capital addicuacy ratio

8/6/2019 Capital Addicuacy Ratio

1/31

Capital Adequacy


2/31

Basel II AccordsProposed 2004, Implemented Soon

Three Pillars

1. Minimum capital requirements,

New methodology for calculating requiredcapital for credit risk.

Charges for operational risk

2. Supervisory review - regulators use more

comprehensive tools for assessing risk.3. Market discipline banks expected to

increase reporting to financial markets.


3/31

Basel Accords

Under the Auspices of the Bank for InternationalSettlements, the Basle Committee (whichconsists of the G-10 countries central bankgovernors), have agreed upon a scheme of

regulation which will be applied to internationalbanks. (What is the BIS?)

The key element of this scheme is a set ofrequirements relating a minimum amount of

bank capital relative to a risk based measure ofassets.

Why capital?


4/31

Capital: Tension between profitsand risk

The equity multiplier magnifies the effect ofprofits on returns which gives bank owners anincentive to increase leverage.

Bank capital absorbs losses before depositors orcreditors absorb losses. So bank depositors andcreditors prefer capital.

Risky banks may pay higher interest rates so

banks may internalize depositors preferencesBut regulators have adopted a preferencetoward capital requirements institutionalized byBasel.


5/31

Capital and Moral Hazard Consider a bank with 0 capital, full financed with deposits of $100

(which for convenience pay 0 interest rate).

Bank managers face two loan projects with differing payoff profiles. Which will the bank choose? Which is socially optimal?

Prob. ofGoodOutcome

Prob. ofBadOutcome

Interest Recovery%

Project A(Risky)

.5 .5 .2 0

Project B

(Safe)

1 0 .05 N/A


6/31

Expected Payoffs to depositors andbankers

The safe project creates value in excess ofcustomers demand for funds. The expectedvalue of the risky project is just $60, less than

what was put in the project.Assume that in the event of bankruptcy, depositors

claim all remaining assets.

The depositors have an expected payoff of 100under the safe scheme and only 50 under therisky lending scheme. They prefer safety.


7/31

Bankers payoffs

Under the safe scheme, the bankers willget a payoff of 5. Under the risky schemethe bankers will get an expected payoff of

10. They will prefer the destructive, riskyscheme. Why?

Bankers get upside pay-off of risky

scheme but put downsize risk ondepositors.


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Well capitalized banks?

Compare with bank finance by 80% depositsand 20% equity.

Under safe scheme, bank gets an expected

payoff of 25 for a 25% ROE. Under risky scheme, the bank owners receives

40 back in a good outcome and 0 back in a badoutcome for an expected payoff of 20.

Bank owners share the downside risk and avoidthe risky scheme.


9/31

Measures of Capital Risk

Chief measures are Tier 1 leverageratio and CAR (capital adequacy) ratio.

(Tier 1+ Tier 2)/RAA Tier 1/RAA Tier 1/aTA

Well Capitalized > 10% > 6% > 5%

Adequately Capitalized 8-10% 4-6% 4-5%Undercapitalized 6-8% 3%-4% 3%-4%

Significantly Undercapitalized


10/31

Recent rise in US capital ratios aswell

FDIC Historical Banking StatisticsCapita/Asset Ratio

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

1934

1938

1942

1946

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

http://www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=10


11/31

Rising Capitalization Ratios inHong Kong

Source: CEIC/HKMA

Capital/Asset Ratio

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05


12/31

Capital Adequacy Ratio

Main regulatory requirement of HK banks isthe CAR: Capital Adequacy Ratio.

CAR is

Since 1987, the Basel Accords imposed in

HK and CAR > .08. What is regulatory capital? How do you

adjust for risk?

Regulatory CapitalRisk Adjusted Assets


13/31

Historical Capital Adequacy for HKSource:

Sep-1997 Sep-1999 Sep-2001 Sep-2003 Sep-2005

20.5

20.0

19.5

19.0

18.5

18.0

17.5

17.0

16.5

16.0

15.5

15.0

HK: Capital Adequacy Ratio

%


14/31

Types of Capital

Tier 1 capital is thought to be more stable andmore aligned with the concept of capital as thefunds that owners have invested in the banks

(i.e. equity capital, perpetual preferred stock andretained earnings)

Tier 2 capital are funds that protect depositorsbut may be withdrawn (subordinated debt) or is

already somewhat committed to other purposes(reserves).


15/31

Measuring Capital

For regulatory purposes, capital is dividedinto two tiers.

Tier 11. Common Stock at Par + Surplus2. Undivided Profits/Retained Earnings3. Minority Interests

Tier 21. Subordinated Debt2. General Loan Reserves (LLA)3. Other Reserves (similar to undivided profits)

MinusIntangible

Assets, Goodwill


16/31

Risk Adjusted Assets

Loans & securities are placed in a number ofbuckets Aj

On with associated risk weights based on

the identity of the borrower

Off-balance sheet items are converted to creditequivalents with credit conversion factor, ccfk, based

on type of item.

AjOff = ccf1 Aj,1

Off + ..

Aj = AjOn + Aj

Off

Risk Adjusted Assets: w1A1 + w2A2 + w4A4


17/31

Risk adjustment ofassets:

Standardized Approach

Different assets aredifferentiated into bucketswhich have different riskweights.

Risk Bucket Loans Risk Weights

1. Domestic Central Govt. 0%

2. Public Entities, ForeignGovernments (OECD),

Banking.

20%

3. Secured Residential Lending. 50%

4. Commercial and consumer loans 100%


18/31

Timeline

Basel Accords signed in 1987 imposed risk-based capital requirements

Basel Market Risk Amendment in 1996.

Impose market risk requirement

Problems with Basel I

Risk weights too broad

Does not account for new risk managementtechniques.


19/31

Standardized ApproachBasel II

Meant for smaller, less sophisticated banks. New risk weights (0%; 20%; 50%; 100%, 150%)

used for assessing capital required based on creditrating and type of assets.

Uses External Ratings (where available)

Unrated (most SMEs) weighted at 100%

35% weight for claims secured by ResidentialMortgage

100% weight for claims secured by CommercialMortgage


20/31

Set of risk weights(ranging from 0 to150%) for differenttypes of assets with

different credit ratingsclaims on

Sovereign

Public Entities

MDB

Banks

Securities Firms

Corporate

Residential Lending

Cash

Regulatory Retail

Other Assets Past Due


21/31

Credit Conversion FactorsOff Balanced Sheet

Type ccf

1. Standby LOC, Guarantees,Securitization w/ Recourse

100%

2. LT Loan Commitments 50%

3. Commercial LOC 20%

4. Finanical Derivatives (dependson type & maturity) 0-15%

5. ST Loan Commitments 0%


22/31

Market Risk

Banks with significant trading activity(trading assets+liabilities > 10% of totalassets) must have additional capital

beyond 8% of credit risk adjusted assets.

Banks should calculate VAR of foreignexchange and securities positions and

allocate some capital equal to 8% of VAR.


23/31

IRB Approach

Internal Ratings Based: Foundation ApproachBanks examine lending and associated assets and calculate probability of default

for loans. Regulators provide formulas for associated capital requirement.

Only banks that can demonstrate

competence can use IRB approac

Internal Ratings Based: Advanced ApproachBank constructs own (supervisor approved) formulas tocalculate.

PD: probability of default,EAD: exposure of bank to defaultLAD: Loss at defaultM: remaining maturity

and uses these to determine required capital.


24/31

Operations Risk

Loss of funds through operatingcircumstances may be a source of risk forbanks.

Standardized Approach: Allocate capital toequal 15% of 3year lagged moving average ofrevenues.

Subject to regulatory approval, most

sophisticated banks may design their ownsystems for operations risk.


25/31

How much capital?

Depends on risk appetite of the bank,regulatory requirements, maintaining agood debt rating, limits of internal growth,

relative cost of debt and equity financing.

Use statistical ratios to describe the riskappetite of banks.


26/31

Capital and Growth

Capital adequacy limitations can act asbrake on bank growth.

Consider a bank that can achieve 10%

growth on the asset side of its balancesheets and also can borrow freely toachieve that growth.

An adequately capitalized bank mustachieve 10% capital growth or fall belowthe adequacy standard.


27/31

Achieving Capital Growth

Reduce dividend payout ratios

Earn higher ROA to increase cash flow (mayincrease risk)

Change mix of assets to those with smallercapital charges

Move assets off balance sheet

Issue more stock/subordinated debt.


28/31

Internal Growth Rate

The change in the capital of the bank thatcan be obtained from internal sources is:

Retained Earnings Retained Earnings Net Income

Equity Capital Net Income Equity Capital =


29/31

Modern Capital Management

Instead of evaluating how much capital the bankneeds, modern banks will evaluate lines ofbusiness and how much capital should be

allocated for the assets needed to generateincome in that line.

Different businesses require different quantitiesof capital. Capital is more expensive than debt,

so business requiring heavy capitalization mustearn higher returns.


30/31

Basel II Accords

In what ways have recent eventschallenged the Basel Accords?


31/31

Reading List

Bank for International Settlements BaselII OverviewInternational Convergence of Capital Standar

KPMG Canada, 2006, -Basel II: A Worldwide Challenge for the Banki
http://www.bis.org/publ/bcbs128a.pdfhttp://www.kpmg.ca/en/industries/fs/banking/documents/BaselII.pdfhttp://www.kpmg.ca/en/industries/fs/banking/documents/BaselII.pdfhttp://www.bis.org/publ/bcbs128a.pdf

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