BASEL

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Why Worry About Bank
Capital?
Capital requirements reduce the risk of failure by acting as a
cushion against losses, providing access to financial markets
to meet liquidity needs, and limiting growth
Bank capital-to-asset ratios have fallen from about 20% a
hundred years ago to around 8% today

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Risk-Based Capital
Standards
Historically, the minimum capital requirements for banks
were independent of the riskiness of the bank
Prior to 1990, banks were required to maintain:
◦ A primary capital-to-asset ratio of at least 5% to 6%, and
◦ A minimum total capital-to-asset ratio of 6%

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Risk-Based Capital
Standards
Primary Capital (Tier 1, Core Capital)
◦ Common stock
◦ Perpetual preferred stock
◦ Surplus
◦ Undivided profits
◦ Contingency and other capital reserves
◦ Mandatory convertible debt

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Risk-Based Capital
Standards
Secondary Capital (Tier 2, Supplementary Capital)
◦ Long-term subordinated debt
◦ Limited-life preferred stock
◦ Allowance for loan and lease losses
◦ Deposit ratio

Total Capital= Tier 1+Tier 2

◦ Primary Capital + Secondary Capital

Capital requirements were independent of a bank’s asset

quality, liquidity risk, interest rate risk, operational risk, and
other related risks

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Risk-Based Capital
Standards
The 1986 Basel Agreement
◦ In 1986, U.S. bank regulators proposed that U.S. banks be required to
maintain capital that reflects the riskiness of bank assets
◦ The Basel Agreement grew to include risk-based capital standards for
banks in 12 industrialized nations
◦ Regulations apply to both banks and thrifts and have been in place since
the end of 1992
◦ Today, countries that are members of the Organization for Economic
Cooperation and Development (OECD) enforce similar risk-based
requirements on their own financial institutions

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Risk-Based Capital
Standards
The 1986 Basel Agreement
◦ A bank’s minimum capital requirement is linked to its credit risk
◦ The greater the credit risk, the greater the required capital
◦ Stockholders' equity is deemed to be the most valuable type of
capital

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BASEL I
BASEL ii
BASEL iii

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Risk-Based Capital
Standards
The 1986 Basel Agreement
◦ Minimum capital requirement increased to 8% total capital to risk-
adjusted assets
◦ Total capital to risk weighted asset (RWA)= minimum 8%
◦ There are two tiers of capital
◦ Tier 1 and tier 2
◦ Total capital= tier 1 + tier 2
◦ Tier 1/RWA= 4% ( minimum)
◦ Total capital/ RWA= 8% (minimum)
◦ Capital requirements were approximately standardized between
countries to ‘level the playing field'

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EXAMPLE
CASH= $1000 - 0%
US TREASURY SECURITIES= $2000 -0%
REPURCHASE AGREEMENT= $4000 - 20%
INTERBANK DEPOSIT= $3000 - 20%
COMMERCIAL LOANS= $5000 - 100%
FAMILY RESIDENTIAL MORTGAGE= $6000 - 50%

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RISK WEIGHTED ASSET= ASSET X RISK WEIGHTS
= (1000)*0 + (2000)*0+ (4000)0.2+ (3000)*0.2 + (5000)*1+
(6000)*0.5
= $9400
Tier 1/RWA = Minimum 4%
Tier1+ Tier 2/ RWA = 8%

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Risk-Based Capital
Standards
Risk-Based Elements of Basel I
1. Classify assets into one of four risk categories (0%, 20%, 50%,
100%)
2. Classify off-balance sheet commitments into the appropriate
risk categories
3. Multiply the dollar amount of assets in each risk category by
the appropriate risk weight
◦ This equals risk-weighted assets
4. Multiply risk-weighted assets by the minimum capital
percentages, currently 4% for Tier 1 capital and 8% for total
capital
5. CMO - Collateralized Mortgage Obligations

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RWA= (10000*0)+ (1500*0.2)+ (3000*0.2)+ (2700*0.5)+
(1500*0.5)+ (2500*1)+(2100*1)+ (2000*1)
= $9600
Tier 1= 250+300+300= $850
Tier 2= -300+150= ($150)
Tier1/RWA = 850/9600 = 8%
Total capital/ RWA= 850-150/9600 = 7%

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T1=35
T2-=3.2
Total Capital= 35+3.2= $38.2
RWA= $128.3 mil
T1/RWA= 27%
(T1+T2)/RWA=29.77%

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Risk-Based Capital
Standards

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Risk-Based Capital
Standards

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What Constitutes Bank
Capital?
Capital (Net Worth)
◦ The cumulative value of assets minus the cumulative value of
liabilities
◦ Represents ownership interest in a firm

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What Constitutes Bank
Capital?
Total Equity Capital- Tier 1 Capital (Core Capital)
◦ Equals the sum of:
◦ Common Stock
◦ Surplus
◦ Undivided Profits And Capital Reserves
◦ Net Unrealized Holding Gains (Losses) On Available-for-sale Securities
◦ Preferred Stock

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What Constitutes Bank
Capital?
Tier 1 (Core) Capital
◦ Equals The Sum Of:
◦ Common Equity
◦ Non-cumulative Perpetual Preferred Stock
◦ Minority Interest In Consolidated Subsidiaries, Less Intangible Assets Such
As Goodwill
◦ Retained Earnings

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What Constitutes Bank
Capital?
Tier 2 (Supplementary) Capital
◦ Equals The Sum Of:
◦ Cumulative Perpetual Preferred Stock
◦ Long-term Preferred Stock
◦ Limited Amounts Of Term-subordinated Debt
◦ Limited Amount Of The Allowance For Loan Loss Reserves (Up To 1.25
Percent Of Risk-weighted Assets)
◦ Equity Notes
◦ Subordinated Debt

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What Constitutes Bank
Capital?
Leverage Capital Ratio
◦ Tier 1 capital divided by total assets net of goodwill and disallowed
intangible assets and deferred tax assets
◦ Regulators are concerned that a bank could acquire practically all low-risk
assets such that risk-based capital requirements would be virtually zero
◦ To prevent this, regulators have also imposed a 3 percent leverage capital ratio

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Basel II
So, Basel II has 3 pillars of foundation:
1. Minimum Capital Requirement :
◦ operational risk:
◦ Credit risk:
◦ Market Risk

2. Supervisory Review
3. Market Discipline
Principle Rationales
behind Basel II
To promote soundness and stability of the global banking
and financial sector.
To provide a more competitive approach to addressing risk
and promote best practices in risk management .
To enhance competitive equality
To provide a wider approach to the capital assessment
process
Internal Ratings Based (IRB) approach. Banks with sufficient
capability can calculate their own risk weights using internal
loan data rather than the given weights in BASEL I.
BASEL iii
Basel III reforms are the response of Basel Committee on Banking
Supervision (BCBS) to improve the banking sector’s ability to absorb
shocks arising from financial and economic stress, whatever the
source, thus reducing the risk of spillover from the financial sector
to the real economy. Basel III mainly addresses the following areas:
◦ Raise the quality and level of capital to ensure banks are better able to
absorb losses on both a going concern and a gone concern basis
◦ Increase the risk coverage of the capital framework
◦ Introduce leverage ratio to serve as a backstop to the risk-based capital
measure
◦ Raise the standards for the supervisory review process (pillar 2) and public
disclosures (pillar 3)
They Consider The Macroeconomic Conditions. The main
objective of Basel 3 is to specify an additional layer of common
equity for banks and target greater resilience at the individual
bank level and reduce the risk of system wide shocks by
strengthening micro prudential regulation and supervision, and
add a macro prudential cover that includes capital buffers
 BASEL 3 is forward looking like macroeconomic environmental factors
are considered in addition to the individual bank criteria
 Includes liquidity risks in addition to the risks introduced by Basel 2
When breached, restricts payouts to help meet the minimum
common equity requirement. Additionally, the following
guidelines are also included in Basel 3.

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 A countercyclical capital buffer, which places restrictions on participation by
banks in system-wide credit booms with the aim of reducing their losses in credit
busts
 A leverage ratio – a minimum amount of loss-absorbing capital relative to all a
bank’s assets and off-balance sheet exposures regardless of risk weighting Total
capita/ RWA
 Liquidity requirements – a minimum liquidity ratio, the Liquidity Coverage
Ratio (LCR), intended to provide enough cash to cover funding needs over a 30-
day period of stress; a longer-term ratio, the Net Stable Funding Ratio (NSFR),
intended to address maturity mismatches over the entire balance sheet
 Additional proposals for systemically important banks, including requirements
for supplementary capital, augmented contingent capital and strengthened
arrangements for cross-border supervision and resolution

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What Constitutes Bank
Capital?

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What Constitutes Bank
Capital?

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What Constitutes Bank
Capital?
Tier 3 Capital Requirements for Market Risk Under Basel I
◦ Market Risk
◦ The risk of loss to the bank from fluctuations in interest rates, equity
prices, foreign exchange rates, commodity prices, and exposure to specific
risk associated with debt and equity positions in the bank’s trading
portfolio

Tier 3 Capital Requirements for Market Risk Under Basel I

◦ Banks subject to the market risk capital guidelines must maintain an
overall minimum 8 percent ratio of total qualifying capital [the sum
of Tier 1 capital, Tier 2 capital, and Tier 3 capital allocated for market
risk, net of all deductions] to risk-weighted assets and market risk–
equivalent assets

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What Constitutes Bank
Capital?
Basel II Capital Standards
◦ Risk-based capital standards that encompass a three-pillar approach
for determining the capital requirements for financial institutions
◦ Basel II capital standards are designed to produce minimum capital
requirements that incorporate more types of risk than the credit risk-
based standards of Basel I
◦ Basel II standards have not been finalized

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What Constitutes Bank
Capital?
Basel II Capital Standards
◦ Pillar I
◦ Credit risk
◦ Market risk
◦ Operational risk
◦ Pillar II
◦ Supervisory review of capital adequacy
◦ Pillar III
◦ Market discipline through enhanced public disclosure

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What Constitutes Bank
Capital?
Weaknesses of the Risk-Based Capital Standards
◦ Standards only consider credit risk
◦ Ignores interest rate risk and liquidity risk
◦ Core banks subject to the advanced approaches of Basel II use
internal models to assess credit risk
◦ Results of their own models are reported to the regulators

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What Constitutes Bank
Capital?
Weaknesses of the Risk-Based Capital Standards
◦ The new risk-based capital rules of Basel II are heavily dependent on
credit ratings, which have been extremely inaccurate in the recent
past
◦ Book value of capital is often not meaningful since It ignores:
◦ changes in the market value of assets
◦ unrealized gains (losses) on held-to-maturity securities
◦ 97% of banks are considered “well capitalized” in 2007
◦ Not a binding constraint for most banks

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What is the Function of
Bank Capital
For regulators, bank capital serves to protect the deposit
insurance fund in case of bank failures
Bank capital reduces bank risk by:
◦ Providing a cushion for firms to absorb losses and remain solvent
◦ Providing ready access to financial markets, which provides the bank
with liquidity
◦ Constraining growth and limits risk taking

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What is the Function of
Bank Capital

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How Much Capital Is
Adequate?
Regulators prefer more capital
◦ Reduces the likelihood of bank failures and increases bank liquidity

Bankers prefer less capital

◦ Lower capital increases ROE, all other things the same

Riskier banks should hold more capital while lower-risk

banks should be allowed to increase financial leverage

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The Effect of Capital
Requirements on Bank
Operating Policies
Limiting Asset Growth
◦ The change in total bank assets is restricted by the amount of bank
equity
ROA(1  DR)  ΔEC/TA 2
ΔTA/TA 1 
EQ1/TA 1
◦ were
◦ TA = Total Assets
◦ EQ = Equity Capital
◦ ROA = Return on Assets
◦ DR = Dividend Payout Ratio
◦ EC = New External Capital

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The Effect of Capital
Requirements on Bank
Operating Policies
Changing the Capital Mix
◦ Internal versus External capital

Change Asset Composition

◦ Hold fewer high-risk category assets

Pricing Policies
◦ Raise rates on higher-risk loans

Shrinking the Bank

◦ Fewer assets requires less capital

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Characteristics of
External Capital Sources
Subordinated Debt
◦ Advantages
◦ Interest payments are tax-deductible
◦ No dilution of ownership interest
◦ Generates additional profits for shareholders if earnings before interest
and taxes exceed interest payments

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Characteristics of
External Capital Sources
Subordinated Debt
◦ Disadvantages
◦ Does not qualify as Tier 1 capital
◦ Interest and principal payments are mandatory
◦ Many issues require sinking funds

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Characteristics of
External Capital Sources
Common Stock
◦ Advantages
◦ Qualifies as Tier 1 capital
◦ It has no fixed maturity and thus represents a permanent source of funds
◦ Dividend payments are discretionary
◦ Losses can be charged against equity, not debt, so common stock better protects the
FDIC

Common Stock
◦ Disadvantages
◦ Dividends are not tax-deductible,
◦ Transactions costs on new issues exceed comparable costs on debt
◦ Shareholders are sensitive to earnings dilution and possible loss of control in
ownership
◦ Often not a viable alternative for smaller banks

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Characteristics of
External Capital Sources
Preferred Stock
◦ A form of equity in which investors' claims are senior to those of
common stockholders
◦ Dividends are not tax-deductible
◦ Corporate investors in preferred stock pay taxes on only 20 percent
of dividends
◦ Most issues take the form of adjustable-rate perpetual stock

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Characteristics of
External Capital Sources
Trust Preferred Stock
◦ A hybrid form of equity capital at banks
◦ It effectively pays dividends that are tax deductible
◦ To issue the security, a bank establishes a trust company
◦ The trust company sells preferred stock to investors and loans the
proceeds of the issue to the bank
◦ Interest on the loan equals dividends paid on preferred stock
◦ The interest on the loan is tax deductible such that the bank deducts
dividend payments
◦ Counts as Tier 1 capital

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Characteristics of
External Capital Sources
TARP Capital Purchase Program
◦ The Troubled Asset Relief Program’s Capital Purchase Program (TARP-
CPP), allows financial institutions to sell preferred stock that qualifies
as Tier 1 capital to the Treasury
◦ Qualified institutions may issue senior preferred stock equal to not less
than 1% of risk-weighted assets and not more than the lesser of $25
billion, or 3%, of risk-weight assets

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Characteristics of
External Capital Sources
Leasing Arrangements
◦ Many banks enter sale and leaseback arrangements
◦ Example:
◦ The bank sells its headquarters and simultaneously leases it back from
the buyer
◦ The bank receives a large amount of cash and still maintains control of
the property
◦ The net effect is that the bank takes a fully depreciated asset and turns it
into a tax deduction

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Capital Planning
Process of Capital Planning
◦ Generate pro formal balance sheet and income statements for the
bank
◦ Select a dividend payout
◦ Analyze the costs and benefits of alternative sources of external
capital

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Capital Planning
Application
◦ Consider a bank that has exhibited a deteriorating profit trend
◦ Assume as well that federal regulators who recently examined the bank
indicated that the bank should increase its primary capital-to-asset ratio to
8.5% within four years from its current 7%
◦ The $80 million bank reported an ROA of just 0.45 percent
◦ During each of the past five years, the bank paid $250,000 in common
dividends
◦ Consider a bank that has exhibited a deteriorating profit trend
◦ The following slide extrapolates historical asset growth of 10%
◦ Under this scenario, the bank will see its capital ratio fall
◦ The following slide also identifies three different strategies for meting the
required 8.5% capital ratio

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