1. Capital Adequacy

2. Basel II Accords Proposed 2004, Implemented Soon
Three Pillars
Minimum capital requirements,
New methodology for calculating required capital for credit risk.
Charges for operational risk
Supervisory review - regulators use more comprehensive tools for assessing risk.
Market discipline – banks expected to increase reporting to financial markets.

3. 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?

4. 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.

5. 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 .2
Project B
(Safe) 1
.05
N/A

6. 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.

7. 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.

8. 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.

9. Measures of Capital Risk
Chief measures are Tier 1 leverage ratio and CAR (capital adequacy) ratio.
CAMELS rating system

10. Recent rise in US capital ratios as well FDIC Historical Banking Statistics

11. Rising Capitalization Ratios in Hong Kong Source: CEIC/HKMA

12. 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?

13. Historical Capital Adequacy for HK Source:

14. 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).

15. Measuring Capital
For regulatory purposes, capital is divided into two tiers.
Tier 2
Subordinated Debt
General Loan Reserves (LLA)
Other Reserves (similar to undivided profits)
Tier 1
Common Stock at Par + Surplus
Undivided Profits/Retained Earnings
Minority Interests
Minus
Intangible
Assets, Goodwill

16. Risk Adjusted Assets
Loans & securities are placed in a number of buckets AjOn 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,1Off + …..
Aj = AjOn + AjOff
Risk Adjusted Assets: w1A1 + w2A2 + …w4A4

17. 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%

18. 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.

19. Standardized Approach Basel 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

20. 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

21. Credit Conversion Factors Off 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%

22. 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.

23. IRB Approach Internal Ratings Based: Foundation Approach
Only banks that can demonstrate competence can use 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.
Internal Ratings Based: Advanced Approach
Bank constructs own (supervisor approved) formulas to calculate.
PD: probability of default,
EAD: exposure of bank to default
LAD: Loss at default
M: remaining maturity
and uses these to determine required capital.

24. 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.

25. 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.

26. 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.

27. 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.

28. Internal Growth Rate
The change in the capital of the bank that can be obtained from internal sources is:

29. 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.

30. Basel II Accords
In what ways have recent events challenged the Basel Accords?

31. 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