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Lecture 3: Capital Adequacy

Dr Lixiong Guo
Semester 2 ,2014

Functions of Capital
To absorb unanticipated losses with enough margin to inspire

confidence and enable the FI to continue as a going concern.

To protect uninsured depositors, bondholders, and creditors in
the event of insolvency, and liquidation.
To protect FI insurance fund and the tax payers.
To protect the FI owners against increases in insurance
To fund the branch and other real investments necessary to
provide financial services.

Part I


The Market vs Book Value of Capital

The Market Value of Capital
The difference between the market value of assets and the market
value of liabilities. This is also called the net worth of an FI.
The Book Value of Capital
The difference between the book value of assets and the book
value of liabilities.
Even though trading assets are carried at fair value, significant
amount of assets and liabilities are carried at amortized costs.

Capital requirements are based on regulators definition of

capital, which is neither the market value of capital nor the book
value of capital.
The objective of regulators is to require FIs to hold a large enough
buffer to protect depositors and insurance fund against losses.

How is a $12 million market value loan loss reflected in a

market value balance sheet?

How may a $12 million market value loan loss reflected in

a book value balance sheet?

Market Value vs. Book Value Accounting

Under book value accounting, FIs have greater discretion in

recognizing loan loss on their balance sheet both in terms of the

amount of the loss and the timing of when it is recognized.
If an FI were closed by regulators before its book value of capital
became zero, liability holders and deposit insurance fund may still
suffer a loss.

Market value accounting is advocated by many academics and

analysts because the capital value under market value

accounting presents a more accurate picture of the net worth of
the FI, and thus, its ability to absorb losses before liability holders
If an FI were closed by regulators before its economic net worth
became zero, neither liability holders nor deposit insurance fund
would stand to loose.

Arguments Against Market Value Accounting

It can be difficult to implement when a FI hold a large amount of

non-traded assets.
Market value accounting introduces an unnecessary degree of
variability into an FIs earnings and thus capital because
paper gains and losses on assets are passed through the FIs
income statements.
In many cases, the paper gains and losses never realize when the FI
hold loans and other assets to maturity.
Regulators may be forced to close the banks too early under the prompt
corrective action (PCA) requirement imposed by the FDICIA.

FIs would be less willing to accept long-term asset exposures

under market value accounting.

Long-term assets are more sensitive to interest rate changes than short-term

Mark-to-Market Accounting Rules in the U.S.

In 2007, FAS 157 went into effect which specified a hierarchy of

valuation techniques to determine fair value.

Level 1 Quoted prices for identical instruments in active

Level 2 Quoted prices for similar instruments in active markets

or model-derived valuations based on observable market inputs.
Level 3 Model-derived valuations based on one or more
unobservable inputs.

During the financial crisis, under pressure from the U.S.

Congress, FASB eased its position on FAS 157 and allowed the
banks to use significant judgment when valuing illiquid assets,
such as MBS.
Example: Citigroup has $1.6 billion losses in 2008, under the new
guidance, this loss would be erased.


Mark-to-Market Accounting Rules in the U.S. (cont.)

In 2010, FASB proposed to mark loans to market.
In 2011, FASB withdrew the proposal under strong opposition.

This brings the FASB in line with ISAB which follows the book
value approach on valuing loans on the balance sheet.


Part II



Capital Ratio
Q1: How is capital defined?

Q2: How are assets measured? Especially, how are

assets adjusted for credit risk?


The Basel Agreement or Accord

The Basel Committee on Banking Supervision (BCBS) was

formed in 1974 by banking authorities from the G-10 nations to

strengthen the soundness and stability of the international
banking system while maintaining sufficient consistency that
capital adequacy regulation will not be a significant source of
competitive inequality among internationally active banks.
While the Basel Committee develops global capital and
regulatory guidelines, the government of each participating
nation are responsible for local adoption, implementation, and
enforcement of the guidelines.
In Australia, APRA makes and enforces the capital adequacy
rules for Australian authorized depository institutions (ADIs).


Basel I and II
The first Basel agreement was fully implemented on January 1,

1993, now known as Basel I.

Explicitly incorporate the different credit risks of assets into capital
adequacy measures.
Risk weights depend on the broad categories of borrowers.

Both on- and off-balance-sheet assets are considered in the

calculation of credit risk-weighted assets (RWA).
Market risk was incorporated in a 1998 revision.

The Basel Agreement of 2006 (known as Basel II) used a wider

differentiation of credit risk weights than Basel I and added a

capital charge for operational risk. It consists of three pillars.



Basel II Framework of Calculating Minimum Capital


Basel III
On 16 December 2010, the BCBS released the final text of the

Basel III capital framework. The framework was revised in June

Raised the quality and quantity of capital with a focus on common
Introduced an internationally harmonized leverage ratio to serve
as a backstop to the risk-based capital requirements.
Introduced additional capital surcharge for systemically important
Introduced capital buffers which should be built up in good times
or during periods of excess credit growth.
Introduced minimum global liquidity standards to improve banks
resilience to acute short term stress and to improve long term


Implementation of Basel III in Australia

Australias risk-based capital adequacy guidelines are generally

consistent but not completely aligned with the approach agreed

upon by the Basel Committee on Banking Supervision (BCBS).
APRA has exercised its discretion in applying the Basel
framework to Australian ADIs, resulting in a more conservative
approach than the minimum standards published by the BCBS.
APRA also introduced the new standards from 1 January 2013
with no phasing in of higher capital requirements as allowed by
the BCBS. The application of these discretions act to reduce
reported capital ratios relative to those reported in other


Basel III Capital Requirements

1 =

1 =

1 + 2

1 =
( + )


Basel III: Tier 1 Capital

Common Equity Tier 1 Capital (CET1)
Common shares and stock surplus.
Retained earnings.
Accumulated other comprehensive income and other disclosed
Common shares issued by consolidated subsidiaries of the bank
and held by third parties (i.e. minority interests).
Less goodwill.
Regulatory adjustments applied in the calculation of CET1.

Basically, it includes the book value of common equity plus

minority equity interests held by the DI in subsidiaries minus

good will.


Basel III: Tier 1 Capital (cont.)

Additional Tier 1 Capital
This include other options to absorb losses of the bank beyond
common equity.
Tier 1 capital is the sum of
Common Equity Tier 1 Capital (CET1)
Additional Tier 1 Capital.

Overall, Tier 1 capital is the capital that is available to absorb

losses on a going-concern basis or capital that can be depleted

without placing the bank into insolvency or liquidation. It is the
primary capital of the DI.


Basel III: Tier 2 Capital

Tier 2 capital is a broad array of secondary equity-like capital

resources. It is capital that can absorb losses on a "goneconcern" basis, or capital that absorbs losses in insolvency prior
to depositors losing any money.
It mainly includes:
Convertible and subordinated debt instruments.
Allowances for loan and lease losses not exceeding 1.25 percent
of the banks total credit risk-weighted assets.
General loan-loss reserves held against future, presently unidentified
losses are freely available to meet losses which subsequently
materialize and therefore qualify for inclusion within Tier 2.
Provisions ascribed to identified losses should be excluded.

Regulatory adjustments applied to calculation of Tier II capital.


Basel III Capital Requirements (cont.)

Capital Conservation Buffer
In good times, DIs are required to build up a capital conservation
buffer of greater than 2.5% of total risk-weighted assets (RWA).
The capital conservation buffer must be composed of CET1
capital and is held separately from the minimum risk-based capital

Countercyclical Capital Buffer

A buffer between 0% to 2.5% of total risk-weighted assets (RWA)
may be declared by any country when experiencing excess
aggregate credit growth.
This buffer must be met with CET1 capital, and DIs are given 12
months to adjust to the buffer level.


Basel III Capital Requirements (cont.)

Leverage ratio
A simple, non-risk based leverage ratio of Tier 1 capital to total
exposure (on- and off-balance-sheet) to serve a backstop to the
risk-based capital ratios.
Initially set at a 3% minimum. Final adjustment in 2017.

Globally systemically important banks

Global systemically important banks (G-SIBs) must have higher
loss absorbency capacity than other FIs because their failure
would cause significant disruption to the wider financial system
and economic activity.
Additional CET1 capital surcharge of 1% to 3.5% to be held above
the 7% minimum CET1 plus conservation buffer requirement.
The initial list include 29 G-SIBs in 12 countries. The sample of
banks to be assessed will be reviewed every three years.



Prompt Corrective Actions (PCA) in the U.S.

Besides meeting the minimum capital ratios, a DIs capital

adequacy is also monitored based on its place in one of five

capital target zones by regulators under the FDIC Improvement
Act (FDICIA) of 1991.
FDICIA requires regulators to take specific actions prompt
corrective actions when a DI falls outside the zone 1, or wellcapitalized, category.
A receiver must be appointed when a DIs tangible equity (Tier 1
+ Non-Tier 1 perpetual preferred stock) to total assets falls to 2
percent or less.
The idea of PCA is to limit the ability of regulators to show
forbearance to the worst capitalized DIs.




Part III




Credit Risk-Adjusted On-Balance-Sheet Assets

Under the Standardized Approach of Basel III:


Cash assets have a risk weight of zero.

Commercial loans and consumer loans are in the 100% risk

Residential 1-4 family mortgages are first separated into two
Category 1 includes traditional, first-lien, prudently underwritten
mortgage products. Category 2 includes junior liens and nontraditional mortgage products.
The risk weight assigned to the residential mortgage exposure
then depends on the mortgages loan-to-value ratio.


Credit Risk-Adjusted On-Balance-Sheet Assets (cont.)

Risk weights for sovereign exposures are determined using

OECD risk classifications (CRCs).

Countries are classified into one of eight risk categories (0-7).
Categories 0-1 have the lowest possible risk and are assigned a
risk weight of 0%, while category 7 is assigned a risk weight of
A 150% risk weight is assigned to a sovereign exposure
immediately after an event of sovereign default or if a sovereign
default has occurred during the previous 5 years.

Risk weights on exposures to foreign banks are also based on

the CRCs for the banks home country.


Credit Risk-Adjusted Off-Balance-Sheet Assets

A DIs off-balance-sheet (OBS) activities represent contingent

rather than actual claims against the DI.

Regulations require that capital be held not against the full face
value of these items, but an amount equivalent to any eventual
on-balance-sheet credit risk these securities might create for a
To calculate the credit risk-adjusted asset values for these OBS
items, we first convert them into credit equivalent amounts
amounts equivalent to an on-balance-sheet item.
We then assign the OBS credit equivalent amount to an
appropriate risk category to calculate the credit risk-adjusted of
these items.


Contingent Guaranty Contracts

The calculation of the credit equivalent amounts depends on the

type of the OBS items.

Contingent guaranty contracts (e.g. SLCs, loan commitment).
Derivative contracts (e.g. interest rate forward, option and swap

For guaranty contracts,

Conversion factors are provided (Table 20-10) based on the
guaranty type, one simply multiplies the amount of the OBS
guaranty contract by the conversion factor to arrive at the Credit
Equivalent Amount.
Credit risk weights for the OBS guaranty contracts are the same
as that for on-balance-sheet credit risk exposures to the same


Conversion Factors for OBS Guaranty Contracts


Derivative Contracts
Derivative contracts expose DIs to counterparty credit risk.
This is the risk that counterpart will default when suffering large
actual or potential losses on its position.
Such default means the DI would have to go back to the market to
replace such contract at (potentially) less favorable terms.

A major distinction is made between exchange-traded derivatives

and over-the-counter (OTC) derivatives.

The credit or default risk of exchange-traded derivatives is
approximately zero because when a counterparty defaults on its
obligations, the exchange itself adopts the counterpartys
obligations in full.
Most OBS futures and options positions have virtually no capital
requirement for a DI.


Derivative Contracts (cont.)

The credit equivalent amount of OBS derivatives is divided into a

potential exposure and a current exposure.

The potential exposure reflects the risk if the counterparty to
the contract defaults in the future.
Calculated by multiplying the notional amount of the contract by
some given conversion factor (Table 20-11)

The current exposure reflects the cost of replacing a contract if

a counterparty to the contract defaults today.

This equals to the replacement cost when it is positive.
If the contracts replacement cost is negative, regulations require
the replacement cost to be set to zero.

Under Basel III, the risk weights for OCT derivatives is generally

1.0 or 100%.


Conversion Factors for Calculating Potential Exposure