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Capital AdequacyChapter 20

Financial Institutions Management, 3/e

By Anthony Saunders

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Importance of Capital Adequacy

• Preserve confidence in the FI• Protect uninsured depositors• Protect FI insurance funds and taxpayers• To acquire real investments in order to provide

financial services

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Cost of Equity

• P0 = D1/(1+k) + D2/(1+k)2 +…

Or if growth is constant,

P0 = D0(1+g)/(k-g)

• May be expressed in terms of P/E ratio as

P0 /E0 = (D0/E0)(1+g)/(k-g)

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Capital and Insolvency Risk

• Capital» net worth

» book value

• Market value of capital» credit risk

» interest rate risk

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Capital and Insolvency Risk (continued)

• Book value of capital» par value of shares

» surplus value of shares

» retained earnings

» loan loss reserve

• Credit risk• Interest rate risk

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Discrepancy Between Market and Book Values

• Factors underlying discrepancies:» interest rate volatility

» examination and enforcement

• Market value accounting» market to book

» arguments against market value accounting

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Capital Adequacy in Commercial Banking and Thrifts

• Actual capital rules• Capital-assets ratio (Leverage ratio)

L = Core capital/Assets

» 5 categories associated with set of mandatory and discretionary actions

» Prompt corrective action

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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 and interest rate risks» Off-balance-sheet activities: escape capital

requirements in spite of attendant risks

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Risk-based Capital Ratios

• Basle agreement» Enforced alongside traditional leverage ratio

» Minimum requirement of 8% total capital (Tier I core plus Tier II supplementary capital) to risk-adjusted assets ratio.

» Also, Tier I (core) capital ratio

= Core capital (Tier I) / Risk-adjusted assets must meet minimum of 4%.

» Crudely mark to market on- and off-balance sheet positions.

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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

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Calculating Risk-based Capital Ratios

• 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 four 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.

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Risk-adjusted Off-balance-sheet Activities

• Off-balance-sheet contingent guaranty contracts» Conversion factors used to convert into credit

equivalent amounts—amounts equivalent to an on-balance-sheet item. Conversion factors used depend on the guaranty type.

• Two-step process:» Derive credit equivalent amounts as product of face

value and conversion factor.

» Multiply credit equivalent amounts by appropriate risk weights (dependent on underlying counterparty)

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Risk-adjusted Off-balance-sheet Activities

• Off-balance-sheet market contracts or derivative instruments:

» Issue is counterparty credit risk

• 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.

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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 today’s prices.

• Risk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight.

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Risk-adjusted Asset Value of OBS Derivatives With Netting

• With netting, total credit equivalent amount equals net current exposure + net potential exposure.

• Net current exposure = sum of all positive and negative replacement costs.

» If the sum is positive, then net current exposure equals the sum.

» If negative, net current exposure equals zero.

Anet = (0.4 × Agross ) + (0.6 × NGR × Agross )

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Interest Rate Risk, Market Risk, and Risk-based Capital

Risk-based capital ratio is adequate as long as the bank is not exposed to:• undue interest rate risk• market risk

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Criticisms of Risk-based Capital Ratio

• Risk weight categories may not closely reflect true credit risk.

• Balance sheet incentive problems.• Portfolio aspects: Ignores credit risk portfolio

diversification opportunities.• Reduces incentives for banks to make loans.

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Criticisms (continued)

• All commercial loans have equal weight.• Ignores other risks such as FX risk, asset

concentration and operating risk.• Adversely affects competitiveness.

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Capital Requirements for Other FIs

Securities firms• Broker-dealers:

Net worth / total assets ratio must be no less than 2% calculated on a day-to-day market value basis.

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Capital Requirements (continued)

Life insurance• C1 = Asset risk• C2 = insurance risk• C3 = interest rate risk• C4 = Business risk

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Capital Requirements (continued)

Risk-based capital measure for life insurance companies:RBC = [ (C1 + C3)2 + C22] 1/2 + C4• If

(Total surplus and capital) / (RBC) < 1.0,

then subject to regulatory scrutiny.

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Capital Requirements (continued)

Property and Casualty insurance companies• similar to life insurance capital requirements.• Six (instead of four) risk categories