Capital Adequacy
Chapter 20
Financial Institutions Management, 3/e
By Anthony Saunders
Irwin/McGraw-Hill
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Importance of Capital Adequacy
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•
•
•
Preserve confidence in the FI
Protect uninsured depositors
Protect FI insurance funds and taxpayers
To acquire real investments in order to provide
financial services
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Cost of Equity
• P0 = D1/(1+k) + D2/(1+k)2 +…
Or if growth is constant,
P0 = D0(1+g)/(k-g)
• May be expressed in terms of P/E ratio as
P0 /E0 = (D0/E0)(1+g)/(k-g)
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Capital and Insolvency Risk
• Capital
» net worth
» book value
• Market value of capital
» credit risk
» interest rate risk
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Capital and Insolvency Risk
(continued)
• Book value of capital
» par value of shares
» surplus value of shares
» retained earnings
» loan loss reserve
• Credit risk
• Interest rate risk
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Discrepancy Between Market and Book
Values
• Factors underlying discrepancies:
» interest rate volatility
» examination and enforcement
• Market value accounting
» market to book
» arguments against market value accounting
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Capital Adequacy in Commercial
Banking and Thrifts
• Actual capital rules
• Capital-assets ratio (Leverage ratio)
L = Core capital/Assets
» 5 categories associated with set of mandatory and
discretionary actions
» Prompt corrective action
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Leverage Ratio
• Problems with leverage ratio:
» Market value: may not be adequately
reflected by leverage ratio
» Asset risk: ratio fails to reflect differences in
credit and interest rate risks
» Off-balance-sheet activities: escape capital
requirements in spite of attendant risks
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Risk-based Capital Ratios
• Basle agreement
» Enforced alongside traditional leverage ratio
» Minimum requirement of 8% total capital (Tier I
core plus Tier II supplementary capital) to riskadjusted assets ratio.
» Also, Tier I (core) capital ratio
= Core capital (Tier I) / Risk-adjusted assets must
meet minimum of 4%.
» Crudely mark to market on- and off-balance sheet
positions.
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Calculating Risk-based Capital
Ratios
• Tier I includes:
» book value of common equity, plus perpetual
preferred stock, plus minority interests of the bank
held in subsidiaries, minus goodwill.
• Tier II includes:
» loan loss reserves (up to maximum of 1.25% of riskadjusted assets) plus various convertible and
subordinated debt instruments with maximum caps
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Calculating Risk-based Capital
Ratios
• Risk-adjusted assets:
Risk-adjusted assets = Risk-adjusted on-balance-sheet
assets + Risk-adjusted off-balance-sheet assets
• Risk-adjusted on-balance-sheet assets
» Assets assigned to one of four categories of credit risk
exposure.
» Risk-adjusted value of on-balance-sheet assets equals
the weighted sum of the book values of the assets,
where weights correspond to the risk category.
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Risk-adjusted Off-balance-sheet
Activities
• Off-balance-sheet contingent guaranty contracts
» Conversion factors used to convert into credit
equivalent amounts—amounts equivalent to an onbalance-sheet item. Conversion factors used depend
on the guaranty 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)
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Risk-adjusted Off-balance-sheet
Activities
• Off-balance-sheet market contracts or derivative
instruments:
» Issue is counterparty credit risk
• Basically a two-step process:
» Conversion factor used to convert to credit equivalent
amounts.
» Second, multiply credit equivalent amounts by
appropriate risk weights.
• Credit equivalent amount divided into potential and
current exposure elements.
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Credit Equivalent Amounts of
Derivative Instruments
• Credit equivalent amount of OBS derivative
security items = Potential exposure + Current
exposure
• Potential exposure: credit risk if counterparty
defaults in the future.
• Current exposure: Cost of replacing a derivative
securities contract at today’s prices.
• Risk-adjusted asset value of OBS market contracts
= Total credit equivalent amount × risk weight.
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Risk-adjusted Asset Value of OBS
Derivatives With Netting
• With netting, total credit equivalent amount
equals net current exposure + net potential
exposure.
• Net current exposure = sum of all positive and
negative replacement costs.
» If the sum is positive, then net current exposure
equals the sum.
» If negative, net current exposure equals zero.
Anet = (0.4 × Agross ) + (0.6 × NGR × Agross )
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Interest Rate Risk, Market Risk, and
Risk-based Capital

Risk-based capital ratio is adequate as long
as the bank is not exposed to:
• undue interest rate risk
• market risk
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Criticisms of Risk-based Capital
Ratio
• Risk weight categories may not closely reflect true
credit risk.
• Balance sheet incentive problems.
• Portfolio aspects: Ignores credit risk portfolio
diversification opportunities.
• Reduces incentives for banks to make loans.
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Criticisms (continued)
• All commercial loans have equal weight.
• Ignores other risks such as FX risk, asset
concentration and operating risk.
• Adversely affects competitiveness.
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Capital Requirements for Other FIs

Securities firms
• Broker-dealers:
Net worth / total assets ratio must be no less
than 2% calculated on a day-to-day market
value basis.
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Capital Requirements (continued)

Life insurance
•
•
•
•
C1 = Asset risk
C2 = insurance risk
C3 = interest rate risk
C4 = Business risk
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Capital Requirements (continued)

Risk-based capital measure for life
insurance companies:
RBC = [ (C1 + C3)2 + C22] 1/2 + C4
• If
(Total surplus and capital) / (RBC) < 1.0,
then subject to regulatory scrutiny.
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Capital Requirements (continued)

Property and Casualty insurance companies
• similar to life insurance capital requirements.
• Six (instead of four) risk categories
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