Overview - University of Nevada, Reno



Bank Capital Management

Capital and Insolvency Risk

Importance of Capital Adequacy

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

Bank capital

Net worth

Market value of capital

Credit risk

Interest rate risk

Example

Book value of capital

Components: par value of shares, surplus value of shares, retained earnings, loan loss reserve

Credit risk: tendency to defer write-downs

Interest rate risk: effects not recognized in book value accounting method

5 Discrepancy between market and book values

Factors underlying discrepancies:

Interest rate volatility

Examination and enforcement

Arguments against market value accounting

Capital Adequacy in Commercial Banks and Thrifts

Actual capital rules

Capital-assets ratio (Leverage ratio)

L = Core capital/Assets

5 target zones associated with set of mandatory and discretionary actions

Problems with leverage ratio:

Market value: may not be adequately reflected by leverage ratio

Asset risk: ratio fails to reflect differences in credit and interest rate risks

Off-balance-sheet activities: escape capital requirements in spite of attendant risks

Risk-based capital ratios (Basel I, II agreements)

Enforced alongside traditional leverage ratio

Minimum requirement of 8% total capital (Tier I core plus Tier II supplementary capital) to risk-adjusted assets ratio.

Also requires, Tier I (core) capital ratio

= Core capital (Tier I) / Risk-adjusted ( 4%.

Calculating risk-based capital ratios

Tier I includes:

Book value of common equity, plus perpetual preferred stock, plus minority interests of the bank held in subsidiaries, minus goodwill.

Tier II includes:

Loan loss reserves (up to maximum of 1.25% of risk-adjusted assets) plus various convertible and subordinated debt instruments with maximum caps

Credit risk-adjusted assets:

Risk-adjusted assets = Risk-adjusted on-balance-sheet assets + Risk-adjusted off-balance-sheet assets

Risk-adjusted on-balance-sheet assets

Assets assigned to one of four categories of credit risk exposure

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

Risk-adjusted off-balance-sheet activities

Conversion factors used to convert into credit equivalent amounts—amounts equivalent to an on-balance-sheet item. Conversion factors used depend on the type of off-balance-sheet activities

← Basel I criticized since individual risk weights depend on broad borrower categories

For example, all corporate borrowers in 100% risk category

← Example

New Basel Accord (Basel II)

Basle II widens differentiation of credit risks

Refined to incorporate credit rating agency assessments

Pillar 1: Credit, market, and operational risks

Credit risk:

Standardized approach

Internal Rating Based (IRB)

Market Risk

Operational:

Basic Indicator

Standardized

Advanced Measurement Approaches

Pillar 2

Specifies importance of regulatory review

Pillar 3

Specifies detailed guidance on disclosure of capital structure, risk exposure and capital adequacy of banks

Risk-based capital ratio is focusing on credit risk, but how about:

Interest rate risk

Market risk

Operational risk

12 Criticisms of risk-based capital ratio

Risk weight categories versus true credit risk.

Risk weights based on rating agencies

Portfolio aspects: Ignores credit risk portfolio diversification opportunities.

DI Specialness

May reduce incentives for banks to make loans

Other risks: Interest Rate, Foreign Exchange, Liquidity

Competition and differences in standards

Capital Requirements for Other FIs

Securities firms

Broker-dealers:

Net worth / total assets ratio must be no less than 2% calculated on a day-to-day market value basis.

Life insurance

Risk-based capital measure for life insurance companies:

RBC = [ (C1 + C3)2 + C22] 1/2 + C4

C1 = Asset risk

C2 = Insurance risk

C3 = Interest rate risk

C4 = Business risk

If (Total surplus and capital) / (RBC) < 1.0, then subject to regulatory scrutiny

Property and Casualty insurance companies

Similar to life insurance capital requirements

Six (instead of four) risk categories

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