Capital Adequacy
Basel Accords
• Under the Auspices of the Bank for International
Settlements, the Basle Committee (which
consists of the G-10 countries’ central bank
governors), have agreed upon a scheme of
regulation which will be applied to international
banks. (What is the BIS?)
• The key element of this scheme is a set of
requirements relating a minimum amount of
bank capital relative to a risk based measure of
assets.
• Why capital?
Capital: Tension between profits
and risk
• The equity multiplier magnifies the effect of
profits on returns which gives bank owners an
incentive to increase leverage.
• Bank capital absorbs losses before depositors or
creditors absorb losses. So bank depositors and
creditors prefer capital.
• Risky banks may pay higher interest rates so
banks may internalize depositors preferences…
But regulators have adopted a preference
toward capital requirements institutionalized by
Basel.
Capital and Moral Hazard
• Consider a bank with 0 capital, full financed
with deposits of $100 (which for convenience
pay 0 interest rate).
• Bank managers face two loan projects with
differing payoff profiles.
• Which will the bank choose? Which is socially
optimal?
Project A
(Risky)
Project B
(Safe)
Prob. of
Good
Outcome
Prob. of
Bad
Outcome
Interest
Recovery
%
.5
.5
.2
0
1
0
.05
N/A
Expected Payoffs to depositors and
bankers
• The safe project creates value in excess of
customers demand for funds. The expected
value of the risky project is just $60, less than
what was put in the project.
Assume that in the event of bankruptcy, depositors
claim all remaining assets.
• The depositors have an expected payoff of 100
under the safe scheme and only 50 under the
risky lending scheme. They prefer safety.
Bankers payoffs
• Under the safe scheme, the bankers will
get a payoff of 5. Under the risky scheme
the bankers will get an expected payoff of
10. They will prefer the destructive, risky
scheme. Why?
• Bankers get upside pay-off of risky
scheme but put downsize risk on
depositors.
Well capitalized banks?
• Compare with bank finance by 80% deposits
and 20% equity.
• Under safe scheme, bank gets an expected
payoff of 25 for a 25% ROE.
• Under risky scheme, the bank owners receives
40 back in a good outcome and 0 back in a bad
outcome for an expected payoff of 20.
• Bank owners share the downside risk and avoid
the risky scheme.
Recent rise in US capital ratios as
well
FDIC Historical Banking Statistics
Capita/Asset Ratio
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
19
34
19
38
19
42
19
46
19
50
19
54
19
58
19
62
19
66
19
70
19
74
19
78
19
82
19
86
19
90
19
94
19
98
20
02
0.00%
http://www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=10
Measuring Capital
• For regulatory purposes, capital is divided
into two tiers.
Tier 2
1. Subordinated Debt
2. General Loan Reserves (LLA)
3. Other Reserves (similar to undivided profits)
Tier 1
1. Common Stock at Par + Surplus
2. Undivided Profits/Retained Earnings
3. Minority Interests
Minus
Intangible
Assets, Goodwill
Types of Capital
• Tier 1 capital is thought to be more stable and
more aligned with the concept of capital as the
funds that owners have invested in the banks
(i.e. equity capital, perpetual preferred stock and
retained earnings)
• Tier 2 capital are funds that protect depositors
but may be withdrawn (subordinated debt) or is
already somewhat committed to other purposes
(reserves).
Measures of Capital Risk
Tier 1 Capital
• Chief measures are Tier 1 leverage
ratio and CAR (capital adequacy) ratio. Total Assets
Tier 1 Capital +Tier 2 Capital
CAR 
Risk Adjusted Assets
(Tier 1+ Tier 2)/RAA
Well Capitalized
> 10%
Adequately Capitalized
8-10%
Undercapitalized
6-8%
Significantly Undercapitalized
<6%
Critically Undercapitalized
<2%
CAMELS rating system
Tier 1/RAA
> 6%
4-6%
3%-4%
<3%
<2%
Tier 1/aTA
> 5%
4-5%
3%-4%
<3%
<2%
Basilea 1
Risk adjustment of
assets:
Standardized Approach
•
Different assets are
differentiated into
buckets which have
different risk
weights.
Risk Bucket Loans
Risk Weights
1.
Domestic Central Govt.
0%
2.
Public Entities, Foreign
Governments (OECD),
Banking.
Secured Residential Lending.
20%
Commercial and consumer
loans
100%
3.
4.
50%
Timeline
• Basel Accords signed in 1987 imposed
risk-based capital requirements
• Basel Market Risk Amendment in 1996.
– Impose market risk requirement
• Problems with Basel I
– Risk weights too broad
– Does not account for new risk management
techniques.
Basel II Accords 2004
Three Pillars
1. Minimum capital requirements,
• New methodology for calculating required
capital for credit risk.
• Charges for operational risk
2. Supervisory review - regulators use more
comprehensive tools for assessing risk.
3. Market discipline – banks expected to
increase reporting to financial markets.
Standardized Approach
Basel II
• Meant for smaller, less sophisticated banks.
• New risk weights (0%; 20%; 50%; 100%, 150%)
used for assessing capital required based on
credit rating and type of assets.
• Uses External Ratings (where available)
• Unrated (most SMEs) weighted at 100%
• 35% weight for claims secured by Residential
Mortgage
• 100% weight for claims secured by Commercial
Mortgage
IRB Approach
Only banks that can demonstrate
competence can use IRB approach
Internal Ratings Based: Foundation Approach
Banks examine lending and associated assets and
calculate probability of default for loans. Regulators
provide formulas for associated capital requirement.
Internal Ratings Based: Advanced Approach
Bank constructs own (supervisor approved) formulas to
calculate.
PD: probability of default,
EAD: exposure of bank to default
LAD: Loss at default
M: remaining maturity
and uses these to determine required capital.
Operations Risk
• Loss of funds through operating
circumstances may be a source of risk for
banks.
• Standardized Approach: Allocate capital to
equal 15% of 3year lagged moving
average of revenues.
• Subject to regulatory approval, most
sophisticated banks may design their own
systems for operations risk.
How much capital?
• Depends on risk appetite of the bank,
regulatory requirements, maintaining a
good debt rating, limits of internal growth,
relative cost of debt and equity financing.
• Use statistical ratios to describe the risk
appetite of banks.
Capital and Growth
• Capital adequacy limitations can act as
brake on bank growth.
• Consider a bank that can achieve 10%
growth on the asset side of its balance
sheets and also can borrow freely to
achieve that growth.
• An adequately capitalized bank must
achieve 10% capital growth or fall below
the adequacy standard.
Achieving Capital Growth
• Reduce dividend payout ratios
• Earn higher ROA to increase cash flow
(may increase risk)
• Change mix of assets to those with
smaller capital charges
• Move assets off balance sheet
• Issue more stock/subordinated debt.
Basel II Accords
• In what ways have recent events
challenged the Basel Accords?
Obiettivi Basilea 3
1.
−
−
i
−
−
Definire regole generali per le banche in modo da:
innalzare la qualità e la quantità del patrimonio;
migliorare la capacità dei requisiti patrimoniali di catturare
rischi;
contenere la leva finanziaria;
tenere sotto controllo il rischio di liquidità
2. Introdurre disposizioni specifiche per gli intermediari
sistemici e rendere più agevole la risoluzione delle crisi