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BNFN 501- ASSET AND LIABILITY

MANAGEMENT

CAPITAL ADEQUACY
WEEK 8
Saunders and Cornett (2003)
Chp. 20
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Overview
This chapter discusses
the functions of capital,
different measures of capital adequacy,
current and proposed capital adequacy
requirements, and
advanced approaches used to calculate
adequate capital according to internal
rating based models of credit risk.
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Functions of Capital
1. The primary means of protection against
the risk of insolvency and failure is a FIs
capital. Capital absorb unanticipated
losses with enough margin to inspire
confidence.
2. To protect uninsured depositors
bondholders and creditors in the event of
insolvency and liquidation
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Functions of Capital
3. To protect FI insurance funds and the
taxpayers.
4. To protect the FI owners against
increases in insurance premiums.
5. To fund the branch and other real
investments necessary to provide
financial services.

Cost of Equity Capital as a Funding


Source
The value of an FIs stocks or equities sold in the
capital market reflects the current and expected
future dividends to be paid by the FI from its
earnings.
P0 = D1/(1+k) + D2/(1+k)2 +

P0 =Current price of the stock


Di

= Dividends expected in year i =1..

k = Discount rate or required return on the stock

Suppose dividends are growing at a


constant annual rate (g), so that:
D1 = (1+g) D0
D2 = (1+g)2 D0
This can be expresses as :
P0 = D0(1+g)/(k-g)
This is the well-known dividend growth model
of stock price determination
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The P/E Ratio: The price of a share per


dollar of earnings.
P0 /E0 = (D0/E0)(1+g)/(k-g)
The P/E ratio, or the price of a share per dollar
of earnings is greater:
(1) The higher the dividend payout ratio (D/E),
(2) the higher the growth in dividends (g), and
(3) The lower the required return on the FIs equity
(k) payout ratio.
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Capital and Insolvency Risk


FIs capital is the difference between the
market values of its assets and its
liabilities. This is also called the net worth
of an FI.
Book Value: Asset and liability values are
based on their historical costs.

Market Value: Allowing balance sheet


values to reflect current rather than
historical prices.
Market value of capital
credit risk
interest rate risk
exemption from mark-to-market for banks
securities losses

Example:
Assets (mill. $)
Long-term securities
Long-term loans

Liabilities (mill. $)
80
20
100

Assets
Long-term securities
Long-term loans

Liabilities
Net worth

90
10
100

Liabilities
80
12
100

Liabilities
Net worth

90
2
100

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Book Value of Capital


Credit risk
tendency to defer write-downs

Interest rate risk


Effects not recognized in book value
accounting method

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The book value of capital ( the difference


between the book values of assets and
liabilities) usually comprises the following four
components for an FI.
1- Par value of shares: the face value of the
common stock shares issued by the FI times the
number of shares outstanding.
2. Surplus value of shares:The difference between
the price the public paid for common stock or
shares when originally offered (eg. $5 share)
and their par values (eg. $1) times the number
of shares outstanding.
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3. Retained earnings. The accumulated value of


past profits not yet paid out in dividends to
shareholders. Since these earnings could be
paid out in dividends, they are part of the equity
owners stake in the FI.

Loan loss reserve: A special reserve set aside


out of retained earnings to meet expected and
actual losses on the portfolio. Loan loss
reserves reflect an estimate by the FIs
management of the losses in the loan portfolio.
While tax laws influence the reserves size FI
managers actually set the level.

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Consequently, the book value of


capital is:
= the par value of shares + surplus
value of shares + retained earnings +
loan loss reserves

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The Book Value of Capital and Credit Risk


FIs may resist writing down the values of bad
assets as long as possible in order to present a
more favorable picture to depositors and
regulators.
Eg. Japaneses banks loan losses between
1996-2000 Asian financial crises exceeded 32
trillion yen but they remained on the balance
sheet of the banks at their book value for a long
time.

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Discrepancy Between Market and


Book Values
Factors underlying discrepancies: The degree to
which the book value of an FIs capital deviates from its
true economic market value depends on a number of
factors , specially:

interest rate volatility: The higher the interest rate


volatility, the greater the discrepancy.

examination and enforcement: The more


frequent the on-site and off-site examinations and the
stiffer the examiner/regulator standards regarding
charging off problem loans, the smaller the
discrepancy.
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In actual practice, for large publicly traded FIs we


can get a good idea of the discrepancy between
book values (BV) and market values (MV) of equity
even when the FI itself does not mark its balance
sheet to market.
Specifically, in an efficient capital market, investors
can value the shares of an FI by doing an as-if
market value calculation of the assets and liabilities
of the FI. This valuation is based on the FIs current
and expected future net earnings or dividend flows.

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The stock price of the FI reflects this valuation and thus


the market value of its shares outstanding.
The market value of equity per share is:
market value of equity ownership shares outstanding
MV =
Number of shares
The book value of equity per share is:
the par value of shares + surplus value of shares +
retained earnings + loan loss reserves
BV=
Number of shares
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MV / BV is often called market the book value:

Market to Book Ratio: Shows the degree of


discrepancy between the market value of an FIs
equity capital as perceived by investors in the
stock market and the book value of capital on its
balance sheet.
The lower the MV/BV ratio the greater the book
value overstates the true equity of an FI.

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The Capital-Asset Ratio (or the leverage


Ratio)
The capital-asset or leverage ratio measures
the ratio of a banks book value of primary or
core capital to the book value of its assets.
L = core capital / Assets
With the passage of the FDIC improvement Act
in 1991, a banks capital adequacy is assessed
according to where its leverage ratio (L) places
in one of the five target zones.

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Zone
Total Risk-based Ratio
Well capitalized
10% or >
Adequately capitalized
8% or >
Undercapitalized
8%<
Singnificantly undercapitalized
6%<
Critically undercapitalized
2% <

Prompt corrective action: Mandatory actions


that have to be taken by regulators as a banks
capital ratio falls.

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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
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Risk-Based Capital Ratios


Because of the weaknesses of the simple capital
assets ratio, Bank for International Settlements
(BIS) introduced two new risk based capital
ratios in 1993, which known as the Basel
Agreement (now called Basel I).
The Basel agreement explicitly incorporated the
different credit risks of assets (both on and off
the balance sheet) into capital adequacy
measures.

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In 1998, Basel Agreement was revised and


market risk was incorporated into risk based
capital into the form of an add-on to the 8%
ratio for credit risk exposure.
In 2001, BIS issued The New Basel Capital
Accord that proposed the incorporation of
operational risk into capital requirements and
updated the credit risk assessments in the 1993.
The new Basel Capital Accord, called Basel II
will be effective in 2006.

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The Basel II consist of three mutually reinforcing


pillars which together, contribute to the safety and
soundness of the financial system.
Pillar 1 covers regulatory capital requirements for credit,
market, and operational risk.
Pillar 2 stress the importance of the regulatory review
process as a critical complement to minimum capital
requirements. Each bank should have sound internal
processes in place to assess the adequacy of its capital
and set targets for capital that are commensurate with
the banks specific risk profile and control environment.
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Pillar 3 provides detailed guidance on the


disclosure of capital structure, risk exposures,
and capital adequacy.

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Risk-based Capital Ratios


Basle I Agreement
Enforced alongside traditional leverage ratio
Minimum requirement of 8% total capital (Tier
I core plus Tier II supplementary capital) to
credit risk-adjusted assets ratio.
Also requires, Tier I (core) capital ratio
= Core capital (Tier I) / Credit Risk-adjusted
assets 4%.
Crudely mark to market on- and off-balance
sheet positions.
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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
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Credit risk-adjusted assets: are on and off


balance sheet assets whose values are
adjusted for approximate credit risk.
Risk-adjusted assets = Risk-adjusted onbalance-sheet assets + Risk-adjusted offbalance-sheet assets

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To be adequately capitalized a bank must


hold a minimum ratio of total capital (Tier I
core capital plus Tier II supplementary
capital) to credit risk-adjusted assets of
8% that is its total risk based capital ratio
is calculated as:
Total risk based capital ratio is equal to:
total capital (Tier I+II)
> 8
Credit risk-adjusted assets
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Tier I Core Capital Ratio


Tier I (Core) Capital Ratio is equal to:
Core Capital (Tier I)

>4%

Credit risk adjusted assets


That is, of the 8% total risk based capital
ratio, a minimum of 4% has to be held in
core or primary capital.
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Credit risk-adjusted On Balance Sheet


Assets Under Basel I
Risk-adjusted assets = Risk-adjusted on-balancesheet assets + Risk-adjusted off-balance-sheet
assets
Risk-adjusted on-balance-sheet assets
Assets assigned to one of four categories of credit
risk exposure (see table 20.10)
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. (see example 20.11)

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Calculating Risk-based Capital


Ratios under Basel II
Basel I criticized since individual risk weights
depend on broad borrower categories
Each bank assigns its assets to one of four categories
of credit risk exposure (0%,20%,50%,100%)
All corporate borrowers in 100% risk category

Basle II widens differentiation of credit risks


Refined to incorporate credit rating agency
assessments (see table 20.12)
Each bank assigns its assets to one of five categories
of credit risk exposure (0%,20%,50%,100%, 150%)
(See example 20.2 and table 20.13)
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Risk-adjusted off-balance-sheet Activities


Off-balance-sheet (contingent) assets:
Step One:
Conversion factors used to convert into credit
equivalent amountsamounts equivalent to an onbalance-sheet item. Conversion factors used
depend on the guaranty type.

Step Two:
Multiply credit equivalent amounts by appropriate
risk weights (dependent on underlying
counterparty)

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Credit Equivalent Amounts


of Derivative Instruments
Credit equivalent amount of OBS derivative
security items = Potential exposure + Current
exposure
Potential exposure: credit risk if counterparty
defaults in the future.
Current exposure: Cost of replacing a
derivative securities contract at todays prices.
Risk-adjusted asset value of OBS market
contracts = Total credit equivalent amount
risk weight.
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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.
May reduce incentives for banks to make
loans.
Other risks: Interest Rate, Foreign Exchange,
Liquidity
Competition and differences in standards
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