FIN 683 Financial Institutions Management Capital Adequacy
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1 FIN 683 Financial Institutions Management Capital Adequacy Professor Robert B.H. Hauswald Kogod School of Business, AU Why Regulate Banks? The case for regulation financial markets are different: why? Various levels of market failure borrowers depositors shareholders The issue: banks central to economy positive and negative externalities: regulation 2
2 Cause and Effect Rationale of bank regulation macroeconomic importance Regulatory instruments 1. Reserve requirements 2. Suspension of convertibility 3. Deposit insurance 4. Capital-adequacy requirements Regulation and its political economy 3 EVOLUTION OF THE WORK OF THE BASEL COMMITTEE ON BANKING SUPERVISION Issued Implemented Basel I July 1988 December Market risk December 1996 December 1997 amendment Basel II June 2004 December 2007 Basel 2.5 July 2009 December 2011 Basel III December 2010 January 2013 January Amendment June 2011 January
3 Importance of Capital Adequacy Absorb unanticipated losses 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 5 Banks Long-Run Capital Levels Per cent 25 United (c) (d) States (a) United Kingdom (b)
4 Capital Adequacy and TARP Part of TARP : Capital Purchase Program Encourage building of capital to increase flow of funds Treasury purchase of $200 billion of senior preferred shares scandal: a lot of the money directly shooting through to shareholders cashing out 7 TARP No compensation incentives for senior management to take excessive risks Required payback of bonuses based on inaccurate financial reports Prohibition of golden parachutes Agreement not to deduct more than $500,000 for each senior executive for tax purposes Emergency funding to Citigroup ($25 billion), BOA ($20 billion) August 2009: $250B allocated. $72.5B paid back, $9.5B in dividends and assessments 8
5 Capital and Insolvency Risk Capital: net worth vs. book value what matters? Vitamin C(ash) Market value of capital Credit risk Interest rate risk During financial crisis, FASB clarified (?) position on market value accounting allowed management to exercise greater discretion for pricing illiquid assets: dangerous? 9 Book Value and Credit Risk Book value of capital Par value of shares + surplus value of shares Retained earnings Loan loss reserve Credit risk: tendency to defer write-downs May require pressure from regulators to actually write-down substandard loans Only an outright loss requires 100 percent charge-off 10
6 Discrepancy: Market vs Book Values Market value accounting Market to book: lower ratio indicates greater overstatement of true economic value Arguments against market value accounting: Contention that it is difficult to implement, especially for small banks Increase in volatility of earnings: who said cash? Premature closure under prompt corrective action Bias against long term assets 11 Capital Adequacy: Commercial Banks and Thrifts Capital - Assets ratio (Leverage ratio) L = Core capital/assets 5 target zones associated with set of mandatory and discretionary actions : Regulators acted quickly Stress tests of 19 largest DIs (February 2009) By early June 2009, DIs had raised $149.45B of capital 12
7 Leverage Ratio Market value may not be adequately reflected by leverage ratio Asset risk ratio fails to reflect differences in credit & interest rate risks Off-balance-sheet activities escape capital requirements 13 Capital Adequacy Ratio Main regulatory requirement of US banks is the CAR: Capital Adequacy Ratio. CAR is Regulatory Capital Risk Adjusted Assets Since 1987, the Basel Accords imposed in US so that CAR > 0.08 on average CAR about 9.6%: why? what is regulatory capital? how do you adjust for risk? 14
8 Types of Capital Tier 1 capital is thought to be more stable and more aligned with the concept of capital as the funds that owners have invested in the banks (i.e. equity capital, perpetual preferred stock and retained earnings) Tier 2 capital are funds that protect depositors but may be withdrawn (subordinated debt) or is already somewhat committed to other purposes (reserves). 15 Measuring Capital For regulatory purposes, capital is divided into two tiers. Tier 2 1. Subordinated Debt 2. General Loan Reserves (LLA) 3. Other Reserves (similar to undivided profits) Tier 1 1. Common Stock at Par + Surplus 2. Undivided Profits/Retained Earnings 3. Minority Interests Minus Intangible Assets, Goodwill 16
9 Three Pillars of Basel II and III Capital Adequacy Pillar I Pillar II Pillar III Minimum Capital Requirement Supervisory Review Process Market Discipline 17 Basel II Accord Pillar 1: Credit, market, and operational risks Credit risk: Standardized approach Internal Rating Based (IRB): supervisory validation of proprietary model Market risk unchanged (from 1998) Operational: Basic indicator 18 Standardized
10 Basel II Pillar 2: importance of regulatory review Ensures sound internal processes to manage capital adequacy Pillar 3: detailed guidance on disclosure about capital structure risk exposure capital adequacy of banks 19 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 20
11 Risk-based Capital Measurement 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% Enforced alongside traditional leverage ratio Banks typically hold more capital: 9.6% tells us what? 21 Risk Adjusted Assets Loans & securities are placed in a number of buckets A j On with associated risk weights based on the identity of the borrower Off-balance sheet items are converted to credit equivalents with credit conversion factor, ccf k, based on type of item. A j Off = ccf 1 A j,1 Off +.. A j = A j On + A j Off Risk Adjusted Assets: w 1 A 1 + w 2 A 2 + w 4 A 4 22
12 Risk adjustment of assets: Standardized Approach Risk Bucket Loans Different assets are differentiated into buckets which have different risk weights. Risk Weights 1. Domestic Central Govt. 0% 2. Public Entities, Foreign Governments (OECD), Banking. 20% 3. Secured Residential Lending. 50% 4. Commercial and consumer loans % Standardized Approach Basel II Meant for smaller, less sophisticated banks. New risk weights (0%; 20%; 50%; 100%, 150%) used for assessing capital required based on credit rating and type of assets. Uses External Ratings (where available) Unrated (most SMEs) weighted at 100% 35% weight for claims secured by Residential Mortgage 100% weight for claims secured by Commercial Mortgage 24
13 IRB Approach Only banks that can demonstrate competence can use IRB approach Internal Ratings Based: Foundation Approach Banks examine lending and associated assets and calculate probability of default for loans. Regulators provide formulas for associated capital requirement. Internal Ratings Based: Advanced Approach Bank constructs own (supervisor approved) formulas to calculate. PD: probability of default, EAD: exposure of bank to default LAD: Loss at default M: remaining maturity 3/16/2016and uses these Capital to Adequacy determine Robert required B.H. Hauswald capital. 25 Market Risk Banks with significant trading activity (trading assets+liabilities > 10% of total assets) must have additional capital beyond 8% of credit risk adjusted assets. Banks should calculate VAR of foreign exchange and securities positions and allocate some capital equal to 8% of VAR. 26
14 Economic capital Target Loss Coverage Level Requirement depends on both the nature of its business and its risk tolerance Shape of loss distribution and desired level of coverage Assigned to all businesses based on a common point on the Bank s loss distribution This ensures that return measures are comparable Example: Bank of America covers 99.97% of the one-year portfolio loss distribution This is the risk of default for AA-rated debt S&P Rating 1Yr Default Probability Capital Coverage AAA 0.01% 99.99% AA 0.03% 99.97% A 0.11% 99.89% BBB 0.30% 99.70% BB 0.81% 99.19% B 2.21% 97.79% CCC 6.00% 94.00% CCC 11.68% 88.32% C 16.29% 83.71% Probability Capital Standard A AA AAA Coverage Level Loss Rate 99.90% 99.97% 99.99% Capital required to achieve target coverage 3/16/2016 Capital Adequacy 27 Robert B.H. Hauswald Calculating Risk-based Capital Ratios Credit risk-adjusted assets: Risk-adjusted assets = Risk-adjusted on-b/s assets + Risk-adjusted off-b/s assets Risk-adjusted on-balance-sheet assets assets assigned to one of five categories of credit risk exposure: reflects credit rating agency assessments = equals the weighted sum of the book values of the assets, where weights correspond to the risk category 28
15 Risk-adjusted OBS Activities Off-balance-sheet contingent guaranty contracts Conversion factors used to convert into credit equivalent amounts equivalent to an on-balance-sheet item Conversion factors used depend on the guaranty type the liquidity put example 29 Aggregating OBS Activities Credit risk weights for OBS are the same as the weights assigned to on-balance-sheet items 1. Conversion factor used to convert to credit equivalent amounts 2. multiply credit equivalent amounts by appropriate risk weights Off-balance-sheet market contracts or derivative instruments: counterparty credit risk market-traded vs. over-the-counter derivatives Credit equivalent amount divided into potential and current exposure elements 30
16 Credit Risk Capital Model Schema Credit Risk Capital Migration Risk Scalar Default Risk Capital Unexpected Loss Contribution Capital Multiplier Expected Loss Unexpected Loss Diversification Factor Default Probability Exposure Severity Volatility of Severity Correlation Relative Exposure Size 31 Credit Equivalent Amounts of Derivative Instruments Credit equivalent amount of OBS derivative 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 32
17 Interest Rate and Market Risk Risk-based capital ratio is adequate as long as the bank is not exposed to: Undue interest rate risk Market risk Since 1998, DIs required to calculate an add on to 8% capital requirement for market risk Standardized model Internal model 33 Criticisms of Risk-Based Capital 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 to lend Excessive complexity Other risks such as interest rate and liquidity Impact on capital requirements Competition and differences in standards Pillar 2 demands on regulators may be too great 34
18 Obfuscation and Opacity of Complex Financial Giants WELL, YA BETTER L ARN HOW IF YO RE GONNA BE A GOVERNMENT OFFICIAL!! Basel II does not specify what a country should do if standards are violated. Also, no penalties specified for countries that breach standards. 35 Operational Risk and Risk-Based Capital Basel II implemented: add-on for operational risk Basic Indicator Approach Gross income = Net interest Income + Noninterest income Operational capital = α Gross income Top-down: too aggregative, because all operational risks are not the same 36
19 Operational Risk Advanced Measurement Approaches: Regulatory capital requirement as sum of expected loss and unexpected loss for each type of event: Internal fraud External fraud Employment practices and workplace safety Clients, products, and business practices Damage to physical assets Business disruption and system failures Execution, delivery, and process management 37 KEY BUILDING BLOCKS OF BASEL III Increased Quantity / Quality of Capital Countercyclical Capital Buffer Conservation Capital Buffer Additional requirements for Global and Domestic Systemic Banks Global Liquidity Standards Leverage Ratio 38
20 Building Blocks of Basel III 1. Raising quality (Tier 1 6%, of which TCE - 4.5%), level (8+2.5% CCB), consistency (deductions mostly from TCE) and transparency of capital base 2. Improving/enhancing risk coverage on account of counterparty credit risk 3. Supplementing risk based capital requirement with leverage ratio 4. Addressing systemic risk and interconnectedness 5. Reducing pro-cyclicality and introducing countercyclical capital buffers (0-2.5%) 6. Minimum liquidity standards 39 Implications of Basel III: Economy IIF study: loss of output of 3% in G3 (US, Euro Area and Japan) on full implementation during Basel Committee study: modest impact of 0.2% on GDP for each year for 4 years for 1% increase in TCE Similarly, for 25% increase in liquid assets, half the impact of 1% increase in TCE however, long term gains will be immense 40
21 Implications of Basel III: Banks Global banks could have a gap of liquid assets of 1,730 billion: to be met in four years Global banks could have a capital shortfall of 577 billion to meet 7% common equity norm to be met in eight years Tier 1 capital ratio falls to 5.7% from 11.1% under the new definition / adjustment of capital and increase in risk coverage (RWAs) Therefore, long phase-in arrangements 41 IMPLEMENTATION OF BASEL III Leverage ratio Minimum Common Equity Capital Ratio Supervisory monitoring Parallel run 1 January January 2017 Disclosure starts 1 January 2015 Migration to Pillar 1 As of 1 Jan % 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital Conservation Buffer 0.625% 1.25% 1.875% 2.5% Minimum common equity plus capital conservation buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Phase-in deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials) 20% 40% 60% 80% 100% 100% Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum Total Capital plus conservation buffer Capital instruments that no longer qualify as non-core Tier 1 or Tier 2 capital 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5% Phased out over 10 year horizon beginning 2013 Liquidity coverage ratio Net stable funding ratio Observation period begins Observation period begins 60% 70% 80% 90% 100% CET1 = Common Equity Tier 1; DTAs = Deferred Tax Assets; MSRs = Mortgage Servicing Rights Introduce minimum standard 42
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