Banking Chapter 20 Capital adequacy – Flashcards
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Why did banks run low on capital during the recent financial crisis ?
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-Because of losses on real estate related assets -Most large banks raised more capital than they lost on their books (lost a lot more in market value terms)
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How did the g/v help during the financial crisis?
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they stepped in anyway they could to restore public confidence with TARP and injected preferred equity into all of the largest banks and many small banks
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What are the functions of Capital?
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-Provide a cushion to absorb unanticipated loses -Reduce moral hazard incentives created by deposit insurance and too big to fail policies -Preserve confidence in the FI and avoid runs by depositors -Protect uninsured depositors and other stakeholders -Protect deposit insurance funds and taxpayers -To fund the branch and other real investments that are necessary in order to provide financial services
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What are the two concepts of Capital?
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Market value and book value
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What is the current accounting system for commercial banks?
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-a mix of book values and market values -some assets and off balance sheet items are marked to market and others are kept at historical basis
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Market Value of Capital
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-Incorporates credit risk gains and losses -incorportates interest rate risk gains and losses -exemption from mark-to-market for some of the banks' securities losses -during financial crisis, FASB clarified position on market value accounting and allowed MGMT to exercise greater discretion for pricing illiquid assets (moved backwards from market value accounting)
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Arguments against Market Value Accounting
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-Difficult to implement, especially for small banks with many non-traded assets and liabilities (However, market values can be estimated even when an item is not traded) -Increase in volatility of earnings, which will not be realized if the assets and liabilities are not sold but held until maturity (could force premature closure under prompt corrective action) -Bias against long term assets (FIs will be less willing to accept longer-term asset exposures, which are more sensitive to interest rate changes) This may lead to credit crunches in some types of loans
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Book Value of Capital
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-sum of four values -Par value of shares (The face value of the common stock shares issued by the FI (usually $1 per share) times the number of shares outstanding.) -Surplus value of shares (The difference between the price the public paid for the shares and their par value times the number of shares outstanding.) -Retained Earnings -loan loss reserve (Reserves set aside out of retained earnings to meet expected and actual losses on the portfolio)
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What are the two items resulting for investment by stockholders?
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Par value of shares and surplus value of shares
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What are the two items resulting from the bank's actions?
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Retained earnings and loan loss reserve
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Arguments against book value accouting
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-Ignores credit risk gains and losses --Creates a tendency to defer write-downs (In the recent financial crisis, banks often did not write down the values of their mortgage-related assets, and were aided in this effort by the FASB decision) -Ignores interest risk gains and losses --These can be substantial (recall the S&L (savings and loan) industry in the 1980s).
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Capital-asset ratio
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-L=Core capital/assets -the higher the ratio, the less levered the bank is -Prompt corrective action based in part on the leverage ratio (Five target zones associated with set of mandatory and discretionary actions based upon the leverage ratio as well as the risk-based capital ratios.)
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Core Capital
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bank's common equity (book value) plus qualifying cumulative perpetual preferred stock plus minority interests in equity accounts of consolidated subsidiaries
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Problems with using the Leverage Ratio alone
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-Market value: May not be adequately reflected by numerator of leverage ratio -Asset risk: Denominator of 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 (basel I agreement)
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-early 1990s to the present -currently applies to all US banks -Enforced alongside traditional leverage ratio -Requires tier I capital ratio = Tier I capital / Risk-adjusted assets >=4%. -requires total capital (tier I plus tier II) ratio = [Tier I Capital plus Tier II Capital] / Risk-adjusted assets >=8%. --In practice, most banks carry very little Tier II, and cover most capital requirements with Tier I capital
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Tier I includes
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Book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill (similar to core capital used in the leverage ratio).
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Tier II includes
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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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Risk adjusted assets
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-(denominator of risk-based capital ratios) Risk-adjusted assets = Risk-adjusted on-balance sheet assets + Risk-adjusted off-balance sheet assets.
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Risk adjusted on balance sheet assets
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-Assets assigned to one of four categories of credit risk exposure (0%, 20%, 50%, 100%). Examples of 0%: Treasury securities, reserves. Examples of 20%: Mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac. Examples of 50%: Residential mortgages. Examples of 100%: All business loans. -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
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-Basically a two-step process: --Conversion factor used to convert to credit equivalent amounts. --Second, multiply credit equivalent amounts by appropriate risk weights.
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OBS contingent guaranty contracts
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-loan commitments, letters of credit, etc. -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. EX:Commercial letters of credit (20%) Direct-credit substitute standby letters of credit (100%) Performance-related standby letters of credit (50%) Unused portion of loan commitments with original maturity of less than one year (20%) Unused portion of loan commitments with original maturity of one year or more (50%) - Conversion factor then multiplied by the appropriate risk weight for the counterparty.
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Off balance sheet market contracts or derivative instruments
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futures, swaps, options, forwards, caps -issue is counterparty credit risk -ignores market risk( risk from changes in underlying market prices)
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Credit equivalent amounts of derivative instruments
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-Credit equivalent amount of OBS derivative security items = Potential exposure + Current exposurer.
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Potential exposure of credit equivalent amount of OBS derivative security items
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Potential exposure: credit risk if counterparty defaults in the future.
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Current exposure of credit equivalent amount of OBS derivative security items
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Current exposure: Cost of replacing a derivative securities contract at today's prices. If the contract's replacement cost is negative, regulations require the replacement cost to be set to zero.
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Risk adjusted asset value of OBS market contracts
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Risk-adjusted asset value of OBS market contracts = Total credit equivalent amount × risk weight.
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Basel II
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Basel II was created in the mid-2000s to fix some of the shortfalls of Basel I.
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What are the three forms of Basel II capital standards?
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-Standardized approach -Foundation internal ratings based (F-IRB) approach -Advanced internal ratings based (A-IRB) approach -Standardized approach is similar to Basel I with slightly different risk weights -IRB approaches are based upon models of credit risk --A-IRB is based on internal models created by financial institutions themselves
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Pillar 1 of Basel II
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-Calculation of regulatory minimum capital requirements based on: -Credit risk -Market risk -- measurement of market risk did not change from that adopted in 1988 (basically, just and add-on to the charge for credit risk -operational risk (basic indicator approach, standardized approach, advanced measurement approaches)
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Pillar 2
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-Specifies importance of regulatory review. -Ensures sound internal processes to manage capital adequacy
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Pillar 3
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-Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks. -The goal is to improve market discipline of bank customers.
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Why was Basel I criticized?
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-Basel I criticized since individual risk weights depend on broad borrower categories. -All corporate borrowers in 100% risk category
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What does the Basel II standardized approach do?
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-Basel II standardized approach widens differentiation of credit risks. -Refined to incorporate credit rating agency assessments -Adds 150% category for credit risk exposure for those with the worst credit ratings -Borrowers with better credit ratings are in the 20%, 50%, or 100% categories
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What are some problems with using credit ratings?
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-Standard & Poor's and Moody's ratings are often accused of lagging behind rather than leading the business cycle -Rating agencies did very poorly in the recent financial crisis
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What did Basel II add to capital?
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-Basel II implemented an additional add-on to capital for operational risk
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Operational Risk
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Risk of direct or indirect loss resulting from inadequate or failed internal processes, people, systems, or from external events EX: fraud, cost of computer tapes, computer failures
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Basic Indicator approach
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Gross income = Net interest Income + Noninterest income Operational capital = Alpha × Gross income Alpha to be set initially at 15%
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Criticisms of basic indicator approach
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top down too aggregative
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Standardized approach
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-Eight major business units and lines of business -Capital charge computed by multiplying a weight, Beta, for each line, then summed
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Criticism of Standardized approach
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only slightly less crude than the basic indicator approach
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Advanced measurement approach
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-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 -Must be based on a minimum 3-year observation period of internal loss data.
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Who has to comply with Basel I vs Basel II?
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-All U.S. banks have to comply with Basel I -The largest, internationally active U.S. banks were in the process of doing a "parallel run" with Basel II A-IRB approach when the recent financial crisis hit. --They still had to compute and comply with Basel I and only compute Basel II, but not comply with it yet --Basel II has essentially been rendered inactive by the Dodd-Frank Act because credit ratings are not supposed to be used under US regulations. -European banks had to comply with Basel II prior to the recent Financial Crisis --A consequence of Basel II was that European banks loaded up on AAA rated US mortgage-backed securities because they required little capital ---Thus, Basel II is partially responsible for the transmission of the US financial crisis to Europe
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Basel III
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Both small and large banks will be subject to Basel III in the future (discussed in the Financial Crisis slides). -Higher capital standards for all U.S. banks over $500 million in assets -Smallest banks continue to have same level of capital standards as Basel I. -Slight change in risk weights for all banks. -New liquidity standards
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Risk weight categories versus true credit risk
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Only a few risk buckets rather than the true continuum of risk
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Risk weights on the Basel II
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based on rating agencies (weaknesses shown in recent credit crisis).
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Portfolio aspects
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Ignores credit risk portfolio diversification opportunities.
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DI Specialness
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May reduce incentives for banks to make loans
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Criticisms of Risk-Based Capital Ratios
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-Risk weight categories versus true credit risk -Risk weights on the Basel II based on rating agencies -Portfolio aspects -DI Specialness -Excessive complexity -Other risks not explicitly included are: Interest Rate, Foreign Exchange, Liquidity -Different countries may impose standards differently.
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Problem with Contingent Capital
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Want large financial institutions to have capital during a systemic crisis but capital is difficult and expensive to raise during a financial crisis.
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Proposals to address this Contigent Capital problem
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-CoCos (Contingent Convertibles): A form of debt that converts to equity when a bank gets in trouble. -There are lots of proposals for these with various trigger mechanisms for the conversion -Insurance Policies
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Example of Insurance policy on slide 33-34
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