COBK Session 3

Pradeepta Sethi
TAPMI
 What is capital ?

Capital can be considered as a banks own funds, rather

than borrowed money such as deposits.
A banks own funds are items such as its ordinary share
capital and retained earnings in other words, not money
lent to the bank that has to be repaid no associated
contractual commitment for repayment.
Taken together, these own funds are equivalent to the
difference between the value of total assets and liabilities.
Capital appears alongside liabilities as a source of funding
one that can absorb losses that could otherwise threaten a
banks solvency.
 What is Capital ?

It provide funds to finance fixed investments investment in

building, land, equipment, to finance growth and expansion
etc.

During a banks life, it generates new capital from its profits.

Profits not distributed to shareholders are allocated to other

components of shareholders equity, resulting in a permanent
increase.

Capital growth is a source of additional funds used to finance

new assets.
 Key characteristics of Capital

It represents a banks ability to absorb losses while it remains

a going concern keeps it balance-sheet solvent.

Unlike a banks liabilities, it is perpetual: as long as it

continues in business, the bank is not obligated to repay the
original investment to capital investors.

Typically, distributions to capital investors (dividends to

shareholders) are not obligatory and usually vary over time,
depending on the banks profitability.
Why capital is so important?

Capital as Incentive

Capital as a Buffer

Capital for Intervention

 Why capital is so important?
To absorb losses, acting as a cushion to protect those who have
entrusted the bank with their money from the mistakes of those
who own and run it provides a buffer against bank failure.
It exposes shareholders directly to the risk of failure capital
requirements serve to encourage good risk management practices
restrain bankers' instinct for gambling by raising the stakes.
In the event of bank failure, non-equity, or tier two, capital provides
a buffer against losses by depositors.
In Toto, prevent a bank's financial problems from spreading and
threatening financial stability.
Minimum capital requirements prevent the value of assets in a
failing bank from dropping below the value of the depositors'
claims.
 What is liquidity risk?
Liquid assets (such as cash, central bank reserves or government
bonds) appear on asset side of the balance sheet as a use of
funding.
A bank holds a buffer of liquid assets to mitigate against the risk of
liquidity crises caused where other sources of funding dry up.
Liquidity risk It is the risk that a large number of depositors and
investors may withdraw their savings that is, the banks funding
at once, leaving the bank short of funds.
Such situations can force banks to sell off assets most likely at
an unfavorably low price.
Broadly two types of liquidity risk - Funding liquidity risk & Market
liquidity risk
 Funding liquidity risk

The risk that a bank does not have sufficient cash or

collateral to make payments to its counterparties and
customers as they fall due (or can only do so by liquidating
assets at excessive cost).

In this case the bank has defaulted. This is sometimes

referred to as the bank having become cash-flow insolvent.

A bank run is an acute crystallization of funding liquidity risk.

Balance sheet insolvency is another trigger for bank run.

 Market liquidity risk

This is the risk that an asset cannot be sold in the market

quickly, or, if its sale is executed very rapidly, that this can
only be achieved at a heavily discounted price.
It is primarily a function of the market for an asset, and not
the circumstances of an individual bank.
Market liquidity risk can soon result in the bank facing a
funding liquidity crisis.
Alternatively, with a fire sale (selling at a heavily discounted
price), it may result in the bank suffering losses which deplete
its capital.
 Expected and Unexpected loss
Losses of interest and principal occur all the time - there are
always some borrowers that default on their obligations.
While it is never possible to know in advance the losses a bank will
suffer in a particular year, a bank can forecast the average level of
credit losses it can reasonably expect to experience. These losses
are referred to as Expected Losses (EL).
Financial institutions view Expected Losses as a cost component
of doing business.
They manage them through the pricing of credit exposures and
through provisioning.
One of the functions of bank capital is to provide a buffer to protect
a banks debt holders against peak losses that exceed expected
levels.
Expected and Unexpected loss
 Expected and Unexpected loss

Peak losses do not occur every year, but when they occur, they
can potentially be very large.
Losses above expected levels are usually referred to as
Unexpected Losses (UL).
Interest rates, including risk premia, charged on credit exposures
may absorb some components of unexpected losses, but the
market will not support prices sufficient to cover all unexpected
losses.
Capital is needed to cover the risks of such peak losses, and
therefore it has a loss-absorbing function.
 Bank Capital How much is Enough?

Banks have an incentive to minimize the capital they hold, because

reducing capital frees up economic resources that can be directed
to profitable investments.

On the other hand, the less capital a bank holds, the greater is the
likelihood that it will not be able to meet its own debt obligations,
i.e. that losses in a given year will not be covered by profit plus
available capital, and that the bank will become insolvent.

Thus, banks and their supervisors must carefully balance the risks
and rewards of holding capital.
 Capital regulations

Bank capital regulations were introduced in order to redress the

natural tendency of banks to hold insufficient capital.
The Basel capital adequacy regime dates back to the Basel Accord
of 1988, which led to the introduction of what we now know as
Basel I.
Has its origins in the financial market turmoil that followed the
breakdown of the Bretton Woods system of managed exchange
rates in 1973.
After the collapse of Bretton Woods, many banks incurred large
foreign currency losses.
 Origins of Capital regulations

On 26th June 1974, West Germanys Federal Banking Supervisory

Office withdrew Bankhaus Herstatts banking license after finding
that the banks foreign exchange exposures amounted to three
times its capital.
Banks outside Germany took heavy losses on their unsettled
trades with Herstatt, adding an international dimension to the
turmoil.
In October the Franklin National Bank of New York also closed its
doors after incurring large foreign exchange losses.
The central bank governors of the G10 countries established a
Committee on Banking Regulations and Supervisory Practices at
the end of 1974. Later renamed it as Basel Committee on Banking
Supervision (BCBS).
 Basel Committee

Committee was designed as a forum for regular cooperation

between its member countries on banking supervisory
matters.
Its aim was and is to enhance financial stability by improving
supervisory know how and the quality of banking supervision
worldwide.
Currently there are 28 member countries.
Countries are represented on the Committee by their central
bank and also by the authority for the prudential supervision
of banking business.
 Basel I: the Basel Capital Accord

Capital adequacy became the main focus of the Committees

activities.
Capital measurement system International Convergence of
Capital Measurements and Capital Standards commonly
referred to as the Basel Capital Accord (1988 Accord) was
approved by the G10 Governors and released to banks in
July 1988.
The 1988 Accord called for a minimum capital ratio of capital
to risk-weighted assets of 8% to be implemented by the end
of 1992.
 Features of Basel I

Focused mainly on the assessment of the quantity of credit

risk - created a cushion against credit risk.

The norm comprised of four pillars

l Constituents of Capital,
l Risk Weighting,
l Target Standard Ratio, &
l Transitional and implementing arrangements
 Pillar I - Constituents of Capital

Prescribes the nature of capital that is eligible to be treated as reserves.

Capital as per Basel Accord, better known as regulatory capital, is sum of
Tier I and Tier II capital.
Tier I capital or Core Capital consists of elements that are more
permanent in nature and as a result, have high capacity to absorb losses.
l This comprises of equity capital and disclosed reserves.
l Equity capital includes fully paid ordinary equity/common shares and
non-cumulative perpetual preference capital.
l Disclosed/published reserves include post-tax retained earnings.
l The accord requires Tier I capital to constitute at least 50 percent of
the total capital base of the banking institution.
 Pillar I - Constituents of Capital

Tier II capital is more ambiguously defined, as it may also arise

from difference in accounting treatment in different countries.
Tier II Capital (or supplementary capital) is made up of a broad
mix of near equity components and hybrid capital/debt instruments.
l Upper Tier 2 comprises of items closer to common equity, like
perpetual subordinated debt;
l Lower Tier 2 comprises of items closer to debt than of equity.
The total of Tier II Capital is limited to 100 per cent of Tier 1
Capital.
Tier 3 Capital (or additional supplementary capital) was added in
1996 and can only be used to meet capital requirements for market
risk.
 Pillar II Risk Weighting

Some assets (i.e. loans) are riskier than others, and each asset
class can be assigned a risk weight according to how risky it is
judged to be.
These weights are then applied to the banks assets, resulting in
risk-weighted assets (RWAs).
Capital Adequacy Ratio (CAR) = Capital-to-risk weighted assets
ratio (CRAR) measure of a banks capital It is the ratio of a
bank's capital in relation to its risk weighted assets .
The framework of weights was kept simple with five weights used
for on-balance sheet assets.
The risk weights include 0, 10, 20, 50 & 100% as weights.
 Pillar II Risk Weighting

Categories of assets Risk Weights (%)

Cash and Government bonds of OECD 0
member
Claims on domestic public sector entities 10
Inter-bank loans to bank headquartered in 20
OECD member countries
Home mortgages 50
Other loans 100
 Pillar II Risk Weighting

Off-balance sheet elements, essentially in the nature of

contingent liabilities such as letters of credit, guarantees and
commitments, and Over-The-Counter (OTC) derivative
instruments, were to be first converted to a credit equivalent
and then, appropriate risk weights were to be assigned.
Instruments Credit Conversion
Factors (%)

Commitments with an original maturity of up to one year, or which can

0
be unconditionally cancelled at any time
Short-term self-liquidating trade-related contingencies (such as
shipments documentary credits collateralized by the underlying 20
shipments)
Certain transaction-related contingent items (for example,
performance bonds, bid bonds, warranties and standby letters of
credit related to particular transactions)
50
Note issuance facilities and revolving underwriting facilities
Other commitments (for example, formal standby facilities and
credit lines) with an original maturity of over one year
Direct credit substitutes, for example, general guarantees of
indebtedness (including standby letters of credit serving as
financial guarantees for loans and securities) and acceptances
(including endorsements with the character of acceptances)
Sale and repurchase agreements and asset sales with 100
recourse,1 where the credit risk remains with the bank
Forward asset purchases, forward deposits and partly-paid
shares and securities, which represent commitments with certain
drawdown
 Pillar II Risk Weighting

The risk weighted method is favored over a simple gearing

ratio method due to the following benefits:
l Provides for a fair basis of comparison between
international banks with different capital structures;
l Enables accountability of off-balance sheet elements;
l Avoids discouraging banking institutions to hold liquid and
low risk assets to manage capital adequacy.
 Pillar III Target Standard Ratio

The initial standards required internationally active banks to

meet two minimum capital ratios, both computed as a
percentage of the risk-weighted (both on- and off-balance
sheet) assets.
The minimum Tier 1 ratio was 4 per cent of risk-weighted
assets, while total capital (tiers 1 and 2) had to exceed 8
per cent of risk-weighted assets.
 Major principles of Basel Accord

A bank must hold equity capital to at least 8 per cent of its

risk-weighted credit exposures as well as capital to cover
market risks in the banks trading account.
When capital falls below this minimum requirement
shareholders may be permitted to retain control, provided
that they recapitalize the bank to meet the minimum capital
ratio.
If the shareholders fail to do so, the banks regulatory agency
is empowered to sell or liquidate the bank.
 Pillar IV Transitional &
Implementing Arrangement

Sets different stages of implementation of the norms in a

phased manner.
Due to widespread undercapitalization of the banking
community during that time, a phased manner of
implementation was agreed upon, wherein a target of 7.25
percent was to be achieved by the end of 1990 and 8 percent
by the end of 1992.
 Amendment in 1996
Amended in January 1996 for providing an additional buffer for risk
due to fluctuations in prices, on account of trading activities carried
out by the banks.
Banks were permitted to use internal models to determine the
additional quantum of capital to be provided.
Banks had to estimate value-at-risk (VAR) on account of its trading
activities that is the maximum quantum of loss the portfolio could
suffer over the holding tenure at a certain probability.
The capital requirement is then set on the basis of higher of the
following estimate.
l Previous days Value-at-risk; and,
l Three times the average of the daily value-at-risk of the preceding
sixty business days
 Criticism of Basel I
Basel I standards stems from the fact that they attempt to define and
measure bank portfolio risk categorically by placing different types of bank
exposures into separate buckets.
Banks are then required to maintain minimum capital proportional to a
weighted sum of the amounts of assets in the various risk buckets.
That approach incorrectly assumes that risks are identical within each
bucket and that the overall risk of a banks portfolio is equal to the sum of
the risks across the various buckets.
Standards have not been able to meet one of the central objectives, viz.,
to make the competitive playing field more even for international banks.
One-size-fits-all imposing same rules on all banks even within a
country.
Basel I encouraged transactions using securitization and off balance
sheet exposures.