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

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Presentation on theme: "Irwin/McGraw-Hill 1 Capital Adequacy Chapter 20 Financial Institutions Management, 3/e By Anthony Saunders."— Presentation transcript:

1 Irwin/McGraw-Hill 1 Capital Adequacy Chapter 20 Financial Institutions Management, 3/e By Anthony Saunders

2 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 3 Cost of Equity P 0 = D 1 /(1+k) + D 2 /(1+k) 2 +… Or if growth is constant, P 0 = D 0 (1+g)/(k-g) May be expressed in terms of P/E ratio as P 0 /E 0 = (D 0 /E0)(1+g)/(k-g)

4 Irwin/McGraw-Hill 4 Capital and Insolvency Risk Capital »net worth »book value Market value of capital »credit risk »interest rate risk

5 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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. A net = (0.4 × A gross ) + (0.6 × NGR × A gross )

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

17 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 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 Irwin/McGraw-Hill 19 Capital Requirements for Other FIs n 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 Irwin/McGraw-Hill 20 Capital Requirements (continued) n Life insurance C1 = Asset risk C2 = insurance risk C3 = interest rate risk C4 = Business risk

21 Irwin/McGraw-Hill 21 Capital Requirements (continued) n Risk-based capital measure for life insurance companies: RBC = [ (C1 + C3) 2 + C2 2 ] 1/2 + C4 If (Total surplus and capital) / (RBC) < 1.0, then subject to regulatory scrutiny.

22 Irwin/McGraw-Hill 22 Capital Requirements (continued) n Property and Casualty insurance companies similar to life insurance capital requirements. Six (instead of four) risk categories

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