Professional Documents
Culture Documents
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
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-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Capital Adequacy Ratio
• Main regulatory requirement of HK banks
is the CAR: Capital Adequacy Ratio.
• CAR is
Regulatory Capital
Risk Adjusted Assets
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
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
Risk adjustment of • Different assets are
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%