Bank Capital

What is bank capital?

• Capital or net worth equals the cumulative value of assets

minus the cumulative value of liabilities and represents the
ownership of the firm
• It is traditionally measured on a book value basis where
assets and liabilities are listed in terms of historical cost
• In banking, regulators include certain forms of debt and loan
loss reserves while measuring capital adequacy ratio
Importance of Bank Capital

• Provides cushion for banks to absorb losses and remain solvent

• Provides ready access to financial markets
• Guards against liquidity problems caused by the deposit outflows
• Reduces risk of failure
• Increases the public confidence
Constituents of Bank Capitals
• Common stocks equal the par value of common stock outstanding
• Preferred stocks measured by the par value of any shares outstanding that promise to
pay a fixed rate of return
• Surplus equals the excess amount above each share of stock’s par value paid
• Undivided profit is the net earnings that have been retained in the business rather than
being paid out as dividend
• Equity reserves representing funds set aside for contingencies such as legal action
against institution, expected dividends to be paid etc.
• Subordinated debentures represent long-term debt capital contributed by outside
investors. This instrument may carry a convertible feature, permitting their future
exchanges for shares of stock.
• Minority interest in consolidated subsidiaries where the financial firm holds ownership
shares in other businesses
• Equity commitment notes, which are debt securities repayable from the sale of the stock
Relative importance of Different Sources of Capital

• Surplus market value of common and preferred stocks

• Retained earnings
• Long term debt
• The relative importance of different components varies across the
size of banks
How much capital a bank should hold?

• Who should set capital standards, market or regulatory agencies?

• What is a reasonable standard for the proper amount of capital?
• Bank capital is regulated
• To limit the risk of failures
• To preserve public confidence
• To limit losses to the government arising from deposit insurance claim
 The Basel Agreement: Basel I

• The Basel Agreement of 1988 includes risk-based capital standards

designed to:
• Encourage banks to keep their capital positions strong
• Reduce inequalities in capital requirements between countries
• Promote fair competition
• Account for financial innovations (OBS, etc.)
• Stockholders' equity is deemed to be the most valuable type of capital
• Minimum capital requirement increased to 8% total capital to risk-adjusted
assets
 The Basel Agreement: Basel I

• A Bank’s Minimum Capital Requirement is Linked to its Credit Risk

• The greater the credit risk, the greater the required capital
• Capital is divided into Two Tiers
• Basel I required bankers to determine the current market value for a
contract that is similar to the contract they have actually made with
a customer in order to figure out the latter’s replacement cost.
 The Basel Agreement: Basel I
Tier I Capital Tier II Capital
• Common stock and surplus • Allowance (reserves) for loan and lease losses
• Undivided profits (retained earnings) • Subordinated debt capital instruments
• Qualifying noncumulative perpetual • Mandatory convertible debt
preferred stock • Intermediate-term preferred stock
• Minority interests in the equity accounts of • Cumulative perpetual preferred stock with
consolidated subsidiaries unpaid dividends
• Selected intangible assets less goodwill and • Equity notes
other intangible assets • Other long term capital instruments that
combine debt and equity features

Total Regulatory Capital:

Tier 1 Capital + Tier 2 Capital – investments in unconsolidated subsidiaries – capital securities held
by the bank that were issued by other depository institutions and are held under a reciprocity
agreement – activities pursued by savings and loan association that may have been acquired by a
banking organization but are not permissible for national banks – other items
 Basel I: Capital Requirements

•   • Ratio of core capital (Tier 1) to risk weighted assets must be at least 4 %

• Ratio of total capital (Tier 1 and Tier 2) to risk weighted assets must be
at least 8 %
• The amount of Tier 2 capital limited to 100 percent of Tier 1 capital
Tier 1 risk based capital ratio =

Total risk based = =

capital ratio
 Basel I: Capital Requirements

• Basel I dictated there should be 4 Risk Groups of Assets

1. 0.00 items→ 0 % Risk weighting category
2. 0.20 items → 20 % Risk weighting category
3. 0.50 items → 50 % Risk weighting category
4. 1.00 items → 100 % Risk weighting category
• As the credit risk increases so does the capital requirement
• The same 0.00; 0.20; 0.50 and 1.00 apply to off-balance sheet items.
 Basel I: Risk Weights Applied to Bank Assets & OBS
Credit Risk Categories for Bank Assets on the Balance Sheet
Credit Risk Weights Assumed Amount of Examples of Types of Bank Assets in Each Credit-Risk Category
Used in the Credit Risk Exposure
Calculation of a from Each Category of
Bank’s Risk-Weighted Bank Assets
Assets (percentage of
amount of each
asset)

Cash deposits at the Federal Reserve Banks; U.S. Treasury bills, notes and bonds
of all maturities, Government National Mortgage Association (GNMA) mortgage
0% Zero credit risk
backed securities; and debt securities issued by governments of the world’s
leading industrial countries.
Interbank (correspondent) deposits, general obligation bonds and notes issued
by states or backed by U.S. government agencies, and mortgage-backed
20% Low credit risk
securities issued or guaranteed by the Federal National Mortgage Association
(FNMA) or by the Federal Home Loan Mortgage Corporation (FHLMC)
Residential mortgage loans and revenue bonds issued by state and local
50% Moderate credit risk
government units or agencies
Commercial and industrial (business) loans, credit card loans, real property,
100% Highest credit risk investments in bank subsidiary companies, and all other assets not listed
previously
 Basel I: Risk Weights Applied to Bank Assets & OBS
Credit Risk Categories for Off Balance Sheet Items

Conversion Credit Risk Assumed Amount of Examples of Types of Off-Balance Sheet Items in
Factor for Weights Used in Credit Risk Each Credit-Risk Category
Converting Off- the Calculation of
Balance-Sheet a Bank’s Risk-
Items into Weighted Assets
Equivalent (percentage of
Amounts of On- amount of each
Balance-Sheet asset)
Items
0.00 0% Zero credit risk Loan commitments with less than one year to go
Standby credit letters backing the issue of state
0.20 20% Low credit risk and local government general obligation bonds
Trade based commercial letters of credit and
0.20 100% Modest credit risk banker’s acceptances
Standby credit letters guaranteeing customer’s
0.50 100% Moderate credit risk future performance and unused bank loan
commitments longer than a year
Standby credit letters issued to back repayment of
1.00 100% Highest credit risk commercial paper
 Basel I: Risk Weights Applied to Bank Assets & OBS
Credit Risk Categories for Derivatives & Other Market-Based Contracts Not Shown on a Bank’s Balance
Sheet
Conversion Factor Credit Risk Assumed Amount of Categories or Types of Off-Balance Sheet Currency
for Converting Weights Credit Risk and Interest Rate Contracts
Interest Rate and (percentage)
Currency into
Equivalent
Amounts of On-
Balance-Sheet
Items

0.00 50% Lowest credit risk Interest rate contracts one year or less to maturity

0.005 50% Modest credit risk Interest rate contracts over one year to maturity

0.01 50% Moderate credit risk Currency contracts one year or less to maturity

0.05 50% Highest credit risk Currency contracts over one year to maturity
 Basel I: Calculating Risk-Weighted Assets

1. Compute Credit-Equivalent Amount of Each Off-Balance Sheet

(OBS) Item
2. Find the Appropriate Risk-Weight Category for Each Balance Sheet
and OBS Item
3. Multiply Each Balance Sheet and Credit-Equivalent OBS Item By
the Correct Risk-Weight
4. Add to Find the Total Amount of Risk-Weighted Assets
 Basel I: 1993 Proposal: Standard Model

• Total Risk= Credit Risk+ Market Risk

• Market Risk= General Market Risk+ Specific Risk
• General Market Risk= Interest Rate Risk+ Currency Risk+ Equity Price
Risk + Commodity Price Risk
• Specific Risk= Instruments Exposed to Interest Rate Risk and Equity
Price Risk
 Basel II
• Aims to correct the weaknesses of Basle I
• Three Pillars of Basel II:
1. Pillar I: Minimum Capital Requirements
Capital requirements for each bank are based on their own estimated risk
exposure from credit, market and operational risks
2. Pillar II: Supervisory review
Supervisory review of each bank’s risk assessment procedures and the adequacy
of its capital, solvency reports
3. Pillar III: Market Discipline
Greater disclosure of each bank’s true financial condition (market works),
capital transparency, capital adequacy, risk measurement and management, risk
profiting
Tier 1 Capital

Deemed to have highest capacity to absorbing losses in order to allow

banks continue to operate on ongoing basis
• Common shareholder equity
• Disclosed Reserves
 Published reserves derived from post-tax retained earnings and after dividend
payments
• Non-cumulative perpetual preferred stock
Tier 2 & 3 Capital
Tier 2 cannot exceed 100% of Tier 1 capital
 Subordinated debt
 Undisclosed reserves: availability is more uncertain
 General loan loss reserves
 Hybrid debt equity capital instruments
Tier 3 can be used to meet a proportion of the capital requirements of
market risk
 Consist of subordinated debt with some limitations
Tier II capital restricted to 100% of Tier-I capital; Long term subordinated
debt to be < 50 % of tier-I capital
Tier III to be less than 250 %of Tier-I capital assigned to market risk, i.e., a
minimum of 28.5 % of market risk must be covered by tier-I
 Basel II: Amends over Basel I

Minimum capital requirements

• Definition of capital is unchanged and the minimum capital
requirement remains 8%, but risk-adjusted assets in the
denominator will be calculated differently
• Denominator of minimum total capital ratio will consist of 3
parts: the sum of all risk-weighted assets for credit risk, plus 12.5
times the sum of the capital charges for market risk and
operational risk.
 Basel II: Minimum Capital Requirement (MCR)

• 
The total capital ratio must not be lower than 8%
Total risk-weighted assets = Risk weighted assets for credit risk
+ 12.5* Capital for market risk
+ 12.5*Capital for operational risk
 Basel II: Minimum Capital Requirement (MCR)

Capital for credit risk

I. Standard approach
Based on ratings of External Credit Assessment Institutions ( ECAI ),
satisfying seven requisite criteria and to be approved by national
supervisors. A simplified standard approach (SSA) is also put in place.
Apply fixed risk weighting to assets based on:
Type of entity (Sovereign, Commercial bank, Corporates, retail,
etc.)
Credit rating (AAA, Aaa,…, Bbb)
 Basel II: Minimum Capital Requirement (MCR)

Capital for credit risk

II. Internal rating based (IRB) approaches :
Based on the bank’s internal assessment of key risk parameters such as,
probability of default (PD), loss given at default (LGD), exposure at default (
ED), and effective maturity ( M ) etc.
Two approaches
Foundation: Bank produces own loss probability models (i.e. own credit
ratings), but uses prescribed estimates of Loss Given Default (LGD) based
on ratings
Advanced: Bank uses own loss probability models and LGD models
 Basel II: Minimum Capital Requirement (MCR)

Capital for market risk

• The risk of losses in on-balance sheet and off-balance sheet positions
arising from movements in market prices.

• Following Market risk positions require capital charge:

1. Interest rate related instruments in trading book
2. Equities in trading book
3. Forex open positions
 Basel II: Minimum Capital Requirement (MCR)

Capital for market risk

• The capital requirement is
k  VaR  SRC
where k is a multiplicative factor chosen by regulators (at least 3), VaR is
the 99% 10-day value at risk, and SRC is the specific risk charge for
idiosyncratic risk related to specific companies
 Basel II: Minimum Capital Requirement (MCR)

Capital for market risk cont..

• The minimum capital required comprises two components:
1. Specific charge for each security
2. General market risk charge towards interest rate risk in the portfolio

• Capital charge for interest rate related instruments

Banks have to follow specific capital charges prescribed by RBI for interest rate
related instruments. These charges range from 0 % to 9 % for different
instruments and for different maturities.
As regards general market risk, RBI has prescribed ‘duration ’ method to arrive at
the capital charge for market risk ( modified duration ).
 Basel II: Minimum Capital Requirement (MCR)

Capital for operational risk

I. Basic Indicator Approach
II. Standardized Approach
III. Advanced Management Approach
 Basel II: Minimum Capital Requirement (MCR)

•  Capital for operational risk

I. Basic Indicator Approach:
Average over the three years of a fixed percentage (denoted by =
15% ) of positive annual gross income
Operational Risk Capital= α* Gross Revenue
where α is a percentage set by regulator
 Basel II: Minimum Capital Requirement (MCR)

•  Capital for operational risk

II. Standardized Approach:
Bank’s activities are divided into 8 business lines such as corporate
finance, retail banking, asset management etc.
Each business line is assigned a factor say, , which determines the
capital requirement for that business line.
Average for three years gives capital for operational risks
Operational Risk Capital= β* Gross Revenue per Business Line
 Basel II: Minimum Capital Requirement (MCR)

Capital for operational risk

III. Advanced Management Approach
Bank’s internal risk measurement system is used after due vetting
by the supervisor. As a minimum five year observation period of
internal loss data is required this method may evolve over a period
of time
Operational Risk Capital= the risk measure generated by the
bank’s own operational risk measurement system
 Basel II: Capital Standards

Banks are classified as being

1. Well Capitalized
2. Adequately Capitalized
3. Under Capitalized
4. Significantly Undercapitalized
5. Critically Undercapitalized
 Basel II: Capital Standards

A. Well Capitalized
Total Capital to Risk Adjusted Assets  0.10
Tier 1 Capital to Risk Adjusted Assets  0.06
Tier 1 Capital to Total Assets  0.05 (Leverage Ratio)
B. Adequately Capitalized
Total Capital to Risk Adjusted Assets  0.08
Tier 1 Capital to Risk Adjusted Assets  0.04
Tier 1 Capital to Total Assets  0.04 (Leverage Ratio)
 Basel II: Capital Standards

C.Under Capitalized:
(Depository institution that fails to meet one or more of the capital minimums
for an adequately capitalized institution)
Total Capital to Risk Adjusted Assets  0.08
Tier 1 Capital to Risk Adjusted Assets  0.04
Tier 1 Capital to Total Assets  0.04 (Leverage Ratio)
D.Significantly Undercapitalized:
Total capital ratio < 0.06
Tier I Capital < 0.03
No pay raises for senior officers, limits on deposit interest rates
E. Critically Undercapitalized:
Tangible equity capital to total assets is ≤ .02
 Basel II: Strategies to Meet a Bank’s Capital Needs

• Raising Capital Internally

• Dividend Policy
• Internal Capital Growth Rate
• Raising Capital Externally
• Issuing Common Stock-most expensive
• Issuing Preferred Stock
• Issuing Subordinated Notes and Debentures
• Selling Assets and Leasing Facilities-often creates a substantial inflow of cash
• Swapping Stock for Debt Securities-may get rid of sinking fund provisions
• Choosing the Best Alternative
 Why Basel-III?

• Capital charge framework for market risk did not keep pace with
new market developments and practices
• Capital charge for market risk in trading book calibrated much
lower compared to banking book positions on the assumption that
markets are liquid and positions can be wound up or hedged
quickly
• Capital charge for specific risk (credit risk) in market risk
framework (trading book) was lower than capital charge for credit
risk in banking book
Why Basel-III?...

• Capital charge for counterparty credit risk for derivative positions

also covered only the default risk and migration risk was not
captured
• The global financial crisis mostly happened in the areas of trading
book /off balance sheet derivatives / market risk and inadequate
liquidity risk management
• Banks suffered heavy losses in their trading book
• Banks did not have adequate capital to cover the losses
• Insufficient liquidity assets to raise finance during stressed period
 Basel III: Enhancement to Basel II

During Pittsburgh summit in September 2009, the G20 leaders committed

to
• Strengthen the regulatory system for banks and other financial firms
• Act together to raise capital standards
• Implement strong international compensation standards aimed at ending
practices that lead to excessive risk-taking
• Improve the over-the-counter derivatives market and to create more
powerful tools to hold large global firms to account for the risks they take
Consequently, the Basel Committee on Banking Supervision (BCBS)
released comprehensive reform package entitled “Basel III: A global
regulatory framework for more resilient banks and banking systems”
(known as Basel III capital regulations) in December 2010
 Basel III

• Originally published in December 2010 in response to the global

financial crisis and is expected to be phased in between 2013 and 2019
• Raises both the quality and quantity of required regulatory capital bases
• Objectives
– Improving banking sector’s ability to absorb shocks
– Reducing risk spillover to the real economy
• Fundamental reforms proposed in the areas of
– Micro prudential regulation – at individual bank level
– Macro prudential regulation – at system wide basis
 Basel III
• Basel III reforms strengthen the bank-level i.e. micro prudential
regulation, with the intention to raise the resilience of individual
banking institutions in periods of stress
• The reforms have a macro prudential focus- addressing system wide
risks, which can build up across the banking sector, as well as the
procyclical amplification of these risks over time
• The macro prudential aspects of Basel III are largely enshrined in the
capital buffers
• Both the buffers i.e. the capital conservation buffer and the
countercyclical buffer are intended to protect the banking sector
from periods of excess credit growth
 Basel III

• Basel III strengthens the Basel II framework rather than replaces it

• Whereas Basel II focused on the asset side of the balance sheet, Basel
III mostly addresses the liabilities, i.e. capital and liquidity
• The new framework will
a. Impose higher capital ratios, including a new ratio focusing on
common equity
b. Increase capital charges for many activities, particularly involving
counterparty risk
c. Narrow the scope of what constitutes tier 1 (T1) and tier 2 (T2)
capital
 Basel III: Framework
The Basel framework (continues to) consists of three pillars:
1. Pillar 1 : Calculations of regulatory capital requirements for credit,
market and operational risk.
2. Pillar 2 : Process by which a bank should review its overall capital
adequacy and the process under which the supervisors evaluate how
well financial institutions are assessing their risks and take appropriate
actions in response to the assessments
3. Pillar 3: Disclosure requirements for banks to publish certain details of
their risks, capital and risk management, with the aim of strengthening
market discipline. This is intended to improve effective risk
management by allowing for comparison of the performance across
sectors through these disclosure requirements.
 Basel III: Framework-Capital

To improve the quality, consistency and transparency of the capital base

the following changes are proposed under the new Basel III framework:
1. Increase of requirements on minimum Tier 1 (T1) capital
2. Increase in the standards for instruments to qualify as T1 capital
3. Harmonization of Tier 2 (T2) capital instruments and the elimination of
Tier 3 (T3) capital
4. Revision of appropriate capital deductions such as minority interests
and deferred tax assets
 Basel III: Framework-Capital
The new minimum capital ratio:
• The minimum requirement for common equity will be raised from the
current 2% level to 4.5%
• T1 capital requirement will increase from 4% to 6%
• The capital conservation buffer above the regulatory minimum
requirement must be calibrated at 2.5% and be met with common equity
countercyclical buffer within a range of 0-2.5% of common equity or other
fully loss-absorbing capital is implemented according to national
circumstances.
 This buffer is to be implemented by the national supervisor when there is excessive
credit growth in the economy
 These buffers are designed to restrict the bank’s ability to distribute its
earnings until the buffers are rebuilt
 Basel III: Framework-Capital
• Systematically important financial institutions (SIFIs): global financial
services firms - almost exclusively banks - so big that governments believe
they will be forced to rescue these institutions rather than risk lasting
damage to the world financial system
• SIFIs should have loss absorbing capacity beyond the standards announced
• The additional loss absorbency requirements are to be met with a
progressive Common Equity Tier 1 (CET1) capital requirement ranging from
1% to 2.5%, depending on a bank’s systemic importance
• For banks facing the highest SIB (systemically important bank) surcharge,
an additional loss absorbency of 1% could be applied as a disincentive to
increase materially their global systemic importance in the future
 Basel III: Framework-Capital

Tier 1 capital: intended to ensure that each bank remains a

“going-concern”
Highest quality form of a bank’s capital as it can be used to write off
losses
Innovative hybrid capital instruments with step-up clauses are being
phased out
Not included (i.e. deductions) in common equity are among others
goodwill, minority interest, deferred tax assets, provisioning
shortfalls, bank investments in its own shares and bank investments
in other banks, financial institutions and insurance companies (to
avoid double counting of equity)
 Basel III: Framework-Capital

Tier 2 capital: intended to protect depositors in the event of

insolvency; re-categorized as a “gone-concern” reserve
Subordinated debt remains eligible as T2 capital

Tier 3 capital is to be completely abolished

 T3 capital is short-term subordinated debt and was used under Basel
II to support market risk from trading activities
 Basel III: Framework-Risk Coverage

Counterparty credit risk:

(Measures intended to address perceived deficiencies in Basel II during
periods of acute market volatility)
 Capital requirements must be determined using “stressed” inputs when
calculating counterparty credit risk
 Banks must implement a new capital charge - credit value adjustment
(CVA) - to cover the risk of mark-to-market losses on the expected
counterparty risk to OTC derivatives; this is additional to default risk
capital charge
 Basel III: Framework-Risk Coverage

• Banks must implement a new capital charge for wrong-way risk.

• Wrong-way risk: risk that arises when (credit) exposure at default is positively
(adversely) correlated with the probability of default (i.e. the credit quality of the
counterparty)when default risk and credit exposure increase together
• This will be achieved by adjusting the multiplier applied to the exposure amount
identified as wrong way risk.
• Apply a multiplier of 1.25 to the asset value correlation (AVC) of
exposures to regulated financial firms with assets of at least $25 bn.,
since AVC’s were 25% higher during the crisis for financial versus non-
financial firms
 Basel III: Framework-Risk Coverage

• Banks will be required to apply tougher (longer) margining periods

(potential losses may occur over a longer specified period of time) to
determine capital requirements when they have large and illiquid
derivative exposures to a counterparty
• Lower risk weightings (even zero weights) for counter-party risk
exposure may be applied if they deal with centralized exchanges
that meet certain criteria
 Basel III: Capital Leverage Ratio

• Leverage
  ratio is intended to serve as a simple non-risk based metric to
supplement risk-based requirements

• As a Pillar 2 measure to start with but will be integrated with Pillar 1

 Basel III: Liquidity Metrics

• Key characteristic of the financial crisis was inaccurate and ineffective

management of liquidity risk
• Two standards/ratios proposed
• Liquidity Coverage Ratio (LCR) for short term (30 days) liquidity risk
management under stress scenario
• Net Stable Funding Ratio (NSFR) for longer term structural liquidity
mismatches
 Basel III: Liquidity Metrics

•Liquidity
  Coverage Ratio (LCR)
Designed to ensure that a bank maintains an adequate level of
unencumbered assets that can meet its liquidity needs for a 30-day
period under a severe stress scenario

*High quality assets include those that can easily be converted into
cash in stressed markets
 Basel III: Liquidity Metrics

• Fundamental characteristics of liquid assets

 Low credit and market risk
 Ease and certainty of valuation
 Low correlation with risky assets
 Listed in a developed and recognized exchange
• Market-related characteristics
 Active and sizable market
 Presence of committed market makers
 Low market concentration
 Flight to quality
 Basel III: Liquidity Metrics

•Net
  Stable Funding Ratio (NSFR)
Designed to ensure that a bank holds an amount of long-term funding at
least equal to its long-term assets, such as lending

This measure depends on the ability of firms and supervisors to model

investor behavior, which is “stable” or “unstable” in a crisis situation