Drake DRAKE UNIVERSITY Fin 129 Capital Adequacy

Drake Drake University Fin 129 Overview The underlying goal of analyzing risk has been to assure that the institution does not become insolvent. The primary insurance against failure is capital. This chapter discusses the functions of capital, different measures of capital adequacy, current and proposed capital adequacy requirements and advanced approaches used to calculate adequate capital according to internal rating based models of credit risk.

Drake Drake University Fin 129 Importance of Capital Adequacy Absorb unanticipated losses and preserve confidence in the FI Protect uninsured depositors and other stakeholders Protect FI insurance funds and taxpayers Protect FI owners against increases in insurance premiums To acquire real investments in order to provide financial services

Drake Drake University Fin 129 Equity Capital as a Funding Source The institution must compete for equity funds in the same manner that it competes for borrowed funds. The suppliers of equity will base the value of the equity on the discounted value of future cash flows expected to be received from the asset.

Drake Drake University Fin 129 Cost of Equity The value of a share of stock can be found using the dividend discount model 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 /E 0 )(1+g)/(k-g)

Drake Drake University Fin 129 Capital and Insolvency Risk Capital net worth = market value of assets – market value of liabilities book value – values based o historical costs Market Value of capital credit risk interest rate risk exemption from mark-to-market for banks’ securities losses

Drake Drake University Fin 129 Credit Risk Example Basic Balance Sheet AssetsLiabilities Assets80Liabilities (ST, deposits)90 L-T Loans20Net Worth10 Total What happens if the loans default and the market value of loans decreases to 12?

Drake Drake University Fin 129 Credit Risk Example Basic Balance Sheet AssetsLiabilities Assets80Liabilities (ST, deposits)90 L-T Loans12Net Worth 2 Total92 92 The equity holders bear the risk, what if the loss had been 12 instead of 8?

Drake Drake University Fin 129 Credit Risk Example Basic Balance Sheet AssetsLiabilities Assets80Liabilities (ST, deposits)90 L-T Loans 8Net Worth- 2 Total88 88 Insolvency would cause the liquidation of assets and liability holders would not receive full value of their claims

Drake Drake University Fin 129 Interest Rate Risk Example Basic Balance Sheet AssetsLiabilities Assets80Liabilities (ST, deposits)90 L-T Loans20Net Worth10 Total What happens if the loans the level of interest rates increases, decreasing the value of assets, but not liabilities?

Drake Drake University Fin 129 Interest Rate Risk Example Basic Balance Sheet AssetsLiabilities Assets75Liabilities (ST, deposits)90 L-T Loans17Net Worth 2 Total92 92 The equity holders would be forced to take the loss in terms of net worth.

Drake Drake University Fin 129 Market vs Book Value The previous examples assume that the market value is used in the balance sheet. However, banks are exempted from marking to market the asset side of the balance sheet to adjust their net worth. The fear was that volatility in interest rates could cause solvent institutions to appear insolvent and be closed.

Drake Drake University Fin 129 Capital and Insolvency Risk (continued) Book value of capital = par value of shares (the face value of stock usually $1 multiplied by # of shares) +surplus value of shares (difference between price paid by the public and face value at initial issuance multiplied by # of shares) + retained earnings (accumulated value of past profits not paid in dividends) + loan loss reserve

Drake Drake University Fin 129 Credit Risk Example Revisited Basic Balance Sheet AssetsLiabilities Assets80Liabilities (ST, deposits)90 L-T Loans20Net Worth10 Total What happens if the loans are in trouble? Previously the market value of loans decreases to 12. Now there is discretion in writing down the loans. Maybe only 3 is written down

Drake Drake University Fin 129 Credit Risk Example Revisited Basic Balance Sheet AssetsLiabilities Assets80Liabilities (ST, deposits)90 L-T Loans17Net Worth 7 Total97 97 The equity holders bear the risk, but it is not as large as it previously was.

Drake Drake University Fin 129 Book Value of Capital Credit risk tendency to defer write-downs Interest rate risk Effects not recognized in book value accounting method

Drake Drake University Fin 129 Discrepancy Between Market and Book Values Factors underlying discrepancies: interest rate volatility (increased volatility increased discrepancy) examination and enforcement (increased enforcement, decreased discrepancy) Market value accounting market to book ratio

Drake Drake University Fin 129 Arguments against market value accounting Difficult to implement Especially if the Institution has small loans and other nontraded assets Counter argument is that error from estimating value may be less than error from using book value Introduces variability in net worth Especially if assets are held to maturity and it is only a temporary paper loss Counter is that failure to report gain and loss misrepresent true value of institution

Drake Drake University Fin 129 Arguments against market value accounting FI’s may be less wiling to accept long term asset exposure if it is going to be marked to market Since long term assets are more interest rate sensitive this increases fluctuations in net worth. May interfere with intermediary roles as lenders and monitors and also increase impact of credit crunch.

Drake Drake University Fin 129 Capital Adequacy in Commercial Banks and Thrifts Requirements for capital asset ratio and for risk based capital ratio Capital-assets ratio (Leverage ratio) L = Core capital/Assets 5 target zones associated with set of mandatory and discretionary actions Prompt corrective action if outside of well capitalized level Receivership if l fall s below 2%

Drake Drake University Fin 129 Capital Categories Zone Total Risk Based Ratio Tier 1 Risk Based Ratio Leverage Ratio Well Capitalized10% or above6% or above5% or above Adequately Capitalized 8% or above4% or above UndercapitalizedUnder 8%Under 4% Significantly undercapitalized Under 6%Under 3% Critically Undercapitalized 2% or under

Drake Drake University Fin 129 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

Drake Drake University Fin 129 New Basel Accord (Basel II) Basel Agreement – imposes risk based capital requirements on banks in major industrialized countries Pillar 1: Credit, market, and operational risks Credit risk: Standardized approach Internal Rating Based (IRB) Market Risk --Unchanged

Drake Drake University Fin 129 Basel II continued Operational: Basic Indicator Standardized Advanced Measurement Approaches

Drake Drake University Fin 129 Basel II continued Pillar 2 Specifies importance of regulatory review Pillar 3 Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks

Drake Drake University Fin 129 Capital Divided into Tier I and Tier II Tier I – closely linked to book value, represents the core contributions to banks owners. Includes common stockholders equity, some preferred stock, equity interests of subsidiaries Tier II – secondary capital. Includes loan and lease losses, hybrid capital (perpetual debt), subordinated debt, revaluation reserves

Drake Drake University Fin 129 Risk-based Capital Ratios Basle I 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 requires, Tier I (core) capital ratio = Core capital (Tier I) / Risk-adjusted  4%. Crudely mark to market on- and off-balance sheet positions.

Drake Drake University Fin 129 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

Drake Drake University Fin 129 Calculating Risk-based Capital Ratios Credit 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 five 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.

Drake Drake University Fin 129 Risk Categories Category 1 (0%) Cash, Fed Reserve Balances, US Treas. Sec, etc Category 2 (20%) Cash in process of collection, some MBS, Loans to banks and corps S&P rated AA- or better, etc. Category 3 (50%) Muni bonds, S&P A+to A- Category 4 (100%) Loans to banks BBB+to B-,loans to private individuals. Category 5 (150%) Loans to banks rated B- or less, corporate BB- or less

Drake Drake University Fin 129 Risk Adjusted Value The risk adjusted value of the assets is then simply the sum of the total amount of assets in each category multiplied by the risk weight for that category.

Drake Drake University Fin 129 Calculating Risk-based Capital Ratios under Basel II Basel I criticized since individual risk weights depend on broad borrower categories All corporate borrowers in 100% risk category Basle II widens differentiation of credit risks Refined to incorporate credit rating agency assessments

Drake Drake University Fin 129 Risk-adjusted 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 depend on guaranty type. Two-step process : Calculate credit equivalent amounts as product of face value and conversion factor. Multiply credit equivalent amounts by appropriate risk weights (dependent on underlying counterparty)

Drake Drake University Fin 129 Risk-adjusted Off-balance-sheet Activities Market Contracts and Derivatives 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.

Drake Drake University Fin 129 Risk-adjusted Off-balance-sheet Activities Potential Exposure -- The credit risk if the counterparty defaults it the future Current Exposure – The cost of replacing a derivative contract at today’s prices. (cost if counterparty defaults today)

Drake Drake University Fin 129 Credit Equivalent Amounts of Derivative Instruments Credit equivalent amount of OBS derivative security items = Potential exposure + Current exposure Risk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight.

Drake Drake University Fin 129 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 )

Drake Drake University Fin 129 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

Drake Drake University Fin 129 Operational Risk and Risk-Based Capital 2001 Proposed amendments Add-on for operational risk Basic Indicator Approach Gross income = Net interest Income + Noninterest income Operational capital =  × Gross income Top-down. Too aggregative.

Drake Drake University Fin 129 Operational Risk and Risk-Based Capital Standardized Approach Eight major business units and lines of business Capital charge computed by multiplying a weight, , for each line, by the indicator set for each line, then summing.

Drake Drake University Fin 129 Operational Risk and Risk-Based Capital Advanced Measurement Approaches: Three broad categories: Internal Measurement Approach (IMA) Loss Distribution Approach (LDA) Scorecard Approach (SA).

Drake Drake University Fin 129 Criticisms of Risk-based Capital Ratio Risk weight categories versus true credit risk. Risk weights based on rating agencies Portfolio aspects: Ignores credit risk portfolio diversification opportunities. DI Specialness May reduce incentives for banks to make loans. Other risks: Interest Rate, Foreign Exchange, Liquidity Competition and differences in standards

Drake Drake University Fin 129 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.

Drake Drake University Fin 129 Capital Requirements (cont’d) Life insurance C1 = Asset risk C2 = Insurance risk C3 = Interest rate risk C4 = Business risk

Drake Drake University Fin 129 Capital Requirements (cont’d) 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.

Drake Drake University Fin 129 Capital Requirements (cont’d) Property and Casualty insurance companies similar to life insurance capital requirements. Six (instead of four) risk categories