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BNFN 501- ASSET AND LIABILITY MANAGEMENT

CAPITAL ADEQUACY

WEEK 8

Saunders and Cornett (2003)

Chp. 20

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OverviewThis chapter discusses

• the functions of capital,

• different measures of capital adequacy,

• current and proposed capital adequacy requirements, and

• advanced approaches used to calculate adequate capital according to internal rating based models of credit risk.

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Functions of Capital

1. The primary means of protection against the risk of insolvency and failure is a FI’s capital. Capital absorb unanticipated losses with enough margin to inspire confidence.

2. To protect uninsured depositors bondholders and creditors in the event of insolvency and liquidation

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Functions of Capital

3. To protect FI insurance funds and the taxpayers.

4. To protect the FI owners against increases in insurance premiums.

5. To fund the branch and other real investments necessary to provide financial services.

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Cost of Equity Capital as a Funding Source

The value of an FI’s stocks or equities sold in the capital market reflects the current and expected future dividends to be paid by the FI from its earnings.

• P0 = D1/(1+k) + D2/(1+k)2 +…

P0 =Current price of the stock

Di = Dividends expected in year i =1…..

k = Discount rate or required return on the stock

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Suppose dividends are growing at a constant annual rate (g), so that:

D1 = (1+g) D0

D2 = (1+g)2 D0

This can be expresses as :

P0 = D0(1+g)/(k-g)

This is the well-known dividend growth model of stock price determination

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The P/E Ratio: The price of a share per dollar of earnings.

P0 /E0 = (D0/E0)(1+g)/(k-g)

The P/E ratio, or the price of a share per dollar of earnings is greater:

(1) The higher the dividend payout ratio (D/E),

(2) the higher the growth in dividends (g), and

(3) The lower the required return on the FI’s equity (k) payout ratio.

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Capital and Insolvency RiskFIs capital is the difference between the market values of its assets and its liabilities. This is also called the net worth of an FI.

• Book Value: Asset and liability values are based on their historical costs.

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Market Value: Allowing balance sheet values to reflect current rather than historical prices.

• Market value of capital– credit risk– interest rate risk– exemption from mark-to-market for banks’

securities losses

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Example:Assets (mill. $) Liabilities (mill. $)

Long-term securities 80 Liabilities 90

Long-term loans 20 Net worth 10

100 100

Assets LiabilitiesLong-term securities 80 Liabilities 90

Long-term loans 12 Net worth 2

100 100

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Book Value of Capital

• Credit risk– tendency to defer write-downs

• Interest rate risk– Effects not recognized in book value

accounting method

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The book value of capital ( the difference between the book values of assets and liabilities) usually comprises the following four components for an FI.

1- Par value of shares: the face value of the common stock shares issued by the FI times the number of shares outstanding.

2. Surplus value of shares:The difference between the price the public paid for common stock or shares when originally offered (eg. $5 share) and their par values (eg. $1) times the number of shares outstanding.

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3. Retained earnings. The accumulated value of past profits not yet paid out in dividends to shareholders. Since these earnings could be paid out in dividends, they are part of the equity owners’ stake in the FI.

• Loan loss reserve: A special reserve set aside out of retained earnings to meet expected and actual losses on the portfolio. Loan loss reserves reflect an estimate by the FI’s management of the losses in the loan portfolio. While tax laws influence the reserve’s size FI managers actually set the level.

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Consequently, the book value of capital is:

= the par value of shares + surplus value of shares + retained earnings + loan loss reserves

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The Book Value of Capital and Credit Risk

• FIs may resist writing down the values of bad assets as long as possible in order to present a more favorable picture to depositors and regulators.

• Eg. Japanese’s banks loan losses between 1996-2000 Asian financial crises exceeded 32 trillion yen but they remained on the balance sheet of the banks at their book value for a long time.

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Discrepancy Between Market and Book Values

• Factors underlying discrepancies: The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of factors , specially:

– interest rate volatility: The higher the interest rate volatility, the greater the discrepancy.

– examination and enforcement: The more frequent the on-site and off-site examinations and the stiffer the examiner/regulator standards regarding charging off problem loans, the smaller the discrepancy.

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In actual practice, for large publicly traded FIs we can get a good idea of the discrepancy between book values (BV) and market values (MV) of equity even when the FI itself does not mark its balance sheet to market. Specifically, in an efficient capital market, investors can value the shares of an FI by doing an as-if market value calculation of the assets and liabilities of the FI. This valuation is based on the FI’s current and expected future net earnings or dividend flows.

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The stock price of the FI reflects this valuation and thus the market value of its shares outstanding.

The market value of equity per share is:

market value of equity ownership shares outstanding

MV =

Number of shares

The book value of equity per share is:

the par value of shares + surplus value of shares + retained earnings + loan loss reserves

BV=

Number of shares

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MV / BV is often called market the book value:

Market to Book Ratio: Shows the degree of discrepancy between the market value of an FIs equity capital as perceived by investors in the stock market and the book value of capital on its balance sheet.

The lower the MV/BV ratio the greater the book value overstates the true equity of an FI.

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The Capital-Asset Ratio (or the leverage Ratio)

The capital-asset or leverage ratio measures the ratio of a bank’s book value of primary or core capital to the book value of its assets.

L = core capital / Assets

With the passage of the FDIC improvement Act in 1991, a bank’s capital adequacy is assessed according to where its leverage ratio (L) places in one of the five target zones.

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Zone Total Risk-based Ratio• Well capitalized 10% or >• Adequately capitalized 8% or >• Undercapitalized 8%<• Singnificantly undercapitalized 6%<• Critically undercapitalized 2% <

Prompt corrective action: Mandatory actions that have to be taken by regulators as a bank’s capital ratio falls.

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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

• Because of the weaknesses of the simple capital assets ratio, Bank for International Settlements (BIS) introduced two new risk based capital ratios in 1993, which known as the Basel Agreement (now called Basel I).

• The Basel agreement explicitly incorporated the different credit risks of assets (both on and off the balance sheet) into capital adequacy measures.

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• In 1998, Basel Agreement was revised and market risk was incorporated into risk based capital into the form of an “add-on” to the 8% ratio for credit risk exposure.

• In 2001, BIS issued “The New Basel Capital Accord” that proposed the incorporation of operational risk into capital requirements and updated the credit risk assessments in the 1993.

• The new Basel Capital Accord, called Basel II will be effective in 2006.

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The Basel II consist of three mutually reinforcing pillars which together, contribute to the safety and soundness of the financial system.

• Pillar 1 covers regulatory capital requirements for credit, market, and operational risk.

• Pillar 2 stress the importance of the regulatory review process as a critical complement to minimum capital requirements. Each bank should have sound internal processes in place to assess the adequacy of its capital and set targets for capital that are commensurate with the bank’s specific risk profile and control environment.

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• Pillar 3 provides detailed guidance on the disclosure of capital structure, risk exposures, and capital adequacy.

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Risk-based Capital Ratios• Basle I Agreement

– Enforced alongside traditional leverage ratio– Minimum requirement of 8% total capital (Tier

I core plus Tier II supplementary capital) to credit risk-adjusted assets ratio.

– Also requires, Tier I (core) capital ratio

= Core capital (Tier I) / Credit Risk-adjusted assets 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 risk-adjusted assets) plus various convertible and subordinated debt instruments with maximum caps

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Credit risk-adjusted assets: are on and off balance sheet assets whose values are adjusted for approximate credit risk.

Risk-adjusted assets = Risk-adjusted on-balance-sheet assets + Risk-adjusted off-balance-sheet assets

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• To be adequately capitalized a bank must hold a minimum ratio of total capital (Tier I core capital plus Tier II supplementary capital) to credit risk-adjusted assets of 8% that is its total risk based capital ratio is calculated as:

• Total risk based capital ratio is equal to:

total capital (Tier I+II)

Credit risk-adjusted assets> 8

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Tier I Core Capital Ratio

Tier I (Core) Capital Ratio is equal to:

Core Capital (Tier I)

Credit risk adjusted assets

That is, of the 8% total risk based capital ratio, a minimum of 4% has to be held in core or primary capital.

> 4 %

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Credit risk-adjusted On Balance Sheet Assets Under Basel I

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 (see table 20.10)

• 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. (see example 20.11)

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Calculating Risk-based Capital Ratios under Basel II

• Basel I criticized since individual risk weights depend on broad borrower categories– Each bank assigns its assets to one of four categories

of credit risk exposure (0%,20%,50%,100%)– All corporate borrowers in 100% risk category

• Basle II widens differentiation of credit risks– Refined to incorporate credit rating agency

assessments (see table 20.12)– Each bank assigns its assets to one of five categories

of credit risk exposure (0%,20%,50%,100%, 150%)(See example 20.2 and table 20.13)

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Risk-adjusted off-balance-sheet Activities

Off-balance-sheet (contingent) assets:

Step One:• Conversion factors used to convert into credit

equivalent amounts—amounts equivalent to an on-balance-sheet item. Conversion factors used depend on the guaranty type.

Step Two:• Multiply credit equivalent amounts by appropriate

risk weights (dependent on underlying counterparty)

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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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Criticisms of Risk-based Capital Ratio

– Risk weight categories versus true credit risk.– Risk weights based on rating agencies– Portfolio aspects: Ignores credit risk portfolio

diversification opportunities.– May reduce incentives for banks to make

loans.– Other risks: Interest Rate, Foreign Exchange,

Liquidity– Competition and differences in standards