Chapter 20

Capital Adequacy

McGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Overview
Thischapter discusses the functions of
capital, different measures of capital
adequacy, current capital adequacy
requirements and advanced approaches
used to calculate adequate capital
according to internal rating based models of
credit risk.
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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 DI owners against increases in
insurance premiums
To acquire real investments in order to provide
financial services
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Capital and Insolvency Risk

Capital
net worth
book value
Market value of capital
credit risk
interest rate risk
exemption from mark-to-market for banks
securities losses
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Capital and Insolvency Risk (continued)

Book value of capital

par value of shares
surplus value of shares
retained earnings
loan loss reserve
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Book Value of Capital

Credit risk
tendency to defer write-downs
Interest rate risk
Effects not recognized in book value accounting
method
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Discrepancy: Market versus Book Values

Factors underlying discrepancies:

interest rate volatility
examination and enforcement
Market value accounting
market to book
arguments against market value accounting
Contention that it is difficult to implement
Increase in volatility of earnings
Bias against long term assets
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Capital Adequacy: Commercial Banks and Thrifts

Actual capital rules

Capital-assets ratio (Leverage ratio)

L = Core capital/Assets
5 target zones associated with set of mandatory
and discretionary actions
Prompt corrective action
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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
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New Basel Accord (Basel II)

Pillar 1: Credit, market, and operational
risks
Credit risk:
Standardized approach
Internal Rating Based (IRB)
Market Risk --Unchanged
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Basel II continued
Operational:
Basic Indicator
Standardized
Advanced Measurement Approaches
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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
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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.
 Calculating Risk-based Capital Ratios
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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
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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 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.
 Calculating Risk-based Capital Ratios 20-16
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under Basel II
BaselI 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
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Risk-adjusted OBS Activities

Off-balance-sheet contingent guaranty contracts
Conversion factors used to convert into credit
equivalent amountsamounts equivalent to an on-
balance-sheet item. Conversion factors used depend
on the guaranty type.
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Risk-adjusted OBS Activities

Off-balance-sheet market contracts or

derivative instruments:
Issue is counterparty credit risk
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Risk-adjusted OBS Activities

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 20-20
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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 todays prices.

Risk-adjusted asset value of OBS market

contracts = Total credit equivalent amount
risk weight.
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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
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Operational Risk and Risk-Based Capital

Basel II implemented
Add-on for operational risk
Basic Indicator Approach
Gross income = Net interest Income +
Noninterest income
Operational capital = Gross income
Top-down.

Too aggregative.
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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.
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Operational Risk and Risk-Based Capital

Advanced Measurement Approaches:

Regulatory capital requirement as sum of
expected loss and unexpected loss for each
type of event:
Internal fraud
External fraud
Employment practices and workplace safety
Clients, products and business practices
Damage to physical assets
Business disruption and system failures
Execution, delivery and process management
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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.
Excessive complexity
Other risks: Interest Rate, Foreign Exchange, Liquidity

Impact on capital requirements

Competition and differences in standards
Pillar 2 demands on regulators
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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.
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Capital Requirements (contd)

Life insurance
C1 = Asset risk
C2 = Insurance risk
C3 = Interest rate risk
C4 = Business risk
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Capital Requirements (contd)

Risk-basedcapital 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.
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Capital Requirements (contd)

Property and Casualty insurance companies

similar to life insurance capital requirements.
Six (instead of four) risk categories
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Pertinent Websites

BIS www.bis.org
Federal Reserve www.federalreserve.gov
Federal Deposit Insurance Corporation
www.fdic.gov
National Association of Insurance
Commissioners www.naic.org
Securities and Exchange Commission
www.sec.gov