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Capital Adequacy

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Functions of Capital
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

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McGraw-Hill/Irwin

Book Value Definition of Capital


Also known as accounting net worth value of assets minus liabilities as found on the balance sheet. value of assets and liabilities at the time they were placed on the books or incurred by the firm, l losses are not recognized until the assets are sold or regulatory requirements force the firm to make balance sheet accounting adjustments
In the case of credit risk, these adjustments usually occur after all attempts to collect or restructure the loans have occurred. In the case of interest rate risk, the change in interest rates will not affect the recognized accounting value of the assets or the liabilities.
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Economic Definition of Capital


difference between the market value of assets and the market value of liabilities The loss in value caused by credit risk and interest rate risk is borne first by the equity holders, and then by the liability holders With market value accounting, the adjustments to equity value are made simultaneously as the losses due to these risk elements occur. Thus, economic insolvency may be revealed before accounting value insolvency occurs

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McGraw-Hill/Irwin

Market Value Accounting


Market values produce a more accurate picture of the FI s current financial position
Stockholders can more easily see the effects of changes in interest rates on the FI s equity, and they can evaluate more clearly the liquidation value of a distressed FI.

Arguments against market value accounting


market values sometimes are difficult to estimate, particularly for small FIs with non-traded assets
market value accounting can produce higher volatility in the earnings of FIs. regulators may close an FI too quickly under the prompt corrective action requirements of FDICIA.

Argument for MV accounting


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asset securitization can be used as a means to determine value of even thinly traded assets.

Leverage Ratio
The leverage ratio is the ratio of book value of core capital divided by the book value of total assets. L = Core capital/Assets Core capital is the book value of equity plus qualifying cumulative perpetual preferred stock plus minority interests in equity accounts of consolidated subsidiaries.
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Leverage Ratio Inadequate as Measure of Capital Adequacy


No guarantee that the depositors are adequately protected. In many cases of financial distress, the actual market value of equity is significantly negative by the time the leverage ratio reaches 2 percent. Using total assets as the denominator does not consider the different credit and interest rate risks of the individual assets. The ratio does not capture the contingent risk of the off-balance sheet activities of the FI.
9-7 McGraw-Hill/Irwin

Tier I and Tier II Capital


Tier I capital

most junior (subordinated) securities issued by the firm


equity and qualifying perpetual preferred stock.

Tier II capital/ supplementary or secondary capital

subordinated to deposits and the deposit insurer's claims


include preferred stock with fixed maturities and long-term debt with minimum maturities over 5 years

The amount of subordinated debt that can count towards capital cannot exceed 50% of Tier I capital. loan loss reserves (up to maximum of 1.25% of riskadjusted assets) 9-8

FDIC Zones
Zones Well capitalized Adequately capitalized Total RBC  10 10 > RBC > 8 Tier I  6 >4 4>TI>3 3>TI>2 < 2
McGraw-Hill/Irwin

Leverage Ratio Regulatory action  5 >4 4 > LR > 3 3 > LR > 2 < 2 None No brokered deposits several

Undercapitalized 8 > RBC > 6 Significantly 6 > RBC > 2 Undercapitalized Critically < 2 Undercapitalized
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Zone 3 Regulatory Action


capital restoration plan required asset growth restricted, approval for acquisitions, branching, and new activities required use of brokered deposits disallowed dividends and management fees suspended

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Functions of Capital Zone 4 Regulatory Action


Zone 3 penalties mandatory recapitalization restrictions on
deposit interest rate inter-affiliate transactions pay level of officers.

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Functions of Capital Zone 5 Regulatory Action


Zone 3 and 4 penalties bank placed in receivorship within 90 days, payment on subordinated debt suspended other activities restricted at the discretion of the regulator.

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Why use Leverage Ratio


stringency of regulatory monitoring is increased bank can reduce its capital requirement by adjusting its portfolio leverage ratio test sets a minimum required capital level

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Capital Requirements of the Basel Accord


capital of banks must be measured as an average of credit-risk-adjusted total assets both on and off the balance sheet. The total risk-based capital ratio divides total capital by the total of risk-adjusted assets. This ratio must be at least 8 percent for a bank to be considered adequately capitalized. at least 4 percent of the risk-based assets must be supported by core capital.
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Basel I vs Basel II
Basel I criticized since individual risk weights depend on broad borrower categories
All corporate borrowers in 100% risk category

Basle II widens differentiation of credit risks


Refined to incorporate credit rating agency assessments

Both have 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.

RBC under Basel I


Category 1 (0% weight) Cash, Federal Reserve Bank balances, securities of the U.S.Treasury, OECD governments, and some U.S. agencies. Category 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-backed securities, Claims collateralized by the U.S. Treasury and some other government securities. Category 3 (50% weight) Loans fully secured by first liens on one- to four-family residential properties. Other (revenue) municipal bonds.
McGraw-Hill/Irwin

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RBC under Basel I


Category 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.

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McGraw-Hill/Irwin

RBC under Basel II


Category 1 (0% weight)
Cash, Federal Reserve Bank balances, securities of the U.S.

Treasury, OECD governments, some U.S. agencies, and loans to sovereigns with an S&P credit rating of AA- or better.

Category 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-backed securities. Claims collateralized by the U.S. Treasury and some other government securities. Loans to sovereigns with an S&P credit rating of A+ to A Loans to banks and corporates with an S&P credit rating of AA- or better.
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RBC under Basel II


Category 3 (50% weight)
Loans fully secured by first liens on one- to four-family residential properties Other (revenue) municipal bonds. Loans to sovereigns with an S&P credit rating of BBB + to BBB Loans to banks and corporates : S&P credit rating of A+ to A-

Category 4 (100% weight)



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Loans to sovereigns with an S&P credit rating of BB+ to BLoans to banks with a credit rating of BBB+ to BLoans to corporates with a credit rating of BBB+ to BBAll 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.

RBC under Basel II


Category 5 (150% weight)
Loans to sovereigns, banks, and securities firms with an S&P credit rating below B Loans to corporates with a credit rating below BB-

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McGraw-Hill/Irwin

Calculating On-balance Sheet RWA


Assets assigned to five categories of credit risk exposure Dollar amount of assets in each category is multiplied by the appropriate risk weight 5 categories representing no risk to full credit risk Risk Weights are 0 percent, 20 percent, 50 percent, 100 percent, and 150 percent, respectively The weighted dollar amounts of each category are added together to get the total credit-risk-adjusted onbalance-sheet assets
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Calculating Off-balance Sheet RWA


Convert off-balance-sheet items to credit equivalent amounts of an on-balance-sheet item
multiply the notional amounts by an appropriate conversion factor

The converted amounts are then multiplied by the appropriate risk weights as if they were on-balancesheet items.
appropriate risk weights depend on the counterparty risk to off-balance-sheet activity

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Conversion Factors for Off-Balance-Sheet, Contingent or Guaranty Contracts: Basel I and Basel II Sale and repurchase agreements and assets sold with

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recourse that are not included on the balance sheet (100%) Direct-credit substitute standby letters of credit (100%) Performance-related standby letters of credit (50%) Unused portion of loan commitments with original maturity of more than one year (50%)* Commercial letters of credit (20%) Bankers acceptances conveyed (20%) Other loan commitments (10%)
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Pillars of Basel Accord (II)


Pillar 1 :Maintain and update regulatory capital requirements for credit, market and operational risk. Pillar 2: Stress the continued importance of the regulatory evaluation process in addition to capital requirements.
In particular ensuring that the bank has valid internal control procedures in place to measure and manage risk.

Pillar 3: Promote disclosure of the institution s capital structure, risk exposure and capital adequacy.

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Criticisms of Risk-based Capital Ratio


1. Risk weight categories versus true credit risk. 2. Risk weights based on rating agencies 3. Portfolio aspects: Ignores credit risk portfolio diversification opportunities. 4. DI Specialness
1. May reduce incentives for banks to make loans.

5. 6. 7. 8. 9.

Excessive complexity Other risks: Interest Rate, Foreign Exchange, Liquidity Impact on capital requirements Competition and differences in standards Pillar 2 demands on regulators

Homework Assignment
practice questions in handout

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