Independent
work
Theme: The capital of a commercial bank is a requirement
for its composition and sufficiency.
Today, all operations performed by commercial banks directly or
indirectly depend on the adequacy of bank capital and its quality, and the
adequacy of bank capital is the main factor in assessing the solvency and
risk-freeness of any commercial bank. Having a sufficient amount of bank
capital of commercial banks provides an opportunity to ensure their
liquidity and to exit without damage from the risks they face during their
activities.
The main requirements for capital adequacy of commercial banks of
Uzbekistan are defined in Regulation No. 420 of the Central Bank "On
Requirements for Capital Adequacy of Commercial Banks".
The requirements for capital adequacy of commercial banks
according to the regulation correspond to the requirements stipulated in
the standards of the international Basel Committee . The templates of the
Basel Committee were developed in 1998 with the participation of
representatives of the central banks of the twelve member countries and
put into practice in 1993 . The capital of commercial banks consists of
first-tier capital and second-tier capital. In economic literature, it is also
referred to as basic capital and additional capital. The division of the
capital of commercial banks into primary and additional capital is
important in the formation of resources in the total capital and its
management.
The main capital of commercial banks of the Republic of Uzbekistan
consists of fully paid and issued ordinary shares of the bank, noncumulative, indefinite preferred shares, issue income, retained earnings,
funds allocated to consolidated subsidiaries and general reserves. One of
the main tasks of the day is the formation of capital of the commercial
banks of our republic, the income of the issue and the funds directed to
the consolidated subsidiaries. The non-formation of emission income in
the main capital of commercial banks is related to the trading of ordinary
and preferred shares of banks on the stock exchanges of the country. As
we know, the emission income is generated by the positive difference
between the nominal value and the actual sale price of the ordinary and
preferred shares of the commercial bank through the financial markets.
Currently, due to the fact that this market is not fully functioning
and the influence of other economic factors, it is not possible for
commercial banks to generate emission income. When the secondary
market for securities is fully operational, when the stock exchange is fully
functional, when the share price is regularly published and the public is
eager to buy shares, the shares themselves become not just ordinary paper,
but real securities, important to their owners. it can be achieved only if
there is a source of income. The lack of investments in consolidated
subsidiaries in the capital of commercial banks can be explained by the
fact that the experience of establishing separate credit institutions such as
leasing, trust, factoring, and forfeiting companies is not used in the
practice of commercial banks. However, in the practice of international
banking, the effectiveness of such institutions established under
commercial banks has been proven.
Subsidiaries established under banks do not have an independent
balance sheet, they operate on the basis of a fixed cost estimate, and their
profit is added to the bank's profit. Most importantly, the efficiency of
their activity can be expressed in concrete indicators. This allows to
develop measures to improve the efficiency of the activities of
subsidiaries. The additional capital of commercial banks consists of the
net profit of the bank for the current year, the amount of reserves made
against credit risks not exceeding 1.25% of the amount of the bank's assets
at risk, mixed liabilities and subordinated debt liabilities. One of the main
tasks is to form the practice of introducing subordinated debt obligations
in the structure of the capital of commercial banks of our republic. The
formation of subordinated debt obligations within the capital of
commercial banks will be an important incentive for their further
development of the market of medium and long-term loans. Because
subordinated debt obligations are a convenient and low-cost means of
attracting medium and long-term resources for commercial banks.
At the same time, there are high-yield investment projects financed
by medium- and long-term lending, which force banks to find mediumand long-term resources. Subordinated debt obligations are used as a
means of raising such resources. In order to cover unforeseen risks in the
conditions of the market economy, the Basel Committee introduced Tier
III capital in 1997. According to it, third-tier capital is short-term (no more
than two years).
A bank's capital is simply the difference between its assets and
liabilities, i.e., the value of what the bank owners actually own. Because
banks use extensive leverage to augment profits, a small decrease in the
value of its assets can wipe out the bank's capital, causing it to fail. To
lessen the probability of failure, banks must maintain a minimum of
capital, called regulatory capital, because the amount that must be
maintained, which varies according to the riskiness of the assets, is
stipulated by law. Regulatory capital, which includes equity, preferred
stock, subordinated debt, and general reserves, must be sufficient to repay
depositors and senior debtholders in the event of a bankruptcy. In the
aftermath of the Great Recession, banks have started to issue a new type
of bond called contingent convertible bonds (CoCos), which convert to
equity when a bank's common equity tier 1 ratio drops below 7%.
Barclays has even issued total-loss bonds, so-called because bondholders
lose the entire principal if financially triggered. These 10 year bonds were
sold for a 7.625% interest rate. CoCos and total-loss bonds lower risk by
eliminating the legal obligation to pay interest when the issuing bank
becomes financially stressed.
Bank owners generally want lower capital ratios because they
increase the return on assets and the return on equity. Banks earn a profit
from the net interest margin, which is the difference between the interest
rates received on loans and interest rates paid on deposits and short-term
debt, so leverage increases profits for a given investment of bank
capital. But that also increases risk. Banks have various means of
modifying the capital to assets ratio. Banks can reduce capital to assets by
paying a higher dividend; buying back company shares, or increase
lending that is financed by issuing CDs, bonds, commercial paper, or by
attracting more deposits. Banks can increase the capital to assets by
reducing dividends; selling new shares; reducing assets by borrowing less
or selling off existing loans; by selling securities; or by reducing costs,
such as pay, bonuses, and other costs.
Banks must also maintain a minimum liquidity, as measured by
the liquidity coverage ratio. While increased capital helps to protect
against insolvency, increased liquidity allows banks to weather runs on
the bank, freezes in the short term debt markets, and higher credit
demands from existing customers.
Liquidity Coverage Ratio = High-Quality Liquid Assets/Total
Net Cash Outflows
Liquidity coverage ratios are required to be 60% by 2015, which
will gradually increase to 100% by 2019. Of its liquid assets, 60% must
be cash, central bank reserves, and government bonds; 40% may be
corporate bonds, residential mortgage-backed securities, and stocks of
creditworthy corporations, but RMBSs and stocks cannot compose more
than 15% of liquid assets.
Capital adequacy requirements are based on a minimum ratio of
capital to risk-weighted assets. For assets that are essentially risk free,
such as Treasuries, the ratio is 0%. For risky assets, the ratio can exceed
100%. If a bank buys $1 million worth of assets with a risk rating of 100%,
then the bank must hold $1 million of capital to cover the risk of those
assets. On the other hand, if a bank invests $1 million in Treasuries, which
have a risk rating of 0%, then no additional capital must be maintained for
that asset.
Cash instruments — instruments that must be paid for, such as
stocks or bonds — have risk-weighted capital requirements based on the
amount invested, the type of instrument, and the creditworthiness of the
issuer. Derivatives have lower requirements because they generally do
not have an initial cash flow. The notional principal is required to
calculate subsequent cash flows, but is never exchanged, so the capital
adequacy requirements are less for derivatives. The main risk associated
with derivatives is counterparty risk, which can be lowered through the
exchange of collateral. If there is a default, then the surviving party does
not lose any principal, but may incur only the replacement cost. Thus,
capital adequacy requirements only apply to potential losses incurred by
the replacement cost, which is generally a small fraction of the notional
principal. The creditworthiness of the counterparties is also pertinent to
the riskiness of derivatives.
The Basel accords determine procedures that should be followed to
ensure adequate capital for risky assets. All assets have a risk weighting
proportional to their riskiness, requiring a proportional amount of capital
to be set aside in case of default or loss. This proportional percentage is
called the capital charge. For purposes of determining capital adequacy
requirements, a bank's business is divided into the banking book and the
trading book. The banking book lists transactions by the bank's lending
department that mostly consists of loans, which is the bank's normal
business. The trading book lists transactions by the banks dealing desk,
buying and selling securities so that either additional profits can be made
from trading or to hedge held positions. Stricter capital adequacy
requirements apply to the trading book, since trading is a greater risk.
Basel I defined 2 tiers of capital: Tier 1 and Tier 2. Tier 1 capital is
composed of stockholders equity and noncumulative preferred stock,
which allows the bank to suspend dividend payments, if necessary. Tier
2 was composed of all other assets. The required capital is based on the
risk adjusted exposure:
Risk-Adjusted Exposure = Principal × Risk Weighting × Capital Charge
Based on the risk-adjusted exposure, the capital requirements are
determined by the following:
The total risk exposure is determined by adding the risk-adjusted
exposure for each asset. However, banks may use netting or portfolio
modeling to reduce the principal value. Because the notional principal of
derivatives is not at risk, their capital requirements are considerably less
than for cash instruments. For instance, there is no capital requirement
for forward rate agreements with less than 1-year maturity, while long-
term currency swaps may have a capital charge ratio of between 0.08%
and 0.2% of the notional principal.
Basel II rules are based on 3 pillars, or approaches: minimum capital
requirements, minimum supervision by regulators, and minimum
disclosures.
The 1st pillar is minimum capital requirements based on risk that is
more detailed than in Basil I. In determining the risk of assets, 3 different
types of risk must be assessed separately: market risk, credit risk, and
operational risk. The 3 risk numbers are then added together to determine
the overall risk:
Market risk is the risk that the market value of the bank's assets will
fall.
Credit risk is the risk that borrowers or counterparties to derivatives
will default.
Operational risk is the risk incurred because of faulty operational
procedures, including the failure to detect risks posed by employees,
fraud, general computer failures, IT deficiencies, and legal risk.
.
There are 2 methods for calculating the required capital to cover
market risk: standardized approach and internal models approach.
The standardized approach uses standard rules for assessing the risk of
particular securities and positions. Capital adequacy requirements will be
less for net positions, if netting reduces the overall risk. A minimum risk
asset ratio (aka capital adequacy ratio) is required, based on a credit rating
matrix with specific weights according to type of asset and its credit
rating. So, for instance, a loan to a corporation with a credit rating of less
than B- may have a risk weighting of 150%. Additionally, more types of
assets are recognized as collateral, such as equities and gold. However,
only a portion of the market value of the securities can serve as collateral,
to reduce the effects of price volatility. The ratio of the bank's capital and
reserves must meet or exceed a percentage of the risk-weighted assets:
The internal models approach allows the bank to use its own valueat-risk models, if they are approved by a bank supervisor, and the
following requirements are satisfied:
the holding period cannot be fewer than 10 days
the confidence level must meet or exceed 99%
the observation period must be at least 1 year.
There are also 2 approaches for determining credit risk. The
standardized approach requires an assessment of the creditworthiness of
the counterparty, based on published ratings by credit rating agencies,
such as Standard & Poor's, multiplied by the factor assigned for the type
of transaction, based on the potential loss from the transaction. For
instance, a forward rate agreement with a notional principal of $1 million
is considerably less risky than a $1 million loan, because the FRA simply
uses the notional principal to calculate interest payments — the notional
principal is not lent. On the other hand, the entire principal of a loan is at
stake, so its risk is higher. For derivative transactions that use a
clearinghouse, where the clearinghouse acts as the counterparty to both
the buyer and the seller and where margin requirements are marked to
market daily, the credit risk rating is 0.
The other approach for determining credit risk is the internal ratingsbased approach. The bank can use its own methods for the calculation, but
only if they are approved by the relevant supervisory body and were used
for at least 3 years. Loans must be categorized into buckets of probabilityto-default (PD) bands, allocating greater amounts of capital to the higher
risk bands. Additionally, the following items must be determined for each
exposure:
exposure at default (EAD), which is the total cash amount of the
exposure
loss given default (LGD), which is the actual loss percentage of the
EAD that the bank would suffer from a default effective maturity of the
transaction
The 2nd pillar is the supervisory approach to capital allocation.
Banks must calculate their capital requirements according to their own
risk profiles, such as calculating prepayment risk with mortgages.
Supervisors will have the authority to review the capital allocation and set
a higher amount if deemed necessary.
The 3rd pillar is increased disclosure. The purpose of increasing
disclosure is so that the market can more readily assess the risk taken by
financial institutions. Core disclosure rules dictate what must be reported
by the banks, but supplementary disclosure rules apply to only
information that must be reported if the bank determines that they are
relevant and material. The main elements that must be disclosed are the
type of instruments that make up the bank's Tier 1 and Tier 2 capital, the
capital adequacy requirements that apply to the bank, and the overall risk
exposure, especially concerning the maturity of its loans, interest-rate
risk, and other market risks.
The Great Recession demonstrated that capital adequacy
requirements were not strong enough. Therefore, Basel III rules were
published and will be enacted gradually, from 2013 until 2019. Basel III
rules that will be enacted in 2015:
1)banks are required to have an increased liquidity coverage ratio, holding
enough cash and liquid assets to pay all debts due within 30 days
2)capital must be maintained as a percentage of all assets, including riskfree government bonds, with a minimum leverage ratio of 3%
3)bank authorities can require counter-cyclical regulatory capital during
boom times to help cool the economy and to prevent asset bubbles
4)the largest global banks will require a 9.5% core tier 1 ratio before they
can distribute dividends in the US, banks will be restricted from making
investments with their own capital, including investments in hedge
funds and private equity firms
5)in the European Union, bonuses for bankers will be capped at twice their
salary