Chapter 20- Capital Adequacy Capital & Insolvency Risk Capital Net worth: measure of FI capital= market value

of assets market value of liabilities Market Value of Capital Credit Risk -decline in current/ expected future CF on loans lowers market value of the loan portfolio -loss in market value of loans is charged against the equity owners capital/ net worth -liability holders are protected b/c they are senior claimants to FIs assets (only begin to lose after equity holders are wiped out) -equity holders bear losses on asset portfolio first b/c they are junior claimants -larger loss = FI insolvent= negative net worth = liability holders are hurt a bit *larger net worth of FI relative to size of assets- more insolvency protection/insurance for liability holders Interest Rate Risk -rise in interest rates reduce market value of long-term fixed-income securities & loans -short-term floating rate deposits= unchanged -losses are borne on equity holders first (charges against value of their ownership claims in FI) trading securities: held for short time & carried at market value available for sale securities: carried at FV whose gains/losses are charged to OCI until sold held to maturity securities: carried at cost Book Value of Capital Components: Preferred Shares: equivalent of fixed rate debt (dividends are non deductible for tax) Common shares: BV= issue price x # of shares issued Contributed surplus: BV= (price public paid when offered par values) x # shares outstanding Retained earnings: accumulated value of past profits not paid out in dividends to shareholders Foreign currency translation adjustments: unrealized gains/losses from translations into C $ Credit Risk Under GAAP, FIs have greater discretion in reflecting/ timing problem loan loss recognition on b/s & can control impact of losses on capital If forced to be recognized- until actual loss occurs- recognized in contra account- loss realized = recognized on i/s Interest Rate Risk When all assets/ liabilities reflect their original cost- rise in interest rates has no effect on their value (b/s remains unchanged) Discrepancy b/w Market & Book Values of Equity Interest rate volatility: larger volatility- larger discrepancy Examination & enforcement: more frequent/ stricter standards- smaller discrepancy

MV= market value of equity ownership shares outstanding/ # of shares BV= (common share+ contributed surplus+ r/e + net unrealized foreign)/ # common shares outstanding Market-to-book ratio: MV/ BV: degree of discrepancy b/w MV as perceived & BV on b/s -lower the ratio: more BV capital overstates true net worth Arguments against MV -MV is difficult to implement (especially for smaller FIs w/ larger amounts of non-traded assets) -MV puts unnecessary degree of variability into FIs earnings/ net worth b/c paper capital gains/losses are put on I/S -MV makes FIs less wiling to accept longer-term asset exposures if they have to be continuously marked to market to reflect changing credit/ interest rates Capital Adequacy for Deposit-Taking Institutions Assets to Capital Multiple (ACM) -reported to OSFI by banks/trust/insurance companies ACM= total assets (including specified OBS items)/ total capital < 20 Total assets= all b/s assets + notional amount of OBS (direct credit substitutes- letters of credit & guarantees, transaction & trade related contingencies, sale & repurchase agreements) Total capital= common equity (BV) + qualifying cumulative perpetual preferred stock + minority interest in equity accounts of consolidated subsidiaries -higher the assets to capital multiple- greater the leverage -OSFI requires multiple be less than 20 Problems: -MV of FI assets could have resulted in negative MV net worth (not adequately protected against losses) -asset risk: doesnt take into account different credit, interest rate risks of assets -off-balance sheet: not all OBS activities are included Risk- Based Capital Ratios: Basel II Basel Agreement: requirement to impose risk-based capital ratios on banks in major industrialized countries Basel II: 3 pillars that together contribute to safety/ soundness of financial system Pillar 1: regulatory minimum capital requirements for credit, market & operational risk Pillar 2: regulatory supervisory review process as critical complement to min capital requirements (ensures sound internal processes & sets target capitals) Pillar 3: market discipline by developing set of requirements on disclosure of capital structure, risk exposures & capital adequacy (allows market to assess critical info) Formulas: Total risk-weighted assets (RWA): on & off b/s assets values adjusted for approx. credit/market/operational risk Capital: Tier 1 Capital: primary/ core capital (must be intended to be permanent) = common equity (BV) + non-cumulative perpetual preferred stock + innovative instruments + interests in subsidiaries intangible assets goodwill

Tier 2 Capital: supplementary capital =secondary capital resources (ex. Non-perpetual preferred shares + subordinated debt + non-controlling interest in subsidiaries Tier 3 Capital =subordinated debt used only to offset part of capital requirements for market risk Limitations: Less than 25% of T1= innovative instruments + perpetual preferred shares Less than 15% of T1= innovative instruments T2 less than 100% of T1 Less than 50% of T1= limited life instruments Total risk-based capital ratio: total capital (T1+T2)/ risk weighted assets > 10% Tier 1 core Capital ratio: core capital (T1)/ risk weighted assets > 7% RWA= Credit RWA + 12.5 x Operational risk + 12.5 x Market risk Calculating Risk- Based Capital Ratios Credit RWA= Credit RWA on B/S + credit RWA off b/s Credit Risk Weighted On-Balance-Sheet Assets under Basel II Standardized approach: each bank assigns its assets to 1 of 7 credit risk exposure categories (0,20,35,50,75,100,150%) -cash & claims on governments w/ high credit rating = 0% risk weight -risk weight increases as credit declines Credit RWA= $ amount of assets in each category x appropriate risk weight Credit Risk Weighted Off-Balance-Sheet Activities -represent contingent claims against DTI Credit-equivalent amounts: on-balance-sheet equivalent credit risk exposure of off b/s (must convert) Contingent Guarantee Contracts- Conversion Factors: -direct credit substitute standby letter of credit (SLC) guarantees= 100% conversion factor rating -sale & repurchase agreements= 100% -future performance related SLCs & unused loan commitments over a year= 50% -loan commitments under 1 year= 20% -trade-related commercial letters of credit & bankers acceptances sold= 20% Step 1: Convert OBS values into On BS equivalent amounts = FV x conversion factor Step 2: Assign OBS credit-equivalent amount to risk category = credit equivalent amount x risk weight Market Contracts/ Derivative Instruments: -counterparty credit risk: risk that counterparty will default on payment obligations (FIs would have to go back to market to replace contracts @ less favourable terms) -exchange-traded derivatives= 0% risk Over-the-counter contracts (futures, options, forwards): Step 1: Convert OBS values into On BS equivalent amounts Credit equivalent amount= potential exposure + current exposure Potential exposure: risk that counterparty will default in future (depends on future volatility of interest/ exchange rates)

Current exposure: cost of replacing derivative securities @ todays price (current rate/price for similar contract & recalculates all current/ discounted future CFs w/ current price terms) - if negative must be set to zero Step 2: Assign OBS credit equivalent risk category (100%) Credit RW value of OBS market contracts= total credit equivalent amount x 1.0 (risk weight) Netting under Basel II Netting of OBS derivatives contracts as long as bank has bilateral netting contract that clearly establishes a legal obligation by counterparty to pay/receive a single net amount on the different contracts Net potential exposure: Anet= (0.4 x Agross) + (0.6 x NPR x Agross) Agross= sum of individual potential exposures NPR= ratio of net current exposure to gross current exposure Net current exposure= sum of replacement costs Total credit equivalent= net potential exposure + net current exposure Calculating Overall Risk-Based Capital Position Interest Rate & Market Risk: determined by standardized model or internal model Operational Risk: Basic Indicator approach: structured so banks will hold 12% of their total regulatory capital for operational risk Gross income= net interest income + net non-interest income Operational capital= 0.15 x Gross income - doesnt differentiate among different areas in which operational risks differ Standardized approach: -Divides activities into 8 major business units & lines -each line has broad indicator (beta) that reflects scale/volume of activities in that area indicator= gross income reported Capital= Beta x gross income from specific line of business Total Capital= sum of each 8 business lines capital charge Advanced measurement approach: internal data subject to supervisory approval Review of Risk-Based Capital Ratio 1) incorporates credit/market/operational risks into determination of capital adequacy 2) systematically accounts for credit risk among different assets 3) incorporating off balance sheet risk exposure 4) applying similar capital requirement across all major DTIs in world Criticisms -risk weights: unclear how closely relates to true credit risk -risks weights based on external credit rating agencies: unclear if it accurately measures relative risk exposures of individual borrowers -portfolio aspects: ignores correlation/ covariances among assets

-FI specialness: DTIs wont have incentive to make loans for private sector/ corporate loans since it has such high credit risk weighting (negative effects on economy) -excessive complexity: cost vs benefits -doesnt include other risks -impact on capital requirements- causes to be more volatile -doesnt apply internationally Capital Requirements For Other FIs Securities firm: governed by provincial & self-regulatory organization Life insurance companies: Minimum continuing capital and surplus requirements (MCCSR): Tier 1= Net T1 capital/ Total capital required > 60% Total capital ratio= total capital available/ total capital required > 120% RWA= default/credit risk + market risk+ insurance risks+ interest rate + other risks Insurance risks= changes in mortality risk (death) & morbidity risk (ill health) Property & Causality Insurance Companies: Minimum Captial Test (MCT): Total capital available/ minimum capital required > 100% 150%= supervisory target w/ buffer to deal with market volatility