CAPITAL ADEQUACY

1
CAPITAL ADEQUACY

• FIN 653 Lecture Notes
• (Adapted from Saunders and Cornetts Textbook,
  for class presentation only)

2
THE FIVE FUNCTIONS OF CAPITAL

• 1. To absorb unanticipated losses with enough
  margin to inspire confidence and enable the FI to
  continue as a going concern.
• 2. To protect uninsured depositors in the event
  of insolvency and liquidation.
• Capital protects non-equity liability holders
  against losses.
• 3. To protect FI insurance funds and the
  tax-payers.
• An FI's capital offers protection to insurance
  funds and ultimately the taxpayers who bear the
  cost of insurance fund insolvency.

3
THE FIVE FUNCTIONS OF CAPITAL

• 4. To protect the industry against increases in
  insurance premiums.
• By holding capital and reducing the risk
  insolvency, an FI protects its industry from
  larger insurance premiums.
• 5. To fund new assets and business expansion.
• FIs have a choice, subject to regulatory
  constraints, between debt and equity to finance
  new projects and business expansion.

4
US Capital Regulation

• U.S. banks are required to comply with two sets
  of capital regulation
• 1. the capital/asset (leverage) ratio place
  banks into one of the five categories
• 2. the risk-based capital requirements comply
  with the Basel I regulation (only a few largest
  commercial banks are strictly required to follow
  Basel II)

5
THE CAPITAL-ASSET (LEVERAGE) RATIO

• The capital-assets or leverage ratio measures the
  ratio of a bank's book value of primary or core
  capital to the book value of its assets.
• Core capital
• L -----------------------
• Assets
• The lower this ratio, the more highly leveraged
  the bank is.
• Primary or core capital is a bank's common equity
  (book value) plus qualifying cumulative perpetual
  preferred stock plus minority interests in equity
  accounts of consolidated subsidiaries.
• The FDICIA of 1991 assesses a bank's capital
  adequacy according to where its leverage ratio
  (L) places in one of five target zones.

6
THE CAPITAL-ASSET (LEVERAGE) RATIO

• Specifications of Capital Categories for Prompt
  Corrective Action
• Zone Leverage Total Risk Tier I
  Risk Capital
• __________________________________________________
  ____________________________________________
• Well Capitalized 5 or and 10 or
  and 6 or and Not subject to a
  capital
• above
  above
  above directive to meet a
  specific
  
• 
  
  level
  for any capital
• 
  
  measure
• Adequately 4 or and
  8 or and 4 or and
  does not meet the
• Capitalized above above
  above definition of well capitalized
• 
  
  
• Undercapitalized under 4 or
  under 8 or under 4
• Significantly under 3 or
  under 6 or under 4
• Undercapitalized
• Critically under 2 or
  under 2 or under 2
• Undercapitalized
• __________________________________________________
  _____________________________________________

7
THE CAPITAL-ASSET (LEVERAGE) RATIO

• Adequacy with the leverage ratio
• Higher than 5 percent, well capitalized.
• At 4 percent or more, adequately capitalized
• Less than 4 percent, undercapitalized
• Less than 3 percent, significantly
  undercapitalized and
• At 2 percent or loss, critically
  undercapitalized.
• Under the FDICIA legislation, prompt corrective
  action (PCA) would be taken when a bank falls
  outside zone 1, or the well under-capitalized
  category.
• Most critically, a receiver must be appointed
  when a bank's book value of capital-assets
  (leverage) ratio falls to 2 percent or lower.

8
THE CAPITAL-ASSET (LEVERAGE) RATIO

• Summary of Prompt Corrective Action Provisions of
  the FDIC Improvement Act of 1991
• Zone Mandatory Discretionary
  Provisions Provisions
• __________________________________________________
  _______________________________
• Well Capitalized None None
• Adequately capitalized 1. No brokered deposits
  except None
• 
  with FDIC approval
• Undercapitalized 1. Suspend dividends and 1.
  Order recapitalization
• management fees
• 2. Require restoration plan 2. Restrict
  interaffiliate
• transactions
• 3. Restrict asset growth 3. Restrict
  deposit rates
• 4. Approval required for 4. Restrict
  certain other
• acquisitions, branching, and new
  activities
• activities
• 5. No brokered deposits 5. Any other action
  that
• would better carry out
• prompt corrective action

9
THE CAPITAL-ASSET (LEVERAGE) RATIO

• Significantly 1. Same as for Zone
  3 1. Any Zone 3 discretionary actions
• Undercapitalized 2. Order
  recapitalizetion 2. Conservatorship or
  receivership if fails
• 
  3. Restrict interaffiliate to submit
  or implement plan or
• 
  transactions
  recapitalize pursuant to order
• 
  4. Restrict deposit rates 3. Any other
  Zone 5 provisions if such
• 
  5. Pay of officers restricted action is
  not necessary to carry out
• 
  
  prompt corrective action
• Critically 1. Same as for Zone 4
• Undercapitalized 2.
  Receiver/conservator within 90 days
• 
  3. Receiver if still in Zone 5 four quarters
• 
  after becoming critically undercapitalized
• 
  4. Suspend payments on subordinated debt
• 
  5. Restrict certain other activities
• __________________________________________________
  _______________________________
  

10
THE CAPITAL-ASSET (LEVERAGE) RATIO

• Problems with the Leverage Ratio as a measure of
  capital adequacy
• 1. Market Value.
• Even if a bank is closed when its leverage ratio
  falls below 2 percent, a 2 percent book
  capital-asset ratio could be consistent with a
  massive negative market value net worth.
• 2. Asset Risk.
• By taking the denominator of the leverage ratio
  as total assets, the leverage ratio fails to
  consider, even partially, the different credit
  and interest rate risks of the assets that
  comprise total assets.
• 3. Off Balance-Sheet Activities.
• Banks are nor required to hold capital to meet
  the potential insolvency risks involved with such
  contingent assets and liabilities of
  off-balance-sheet activities.

11
RISK BASED CAPITAL RATIOS

• The 1993 Basel Agreement (Basel I)
• Explicitly incorporated the different credit
  risks of assets into capital adequacy measures.
• The 1998 Amendment
• Market risk was incorporated into risk-based
  capital in the form of an add-on to the 8
  ratio for credit risk exposure.
• The 2006 New Basel Capital Accord (Basel II)
• The incorporation (effective in 2006) of
  operating risk into capital requirements and
  updated the credit risk assessments in the 1993
  agreement.

12
RISK BASED CAPITAL RATIOS

• Regulators currently enforce the Basle Accord's
  risk-based capital ratios as well as the
  traditional leverage ratio. Their major-
  innovation is to distinguish among the different
  credit risks of asset on the balance sheet and to
  identify the credit risk inherent in instruments
  off the balance sheet by using a risk adjusted
  assets denominator in these capital adequacy
  ratios.

13
RISK BASED CAPITAL RATIOS

• A bank's capital is divided into Tier I and Tier
  II.
• Tier I capital is primary or core capital.
• Tier II capital is supplementary capital.
• The total capital that the bank holds is defined
  as the sum of Tier I and Tier II capital.

14
RISK BASED CAPITAL RATIOS

• Tier I capital is closely linked to a bank's book
  value equity reflecting the concept of the core
  capital contribution of a bank's owners.
  Basically, it includes
• the book value of common equity
• an amount of perpetual (nonmaturing) preferred
  stock
• minority equity interests held by the bank in
  subsidiaries minus goodwill.
• Goodwill is an accounting item that reflects the
  amount a bank pays above market value when it
  purchases or acquires other banks or
  subsidiaries.

15
RISK BASED CAPITAL RATIOS

• Tier II capital is a broad array of secondary
  capital resources.
• It includes a banks loan loss reserves up to 3
  maximum of 1.25 percent of risk-adjusted assets
  plus various convertible and subordinated debt
  instruments with maximum caps.

16
RISK BASED CAPITAL RATIOS

• Total Risk-Adjusted Assets
• Risk-Adjusted On-Balance-Sheet Assets
• Risk-Adjusted Off-Balance-Sheet Assets
• Risk-Adjusted Off-Balance-Sheet Assets
• The Risk-Adjusted Asset Value of Off-Balance-
• Sheet Contingent Guaranty Contracts
• The Risk-Adjusted Asset Value of Off-
• Balance-Sheet Market Contracts or Derivative
  
• Instruments

17
RISK BASED CAPITAL RATIOS

• To be adequately capitalized, a bank must hold a
  minimum total capital (Tier I core capital plus
  Tier II supplementary capital) to risk-adjusted
  assets ratio of 8 percent that is, its total
  risk-based capital ratio is calculated as
• Tier I Capital
• Total risk-based capital ratio
  ---------------------------------- ? 4
• Risk-adjusted
  assets
• Total capital (Tier I plus Tier II)
• Total risk-based capital ratio
  ---------------------------------------- ? 8
• Risk-adjusted
  assets

18
Risk-Adjusted On-Balance-Sheet Assets

• The Risk-Based Capital Standard for
  On-Balance-Sheet Items under Basel I
• Risk Categories Assets
• __________________________________________________
  ____________________
• 1 (0 weight) Cash, Federal Reserve Bank
  balances, securities of the
• U.S. Treasury, OECD governments, and some
  U.S.
• agencies.
• 2 (20 weight) Cash items in the process of
  collection. U.S. and
• OECD interbank deposits and guaranteed
  claims.
• Some non-OECD bank and government deposits
• and securities. General obligation
  municipal bonds. Some
• mortgage-basked securities. Claims
  collateralized by the
• U.S. Treasury and some other government
  securities.
• 3 (50 weight) Loans fully secured by first
  liens on one- to four-family
• residential properties. Other (revenue)
  municipal bonds.
• 4 (100 weight) All other on-balance-sheet
  assets not listed above,
• including loans to private entities and
  individuals, some
• claims on non-OECD governments and banks,
  real assets,
• and investments in subsidiaries.
• __________________________________________________
  ____________________

19
Risk-Adjusted On-Balance-Sheet Assets

• (Items Added to) The Risk-Based Capital Standard
  for On-Balance-Sheet Items under Basel II
• Risk Categories Assets
• __________________________________________________
  _________________________
• 1 (0 weight) Loans to sovereigns with an SP
  credit rating of AA- or better.
• 2 (20 weight) Loans to sovereigns with an SP
  credit rating of A to A-.
• Loans to banks and corporates with an SP
  credit rating
• of AA- or better.
• 3 (50 weight) Loans to sovereigns with an SP
  credit rating
• of BBB to BBB-.
• Loans to banks and corporates with an SP
  credit rating
• of A to A-.
• 4 (100 weight) Loans to sovereigns with an SP
  credit rating
• of BBB to B-.
• Loans to coporates with a credit rating of
  BBB to BB-.
• 5 (150 weight) Loans to sovereigns with an SP
  credit rating below B-.
• Loans to corporates with an SP credit
  rating below BB-.
• __________________________________________________
  ________________________

20
Risk-Adjusted On-Balance-Sheet Assets

• Risk-adjusted On-Balance-Sheet Assets
• Category 1 Assets 0
• Category 2 Assets 20
• Category 3 Assets 50
• Category 4 Assets 100
• Category 5 Assets 150

21
Risk-Adjusted On-Balance-Sheet Assets

• A Banks Balance Sheet (Assets, m)
• __________________________________________________
  __________________________________________
• Weight Assets Amount
• __________________________________________________
  _________________________________________
• Cash 5
• 0 Balance due from Fed 13
• T-Bills 60
• Long-term Treasury securities 50
• GNMA securities 42
• __________________________________________________
  _____________________________
• 20 Items in process of collection 10
• FNMA securities 10
• Munis (general obligation) 20
• AA rated loans of BOA 10
• Commercial loans, AAA- rated 55
• __________________________________________________
  _____________________________
• 50 University dorm bonds (revenue) 34
• Residential 1-4 family mortgages 308
• Commercial loans, A rated 75

22
Risk-Adjusted On-Balance-Sheet Assets

• A Banks Balance Sheet (Liabilities, m)
• __________________________________________________
  _______________________________
• Liabilities/Equity Amount Capital Class
• __________________________________________________
  _______________________________
• Demand deposits 150
• Time deposits 500
• CDs 400
• Fed funds purchased 80
• __________________________________________________
  _________________________
• Convertible bonds 15 Tied II
• Subordinated bonds 15 Tier II
• __________________________________________________
  _________________________
• Perpetual preferred stock (non-qualifying) 5 Tier
  I
• __________________________________________________
  _________________________
• Retained earnings 10 Tier I
• Common stock 30 Tier I
• Perpetual preferred stock (qualifying) 10 Tier
  I
• __________________________________________________
  _________________________
• Total 1,215

23
Risk-Adjusted On-Balance-Sheet Assets

• A Banks Balance Sheet (Off-balance-sheet, m)
• __________________________________________________
  _______________________________
• Weight Off-balance sheet Amount
• __________________________________________________
  _______________________________
• 100 2-year loan commitments to a large BB
  rated 80m
• U.S. corporation
• Direct credit substitute standby letter of
  credit 10m
• issued to a BBB rated U.S. corporate
• Commercial letters of credit issued to a BBB-
  rated 50m
• U.S. corporation
• __________________________________________________
  _________________________
• 50 One fixed floating interest rate swap for 4
  years 100m
• with notional dollar value of 100m and
  replacement cost
• of 3m
• One two-eay Euro contract for 40m with a
  replacement 40m
• cost of -1m
• __________________________________________________
  _______________________________

24
Risk-Adjusted Off-Balance-Sheet Activities

• The calculation of the risk-adjusted values of
  the off balance-sheet (OBS) activities involves
  some initial segregation of these activities.
• The credit risk exposure or the risk-adjusted
  asset amount of contingent or guaranty contracts,
  such as letters of credit or loan commitments,
  differs from the risk-adjusted asset amounts for
  foreign exchange and interest rate forward,
  option, and swap contracts

25
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts

• First step multiply the dollar amount
  outstanding of these items by the conversion
  factors to derive the credit equivalent amounts.
• These conversion factors convert an
  off-balance-sheet item into an equivalent credit
  or on-balance-sheet item.

26
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts

• Conversion Factors for Off-Balance-Sheet
  Contingent or Guaranty Contracts
• __________________________________________________
  ________________
• (100) Sales and purchase agreements and assets
  sold with recourses that are not included on
  the balance sheet
• (100) Direct credit substitute standby letters
  of credit
• (50) Performance-related standby letter of
  credit
• (50) Unused portion of loan commitments with
  original maturity of more
• than one year
• (20) Commercial letters of credit
• (20) Bankers acceptance conveyed
• (10) Other loan commitment
• __________________________________________________
  ________________________

27
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts

• Second step multiply these credit equivalent
  amounts by their appropriate risk weights.
• The appropriate risk weight depends on the
  underlying counterparty, such as a municipality,
  a government, or a corporation, to the
  off-balance-sheet activity.
• For example, if the underlying party being
  guaranteed were a municipality issuing general
  obligation (GO) bonds and a bank issued an
  off-balance-sheet standby letter of credit
  backing the credit risk of the municipal GO
  issue, the risk weight is 0.2.
• If, on the other hand, the counterparty being
  guaranteed is a private entity, the appropriate
  risk weight is 1.
• Note that if the counterparty had been the
  central government, the risk weight is zero.

28
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts

• Example a bank with the following
  off-balance-sheet contingencies or guarantees
• 1. 80 m two-year loan commitments to large US
  corporations.
• 2. 10m standby letters of credit backing an
  issue of commercial paper.
• 3. 50m commercial letters of credit.

29
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts

• Step 1 Credit Equivalent Amounts (CEA)
• OBS item Face Conversion Credit
  Value Factor Equivalent
• Amount
• __________________________________________________
  _______
• Two-year loan commitment 80 .5 40
• Standby letter of credit 10 1.0 10
• Commercial letter of credit 50 .2 10
• __________________________________________________
  _______

30
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Contingent Guaranty Contracts

• Step 2 Risk-Adjusted Asset Amount
• OBS item Credit Risk Risk-Adj.
• Equivalent Weight Asset
• Amount Amount
• __________________________________________________
  _______
• Two-year loan commitment 40 1.0 40m
• Standby letter of credit 10 1.0 10
• Commercial letter of credit 10 1.0 10
• Total 60m
• __________________________________________________
  _______

31
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• Modem FIs engage heavily in buying and selling
  OBS futures, options, forwards, swaps, caps, and
  other derivative securities contracts for
  interest rate and foreign exchange (FX)
  management and hedging reasons and to buy and
  sell such products on behalf of their customers.
• Each of these positions potentially exposes banks
  to counterparty credit risk, that is, the risk
  that the counterparty (or other side of
  contract) will default if it suffers large actual
  or potential losses on its position. Such
  defaults mean that a bank must go back to the
  market to replace such contracts at (potentially)
  less favorable terms.

32
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• Two-Step Approach for calculating the
  risk-adjusted asset values of OBS market
  contracts
• First, convert to the credit equivalent amount
  with a conversion factor for each derivative
  instrument.
• Second, multiply the credit equivalent amounts by
  the appropriate risk weights.
• The credit equivalent amount itself is divided
  into a potential exposure element and a current
  exposure element.
• Credit equivalent amount of OBS Derivative
  security items Potential exposure () Current
  exposure ()

33
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• The Potential Exposure
• The potential exposure conversion component
  reflects the credit risk if the counterparty to
  the contract defaults in the future.
• The probability of such an occurrence depends on
  future volatility of either interest rates for an
  interest rate contract or exchange rates for an
  exchange rate contract.
• The Bank of England and the Federal Reserve
  performed an enormous number of simulations and
  found that FX rates are far more volatile than
  interest rates. Thus, the potential exposure
  conversion factors are larger for foreign
  exchange contracts than for interest rate
  contracts.

34
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• Credit conversion factors for Interest Rate and
  Foreign Exchange Contracts in Calculating
  Potential Exposure
• Remaining Interest Rate Exchange Rate
• Maturity Contracts Contracts
• _______________________________________________
• Less than one year 0 1.0
• One to five years 0.5 5.0
• Over five years 1.5 7.5
• _______________________________________________

35
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• The Current Exposure
• This reflects the cost of replacing a contract
  should a counterparty default today.
• The bank calculates this replacement cost or
  current exposure by replacing the rate or price
  initially in the contract with the current rate
  or price for a similar contract and recalculates
  all the current and future cash flows that the
  current rate or price terms generate. The bank
  discounts any future cash flows to give a current
  present value measure of the contract's
  replacement cost.
• If the contract's replacement cost is negative,
  the replacement cost (current exposure) to be set
  to zero. If the replacement cost is positive
  (i.e., the contract is profitable to the bank but
  it is harmed if the counterparty defaults), this
  value is used as the measure of current exposure.

36
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• Once we total the current and potential exposure
  amounts to produce the credit equivalent amount
  for each contract, we multiply this dollar number
  by a risk weight to produce the final
  risk-adjusted asset amount for OBS market
  contracts.

37
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• Example Suppose the bank in the previous example
  has take on interest rate hedging position in the
  fixed-floating interest rate swap market for 4
  years with a notional dollar amount of 100m and
  one two-year forward foreign exchange contract
  for 40m. Calculate the credit equivalent amount
  for each contract.

38
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• Potential Exposure Current Exposure
• Contract Notional Conversion Potential Replacemen
  t Current Credit
• Principal Factor Exposure Costs
  Exposure Equiv.
• __________________________________________________
  _____________________
• 4-year fixed- 100m .005 .5m
  3m 3m 3.5m
• Floating interest
• Rate swap
• 2-year forward 40m .050
  2m -1m 0m 2m
• Foreign Exchange
• Contract
• __________________________________________________
  _____________________
• Total Credit Equivalent Amount 5.5m

39
The Risk-Adjusted Asset Value of
Off-Balance-Sheet Market Contracts or Derivative
Instruments

• To calculate the risk-adjusted asset value for
  the banks OBS derivative or market contracts,
  multiply the credit equivalent amount by the
  appropriate risk weight, which under the Basel I
  is generally .5 or 50
• Credit Risk-Adjusted
• Asset Value of OBS 5.5m 0.5 2.75m
• Derivatives
• Under Basel II, the risk weight assigned to the
  credit equivalent amount, 5.5m is 100. Thus,
  the credit risk-adjusted value of the OBS
  derivatives is 5.5m.

40
Criticisms of the Risk-Based Capital Ratio

• The risk-based capital requirement seeks to
  improve on the simple leverage ratio by
• more systematically accounting for credit risk
  differences among assets,
• incorporating off-balance-sheet risk exposures,
  and
• applying a similar capital requirement across all
  the major banks (and banking centers) in the
  world..

41
Criticisms of the Risk-Based Capital Ratio

• Risk weights. It is unclear how closely the four
  risk weight categories reflect true credit risk.
• For example, residential mortgage loans have a 50
  percent risk weight commercial loans have a 100
  percent risk weight. Taken literally, these
  relative weights imply that commercial loans are
  exactly twice as risky as mortgage loans.

42
Criticisms of the Risk-Based Capital Ratio

• Balance sheet incentive problems. The fact that
  different assets have different risk weights may
  induce bankers to engage in balance sheet asset
  allocation games.
• For example, residential mortgages have a 50
  risk weight, and GNMA mortgage-backed securities
  have 0 risk weight. Suppose that a bank pools
  all its mortgages and then sells them to outside
  investors. If it then replaced the mortgages it
  sold with GNMA securities backing similar pools
  of mortgages to those securitized, it could
  significantly reduce its risk-adjusted asset
  amount.

43
Criticisms of the Risk-Based Capital Ratio

• Portfolio aspects. The new plan also ignores
  credit risk portfolio diversification
  opportunities. When returns on assets have
  negative or less than perfectly positive
  correlations, an FI may lower its portfolio risk
  through diversification.
• The new capital adequacy plan is essentially a
  linear risk measure that ignores correlations or
  covariances among assets and asset group credit
  risks, such as between residential mortgages and
  commercial loans. That is, the banker weights
  each asset separately by the appropriate risk
  weight and then sums those numbers to get an
  overall measure of credit risk.

44
Criticisms of the Risk-Based Capital Ratio

• Bank specialness. Giving private sector
  commercial loans the highest credit risk
  weighting may reduce the incentive for banks to
  make such loans relative to holding other assets.
  This may reduce the amount of bank loans to
  business as well as the degree of bank monitoring
  and may have associated negative externality
  effects on the economy. That is, one aspect of
  banks' special functions--bank lending--may be
  muted.
• Equal weight of all commercial loans. Loans made
  to an AAA-rated company have a credit risk weight
  of 1, as do loans made to a CCC-rated company.
  That is, within a broad risk-weight class such as
  commercial loans, credit risk quality differences
  are not recognized. This may create perverse
  incentives for banks to pursue lower-quality
  customers, thereby increasing the risk of the
  bank.

45
Criticisms of the Risk-Based Capital Ratio

• Other risks. Although market risk exposure has
  now been integrated into the risk-based capital
  requirements, the plan does not yet account for
  other risks such as foreign exchange rate risk,
  asset concentration risk, and operating risk. A
  more complete risk-based capital requirement
  would include these risks.

46
Criticisms of the Risk-Based Capital Ratio

• Competition. As a result of tax and accounting
  differences across banking systems and in safety
  net coverages, the 8 percent risk-based capital
  requirement has not created a level competitive
  playing field across banks as intended by many
  proponents of the plan. In particular, Japan and
  the United States have very different accounting,
  tax, and safety net rules that significantly
  affect the comparability of U.S. and Japanese
  bank risk-based capital ratios. The provisions of
  the Basle Accord also allow differences in bank
  capital rules to persist among countries.
  Different capital elements are allowed for both
  Tier I and Tier II capital across countries.
  Also, many countries use a 10 percent risk
  category that is not used in the United States.

47
Objectives of the New Basel Accord

• The objectives of Basel II are to encourage
  better and more systematic risk management
  practices, especially in the area of credit risk,
  and to provide improved measures of capital
  adequacy for the benefit of supervisors and the
  marketplace more generally.

48
Objectives of the New Basel Accord

• The three pillars approach to capital adequacy
  involving
• (1) minimum capital requirements,
• (2) supervisory review of internal bank
  assessments of capital relative to risk, and
• (3) increased public disclosure of risk and
  capital information sufficient to provide
  meaningful market discipline.

49
Key Elements of the New Basel Accord

• Pillar 1 Two Approaches for Assessing Credit
  Risk
• The standardized approach incorporates modest
  changes in risk sensitivities to improve risk
  sensitivities through readily observable risk
  measures such as external credit ratings.
• Consistent with the Basel Committees
  objectives, it is intended to produce a capital
  requirement more closely linked to each banks
  actual credit risks a lower-quality portfolio
  will face a higher capital charge, a
  higher-quality portfolio a lower capital charge.

50
Key Elements of the New Basel Accord

• Pillar 1 Credit Risk
• The IRB approach is based on four key parameters
  used to estimate credit risks
• 1. PD The probability of default of a borrower
  over a one-year horizon
• 2. LGD The loss given default (or 1 minus
  recovery) as a percentage of exposure at
  default
• 3. EAD Exposure at default (an amount, not a
  percentage)
• 4. M Maturity

51
Key Elements of the New Basel Accord

• Pillar 1 Credit Risk
• For a given maturity, these parameters are used
  to estimate two types of expected loss (EL).
• Expected loss as an amount
• EL PD LGD EAD
• and expected loss as a percentage of exposure at
  default
• EL PD LGD

52
Key Elements of the New Basel Accord

• Pillar 1 Credit Risk
• The two variants of IRB, the foundation approach
  and the advanced approach, differ principally in
  how the four parameters can be measured and
  determined internally, but an essential feature
  of both approaches is their use of the banks own
  internal information on an assets credit risk.
• In the advanced approach all four parameters are
  determined by the bank and are subject to
  supervisory review.

53
Key Elements of the New Basel Accord

• Pillar 1 Credit Risk
• For the foundation approach
• 1. Only PD may be assigned internally, subject to
  supervisory review (Pillar 2).
• 2. LGD is fixed and based on supervisory values.
  For example, 45 for senior unsecured claims and
  75 for subordinated claims.
• 3. EAD is also based on supervisory values in
  cases where the measurement is not clear. For
  instance, EAD is 75 for irrevocable undrawn
  commitments.
• 4. Finally, a single average maturity of three
  years is assumed for the portfolio.

54
Key Elements of the New Basel Accord

• Pillar 1 Credit Risk
• A critical issue with respect to the IRB
  approach is the reliability of the credit risk
  parameters supplied by banks, upon which the
  capital charges are based .
• If these estimates prove unreliable, the IRB
  approach would provide little, if any,
  improvement in risk sensitivity over the current
  Accord.
• Thus, it is essential that prior to IRB
  implementation supervisors ensure that a banks
  internal processes for determining internal risk
  ratings, PDs, LGDs, and EADs are credible and
  robust.

55
Key Elements of the New Basel Accord

• Pillars 2 and 3 Supervisory review and public
  disclosure
• Pillar 2 provides a basis for supervisory
  intervention to prevent unwarranted declines in a
  banks capital. The Basel Committee has
  articulated four principles consistent with these
  objectives
• (1) Each bank should assess its internal capital
  adequacy in light of its risk profile,
• (2) Supervisors should review internal
  assessments,
• (3) Banks should hold capital above regulatory
  minimums, and
• (4) Supervisors should intervene at an early
  stage.

56
Key Elements of the New Basel Accord

• Operational Risk 3 Flavors
• Operational risk is defined as the risk of
  direct of indirect loss resulting from inadequate
  or failed internal processes, people and systems
  or from external events
• Developing a capital charge for operational risk
  is challenging both because of a lack of agreed
  methodology, and because of limited historical
  loss data.

57
Key Elements of the New Basel Accord

• Operational Risk 3 Approaches
• The Basic Indicator approach provides a simple
  way to determine a capital requirement, based on
  a percentage of gross income.
• The Standardized approach assigns a capital
  charge for each of eight business lines based
  upon a fixed relation between average industry
  allocated economic capital and gross income for
  each business line.
• Finally, through the Advanced Measurement
  approach (AMA) the Committee sought to provide
  flexibility for banks to use their own internal
  measurement approaches.

58
Key Elements of the New Basel Accord

• Operational Risk 3 Approaches
• The Basic Indicator approach provides a simple
  way to determine a capital requirement, based on
  a percentage of gross income.
• The Standardized approach assigns a capital
  charge for each of eight business lines based
  upon a fixed relation between average industry
  allocated economic capital and gross income for
  each business line.
• Finally, through the Advanced Measurement
  approach (AMA) the Committee sought to provide
  flexibility for banks to use their own internal
  measurement approaches.