Download Australia`s Authorised Depository Institutions The Capital–Assets Ratio

Chapter 17
Capital Adequacy
Overview
• This chapter discusses the functions of capital in
modern FIs.
• We learn that capital is not only a source of funds,
but further protects an FI from insolvency.
• We discuss the various measures of capital in FIs.
• We also discuss the various measures of capital by
accounting bodies and regulators, such as the Bank
for International Settlements.
• We explore how regulators measure capital
adequacy in FIs.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-2
Introduction to Capital Adequacy
• The major functions of capital are:
– To absorb unanticipated losses.
– To protect uninsured depositors, bondholders and creditors
in case of insolvency and liquidation.
– To protect FI insurance funds and the taxpayer.
– To protect the FI owners against increases in insurance
premiums and lowering the cost of funds.
– To partially fund the FI’s investment activities.
• Sufficient capital levels inspire confidence in the FI.
• Sufficient capital levels enable the FI to continue as a
going concern even in difficult times.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-3
The Cost of Equity Capital as a
Funding Source
• The value of an FI’s share reflects the current and
expected future dividends to be paid by the FI from
its earnings.
D1
D2
D
P0 

 ... 
2
(1  k ) (1  k )
( 1  k )
Where:
P0 = current price of share,
Di = dividends expected in year i = 1 …∞,
k = discount rate (required return on the share).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-4
The Cost of Equity Capital as a
Funding Source
• If dividends are growing at a constant rate g, we find
that:
D0 ( 1  g )
P0 
(k g )
• Dividing both sides of the equation by current earnings
per share (E):
D0
 (1  g )
P0
E0

E0
(k  g )
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-5
The Cost of Equity Capital as a
Funding Source
• Thus:
– P/E is greater, the higher D/E,
– P/E is greater, the higher g,
– P/E is higher, the lower k.
• The P/E of an FI influences the attractiveness of
issuing additional equity.
• The higher the P/E, the more investors are willing to
pay for a dollar of earnings.
• The higher the P/E, the cheaper for an FI to issue
equity.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-6
Capital and Insolvency Risk
Defining ‘capital’:
• Net worth: market value of assets minus market
value of liabilities.
• Book value: asset and liability values based on
historical cost
• Economists prefer the market value definition, while
most regulators prefer the book value definition.
• The book value method can be misleading.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-7
Capital and Insolvency Risk
The Market Value of Capital:
• The marking-to-market method allows balance sheet
values to reflect current rather than historic prices.
• Consider the following market value balance sheet of
an FI.
Assets ($m)
Liabilities ($m)
Securities 70
Loans
30
Deposits 95
Net worth 5
TA = 100
TL + E = 100
• In this example the FI is solvent on a market value
basis.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-8
Capital and Insolvency Risk
The Market Value of Capital and Credit Risk:
• Consider a fall in the market value of loans to $27.
Assets ($m)
Securities
Loans
TA = 97
Liabilities ($m)
70 Deposits
27 Net worth
95
2
TL + E = 97
• While the FI is still solvent, its net worth has declined
from $5 to $2.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-9
Capital and Insolvency Risk
The Market Value of Capital and Credit Risk:
• Consider a further fall in the market value of loans of
$5.
Assets ($m)
Securities
Loans
TA = 92
Liabilities ($m)
70 Deposits
22 Net worth
95
-3
TL + E = 92
• The FI is insolvent.
• After insolvency and the liquidation of the remaining
$92 in assets, depositors would get only 92/95 in the
dollar (96.84%).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-10
Capital and Insolvency Risk
The Market Value of Capital and Interest Rate Risk:
• Losses in asset values due to adverse interest rate
changes are borne first by equity holders.
• If losses exceed the value of equity, liability holders
will be affected.
• Sufficient capital levels will protect liability holders
from losses.
• Since new accounting rules introduced in Australia
(1995):
– Fair market value of most assets and liabilities has to
be disclosed.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-11
Capital and Insolvency Risk
The Book Value of Capital:
• Components of the book value of capital for FIs:
–
–
–
–
Par value of shares,
Surplus value of shares,
Retained earnings,
Loan loss reserve.
• In Australia, accounting convention of par value has
been replaced by the representation of book value of
equity as price paid on shares when originally
offered.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-12
Capital and Insolvency Risk
The Book Value of Capital and Credit Risk:
• Tendency to defer write-downs.
The Book Value of Capital and Interest Rate Risk:
• Effects not recognised in book value accounting
method.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-13
Capital and Insolvency Risk
The Discrepancy between the Market and Book Values
of Equity:
• Factors underlying discrepancies:
– Interest rate volatility,
– Examination and enforcement.
• MV of equity per share: MV of equity ownership
shares outstanding / numbers of shares.
• BV of equity per share: (Par value of equity + surplus
value + retained earnings + loan reserves) / number
of shares.
• Market to book ratio: MV / BV.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-14
Capital and Insolvency Risk
Arguments Against Market Value Accounting:
• Difficult to implement,
• Introduces unnecessary variability into an FI’s
earnings,
• FIs are less willing to take longer-term asset
exposures.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-15
Capital Adequacy: Australia’s
Authorised Depository Institutions
• Risk-based capital ratio introduced in Australia in
1989.
• Capital ratio divided into:
– Tier 1 capital risk-based ratio,
– Total capital risk-based ratio.
• Total capital risk-based ratio consists of:
– Tier 1, plus
– Tier 2 capital.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-16
Capital Adequacy: Australia’s
Authorised Depository Institutions
The Capital–Assets Ratio (L):
• Measures the ratio of an FI’s core capital to its
assets.
• Leverage ratio.
• L = Core capital / assets
• Problems:
– Market value,
– Asset risk,
– Off-balance-sheet activities.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-17
Capital Adequacy: Australia’s
Authorised Depository Institutions
Risk-Based Capital Ratios:
• Proposed by the Bank for International Settlements
(BIS): www.bis.org
• Full implementation in January 1993.
• Arrangement known as Basel Agreement (Basel I).
• Initially, capital requirements against credit risk
exposures only.
• Since 1989: additional capital requirements for
market risk exposures.
• 2001: publication of Basel II.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-18
Capital Adequacy: Australia’s
Authorised Depository Institutions
Risk-Based Capital Ratios:
• Basel II requirement: additional capital against
operational risk exposures.
• Basel II consists of three mutually reinforcing pillars:
– Pillar I: regulatory capital requirements,
– Pillar 2: supervisory review process.
– Pillar 3: market discipline.
• In Australia, Basel I currently enforced by APRA.
• Basel II yet to be implemented.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-19
Capital Adequacy: Australia’s
Authorised Depository Institutions
Risk-Based Capital Ratios:
• Total capital = Tier 1 + Tier 2 capital – deductions.
• Tier 1 = core capital.
• Tier 2 = supplementary capital.
• Tier 1 capital must equal or exceed 4% of riskweighted assets.
• Tier 2 capital is limited to 100% of Tier 1 capital.
• Total capital must equal or exceed 8% of riskweighted assets.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-20
Capital Adequacy: Australia’s
Authorised Depository Institutions
Risk-Based Capital Ratios:
• Credit-risk adjusted assets: on- and off-balance-sheet
assets whose values are adjusted for approximate
credit risk.
• Total risk-based capital ratio = Total capital / credit
risk adjusted assets ≥ 8%.
• Tier 1 (core) capital ratio = Core capital / credit risk
adjusted assets ≥ 4%.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-21
Capital Adequacy: Australia’s
Authorised Depository Institutions
Calculating Risk-Based Capital Ratios – Basel I:
• Assets subdivided into four categories dependent on
counterparty default risk:
– 0% risk-weight, such as notes and coins,
– 20% risk-weight, such as claims on international
banking organisations,
– 50% risk-weight, such as loans fully secured by
mortgage against eligible residential mortgages,
– 100% risk-weight, such as claims on commercial
companies.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-22
Capital Adequacy: Australia’s
Authorised Depository Institutions
Calculating Risk-Based Capital Ratios – Basel I:
n
w a
i 1
i
i
Where:
wi = risk-weight of ith asset, where i = 1 to n,
ai = dollar (book) value of the ith asset on the balance
sheet.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-23
Capital Adequacy: Australia’s
Authorised Depository Institutions
Calculating Risk-Based Capital Ratios – Basel I:
Example:
• Suppose an FI holds the following assets:
– Notes and coins: $10 million
– Loans to Australian banks: $20 million,
– Loans fully secured by mortgages: $70 million,
– Commercial loans: $100 million.
• Total assets: $200 million.
• Risk-adjusted assets = 0%×10 + 20%×20 +
50%×70 + 100%×100 = $139 million.
• The FI needs to hold at a minimum $139 million ×
8% = $11.12 million in capital.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-24
Capital Adequacy: Australia’s
Authorised Depository Institutions
Credit Risk Adjusted On-Balance-Sheet Assets under Basel II:
• Major criticisms of Basel I: risk-weights dependent on
broad categories of borrowers.
• Basel II widens differentiation of credit risks: refined to
incorporate external credit rating agency assessments.
• Risk-weight classes: 0%, 20%, 50%, 100%, 150%.
• Risk weights dependent on:
– Counterparty,
– Credit rating of counterparty.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-25
Capital Adequacy: Australia’s
Authorised Depository Institutions
Credit Risk Adjusted On-Balance-Sheet Assets under Basel II:
• Risk weightings for residential mortgage loans
determined by relative risk.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-26
Capital Adequacy: Australia’s
Authorised Depository Institutions
Credit Risk Adjusted On-Balance-Sheet Assets under Basel II:
Example:
• Suppose an FI holds the following assets:
– Notes and coins: $10 million,
– Loans to international banks with a credit rating of BBB:
$20 million,
– Residential mortgage loans (LVR = 80%, no mortgage
insurance): $70 million,
– Loans to international corporates with a credit rating of
AA: $50 million,
– Loans to corporates with a credit rating of B: $50 million.
• Total assets: $200 million.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-27
Capital Adequacy: Australia’s
Authorised Depository Institutions
Credit Risk Adjusted On-Balance-Sheet Assets under Basel II:
Example (continued):
• Risk-adjusted assets
= 0%×10 + 50%×20 + 35%×70 + 20%×50 + 150%×50
= $119.5 million.
• The FI needs to hold at a minimum:
$119.5 million × 8%
= $9.56 million in capital.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-28
Capital Adequacy: Australia’s
Authorised Depository Institutions
Credit Risk Adjusted Off-Balance-Sheet Assets Under
Basel I and II:
• Conversion factors used to convert into credit
equivalent amounts – amounts equivalent to an
on-balance-sheet item.
• Conversion factors used depend on the guarantee
type.
• Two-step process:
– Derive credit equivalent amounts as product of face
value and conversion factor.
– Multiply credit equivalent amounts by appropriate risk
weights (dependent on underlying counterparty).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-29
Capital Adequacy: Australia’s
Authorised Depository Institutions
Credit Risk Adjusted Off-Balance-Sheet Assets Under
Basel I and II:
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-30
Capital Adequacy: Australia’s
Authorised Depository Institutions
The Credit Risk Adjusted Asset Value of Off-BalanceSheet Market Contracts or Derivative Instruments:
• Counterparty credit risk:
The risk that the other side of a contract will default
on payment obligations.
• Credit equivalent amount of OBS derivative security
item ($) =
potential exposure ($) + current exposure ($)
• Potential exposure: the risk of a counterparty to a
derivative securities contract defaulting in the future.
• Current exposure: the cost of replacing a derivative
securities contract at today’s prices.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-31
Capital Adequacy: Australia’s
Authorised Depository Institutions
The Credit Risk Adjusted Asset Value of Off-BalanceSheet Market Contracts or Derivative Instruments:
• Credit risk adjusted value of OBS market contracts =
total credit equivalent amount × risk weight.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-32
Capital Adequacy: Australia’s
Authorised Depository Institutions
The Credit Risk Adjusted Asset Value of Off-Balance-Sheet
Derivative Instruments with Netting:
• Addresses the problem that netting of exposures is
ignored.
• Approach adopted by APRA under the condition that an FI
has a bilateral netting contract.
• Net potential exposure (PFCEadj):
(0.4 × PCFEgross) + (0.6 × NGR × PCFEgross)
Where:
PCFEgross = sum of the potential future credit exposures of
each contract,
NGR = ratio of net current exposure to gross current
exposure.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-33
Capital Adequacy: Australia’s
Authorised Depository Institutions
The Credit Risk Adjusted Asset Value of Off-BalanceSheet Derivative Instruments with Netting:
• Current exposure: net sum of all positive and
negative replacement costs.
• If result is positive, then the net current exposure
equals the sum.
• If result is negative, the net current exposure is zero.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-34
Capital Adequacy: Australia’s
Authorised Depository Institutions
Interest Rate Risk, Market Risk and Risk-Based Capital:
• Insolvency risk arising from duration mismatches and
trading risk were not explicitly accounted for in the
original capital framework.
• Since 1998: FIs have had to calculate an ‘add-on’ to
cover market risk.
• Two different approaches:
– Standardised model (predetermined by regulators),
– FI’s own internal market risk model.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-35
Capital Adequacy: Australia’s
Authorised Depository Institutions
Operational Risk and Risk-Based Capital:
• Three increasingly sophisticated approaches to calculate
operational risk capital:
– Basic Indicator Approach,
– Standardised Approach,
– Advanced Measurement Approach.
• Basic Indicator Approach:
– On average banks hold 12% of total regulatory capital
against operational risk exposures,
– Operational capital = α × gross income.
• α = 17 – 20%.
• Gross income =
net interest income + net non-interest income
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-36
Capital Adequacy: Australia’s
Authorised Depository Institutions
Operational Risk and Risk-Based Capital:
• Standardised Approach:
– Refinement to Basic Indicator Approach,
– FI’s activities divided into eight business units and
lines,
– Risk indicator (β) in each business line reflects the
business line’s riskiness.
– Operational capital in each business line =
β × gross income.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
Slides prepared by Maike Sundmacher
17-37
Capital Adequacy: Australia’s
Authorised Depository Institutions
Operational Risk and Risk-Based Capital:
• Standardised Approach:
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17-38
Capital Adequacy: Australia’s
Authorised Depository Institutions
Operational Risk and Risk-Based Capital:
• Advanced Measurement Approach:
– Internal Measurement Approach (IMA),
– Loss Distribution Approach (LDA),
– Scorecard Approach (SA).
• Requirements to be fulfilled by FIs to qualify for the
Advanced Measurement Approach:
– Systematic and transparent operational risk management
and measurement practices (capable of independent review
and validation),
– Framework to manage, measure and monitor operational
risk.
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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17-39
Capital Adequacy: Australia’s
Authorised Depository Institutions
Operational Risk and Risk-Based Capital :
• Requirements to be fulfilled by FIs to qualify for the
Advanced Measurement Approach (continued):
– Collection of operational risk data,
– Use of internal and relevant external operational risk
data, scenario analysis, specific indicators of the
FI’s current and future operational risk profile.
– Operational risk capital must cover expected and
unexpected losses,
– Operational risk requirement must be comparable to a
99.9% confidence level and a one-year holding period.
• Risk mitigators might be allowed, subject to APRA’s approval
(maximum: 20%).
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PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett
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17-40
Capital Adequacy: Australia’s
Authorised Depository Institutions
Criticisms of the Risk-Based Capital Ratio:
• Risk weights,
• Risk weights based on external credit rating
agencies,
• Portfolio aspects,
• DI specialness,
• Other risks, e.g. credit crunches.
• Competition.
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17-41
Internal Ratings Based Approach to
Measuring Credit Risk Adjusted Assets
• Two Internal Ratings Based (IRB) Approaches:
– Foundation IRB Approach,
– Advanced IRB Approach.
• Foundations IRB Approach:
– Bank internally estimates the one-year probability of default
(PD),
– Supervisor determines other risk determinants.
• Advanced IRB Approach:
– Bank determines PD, loss given default (LGD), exposure at
default (EAD) and maturity (M).
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17-42
Internal Ratings Based Approach to
Measuring Credit Risk Adjusted Assets
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17-43