basel i and ii

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BASEL I and II

CAPITAL ADEQUACY

Fulbright Scholar at XIMB

Dr. Sunil Mohanty

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Role Of Capital• The primary role of capital is to protect a FI against

the risk of insolvency/failure.• Several Functions of Capital

1. To absorb unanticipated loss.

2. To protect uninsured depositors, bondholders, and creditors in the event of insolvency and liquidation.

3. To protect FI insurance funds and the tax payers.

4. To protect FI against increases in insurance premium

5. To acquire the plant and other real investments necessary to provide financial services.

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Capital and Insolvency Risk

• To see how capital protects an FI against insolvency risk,we define the market value versus book value of capital.

• Market Value of an FI’s Capital = Net WorthA measure of an FI’s capital which is equal to the difference between the market value of its assets and the market value of its liabilities.

• Book Value of CapitalThe difference between the asset and liability values based on their historical costs.

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• Table 1

An FI’s Market Value Balance Sheet (in millions of dollars)

• Table 2

An FI’s Market Value Balance Sheet after a Decline in the Value of Loans ( in millions of dollars)

Assets LiabilitiesLong-term securities $80 Liabilities

(short-term, floating-rate deposits) $90Long-term loans 20 Net worth 10

$100 $100

Assets LiabilitiesLong-term securities $80 Liabilities $90Long-term loans 12 Net worth 2

$92 $92

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(short-term, floating-rate deposits)$90Long-term loans 8 Net worth -2

$88 $88


(short-term, floating-rate deposits)$90Long-term loans 17 Net worth 2

$92 $92

•Table 3

An FI’s Balance sheet after a Major Decline in the Value of the Loan Portfolio(in millions of dollars)

•Table 4

An FI’s Market Value Balance Sheet after a rise in Interest Rates (in millions of dollars)

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$100 $100

•Table 5



$97 $97

•Table 6

Book Value of an FI’s Assets and Liabilities (in millions of dollars)

The effect of a Loan Loss Charge-Off against the Book Value of anFI’s Equity (in millions of dollars).

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The Discrepancy Between the Market and Book Values Of Equity

1. Interest rate volatility: The higher the interest rate volatility, the greater the discrepancy.

2. Examination and Enforcement: The more frequent the on-site and off-site examination and the stiffer the examiner/regulator standards regarding changing of problem loans, the smaller the discrepancy.

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Market To Book RatioThe Ratio MV/BV

For publicly traded FI’s MV = Market value of equity ownership outstanding

Number of shares

BV= Par value of equity + surplus value +retained earnings + loan loss reserves

Number of Shares

The lower the ratio (MV/BV) , book value of capital overstate the economic net worth of an FI.

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(1) (2) (3) Total Risk- Tier I Risk- Leverage

Zone Based Ratio Based Ratio Ratio

1.Well capitalized 10% or above & 6% or above & 5% orabove

2.Adequately capitalized 8% or above & 4% or above & 4% or above

3.Undercapitalized Under 8% or Under 4% or Under 4%4.Significantly Undercapitalized Under 6% or Under3% or Under 3%5.Critically Undercapitalized 2% or Under or 2% or Under or 2% or Under

•Table 7

Specifications of Capital Categories for Prompt Corrective Action (in present)

FDICIA and Capital Regulations

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Zone Mandatory Provisions Discretionary Provisions

1.Well capitalized 2.Adequately capitalized 1.No brokered deposits except with

FDIC3.Undercapitalized 1. Suspend dividend & Management 1. Order restriction.

Fees.2. Require capital restoration plan. 2. Restrict interaffiliate

transactions.3. Restrict Asset growth. 3. Restrict deposit

interest rates.4. Approval required for acquisitions, 4. Restrict certain other branching, and new activities. activities.5. No brokered deposits. 5. Any other action that

would better carry out prompt corrective action.

•Table 8A

Summary of prompt Corrective Action Provisions of the Federal DepositInsurance


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•Table 8B

Zone Mandatory Provisions Discretionary Provisions 4.Significantly

Undercapitalized 1.Same as for Zone 3 1. Any Zone 3 discretionary actions.

2. Order recapitalization 2. Conservatorship or receivership if fails to submit

or implement plan or recapitalize pursuant to order.

3. Restrict interaffiliate 3. Any other Zone 5 transactions. provisions if such action

is necessary to carry out prompt corrective action.

4. Restrict deposit interest rate.5. Pay of officers restricted.

5.Critically Undercapitalized 1.Same as for Zone 3.

2.Receiver/Conservator within 90 days.3. Receiver if still in Zone 5 four quarters after becoming critically undercapitalized.4. Suspend payments on subordinated debt.5. Restrict certain other activities.


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Risk-based Capital Standards

• The 1988 Based Accord (Basel I) or the New Basel II Capital Accord (Basel II) is applicable to Banks only

• Basel Accords are Regulatory frameworks

• Basel Committee on Banking Supervision (BCBS) of the Bank for International Settlements (BIS)

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Brief History of Basel I

• 1988, the G-10 central banks agreed to apply a common minimum capital standards to all internationally active banks

• Basel I is not applicable directly, but through national regulatory authorities or through transnational rules (EU Directive: Capital Adequacy Directive)

• A huge success for Basel I, which is applied to all internationally active banks in most countries (Approx, 100 countries)

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Minimum Capital Requirements Under Basel I

Assets = Liability + EquityLoan Assets ($100) = Debt ($92) + Equity ($8)Minimum Capital Requirements:

8% * Loan Amount * Risk Weight• Basel I Risk Weightings

(OECD) Sovereigns: 0%(OECD) Banks: 20%Mortgage Loans: 50%

Other Loans : 100%

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•Table 9

Basel ICategory 1 (0% weight)Cash, Federal Reserve Bank balances, securities of the U.S. Treasury, QECD governments, some U.S. agencies.

Category 2 (20% weight)Cash items in the process of collection. U.S. and OECD interbank deposits and guaranteeddeposits and guaranteed claims. Some non-OECD bank and government deposits and securities.General obligation municipal bonds. Some mortgage backed securities. Claims collateralized bythe U.S. Treasury and some other government securities.

Category 3 (50% weight)Loans fully secured by first liens on the one-to four-family residential properties. Other (revenue)municipal bonds.

Category 4 (100% weight)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 insubsidiaries.

Summary of the Risk-based Capital Standards for On-Balance-Sheet Itemsunder Basel I

Risk Categories

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Sale and repurchase agreements and assets sold with recourse that are not included on the balance sheet (100%).

Direct credit substitute standby letters of credit (100%).Performance-related standby letters of credit (50%).Unused portion of loan commitments with original maturity of more than one year

(50%).Commercial letters of credit (20%).Bankers acceptances conveyed (20%).Other loan commitments (10%).

•Table 10

Conversion factors for Off-Balance-Sheet Contingent or Guaranty Contracts, Basel I

Off-Balance-Sheet Items (Basel I)

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Capital Adequacy Rules ( Basel I)

Under the Risk-based Capital Plan, banks must meet three minimum capital requirements simultaneously.

Tier I (core) Capital Ratio= Core Capital (Tier1) > 4% Risk-adjusted assets

Core capital is primarily the book value of stockholders’ equity.Total Risk-based Capital Ratio

= Total Capital (Tier1+Tier 2) > 8% Risk-adjusted assets

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Capital Adequacy Rules (cont.)

• Tier II capital is supplementary capital which includes subordinate debt, convertible debt instruments, and loan loss reserve.

Leverage Ratio = Core capital = Tier1 > 3%

Assets Assets

• Risk-adjusted Assets= Risk-adjusted on-balance-sheet assets + Risk-adjusted off-balance-sheet assets

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Bank’s Balance Sheet (in million $)Basel I

• An example – See Appendix A

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Risk Adjusted On-Balance-Sheet Assets (Basel I)

= 0 ( 8m +13m + 60 m + 50m + 42m) + 0.2 ( 10m + 10m + 20) + 0.5 (34m + 308m) + 1.0 (10m + 55m + 75m + 390m + 10m +

108m + 22 ) = $849 millionNote: Book value of On-Balance-Sheet

Assets = $1,215 million

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• Risk-adjusted Asset Value of OBS Contingent Guaranty ContractsA.Credit Equivalent Amount

OBS Item Face Conversion CreditValue Factor Equivalent Amount

Two-year loan commitment $80 .5 = $40Standby letter of credit 10 1.0 = 10Commercial letter of credit 50 .2 = 10

• Note: See Table 1 Conversion Factor

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B. Risk-adjusted Assets for OBS Guaranty Contracts

OBS Item Credit Equivalent Risk Weight Risk-adjusted Asset

Amount, $ mil (wi) Amount, $millions

Two-year loan

commitment $40 X 1.0 = $40

Standby

letter of credit 10 X 1.0 = 10

Commercial

letter of credit 10 X 1.0 = 10

$60

Note: The bank’s risk-adjusted asset value of its OBS contingent/ guaranty contracts is $60.

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Calculating the Overall Risk-based Capital Position of a Bank (Basel I)

1. Tier I capital = Common stock + perpetual preferred Stock + Retained earnings

= 30 + 10 + 10

= 50 million

2. Tier II capital = Convertible bonds +Subordinate bonds +Perpetual Preferred Stock (nonqualifying) + Reserve

for Loan losses

= 15 + 15 + 5 + 10

= 45 million.

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Risk-based Capital Ratios• Total Risk-adjusted Assets = Risk-adjusted On-Balance-Sheet assets +

Risk-adjusted assets for OBS items = 849m + 60m = 909 million.

• Total Risk-based capital Ratio = Tier I + Tier II capital Total Risk-adjusted assets= (50 + 45) 909= 10.45% > 8%

• Tier I Capital Ratio = Tier I Capital Total Risk-adjusted Asset= 50 909= 5.1 % > 4%

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• Leverage Ratio = Tier I Capital

Total Assets

= 50

1,215

= 4.11% < 5%

Note: The bank meets risk –based capital requirements under Basel I. The Bank is adequately capitalized.

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Why New Capital Standards ?(Basel II)

• Basel II aims to better align regulatory capital with underlying risk

• Basel II explicitly accounts for credit risk, market risk and operational risk

• Better address capital requirements for banking innovation such as asset securitization

• Basel II will be implemented by year end 2006

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Deficiencies of Basel I

• While simple in application, it is easy to achieve significant capital reduction with little or no risk transfer

• Did not sufficiently discriminate between different levels of risks

• Encouraged excessive risky lending and investing in certain areas [Subprime loans, asset-backed securities (ABS)]

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The New Capital Standards (Basel II)

• Risk sensitivity of capital requirements for credit risk

• New capital charges for operational risk• No more “one-size-fits-all” approach• More flexible approach through a menu

options• New incentives for sound risk management

practices

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Three Pillars of Basel II

Basel II

Minimum Capital Supervisory Disclosure &Requirement Review Process Market

(Pillar 1) (Pillar 2) Discipline(Pillar 3)

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Flexible Approach to Determine Regulatory Capital under Basel II

• Basel II offers many different approaches to compute regulatory capital against credit risk and operational risk

• Banks opt for one approach for all for some segments of activities or some asset classes

• Banks opting for the most advanced approaches must be authorized by their supervisors

• Basel II incorporates minimum capital requirements into a three pillar structure that includes supervisory review and market discipline

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Calculating Risk Weighted Assets

Risk Weighted Assets

Market Risk

Standardized Approach

Credit Risk Op Risk

Internal ModelApproach

Foundation IRBApproach


Advanced IRBApproach


Basic Indication Approach

Advanced Measurement

Approach

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Standardized Approach to Credit Risk

• Use fixed risk weights based on external credit ratings

• Least sophisticated capital calculation with highest capital burden

• Except for the largest 20 banks, most US banks will use standardized approach

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Internal Ratings-Based (IRB) Approaches to Credit Risk

Substantially differ from the standardized approach• Banks internal assessments of key risk drivers serve

as primary inputs to the capital calculation• The risk weights and capital changes are

determined through the combination of quantitative inputs provided by banks and formulas specified by the committee

• Banks have strong incentive to move to IRB status and reduce capital changes by improving risk management system.

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Foundation IRB VS. Advanced IRB

-Probability of -Provided by bank based - Provided by bank

Default (PD) on own estimates based on own estimates -Loss Given -Supervisory Values set - Provided by bank based on Default (LGD) by the committee own estimates -Exposure at -Supervisory values set - Provided by bank based on Default (EAD) by the committee own estimates -Maturity (M) -Supervisory values - Provided by bank based on

provided by the own estimatescommittee

Data Input Foundation IRB Advanced IRB

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Category 1 (0% weight)Cash, Federal Reserve Bank balances, securities of the U.S. Treasury, QECD governments, some U.S. agencies, and loans to sovereigns with an S&P credit rating of AA – or better.

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

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 of A+ or A-. Loans to banks and corporates with

an S&P credit rating of AA- or better.

•Table 11A

Summary of the Risk-Based Capital Standards for On-Balance Sheet ItemsUnder Basel II effective 2006

Risk Categories under Basel II

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Category 3 (50% weight)Loans fully secured by first liens on the one-to four-family residential properties. Other (revenue)

municipal bonds. Loans to Sovereign with an S&P credit rating of BBB+ to BBB-. Loans to banks and corporates with an S&P credit rating of A+ to A-.

Category 4 (100% weight)Loans to Sovereigns with an S&P credit rating of BB+ to B-. Loans to banks with a credit rating

of BBB+ to B-. Loans to corporates with a credit rating of BBB+ to BB-.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.

Category 5 (150% weight)Loans to sovereigns, banks and securities firm with an S&P credit rating below B-. Loans to

corporates with a credit rating below BB-.

•Table 11B CONTINUED from Table 11A

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Sale and repurchase agreements and assets sold with recourse that are not included on the balance sheet (100%).

Direct credit substitute standby letters of credit (100%).Performance-related standby letters of credit (50%).**Unused portion of loan commitments with original maturity of more than one

year (50%).Commercial letters of credit (20%).Bankers acceptances conveyed (20%).Other loan commitments (10%).** Loan commitments with original maturity < 1year (Conversion factor is zero

based on Basel I and 20 percent based on Basel II)

Conversion factors for Off-Balance-Sheet Contingent or Guaranty Contracts, Basel II (Same as Basel I)

•Table 12 Conversion Factors for OBS items

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Bank’s Balance-Sheet under Basel II

• An example = See Appendix B

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Risk-adjusted On-Balance-Sheet Assets

= 0 ( 8m +13m + 60 m + 50m + 42m) + 0.2 ( 10m + 10m + 20 + 10m + 55m) + 0.5 (34m + 308m + 75m) + 1.0 (390m + 108m + 22m ) + 1.5 (10) = $764.5 millionRisk-Adjusted assets for Off-Balance-Sheet items = 60 million (same as before)Total Risk-adjustment assets = 764.5 million + 60 = 824.5 million

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Risk-based Capital Ratios under Basel II

• Tier I (Core) Capital Ratio = Core Capital Total Risk-adjusted Assets = $50 million 824.5 million = 6.06% > 4%

• Total Risk-based Capital Ratio = Tier I + Tier II Capital Total Risk-adjusted Assets = (50 m + 45) m

824.5 = 11.52% > 8%

• Leverage Ratio = Tier I Capital Total Assets= 50 mil 1,215 mil= 4.11 % < 5%

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Comparison of Basel I & Basel II

Basel IBasel II

• Tier 1 (core) capital Ratio = 5.5% 6.06%

• Total risk-based Capital Ratio= 10.45% 11.52%

• Leverage Ratio = 4.11% 4.11%

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Bank Book Capital RatiosTable 13

Asset Size Bucket

1996(in $bn) 0.5-1 1-2 2-5 5-10 10-30 > 30

Number of Banks 203 112 65 33 32 29

Tier 1 capital/Avg Assets (in %)

8.58 8.57 7.80 8.46 7.50 7.14

Total Capital (Tier 1+Tier2)/ Risk-Weighted Assets

14.47 14.23 13.46 13.75 13.25 12.80

Source: Adapted from Davis and Lee (1997)

Observation #1: Smaller banks hold (relatively) more capital. Why?

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Capital serves as substitute for Risk Management to ensure bank safety

• Smaller banks tend to have following characteristics: Concentrated ownership and owner-managers, thus prefer more risk

management to less. Limited access to sophisticated risk management. More operating risk due to the lack of management depth. Lack of fee-based income might lead to more earnings volatility. Lack of diversification of their credit portfolios (with geographical and/or

industry concentrations).

• The capital structure choice in banks is closely related to the underlying risks held on the books of a bank.

basel i and ii

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