14818 capital adequacy

8/6/2019 14818 Capital Adequacy

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7-1 McGraw-Hill/Irwin

Capital Adequacy


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Functions of Capital

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 providefinancial services



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Book Value Definition of Capital

Also known as accounting net worth

value of assets minus liabilities as found on the balancesheet.

value of assets and liabilities at the time they wereplaced on the books or incurred by the firm, l

losses are not recognized until the assets are sold orregulatory requirements force the firm to make balancesheet accounting adjustments

In the case of credit risk, these adju

stmentsu

su

ally occu

rafter all attempts to collect or restructure the loans haveoccurred.

In the case of interest rate risk, the change in interest rateswill not affect the recognized accounting value of the assetsor the liabilities.



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Economic Definition of Capital

difference between the market value of assets and the

market value of liabilities

The loss in value caused by credit risk and interest rate

risk is borne first by the equity holders, and then by theliability holders

With market value accounting, the adjustments to equity

value are made simultaneously as the losses due to these

risk elements occur. Thus, economic insolvency may berevealed before accounting value insolvency occurs



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Market Value Accounting

Market values produce a more accuratepicture of the FIs current financial position Stockholders can more easily see the effects of

changes in interest rates on the FIs equity, and

they can evaluate more clearly the liquidationvalue of a distressed FI.

Arguments against market value accounting market values sometimes are difficult to estimate,

particu

larly for smallF

Is with non-traded assets market value accounting can produce higher volatility in the earnings ofFIs. regulators may close an FI too quickly under the prompt corrective action

requirements ofFDICIA.

Argument for MV accountingasset securitization can be used as a means to

determine value of even thinly traded assets.9-5


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Leverage Ratio

The leverage ratio is the ratio of book value ofcore capital divided by the book value of totalassets.

L = Core capital/Assets

Core capital is the book value of equity plus

qualifying cumulative perpetual preferredstock plus minority interests in equityaccounts of consolidated subsidiaries.



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Leverage Ratio Inadequate as Measure of

Capital Adequacy

No guarantee that the depositors are adequatelyprotected. In many cases of financial distress, theactual market value of equity is significantly

negative by the time the leverage ratio reaches 2percent.

Using total assets as the denominator does notconsider the different credit and interest rate

risks of the individual assets. The ratio does not capture the contingent risk of

the off-balance sheet activities of the FI.



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Tier I and Tier II Capital

Tier I capital

most junior (subordinated) securities issued by thefirm equity and qualifying perpetual preferred stock.

Tier II capital/ supplementary or secondary capital

subordinated to deposits and the deposit insurer'sclaims include preferred stock with fixed maturities and long-term debt

with minimum maturities over 5 years

The amount of subordinated debt that can counttowards capital cannot exceed 50% of Tier I capital.

loan loss reserves (up to maximum of 1.25% of risk-

adju

sted assets)9-8


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FDIC Zones

Zones Total RBC Tier I Leverage Ratio Regulatory

action

Well capitalized 10 6 5 None

Adequately

capitalized

10 > RBC > 8 >4 >4 No brokered

deposits

Undercapitalized 8 > RBC > 6 4 > T I > 3 4 > LR > 3 several

Significantly

Undercapitalized

6 > RBC > 2 3 > T I > 2 3 > LR > 2

Critically

Undercapitalized

< 2 < 2 < 2



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Zone 3 Regulatory Action

capital restoration plan required

asset growth restricted,

approval for acquisitions, branching, and newactivities required

use of brokered deposits disallowed

dividends and management fees suspended



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Zone 3 penalties

mandatory recapitalization

restrictions on deposit interest rate

inter-affiliate transactions

pay level of officers.


Zone 4 Regulatory Action


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Zone 3 and 4 penalties

bank placed in receivorship within 90 days,

payment on subordinated debt suspended

other activities restricted at the discretion of

the regulator.


Zone 5 Regu

latory Action


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Why use Leverage Ratio

stringency of regulatory monitoring is increased

bank can reduce its capital requirement by adjusting

its portfolio

leverage ratio test sets a minimum required capital

level



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Capital Requirements of the Basel Accord

capital of banks must be measured as an average of

credit-risk-adjusted total assets both on and off the

balance sheet.

The total risk-based capital ratio divides total capitalby the total of risk-adjusted assets.

This ratio must be at least 8 percent for a bank to be

considered adequately capitalized.

at least 4 percent of the risk-based assets must be

supported by core capital.



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Basel I vs Basel II

Basel I criticized since individual risk weights dependon broad borrower categories

All corporate borrowers in 100% risk category

Basle II widens differentiation of credit risks Refined to incorporate credit rating agency assessments

Both have off-balance-sheet contingent guarantycontracts

Conversion factorsu

sed to convert into credit equ

ivalentamountsamounts equivalent to an on-balance-sheetitem

Conversion factors used depend on the guaranty type.


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Category 1 (0% weight)

Cash, Federal Reserve Bank balances, securities of the U.S.Treasury, OECD

governments, and some U.S. agencies.

Category 2 (20% weight) Cash items in the process of collection, U.S. and OECD interbank deposits

and guaranteed claims.

Some non-OECD bank and government deposits and securities

General obligation municipal bonds.

Some mortgage-backed secu

rities, Claims collateralized by the U.S.Treasury and some other government securities.


Loans fully secured by first liens on one- to four-family residential

properties.

Other (revenue) municipal bonds.


RBC under Basel I


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All other on-balance-sheet assets not listed

above, including loans to private entities and

individuals, some claims on non-OECD

governments and banks, real assets, and

investments in subsidiaries.


RBC under Basel I


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Cash, Federal Reserve Bank balances, securities of the U.S.

Treasury, OECD governments, some U.S. agencies, and

loans to sovereigns with an S&P credit rating ofAA- or better.


Cash items in the process of collection.

U.S. and OECD interbank deposits and guaranteed claims.

Some non-OECD bank and government deposits and securities. General

obligation municipal bonds. Some mortgage-backed securities. Claims collateralized by the U.S.

Treasury and some other government securities.

Loans to sovereigns with an S&P credit rating ofA+ to A-

Loans to banks and corporates with an S&P credit rating ofAA- or better.


RBC under Basel II


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Category 3 (50% weight) Loans fully secured by first liens on one- to four-family

residential properties

Other (revenue) municipal bonds.

Loans to sovereigns with an S&P credit rating ofBBB+ toBBB-

Loans to banks and corporates : S&P credit rating ofA+ toA-


Loans to sovereigns with an S&P credit rating ofBB+ to B- Loans to banks with a credit rating ofBBB+ to B-

Loans to corporates with a credit rating ofBBB+ to BB-

All other on-balance-sheet assets not listed above, includingloans to private entities and individuals, some claims onnon-OECD governments and banks, real assets, andinvestments in subsidiaries.9-19

RBC under Basel II


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Loans to sovereigns, banks, and securities firms

with an S&P credit rating below B-

Loans to corporates with a credit rating below

BB-


RBC under Basel II


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Calculating On-balance Sheet RWA

Assets assigned to five categories of credit riskexposure

Dollar amount of assets in each category is multiplied

by the appropriate risk weight 5 categories representing no risk to full credit risk

Risk Weights are 0 percent, 20 percent, 50 percent, 100percent, and 150 percent, respectively

The weighted dollar amounts of each category areadded together to get the total credit-risk-adjusted on-balance-sheet assets



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Calculating Off-balance Sheet RWA

Convert off-balance-sheet items to credit equivalent

amounts of an on-balance-sheet item

multiply the notional amounts by an appropriate

conversion factor

The converted amounts are then multiplied by the

appropriate risk weights as if they were on-balance-

sheet items.

appropriate risk weights depend on the counterparty risk

to off-balance-sheet activity



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Conversion Factors for Off-Balance-Sheet,

Contingent or Guaranty

Contracts:

B

asel I andBasel II Sale and repurchase agreements and assets sold with

recourse that are not included on the balance sheet(100%)

Direct-credit su

bstitu

te standby letters of credit (100%) Performance-related standby letters of credit (50%)

Unused portion of loan commitments with originalmaturity ofmore than one year (50%)*

Commercial letters of credit (20%) Bankers acceptances conveyed (20%)

Other loan commitments (10%)



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Pillars ofBasel Accord (II)

Pillar 1 :Maintain and update regulatory capital

requirements for credit, market and operational risk.

Pillar 2: Stress the continued importance of the

regulatory evaluation process in addition to capitalrequirements.

In particular ensuring that the bank has valid internal control

procedures in place to measure and manage risk.

Pillar 3: Promote disclosure of the institutions capitalstructure, risk exposure and capital adequacy.



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Criticisms of Risk-based Capital Ratio

1. Risk weight categories versus true credit risk.

2. Risk weights based on rating agencies3. Portfolio aspects: Ignores credit risk portfolio

diversification opportunities.

4. DI Specialness

1. May reduce incentives for banks to make loans.

5. Excessive complexity

6. Other risks: Interest Rate, Foreign Exchange, Liquidity

7. Impact on capital requirements

8. Competition and differences in standards

9. Pillar 2 demands on regulators


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Homework Assignment

practice questions in handout

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14818 capital adequacy

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