Capital Adequacy
Session 9
Capital Adequacy
Capital Adequacy
Why must the bank manager be concerned about managing the capital account?
Important (but most expensive) source of funding
Adequate capital necessary to maintain confidence in the bank
Regulatory constraints
Moral: Too little capital will incur the wrath of the regulator; too much capital will incur the wrath of the shareholder
Capital Adequacy
The Cost of Capital
Why is equity the most expensive form of funding?
Common stock is the residual security - it is entitled to whatever is left after the more senior claimants have been satisfied.
Because the returns to the common are not specified, they are the most volatile.
In finance, volatility equates to risk!
The higher the risk, the higher the expected return!
Capital Adequacy
Capital Adequacy:
Measuring Shareholder Returns
Capital is the most expensive form of funding available to the bank. How do we measure the required return to the shareholder
Use the Gordon Growth Model of Stock Valuation
If P = Div1
r - g
Then r = Div1 + g
P
Use the CAPM
Rstock = Rfree + Betastock(RMarket - Rfree)
Capital Adequacy
Regulatory Capital Adequacy
In Canada
OSFI establishes minimum capital guidelines for banks in its publication “Guidelines for Banks”
Federally regulated Financial Institutions must pass two capital adequacy tests
Assets-to-capital multiple
Risk-based capital adequacy
Capital Adequacy
Regulatory Capital Adequacy:
Assets-to-Capital Multiple
Calculation:
Assets-to-capital multiple = Total Assets
Capital
Where: Capital is Tier One plus Tier Two capital
Total Assets all on-BS assets plus off-BS credit substitutes
Must maintain an assets to capital multiple less than twenty
Problems as a measure of capital adequacy:
Based on book values, not market values
Ignores the different credit, interest and market risks embedded in the total assets figure
Ignores off-Balance Sheet activities which are not credit substitutes (... most derivatives)
Capital Adequacy
Risk-Based Capital Adequacy = Capital_______
Risk-weighted assets
Where: Capital is both Tier One & Tier Two capital
Both on-BS and off-BS assets are risk weighted
Ratio must be greater than or equal to 8%
Cannot directly compare this ratio to the assets-to-capital multiple because;
In the assets-to-capital multiple, all assets and credit-substitute off-BS assets are simply added together
In the risk-based capital adequacy framework, each exposure is multiplied by a weighting factor before being added
Regulatory Capital Adequacy: Assets-to-Capital Multiple
Capital Adequacy
Regulatory Capital Adequacy:
Tier One Capital
Tier One capital is comprised of:
Common shareholder’s equity
Common stock, contributed surplus & retained earnings
Noncumulative preferred shares
Minority interest in subsidiaries arising from consolidation (Tier one capital portion)
Less Goodwill
Capital Adequacy
Regulatory Capital Adequacy:
Tier Two (A) Capital
Tier Two (A) capital comprised of instruments with the following characteristics:
Unsecured, subordinated to deposits and senior debt and fully paid up
Not redeemable at the option of the holder
Redeemable only after five years (at the option of the FI) and with OSFI’s permission
Available to participate in losses (dividend default gives no additional rights)
Allows dividends to be deferred
Example: cumulative, convertible, callable preferred shares
Capital Adequacy
Regulatory Capital Adequacy:
Tier Two (B) Capital
Limited life (Tier 2B) capital instruments have the following characteristics:
Subordinate to deposits and senior debt
Initial minimum term greater than ten years
Redemption in the first five years only at the option of the FI and with OSFI’s permission
Example: 10 year subordinate notes
Capital Adequacy
All of the following must be true:
Tier 1 capital + Tier 2 capital > 8% of risk-adjusted assets
Tier 2 capital < Tier 1 capital
Tier 2B capital < 50% of Tier 1 capital
Regulatory Capital Adequacy: Risk Weighting of Assets
Capital Adequacy
Regulatory Capital Adequacy:
Risk Weighting of Assets
On Balance Sheet Item Risk Weight
1. Cash & deposits with CB 0%
2. Deposits with other banks 20%
3. Securities issued by/guaranteed by an OECD govn’t 0%
4. Other securities 100%
5. Loans issued by/guaranteed by an OECD govn’t 0%
6. Residential mortgages 50%
7. Other loans 100%
8. Customer liability under Acceptances 100%
9. Other assets 100%
Capital Adequacy
Regulatory Capital Adequacy:
Off-Balance Sheet Credit Substitutes
Credit Instruments Credit Conversion Risk
Factor Weight
1. Guarantees & SBLCs
a) Financial 100% 100%
b) Non-financial 50% 100%
2. Securities lending 100% 100%
3. Documentary & commercial L/Cs 20% 100%
4. Commitments to extend credit
a) Term less then 1 year 0% 0%
b) Term more than 1 year 50% 100%
5. Note issuance/Revolving under-
writing facility 50% 100%
Capital Adequacy
Regulatory Capital Adequacy:
Off-Balance Sheet Items - Derivatives
First partition into exchange traded and OTC derivatives. No counterparty risk to exchange traded derivatives.
OTC derivatives
First multiply the notional amount by a conversion factor to create a credit equivalent amount
Then multiply the credit equivalent amount by the appropriate risk weights
Capital Adequacy
Regulatory Capital Adequacy:
Off-Balance Sheet Items - Derivatives
Derivative Security Risk Weight
Interest Rate Contracts:
a) Forward Rate Agreements 20%
b) Futures contracts 0%
c) Swap contracts 20%
d) Options purchased 20%
e) Options written 0%
Foreign Exchange contracts:
a) Sport & forward contracts 20%
b) Futures contracts 0%
c) Swap contracts 20%
d) Options purchased 20%
e) Options written 0%
Capital Adequacy
Regulatory Capital Adequacy:
Problems with the BIS Rules
Differential treatment between OECD & non-OECD borrowers
100% risk weighting applied to all loans (even if the borrower has a higher risk rating than a bank, which attracts only a 20% risk weighting
Inter-country differences in the calculation of Tier 2 capital
Japanese banks allowed to include a portion of unrealized capital gains on real estate and securities
UK banks allowed to include a portion of the unrealized gain on real estate assets
Capital Adequacy
Regulatory Capital Adequacy:
Problems with the BIS Rules
Does not include various forms of market risk:
foreign exchange risk
interest rate risk
position risk in traded-equity securities
Does not capture large exposures to a single borrower (which perhaps should have more than a 100% risk weighting)
Capital Adequacy
