CAPITAL ADEQUACY Class 12, Chap 20 1

Lecture outline 2  Introduction to capital adequacy  What is it and why is it important  What are the costs and benefits to regulation  How to measure capital  Calculation of Capital Ratios  Leverage  Risk-based Tier I capital ratio Total capital ratio Purpose: Gain a general understanding of why equity capital is important, how it is measured and how it is regulated

Why is Capital Adequacy Important? 3  What happens when banks are under capitalized? What happens when banks are under capitalized  Should banks be forced to hold more capital? Should banks be forced to hold more capital?

Cost/Benefit of Regulating Capital 4 Increasing Capital Capital Requirements Lowers Insolvency Risk  Absorbs unanticipated losses – equity capital acts as a buffer between the value of assets and liabilities. Losses in asset values decrease the value of equity. At zero equity value the firm is insolvent.  Protects unsecured creditors against losses in the event of liquidation.  Proceeds from the sale of assets will more likely cover creditor claims for firms with high equity capital  Protects FDIC insurance fund DIF and tax payers  Lower insolvency risk means fewer payouts from the FDIC insurance fund and lower likelihood of a tax-payer bailout of the FDIC Economic Growth Economic Stability

Cost Benefit of Regulating Capital 5 Economic Growth Economic Stability Increasing capital requirements decreases the credit supply  Banks are required to hold more capital on their balance sheet which decreases the lending capacity of banks  Decreased credit supply reduces corporate investment activity, which slows economic growth. Increasing capital requirements can promote economic growth  Increased stability increases consumer confidence which can promote growth  More capital reduces FDIC Premiums which increases lending capacity

Measuring Equity Capital 6

Book Value of Equity 7 Definition  The historic value of assets/ liabilities. Reflects total purchase price of all assets on the balance sheet less the face value of liabilities Main Advantages  Easy to measure  Easy to observe (regulate) Main Disadvantages  The book value may not reflect the current value of the asset i.e. What you could buy/sell it for  Gives managers more discretion on when they report (realize) losses  Does not consider off-balance sheet items

Market Value of Equity 8 Definition:  Difference between the market value of assets and liabilities.  Market value of equity is the remaining value after assets have been liquidated at market price and all liabilities have been repaid (or repurchased in the market) Main Advantages:  More current measure of liquidation value  Quick to adjust Main Disadvantage:  Hard to measure especially for assets that do not have secondary markets  Market prices do not always reflect the true (fundamental) asset value due to market imperfections – crisis

Types of Capital (Basel III)  Common Equity Tier I (CET1)  Tier I Capital  Tier II Capital 9

Common Equity Tier I (CET1)  Strict definition of capital, closely related to book value of common stock  The contribution of DI owner’s available to absorb losses 10 (1)Common shares issued and stock surplus that meets regulatory requirements (2)Undistributed earnings (3)Ex: losses on defined benefits pension obligations (4)Shares issued by subsidiaries and held by a 3 rd party (50% ownership <) (5)Technical adjustments made to CET1 (6)Amount paid for acquisitions above Market value CET1 = Common stock Retained earnings Regulatory adjustments to common equity Tier Minority interest in consolidated subsidiaries + Accumulated income and disclosure reserves + (1) (2) (3) (4) (5) –Goodwill (6)

Tier I = CET1 Other perpetual securities Other Tier I securities + + Tier I minority Interests + Noncumulative perpetual preferred stock + (1) (2) (3) (4)(5) + Regulatory adjustments (6) Tier I Capital  Broader definition of capital: includes options other than common equity for absorbing losses 11 (1)Common stock Tier 1 (CET1) (2)Instruments with no maturities date or incentive to redeem (may be called within 5 years of issue if replaced with better capital) (3)Perpetual prefer stock that does not cumulate (4)Tier I capital of minority interest not included in CET1 (5)Securities issued under small business jobs act 2008 that qualify as Tier 1 equity capital (6)Technical adjustments made to additional Tier I capital

Tier II = Subordinate debt Other subordinate securities Other Tier II securities ++ Loan loss reserves + Total capital of minority interest + (1)(2) (3) (4)(5) + Regulatory adjustments (6) Tier II Capital  The broadest definition of capital including all equity-like resources not accounted for else where 12 (1)Subordinate bonds and preferred stock (2)Instrument subordinate to deposits and general creditor claims (3)Tier II capital of minority interest not included in minority Tier I capital (4)Reserve account to absorb losses on loans and leases (5)Securities issued under small business jobs act 2008 that qualify as Tier II equity capital (6)Technical adjustments made to additional Tier II capital

CET1, Tier I, & Total Capital  CET1 = CET1  Tier I capital = CET1 + additional Tier I  Total capital = Tier I + Tier II 13

Equity Capital Ratios 14

Capital Ratios Leverage Ratio 2. Tier I risk-based capital ratio 3. Total risk-based capital ratio Book Value Measure Book & Market Value – includes OBS Risk-Based Ratios are defined in the Basel Accord Book & Market Value – includes OBS

16 Leverage Ratio(s)

Leverage Ratio (Capital-to-Asset) 17 Standard approach Advanced approach Derivatives: Potential + Current Exposure Guarantee contracts: - Conversion factor = 100% - 10% if contract is immediately cancelable

Working with Capital ratios 18 Assets = 400M Liabilities =300M Equity = 100M

Working with Capital ratios 19 Assets = 325M Equity = 25M Liabilities =300M Lower ratio = higher leverage, more risk – regulator want high L ratios

20 Given the following balance sheet calculate the leverage ratio

Draw-backs of leverage ratio 21  Does not consider off-balance sheet risks  Measures asset values using book value  Assumes that all assets are equally risky 100 Billion in cash 100 Billion in Greek bonds (purchased in 2005) Is there a difference in risk?

Risk Based Capital Ratios 22 The Basel Accord

Basel Accord  Banking regulation recommended by the Basel Committee on Banking Supervision (BCBS) a division of the Bank of International Settlement (BIS)  US DI regulators agreed, with other BIS member countries, to enforce regulation outlined in the Basel Accord  Three main versions  Basel I  Basel II  Basel II.5  Basel III 23

Basel Accords I & II 24  Basel I (1993)  Introduced risk-based capital ratios  Credit-risk adjust assets  Include off-balance sheet items  Set capital requirement thresholds 8% adequately capitalized  Prompt corrective action  Market risk (1998) revision to include market risk as an add-on to the 8% capital requirement  Basel II (2006)  Increased option to account for credit risk  Standard approach  Internal Ratings Based (IRB)  Recommended holding capital against operational risk

Basel Accords II.5 & III 25  Basel II.5 (2009 passed, 2013 effective)  Updated capital requirements on market risk for banks’ trading operations  Basel III (2010 passed, 2019 effective)  Raised quality consistency and transparency of capital base at banks  Redefined capital to emphasize common equity  Refined risk weight categories  Introduced conservation buffer  Introduced countercyclical capital buffer  Introduced global systemically important bank (G-SIB) surcharge  Also has provisions for supervision (Pillar 2) and disclosure (Pillar 3)

26 Risk-Based Capital Ratio Calculation

 The Basel III proposed 3 risk-adjusted capital ratios  Common Equity Tier I capital ratio  Tier 1 risk-adjusted capital ratio  Total risk-adjusted capital ratio  There are 2 components of risk adjusted asset value 1. Credit risk-adjustment of on-balance sheet asset values 2. Credit risk adjustment of off-balance sheet asset values Risk Adjustment Overview 27

CET1, Tier I & Total Capital Ratios 28  CET1 Capital Ratio:  Tier I Capital Ratio:  Tier II Capital Ratio:

Calculating Risk-Adjusted Assets 29 Procedure 1. Calculate credit-risk adjusted asset value of on- balance-sheet assets 2. Calculate credit risk adjusted asset value of off- balance-sheet assets

30 1. Calculate credit-risk adjusted asset value of on-balance-sheet assets

Calculating Risk-Adjusted Assets - On Balance-Sheet Items – Procedure 31 2 steps to risk-adjusting on-balance sheet asset values 1. Classify assets into 1 of 9 risk categories to obtain the risk weight 2. Risk-adjust asset values: multiply risk weights by balance sheet asset values and sum = Risk-adjusted asset value WeightAsset Value Σ

Calculating Risk-Adjusted Assets - On Balance-Sheet Items – Risk Weights 32 Step 1: Under Basel III assets are assigned to 1 of 9 categories

Step 2: Convert to credit equivalent amounts and sum Calculating Risk-Adjusted Assets - On Balance-Sheet Items – Example 33 Category 1: Category 2: Category 3: Category 4: Category 5: Mill On Balance-sheet risk adjusted asset value = Risk-adjusted asset value Weight Asset Value Risk Weights #1 Risk Weights #2 Consumer Loans

34 Back

35 Back High Quality Traditional, First lien, and prudentially underwritten Low Quality Junior liens Non-traditional

36 2. Calculate credit-risk adjusted asset value of off-balance-sheet assets

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items - Procedure 37 1.Convert to on-balance sheet credit equivalent amounts using Basel conversion factors 2.Classify off-balance sheet items into 1 of 9 risk categories to determine risk weights 3. Risk-adjust asset values: multiply risk weights by balance sheet asset values and sum New Contingent or guaranty contracts Market & Derivatives contracts

38 Step #1 Contingent or guaranty contracts

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents 39 Step 1 Convert to credit equivalent amounts (CEA) using the Basel conversion factors CEA = Off-balance sheet value (notional) Basel Factor Contingent or guaranty contracts:

40 Step #1 Market contracts or derivatives (FX, interest rate forwards, options and swaps)

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents 41 Potential Exposure: Captures expected losses from future counterparty default. Step 1 Convert to credit equivalent amounts (CEA) using the Basel conversion factors Market contracts or derivatives: Credit Equivalent Amount = Potential Exposure + Current Exposure Potential Exposure = [Off-balance sheet value (notional)] × [Basel Factor]

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents 42 Current Exposure: Replacement cost of the contract if counter party defaults today Step 1 Convert to credit equivalent amounts (CEA) using the Basel conversion factors Market contracts or derivatives: Credit Equivalent Amount = + Current Exposure Potential Exposure Positive value (in the money): The FI would have to pay out-of-pocket to reestablish the contract – regulators will recognize this (market) value as the replacement cost Negative value (out of the money): The FI would not likely actively seek to reestablish a negative position – regulators require that the FI sets replacement costs equal to zero.

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Risk adjustment 43 Step 2 Classify Credit Equivalent Amounts into 1 of 9 categories using Basel tables Step 3 Sum risk adjusted Credit Equivalent Amounts = Risk-adjusted asset value Weight CEA Σ

44 Example Off Balance Sheet Adjustment

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents 45 Step 1 Contingent or guaranty contracts: Example Example  Conversions Total = $60M

Guarantee Contract Conversions 46 Back

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents 47 Suppose an FI has the following off-balance-sheet items: 1. 4-year Fixed for floating Interest rate swap with notional amount of $100 mill and current market value of 3 Mill 2. 2-year forward foreign exchange contract with $40 mill In notional value and calculated value of -1Mill to the FI Convert OBS items to on-balance-sheet credit equivalent amounts by adding potential and current exposures: Step 1 Market contracts or derivatives: Example Example  4-year Fixed for floating Interest rate swaps Conversions Replacement cost Credit Equivalent Amount = $3,500,000

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents 48 Suppose an FI has the following off-balance-sheet items: 1. 4-year Fixed for floating Interest rate swap with notional amount of $100 mill and current market value of 3 Mill 2. 2-year forward foreign exchange contract with $40 mill In notional value and calculated value of -1Mill to the FI Convert OBS items to on-balance-sheet credit equivalent amounts by adding potential and current exposures: Step 1 Market contracts or derivatives: Example Example  2-year forward foreign exchange contract Conversions Replacement cost Credit Equivalent Amount = $2,000,000

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Convert to Credit Equivalents 49 Example Contingent and Guarantee ContractsCEA Loan commitment40,000,000 Direct-credit substitute standby letter of credit10,000,000 Commercial letter of credit10,000,000 Market & Derivative ContractsCEA 4-year Fixed for floating Interest rate swap3,500,000 2-year forward foreign exchange contract2,000,000

Market & Derivative Contract Conversions 50 Back

Calculating Risk-Adjusted Assets Step #2 Adjust for credit risk 51 Example

52  Contingent or Guaranty contracts  Use the same risk category classifications as we used for on-balance sheet items  Classify the OBS item as if the contingent event had occurred and the asset was brought back on the balance sheet.  Market contracts or derivatives  Derivatives and market contracts are assessed at 100% of their risk i.e. risk weight = 100% Step 2: Classify OBS items into risk categories Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Determine Risk Weights

53 Example  Contingent or guaranty contracts: Step #2: Apply risk weights to Credit Equivalent Amounts Conversions

Market and Derivative contracts mostly have 100% risk weight Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Determine Risk Weights 54 Example  Market and Derivative contracts: Step #2: Apply risk weights to Credit Equivalent Amounts

55 Back

Calculating Risk-Adjusted Assets Step #3 Total risk-adjusted OBS assets 56 Example

Calculating Risk-Adjusted Assets - Off Balance-Sheet Items – Total OBS RAA value Step #3 Total Off-Balance Sheet risk-adjusted asset value Guarantee contracts:  2-year loan commitments $40,000,000  Direct credit substitutes standby letters of credit $10,000,000  Commercial letter of credit $10,000,000 Market & Derivatives Contracts:  1-year fixed for floating rate swap $3,500,000  2-year foreign exchange contract$2,000, $60,000,000 $5,500,000 Example

Calculating Risk-Adjusted Assets - Total Risk Adjusted Capital 58  Total risk adjusted capital is the sum of:  Risk adjusted on-balance-sheet assets  Risk adjusted off-balance-sheet assets – contingent guaranty contracts  Risk adjusted off-balance-sheet assets – market contracts or derivatives  From the above examples: Risk-Adjusted Capital On-balance-sheet764.5 mill Off-balance-sheet (Contingent or guaranty )60 mill Off-balance-sheet (Market and Derivative )5.5 mill Total Risk Adjusted Asset Value830 mill

Calculate Ratios 59

What was the point of all that? 60  The Basel Accord proposed 2 risk-adjusted capital ratios  Common Equity Tier I (CET1)  Tier 1 risk-adjusted capital ratio  Total risk-adjusted capital ratio We now have credit-risk adjusted asset values

Risk-Based Capital Ratios 61 CET1 Retained Earnings Common Stock 30 Tier 1 Qualified perpetual preferred stock 10 CET

Risk-Based Capital Ratios 62 Qualified perpetual preferred stock 10 Tier II Convertible Bonds Subordinate Debt 10 Non-Qualified perpetual preferred stock 5 Loan loss reserves 10

63 Capital Adequacy Regulation

Regulation 64 After obtaining the capital ratios, the bank capital adequacy can be assessed and regulated

Corrective Action 65

Other Capital Requirements  Conservation Buffer  Account that banks build up during good time to drawdown on in bad times  Made up of CET1 but does not count toward CET1  Phased in over 3013 – 2019; 0% – 2.5% add-on to capital ratios  Countercyclical Buffer  Banks in countries experiencing abnormal growth in credit supply must hold an additional capital buffer  0% – 2.5% add-on to the capital ratios  Must be met with CET1 and banks are given 12 month to comply  Global systemically important surcharge  Top-ranked G-SIB’s must hold additional CET1 capital 1% - 3.5% add-on  Ranked by: size, interconnectedness, cross-jurisdiction, complexity, no subs  Exact charge depends on the ranking into 5 buckets 66

Lecture Summary 67  What is capital adequacy and why is it important  What are the costs and benefits to regulation  How to measure capital  How to measure capital adequacy (capital ratios)  Leverage  Risk-based CETI capital ratio Tier I capital ratio Total capital ratio  Regulation