Objectives. How Much Capital Is Enough. Capital Adequacy. Cost of holding capital

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1 How Much Capital Is Enough? Objectives To understand how and why the current regulatory regime came into being To understand the changes in bank risk profiles and banking market structure that provide momentum for new regulations Capital Adequacy Key element to bank safety and soundness Cost of holding capital Restricts banks ability to borrow Reduces ROE Ultimately reduces banks ability to lend

2 Historical Context 1864, National Bank Act set static minimum capital requirements based on population of banks service area Example: 1954 American Bankers Association statement f principles rejected numerical formulas for determining capital adequacy Historical Context Judgment based, subjective bank-bybank approach Franklin National bank (1974) and First Pennsylvania Bank(1980) were relatively large banks that failed 80 s 1981, Federal banking agencies introduced explicit numerical regulatory requirements Minimum primary capital adequacy ratio of 6 percent for community banks and 5 percent for larger regional institutions. Threshold capital-to-assets ratio of 6 percent and minimum ratio of 5 percent 80 s 1983, Congress passed International Lending and Supervision Act (ILSA) directing federal banking agencies to issue regulations addressing capital adequacy uniform capital requirements Minimum primary capital for: Large banking organizations increased from 5 percent to 5.5 percent of adjusted total assets Community banks capital requirements fell from 6 percent to 5.5 percent

3 80 s Cont. 1986, Concern that the primary capital ratio failed to differentiate among risks and did not provide an accurate measure of the risk exposures Regulators began to study the risk-based capital framework of other countries France-1979 UK-1980 West Germany-1985 Basel Accord 1988, the central bank governors of the Group of Ten (G-10) countries adopt the Basel Accord Under Accord, U.S. assets and off-balanceitems are risk-weighted based on their perceived credit risk using four categories Risked based capital framework remains in effect today Credit Risk Categories Most claims are weighted at 100 percent Residential mortgages are weighted at 50 percent Claims on or guarantees provided by qualifying banks and other entities are weighted at 20 percent Very low risk, such as those guaranteed by qualifying government are weighted at 0 percent Basel I Capital Requirements

4 Prompt Corrective Action U.S. depository institutions are subject to PCA regulations, institutions are classified into categories based on their regulator capital ratios Highest capital ratios classified as well capitalized Lower capital ratios assigned lower capital categories Less than well capitalized have restrictions or conditions on certain activates Minimum leveraged ratio for strong institutions is 3 percent and 4 percent for other banks Bank Capital Levels Results of Risk-Weighted Capital Requirements Measured on-balance-sheet capital ratios have risen since Accord took effect in 1992 without evident contraction in credit availability Banks seen increase not only in equity capital, but also revenues and income Capital Growth

5 The need for change Blunt instrument with respect to credit-risk differentiation Measure tends to understate true degree of credit risk in bank portfolio To enhance ability to enforce capital adequacy bank supervisor s need the ability to harness two tools: Market Discipline Risk Metrics employed by banks Change in Bank Asset Mix The need for change Reasons for New Accord Need for Financial Transparency For market discipline to be effective,market participants must be adequately informed about the risks banks are taking Use of internal measures to set capital requirements for credit risk Regulators Keep pace with financial innovation Better align capital charges with underlying risk Promote better risk management Financial Institutions Better aligns business decisions with internal capital allocation methods Potential for lower minimum capital charge

6 Pillar 1: Minimum Capital Requirements Basel II Framework Three Pillars Pillar 2: Supervisory Review Process Pillar 3: Market Discipline Basel II Will include more risk buckets to provide enhanced risk sensitivity Will rely on on external ratings agencies to help determine risks Internal ratings based (IRB) approach Credit Risk Operational Risk Market Risk Banks review own capital adequacy Supervisors evaluate bank assessments Increased disclosure given reliance on internal assessments Difference in Capital Requirements Under Basel II, Capital Requirements Will Vary Much More With the Risk of the Borrower Minimum Capital Required for a $100 Commercial Loan of Quality: a Capital Standards in Place Present AAA Credit Risk BBB- Credit Risk B Credit Risk Prior to 1981 Judgmental Judgmental Judgmental (Prior to risk-based framework) $5.00 $5.00 $ Present (Risk-based standards of Basel Accord) $8.00 $8.00 $8.00 Proposed Basel II Standards AAA Credit Risk BBB- Credit Risk B Credit Risk Proposed Basel II Standardizedb $1.81 $8.21 $12.21 Proposed Basel II Foundation IRBc $1.41 $5.01 $18.53 Proposed Basel II Advanced IRB d $0.37 to $4.45 $1.01 to $14.13 $3.97 to $41.65