 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


Fin 129Calculating 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 five 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.


Fin 129Risk Categories

Category 1 (0%)Cash, Fed Reserve Balances, US Treas. Sec, etc

Category 2 (20%)Cash in process of collection, some MBS, Loans to banks and corps S&P rated AA- or better, etc.

Category 3 (50%)Muni bonds, S&P A+to A-

Category 4 (100%)Loans to banks BBB+to B-,loans to private individuals.

Category 5 (150%) Loans to banks rated B- or less, corporate BB- or less


Fin 129Risk Adjusted Value

The risk adjusted value of the assets is then simply the sum of the total amount of assets in each category multiplied by the risk weight for that category.


Fin 129

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


Fin 129

Risk-adjusted 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 depend on guaranty type.Two-step process:

Calculate credit equivalent amounts as product of face value and conversion factor.Multiply credit equivalent amounts by appropriate risk weights (dependent on underlying counterparty)


Fin 129

Risk-adjusted Off-balance-sheet Activities

Market Contracts and Derivatives

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.


Fin 129

Risk-adjusted Off-balance-sheet Activities

Potential Exposure -- The credit risk if the counterparty defaults it the future

Current Exposure – The cost of replacing a derivative contract at today’s prices. (cost if counterparty defaults today)


Fin 129

Credit Equivalent Amounts of Derivative Instruments

Credit equivalent amount of OBS derivative security items = Potential exposure + Current exposureRisk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight.


Fin 129Risk-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.

Anet = (0.4 × Agross ) + (0.6 × NGR × Agross )


Fin 129Interest 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 riskmarket risk


Fin 129Operational Risk and

Risk-Based Capital

2001 Proposed amendmentsAdd-on for operational risk

Basic Indicator ApproachGross income = Net interest Income +

Noninterest incomeOperational capital = × Gross income

Top-down. Too aggregative.


Fin 129

Operational Risk and Risk-Based Capital

Standardized Approach Eight major business units and lines of businessCapital charge computed by multiplying a weight, , for each line, by the indicator set for each line, then summing.


Fin 129

Operational Risk and Risk-Based Capital

Advanced Measurement Approaches:Three broad categories: Internal Measurement Approach (IMA) Loss Distribution Approach (LDA) Scorecard Approach (SA).


Fin 129

Criticisms of Risk-based Capital Ratio

Risk weight categories versus true credit risk.Risk weights based on rating agenciesPortfolio aspects: Ignores credit risk portfolio diversification opportunities.DI Specialness

May reduce incentives for banks to make loans.

Other risks: Interest Rate, Foreign Exchange, LiquidityCompetition and differences in standards


Fin 129

Capital Requirements for Other FIs

Securities firmsBroker-dealers: Net worth / total assets ratio must be no less than 2% calculated on a day-to-day market value basis.


Fin 129

Capital Requirements (cont’d)

Life insuranceC1 = Asset riskC2 = Insurance riskC3 = Interest rate riskC4 = Business risk


Fin 129


Risk-based capital measure for life insurance companies:RBC = [ (C1 + C3)2 + C22] 1/2 + C4

If (Total surplus and capital) / (RBC) <

1.0, then subject to regulatory scrutiny.


Fin 129


Property and Casualty insurance companies

similar to life insurance capital requirements.Six (instead of four) risk categories

drake drake university fin 129 capital adequacy. drake drake university fin 129 overview the...

Documents

drake drake university

equity capital

capital adequacy slide

market value of loans

adequate capital

functions of capital

market vs book value

importance of capital