CAPITAL ADEQUACY
1
Class 12, Chap 20
Lecture outline
2
Purpose: Gain a general understanding of why equity capital is
important, how it is measured and how it is regulated

Introduction to capital adequacy




What is it and why is it important
What are the costs and benefits to regulation
How to measure capital
Calculation of Capital Ratios


Leverage
Risk-based


Tier I capital ratio
Total capital ratio
Why is Capital Adequacy Important?
3

What happens when banks are under capitalized?

Should banks be forced to hold more capital?
Cost/Benefit of Regulating Capital
4
Economic Growth
Economic Stability
Increasing Capital Capital Requirements Lowers Insolvency Risk


Absorbs unanticipated losses – equity capital acts as a buffer between the value of assets
and liabilities. Losses in asset values decrease the value of equity. At zero equity value
the firm is insolvent.
Protects unsecured creditors against losses in the event of liquidation.


Proceeds from the sale of assets will more likely cover creditor claims for firms with high equity
capital
Protects FDIC insurance fund DIF and tax payers

Lower insolvency risk means fewer payouts from the FDIC insurance fund and lower likelihood of a
tax-payer bailout of the FDIC
Cost Benefit of Regulating Capital
5
Economic Growth
Economic Stability
Increasing capital requirements decreases the credit supply


Banks are required to hold more capital on their balance sheet which decreases the
lending capacity of banks
Decreased credit supply reduces corporate investment activity, which slows
economic growth.
Increasing capital requirements can promote economic growth


Increased stability increases consumer confidence which can promote growth
More capital reduces FDIC Premiums which increases lending capacity
6
Measuring Equity Capital
Book Value of Equity
7
Definition
 The historic value of assets/ liabilities. Reflects total purchase price of
all assets on the balance sheet less the face value of liabilities
Main Advantages
 Easy to measure
 Easy to observe (regulate)
Main Disadvantages
 The book value may not reflect the current value of the asset i.e. What
you could buy/sell it for
 Gives managers more discretion on when they report (realize) losses
 Does not consider off-balance sheet items
Market Value of Equity
8
Definition:
 Difference between the market value of assets and liabilities.
 Market value of equity is the remaining value after assets have been
liquidated at market price and all liabilities have been repaid (or
repurchased in the market)
Main Advantages:
 More current measure of liquidation value
 Quick to adjust
Main Disadvantage:
 Hard to measure especially for assets that do not have secondary markets
 Market prices do not always reflect the true (fundamental) asset value
due to market imperfections – crisis
Types of Capital (Basel III)
9

Common Equity Tier I (CET1)

Tier I Capital

Tier II Capital
Common Equity Tier I (CET1)
10


Strict definition of capital, closely related to book value of
common stock
The contribution of DI owner’s available to absorb losses
(4)
(3)
(1)
(2)
Minority interest in
Accumulated
Common
CET1 =
+
consolidated
income and
+
+ Retained +
stock
earnings
subsidiaries
disclosure reserves
(1)
(2)
(3)
(4)
(5)
(6)
(5)
Regulatory
adjustments to –
common equity
Tier 1
(6)
Goodwill
Common shares issued and stock surplus that meets regulatory requirements
Undistributed earnings
Ex: losses on defined benefits pension obligations
Shares issued by subsidiaries and held by a 3rd party (50% ownership <)
Technical adjustments made to CET1
Amount paid for acquisitions above Market value
Tier I Capital
11

Broader definition of capital: includes options other than
common equity for absorbing losses
(3)
(4)
(2)
(1)
Noncumulative
Other perpetual
Tier I minority
Tier I = CET1 +
perpetual
preferred
+
+
securities
Interests
stock
(5)
Other Tier I +
+
securities
(6)
Regulatory
adjustments
(1) Common stock Tier 1 (CET1)
(2) Instruments with no maturities date or incentive to redeem (may be called
within 5 years of issue if replaced with better capital)
(3) Perpetual prefer stock that does not cumulate
(4) Tier I capital of minority interest not included in CET1
(5) Securities issued under small business jobs act 2008 that qualify as Tier 1
equity capital
(6) Technical adjustments made to additional Tier I capital
Tier II Capital
12

Tier II
(1)
(2)
(3)
(4)
(5)
The broadest definition of capital including all equity-like
resources not accounted for else where
=
(4)
(5)
(1)
(2)
(3)
Subordinate + Other subordinate + Total capital of + Loan loss + Other Tier II +
securities
reserves
securities
minority interest
debt
(6)
Regulatory
adjustments
Subordinate bonds and preferred stock
Instrument subordinate to deposits and general creditor claims
Tier II capital of minority interest not included in minority Tier I capital
Reserve account to absorb losses on loans and leases
Securities issued under small business jobs act 2008 that qualify as Tier II
equity capital
(6) Technical adjustments made to additional Tier II capital
CET1, Tier I, & Total Capital
13

CET1 = CET1

Tier I capital = CET1 + additional Tier I

Total capital = Tier I + Tier II
14
Equity Capital Ratios
Capital Ratios
15
Book Value
Measure
1.
Leverage Ratio
2.
Tier I risk-based capital ratio
Book & Market Value – includes OBS
3.
Total risk-based capital ratio
Book & Market Value – includes OBS
Risk-Based
Ratios are
defined in the
Basel Accord
16
Leverage Ratio(s)
Leverage Ratio (Capital-to-Asset)
17
Standard approach
L
Tier I Capital
Total Assets
Advanced approach
L
Tier I Capital
Total exposure(on  off balancesheet)
Derivatives:
Potential + Current Exposure
Guarantee contracts:
- Conversion factor = 100%
- 10% if contract is immediately cancelable
Working with Capital ratios
18
L
Equity
= 100M
Assets
= 400M
Capital
Assets
L
Capital 100

 25%
Asset
400
Liabilities
=300M
Old Leverage Ratio 
Liabilities 300

 75%
Assets
400
Working with Capital ratios
19
L
Equity
= 25M
Assets
= 325M
Capital
Assets
L
Capital
25

 7.69%
Asset
325
Liabilities
=300M
Old Leverage Ratio 
Liabilities 300

 92.31%
Assets
325
Lower ratio = higher leverage, more risk – regulator want high L ratios
Given the following balance sheet calculate the leverage ratio
20
Draw-backs of leverage ratio
21

Does not consider off-balance sheet risks

Measures asset values using book value

Assumes that all assets are equally risky
Is there a
difference in risk?
100 Billion in cash
100 Billion in Greek bonds
(purchased in 2005)
Risk Based Capital Ratios
The Basel Accord
22
Basel Accord
23



Banking regulation recommended by the Basel Committee on
Banking Supervision (BCBS) a division of the Bank of
International Settlement (BIS)
US DI regulators agreed, with other BIS member countries, to
enforce regulation outlined in the Basel Accord
Three main versions




Basel I
Basel II
Basel II.5
Basel III
Basel Accords I & II
24

Basel I (1993)

Introduced risk-based capital ratios






Credit-risk adjust assets
Include off-balance sheet items
Set capital requirement thresholds 8% adequately capitalized
Prompt corrective action
Market risk (1998) revision to include market risk as an add-on to the 8%
capital requirement
Basel II (2006)

Increased option to account for credit risk



Standard approach
Internal Ratings Based (IRB)
Recommended holding capital against operational risk
Basel Accords II.5 & III
25

Basel II.5 (2009 passed, 2013 effective)


Basel III (2010 passed, 2019 effective)







Updated capital requirements on market risk for banks’ trading operations
Raised quality consistency and transparency of capital base at banks
Redefined capital to emphasize common equity
Refined risk weight categories
Introduced conservation buffer
Introduced countercyclical capital buffer
Introduced global systemically important bank (G-SIB) surcharge
Also has provisions for supervision (Pillar 2) and disclosure (Pillar 3)
26
Risk-Based Capital Ratio
Calculation
Risk Adjustment Overview
27

The Basel III proposed 3 risk-adjusted capital ratios



Common Equity Tier I capital ratio
Tier 1 risk-adjusted capital ratio
Total risk-adjusted capital ratio
L

Capital
Assets
L
Capital
Credit risk - adjusted assets
There are 2 components of risk adjusted asset value
1.
2.
Credit risk-adjustment of on-balance sheet asset values
Credit risk adjustment of off-balance sheet asset values
CET1, Tier I & Total Capital Ratios
28

CET1 Capital Ratio:
ECT1 

CET1
Credit risk - adjusted asset value
Tier I Capital Ratio:
Tier I 

Tier I
Crdit risk - adjusted asset value
Tier II Capital Ratio:
Tier I 
Tier I  Tier II
Crdit risk - adjusted asset value
Calculating Risk-Adjusted Assets
29
Procedure
1. Calculate credit-risk adjusted asset value of on-
balance-sheet assets
2. Calculate credit risk adjusted asset value of off-
balance-sheet assets
30
1 . Calculate credit-risk adjusted asset
value of on-balance-sheet assets
Calculating Risk-Adjusted Assets
- On Balance-Sheet Items – Procedure
31
2 steps to risk-adjusting on-balance sheet asset values
1. Classify assets into 1 of 9 risk categories to obtain the risk
weight
2. Risk-adjust asset values: multiply risk weights by balance sheet
asset values and sum
Risk-adjusted
=
asset value
Σ Asset Value Weight
Calculating Risk-Adjusted Assets
- On Balance-Sheet Items – Risk Weights
32
Step 1: Under Basel III assets are assigned to 1 of 9 categories
Calculating Risk-Adjusted Assets
- On Balance-Sheet Items – Example
33
Step 2: Convert to credit equivalent amounts and sum
Risk-adjusted
Asset Value Weight
asset value =
Category 1:
0  (8  13  60  50  42)  0
Category 2: .2  (10  10  20  10  55)  21
Category 3: .5  (34  308 75) 
208.5
Category 4:
1 (390 108 22) 
520
Category 5:
1.5  (10) 
15
764.5 Mill
Consumer Loans
On Balance-sheet risk
adjusted asset value
Risk Weights #1
Risk Weights #2
34
Back
High Quality
• Traditional, First lien, and
prudentially underwritten
Low Quality
• Junior liens
• Non-traditional
35
Back
36
2 . Calculate credit-risk adjusted asset
value of off-balance-sheet assets
Calculating Risk-Adjusted Assets
- Off Balance-Sheet Items - Procedure
37
1. Convert to on-balance sheet credit equivalent amounts using
Basel conversion factors
New
Contingent or
guaranty contracts
Market &
Derivatives contracts
2. Classify off-balance sheet items into 1 of 9 risk categories to
determine risk weights
3. Risk-adjust asset values: multiply risk weights by balance sheet
asset values and sum
38
Step #1
Contingent or guaranty contracts
Calculating Risk-Adjusted Assets
- Off Balance-Sheet Items – Convert to Credit Equivalents
39
Step 1 Convert to credit equivalent amounts (CEA) using the Basel
conversion factors
Contingent or guaranty contracts:
CEA =
Off-balance sheet
value (notional)
Basel Factor
40
Step #1
Market contracts or derivatives
(FX, interest rate forwards, options and swaps)
Calculating Risk-Adjusted Assets
- Off Balance-Sheet Items – Convert to Credit Equivalents
41
Step 1 Convert to credit equivalent amounts (CEA) using the Basel
conversion factors
Market contracts or derivatives:
Credit Equivalent
Amount
=
Current
Potential
+
Exposure
Exposure
Potential Exposure: Captures expected losses from future counterparty default.
Potential Exposure = [Off-balance sheet value (notional)] × [Basel Factor]
Calculating Risk-Adjusted Assets
- Off Balance-Sheet Items – Convert to Credit Equivalents
42
Step 1 Convert to credit equivalent amounts (CEA) using the Basel
conversion factors
Market contracts or derivatives:
Credit Equivalent
Amount
=
Current
Potential
+
Exposure
Exposure
Current Exposure: Replacement cost of the contract if counter party defaults today
• Positive value (in the money): The FI would have to pay out-of-pocket to
reestablish the contract – regulators will recognize this (market) value as the
replacement cost
• Negative value (out of the money): The FI would not likely actively seek to
reestablish a negative position – regulators require that the FI sets replacement
costs equal to zero.
Calculating Risk-Adjusted Assets
- Off Balance-Sheet Items – Risk adjustment
43
Step 2 Classify Credit Equivalent Amounts into 1 of 9 categories
using Basel tables
Step 3 Sum risk adjusted Credit Equivalent Amounts
Risk-adjusted
asset value =
Σ
CEA Weight
44
Example
Off Balance Sheet Adjustment
Calculating Risk-Adjusted Assets
Example
- Off Balance-Sheet Items – Convert to Credit Equivalents
45
Step 1 Contingent or guaranty contracts: Example

Total = $60M
Conversions
Guarantee Contract Conversions
46
Back
Calculating Risk-Adjusted Assets
Example
- Off Balance-Sheet Items – Convert to Credit Equivalents
47
Step 1 Market contracts or derivatives: Example
Suppose an FI has the following off-balance-sheet items:
1.
2.
4-year Fixed for floating Interest rate swap with notional amount of $100 mill and current
market value of 3 Mill
2-year forward foreign exchange contract with $40 mill In notional value and calculated value
of -1Mill to the FI
Convert OBS items to on-balance-sheet credit equivalent amounts by adding potential
and current exposures:

4-year Fixed for floating Interest rate swaps
potential (0.005)($100,000,000)  $500,000
Replacement
cost
Current  max($3,000,000, 0)  $3,000,000
Credit Equivalent Amount
= $3,500,000
Conversions
Calculating Risk-Adjusted Assets
Example
- Off Balance-Sheet Items – Convert to Credit Equivalents
48
Step 1 Market contracts or derivatives: Example
Suppose an FI has the following off-balance-sheet items:
1.
2.
4-year Fixed for floating Interest rate swap with notional amount of $100 mill and current
market value of 3 Mill
2-year forward foreign exchange contract with $40 mill In notional value and calculated value
of -1Mill to the FI
Convert OBS items to on-balance-sheet credit equivalent amounts by adding potential
and current exposures:

2-year forward foreign exchange contract
potential (0.05)($40,000,000)  $2,000,000
Current  max($1,000,000, 0) 
Credit Equivalent Amount
Replacement
cost
0
= $2,000,000
Conversions
Calculating Risk-Adjusted Assets
Example
- Off Balance-Sheet Items – Convert to Credit Equivalents
49
Contingent and Guarantee Contracts
CEA
Loan commitment
40,000,000
Direct-credit substitute standby letter of credit
10,000,000
Commercial letter of credit
10,000,000
Market & Derivative Contracts
CEA
4-year Fixed for floating Interest rate swap
3,500,000
2-year forward foreign exchange contract
2,000,000
Market & Derivative Contract Conversions
50
Back
Example
Calculating Risk-Adjusted Assets
51
Step #2
Adjust for credit risk
Calculating Risk-Adjusted Assets
- Off Balance-Sheet Items – Determine Risk Weights
52
Step 2: Classify OBS items into risk categories


Contingent or Guaranty contracts

Use the same risk category classifications as we used for on-balance sheet items

Classify the OBS item as if the contingent event had occurred and the asset was
brought back on the balance sheet.
Market contracts or derivatives

Derivatives and market contracts are assessed at 100% of their risk i.e. risk
weight = 100%
Calculating Risk-Adjusted Assets
Example
- Off Balance-Sheet Items – Determine Risk Weights
53
Step #2: Apply risk weights to Credit Equivalent Amounts

Contingent or guaranty contracts:
Conversions
Calculating Risk-Adjusted Assets
Example
- Off Balance-Sheet Items – Determine Risk Weights
54
Step #2: Apply risk weights to Credit Equivalent Amounts

Market and Derivative contracts:
Market and Derivative contracts
mostly have 100% risk weight
55
Back
Example
Calculating Risk-Adjusted Assets
56
Step #3
Total risk-adjusted OBS assets
Calculating Risk-Adjusted Assets
Example
- Off Balance-Sheet Items – Total OBS RAA value
57
Step #3 Total Off-Balance Sheet risk-adjusted asset value
Guarantee contracts:

2-year loan commitments
$40,000,000

Direct credit substitutes standby letters of credit
$10,000,000

Commercial letter of credit
$10,000,000
$60,000,000
Market & Derivatives Contracts:

1-year fixed for floating rate swap
$3,500,000

2-year foreign exchange contract
$2,000,000
$5,500,000
Calculating Risk-Adjusted Assets
- Total Risk Adjusted Capital
58

Total risk adjusted capital is the sum of:




Risk adjusted on-balance-sheet assets
Risk adjusted off-balance-sheet assets – contingent guaranty contracts
Risk adjusted off-balance-sheet assets – market contracts or derivatives
From the above examples:
Risk-Adjusted Capital
On-balance-sheet
764.5 mill
Off-balance-sheet (Contingent or guaranty )
60 mill
Off-balance-sheet (Market and Derivative )
5.5 mill
Total Risk Adjusted Asset Value
830 mill
59
Calculate Ratios
What was the point of all that?
60

The Basel Accord proposed 2 risk-adjusted capital ratios



Common Equity Tier I (CET1)
Tier 1 risk-adjusted capital ratio
Total risk-adjusted capital ratio
CET1 Ratio 
Tier I Ratio 
CET1
Risk  adjusted Asset Value
Tier I
Risk  adjusted Asset Value
Total Capital Ratio 
Tier I  Tier II
Risk  adjusted Asset Value
We now have credit-risk
adjusted asset values
Risk-Based Capital Ratios
61
CET1
• Retained Earnings
• Common Stock
40
30
70
CET 1 Ratio 
70
 8.43%
830
Tier 1
• CET1
• Qualified perpetual
preferred stock
70
10
80
Tier I Ratio 
70  10
 9.64%
830
Risk-Based Capital Ratios
• Qualified perpetual
preferred stock
10
62
Tier II
• Convertible Bonds
10
• Subordinate Debt
10
• Non-Qualified perpetual
preferred stock
5
• Loan loss reserves
10
35
Total Capital Ratio 
70  10  35
 13.86%
830
63
Capital Adequacy Regulation
Regulation
64
After obtaining the capital ratios, the bank capital adequacy can be
assessed and regulated
Leverage
70  10
 6.58%
1,215
CET 1 
70
 8.34%
830
Tier I 
70  10
 9.64%
830
Total 
70  10  35
 13 .86%
830
Corrective Action
65
Other Capital Requirements
66



Conservation Buffer

Account that banks build up during good time to drawdown on in bad times

Made up of CET1 but does not count toward CET1

Phased in over 3013 – 2019; 0% – 2.5% add-on to capital ratios
Countercyclical Buffer

Banks in countries experiencing abnormal growth in credit supply must hold an
additional capital buffer

0% – 2.5% add-on to the capital ratios

Must be met with CET1 and banks are given 12 month to comply
Global systemically important surcharge

Top-ranked G-SIB’s must hold additional CET1 capital 1% - 3.5% add-on

Ranked by: size, interconnectedness, cross-jurisdiction, complexity, no subs

Exact charge depends on the ranking into 5 buckets
Lecture Summary
67
 What
is capital adequacy and why is it important
 What
are the costs and benefits to regulation
 How
to measure capital
 How
to measure capital adequacy (capital ratios)


Leverage
Risk-based

CETI capital ratio

Tier I capital ratio
Total capital ratio


Regulation