1. Capital Adequacy Chapter 20
Financial Institutions Management, 3/e
By Anthony Saunders

2. Importance of Capital Adequacy
Preserve confidence in the FI
Protect uninsured depositors
Protect FI insurance funds and taxpayers
To acquire real investments in order to provide financial services

3. Cost of Equity P0 /E0 = (D0/E0)(1+g)/(k-g)
P0 = D1/(1+k) + D2/(1+k)2 +…
Or if growth is constant,
P0 = D0(1+g)/(k-g)
May be expressed in terms of P/E ratio as
P0 /E0 = (D0/E0)(1+g)/(k-g)

4. Capital and Insolvency Risk
net worth
book value
Market value of capital
credit risk
interest rate risk

5. Capital and Insolvency Risk (continued)
Book value of capital
par value of shares
surplus value of shares
retained earnings
loan loss reserve
Credit risk
Interest rate risk

6. Discrepancy Between Market and Book Values
Factors underlying discrepancies:
interest rate volatility
examination and enforcement
Market value accounting
market to book
arguments against market value accounting

7. Capital Adequacy in Commercial Banking and Thrifts
Actual capital rules
Capital-assets ratio (Leverage ratio)
L = Core capital/Assets
5 categories associated with set of mandatory and discretionary actions
Prompt corrective action

8. Leverage Ratio Problems with leverage ratio:
Market value: may not be adequately reflected by leverage ratio
Asset risk: ratio fails to reflect differences in credit and interest rate risks
Off-balance-sheet activities: escape capital requirements in spite of attendant risks

9. Risk-based Capital Ratios
Basle agreement
Enforced alongside traditional leverage ratio
Minimum requirement of 8% total capital (Tier I core plus Tier II supplementary capital) to risk-adjusted assets ratio.
Also, Tier I (core) capital ratio
= Core capital (Tier I) / Risk-adjusted assets must meet minimum of 4%.
Crudely mark to market on- and off-balance sheet positions.

10. Calculating Risk-based Capital Ratios
Tier I includes:
book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill.
Tier II includes:
loan loss reserves (up to maximum of 1.25% of risk-adjusted assets) plus various convertible and subordinated debt instruments with maximum caps

11. Calculating Risk-based Capital Ratios
Risk-adjusted assets:
Risk-adjusted assets = Risk-adjusted on-balance-sheet assets + Risk-adjusted off-balance-sheet assets
Risk-adjusted on-balance-sheet assets
Assets assigned to one of four categories of credit risk exposure.
Risk-adjusted value of on-balance-sheet assets equals the weighted sum of the book values of the assets, where weights correspond to the risk category.

12. Risk-adjusted Off-balance-sheet Activities
Off-balance-sheet contingent guaranty contracts
Conversion factors used to convert into credit equivalent amounts—amounts equivalent to an on-balance-sheet item. Conversion factors used depend on the guaranty type.
Two-step process:
Derive credit equivalent amounts as product of face value and conversion factor.
Multiply credit equivalent amounts by appropriate risk weights (dependent on underlying counterparty)

13. Risk-adjusted Off-balance-sheet Activities
Off-balance-sheet market contracts or derivative instruments:
Issue is counterparty credit risk
Basically a two-step process:
Conversion factor used to convert to credit equivalent amounts.
Second, multiply credit equivalent amounts by appropriate risk weights.
Credit equivalent amount divided into potential and current exposure elements.

14. Credit Equivalent Amounts of Derivative Instruments
Credit equivalent amount of OBS derivative security items = Potential exposure + Current exposure
Potential exposure: credit risk if counterparty defaults in the future.
Current exposure: Cost of replacing a derivative securities contract at today’s prices.
Risk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight.

15. Risk-adjusted Asset Value of OBS Derivatives With Netting
With netting, total credit equivalent amount equals net current exposure + net potential exposure.
Net current exposure = sum of all positive and negative replacement costs.
If the sum is positive, then net current exposure equals the sum.
If negative, net current exposure equals zero.
Anet = (0.4 × Agross ) + (0.6 × NGR × Agross )

16. Interest Rate Risk, Market Risk, and Risk-based Capital
Risk-based capital ratio is adequate as long as the bank is not exposed to:
undue interest rate risk
market risk

17. Criticisms of Risk-based Capital Ratio
Risk weight categories may not closely reflect true credit risk.
Balance sheet incentive problems.
Portfolio aspects: Ignores credit risk portfolio diversification opportunities.
Reduces incentives for banks to make loans.

18. Criticisms (continued)
All commercial loans have equal weight.
Ignores other risks such as FX risk, asset concentration and operating risk.
Adversely affects competitiveness.

19. Capital Requirements for Other FIs
Securities firms
Broker-dealers:
Net worth / total assets ratio must be no less than 2% calculated on a day-to-day market value basis.

20. Capital Requirements (continued)
Life insurance
C1 = Asset risk
C2 = insurance risk
C3 = interest rate risk
C4 = Business risk

21. Capital Requirements (continued)
Risk-based capital measure for life insurance companies:
RBC = [ (C1 + C3)2 + C22] 1/2 + C4 If
(Total surplus and capital) / (RBC) < 1.0,
then subject to regulatory scrutiny.

22. Capital Requirements (continued)
Property and Casualty insurance companies
similar to life insurance capital requirements.
Six (instead of four) risk categories