Structure of the Banks' Capital New Statutory Requirements and Opportunities

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1 27 Structure of the Banks' Capital New Statutory Requirements and Opportunities Birgitte Bundgaard, Financial Markets, and Suzanne Hyldahl, Market Operations INTRODUCTION AND SUMMARY Unlike other business enterprises, due to their importance to the general economy, banks are subject to official requirements concerning the size and structure of their capital. This article outlines the general considerations underlying the regulation of the banks' capital base, and how they have been implemented in Danish legislation. The framework conditions are adjusted regularly in order to ensure that the banks' functions can be performed in a timely and efficient manner. In recent years the regulation of the banks' capital base has been changed in a number of respects. These changes are part of the ongoing balancing of the interests of depositors and financial stability on the one hand, and the competitiveness of the financial sector on the other. The provisions concerning supplementary capital have been changed so that it is no longer included in the assessment of a bank's capital adequacy. However, a solution is yet to be found to the problem of a potentially incorrect basis for the issue of supplementary capital. The banks have been given access to include a new type of capital instrument in their core capital base. This will give Danish banks the same opportunities of attracting capital as banks in many other countries. A number of requirements are to ensure that use of the new capital instruments does not undermine the "real" core capital. Finally, the Danish Financial Supervisory Authority has been given the opportunity to set higher capital-adequacy requirements for financial corporations, including banks, which are exposed to an extraordinarily high risk.

2 28 THE BANKS' CAPITAL BASE The banks perform functions which are important to the general economy. Consequently, the banks have traditionally been subject to the supervision of the authorities, and to extensive legislation. The banks must observe a number of rules laid down to ensure their continued operation. This is in the interest of especially depositors, who must be certain that the funds they have entrusted to the banks are still at their disposal. Borrowers also have an interest in the continued operation of the banks. If their loans are terminated prematurely owing to e.g. the compulsory liquidation of a bank, it can be difficult at short notice to find another source of financing without incurring considerable costs. In addition to safeguarding the interests of the individual banks' customers such regulation also helps to ensure financial stability. Problems in one bank may affect the entire banking sector, which might then have a negative impact on growth and employment. The banks are required to hold liable capital at a certain level, and the requirements concern its size and the capital elements which can be included therein. Liable capital comprises the actual equity capital (primarily share capital and reserves), but may also include external financing which has some of the characteristics of equity capital. In this respect banks differ from other business enterprises, which make a clearer distinction between own funds and external financing. The essential aspect is that the capital elements included in the liable capital can be used to cover losses, that they have been paid up to the bank, and that, as a minimum, the bank is able to defer interest payments on the debt. Finally, in the event of compulsory liquidation, they must be subordinate to all other non-subordinate debt, i.e. ordinary deposits must be fully covered before dividend can be paid on the liable capital. Chart illustrates the ranking of banks' capital in the event of compulsory liquidation. RANKING OF BANKS' CAPITAL IN THE EVENT OF COMPULSORY LIQUIDATION Chart Reserves Tier { Share capital First in line to cover losses Tier ½ 2 Equity capital External financing { { Tier 2 Supplementary capital Other creditors, including deposits 2 Tier ½ is described in detail below. Depositors are covered via the Guarantee Fund for Depositors and Investors for deposits up to kr if the bank is liquidated or suspends its payments.

3 29 DEFINITION OF LIABLE CAPITAL Box Core capital Paid-up share capital + Premium on issue + Reserves (incl. profits) Deductions Own shares - Intangible assets - Tax assets, current deficit for the year = Core capital after deductions Supplementary Revaluation reserves capital + Securities with indefinite maturity and other capital contributions - Deduction of capital elements in other credit or financing institutions which are not consolidated - Deduction of interests in insurance companies = Liable capital The statutory requirements of the size of the banks' capital base are an instrument to support society's wish to protect depositors, and to maintain a stable financial sector. All other things being equal, the higher the capital reserves, the greater the bank's ability to weather unexpected losses without depositors being affected. On the other hand, a requirement for large capital reserves may curb banks' earnings potential. Conflicting interests must therefore be taken into account when setting the banks' minimum capital reserve requirements. Existing rules for the banks' capital base Under the Danish Act on Commercial Banks and Savings Banks, a bank's liable capital must at all times constitute at least 8 per cent of its riskweighted assets, etc. 2 (the capital-adequacy requirement). Danish legislation relating to banks' liable capital is based on the EU's capitaladequacy directive, which adheres to the Basle Committee's 3 overall standards in this area. However, not all capital elements which according to the directive can be part of the liable capital are included in Danish legislation. In relation to liable capital a basic distinction is made between core capital (tier capital) and supplementary capital (tier 2 capital), cf. Box Until January 2003 it is possible to include short-term supplementary capital in the statement of the capital base. Subsequently this option will no longer be available. 2 See section 2 () of the Act. 3 The Basle Committee, whose secretariat is at the Bank for International Settlements, BIS, was set up in 975 with the purpose of strengthening the stability of the international financial system. The following countries are represented on the Committee: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, the UK and the USA.

4 30 CONDITIONS FOR SUPPLEMENTARY CAPITAL Box 2 The following conditions must be met for supplementary capital to be included in the statement of liable capital: The lender's claim on the bank must be subordinate to all other non-subordinated debt in the event of compulsory liquidation. It must not be possible to repay the debt prematurely at the initiative of the holder or without the approval of the Danish Financial Supervisory Authority. The bank must be able to defer interest payments on the debt. The documents related to the issue of the securities must include a provision that it is possible to include debt and unpaid interest to cover losses, regardless of whether the bank is permitted to continue its activities. The amount must be paid up to the bank. When the capital contribution has a fixed maturity, the amount at which the capital contribution can be included is reduced annually by 25 per cent of the original principal in each of the three last years prior to the agreed maturity date. Detailed provisions for supplementary capital and the conditions for writing down the capital can be found in Order no. 040 of 5 December 995 on subordinate capital.. Core capital is what other enterprises would describe as equity capital, i.e. share capital, premiums on issue and reserves, whereas supplementary capital is financing from external sources. The supplementary capital cannot constitute more than 00 per cent of the core capital. This means that the minimum core-capital requirement is 4 per cent of the risk-weighted assets. The limit of 00 per cent for supplementary capital means that a decrease in core capital in principle has a twofold effect, since the basis for the supplementary capital is also reduced. It is possible to raise supplementary capital with a fixed or indefinite maturity. Securities must meet a number of requirements in order to be included in the statement of the liable capital. All these special conditions give the supplementary capital some of the characteristics of share capital. This means that supplementary capital resembles share capital without having its essential characteristics, e.g. that it is only affected in the event of losses, cf. Box 2. Size and structure of the banks' capital base The requirement relating to the relationship between core capital and supplementary capital is a statutory assessment of the ability of the individual types of capital to absorb losses, and the degree to which they are actually at the bank's disposal in a crisis. Moreover, the individual banks may have different incentives as regards the structure of their liable capital. The main incentive is usually the price of the capital. All other things being equal, the price of liable

5 3 PRICE OF CORE CAPITAL AND SUPPLEMENTARY CAPITAL Chart 2 Per cent Calculated interest rate for subordinated capital contributions (price of supplementary capital) Yield on equity capital (price of core capital) 3-month CIBOR (marginal price of other external financing) Note: Weighted average for 45 selected Danish banks. Source: BankScope. capital is higher than that of ordinary external financing, since the greater risk taken by the investor owing to its comparability with share capital is reflected in the price, cf. Chart 2. In addition, it is not without importance that interest paid on supplementary capital is fully taxdeductible, whereas dividend payable to shareholders is taken from the profit after tax. The solvency ratio and its structure may influence a bank's international credit rating and thereby the banks' costs of procuring capital, i.e. funding costs. A bank with a high solvency ratio may obtain funding at a lower interest rate because it has a larger buffer. On the other hand, it could be argued that a bank with a very high solvency ratio is not utilising its capital effectively. The rating agencies' assessment of the capital structure of an individual bank has become a significant factor influencing the banks' choice of capital type. If a bank is assessed to be insufficiently capitalised, including that its core-capital ratio is not sufficient to match its risk 2, it may be given a lower credit rating and thus have to pay a higher interest rate for the capital it raises. 2 The solvency ratio is defined as liable capital in relation to total risk-weighted items. Total riskweighted items consist of the credit-risk-weighted assess and off-balance-sheet items, as well as market risks. International rating agencies emphasise that the core-capital ratio (core capital as a percentage of the risk-weighted assets) should be at least 6.5 per cent.

6 32 SIZE AND STRUCTURE OF SOLVENCY RATIO Chart 3 Per cent 30 Category Category 2 Category 3 Category Core-capital ratio Supplementary capital as a percentage of risk-weighted assets Note: The Danish Financial Supervisory Authority groups Danish banks in 4 categories according to the size of their working capital. The working capital comprises: deposits, issued bonds, etc., subordinated capital and equity. Category : banks with working capital of kr. 25 billion or more (4 banks in total). Category 2: banks with working capital in the range of kr. 3 billion to kr. 25 billion (6 banks in total). Category 3: banks with working capital in the range of kr. 250 million to kr. 3 billion (78 banks in total). Category 4: banks with working capital of less than kr. 250 million (92 banks in total). Categories -3 comprise a total of 98 banks covering more than 99 per cent of the banks' aggregate balance-sheet total. Source: The Danish Financial Supervisory Authority. The capital structures of the large banks are characterised by supplementary capital (tier 2) that accounts for a considerable proportion of the solvency ratio, cf. Chart 3. The Chart also illustrates the relationship between the size of the bank on the one hand, and the supplementary capital as a percentage of the capital base on the other. It is in fact the capital reserves exceeding 8 per cent that enable banks to withstand unexpected losses. Small banks in particular often prefer to operate with larger surplus capital reserves than large banks. This is because it is resource-intensive constantly to manage the capital reserves in order to keep the capital base close to the statutory 8-per-cent requirement. In addition, the surplus reserves (capital buffer) may reflect the fact that it is more costly for small banks to procure capital at short notice. Consequently they opt for a capital buffer which is also sufficient "on a rainy day". Adequate surplus reserves are necessary to ensure both the banks and the stability of the financial sector during a period of cyclical downturn. See also "The Banks' Capital Adequacy and Earnings", Danmarks Nationalbank, Financial Stability 2002.

7 33 IMPROVING THE SUPPLEMENTARY CAPITAL A precondition for covering up to half a bank's capital requirement via supplementary capital is that the supplementary capital can absorb losses and is thereby actually at the disposal of the bank in a crisis. Until 996, the banks were able to raise "subordinate loan capital". This type of capital could only be used to cover the bank's losses in the event of compulsory liquidation. The introduction of supplementary capital in Danish legislation reflected a wish for a type of capital that could be used to cover losses even if the bank continued its activities after restructuring. However, in connection with a crisis in a bank in the early 990s uncertainty arose concerning the status of the supplementary capital. It was not clear whether the holders of the supplementary capital could petition for the liquidation of the bank, thereby obliging it to discontinue its activities. Against this background a number of reports recommended that this uncertainty should be eliminated. This was effected through an amendment of the Danish Act on Commercial Banks and Savings Banks in 200. For future issues of supplementary capital it was specified that supplementary capital is not to be included in the assessment of whether a bank is insolvent or illiquid under the Danish Bankruptcy Act. In practice, this means that if a bank defaults on its supplementary capital this in itself is not sufficient grounds to order the bank to be liquidated. However, holders of supplementary capital can always petition for liquidation if the bank is found to be insolvent or illiquid on disregarding the supplementary capital. In recent years there has been focus on the basis for issuing supplementary capital. In some cases holders of supplementary capital have subsequently claimed that the basis for issuing the supplementary capital was incorrect. This implied that the capital in question should no longer be regarded as supplementary capital, and should thus not be first in line (after core capital) to cover losses, but was solely a simple claim on any liquidated estate, in the same way as ordinary creditors, including depositors. No final solution to this problem has yet been found. A prerequisite for including the supplementary capital in the liable capital should be the certainty that the capital exists in the event of the restructuring or liquidation of a bank, and that the capital can be used as intended. Most recently in the report The Financial Sector After the Year 2000 (in Danish), the Danish Ministry of Economic Affairs' committee on the financial sector after the year 2000, September 999.

8 34 OPPORTUNITY TO INCLUDE A NEW TYPE OF CAPITAL ELEMENT In recent years it has been possible in the USA and in several European countries to take up external financing that can be included in the core capital. In 998, the Basle Committee issued overall guidelines for the use of this type of capital. The "hybrid core capital" (tier ½) has characteristics resembling both core capital (tier ) and supplementary capital (tier 2). This capital instrument takes the form of a debt instrument, and thus resembles tier 2. In the event of compulsory liquidation it is subordinate to all other debt, including the supplementary capital, which places tier ½ closer to core capital (tier ) in that situation. With the amendment of the Danish Act on Commercial Banks and Savings Banks in May 2002 it became possible to include these capital instruments in the capital-adequacy statements for Danish banks. The option to include tier ½ in the core capital will give Danish banks the same opportunities of attracting capital as banks in many other countries. The Danish provisions governing the issue of tier ½ capital have been formulated on the basis of the Basle Committee's overall guidelines, cf. Box 3. This capital instrument is not of quite the same quality as the present core capital, as it is a debt instrument which ranks superior to share capital in the event of liquidation, cf. Chart. Consequently, the Basle Committee recommends that tier ½ should not constitute more than 5 per cent of the core capital. This limitation also applies to Danish banks. Moreover, Denmark has introduced an additional requirement, in that core capital including the new capital instruments must account for at least 5 per cent of the bank's risk-weighted assets in cases where the bank chooses to use tier ½. Since tier ½ may not exceed 5 per cent of the core capital, this means that if a bank wishes to include tier ½ at its maximum, the "real" core capital must constitute at least 4.25 per cent of the risk-weighted assets, compared with the usual requirement of 4 per cent. The aim is to avoid undermining the "real" core capital. Similar requirements exist in Norway and the United Kingdom. With the present actual core capital ratios in Danish banks this requirement will be of no real significance, cf. Chart 3. The deductibility of interest payments on tier ½ makes this type of capital less expensive than traditional share capital. Another advantage is that tier ½ is permanent, unlike supplementary capital, which in Denmark typically has a fixed term to maturity. Danish banks have the opportunity to include tier ½ in their capital-adequacy statements as from January 2003.

9 35 CONDITIONS FOR DANISH BANKS' USE OF TIER ½ Box 3 The following conditions must be met for tier-½ debt instruments to be included in the core capital base of a Danish bank: The capital must be paid up to the bank, i.e. only debt instruments issued directly by the bank may be included. The debt must be of a permanent nature and must consequently not have a fixed maturity. This is to ensure that the capital is always available for the bank's activities, and not only for a limited period of time. Any premature redemption at the initiative of the bank may only take place after at least 0 years and only with the approval of the authorities (under special circumstances redemption after 5 years may, however, be permitted). Such approval will be given as a general rule if the bank still meets the capital-adequacy requirement after redemption, and its contingency capital is still adequate. The debt must be subordinate to all other non-subordinated debt (e.g. deposits and other creditors), as well as supplementary capital. No guarantees or similar may be provided which in reality change this ranking. Interest on the debt lapses if the bank has no free reserves (the profit carried forward from previous years, as well as the profit for the year). The lender is thus not entitled to receive subsequent interest payments for the years in which there was a loss (interest payments are non-cumulative). It must be possible to use debt and unpaid interest to cover losses, regardless of whether the bank is permitted to continue its activities. In comparison with the requirements of supplementary capital, tier ½ differs in that: It is subordinate to supplementary capital. It is permanent (perpetual maturity), but may, however, be redeemed after 0 years or more. For supplementary capital no permanency requirement exists, nor is there any limit to how soon approval of early redemption by the Danish Financial Supervisory Authority may be requested. Interest payments are non-cumulative, i.e. the interest claim lapses, and no arrangement can be made to defer payments. The equity-capital elements of tier ½ are as follows: The capital is subordinate to all other non-subordinated debt, as well as supplementary capital. The capital is permanent. Interest is only payable if there are free reserves, in the same way that dividend is only payable to shareholders if there are free reserves. The lender is not entitled to receive subsequent interest for years in which no free reserves were available. The capital can be used for restructuring. Although the bank can in principle avoid paying interest on tier ½ capital if it has no free reserves, this would be a very unfortunate signal to market participants. Banks will therefore be very unlikely to take this Several rating agencies, including S&P and Fitch IBCA, treat deferment of interest payments on tier ½ as tantamount to compulsory liquidation.

10 36 step. This means that tier ½ does not act as a buffer in bad times to the same extent as core capital. The credit-rating agencies' assessment of how a bank's issue of tier ½ may affect its credit rating is ambiguous, and depends on several circumstances. For instance, Moodys is generally of the opinion that the issue of hybrid core capital as a partial substitute for "real" core capital does not necessarily lead to a weaker capital structure. OPPORTUNITY TO INTRODUCE FLEXIBLE CAPITAL REQUIREMENTS With the adoption of the Financial Business Act in 200 the Danish Financial Supervisory Authority gained the opportunity to impose a higher capital-adequacy requirement on a financial enterprise than the statutory 8 per cent. This may be the case where the financial interests of the depositors, the insured, the bond owners, or other investors are perceived to be at risk. The opportunity to impose a higher capital requirement replaces the Danish FSA's previous opportunity to require extraordinary provisions. The Danish FSA may thus determine a higher capital requirement for financial enterprises which have exposed themselves to an extraordinarily high risk. A similar practice exists in the United Kingdom. Differentiated capital requirements, which to a greater degree reflect the risks taken by the individual bank, are in line with the Basle Committee's proposal for new capital-adequacy rules for banks. See for a description of the proposal.