ACC3019

Capital Regulation Overview

Capital Regulation
 Overview
Functions of capital
Different measures of capital adequacy
Current capital adequacy requirements
Advanced approaches to calculate adequate
capital
 Importance of Capital Adequacy
Absorb unanticipated losses and 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
 Capital Adequacy and TARP
Part of TARP 2008-2009: Capital Purchase
Program
Encourage building of capital to increase flow of
funds
Treasury purchase of $200 billion of senior
preferred shares
 Capital Adequacy and TARP
Required certain standards
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 2012: $245B allocated. $234B paid back, $26.25B in
dividends and assessments
 Capital and Insolvency Risk
Capital
Net worth
Book value
Market value of capital
Credit risk
Interest rate risk
During financial crisis, FASB clarified position on
market value accounting and allowed
management to exercise greater discretion for
pricing illiquid assets
 Capital and Insolvency Risk (continued)

Book value of capital

Par value of shares
Surplus value of shares
Retained earnings
Loan loss reserve
 Book Value of Capital
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
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
Could force premature closure under prompt corrective action
Bias against long term assets
 Capital Adequacy: Commercial Banks and Thrifts

Actual capital rules

Capital - Assets ratio (Leverage ratio)
L = Core capital/Assets
5 target zones associated with set of mandatory
and discretionary actions
2008-2009: Regulators acted quickly
Stress tests of 19 largest DIs (February 2009)
By early June 2009, DIs had raised $149.45B of
capital
 Leverage Ratio
Problems with 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
 New Basel Accord (Basel II)
Pillar 1: Credit, market, and operational risks
Credit risk:
Standardized approach
Internal Rating Based (IRB)* (Appendix 20A)
Market risk unchanged (from 1998)
 Basel II (continued)
Operational:
Basic indicator
Standardized
Advanced measurement approaches
 Basel II (continued)
Pillar 2
Specifies importance of regulatory review
Ensures sound internal processes to manage capital
adequacy
Pillar 3
Specifies detailed guidance on disclosure of capital
structure, risk exposure, and capital adequacy of
banks
 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
 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
 Calculating Risk-based Capital Ratios
Credit risk-adjusted assets:
Risk-adjusted assets = Risk-adjusted on-
balance-sheet assets + Risk-adjusted off-
balance-sheet assets
Risk-adjusted on-balance-sheet assets
Assets assigned to one of five categories of credit risk
exposure
Risk-adjusted value of on-balance-sheet assets equals the
weighted sum of the book values of the assets, where
weights correspond to the risk category
Calculating Risk-based Capital Ratios

Basel I criticized since individual risk weights

depend on broad borrower categories
All corporate borrowers in 100% risk category
Basel II refines differentiation of credit risks
Incorporates credit rating agency assessments
 Risk-adjusted OBS Activities
Off-balance-sheet contingent guaranty
contracts
Conversion factors used to convert into credit
equivalent amountsamounts equivalent to an
on-balance-sheet item
Conversion factors used depend on the
guaranty type
 Risk-adjusted OBS Activities
Credit risk weights for OBS are the same as
the weights assigned to on-balance-sheet
items
Off-balance-sheet market contracts or
derivative instruments:
Issue is counterparty credit risk
Distinction between market traded derivatives
and over-the-counter in terms of counterparty
risk
 Risk-adjusted OBS Activities
Basically a two-step process:
Conversion factor used to convert to credit
equivalent amounts
Second, multiply credit equivalent amounts by
appropriate risk weights
Credit equivalent amount divided into
potential and current exposure elements
 Credit Equivalent Amounts of Derivative Instruments

Credit equivalent amount of OBS derivative security

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 todays prices
Risk-adjusted asset value of OBS market contracts =
Total credit equivalent amount risk weight
 Basel III
Capital Conservations Buffer
Countercyclical Capital Buffer
Global Systemically Important Banks
Leverage Ratio
 Interest Rate Risk, Market Risk & Risk-based Capital

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 to adjust for market risk
Standardized model
Internal model
 Operational Risk and Risk-Based Capital

Basel II implemented
Add-on for operational risk
Basic Indicator Approach
Gross income = Net interest income + Net
noninterest income
Operational capital = Gross income
Top-down
Too aggregative, because all operational risks are
not the same
Operational Risk and Risk-Based Capital

Standardized Approach
Eight major business units and lines of business
Capital charge computed by multiplying a weight,
, for each line, by the indicator set for each line,
then summing
 Operational Risk and Risk-Based Capital
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
 Criticisms of Risk-based Capital Ratio
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 for banks to make loans
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
 Capital Requirements for Other FIs

Securities firms regulated by SEC

Close to a market valuation approach
Broker-dealers
Net worth / total assets ratio must be no less than
2% calculated on a day-to-day market value basis
Special treatment of illiquid assets
 Capital Requirements (continued)

Life insurance
C1 = Asset risk
C2 = Insurance risk
C3 = Interest rate, credit, and market risk
C4 = Business risk
 Capital Requirements (continued)

Risk-based capital measure for life

insurance companies:
RBC = [ (C1 + C3)2 + C22 + C32 + C42] 1/2 + C4
 Capital Requirements (continued)

Property and casualty insurance companies

Similar to life insurance capital requirements, but
some differences since risk exposures for P/C not
identical to life insurance exposures
Six (instead of four) risk categories
 Important Websites
BIS www.bis.org

Federal Reserve www.federalreserve.gov

Federal Deposit Insurance Corp. www.fdic.gov

National Association of Insurance Commissioners www.naic.org

Securities and Exchange Commission www.sec.gov

Basle Presentations
Question to be sent