Capital Requirement

1
Capital Requirement

• Reserve Requirement

2
European Central bank

• In late 1998, ECB implemented interest bearing
  reserve requirement.
• The ECB requires a reserve ratio of 1.5 to 2.5
  percent
• Reserve balances are credited an interest rate
  equal to repo rate.
• Reserve requirement as a tax to the banking system

3
Around the world RR

• There has been a gradual reduction on RR around
  the world.
• Canada, New Zealand, Australia, and Switzerland
  have eliminated the RR all together in 1990.
• RR as a tax on banking system effectively raises
  cost of capital and can make banks less
  competitive in a global market.
• RR in the United States is imposed on 10 to 30
  percent of deposits (checking account).

4
RRR In Islamic Republic

• RR is 17 percent of all deposit.
• This huge tax reduces bank intermediation
  (lending) and raises the cost of fund and reduces
  money supply.
• Banks public or private pass this tax to the
  ultimate borrowers at a margin over the 17
  percent.

5

• Banks in New Zealand, Canada, Australia, and
  Switzerland have created lending facilities for
  conducting monetary policy.
• Banks can borrow at lombard rate from the central
  bank
• Central Banks have created another facility in
  which they pay interest rate on the reserve that
  banks wish to hold

6
RR in Japan and USA

• This ratio is approximately 1 percent of all
  deposit.
• RR is 10 percent of checking deposit and none on
  time deposits in the USA.
• Under 30 percent of all deposits are checking
  deposit subject to the 10 percent RR.

7
Breakdown of Financial risks

• Commercial Investment
  Treasury Retail Asset
• Banking Banking
  Management Management Management

operational
Credit
Market
Source Robert Gescke
8
Market Risk

• Risk of sudden shock, which could damage the
  financial system that the wider economy would
  suffer is an example of systematic or market
  risk.
• Contagious transmission of the shock due to
  actual or suspected exposure to a failing bank or
  banks. Followed by flight to quality.
• Panicky behavior of depositors or investors or
• Interruption in the payment system

9
Capital Requirements for Banks

• Tier 1 capital is related to common stocks,
  non-cumulative perpetual preferred stocks, and
  disclosed reserves
• Tier 2 capital represents debts with fixed or
  cumulative costs, such as cumulative preferred
  stocks, convertible debts, redeemable preferred
  shares, subordinated debts, and general
  provisions and,
• Tier 3 capital represents short-dated
  subordinated debentures retained to support the
  trading desk and market risks associated with
  derivatives transactions.

10
Qualifying Capitals

• The Basle Accord further imposes limits on the
  amount of qualifying capital for the banks, i.e.,
• For example, Tier 2 capital may not exceed 100
  percent of Tier 1 capital, and subordinated debt
  may not amount to more than 60 percent of Tier 1
  capital.
• Tier 3 capital that is retained to support the
  market risk associated with trading desk may not
  exceed 250 percent of a banks tier 1 capital.
• Furthermore, general provisions included in Tier
  2 capital should not be greater than 1.25 percent
  of risk weighted assets

11
Capital Ratio

• A banks capital adequacy requirement for the
  assets held in the bank book is estimated by the
  ratio of total qualifying Tier 1 and Tier 2
  capital over the risk-weighted value of assets,
  both on and off-balance sheet.
• The risk-weighted value of the bank assets is
  calculated as the product of the principal amount
  of the asset weighted by the risk weighting of an
  associated counterparty.
• Based on the Basle Accord, banks are required to
  maintain a minimum capital/risk asset ratio of
  eight percent

12
Historical Simulations

• The historical simulation method takes historical
  movements in the risk factors to simulate
  potential future movements.
• Assume that on December 31,1998, XYZ has a
  forward contract to buy 10 million in exchange
  for delivering 16.5 million in 3 month.

1.65/
XYZ
Bank One
Spot rate
13
Intermediation

• Banks in the Islamic Republic of Iran are largely
  responsible to perform all functions of
• originating,
• servicing,
• credit risk taking
• investing.

14
Disintermediation through securitization

• Loan Originator (Sponsor)
• Third Party Guarantor (Credit enhancer)
• Rating Agency
• Special Purpose Vehicle SPV
• Arranger (underwriter)
• Liquidity Enhancer (secondary market provider)
• Swap Counterparty
• Investors

15
Over-collateralization

• Establishes more collateral than the underlying
  ABS created from the pool, the amount of which
  depends on
• The coupon rates underlying the collateral
• The rates offered to investors,
• The type of rating sought,
• The psychology of the market at the time of the
  issue, among other things.

16
Indication of over-collateralization levels for
traditional and defeasance mortgage backed bonds
(percent of par)
17
Senior/Subordinated Structure

• This is a self-imposed structure by the issuer to
  provide protection for a class of senior
  bondholders at the expense of another (junior)
  class through prioritizing cash flow of the
  entire pool of the underlying collateral.
• This is also the most widely used internal credit
  enhancement structure in securitization of credit
  here in the United States and elsewhere.
• The senior class of bondholders is willing to
  sacrifice yield in securing priority of claims
  over subordinated class in the event of
  bankruptcy or default of the issuer.

18
Shifting Interest Structure

• All securitization programs involving
  senior/subordinated structures have incorporated
  a shifting interest structure, which allows
  disproportionate redistribution of prepayments of
  the underlying collateral from subordinate class
  to senior class according to a well-defined
  pre-specified schedule.

19
Example Shifting Interest Structure
20
Securitization Through Novation Process
21
Potential Achievements in Securitization

• Improved return on assets and return on equity
• Credit risk is reduced as securitization spreads
  the risk among the major players
• Interest rate risk is mitigated as securitization
  of the assets improves asset/liability
  management,
• Concentration risk to particular obligor(s) and
  or industry is mitigated through securitization
  as banks attempt to off-load credits to achieve
  regulatory compliance.
• Strictly speaking, novation represents the
  cleanest form of transfer from legal standpoint.
  However it is rarely used.

22
Assignment

• Under the Common Law, assets can be assigned
  through legal assignment and equitable
  assignment.
• An assignment is a legal assignment that
  satisfies four criteria of the section 136 of the
  1925 of the Law of Property Act, that the
  assignment is
• (a) an absolute assignment,
• (b) in writing,
• (c) of the full amount of debt,
• and (d) notified in writing to the underlying
  debt obligor.
• In the event any of the four criteria is not
  satisfied, the assignment is termed as an
  equitable assignment.
• The method of assignment in transfer of assets to
  SPV in a securitization is through an equitable
  assignment, as originator is unwilling to inform
  the customers that their assets are being sold.

23
Participation

• This is an agreement where the originating bank
  (seller) transfers the right to the investors a
  pro rata share of interest and principal from the
  borrower.
• Participation does not transfer voting rights and
  does not require the consent of the borrower.
• It imposes limits on the ability of the
  originating bank to the changes in interest
  rates, principal, scheduled payments, guarantor,
  and collateral without approval of the buyers
  (investors).

24
Legal Framework

• Common law governs the process of securitization
  in the United States, United Kingdom and
  Australia.
• Civil Law is the governing principle in the most
  other nations in a securitization process.
• Civil law restricts the assignment or transfer of
  assets (removing assets from balance sheet as
  true sale without recourse by the originator or
  obligor). Also, insolvency laws dictate that the
  original obligor is to give its express consent
  or be notified in advance of the transfer or
  assignment of loan. Otherwise, the transfer would
  not constitute a true sale.

25
True Sale

• There are three basic principles that ensure that
  an originator has surrendered control of
  financial assets and can legally record a sale of
  the assets
• - Asset isolation,
• - Originator or SPV control,
• - Originator or seller non-control.

26
Problems for emerging market economies

• 1. Country legal issues as to whether assets can
  be assigned to an SPV,
• 2. Limits imposed by rating agencies (sovereign
  ratings ceilings),
• 3. Local customs, such as whether direct debits
  (automatic/electronic payment of debt servicing
  obligation by a financial institution on behalf
  of an obligor or borrower) may be used for
  receivables and thereby qualify for
  securitization,
• 4. Lack of availability of currency swaps if
  receivables are denominated in the local currency.

27
Four-Tranche Sequential-Pay Structure
Par amount Coupon Rate Maturity in Months Principal Pay-down Window In Months Average Life
Tranche A 21,125,000,000 0.174 36 36 1.625 year
Tranche B 21,125,000,000 0.181 64 29 4.4 years
Tranche C 21,125,000,000 0.190 85 22 6.36 years
Tranche D 21,125,000,000 0.215 102 18 7.84 years
Total collateral IR850 billion
Pass-through Rate 0.190 4.96 years
WAC of Collateral 0.2052
WAM of Collateral 102 Months
28
Four-Tranche Sequential-Pay Structure
Par amount Coupon Rate Maturity in Months Principal Pay-down Window In Months Average Life In year
Tranche A 21,500,000,000 0.174 24 23 1.04
Tranche B 21,500,000,000 0.181 43 20 2.82
Tranche C 21,500,000,000 0.190 61 18 4.40
Z Bonds 21,500,000,000 0.215
Total collateral IR850 billion
Pass-through Rate 0.190 102 4.96 years
WAC of Collateral 0.2052
WAM of Collateral 102 Months
29
Economic Capital

• Economic capital is the amount of risk capital,
  which a firm requires to mitigate risks
  undertaken as a going concern.
• It is estimated by the amount of capital that the
  firm needs to ensure its solvency, over a
  specific horizon, given a pre-specified
  probability.
• It is prudent that financial services aim to hold
  risk capital of an amount equal at least to
  economic capital.

30
Regulatory Capital

• "Regulatory Capital" is the mandatory capital the
  regulators require under Basle Committee in
  Banking Supervesion.
• On the other hand economic capital is the
  institutions best estimate of required capital
  needed for management of various risks, and for
  allocating the cost of maintaining regulatory
  capital among different units within the
  organization.

31
Economic Capital EC

• EC credit risk capital market risk capital
  operational risk capital.
• Economic capital may exceed or fall short of
  regulatory capital.