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RIBT: International Finance

RIBT: International Finance. Fall 2006 SCU School of Law Professor Diamond Week 9, Class 1 Capital Adequacy. Capital Adequacy: The Basel Accords (I & II). Class Outline What is bank “capital”? Why do governments regulate bank capital? Is Basel I adequate? Next class:

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RIBT: International Finance

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  1. RIBT: International Finance Fall 2006 SCU School of Law Professor Diamond Week 9, Class 1 Capital Adequacy

  2. Capital Adequacy:The Basel Accords (I & II) • Class Outline • What is bank “capital”? • Why do governments regulate bank capital? • Is Basel I adequate? • Next class: • What will the world of Basel II look like? • Market Risk and Operational Risk

  3. What is “Capital”? • A term of art • Defined by banks, regulators, BIS • Not the same as the accounting concept • Reflects international politics • GIGO: Garbage in, Garbage Out • Stripped of politics: capital represents the resources available to a financial institution to cover potential losses

  4. What is “Capital”? • Assets - Liabilities = Capital • CAR = C/A • Recalls basic accounting identity -> Assets - Liabilities = Equity • Recall, that in the banking world, loans are “assets” - they generate cash flow • Deposits are liabilities because they cost something • Key is defining what kinds of equity can really be available to help cover losses

  5. What is “Capital”? • Consider a simple example: Bank A Capital at T0 100 - 90 = 10 CAR: 10% Bank A Capital at T1 70 - 90 = -20 Failed How can a bank fail with a CAR of 10%?

  6. Why do governments regulate bank capital? 1. Prevent bank failure to limit systemic risk by providing a cushion for losses 2. Therefore, reduce impact of moral hazard by insuring that owners have substantial capital at risk thus lowering cost of bailout by LOLR 3. Helps insure fair competition

  7. The competition issue Leverage ratios help ROE Assume a $1 profit for $100 loan Country CapitalLoansLeverage% CapitalProfitROE A 10 100 100/10=10 (10/100) 10% 1 (1/10)10% B 10 200 200/10=20 (10/200) 5% 2 (2/10) 20% Regulatory competition: CAR differentials drive “profitability”

  8. A sample bank balance sheet Assets Reserves 5.00 Gov. Sec. 7.70 Bank loans 1.10 Ord. loans 110.00 PPE 1.20 Total Assets: 125.00 Liabilities Ord. Dep. 45.00 Term Dep. 69.50 Total Liabilities: 114.50

  9. A sample bank balance sheet Equity Common Stock 6.00 Retained Earnings 4.50 Total Equity 10.50 ------------------------------------- Operating Ratios: Capital (Adequacy) Ratio: 9.53% (equity to weighted assets) Leverage Ratio: 8.40% (equity to unweighted assets) Reserve Ratio: 11.11% (Central bank reqt. US = .1)

  10. The capital adequacy ratio • How do we calculate the CAR? • Under Basel I, CAR must be 8% • Capital to Asset ratio  8% • Assets are risk weighted • 0 for reserves • 0 for government securities • 20% for loans to other banks • 100% for loans for ordinary loans • So, here:

  11. CAR for sample bank • Relevant Assets include: • 5.00 for reserves but at 0 weighting • 7.70 for gov. securities, but also at 0 • 1.10 for bank loans but only 20% = .22 • 110 mn for ord loans at 100% • Equity is $10.50 • So, CAR = 10.50/110.22 = 9.53% • How would this change under Basel 1? • What if 50 mn was in mortgages and 60 mn in ordinary loans under Basel 1?

  12. A sample bank • What happens to CAR with a new loan? • A new loan changes the CAR: • As the loan is drawn down and cash is deposited in another bank, it reduces Assets, Liabilities and Reserves at the originating bank • The CAR will improve as borrower pays interest on loan (if out of another bank) thus reducing liabilities of bank, increasing capital (numerator in CAR)

  13. Basle I • 1988, Basel Committee establishes initial minimum capital rule (8%) • Recall, BIS emerged to handle war reparations • In 1970s new world of finance led to significant bank failures: most notably, Bankhaus Herstatt • “Herstatt Risk” - cross defaults leading to systemic crisis • Herstatt failed leaving forex counterparties unpaid (1974) • BIS set up Basel Committee on Banking Regulation and Supervisory Practices (1976)

  14. Basel I • Applies to “internationally active banks” • Not a treaty so not formally binding • But does not nec. Req. domestic legislation given central bank power • Can be applied through domestic legislation to all banks (EU and US do) • US will not allow FBs that do not comply with Basel I to operate in US • If not “well-capitalized” (10%CAR), insurance rates in US increase • 120 countries have adopted driven by “race to the top” pressure by US and IMF

  15. Basel I • Basel I is a “credit risk” measurement • Other risks included “market” risk and “operational” risk • Market risk refers to potential impairment of value of an asset held by a bank. • Operational risk assesses processes, people and systems, as well as impact of external shock • More detail next class

  16. Summary of Basle I Risk weights of asset classes: Cash and equivalents: 0 Govt. securities: 0 Interbank loans 0.2 Mortgage loans 0.5* Ordinary loans 1.0 Standby LOC 1.0 Does this make sense? *Why lower than ordinary loans?

  17. Summary of Basel I • Tier I capital (equity and near equity)  4% of risk-weighted assets • Tier II capital: Limited to 100% of Tier I • includes loan loss reserves limited to 1.25% of risk-weighted assets; preferred stock; sub debt • includes unrealized appreciation of 45% of gains on equities • Total capital  8% of risk-weighted assets • (if Tier I is 4%, Tier II must be 4%, and total is 8%) • Risk-based capital needs to exceed 8% to engage in expanded activities and to avoid higher supervisory scrutiny • Overall leverage ratio (capital to total assets) of at least 3%

  18. Basel I: what happens at 8%? • Increase retained earnings (reduce dividends) • Issue equity (expensive) • Issue debt (e.g. sub debt up to 2%, ½ of Tier II) • Reduce loans and/or securitize • Issue new instruments, e.g. trust preferred • Shift loan portfolio to low-risk weighted assets (regulatory arbitrage)

  19. Basel I: real world impact • Issued in 1988 • US recession in early 90s • Coincidence? • Old U.S. rule had been 6% • US gave banks until 1992 • “Right policy at the wrong time” • 80s boom led to higher interest rates leading to business/consumer defaults • Bank profits dropped; NPLs rose; writeoffs up to 25bn p.a. • Banks cut back lending and sold off good assets to meet new CAR rules

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