capital requirement
DESCRIPTION
Capital Requirement. Reserve Requirement. European Central bank. In late 1998, ECB implemented interest bearing reserve requirement. The ECB requires a reserve ratio of 1.5 to 2.5 percent Reserve balances are credited an interest rate equal to repo rate. - PowerPoint PPT PresentationTRANSCRIPT
Capital Requirement
Reserve Requirement
European Central bank
In late 1998, ECB implemented interest bearing reserve requirement.
The ECB requires a reserve ratio of 1.5 to 2.5 percent
Reserve balances are credited an interest rate equal to repo rate.
Reserve requirement as a tax to the banking system
Around the world RR
There has been a gradual reduction on RR around the world.
Canada, New Zealand, Australia, and Switzerland have eliminated the RR all together in 1990.
RR as a tax on banking system effectively raises cost of capital and can make banks less competitive in a global market.
RR in the United States is imposed on 10 to 30 percent of deposits (checking account).
RRR In Islamic Republic
RR is 17 percent of all deposit. This huge tax reduces bank intermediation
(lending) and raises the cost of fund and reduces money supply.
Banks; public or private pass this tax to the ultimate borrowers at a margin over the 17 percent.
Banks in New Zealand, Canada, Australia, and Switzerland have created lending facilities for conducting monetary policy.
Banks can borrow at lombard rate from the central bank
Central Banks have created another facility in which they pay interest rate on the reserve that banks wish to hold
RR in Japan and USA
This ratio is approximately 1 percent of all deposit.
RR is 10 percent of checking deposit and none on time deposits in the USA.
Under 30 percent of all deposits are checking deposit subject to the 10 percent RR.
Breakdown of Financial risks
Commercial Investment Treasury Retail Asset
Banking Banking Management Management Management
operational
Credit
Market
Source: Robert Gescke
Market Risk
Risk of sudden shock, which could damage the financial system that the wider economy would suffer is an example of systematic or market risk.
Contagious transmission of the shock due to actual or suspected exposure to a failing bank or banks. Followed by flight to quality.
Panicky behavior of depositors or investors or Interruption in the payment system
Capital Requirements for Banks
Tier 1 capital is related to common stocks, non-cumulative perpetual preferred stocks, and disclosed reserves
Tier 2 capital represents debts with fixed or cumulative costs, such as cumulative preferred stocks, convertible debts, redeemable preferred shares, subordinated debts, and general provisions; and,
Tier 3 capital represents short-dated subordinated debentures retained to support the trading desk and market risks associated with derivatives transactions.
Qualifying Capitals
The Basle Accord further imposes limits on the amount of qualifying capital for the banks, i.e.,
For example, Tier 2 capital may not exceed 100 percent of Tier 1 capital, and subordinated debt may not amount to more than 60 percent of Tier 1 capital.
Tier 3 capital that is retained to support the market risk associated with trading desk may not exceed 250 percent of a bank’s tier 1 capital.
Furthermore, general provisions included in Tier 2 capital should not be greater than 1.25 percent of risk weighted assets
Capital Ratio
A bank’s capital adequacy requirement for the assets held in the bank book is estimated by the ratio of total qualifying Tier 1 and Tier 2 capital over the risk-weighted value of assets, both on and off-balance sheet.
The risk-weighted value of the bank assets is calculated as the product of the principal amount of the asset weighted by the risk weighting of an associated counterparty.
Based on the Basle Accord, banks are required to maintain a minimum capital/risk asset ratio of eight percent
Historical Simulations
The historical simulation method takes historical movements in the risk factors to simulate potential future movements.
Assume that on December 31,1998, XYZ has a forward contract to buy £10 million in exchange for delivering $16.5 million in 3 month.
XYZ Bank One$1.65/£
Spot rate
Intermediation
Banks in the Islamic Republic of Iran are largely responsible to perform all functions of:
originating, servicing, credit risk taking investing.
Disintermediation through securitization
Loan Originator (Sponsor) Third Party Guarantor (Credit enhancer) Rating Agency Special Purpose Vehicle SPV Arranger (underwriter) Liquidity Enhancer (secondary market
provider) Swap Counterparty Investors
Over-collateralization
Establishes more collateral than the underlying ABS created from the pool, the amount of which depends on:
The coupon rates underlying the collateral The rates offered to investors, The type of rating sought, The psychology of the market at the time of
the issue, among other things.
Indication of over-collateralization levels for traditional
and defeasance mortgage backed bonds (percent of par)
Bond Type of collateral Traditional Defeasance
GNMA pass-through 120-140 110-120 FNMA/FHLMC MBSs 130-145 110-120 US Treasuries 110-130 105-120 Collateralized mortgage obligations 130-150 No standard Whole loans (fixed rate) 155-175 No standard Whole loans (floating rate) 160-190 No standard Corporate bonds (AAA-B) 135-200 No standard Source: Federal Reserve Board.
Senior/Subordinated Structure
This is a self-imposed structure by the issuer to provide protection for a class of senior bondholders at the expense of another (junior) class through prioritizing cash flow of the entire pool of the underlying collateral.
This is also the most widely used internal credit enhancement structure in securitization of credit here in the United States and elsewhere.
The senior class of bondholders is willing to sacrifice yield in securing priority of claims over subordinated class in the event of bankruptcy or default of the issuer.
Shifting Interest Structure
All securitization programs involving senior/subordinated structures have incorporated a shifting interest structure, which allows disproportionate redistribution of prepayments of the underlying collateral from subordinate class to senior class according to a well-defined pre-specified schedule.
Example: Shifting Interest Structure
Shifting Interest Structure Months Percentage of
Prepayments Directed to
Senior Class 1-60 70
61-72 60 73-84 40 85-96 20
97-108 12 109 + pro rata
Source: Frank J. Fabozzi, “Bond Markets, Analysis, and Strategies.” Fifth Edition, 2004, Prentice Hall P. 234.
Arranger fee Servicer fee Liquidity fee
Sponsor BankArranger
$12.5 million
Lender A$12.5 million
Lender B$12.5 million
Lender C$12.5 million
Post Novation: Regional bank sells $50 million loans to SPV
SPV
Clean sales/no recourse proceeds
Securitization Through Novation Process
Potential Achievements in Securitization
Improved return on assets and return on equity Credit risk is reduced as securitization spreads the
risk among the major players Interest rate risk is mitigated as securitization of the
assets improves asset/liability management, Concentration risk to particular obligor(s) and or
industry is mitigated through securitization as banks attempt to off-load credits to achieve regulatory compliance.
Strictly speaking, novation represents the cleanest form of transfer from legal standpoint. However it is rarely used.
Assignment
Under the Common Law, assets can be assigned through legal assignment and equitable assignment.
An assignment is a legal assignment that satisfies four criteria of the section 136 of the 1925 of the Law of Property Act, that the assignment is:
(a) an absolute assignment, (b) in writing, (c) of the full amount of debt, and (d) notified in writing to the underlying debt obligor. In the event any of the four criteria is not satisfied, the
assignment is termed as an equitable assignment. The method of assignment in transfer of assets to SPV in a
securitization is through an equitable assignment, as originator is unwilling to inform the customers that their assets are being sold.
Participation
This is an agreement where the originating bank (seller) transfers the right to the investors a pro rata share of interest and principal from the borrower.
Participation does not transfer voting rights and does not require the consent of the borrower.
It imposes limits on the ability of the originating bank to the changes in interest rates, principal, scheduled payments, guarantor, and collateral without approval of the buyers (investors).
Legal Framework
Common law governs the process of securitization in the United States, United Kingdom and Australia.
Civil Law is the governing principle in the most other nations in a securitization process.
Civil law restricts the assignment or transfer of assets (removing assets from balance sheet as true sale without recourse by the originator or obligor). Also, insolvency laws dictate that the original obligor is to give its express consent or be notified in advance of the transfer or assignment of loan. Otherwise, the transfer would not constitute a true sale.
True Sale
There are three basic principles that ensure that an originator has surrendered control of financial assets and can legally record a sale of the assets:
- Asset isolation, - Originator or SPV control, - Originator or seller non-control.
Problems for emerging market economies
1. Country legal issues as to whether assets can be assigned to an SPV,
2. Limits imposed by rating agencies (sovereign ratings ceilings),
3. Local customs, such as whether direct debits (automatic/electronic payment of debt servicing obligation by a financial institution on behalf of an obligor or borrower) may be used for receivables and thereby qualify for securitization,
4. Lack of availability of currency swaps if receivables are denominated in the local currency.
Four-Tranche Sequential-Pay Structure
Par amount Coupon RateMaturity in
Months
Principal Pay-down
Window In Months*
Average Life**
Tranche A 21,125,000,000 0.174 36 36 1.625 year
Tranche B 21,125,000,000 0.181 64 29 4.4 years
Tranche C 21,125,000,000 0.190 85 22 6.36 years
Tranche D 21,125,000,000 0.215 102 18 7.84 years
Total collateral
IR850 billion
Pass-through
Rate0.190 4.96 years
WAC of Collatera
l0.2052
WAM of Collateral 102 Months
Four-Tranche Sequential-Pay Structure
Par amountCoupon
RateMaturity in
Months
Principal Pay-down
Window In Months*
Average Life**
In year
Tranche A 21,500,000,000 0.174 24 23 1.04
Tranche B 21,500,000,000 0.181 43 20 2.82
Tranche C 21,500,000,000 0.190 61 18 4.40
Z Bonds 21,500,000,000 0.215
Total collateralIR850
billion
Pass-through Rate 0.190 102 4.96 years
WAC of Collateral 0.2052
WAM of Collateral 102 Months
Economic Capital
Economic capital is the amount of risk capital, which a firm requires to mitigate risks undertaken as a going concern.
It is estimated by the amount of capital that the firm needs to ensure its solvency, over a specific horizon, given a pre-specified probability.
It is prudent that financial services aim to hold risk capital of an amount equal at least to economic capital.
Regulatory Capital
"Regulatory Capital" is the mandatory capital the regulators require under Basle Committee in Banking Supervesion.
On the other hand economic capital is the institution’s best estimate of required capital needed for management of various risks, and for allocating the cost of maintaining regulatory capital among different units within the organization.
Economic Capital EC
EC = credit risk capital + market risk capital + operational risk capital.
Economic capital may exceed or fall short of regulatory capital.