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

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

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)

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

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

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

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

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

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.

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

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.

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)

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.

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.

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 )

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

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.

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

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.

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

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.

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