Capital Adequacy

Basel II Accords Proposed 2004, Implemented SoonThree Pillars1. Minimum capital requirements,• New methodology for calculating required

capital for credit risk. • Charges for operational risk2. Supervisory review - regulators use more

comprehensive tools for assessing risk. 3. Market discipline – banks expected to

increase reporting to financial markets.

Basel Accords• Under the Auspices of the Bank for International

Settlements, the Basle Committee (which consists of the G-10 countries’ central bank governors), have agreed upon a scheme of regulation which will be applied to international banks. (What is the BIS?)

• The key element of this scheme is a set of requirements relating a minimum amount of bank capital relative to a risk based measure of assets.

• Why capital?

Capital: Tension between profits and risk

• The equity multiplier magnifies the effect of profits on returns which gives bank owners an incentive to increase leverage.

• Bank capital absorbs losses before depositors or creditors absorb losses. So bank depositors and creditors prefer capital.

• Risky banks may pay higher interest rates so banks may internalize depositors preferences… But regulators have adopted a preference toward capital requirements institutionalized by Basel.

Capital and Moral Hazard• Consider a bank with 0 capital, full financed with

deposits of $100 (which for convenience pay 0 interest rate).

• Bank managers face two loan projects with differing payoff profiles.

• Which will the bank choose? Which is socially optimal?

Prob. of Good Outcome

Prob. of Bad Outcome

Interest Recovery

%

Project A

(Risky)

.5 .5 .2 0

Project B(Safe)

1 0 .05 N/A

Expected Payoffs to depositors and bankers

• The safe project creates value in excess of customers demand for funds. The expected value of the risky project is just $60, less than what was put in the project.

Assume that in the event of bankruptcy, depositors claim all remaining assets.

• The depositors have an expected payoff of 100 under the safe scheme and only 50 under the risky lending scheme. They prefer safety.

Bankers payoffs

• Under the safe scheme, the bankers will get a payoff of 5. Under the risky scheme the bankers will get an expected payoff of 10. They will prefer the destructive, risky scheme. Why?

• Bankers get upside pay-off of risky scheme but put downsize risk on depositors.

Well capitalized banks?

• Compare with bank finance by 80% deposits and 20% equity.

• Under safe scheme, bank gets an expected payoff of 25 for a 25% ROE.

• Under risky scheme, the bank owners receives 40 back in a good outcome and 0 back in a bad outcome for an expected payoff of 20.

• Bank owners share the downside risk and avoid the risky scheme.

Measures of Capital Risk

• Chief measures are Tier 1 leverage ratio and CAR (capital adequacy) ratio.

(Tier 1+ Tier 2)/RAA Tier 1/RAA Tier 1/aTAWell Capitalized > 10% > 6% > 5%Adequately Capitalized 8-10% 4-6% 4-5%Undercapitalized 6-8% 3%-4% 3%-4%Significantly Undercapitalized <6% <3% <3%Critically Undercapitalized <2% <2% <2%

Tier 1 Capital +Tier 2 CapitalCAR

Risk Adjusted Assets

Tier 1 Capital

Total Assets

CAMELS rating system

Recent rise in US capital ratios as well

FDIC Historical Banking Statistics

Capita/Asset Ratio

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

1934

1938

1942

1946

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

http://www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=10

Rising Capitalization Ratios in Hong Kong

Source: CEIC/HKMA

Capital/Asset Ratio

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Capital Adequacy Ratio

• Main regulatory requirement of HK banks is the CAR: Capital Adequacy Ratio.

• CAR is

• Since 1987, the Basel Accords imposed in HK and CAR > .08.

• What is regulatory capital? How do you adjust for risk?

Regulatory Capital

Risk Adjusted Assets

Historical Capital Adequacy for HKSource:

Sep-1997 Sep-1999 Sep-2001 Sep-2003 Sep-2005

20.5

20.0

19.5

19.0

18.5

18.0

17.5

17.0

16.5

16.0

15.5

15.0

HK: Capital Adequacy Ratio%

Types of Capital

• Tier 1 capital is thought to be more stable and more aligned with the concept of capital as the funds that owners have invested in the banks (i.e. equity capital, perpetual preferred stock and retained earnings)

• Tier 2 capital are funds that protect depositors but may be withdrawn (subordinated debt) or is already somewhat committed to other purposes (reserves).

Measuring Capital

• For regulatory purposes, capital is divided into two tiers.

Tier 11. Common Stock at Par + Surplus2. Undivided Profits/Retained Earnings3. Minority Interests

Tier 21. Subordinated Debt2. General Loan Reserves (LLA)3. Other Reserves (similar to undivided profits)

Minus Intangible

Assets, Goodwill

Risk Adjusted Assets

• Loans & securities are placed in a number of buckets Aj

On with associated risk weights based on the identity of the borrower

• Off-balance sheet items are converted to credit equivalents with credit conversion factor, ccfk, based on type of item.

AjOff = ccf1∙ Aj,1

Off + …..

Aj = AjOn + Aj

Off

• Risk Adjusted Assets: w1A1 + w2A2 + …w4A4

Risk adjustment of assets:

Standardized Approach

• Different assets are differentiated into buckets which have different risk weights.

Risk Bucket Loans Risk Weights

1. Domestic Central Govt. 0%

2. Public Entities, Foreign Governments (OECD),

Banking.

20%

3. Secured Residential Lending. 50%

4. Commercial and consumer loans 100%

Timeline

• Basel Accords signed in 1987 imposed risk-based capital requirements

• Basel Market Risk Amendment in 1996.– Impose market risk requirement

• Problems with Basel I– Risk weights too broad– Does not account for new risk management

techniques.

Standardized ApproachBasel II

• Meant for smaller, less sophisticated banks. • New risk weights (0%; 20%; 50%; 100%, 150%)

used for assessing capital required based on credit rating and type of assets.

• Uses External Ratings (where available)• Unrated (most SMEs) weighted at 100%• 35% weight for claims secured by Residential

Mortgage• 100% weight for claims secured by Commercial

Mortgage

Set of risk weights (ranging from 0 to 150%) for different types of assets with different credit ratings claims on

• Sovereign

• Public Entities

• MDB

• Banks

• Securities Firms

• Corporates

• Residential Lending

• Cash

• Regulatory Retail

• Other Assets

• Past Due

Credit Conversion FactorsOff Balanced Sheet

Type ccf

1. Standby LOC, Guarantees, Securitization w/ Recourse

100%

2. LT Loan Commitments 50%

3. Commercial LOC 20%

4. Finanical Derivatives (depends on type & maturity)

0-15%

5. ST Loan Commitments 0%

Market Risk

• Banks with significant trading activity (trading assets+liabilities > 10% of total assets) must have additional capital beyond 8% of credit risk adjusted assets.

• Banks should calculate VAR of foreign exchange and securities positions and allocate some capital equal to 8% of VAR.

IRB Approach

Internal Ratings Based: Foundation Approach Banks examine lending and associated assets and

calculate probability of default for loans. Regulators provide formulas for associated capital requirement.

Only banks that can demonstrate competence can use IRB approach

Internal Ratings Based: Advanced Approach Bank constructs own (supervisor approved) formulas to calculate.

PD: probability of default, EAD: exposure of bank to defaultLAD: Loss at default M: remaining maturityand uses these to determine required capital.

Operations Risk

• Loss of funds through operating circumstances may be a source of risk for banks.

• Standardized Approach: Allocate capital to equal 15% of 3year lagged moving average of revenues.

• Subject to regulatory approval, most sophisticated banks may design their own systems for operations risk.

How much capital?

• Depends on risk appetite of the bank, regulatory requirements, maintaining a good debt rating, limits of internal growth, relative cost of debt and equity financing.

• Use statistical ratios to describe the risk appetite of banks.

Capital and Growth

• Capital adequacy limitations can act as brake on bank growth.

• Consider a bank that can achieve 10% growth on the asset side of its balance sheets and also can borrow freely to achieve that growth.

• An adequately capitalized bank must achieve 10% capital growth or fall below the adequacy standard.

Achieving Capital Growth

• Reduce dividend payout ratios

• Earn higher ROA to increase cash flow (may increase risk)

• Change mix of assets to those with smaller capital charges

• Move assets off balance sheet

• Issue more stock/subordinated debt.

Internal Growth Rate

• The change in the capital of the bank that can be obtained from internal sources is:

Retained Earnings Retained Earnings Net Income

Equity Capital Net Income Equity Capital

Modern Capital Management

• Instead of evaluating how much capital the bank needs, modern banks will evaluate lines of business and how much capital should be allocated for the assets needed to generate income in that line.

• Different businesses require different quantities of capital. Capital is more expensive than debt, so business requiring heavy capitalization must earn higher returns.

Basel II Accords

• In what ways have recent events challenged the Basel Accords?

Reading List

• Bank for International Settlements – Basel II Overview International Convergence of Capital Standards

• KPMG Canada, 2006, -Basel II: A Worldwide Challenge for the Banking Business