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BUFN 722

BUFN 722. ch-20 Capital Adequacy. Overview.

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BUFN 722

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  1. BUFN 722 ch-20 Capital Adequacy BUFN722- Financial Institutions

  2. Overview • 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. BUFN722- Financial Institutions

  3. 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 BUFN722- Financial Institutions

  4. Cost of Equity • P0 = D1/(1+k) + D2/(1+k)2 +… Or if growth is constant, P0 = D0(1+g)/(k-g) • May be expressed in terms of P/E ratio as P0 /E0 = (D0/E0)(1+g)/(k-g) BUFN722- Financial Institutions

  5. 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 BUFN722- Financial Institutions

  6. Capital and Insolvency Risk (continued) • Book value of capital • par value of shares • surplus value of shares • retained earnings • loan loss reserve BUFN722- Financial Institutions

  7. Book Value of Capital • Credit risk • tendency to defer write-downs • Interest rate risk • Effects not recognized in book value accounting method BUFN722- Financial Institutions

  8. Discrepancy Between Market and Book Values • Factors underlying discrepancies: • interest rate volatility • examination and enforcement • Market value accounting • market to book • arguments against market value accounting BUFN722- Financial Institutions

  9. Capital Adequacy in 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 BUFN722- Financial Institutions

  10. 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 BUFN722- Financial Institutions

  11. New Basel Accord (Basel II) • Pillar 1: Credit, market, and operational risks • Credit risk: • Standardized approach • Internal Rating Based (IRB) • Market Risk --Unchanged BUFN722- Financial Institutions

  12. Basel II continued • Operational: • Basic Indicator • Standardized • Advanced Measurement Approaches BUFN722- Financial Institutions

  13. 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 BUFN722- Financial Institutions

  14. 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. BUFN722- Financial Institutions

  15. 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 BUFN722- Financial Institutions

  16. 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. BUFN722- Financial Institutions

  17. 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 BUFN722- Financial Institutions

  18. Risk-adjusted Off-balance-sheet Activities • 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 used depend on the guaranty type. BUFN722- Financial Institutions

  19. Risk-adjusted Off-balance-sheet Activities • Two-step process: • Derive credit equivalent amounts as product of face value and conversion factor. • Multiply credit equivalent amounts by appropriate risk weights (dependent on underlying counterparty) BUFN722- Financial Institutions

  20. Risk-adjusted Off-balance-sheet Activities • Off-balance-sheet market contracts or derivative instruments: • Issue is counterparty credit risk BUFN722- Financial Institutions

  21. Risk-adjusted Off-balance-sheet 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. BUFN722- Financial Institutions

  22. Credit Equivalent Amounts 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 today’s prices. • Risk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight. BUFN722- Financial Institutions

  23. 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. Anet = (0.4 × Agross ) + (0.6 × NGR × Agross ) BUFN722- Financial Institutions

  24. 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 BUFN722- Financial Institutions

  25. 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. BUFN722- Financial Institutions

  26. 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. BUFN722- Financial Institutions

  27. Operational Risk and Risk-Based Capital • Advanced Measurement Approaches: • Three broad categories: • Internal Measurement Approach (IMA) • Loss Distribution Approach (LDA) • Scorecard Approach (SA). BUFN722- Financial Institutions

  28. 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 BUFN722- Financial Institutions

  29. 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. BUFN722- Financial Institutions

  30. Capital Requirements (cont’d) • Life insurance • C1 = Asset risk • C2 = Insurance risk • C3 = Interest rate risk • C4 = Business risk BUFN722- Financial Institutions

  31. Capital Requirements (cont’d) • Risk-based capital 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. BUFN722- Financial Institutions

  32. Capital Requirements (cont’d) • Property and Casualty insurance companies • similar to life insurance capital requirements. • Six (instead of four) risk categories BUFN722- Financial Institutions

  33. Pertinent Websites BIS www.bis.org Federal Reserve www.federalreserve.gov National Association of Insurance Commissioners www.naic.org U.S. Treasury Department www.ustreas.gov Web Surf BUFN722- Financial Institutions

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