Components and calculation of regulatory capital

Muhammad Zulkif, Bilal sabir, Nabeel Tariq, Zahid Iqbal

Regulatory capital

The amount of capital a bank or other

financial institution has to hold as required
by its financial regulator
Types

 Regulatory capital is divided into different types of capital,

categorised based on their ability to absorb losses. This ensures
that banks do not expand their operations without holding
adequate capital. The division has created three tiers of capital,
which are discussed below.
Tier 1 capital

 Tier 1 capital is the core capital of a bank, crucial for financial

stability and absorbing potential losses. It comprises Common Equity
Tier 1 (CET1), which includes common shares and retained earnings,
representing the highest quality and most loss-absorbing form of
capital. Additionally, it encompasses Additional Tier 1 Capital,
consisting of subordinated debt and certain hybrid instruments.
Regulatory authorities set minimum Tier 1 capital requirements to
ensure the resilience of financial institutions, and maintaining a
sufficient Tier 1 capital ratio is fundamental for banks to navigate
economic challenges and adhere to regulatory standards such as
those outlined in the Basel III framework.
Tier 2 capital

 Tier 2 capital is a part of a bank's safety net required by regulators to ensure the bank
can handle losses without collapsing. It includes things like certain types of loans and
shares that can absorb losses if the bank runs into financial trouble. While not as secure
as Tier 1 capital, which includes the main funds like common stocks, Tier 2 capital
provides an extra layer of protection. Regulators set rules for banks to have a certain
amount of Tier 2 capital to make sure they remain stable and can handle tough times
without putting depositors at risk.
Measurement of credit risk exposure

 Measuring credit risk exposure is a critical aspect of financial risk

management, essential for institutions to assess and mitigate potential losses
arising from the failure of borrowers or counterparties to meet their financial
obligations. One widely used method is the reliance on credit ratings assigned
by credit rating agencies, which evaluate the creditworthiness of entities.
Additionally, credit scoring models employ statistical techniques to assess
individual borrower creditworthiness by considering factors like income,
credit history, and debt levels. Setting credit limits and requiring collateral also
serve as risk mitigation strategies, influencing the overall exposure to potential
losses. Portfolio analysis involves scrutinizing the composition of credit
portfolios, emphasizing diversification and monitoring concentration risk.
Stress testing is another approach, simulating adverse economic conditions to
evaluate portfolio resilience. Credit derivatives, such as credit default swaps,
allow the transfer or mitigation of credit risk. Regulatory guidelines, like those
established under Basel III, may prescribe specific methodologies for
Measurement of operational risk exposure.

 The measurement of operational risk exposure involves assessing the

potential financial losses resulting from inadequate or failed internal
processes, systems, people, or external events. This multifaceted evaluation
typically includes identifying and quantifying risks associated with
technology failures, human error, fraud, legal and compliance issues, and
external events. Financial institutions often employ risk indicators, historical
loss data, scenario analysis, and key risk indicators to gauge operational risk
exposure. Stress testing and business impact analysis may be utilized to
assess the resilience of operations under adverse conditions. The goal is to
quantify potential losses, enhance risk management strategies, and allocate
capital effectively to mitigate operational risks, ensuring the overall stability
and resilience of the organization.
Measurement of market risk exposure
 The measurement of market risk exposure involves evaluating the
potential financial losses that may arise from adverse movements
in financial market variables such as interest rates, foreign
exchange rates, equity prices, and commodity prices. Financial
institutions employ various quantitative methods and models to
assess market risk, including Value at Risk (VaR), stress testing,
and scenario analysis. VaR estimates the maximum potential loss
within a specified confidence level over a given time horizon,
considering historical market data and volatility. Stress testing
involves simulating extreme market events to evaluate the impact
on a portfolio or the entire financial institution. Scenario analysis
explores the effects of specific hypothetical scenarios on market
The standardized measurement method

 The standardized measurement method is a regulatory approach used for

assessing credit risk in the banking industry. It is part of the Basel III
framework, which provides guidelines for maintaining adequate capital to
cover potential losses. The standardized measurement method sets predefined
risk weights for different categories of assets based on their credit risk. These
risk weights are applied to the exposure amount of each asset to calculate the
required capital. The goal is to create a standardized and consistent approach
across financial institutions, promoting comparability and simplicity in risk
assessment. While the standardized measurement method is less granular than
internal models, it provides a straightforward and uniform way for banks to
determine their credit risk capital requirements, particularly when they do not
have the necessary data or resources for more sophisticated internal modeling.
Interest rate risk

 Interest rate risk is the potential for adverse impacts on financial

instruments and portfolios due to changes in interest rates. It
encompasses both price risk, affecting the market value of fixed-
income securities in response to interest rate fluctuations, and
reinvestment risk, which arises when cash flows must be
reinvested at different rates. Financial institutions, particularly
banks, are susceptible to interest rate risk as they often hold a mix
of fixed-rate assets and variable-rate liabilities. For investors,
rising interest rates can lead to capital losses on existing fixed-
rate investments, while falling rates may pose reinvestment
challenges. Mitigation strategies involve diversification, duration
management, and hedging, with central banks playing a role in
Equity risk

 Equity risk, also known as stock market risk, is the potential for
financial loss due to fluctuations in the value of equity
investments. It primarily affects investors in stocks or equity-
related instruments, such as mutual funds and exchange-traded
funds (ETFs). The value of equities is influenced by various
factors, including market sentiment, economic conditions,
company performance, and geopolitical events. Investors face the
risk of losing capital when the market value of their equity
holdings declines. Equity risk is inherent in the pursuit of higher
returns associated with stocks, as they can be volatile and subject
to rapid price changes. Diversification, thorough research, and a
long-term investment perspective are common strategies to
Specific Risk

 Specific risk, also known as unsystematic risk or company-

specific risk, refers to the risk associated with an individual
investment or a specific company rather than the overall market
or economy. It is the risk that is unique to a particular asset and
can be mitigated through diversification. Specific risk factors can
include company management issues, operational challenges,
product recalls, legal disputes, and other company-specific events
that may impact the value of an investment. Diversifying a
portfolio by investing in a variety of assets or companies can help
spread and reduce specific risk, as events affecting one
investment may not have the same impact on others. This risk is
distinct from systematic risk, which affects the entire market or a
Foreign exchange risk

 Foreign exchange risk is about the possibility of losing money

because the value of money from different countries changes. This
happens when you deal with other countries or have investments in
their money. There are two main types: transaction risk, when you
have payments in foreign money, and translation risk, which affects
multinational companies when they add up their money from
different countries. To handle this risk, people use strategies like
hedging with financial tools or having a mix of different currencies
in their investments. Managing foreign exchange risk is important
to keep money safe when dealing internationally.