Chapter 5: Capital Requirements &

Securitisation
(A)

CAPITAL MANAGEMENT

The key functions performed by bank capital are:

a) Capital is the centre of the regulatory framework,
and as such provides confidence for depositors and
other non-equity liability holders.

b) Capital provides a buffer intended to absorb

losses arising from any forms of risks, thereby
permitting the bank to continue its operations

Only capital, which has no fixed maturity and no

fixed explicit financing cost, can fully perform the
above functions.
The unique feature of capital of having no fixed
maturity also makes it the best means of financing
long-term assets (e.g. acquisitions).

 Though banks generally prefer to maintain a

relatively low amount of capital in order to boost
their ROE, a prudent regulatory framework
underscores the importance of capital
adequacy to absorb unexpected losses.
Specifically, the Basle Committee on Banking
Supervision formulated a standard approach to
maintaining adequate capital (as measured by
Capital Adequacy Ratio) which has been
adopted by most banks internationally.

 Capital Adequacy Ratio is equal to the capital

divided by the risk-adjusted assets.
The value of the risk-adjusted asset is
calculated as the value of the asset multiplied by
the risk weight. The higher the default risk
associated with an asset, the higher the risk
weight assigned.
Off-balance sheet items are treated similarly by
assigning a credit equivalent percentage that
converts it to on-balance sheet items and then
the appropriate risk weight applies.

 To be adequately capitalized, a bank must

maintain a minimum total capital (Tier 1 + Tier
2) to risk-adjusted asset ratio of 8%.
In addition, the ratio of Tier 1 core capital to
risk-adjusted asset must be at least 4%.

An Illustration on CAR
Assets
Cash
Government Bonds issued by
OECD sovereigns
Mortgages
Commercial loans

($bn)
11
20

Liabilities & Equity

Deposits
Subordinated debt

($bn)
90
10

50
70

40
15

Fixed Asset
Goodwill
Subsidiary
General provision for bad debts
Total Assets

25
3
30
-4
205

Ordinary capital
Preference share (Perpetual
& Non-cumulative)
Convertible preferred shares
Retained earnings
Revaluation reserves
Total Liabilities & Equity

205

15
25
10

Illustration (Cont)

On-Balance Sheet

Direct credit substitutes (guarantee)

Commercial Letters of Credit
4 year interest-rate swap
(replacement costs = $4 bn)*
6 month forward foreign exchange contract
(replacement cost = $4 bn)*

Nominal
principal
amount
($ bn)
25
30
200
100

Illustration (Cont)

Compute the Capital Adequacy Ratio.

Calculation of Capital
Tier 1
Ordinary capital
Retained earnings
Preference share
cumulative)
Goodwill

(Perpetual

Tier 2
Subordinated Debt
Convertible preferred shares
Revaluation Reserves
General bad debt provision

&

Non-

40
25
15
-3
77

10
15
10
4
39

Illustration (Cont)

Capital = 77 + 39 30 * = 86
* investment in subsidiary

Illustration (Cont)

On-Balance Sheet Exposure

Type
Amount
Cash
Government Bonds
Mortgages
Commercial Loans
Fixed Asset

11
20
50
70
25

x Risk Weight
0%
20%
50%
100%
100%
Total

= Risk Weighted
Exposure
0
4
25
70
25
124

Illustration (Cont)
Off- Balance Sheet Exposure
Type
Amount
Guarantee
Commercial
Letters of Credit

25
30
Current
Exposure

Int rate swap

4
Forward foreign 4
currency swap

x
Credit
Conversion
Factor
100%
20%

x
Risk Weight
100%
100%

Sub-Total
+ Potential x Risk Weigh ##
Exposure
#
0.5% x 200
50%
1% x 100
50%
Sub-Total

= Risk
Weighted
Exposure
25
6
21
= Risk
Weighted
Exposure
2.5
2.5
5

Illustration (Cont)
# The potential exposure relates to the credit risk
that the counter-party defaults in the future while
current exposure, which is equal to the
replacement cost of the contract, measures the
credit risk if the counter-party defaults today.
Potential exposure is obtained by multiplying a
specified risk weight depending on the type of
contract with the nominal contract value.
## The risk weight is 50% under Basle 1. With Basle
II, this risk weight has been increased to 100%

Illustration (Cont)

Risk-weighted exposure :
124 + 21 + 5 = 150
Total Capital / Risk-weighted exposure:
86 / 150 = 57 %
Tier 1 Capital / Risk-weighted exposure:
77/ 150 = 51%

Capital Adequacy Ratio

It is argued over the years that the risk weights are
unsophisticated and inadequate related to default
risk. The uniform 100% weighting applied to all
commercial loans particularly receive the most
criticism.
This leads to a revised capital adequacy framework
proposed by the Basle Committee in Jun 1999
whereby external credit assessments (such as credit
ratings) are used to proxy risk of default which in turn
determines the risk weighting to be assigned.

Capital Adequacy Ratio

Generally, the higher the credit rating of a
counterparty, the lower the risk weighting assigned.

For

latest publications of the Basle Committee on

Banking Supervision, please access www.bis.org

(B) SECURITISATION
The main options available to banks to increase
flexibility of operations while adhering to regulatory
capital requirements are to liquidate assets or reduce
risk.
Liquidating of assets can be achieved through direct
sales or through securitisation.

Securitisation
In the literature, securitization is denoted in 2 ways:
1) shift of borrowers from bank loans to securities
(i.e. bonds and/ or commercial papers) issuance to
finance their funding requirements [also known as
dis-intermediation]
2) repackaging of loans and re-issuance of securities
undertaken by banks. This process involves selling
down a banks assets to outsiders which is the focus
of our discussion here.

Securitisation
Securitisation

is recognized as an efficient way of

re-distributing credit risks of the bank to outsiders.
It is also a vehicle to transform illiquid assets into
tradeable capital market instruments, and thus
provides enhanced risk diversifications and
financial stability.

Securitisation
Comparison between functions of traditional
lending and those of securitised lending.
Traditional Lending
Origination
Funding
Servicing

Securitised Lending
Origination
Sale
Servicing

Monitoring
Securitisation lending introduces the possibility of selling
down assets and eliminates the need for funding and
monitoring

 The process of securitisation typically involves

a) the loan originator (a bank)
b) the loan purchaser (an affiliated trust or
sometimes known as S.P.V.
c) the loan packager (underwriter of securities)
d) a guarantor (a government agency or an
insurance company)

e) investors (individuals or other banks who

ultimately buys the securities).
f) Credit rating agencies also play an important
role in the securitization process.

A Simplified Structure of a Securitisation

Transaction
Originating Bank

Rating Agency
Pooled Assets

Credit
Enhancement

Investors

S.P.V.

Underwriter

Securitisation Process
The underlying assets to be securitised are
identified, repackaged and transferred to the S.P.V.
The credit and prepayment risks of these assets are
identified and enhanced by a 3rd party with the
objective of aligning the risk profile of assets with that
of the investors.
A common enhancement is to buy credit insurance
from either a government agency or an insurance
company who guarantees timely payment of interest
and principal in exchange for premiums.

Securitisation Process

Another form of enhancement may involve hedging of

interest rate and foreign exchange risks using options,
swaps, forwards or other derivative instruments.

An independent rating agency evaluates the

transaction and assigns a rating in order to make the
level of risk explicit to investors.

The credit rating assigned is often different from

(usually higher than) that of the originating bank, thus
lowering the funding cost for the originating bank.

Securitisation Process

An underwriter could be engaged to give assurance

that all securities to be issued are sold at the
predetermined price. That is to say, if the issue is
undersubscribed (i.e. when demand for the securities
is less than their supply), the underwriter is obliged to
buy up the difference.

The proceeds from issuing the securities, net of

underwriting fees, are paid by the S.P.V. to the
originating bank.

Securitisation Process

The originating bank continues to collect payments

from the underlying assets which are eventually rerouted to the investors through the S.P.V.

The bank charges a servicing fee for rendering this

administrative service.

It is worth noting that a portion of the future cashflows is uncertain since defaults, payment delays or
prepayments can happen at any time.

Securitisation Process

In order to address such risks to enhance the

attractiveness of the security issue, the bank can
simply use an oversized pool of assets to provide a
safety cushion.

An alternative is to issue different classes of

securities which appeal to investors with differing risk
preferences. When cash-flows do not suffice to meet
obligations to all security holders, the deficiencies hit
the junior-ranking ones first.

Benefits and Costs of Securitisation

Securitisation provides benefits to banks in terms of
both capital and funding costs.
Securitised assets reduce the capital required to meet
regulations, since they no longer appear on the
balance sheet.
In terms of Basle capital adequacy ratio, removing
loans from the balance sheet reduces the denominator
and increases the ratio. This implies that a lesser
amount of capital is needed to maintain a given capital
adequacy ratio.

Benefits and Costs of Securitisation

However, some supervisory authorities (e.g. U.K.
& U.S.A.) only allow securitized assets to be
disregarded in the computation of capital adequacy
ratio if the bank passes on a significant element of
risk to external parties (i.e. non-recourse transfer of
credit risk).
If the credit rating of the issued securities is higher
than that of the originating bank, there is a potential
savings in the cost of funding the assets.

Benefits and Costs of Securitisation

To achieve an overall economy in the funding
cost from the securitisaton process, the reduction
in funding cost should outweigh the additional
costs incurred by the securitisation structure
required.
Bessis (2002) has identified several factors that
affect the costs and benefits of securitisation,
including:

1. The market credit spreads across rating classes

(these are market-driven). There will be a reduced
cost of funds due to the enhanced rating of
securities issued.
2. The potential savings in capital. This decreases
the minimum earnings required to generate an
adequate return to shareholders.

Benefits and Costs of Securitisation

3

Risk of the original assets and the costs of

insuring the cash-flows to investors. The
higher the risk of original assets, the higher the
cost of insuring the cash-flows to low-risk
investors.

The costs of setting up the structure, of

operating the S.P.V. and of servicing the
assets. These overheads increase the all-incost of funding since they add up to the wacc
(weighted average cost of capital) of the
issued securities.

 An additional benefit, as pointed out by

Saunders & Cornett (2003), is that the bank
profits from
servicing fees and any upfront fees from
origination.
At the same time, the bank no longer bears the
illiquidity and maturity mismatch risks, and
regulatory taxes that arise when it acts like an
asset transformer (i.e. loans stay in the balance
sheet till maturity).