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Bank CapitalBank Capital

&&Stock ValuationStock ValuationModule 3Module 3

Session 5 to 7Session 5 to 7

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CapitalCapital comprises ofcomprises of

Equity capitalEquity capital

Hybrid instruments/innovative instrumentsHybrid instruments/innovative instruments( limited to 15% of tier 1 capital)( limited to 15% of tier 1 capital) Perpetual by nature and unsecuredPerpetual by nature and unsecured

Claim of investors will be subordinate to other creditorsClaim of investors will be subordinate to other creditorsbut superior to equity share holdersbut superior to equity share holders

No advance against innovative instrumentsNo advance against innovative instruments

No put option by investorsNo put option by investors

Call option after 10 years with prior RBI approvalCall option after 10 years with prior RBI approval

Fixed interest rate or floating rate bench marked toFixed interest rate or floating rate bench marked tomarket ratemarket rate

Interest will not be paid if CRAR is below prescribedInterest will not be paid if CRAR is below prescribedlevel and interest shall not be cumulativelevel and interest shall not be cumulative

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Debt capital instrumentsDebt capital instruments Minimum maturity of 15 yearsMinimum maturity of 15 years

Redemption at approval of RBIRedemption at approval of RBI

No put optionNo put option Fixed interest rate or floating rate benchFixed interest rate or floating rate bench

marked to market ratemarked to market rate

Interest will not be paid if CRAR is belowInterest will not be paid if CRAR is belowprescribed level and interest shall not beprescribed level and interest shall not becumulativecumulative

Subject to progressive discount on last fiveSubject to progressive discount on last fiveyear of maturityyear of maturity

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Reserves and surplusReserves and surplus

Statutory reservesStatutory reserves

Share premium accountShare premium account Revaluation reservesRevaluation reserves

Balance of P & L accountBalance of P & L account

Retained earningsRetained earnings

Loan loss reservesLoan loss reserves

Provision for loan lossesProvision for loan losses

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Why capital ?Why capital ?

Financing the operations of a bankFinancing the operations of a bank Commence businessCommence business

Bear risk of failureBear risk of failure

Support growth of credit businessSupport growth of credit business

Enter new product and new marketsEnter new product and new markets Start subsidiariesStart subsidiaries

Safety, soundness and systemic stability of the banksSafety, soundness and systemic stability of the banks

Depositors protectionDepositors protection

Confidence to customers, employees and regulatorsConfidence to customers, employees and regulators Capital adequacy to check high financial leverageCapital adequacy to check high financial leverage

( constrain undesirable growth) and to contain risk( constrain undesirable growth) and to contain risk

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Concept of Economic capitalConcept of Economic capital

Accounting capital represents book valueAccounting capital represents book valueAmount of capital necessary to absorb potentialAmount of capital necessary to absorb potential

losses associated with banking riskslosses associated with banking risks

It is a forward looking measure of adequateIt is a forward looking measure of adequatecapital to cover the banking riskscapital to cover the banking risks Protection again Unexpected future losses at aProtection again Unexpected future losses at a

confidence level (say 99. 9) selected by bankconfidence level (say 99. 9) selected by bank Represents confidence level looked by banksRepresents confidence level looked by banks

shareholdersshareholdersAs per McKinsey survey only 15% of banks areAs per McKinsey survey only 15% of banks are

planning for economic capital in Indiaplanning for economic capital in India

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Concept of regulatory capitalConcept of regulatory capital

Banking crisis resulted in regulations to preventBanking crisis resulted in regulations to preventrecurrencerecurrence

Deposit related regulationsDeposit related regulations Run on banksRun on banks

Assurance to depositorsAssurance to depositors CRR and SLR regulationsCRR and SLR regulations Deposit insurance corporationDeposit insurance corporation Lender of last resortLender of last resort Subordinated debtSubordinated debt

Adequate capitalAdequate capital Basel I, II and III is outcome of regulationBasel I, II and III is outcome of regulation Represents confidence level set by regulators inRepresents confidence level set by regulators in

interest of depositorsinterest of depositors

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Capital adequacyCapital adequacy--view pointsview points

Capital/total deposits ratioCapital/total deposits ratio Recommended by James Raj Committee(1978)Recommended by James Raj Committee(1978)

Capital/total assets ratioCapital/total assets ratio Financial leverageFinancial leverage

Capital/risk weighted assets ratioCapital/risk weighted assets ratio

Also known as Capital to Risk adjusted assetsAlso known as Capital to Risk adjusted assetsratioratio

Also known as Basel accordAlso known as Basel accord

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Basel Capital AccordBasel Capital Accord

The Bank for International settlement (BIS) HQ in BaselThe Bank for International settlement (BIS) HQ in Basel(Switzerland)(Switzerland)-- To promote international monetary andTo promote international monetary andfinancial cooperationfinancial cooperation

BCBS (Basel Committee on Banking Supervision)BCBS (Basel Committee on Banking Supervision) -- ToTodecide broad supervisory standards and guidelines fordecide broad supervisory standards and guidelines forCentral BanksCentral Banks

Basel I(1988)Basel I(1988) -- capital measurement system forcapital measurement system forminimum 8% capitalminimum 8% capital

Basel II (1999)Basel II (1999) -- modified risk approaches andmodified risk approaches andintroduced capital charge for operational risksintroduced capital charge for operational risks

Basel IIIBasel III-- (September 2010) proposed minimum(September 2010) proposed minimum

regulatory capital 10.5% by January1, 2019regulatory capital 10.5% by January1, 2019 -- to raiseto raisetier I capital to 7% and contingency capital of 2.5% andtier I capital to 7% and contingency capital of 2.5% andalso asked for counter cyclical provisioningalso asked for counter cyclical provisioning

Systemically Important Financial Institution (SIFI) willSystemically Important Financial Institution (SIFI) willbe required to keep more capital as per decision ofbe required to keep more capital as per decision of

Financial Stability Board (FSB)Financial Stability Board (FSB)

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BASSEL II ACCORDBASSEL II ACCORD

Pillar 1Pillar 1-- Minimum capitalMinimum capitalrequirementsrequirements

Pillar 2Pillar 2--SupervisSupervisoryory

reviewreviewprocessprocess

Pillar 3Pillar 3--MarketMarketdisciplinediscipline

andanddisclosuredisclosure

CreditCreditRiskRisk

MarketMarket(Interest(Interestrate)rate)RiskRisk

OperationOperational Riskal Risk

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Basel II Frame workBasel II Frame work

Three PillarsThree Pillars First PillarFirst Pillar-- Minimum capitalMinimum capital

Minimum required 8%Minimum required 8%

Risk weighted assetsRisk weighted assets

Introduction of market risksIntroduction of market risks

Interest rate risk ( movement causing erosion of portfolio value)Interest rate risk ( movement causing erosion of portfolio value) Equity price risk (fluctuations in equity prices)Equity price risk (fluctuations in equity prices)

Foreign exchange risk (fluctuations in exchange rate)Foreign exchange risk (fluctuations in exchange rate)

Commodity RiskCommodity Risk

Risk in derivatives and off balance sheet such as forward rateRisk in derivatives and off balance sheet such as forward rateagreement, futures, interest rates and cross currency swapsagreement, futures, interest rates and cross currency swaps

Second PillarSecond Pillar-- Supervisory review processSupervisory review process Also addresse those risk which are not measuredAlso addresse those risk which are not measured

Third PillarThird Pillar-- Market disciplineMarket discipline

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RBI guidelines of Basel IIRBI guidelines of Basel II

Capital divided into Tier 1 and Tier 2Capital divided into Tier 1 and Tier 2 Tier I capital to include Paid up capital, statutory reserves and otherTier I capital to include Paid up capital, statutory reserves and other

free reserves and reserves sale of assets and also Perpetual Nonfree reserves and reserves sale of assets and also Perpetual Noncumulative preference sharecumulative preference share

Intangible assets and cumulative losses shall be deducted from TierIntangible assets and cumulative losses shall be deducted from Tier

I capitalI capital Tier II capital to include undisclosed reserves, cumulative perpetualTier II capital to include undisclosed reserves, cumulative perpetual

preference shares, revaluation reserves, hybrid debt capitalpreference shares, revaluation reserves, hybrid debt capitalinstruments, subordinated debts and general provisions and lossinstruments, subordinated debts and general provisions and lossreservesreserves

Tier II capital can not be more than 100% of tier I capitalTier II capital can not be more than 100% of tier I capital

CRAR prescribed 9% on ongoing basis out of this banks areCRAR prescribed 9% on ongoing basis out of this banks areencouraged to maintain 6% Tier I capitalencouraged to maintain 6% Tier I capital Finance Ministry feel that banks need INR 35000 crores by 2012 toFinance Ministry feel that banks need INR 35000 crores by 2012 to

meet CRARmeet CRAR

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Computation of capital adequacyComputation of capital adequacy

Capital to riskCapital to riskweighted assetsweighted assetsratioratio

Also known asAlso known asCRARCRAR

Calculation of riskCalculation of riskweighted assetsweighted assets

(RWA) for credit,(RWA) for credit,market andmarket andoperational riskoperational risk

CRAR =CRAR =

Eligible TotalEligible TotalCapital FundsCapital Funds

Credit Risk RWACredit Risk RWA++

Market Risk RWAMarket Risk RWA++

Operational RiskOperational RiskRWARWA

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Risk TypeRisk Type

Credit RiskCredit Risk

counter party defaultcounter party default

Market riskMarket risk price changes in investments held inprice changes in investments held in

trading booktrading book

Operational riskOperational risk

failed systems and proceduresfailed systems and procedures

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Risk Weight for credit riskRisk Weight for credit risk

RiskRisk weightweight toto bebe assignedassigned onon thethe basisbasis ofof externalexternal creditcreditratingrating excludingexcluding exemptionsexemptions

ICRA,ICRA, CRISIL,CRISIL, CARLCARL andand FITCHFITCH approvedapproved byby RBIRBI MortgageMortgage loans,loans, advanceadvance toto staff,staff, commercialcommercial creditcredit

assignedassigned fixedfixed riskrisk weightsweights (( subjectsubject toto qualifyingqualifying criteriacriteriaseesee nextnext slide)slide) TotalTotal riskrisk weightedweighted assetsassets (TRWA)(TRWA) isis calculatedcalculated byby

multiplyingmultiplying assetsassets byby riskrisk weightweight andand summingsumming themthem upup NettingNetting isis donedone forfor advancesadvances collateralizedcollateralized byby cashcash

marginmargin oror collateralcollateral securitysecurity oror provisionprovision forfor badbad &&doubtfuldoubtful (( subjectsubject toto hairhair cut)cut) OffOff balancebalance sheetsheet itemsitems areare toto bebe multipliedmultiplied byby creditcredit

conversionconversion factorfactor (CCF)(CCF) andand resultedresulted productproduct isis againagain bybyRiskRisk weightweight toto findfind outout TRWATRWA..

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Regulatory retail loansRegulatory retail loans--criteriacriteria

Orientation criteriaOrientation criteria Exposure to individual or to small businessExposure to individual or to small business Small business is one where annual turnover is Rs. 50 crores orSmall business is one where annual turnover is Rs. 50 crores or

lessless

Product criteriaP

roduct criteria Both funded and non funded loansBoth funded and non funded loans Working capital loan, term loan, LC and guarantees etcWorking capital loan, term loan, LC and guarantees etc

Granularity criteriaGranularity criteria Well diversifiedWell diversified Exposure to one counter party must not exceed to 0.2% ofExposure to one counter party must not exceed to 0.2% of

gross retail exposuregross retail exposure Group exposure concept also applicableGroup exposure concept also applicable

Low value of individual exposuresLow value of individual exposures Individual exposure should not be more than Rs. 5 croresIndividual exposure should not be more than Rs. 5 crores

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Major risk weightMajor risk weight

Funded assetsFunded assetsNature of assetsNature of assets Risk weight %Risk weight %Cash in hand , Balance with RBICash in hand , Balance with RBI 00

Balance with other banks ,Balance with other banks ,

Money at call and short noticeMoney at call and short notice

2020

Investment in govt. securities *Investment in govt. securities * 00

Other debt securities & equities*Other debt securities & equities* 100100

Claim on Central Government and LoansClaim on Central Government and Loansguaranteed by Central governmentguaranteed by Central government

00

Other loan and advancesOther loan and advances As per ratingAs per rating

* Additional charge for market risk* Additional charge for market risk(refer slide 20)(refer slide 20)

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Long terms claims on corporateLong terms claims on corporate

Long term ratings through CRAs Risk Weight %

AAAAAA 2020

AAAA 3030

AA 5050

BBBBBB 100100

BB & belowBB & below 150150

UnratedUnrated 100100

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Major risk weight Funded assetsMajor risk weight Funded assets

Nature of assetsNature of assets RW %RW %

Guaranteed by Central government *Guaranteed by Central government * 00

Guaranteed by State Government*Guaranteed by State Government* 2020

* If classified NPA will carry risk weight as per NPA* If classified NPA will carry risk weight as per NPAnorms ( see next slide)norms ( see next slide)

Mortgage loans, Loans to staff covered byMortgage loans, Loans to staff covered bysuperannuation benefitssuperannuation benefits

2020

Mortgage loans, Loans to staff not covered byMortgage loans, Loans to staff not covered bysuperannuation benefitssuperannuation benefits

7575

Home loan up to 30 lakhs with LTV 75%Home loan up to 30 lakhs with LTV 75% 5050

Home loan below Rs. 75 lakhs with LTV below 75%Home loan below Rs. 75 lakhs with LTV below 75% 100100

Home loan above 30 lakhs but below Rs. 75 lakhsHome loan above 30 lakhs but below Rs. 75 lakhswith LTV 75%with LTV 75%

7575

Home loan above 75 lakhs irrespective of LTVHome loan above 75 lakhs irrespective of LTV 125125

Commercial real estateCommercial real estate 100100

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Funded assetsFunded assetsNature of assetsNature of assets RiskRiskweight %weight %

NPA where provision is less than 20%NPA where provision is less than 20% 150150NPA where provision is at least 20%NPA where provision is at least 20% 100100

NPA where provision is at least 50NPA where provision is at least 50 5050

NPA fully secured by collateral ( net ofNPA fully secured by collateral ( net ofspecific provision)specific provision)

100100

Personal credit and credit cardsPersonal credit and credit cards 125125

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NonNon-- Funded assetsFunded assetsNature contingent liabilityNature contingent liability CCF %CCF %

Financial guarantee /acceptanceFinancial guarantee /acceptance 100100

Bid bond or stand by LCBid bond or stand by LC 5050

Documentary LCDocumentary LC 2020

Outstanding forex contractsOutstanding forex contracts 22

Forward assets purchasedForward assets purchased 100100

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Capital Charge for operational riskCapital Charge for operational risk

Basic indicator approachBasic indicator approach-- Banks average annualBanks average annualgross income for previous three years multipliedgross income for previous three years multipliedby factor of 0.15by factor of 0.15

Standardized approachStandardized approach -- Banks activities areBanks activities aresegmented in different business line and grosssegmented in different business line and grossincome of that stream is multiplied by factorincome of that stream is multiplied by factorranging from 12%ranging from 12%--18%18%

Advanced approachAdvanced approach Banks to calculate internalBanks to calculate internalloss data based on qualitative and quantitativeloss data based on qualitative and quantitativeparametersparameters

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Capital Charge for market riskCapital Charge for market risk

Interest rate related instruments and equities inInterest rate related instruments and equities intrading booktrading book

Divides investments in three categoriesDivides investments in three categories

Held for trading (HFT)Held for trading (HFT) Held available for sale (AFS)Held available for sale (AFS)

Held till maturity ( not included in trading book henceHeld till maturity ( not included in trading book henceno capital charge)no capital charge)

Specific capital charge ( see next slide) forSpecific capital charge ( see next slide) forsecurities held of trading, available for sale,securities held of trading, available for sale,open gold position, open forex position, tradingopen gold position, open forex position, tradingposition in derivativesposition in derivatives

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Nature of investmentsNature of investments Specific risk capitalSpecific risk capitalchargecharge

Central and state governmentCentral and state governmentsecuritiessecurities

Other approved securities guaranteedOther approved securities guaranteedby central governmentby central government

0%0%

Approved securities guaranteed byApproved securities guaranteed bystate governmentstate government

1.80%1.80%

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A+ to BBBA+ to BBB 0.28% (residual term to final maturity 6 months0.28% (residual term to final maturity 6 monthsor less)or less)

1.13% ( residual term to final maturity greater1.13% ( residual term to final maturity greaterthan 6 months but up to and including 24 months)than 6 months but up to and including 24 months)

1.80% (residual maturity exceeding 24 months)1.80% (residual maturity exceeding 24 months)

BB and belowBB and below 13.5%13.5%

UnratedUnrated 9%9%

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IntroductionValuation of bank stock

Right of share holders

Right to vote

Right to collect dividend

Right to sell share

Maximization of share holders value

Value is determined by

Discount factor to stream of future cash flows Discount factor is determined by risk of banking

business, degree of financial leverage and futurerevenue stream

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Fundamental of stock valuation

Potential future cash flows Industry and economic outlook

Present and future competition

Sustainable competitive advantages

Capability to grow as per past performance and future plans

Sources of valuations Financial statements

Past performance & future projections

Conceptual difficulty Complete and accurate risk profile of individual bank

Identify business unit which create value and destroy value

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Method of valuation

Dividend valuation method

Price earning ratio

Cash flow method

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Assumptions Annual payment of dividend

First dividend is received after first year of purchase

Single period valuation model Investor keep the share for one year

Po=D1/(1+Ks)+P1/1+Ks)

Po= current price of equity

D1= dividend expected a year henceP1=Price of share expected a year hence

Ks=rate of return required on equity share

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Multi period valuation model

As there is no maturity of equity share the value of anequity share of infinite duration is equal to the

discounted value of the stream of dividend of infiniteduration.

Po=D1/(1+Ks)1+D2/(1+Ks)2+

Po= current price of equity

D1= dividend expected a year henceD2= dividend expected two year hence


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Valuation with constant dividends

Assumption that dividend is constant

Po=D1

/(1+Ks)1+D2

/(1+Ks)2+D=dividend per share is constant


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Valuation with variable growth in dividends

Assumption that dividends tend to increase over time

Po=D1/(1+Ks)1+D2/(1+g)/(1+Ks)2+D3(1+g)2/(1+ks)3+

orPo=D1/Ks-g

Po=current price of equity

D1=dividend expected a year hence


g=constant compound growth rate

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