Managing Bank Capital

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Bank Financial Statements Analysis

Managing bank capital

FFAS 2009


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Session structure

FFAS 2009

Explain the four roles thatcapital plays in a bank

Explain the main componentsof Tier 1 and Tier 2 capital

Explain how risk-weightedassets are calculated under

the standardised approach

On completion of this session students should be able to:

Explain the key differencebetween the standardisedapproach and internal ratingsbased approach

Explain the key changes inmain measures of Basel 3 and

likely implications


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Equity as a funding source

No explicit cost free!

Required return

Hurdle rate - IRR approach

Equitytreated asfree funds

Balance sheet

Loan asset 10,000

Interest bearing funding (e.g. deposits) 9,600Equity 400

Income statement

Interest income (10,000 @ 9.5%) 950

Cost of interest bearing funds (9,600 @ 8.0%) (768)

Pre-tax cost of equity (@ 24%)Operating costs (100)

Operating profit 82

Economic profit

Return on equity 20.5%

ROE in excess of COE -3.5%

Equity charged atCOE

10,000

9,600400

950

(768)

(96)(100)

(14)

Example

Capital charged - NPV approach


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Transaction capital allocation

Capital allocation critical for exposure appraisal

How to determine the appropriate capital for an exposure?

Loan principal

Interest bearing funding

Allocated equity (4% of loan)

Operating profitInterest income (@ 9.5%)

Cost of interest bearing funds (@ 8.0%)

Pre-tax cost of equity (@ 24%)

Operating costs

Value added

Value added (% points above ROE)

4% equity

10,000

9,600

400

950

(768)

(96)

(100)

(14)

-3.5%

Example ($m)

10,000

9,800

200

950

(784)

(48)

(100)

18

9.0%

2% equity


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The Basel Accord Original and Basel 2/3

Bank InternationalSettlements (BIS)

Level playing field forinternationally active banks

Reduce scope for regulatoryarbitrage

Brought in (1988) followingcollapse of Bretton Woods

Volatile interest rates andfloating rate exchange ratesled many to believe thatrisks banks faced weregreater than in the past

General perception that

banks were undercapitalised

Covered credit, FX andinterest rate risk

Market risk amendment2000, revised 2009 (Basel2.5)

Basel 2 implementation 2007-2012

Standardised approach rule drivenand relatively straightforward toimplement

Internal rating based (IRB)approach suitable for banks withmore sophisticated systems andhistoric data on credit losses

Banks can opt for a mix ofapproaches

Basel 3 implementation 2012-18

Three pillars in Basel

Minimum capital requirements

Regulatory responsibilities

Bank risk disclosures Specifies minimum capital

requirements but many regulatorsimpose higher requirements

But many critics of both the need foran accord and its specific nature


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Basel Approach

RiskCapital

Major part of risk-weighted assets(RWAs) relates to credit risk

Assets given risk-weighting toreflect level of credit risk

Other risks (market, interest rate,FX and operational) translated into

RWA equivalents Risk capital comprises equity(less intangibles and otheradjustments) plus certain forms oflong-term debt

Minimum risk capital requiredspecified as % of total RWAs andRWA equivalents

Assets

Government

bonds

Deposits withother banks

Bonds (AAAthrough tounrated)

Residentialmortgages

Ratedcorporates

Credit cards,personal loans

Unrated &SMEs

Other

Other liabilities

Equity

Long term debt

Short andmedium termwholesalefunding

Deposits

Liabilities

RWAs andequivalents*

Operational

Interest rate

FX

Market

Credit

*Not to scale

Convertedinto


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Basel 2 Tier 1 Capital Equity

Core Tier 1 capitalshareholders equity

Less goodwill and intangible assets

Reversal of other comprehensive income (US GAAP)

Reversal of unrealised AFS gains/losses (net of deferred tax)

Reversal of fair value gains/losses on bonds issued by bank from

changing credit spreads (net of deferred tax)

Reversal of revaluation of premises

Reversal of reserves created from use of hedge accounting

Less dividends declared but not paid

Less 50% of excess of expected losses over impairment allowances

Plus minority interests in banking subsidiaries core Tier 1 equity

Less investments in insurance subsidiaries and associates

Less first loss positions in securitisation issues

Local regulators have discretion to amend BIS recommendations to comply withdomestic legislation, accounting standards need to check to be sure


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Basel 2 Tier 1 Capital

FFAS 2009

Preference shares fixed coupon, no tax relief

Senior only to equity holders

Bank restricted on return of capital and dividend payments to ordinary

shareholders

Must be non-cumulative payments missed are lost

Must be perpetual and irredeemable

May have trigger conditions on mandatory conversion to ordinary stock

Innovative Tier 1 securities

Non-cumulative preference shares with coupon step-up and call clauses

Coupon step-up and call clauses result in an economic term

As coupon rate increases incentive to call rises

Restrictions on conditions (number of years before step-up clauses kick in)

Limited to 15% of total Tier 1 capital

Minimum requirement for Tier 1 capital ratio 4%


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Basel 2 Tier 2 Capital

FFAS 2009

Preference shares fixed coupon, no tax relief

Senior only to equity and non-cumulative preference share holders

Cumulative missed payments accumulated

Must be perpetual and irredeemable

Can have step-up and call clauses

Subordinated debt May be term* or perpetual

If outstanding term greater than 5 years all eligible If term less than 5 years the proportion eligible falls

e.g. if 4 years remaining, 80%; if 1 year remaining 20%

Collective allowances/general provisions

Restricted to 1.25% of risk-weighted assets

Less 50% of excess of expected losses over impairment allowances

Plus 45% of any revaluation reserves and gains of securities AFS

* Term subordinated debt classified as lower Tier 2, rest all upper Tier 2


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Basel (2 and 3) Calculation of Risk-Weighted Assets

Three different approaches possible for credit risk

Standardised approach

Simplest approach

Credit risk RWAs calculated by use of standard weightings for differentasset classes

Use of credit ratings from external Credit Rating Agencies (CRAs)important aspect of weightings

Internal ratings based (IRB)

Allows banks to use own systems to estimate PD for exposures

EAD and LGD given as supervisory defaults and specified in Accorddepending on type of exposure

Used as inputs to Basel black-box formulae to generate value for RWAs

Advanced internal ratings based

Allows banks to use own systems to estimate PD and EAD and LGD

Still uses Basel black-box formulae to generate value for RWAs

Choice of standardised or IRB approach affects way in which eligibleTier 1 capital is calculated


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Operational, interest rate and market risk

Operational risk Crude capital charge equivalent to 15% of gross operating income

Converted into RWA equivalents by multiplying this capitalrequirement by 12.5 (= 1/8%) and added to other RWAs

Lower charge for more sophisticated banks based on business profile

Interest rate risk Assets and liabilities put into time buckets based on re-pricing date

Includes derivatives (e.g. interest rate swaps and FRAs)

Size of net position in each bucket calculated

Conversion factors applied to each net position (longer the date to re-pricing larger the factor)

Risk-weight equivalent asset value then calculated

Market Risk

Have covered how regulatory capital requirement was calculated inBasel 2 and the July 2009 (Basel 2.5) amendment

Converted into RWA equivalents by multiplying this capitalrequirement by 12.5 (= 1/8%) and added to other RWAs


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Credit risk - the Standardized Approach to calculating RWAs

Sovereign 0% 20% 50% 100% 150% 100%

Banks

Option 1 (National) 20% 50% ---- 100% ----- 150% 100%

Option 2 (Individual)

Short-term claims ------- 20% ----------- 50% 150% 20%

Other claims ------- 20% --------- 50% 100% 150% 20%

Corporates 20% 50% ----- 100% ---- 150% 100%

Commercial real estate --------------------- 100% ----------------------

Residential mortgages ---------------------- 35% ----------------------

Other retail ---------------------- 75% ----------------------

Past due loans (based on unsecured portion)

NPL cover < 20% ---------------------- 150% ----------------------

NPL cover 20%-50% ---------------------- 100% ----------------------

NPL cover > 50% -------------------- 50%-100% --------------------

Other assets ---------------------- 100% ----------------------

FFAS 2009

1 2 3 4 5 Unrated

Standard and Poors AAA toAA-

A+ toA-

BBB+to BBB-

BB+ toB-

BelowB-

Given 4% Tier 1 capital requirement for $100,000 mortgage riskweighted assets $35,000 (=$100,000 x 35%) 4% = $1,400 (i.e. 1.4%)


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Simplified example of Standardised Basel CAR* calculation

Assets

Cash and governmentsecurities 20,000 0% 0

Deposits with other banks 10,000 20% 2,000

Residential mortgages 45,000 35% 15,750

Other loans 15,000 75% 11,250

Fixed and other assets 8,000 100% 8,000

Goodwill 2,000 0% 0

Total 100,000 37,000

Other RWA equivalents 7,125

Total RWA 44,125

Liabilities

Customer accounts 70,000

Deposits with banks 21,500

Subordinated debt 2,000

Cumulative preference shares 1,000

Perpetual non-cumulativepreference shares 500

Shareholders' equity 4,500

Minority interests in banksubsidiaries 500

Total equity 5,000

Total 100,000

Tier 1 Tier 2

750

1,000

500

2,500

500

3,500 1,750

Tier 1 ratio 3,500 = 7.9%

44,125

Tier 2 ratio 1,750 = 4.0%

44,125

Total Capital Adequacy Ratio (CAR) (5,250/44,125) = 11.9%

* CAR = Capital Adequacy Ratio

Other RWA equivalents from market risk, FX, interest rate risk andoperational risk For sake of example ignoring regulatory reversals and deductions from

equity, expected losses, collective allowances etc.


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Advanced internal rating based (IRB)

Banks classify loans according to BIS classes

For each asset class Basel specifies a complex formula whoseinputs are PD, LGD and EAD

Calculate historic PD (probability of default), LGD (loss givendefault given as a % of exposure at default) and EAD (exposureat default) using historic data at least 5 years

Bank calculates regulatory capital requirement for each class Output from formula gives regulatory capital requirement

PD

LGD

EAD

Regulatorycapitalrequirement

Credit ratings /historic database

Baselformulae


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Banks Securities

firms

Assetbacked

financing

.Projectfinance

Commoditiesfinance

(structuredshort-term)

Real estate

investment

(incomegenerating)

Real estate

development

(high-volatilityfinance)

entities

Sovereign &foreign central

banks

Export CreditAgencies

BIS,IMF, ECB

& EC

Non-governmentpublic sector

Multi-lateraldevelopmentbanks

Residentialmortgages

Revolvingcredit

Other RealestateOther

Assetsecuritizationissues

Equities(includinghybrid &convertibles)

All other

assets

Purchased

receivables

Retail

Public sectorPrivate sector financial

institutions

Corporate Specialized corporate lending

All othercorporate

loans

SMEs

Off-balancesheet items

Other assets on-balance sheet

Internals Rating Based (IRB) Classes for Credit Risk

Regulatory defaults/ over-rides Internal historic databases

FFAS 2009

Each class has its own formula changes in parameters or differentform for formula


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IRB Basel 2 Exacerbates Cyclicality in Downturn

RWAs

EL

--- Tier 1 capital ---

Before After

50% of excess of EL overcollective impairment allowancesdeducted from Tier 1 capital

RWAs and EL driven by PD and

LGD

In a recession PD and LGD bothincrease higher RWAs and EL

Higher EL lowers eligible Tier1capital

Lower Tier 1 ratio results

RWAs

EL

Before After

--- Tier 1 capital ---


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Some general criticisms of Basel 2

Arbitrary absolute capital requirement may beevaded when going gets tough

Mandatory minimum requirements rule based vs. principles

Cyclicality capital & provisions Capital requirement at its lowest when credit losses low (IRBmodelling) Rises as credit-risk increases and rating deteriorate Likely to exacerbate a downturn Fails to encourage banks to build up reserves when earnings arestrong

Capital charge for operational risk does not reward banks for

taking action to reduce operational risk or punish those mostexposed to it

FFAS 2009

Gives competitive advantage to sophisticated banks(IRB versus standardised)

Not in fact a buffer to absorb losses

Nothing on liquidity risk

Some of these criticisms addressed in Basel 3


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Basel 3 Capital Requirements

Reduction in allowable Tier 1 capital Focus on core (eguity less deductions) capital (CET1)

More deductions (deferred tax assets, Tier 1 capital from minority

interests in consolidated bank subsidiaries; deductions in Basel 2that were taken 50% from Tier 1 and Tier 2 increased to 100%from Tier 1)

Move away from preference shares and hybrid equity

Permitted preference shares

Perpetual, i.e. there is no maturity date (and there are no step-upclauses or other incentives to redeem early)

Bank has discretion to suspend dividend payments

Non-cumulative

Can be called but only after 5 years and with supervisory approval

Other hybrid equity to be phased out

Allowable Tier 2 capital

Vanilla subordinated debt; loss absorbing before other creditors,minimum maturity 5 years at issue

Minority interests in consolidated bank subsidiaries

General provisions (Standardised approach)


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Basel 3 Capital Requirements (cont.)

Increase in risk-weighted assets Increases capital requirements for counterparty credit risk arising from

derivatives and repo type deals and central counterparties (settlement

agents) Tighter and higher capital requirements for securitisation issues

Higher capital requirements for trading book positions

Minimum BIS CET1 of 4.5%, Tier 1 6%, total CAR 8% at alltimes

Measures to reduce cyclical effects inherent in Basel 2 Capital Conservation Buffer (2.5% - effectively increases CET1 to 7%),

level banks expected to hold during good times may be drawn on atregulatory discretion

Countercyclical buffer regulators may impose additional 2.5%

requirement during periods of excessive credit growth BIS lobbying IASB on impairment allowances

Systematically important financial institutions Too big/connected to fail

Increase in CET1 by 1%-2.5%

l i


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Basel 3 Leverage ratio

Leverage ratio

Based on Tier 1 capital/Exposures

Exposures not risk-weighted On-balance sheet assets (less deductions included in

calculation of Tier 1 capital)

Off-balance sheet exposures (e.g. commitments, potentialfuture exposures from derivatives)

Minimum leverage ratio of 3% proposed

Long transition period

Parallel run through to January 2017, BIS to track banksdisclosures of calculations of ratio

Implementation January 2018

General acceptance that such a measure will be usefulcomplement to risk-weighted measures but nobody is surewhether 3% is an appropriate level

P d B l 3 I l i Ti bl


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Proposed Basel 3 Implementation Timetable

2013 2014 2015 2016 2017 2018 2019

Min. Core Tier 1 Capital Ratio(% of RWA) 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

Capital Conservation Buffer (%of RWA)

0.625% 1.25% 1.875% 2.5%

Min. Core Tier 1 plus CapitalConservation Buffer(% of RWA)

3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%

Phase-in of deductions from

Core Tier 1

20% 40% 60% 80% 100% 100%

Min. Tier 1 Capital (% of RWA) 4.5% 5.5% 6% 6% 6% 6% 6%

Min. Total Capital (% of RWA) 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Min. Total Capital plus CapitalConservation Buffer(% of RWA)

8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5%

Capital instruments that nolonger qualify asNon-Core Tier 1 Capital or Tier2 Capital

Phased out over 10 year horizon beginning 2013 (reduction of 10%each year)

New leverage ratio 3.0% 3.0%

Many countries and banks moving at a much faster pace and

some meet requirements already


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Some implications of Basel 3

Impact will vary by region, country and bank

- More decisions on required levels and measures being taken by local regulators

- Common framework for calculating ratios and level playing fields?

- Wide and confusing mix of regulatory measures followed by banks increasingcomparability issues

- Lack of clarity in requirements and excessive complexity

Higher capital equity Tier 1 requirements

- Banks will look to raise equity; higher retained earnings lower dividends

- Shrinking of balance sheets (RWAs)

- Shift away from activities regarded as high-risk/requiring higher regulatory capitalunder Basel e.g. Lending to SMEs, some trading and market-making activities

Lower bank ROEs

- Lower leverage (gearing)

- Shift to lower yield assets (G5 bonds) to meet liquidity requirements and away fromhigher risk activities- Shift to funding from higher cost long-term bonds and away from cheap short-termcustomer deposits- Lower bank ROEs and weak growth prospects will make equity issues for some banksunattractive to investors

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Session structure


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Session structure

FFAS 2009

Explain the four roles thatcapital plays in a bank

Explain the main componentsof Tier 1 and Tier 2 capital

Explain how risk-weightedassets are calculated under

the standardised approach

On completion of this session students should be able to:

Explain the key differencebetween the standardisedapproach and internal ratingsbased approach


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A consensus means that everyone agrees to say collectively what no onebelieves individually.

Abba Eban, former Israeli ambassador to the UN

Managing Bank Capital

Managing Bank Capital

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