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CAPITAL ADEQUACY

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Title: CAPITAL ADEQUACY


1
CAPITAL ADEQUACY
  • FIN 653 Lecture Notes
  • (Adapted from Saunders and Cornetts Textbook,
    for class presentation only)

2
THE FIVE FUNCTIONS OF CAPITAL
  • 1. To absorb unanticipated losses with enough
    margin to inspire confidence and enable the FI to
    continue as a going concern.
  • 2. To protect uninsured depositors in the event
    of insolvency and liquidation.
  • Capital protects non-equity liability holders
    against losses.
  • 3. To protect FI insurance funds and the
    tax-payers.
  • An FI's capital offers protection to insurance
    funds and ultimately the taxpayers who bear the
    cost of insurance fund insolvency.

3
THE FIVE FUNCTIONS OF CAPITAL
  • 4. To protect the industry against increases in
    insurance premiums.
  • By holding capital and reducing the risk
    insolvency, an FI protects its industry from
    larger insurance premiums.
  • 5. To fund new assets and business expansion.
  • FIs have a choice, subject to regulatory
    constraints, between debt and equity to finance
    new projects and business expansion.

4
US Capital Regulation
  • U.S. banks are required to comply with two sets
    of capital regulation
  • 1. the capital/asset (leverage) ratio place
    banks into one of the five categories
  • 2. the risk-based capital requirements comply
    with the Basel I regulation (only a few largest
    commercial banks are strictly required to follow
    Basel II)

5
THE CAPITAL-ASSET (LEVERAGE) RATIO
  • The capital-assets or leverage ratio measures the
    ratio of a bank's book value of primary or core
    capital to the book value of its assets.
  • Core capital
  • L -----------------------
  • Assets
  • The lower this ratio, the more highly leveraged
    the bank is.
  • Primary or core capital is a bank's common equity
    (book value) plus qualifying cumulative perpetual
    preferred stock plus minority interests in equity
    accounts of consolidated subsidiaries.
  • The FDICIA of 1991 assesses a bank's capital
    adequacy according to where its leverage ratio
    (L) places in one of five target zones.

6
THE CAPITAL-ASSET (LEVERAGE) RATIO
  • Specifications of Capital Categories for Prompt
    Corrective Action
  • Zone Leverage Total Risk Tier I
    Risk Capital
  • __________________________________________________
    ____________________________________________
  • Well Capitalized 5 or and 10 or
    and 6 or and Not subject to a
    capital
  • above
    above
    above directive to meet a
    specific


  • level
    for any capital


  • measure
  • Adequately 4 or and
    8 or and 4 or and
    does not meet the
  • Capitalized above above
    above definition of well capitalized


  • Undercapitalized under 4 or
    under 8 or under 4
  • Significantly under 3 or
    under 6 or under 4
  • Undercapitalized
  • Critically under 2 or
    under 2 or under 2
  • Undercapitalized
  • __________________________________________________
    _____________________________________________

7
THE CAPITAL-ASSET (LEVERAGE) RATIO
  • Adequacy with the leverage ratio
  • Higher than 5 percent, well capitalized.
  • At 4 percent or more, adequately capitalized
  • Less than 4 percent, undercapitalized
  • Less than 3 percent, significantly
    undercapitalized and
  • At 2 percent or loss, critically
    undercapitalized.
  • Under the FDICIA legislation, prompt corrective
    action (PCA) would be taken when a bank falls
    outside zone 1, or the well under-capitalized
    category.
  • Most critically, a receiver must be appointed
    when a bank's book value of capital-assets
    (leverage) ratio falls to 2 percent or lower.

8
THE CAPITAL-ASSET (LEVERAGE) RATIO
  • Summary of Prompt Corrective Action Provisions of
    the FDIC Improvement Act of 1991
  • Zone Mandatory Discretionary
    Provisions Provisions
  • __________________________________________________
    _______________________________
  • Well Capitalized None None
  • Adequately capitalized 1. No brokered deposits
    except None

  • with FDIC approval
  • Undercapitalized 1. Suspend dividends and 1.
    Order recapitalization
  • management fees
  • 2. Require restoration plan 2. Restrict
    interaffiliate
  • transactions
  • 3. Restrict asset growth 3. Restrict
    deposit rates
  • 4. Approval required for 4. Restrict
    certain other
  • acquisitions, branching, and new
    activities
  • activities
  • 5. No brokered deposits 5. Any other action
    that
  • would better carry out
  • prompt corrective action

9
THE CAPITAL-ASSET (LEVERAGE) RATIO
  • Significantly 1. Same as for Zone
    3 1. Any Zone 3 discretionary actions
  • Undercapitalized 2. Order
    recapitalizetion 2. Conservatorship or
    receivership if fails

  • 3. Restrict interaffiliate to submit
    or implement plan or

  • transactions
    recapitalize pursuant to order

  • 4. Restrict deposit rates 3. Any other
    Zone 5 provisions if such

  • 5. Pay of officers restricted action is
    not necessary to carry out


  • prompt corrective action
  • Critically 1. Same as for Zone 4
  • Undercapitalized 2.
    Receiver/conservator within 90 days

  • 3. Receiver if still in Zone 5 four quarters

  • after becoming critically undercapitalized

  • 4. Suspend payments on subordinated debt

  • 5. Restrict certain other activities
  • __________________________________________________
    _______________________________

10
THE CAPITAL-ASSET (LEVERAGE) RATIO
  • Problems with the Leverage Ratio as a measure of
    capital adequacy
  • 1. Market Value.
  • Even if a bank is closed when its leverage ratio
    falls below 2 percent, a 2 percent book
    capital-asset ratio could be consistent with a
    massive negative market value net worth.
  • 2. Asset Risk.
  • By taking the denominator of the leverage ratio
    as total assets, the leverage ratio fails to
    consider, even partially, the different credit
    and interest rate risks of the assets that
    comprise total assets.
  • 3. Off Balance-Sheet Activities.
  • Banks are nor required to hold capital to meet
    the potential insolvency risks involved with such
    contingent assets and liabilities of
    off-balance-sheet activities.

11
RISK BASED CAPITAL RATIOS
  • The 1993 Basel Agreement (Basel I)
  • Explicitly incorporated the different credit
    risks of assets into capital adequacy measures.
  • The 1998 Amendment
  • Market risk was incorporated into risk-based
    capital in the form of an add-on to the 8
    ratio for credit risk exposure.
  • The 2006 New Basel Capital Accord (Basel II)
  • The incorporation (effective in 2006) of
    operating risk into capital requirements and
    updated the credit risk assessments in the 1993
    agreement.

12
RISK BASED CAPITAL RATIOS
  • Regulators currently enforce the Basle Accord's
    risk-based capital ratios as well as the
    traditional leverage ratio. Their major-
    innovation is to distinguish among the different
    credit risks of asset on the balance sheet and to
    identify the credit risk inherent in instruments
    off the balance sheet by using a risk adjusted
    assets denominator in these capital adequacy
    ratios.

13
RISK BASED CAPITAL RATIOS
  • A bank's capital is divided into Tier I and Tier
    II.
  • Tier I capital is primary or core capital.
  • Tier II capital is supplementary capital.
  • The total capital that the bank holds is defined
    as the sum of Tier I and Tier II capital.

14
RISK BASED CAPITAL RATIOS
  • Tier I capital is closely linked to a bank's book
    value equity reflecting the concept of the core
    capital contribution of a bank's owners.
    Basically, it includes
  • the book value of common equity
  • an amount of perpetual (nonmaturing) preferred
    stock
  • minority equity interests held by the bank in
    subsidiaries minus goodwill.
  • Goodwill is an accounting item that reflects the
    amount a bank pays above market value when it
    purchases or acquires other banks or
    subsidiaries.

15
RISK BASED CAPITAL RATIOS
  • Tier II capital is a broad array of secondary
    capital resources.
  • It includes a banks loan loss reserves up to 3
    maximum of 1.25 percent of risk-adjusted assets
    plus various convertible and subordinated debt
    instruments with maximum caps.

16
RISK BASED CAPITAL RATIOS
  • Total Risk-Adjusted Assets
  • Risk-Adjusted On-Balance-Sheet Assets
  • Risk-Adjusted Off-Balance-Sheet Assets
  • Risk-Adjusted Off-Balance-Sheet Assets
  • The Risk-Adjusted Asset Value of Off-Balance-
  • Sheet Contingent Guaranty Contracts
  • The Risk-Adjusted Asset Value of Off-
  • Balance-Sheet Market Contracts or Derivative
  • Instruments

17
RISK BASED CAPITAL RATIOS
  • To be adequately capitalized, a bank must hold a
    minimum total capital (Tier I core capital plus
    Tier II supplementary capital) to risk-adjusted
    assets ratio of 8 percent that is, its total
    risk-based capital ratio is calculated as
  • Tier I Capital
  • Total risk-based capital ratio
    ---------------------------------- ? 4
  • Risk-adjusted
    assets
  • Total capital (Tier I plus Tier II)
  • Total risk-based capital ratio
    ---------------------------------------- ? 8
  • Risk-adjusted
    assets

18
Risk-Adjusted On-Balance-Sheet Assets
  • The Risk-Based Capital Standard for
    On-Balance-Sheet Items under Basel I
  • Risk Categories Assets
  • __________________________________________________
    ____________________
  • 1 (0 weight) Cash, Federal Reserve Bank
    balances, securities of the
  • U.S. Treasury, OECD governments, and some
    U.S.
  • agencies.
  • 2 (20 weight) Cash items in the process of
    collection. U.S. and
  • OECD interbank deposits and guaranteed
    claims.
  • Some non-OECD bank and government deposits
  • and securities. General obligation
    municipal bonds. Some
  • mortgage-basked securities. Claims
    collateralized by the
  • U.S. Treasury and some other government
    securities.
  • 3 (50 weight) Loans fully secured by first
    liens on one- to four-family
  • residential properties. Other (revenue)
    municipal bonds.
  • 4 (100 weight) All other on-balance-sheet
    assets not listed above,
  • including loans to private entities and
    individuals, some
  • claims on non-OECD governments and banks,
    real assets,
  • and investments in subsidiaries.
  • __________________________________________________
    ____________________

19
Risk-Adjusted On-Balance-Sheet Assets
  • (Items Added to) The Risk-Based Capital Standard
    for On-Balance-Sheet Items under Basel II
  • Risk Categories Assets
  • __________________________________________________
    _________________________
  • 1 (0 weight) Loans to sovereigns with an SP
    credit rating of AA- or better.
  • 2 (20 weight) Loans to sovereigns with an SP
    credit rating of A to A-.
  • Loans to banks and corporates with an SP
    credit rating
  • of AA- or better.
  • 3 (50 weight) Loans to sovereigns with an SP
    credit rating
  • of BBB to BBB-.
  • Loans to banks and corporates with an SP
    credit rating
  • of A to A-.
  • 4 (100 weight) Loans to sovereigns with an SP
    credit rating
  • of BBB to B-.
  • Loans to coporates with a credit rating of
    BBB to BB-.
  • 5 (150 weight) Loans to sovereigns with an SP
    credit rating below B-.
  • Loans to corporates with an SP credit
    rating below BB-.
  • __________________________________________________
    ________________________

20
Risk-Adjusted On-Balance-Sheet Assets
  • Risk-adjusted On-Balance-Sheet Assets
  • Category 1 Assets 0
  • Category 2 Assets 20
  • Category 3 Assets 50
  • Category 4 Assets 100
  • Category 5 Assets 150

21
Risk-Adjusted On-Balance-Sheet Assets
  • A Banks Balance Sheet (Assets, m)
  • __________________________________________________
    __________________________________________
  • Weight Assets Amount
  • __________________________________________________
    _________________________________________
  • Cash 5
  • 0 Balance due from Fed 13
  • T-Bills 60
  • Long-term Treasury securities 50
  • GNMA securities 42
  • __________________________________________________
    _____________________________
  • 20 Items in process of collection 10
  • FNMA securities 10
  • Munis (general obligation) 20
  • AA rated loans of BOA 10
  • Commercial loans, AAA- rated 55
  • __________________________________________________
    _____________________________
  • 50 University dorm bonds (revenue) 34
  • Residential 1-4 family mortgages 308
  • Commercial loans, A rated 75

22
Risk-Adjusted On-Balance-Sheet Assets
  • A Banks Balance Sheet (Liabilities, m)
  • __________________________________________________
    _______________________________
  • Liabilities/Equity Amount Capital Class
  • __________________________________________________
    _______________________________
  • Demand deposits 150
  • Time deposits 500
  • CDs 400
  • Fed funds purchased 80
  • __________________________________________________
    _________________________
  • Convertible bonds 15 Tied II
  • Subordinated bonds 15 Tier II
  • __________________________________________________
    _________________________
  • Perpetual preferred stock (non-qualifying) 5 Tier
    I
  • __________________________________________________
    _________________________
  • Retained earnings 10 Tier I
  • Common stock 30 Tier I
  • Perpetual preferred stock (qualifying) 10 Tier
    I
  • __________________________________________________
    _________________________
  • Total 1,215

23
Risk-Adjusted On-Balance-Sheet Assets
  • A Banks Balance Sheet (Off-balance-sheet, m)
  • __________________________________________________
    _______________________________
  • Weight Off-balance sheet Amount
  • __________________________________________________
    _______________________________
  • 100 2-year loan commitments to a large BB
    rated 80m
  • U.S. corporation
  • Direct credit substitute standby letter of
    credit 10m
  • issued to a BBB rated U.S. corporate
  • Commercial letters of credit issued to a BBB-
    rated 50m
  • U.S. corporation
  • __________________________________________________
    _________________________
  • 50 One fixed floating interest rate swap for 4
    years 100m
  • with notional dollar value of 100m and
    replacement cost
  • of 3m
  • One two-eay Euro contract for 40m with a
    replacement 40m
  • cost of -1m
  • __________________________________________________
    _______________________________

24
Risk-Adjusted Off-Balance-Sheet Activities
  • The calculation of the risk-adjusted values of
    the off balance-sheet (OBS) activities involves
    some initial segregation of these activities.
  • The credit risk exposure or the risk-adjusted
    asset amount of contingent or guaranty contracts,
    such as letters of credit or loan commitments,
    differs from the risk-adjusted asset amounts for
    foreign exchange and interest rate forward,
    option, and swap contracts

25
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts
  • First step multiply the dollar amount
    outstanding of these items by the conversion
    factors to derive the credit equivalent amounts.
  • These conversion factors convert an
    off-balance-sheet item into an equivalent credit
    or on-balance-sheet item.

26
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts
  • Conversion Factors for Off-Balance-Sheet
    Contingent or Guaranty Contracts
  • __________________________________________________
    ________________
  • (100) Sales and purchase agreements and assets
    sold with recourses that are not included on
    the balance sheet
  • (100) Direct credit substitute standby letters
    of credit
  • (50) Performance-related standby letter of
    credit
  • (50) Unused portion of loan commitments with
    original maturity of more
  • than one year
  • (20) Commercial letters of credit
  • (20) Bankers acceptance conveyed
  • (10) Other loan commitment
  • __________________________________________________
    ________________________

27
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts
  • Second step multiply these credit equivalent
    amounts by their appropriate risk weights.
  • The appropriate risk weight depends on the
    underlying counterparty, such as a municipality,
    a government, or a corporation, to the
    off-balance-sheet activity.
  • For example, if the underlying party being
    guaranteed were a municipality issuing general
    obligation (GO) bonds and a bank issued an
    off-balance-sheet standby letter of credit
    backing the credit risk of the municipal GO
    issue, the risk weight is 0.2.
  • If, on the other hand, the counterparty being
    guaranteed is a private entity, the appropriate
    risk weight is 1.
  • Note that if the counterparty had been the
    central government, the risk weight is zero.

28
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts
  • Example a bank with the following
    off-balance-sheet contingencies or guarantees
  • 1. 80 m two-year loan commitments to large US
    corporations.
  • 2. 10m standby letters of credit backing an
    issue of commercial paper.
  • 3. 50m commercial letters of credit.

29
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts
  • Step 1 Credit Equivalent Amounts (CEA)
  • OBS item Face Conversion Credit
    Value Factor Equivalent
  • Amount
  • __________________________________________________
    _______
  • Two-year loan commitment 80 .5 40
  • Standby letter of credit 10 1.0 10
  • Commercial letter of credit 50 .2 10
  • __________________________________________________
    _______

30
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts
  • Step 2 Risk-Adjusted Asset Amount
  • OBS item Credit Risk Risk-Adj.
  • Equivalent Weight Asset
  • Amount Amount
  • __________________________________________________
    _______
  • Two-year loan commitment 40 1.0 40m
  • Standby letter of credit 10 1.0 10
  • Commercial letter of credit 10 1.0 10
  • Total 60m
  • __________________________________________________
    _______

31
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • Modem FIs engage heavily in buying and selling
    OBS futures, options, forwards, swaps, caps, and
    other derivative securities contracts for
    interest rate and foreign exchange (FX)
    management and hedging reasons and to buy and
    sell such products on behalf of their customers.
  • Each of these positions potentially exposes banks
    to counterparty credit risk, that is, the risk
    that the counterparty (or other side of
    contract) will default if it suffers large actual
    or potential losses on its position. Such
    defaults mean that a bank must go back to the
    market to replace such contracts at (potentially)
    less favorable terms.

32
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • Two-Step Approach for calculating the
    risk-adjusted asset values of OBS market
    contracts
  • First, convert to the credit equivalent amount
    with a conversion factor for each derivative
    instrument.
  • Second, multiply the credit equivalent amounts by
    the appropriate risk weights.
  • The credit equivalent amount itself is divided
    into a potential exposure element and a current
    exposure element.
  • Credit equivalent amount of OBS Derivative
    security items Potential exposure () Current
    exposure ()

33
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • The Potential Exposure
  • The potential exposure conversion component
    reflects the credit risk if the counterparty to
    the contract defaults in the future.
  • The probability of such an occurrence depends on
    future volatility of either interest rates for an
    interest rate contract or exchange rates for an
    exchange rate contract.
  • The Bank of England and the Federal Reserve
    performed an enormous number of simulations and
    found that FX rates are far more volatile than
    interest rates. Thus, the potential exposure
    conversion factors are larger for foreign
    exchange contracts than for interest rate
    contracts.

34
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • Credit conversion factors for Interest Rate and
    Foreign Exchange Contracts in Calculating
    Potential Exposure
  • Remaining Interest Rate Exchange Rate
  • Maturity Contracts Contracts
  • _______________________________________________
  • Less than one year 0 1.0
  • One to five years 0.5 5.0
  • Over five years 1.5 7.5
  • _______________________________________________

35
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • The Current Exposure
  • This reflects the cost of replacing a contract
    should a counterparty default today.
  • The bank calculates this replacement cost or
    current exposure by replacing the rate or price
    initially in the contract with the current rate
    or price for a similar contract and recalculates
    all the current and future cash flows that the
    current rate or price terms generate. The bank
    discounts any future cash flows to give a current
    present value measure of the contract's
    replacement cost.
  • If the contract's replacement cost is negative,
    the replacement cost (current exposure) to be set
    to zero. If the replacement cost is positive
    (i.e., the contract is profitable to the bank but
    it is harmed if the counterparty defaults), this
    value is used as the measure of current exposure.

36
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • Once we total the current and potential exposure
    amounts to produce the credit equivalent amount
    for each contract, we multiply this dollar number
    by a risk weight to produce the final
    risk-adjusted asset amount for OBS market
    contracts.

37
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • Example Suppose the bank in the previous example
    has take on interest rate hedging position in the
    fixed-floating interest rate swap market for 4
    years with a notional dollar amount of 100m and
    one two-year forward foreign exchange contract
    for 40m. Calculate the credit equivalent amount
    for each contract.

38
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • Potential Exposure Current Exposure
  • Contract Notional Conversion Potential Replacemen
    t Current Credit
  • Principal Factor Exposure Costs
    Exposure Equiv.
  • __________________________________________________
    _____________________
  • 4-year fixed- 100m .005 .5m
    3m 3m 3.5m
  • Floating interest
  • Rate swap
  • 2-year forward 40m .050
    2m -1m 0m 2m
  • Foreign Exchange
  • Contract
  • __________________________________________________
    _____________________
  • Total Credit Equivalent Amount 5.5m

39
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments
  • To calculate the risk-adjusted asset value for
    the banks OBS derivative or market contracts,
    multiply the credit equivalent amount by the
    appropriate risk weight, which under the Basel I
    is generally .5 or 50
  • Credit Risk-Adjusted
  • Asset Value of OBS 5.5m 0.5 2.75m
  • Derivatives
  • Under Basel II, the risk weight assigned to the
    credit equivalent amount, 5.5m is 100. Thus,
    the credit risk-adjusted value of the OBS
    derivatives is 5.5m.

40
Criticisms of the Risk-Based Capital Ratio
  • The risk-based capital requirement seeks to
    improve on the simple leverage ratio by
  • more systematically accounting for credit risk
    differences among assets,
  • incorporating off-balance-sheet risk exposures,
    and
  • applying a similar capital requirement across all
    the major banks (and banking centers) in the
    world..

41
Criticisms of the Risk-Based Capital Ratio
  • Risk weights. It is unclear how closely the four
    risk weight categories reflect true credit risk.
  • For example, residential mortgage loans have a 50
    percent risk weight commercial loans have a 100
    percent risk weight. Taken literally, these
    relative weights imply that commercial loans are
    exactly twice as risky as mortgage loans.

42
Criticisms of the Risk-Based Capital Ratio
  • Balance sheet incentive problems. The fact that
    different assets have different risk weights may
    induce bankers to engage in balance sheet asset
    allocation games.
  • For example, residential mortgages have a 50
    risk weight, and GNMA mortgage-backed securities
    have 0 risk weight. Suppose that a bank pools
    all its mortgages and then sells them to outside
    investors. If it then replaced the mortgages it
    sold with GNMA securities backing similar pools
    of mortgages to those securitized, it could
    significantly reduce its risk-adjusted asset
    amount.

43
Criticisms of the Risk-Based Capital Ratio
  • Portfolio aspects. The new plan also ignores
    credit risk portfolio diversification
    opportunities. When returns on assets have
    negative or less than perfectly positive
    correlations, an FI may lower its portfolio risk
    through diversification.
  • The new capital adequacy plan is essentially a
    linear risk measure that ignores correlations or
    covariances among assets and asset group credit
    risks, such as between residential mortgages and
    commercial loans. That is, the banker weights
    each asset separately by the appropriate risk
    weight and then sums those numbers to get an
    overall measure of credit risk.

44
Criticisms of the Risk-Based Capital Ratio
  • Bank specialness. Giving private sector
    commercial loans the highest credit risk
    weighting may reduce the incentive for banks to
    make such loans relative to holding other assets.
    This may reduce the amount of bank loans to
    business as well as the degree of bank monitoring
    and may have associated negative externality
    effects on the economy. That is, one aspect of
    banks' special functions--bank lending--may be
    muted.
  • Equal weight of all commercial loans. Loans made
    to an AAA-rated company have a credit risk weight
    of 1, as do loans made to a CCC-rated company.
    That is, within a broad risk-weight class such as
    commercial loans, credit risk quality differences
    are not recognized. This may create perverse
    incentives for banks to pursue lower-quality
    customers, thereby increasing the risk of the
    bank.

45
Criticisms of the Risk-Based Capital Ratio
  • Other risks. Although market risk exposure has
    now been integrated into the risk-based capital
    requirements, the plan does not yet account for
    other risks such as foreign exchange rate risk,
    asset concentration risk, and operating risk. A
    more complete risk-based capital requirement
    would include these risks.

46
Criticisms of the Risk-Based Capital Ratio
  • Competition. As a result of tax and accounting
    differences across banking systems and in safety
    net coverages, the 8 percent risk-based capital
    requirement has not created a level competitive
    playing field across banks as intended by many
    proponents of the plan. In particular, Japan and
    the United States have very different accounting,
    tax, and safety net rules that significantly
    affect the comparability of U.S. and Japanese
    bank risk-based capital ratios. The provisions of
    the Basle Accord also allow differences in bank
    capital rules to persist among countries.
    Different capital elements are allowed for both
    Tier I and Tier II capital across countries.
    Also, many countries use a 10 percent risk
    category that is not used in the United States.

47
Objectives of the New Basel Accord
  • The objectives of Basel II are to encourage
    better and more systematic risk management
    practices, especially in the area of credit risk,
    and to provide improved measures of capital
    adequacy for the benefit of supervisors and the
    marketplace more generally.

48
Objectives of the New Basel Accord
  • The three pillars approach to capital adequacy
    involving
  • (1) minimum capital requirements,
  • (2) supervisory review of internal bank
    assessments of capital relative to risk, and
  • (3) increased public disclosure of risk and
    capital information sufficient to provide
    meaningful market discipline.

49
Key Elements of the New Basel Accord
  • Pillar 1 Two Approaches for Assessing Credit
    Risk
  • The standardized approach incorporates modest
    changes in risk sensitivities to improve risk
    sensitivities through readily observable risk
    measures such as external credit ratings.
  • Consistent with the Basel Committees
    objectives, it is intended to produce a capital
    requirement more closely linked to each banks
    actual credit risks a lower-quality portfolio
    will face a higher capital charge, a
    higher-quality portfolio a lower capital charge.

50
Key Elements of the New Basel Accord
  • Pillar 1 Credit Risk
  • The IRB approach is based on four key parameters
    used to estimate credit risks
  • 1. PD The probability of default of a borrower
    over a one-year horizon
  • 2. LGD The loss given default (or 1 minus
    recovery) as a percentage of exposure at
    default
  • 3. EAD Exposure at default (an amount, not a
    percentage)
  • 4. M Maturity

51
Key Elements of the New Basel Accord
  • Pillar 1 Credit Risk
  • For a given maturity, these parameters are used
    to estimate two types of expected loss (EL).
  • Expected loss as an amount
  • EL PD LGD EAD
  • and expected loss as a percentage of exposure at
    default
  • EL PD LGD

52
Key Elements of the New Basel Accord
  • Pillar 1 Credit Risk
  • The two variants of IRB, the foundation approach
    and the advanced approach, differ principally in
    how the four parameters can be measured and
    determined internally, but an essential feature
    of both approaches is their use of the banks own
    internal information on an assets credit risk.
  • In the advanced approach all four parameters are
    determined by the bank and are subject to
    supervisory review.

53
Key Elements of the New Basel Accord
  • Pillar 1 Credit Risk
  • For the foundation approach
  • 1. Only PD may be assigned internally, subject to
    supervisory review (Pillar 2).
  • 2. LGD is fixed and based on supervisory values.
    For example, 45 for senior unsecured claims and
    75 for subordinated claims.
  • 3. EAD is also based on supervisory values in
    cases where the measurement is not clear. For
    instance, EAD is 75 for irrevocable undrawn
    commitments.
  • 4. Finally, a single average maturity of three
    years is assumed for the portfolio.

54
Key Elements of the New Basel Accord
  • Pillar 1 Credit Risk
  • A critical issue with respect to the IRB
    approach is the reliability of the credit risk
    parameters supplied by banks, upon which the
    capital charges are based .
  • If these estimates prove unreliable, the IRB
    approach would provide little, if any,
    improvement in risk sensitivity over the current
    Accord.
  • Thus, it is essential that prior to IRB
    implementation supervisors ensure that a banks
    internal processes for determining internal risk
    ratings, PDs, LGDs, and EADs are credible and
    robust.

55
Key Elements of the New Basel Accord
  • Pillars 2 and 3 Supervisory review and public
    disclosure
  • Pillar 2 provides a basis for supervisory
    intervention to prevent unwarranted declines in a
    banks capital. The Basel Committee has
    articulated four principles consistent with these
    objectives
  • (1) Each bank should assess its internal capital
    adequacy in light of its risk profile,
  • (2) Supervisors should review internal
    assessments,
  • (3) Banks should hold capital above regulatory
    minimums, and
  • (4) Supervisors should intervene at an early
    stage.

56
Key Elements of the New Basel Accord
  • Operational Risk 3 Flavors
  • Operational risk is defined as the risk of
    direct of indirect loss resulting from inadequate
    or failed internal processes, people and systems
    or from external events
  • Developing a capital charge for operational risk
    is challenging both because of a lack of agreed
    methodology, and because of limited historical
    loss data.

57
Key Elements of the New Basel Accord
  • Operational Risk 3 Approaches
  • The Basic Indicator approach provides a simple
    way to determine a capital requirement, based on
    a percentage of gross income.
  • The Standardized approach assigns a capital
    charge for each of eight business lines based
    upon a fixed relation between average industry
    allocated economic capital and gross income for
    each business line.
  • Finally, through the Advanced Measurement
    approach (AMA) the Committee sought to provide
    flexibility for banks to use their own internal
    measurement approaches.

58
Key Elements of the New Basel Accord
  • Operational Risk 3 Approaches
  • The Basic Indicator approach provides a simple
    way to determine a capital requirement, based on
    a percentage of gross income.
  • The Standardized approach assigns a capital
    charge for each of eight business lines based
    upon a fixed relation between average industry
    allocated economic capital and gross income for
    each business line.
  • Finally, through the Advanced Measurement
    approach (AMA) the Committee sought to provide
    flexibility for banks to use their own internal
    measurement approaches.
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