Lecture 10 (part II)

Capital management

FI's capital guided by two key factors

regulated capital adequacy requirements

risk- return trade- offs available from the use of leverage

regulation introduces moral hazard (excessive risk- taking)

measures of capital adequacy

risk- based capital ratio

leverage ratio

L = core capital/ assets

based on book value

problems

  1. Ignores Non- equity capital (eg: long- term debt)
  1. Bank only ratio: subsidiaries not included in leverage ratio
  1. Ignore off- balance sheet activities
  1. Different risk appetites of DIs: not all FIs have the same risk
  1. Assets risk: fails to consider different risks in asset portfolio
  1. Market value (based on book value)

Risk- based capital ratios

proposed by BIS (Bank for International Settlements)

introduction: page 28 - 32

3 main parts

  1. Tier 1 capital
  1. Total capital
  1. Common Equity Tier (CET) 1

Risk- based capital ratios = capital / risk- adjusted assets

2 approaches

  1. Standardized approaches to calculate risks (used by most smaller banks)
  1. Internal ratings- based (IRB) models if approved by APRA

Measurement of regulatory capital

Tier 1 (going concern) capital

Tier 2 (gone concern) capital

common equity Tier 1: common equity + retained earnings

additional Tier 1 capital: non- common equity elements, subordinated with non- cumulative dividends and no maturity (i.e: non- cumulative preferences shares)

Tier 1 + subordinated to depositors and general creditors (i.e: subordinated bonds, cumulative preferences shares)

capital adequacy ratios (p.37)

general: capital / total risk- adjusted assets

higher risk => require more capital => satisfy the required ratios

Measuring risk- adjusted assets

resulting from credit, operational, market and securitisation risks

credit risk- adjusted assets = risk- adjusted (on + off balance sheet) assets

approach

  1. Identify risk weights for each asset (table 18.5)
  1. Add weighted assets

3. Min capital = Risk weighted assets x required capital

Risk- adjusted off- balance sheet assets

2 types of OBS items (p.44)

  1. OBS contingent guarantee contracts (standby and commercial letters of credit, loan commitments, ...)
  1. OBS market contracts or derivative instruments (futures or forwards)

Calculating

OBS contingent guarantee contracts

  1. Convert OBS values into on- balance- sheet credit equivalent amounts (CEA) (table 18.8)
  1. Multiply the OBS CEA by the appropriate risk category weight (table 18.5)

OBS market contracts or derivative instruments (p.51 - 53)

Other risks

Operational risk- weighted equivalent assets = operational risk capital charge x 12.5 (i.e: fraud, technology failure)

Market risk (due to changes in prices) = Market risk capital charge x 12.5

Non- traded interest rate risk capital charge

securitisation credit risk

backstop measure

Basel III

2 capital buffers

  1. Capital conservation buffer (p.63)
  1. Countercyclical capital buffer (p.64)

Pillar 1: Capital adequacy

Capital adequacy ratios

Leverage ratios

Capital buffers

New definition of capital

Pillar 2: Risk assessment and supervision (p.67)

Pillar 3: Capital and risk disclosure (p.68)