Capital Adequacy

Chapter 20
Financial Institutions Management, 3/e
By Anthony Saunders

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Importance of Capital Adequacy

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 risk-adjusted
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 amountsamounts 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 todays 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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