Capital Adequacy

Basel II Accords
Proposed 2004, Implemented Soon
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.
 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?

Prob. of Prob. of Interest Recovery

Good Bad %
Outcome Outcome
Project A .5 .5 .2 0
(Risky)
Project B 1 0 .05 N/A
(Safe)
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.
 Measures of Capital Risk
• Chief measures are Tier 1 leverage Tier 1 Capital
ratio and CAR (capital adequacy) ratio. Total Assets

Tier 1 Capital +Tier 2 Capital

CAR 
Risk Adjusted Assets

(Tier 1+ Tier 2)/RAA Tier 1/RAA Tier 1/aTA

Well Capitalized > 10% > 6% > 5%
Adequately Capitalized 8-10% 4-6% 4-5%
Undercapitalized 6-8% 3%-4% 3%-4%
Significantly Undercapitalized <6% <3% <3%
Critically Undercapitalized <2% <2% <2%
CAMELS rating system
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%

0.00%
34

38

42

46

50

54

58

62

66

70

74

78

82

86

90

94

98

02
19

19

19

19

19

19

19

19

19

19
19

19

19

19

19

19

19

20
http://www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=10
Rising Capitalization Ratios in
Hong Kong
Source: CEIC/HKMA
Capital/Asset Ratio

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
Jan-92

Jan-98

Jan-04
Jan-91

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-05
 Capital Adequacy Ratio
• Main regulatory requirement of HK banks is
the CAR: Capital Adequacy Ratio.
• CAR is
Regulatory Capital
Risk Adjusted Assets

• Since 1987, the Basel Accords imposed in

HK and CAR > .08.
• What is regulatory capital? How do you
adjust for risk?
Historical Capital Adequacy for HK
Source:
HK: Capital Adequacy Ratio
%

20.5

20.0

19.5

19.0

18.5

18.0

17.5

17.0

16.5

16.0

15.5

15.0
Sep-1997 Sep-1999 Sep-2001 Sep-2003 Sep-2005
 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).
 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 Minus
2. Undivided Profits/Retained Earnings Intangible
3. Minority Interests Assets, Goodwill
 Risk Adjusted Assets
• Loans & securities are placed in a number of
buckets AjOn with associated risk weights
based on the identity of the borrower
• Off-balance sheet items are converted to
credit equivalents with credit conversion
factor, ccfk, based on type of item.
AjOff = ccf1∙ Aj,1Off + …..
Aj = AjOn + AjOff
• Risk Adjusted Assets: w1A1 + w2A2 + …w4A4
 • Different assets are
Risk adjustment of differentiated into
assets: buckets which have
Standardized Approach different risk
weights.
Risk Bucket Loans Risk Weights
1. Domestic Central Govt. 0%
2. Public Entities, Foreign 20%
Governments (OECD),
Banking.
3. Secured Residential Lending. 50%

4. Commercial and consumer loans 100%

 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.
 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
Set of risk weights
(ranging from 0 to
150%) for different
types of assets with
different credit ratings
claims on
• Sovereign
• Public Entities
• MDB
• Banks
• Securities Firms
• Corporates
• Residential Lending
• Cash
• Regulatory Retail
• Other Assets
• Past Due
 Credit Conversion Factors
Off Balanced Sheet
Type ccf
1. Standby LOC, Guarantees, 100%
Securitization w/ Recourse
2. LT Loan Commitments 50%

3. Commercial LOC 20%

4. Finanical Derivatives 0-15%

(depends on type & maturity)
5. ST Loan Commitments 0%
 Market Risk
• Banks with significant trading activity
(trading assets+liabilities > 10% of total
assets) must have additional capital
beyond 8% of credit risk adjusted assets.
• Banks should calculate VAR of foreign
exchange and securities positions and
allocate some capital equal to 8% of VAR.
 Only banks that can demonstrate
IRB Approach 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.
 Internal Growth Rate
• The change in the capital of the bank that
can be obtained from internal sources is:
Retained Earnings Retained Earnings Net Income
 
Equity Capital Net Income Equity Capital
 Modern Capital Management
• Instead of evaluating how much capital the bank
needs, modern banks will evaluate lines of
business and how much capital should be
allocated for the assets needed to generate
income in that line.
• Different businesses require different quantities
of capital. Capital is more expensive than debt,
so business requiring heavy capitalization must
earn higher returns.
 Basel II Accords
• In what ways have recent events
challenged the Basel Accords?
 Reading List
• Bank for International Settlements – Basel
II Overview
International Convergence of Capital Stan
dards
• KPMG Canada, 2006, -
Basel II: A Worldwide Challenge for the Ba
nking Business