MONASH

BUSINESS
SCHOOL

Lecture 10
BANK CAPITAL ADEQUACY

BFF2401 Commercial banking and finance

LEARNING OBJECTIVES

1. Learn about the relationship between capital and

insolvency risk
2. Discover the evolution of capital regulation for Australian
deposit-taking institutions (ADIs)
3. Understand the three-pillar framework for capital
regulation used in Australia (focus on the current Basel
III)
4. Learn how the Australian Prudential Regulation Authority
(APRA) measures capital adequacy

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 REFERENCES

▪ Lange et al. (2015) Chapter 18

▪ APRA (2014), “Overview of the prudential framework” -
part of the APRA submission to the Financial Services
Inquiry
▪ Littrell, C. (2011), “APRA’s Basel III implementation –
Rationale and impacts”, 23 November
▪ APRA and BIS websites on capital adequacy
▪ Basel III summary table
https://www.bis.org/bcbs/basel3/b3_bank_sup_reforms.p
df
https://www.bis.org/bcbs/publ/d424_inbrief.pdf

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LECTURE OUTLINE

▪ Capital and insolvency risk (LO1)

▪ Basel accords: the evolution of ADI capital regulation
▪ Measuring ADI’s capital adequacy
▪ Summary

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INSOLVENCY RISK

▪ Insolvency risk is the risk that a financial institution may

not have sufficient capital to offset a sudden decline in the
value of its assets relative to its liabilities. In other words,
the value of the ADI’s liabilities exceeds that of its
assets.

▪ It is often defined for corporates as a firm being unable to

fulfil its financial obligations when they come due.

▪ The first definition requires both assets and liabilities to be

valued regularly.

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CAPITAL AND INSOLVENCY RISK

Market versus book values:

▪ Net worth: market value of assets minus market value
of liabilities
▪ Book value: asset and liability values based on
historical cost
▪ Economists prefer the market value definition, while
most regulators prefer the book value definition.
▪ The book value, accounting based method can be
misleading.

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CAPITAL AND INSOLVENCY RISK (cont.)

▪ This ADI is solvent on a market value basis.

Assets ($m) Liabilities and equity ($m)
Securities 70 Deposits 95
Loans 30 Net worth 5
TA = 100 TL + E = 100

▪ The marking-to-market method allows balance sheet

values to reflect current rather than historic prices.

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 CAPITAL AND INSOLVENCY RISK (cont.)

What if the market value of loans dropped to $27m?

Assets ($m) Liabilities and equity ($m)

Securities 70 Deposits 95
Loans 27 Net worth 2
TA = 97 TL + E = 97

While the ADI is still solvent, its net worth has declined
from $5m to $2m.

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CAPITAL AND INSOLVENCY RISK (cont.)

Consider a further fall in the market value of loans of $5m

Assets ($m) Liabilities and equity ($m)

Securities 70 Deposits 95
Loans 22 Net worth -3
TA = 92 TL + E = 92

The ADI is now insolvent as from the remaining $92m in

assets, depositors would get only 92/95 in the dollar (96.84
percent).

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CAPITAL AND INSOLVENCY RISK (cont.)

▪ Losses in asset values are borne first by equity holders.

– If losses exceed the value of equity, liability holders will
be affected.
▪ Sufficient capital levels will protect liability holders from
losses.
▪ Since accounting rules introduced in Australia (1995), the
fair market value of most assets and liabilities is required
to be disclosed.

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BOOK VALUE vs. MARKET VALUE

Arguments against book value accounting

▪ Tendency to defer write downs of bad loans
▪ Losses in asset values due to adverse interest rate
changes are not recognised in book value accounting
method.
Arguments against market value accounting
▪ Difficult to implement
▪ Introduces unnecessary variability into an ADI's earnings
▪ ADIs are less willing to take longer-term asset exposures.

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CAPITAL MANAGEMENT

▪ ADI capital is guided by two key factors:

– regulated capital adequacy requirements and
– the risk-return trade-offs available from the use of leverage (see
week 9)
▪ Measures of capital adequacy
– Leverage ratio
– Risk-based capital ratios
▪ Chapter 18 focuses on the regulation of capital adequacy
of Australia’s authorised deposit-taking institutions
(ADIs).

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LECTURE OUTLINE

▪ Capital and insolvency risk

▪ Basel accords: the evolution of ADI capital regulation
▪ Developments (LO2)
▪ The three pillars
▪ Measuring ADI capital adequacy
▪ Summary

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THE EVOLUTION OF CAPITAL REGULATION

▪ Leverage ratio was once the key measure of the ratio of

an ADI's core capital to its assets.
L = Core capital / Assets
▪ It had many problems
– Market value
– Asset risk
– Difference in risk appetites of ADIs
– Off-balance-sheet activities
– Non-equity capital
– Bank only ratio

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BASEL COMMITTEE ON BANKING SUPERVISION

▪ The Basel Committee on Banking Supervision (BCBS)

was established by the central bank governors of the
Group of 10 countries in 1975 after the collapse of the
Bankhaus Herstatt in Germany.
▪ It coordinates improvements in the domestic banking
prudential regulation among its members and other
interested countries.
▪ The Bank for International Settlements (BIS - the central
banks' central bank) provides its secretariat. The BIS is
not a regulator, but the press often incorrectly suggests it
is.

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 BASEL CAPITAL ADEQUACY

▪ The BCBS produced the Basel Capital Accord agreements

on CAR (Capital Adequacy Ratio).
– 1988 credit risk (Basel 1)
– 1996 market risk added
– 2006 operational risk added and other risks more refined (Basel 2)
– 2013 capital adequacy, liquidity risk, leverage and other
measures (Basel 3)
▪ Ideally, a bank’s capital requirements should be related to
its risk taking.

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BASEL AGREEMENTS

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THE INITIAL IMPACT OF BASEL

▪ The 1988 agreement covered four major changes:

– risk adjusted asset weightings
– worldwide consolidations of banking group assets
– including off balance sheet items
– adjustments for market transactions
▪ Worldwide consolidation also meant that the home
country regulator was responsible for the entire group not
just its local assets.
▪ It also re-defined what would be included as regulatory
capital.

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LECTURE OUTLINE

▪ Capital and insolvency risk

▪ Basel accords: the evolution of ADI capital regulation
▪ Developments
▪ The three pillars (LO3)
▪ Measuring ADI capital adequacy
▪ Summary

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 THREE PILLARS OF BASEL III (refer to the summary table)

The Basel III capital agreements have three mutually

reinforcing pillars as the basis for controlling bank risk.
▪ Pillar 1 - Capital adequacy requirements
– Credit risk
– Market risk
– Operational risk
– Other risks
▪ Pillar 2 – Risk management and supervision
▪ Pillar 3 – Market discipline
Note that Basel III also regulates liquidity risk and large
exposure risk (systemic risk) (discussed in previous
topics).
https://www.bis.org/bcbs/basel3/b3_bank_sup_reforms.pdf
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THREE PILLARS OF BASEL III

Pillar 1: capital adequacy requirements

▪ A new definition of capital
▪ Changes to the capital adequacy ratios
▪ Inclusion of a non-risk-based leverage ratio within the
framework of Pillar 1
– Effective in Australia from 1 January 2018
– Australian ADIs have reported the leverage ratio to APRA since
2011 and are required to publicly disclose the ratios from 2015.
– Includes off balance sheet exposures, helps contain system-
wide build-up of leverage.

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 THREE PILLARS OF BASEL III

▪ Minimum CET1 raised to 4.5% of risk-weighted assets

▪ New capital conservation buffer, i.e. 2.5 per cent of
risk-weighted assets, comprised of CET1 only
▪ New countercyclical capital buffer
– To ensure sufficient capital requirements in the financial system
given the macro-financial environment
– Deployed on an infrequent basis, when credit growth is believed
to result in unacceptable build-up of systemic risks
– Expected to be between zero and 2.5 per cent of total risk-
weighted assets, to be met with CET1 only

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THREE PILLARS OF BASEL III

Pillar 2: risk management and supervision

▪ Addresses firm-wide governance and risk management
such as off balance sheet, securitisation, stress testing
etc.
▪ Provides guidance on expectations for a bank’s interest
rate risk in the banking book management process.
Pillar 3: market discipline
▪ Consolidated and enhanced framework allows market
participants (shareholders, bondholders, depositors) to
assess the risk profile of banks and exert corporate
governance
▪ The transparency of bank disclosure is aided by a
dashboard of banks’ key prudential metrics.
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LECTURE OUTLINE

• Capital and insolvency risk

• Basel accords: the evolution of ADI capital regulation
• Measuring ADI capital adequacy (LO4)
• Summary

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RISK BASED CAR

▪ The regulatory capital adequacy requirements described

in Chapter 18 incorporate the development from Basel I
through Basel II to Basel III

▪ Risk-based capital ratios refer to the following:

– Common equity Tier 1 capital risk-based ratio
– Tier 1 capital risk-based ratio
– Total capital risk-based ratio
(review the 4 essential characteristics from week 9 topic)

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A recap of regulatory capital (see week 9 topic)

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REQUIREMENTS FOR CAR – Starting point

▪ Common Equity Tier 1 must be at least 4.5 per cent of risk-weighted

assets at all times; that is
(Common Equity Tier 1 Capital)/(Total Risk Adjusted Assets) ≥ 4.5 per
cent
▪ Total Tier 1 capital must be at least 6 per cent of risk-weighted assets
at all times; that is
(Total Tier 1 Capital)/(Total Risk Adjusted Assets) ≥ 6 per cent
▪ Total Capital (Tier 1 capital plus Tier 2 capital) must be at least 8 per
cent of risk-weighted assets at all times; that is
(Total Regulatory Capital)/(Total Risk Adjusted Assets) ≥ 8 per cent

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REQUIREMENTS FOR CAR – Increasing trend

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HOW MUCH IS ENOUGH?

APRA requires "adequate capital cover against those risks”

given the "size, quality and type" of business.
– quality of assets
– profitability
– liquidity
– market risk
– credit risk concentration in the loan portfolio
– provisioning (set aside against NPLs)
– monitoring system
A bank’s capital adequacy ratio (CAR) should reflect this.

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PILLAR 1 RISK WEIGHTINGS

▪ The level of bank capital is then examined against the

bank’s on and off balance sheet exposures. These
include:
– Credit risk (CR) and credit valuation adjustments (CVA)
– Market risk
– Operational risk
– Other risks
• Non-traded interest rate risk
• Securitisation credit risk

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CR - CREDIT RISK WEIGHTINGS

▪ Credit risk is the risk that a client may default on their

payment obligations.
▪ Banks can address credit risk weighting under one of
three methods.
– standardised approach (SA) – each asset is weighted using a
regulator given weighting.
– foundation internal rating based approach (F-IRB) – bank
determines asset risk but the regulator provides other inputs.
– advanced internal ratings based approach (A-IRB) – bank
determines all of credit risk exposure for risk weighting purposes.
▪ The regulator must approve the approach and in
Australia only five ADIs have advanced approval.

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CR - CREDIT RISK ADJUSTED ASSET VALUES

Standardised approach to credit risk:

▪ Assets assigned to different categories of credit risk
exposure under the standard approach with a weight
of between 0 and 150% respectively.
▪ 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.

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CR - EXAMPLES OF RISK ADJUSTED ASSET WEIGHTINGS

▪ 0% weight for cash, cash equivalents, claims on the

Australian government, deposits with the RBA
▪ 20% weight for corporate securities, S&P rating of
AAA
▪ 35% weight for qualifying mortgage loans, LTV < 80%
with insurance (residential housing loans receive
special attention under the capital rules)
▪ 100% weight for loans and securities, S&P rating of
BB+ to BB-
▪ 150% weight for loans and securities, S&P rating of
below BB-

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CR - RISK WEIGHTING IS COMPLICATED

Risk weightings for residential mortgages are determined by loan

to valuation ratios and the incidence of mortgage insurance.

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CR - CAR IN AUSTRALIA

Calculating risk-based capital ratios

▪ Credit-risk-adjusted on-balance-sheet assets =

𝑛
Σ𝑖=1 𝑤𝑖 𝑎𝑖

Where:
𝑤𝑖 = risk-weight of 𝑖th asset, where 𝑖 = 1 to 𝑛
𝑎𝑖 = dollar (book) value of the 𝑖th asset on the balance sheet

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CR - EXAMPLE

Suppose an FI holds the following assets ($m):

Assets Value Risk Risk-adjusted
weightings assets
Cash, Australian Treasury bonds and 20
deposits and RBA
Local government bonds, S&P rating of AA- 10
Standard residential mortgage loans 40
(LVR<80%, with mortgage insurance)
Corporate loans with a S&P rating of BB+ 25
to BB-
Corporate loans with a S&P rating of B+ or 20
lower
TOTAL 115

Calculate its credit-risk-adjusted assets.

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CR - OFF-BALANCE SHEET (OBS) ASSETS

In addition to on-balance sheet items, banks may also have

off-balance sheet exposures similar to on-balance sheet
assets.

Off-balance sheet activities include:

- Non-market related transactions
- Market-related transactions

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 CR - NON-MARKET RELATED OBS TRANSACTIONS

▪ STEP 1:
– OBS contingent guaranty contracts off-balance sheet
activities (like guarantees or performance bonds) are
captured by converting them into their on-balance sheet
equivalents.
– These conversion factors range from 0%, 20%, 40%, 50%
and 100%. (refer to table 18.8 in textbook)

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CR - NON-MARKET RELATED OBS TRANSACTIONS (cont.)

▪ STEP 2:
– Once converted, the amount is then risk adjusted,
depending on the counter-party involved with the
transaction.
– This conversion follows the same five category
systems as the on-balance sheet assets.
– The same approach is applied for market-related OBS
transaction.

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 CR - MARKET-RELATED OBS TRANSACTIONS

▪ STEP 1: convert OBS values into on-balance-sheet

credit equivalent amounts
– Credit equivalent amount divided into potential and
current exposure elements
– 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

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CR - MARKET-RELATED OBS TRANSACTIONS (cont.)

▪ STEP 2: multiply the OBS credit equivalent amount by

an appropriate risk weight

➢ Risk − adjusted asset value of OBS market contracts

= total credit equivalent amount × risk weight

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CR - INTERNAL RATINGS BASED APPROACH

▪ Both IRB approaches allow banks to measure the risk

of their borrowers and apply value at risk (VaR)
methodology to calculate a capital charge (both
foundation and advanced methods).

▪ It also expands the counterparty risk to several

categories: corporate, sovereign, bank, retail, equity
and securitisation.

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CR - FIRB vs. AIRB

▪ Both internal systems use the bank’s data to determine

the probability of default.

– With FIRB, the loss given default, exposure at default and

maturity are determined by the regulator.

– With AIRB this data is derived from internal bank sources.

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 CR - ADVANTAGES OF A-IRB

▪ The AIRB allows the bank to use its own credit default
experiences to set the risk weightings for specific credit
risks.
▪ A bank with good past loan experiences may be able to
justify a much lower risk weightings than what a standard
approach lender can use for the same client.
▪ This gives them a potential competitive advantage as a
result.

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CR – SHORTCOMINGS OF A-IRB

▪ Excessive complexity
▪ Lack of comparability in banks’ models
▪ Lack of robustness in modelling certain asset classes
Basel III addressed these shortcomings via the following
revisions:
▪ Removed option to use AIRB for certain risk classes
▪ Adopted “input” floors for ensure a minimum level of
conservatism in these models
▪ Provide greater specification of estimation practices to
reduce risk-weighted asset variability

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CREDIT VALUATION ADJUSTMENT (CVA)

▪ A capital charge for potential mark-to market losses of

derivative instruments as a result of the deterioration in
the counterparty’s credit worthiness. This risk – known as
CVA risk – was a major source of losses for banks during
the GFC.
▪ Basel III revisions:
– Enhanced its risk sensitivity
– Strengthened its robustness
– Improved its consistency

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 MARKET RISK

▪ Market risk involves the impact of market price changes

on the ADI’s exposures to equity risks, commodity risks,
interest rate risks, and foreign exchange risks – both on
and off balance sheet.
▪ Two different approaches to estimate capital charge:
– Standardised model (predetermined by regulators)
– Internal market risk model approved by APRA
▪ Revised Basel III revision: Capital requirements for
market risk rise significantly. Requirements are calculated
based on 12 months of market stress.

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OPERATIONAL RISK

▪ Operational risk (OR) is the risk of loss resulting from

inadequate or failed internal processes, people and
systems or from external events (including legal risk but
excluding strategic or reputation risk).

▪ One single risk-sensitive standardised approach

applies to all banks.

▪ The OR capital requirements are based on 1) bank

income and 2) bank’s historical operational losses.

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OTHER RISKS: NON-TRADED INTEREST RATE RISK

▪ A non-traded interest rate risk charge is required only for

those DIs that use internal risk management systems for
credit risk, operational risk and market risk.
▪ Take into account the impact that past interest rate
movements have on future earnings in the banking book
▪ APRA requires that the capital requirement for non-
traded interest rate risk must be calculated at least
quarterly to ensure it adequately reflects the DI's risk
profile.

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OTHER RISKS: SECURITISATION CREDIT RISK

▪ Require DIs to hold sufficient regulatory capital against

securitisation credit risk exposures
▪ Methods consistent with those used for calculating
general credit-risk-adjusted assets

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CAR IN AUSTRALIA – PUT IT TOGETHER

Calculating risk-based capital ratios

▪ STEP 1: Estimate regulatory capital measures
– common equity Tier 1 capital, total Tier 1 capital and Total
regulatory capital, respectively
▪ STEP 2: Estimate the risk adjusted assets for each of the
risk classes and sum them up to have the total risk adjusted assets
for credit risk, market risk, operational risk, non-traded interest rate
risk and securitisation credit risk
▪ STEP 3: Divide each of the three capital measures (Step
1) by the total risk-adjusted assets (Step 2)

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CAR calculation task

• Assume: In addition to the credit-risk weighted assets

calculated on slide 36, the bank also has $95m in market-risk-
weighted assets, and $35m in operational-risk-weighted
assets.

– How much CET1 does the bank need in total to meet the
regulatory minimum requirement (including the
conservation buffer)?

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PILLAR 2 – RISK MANAGEMENT AND SUPERVISION

▪ New capital requirements rely more heavily on banks’

own risk management systems.
▪ To ensure this works well supervisors must review these
systems more closely.
▪ If supervisors find systems are inadequate, they must
intervene, i.e. require the bank to
─ modify its model
─ reduce its risk taking
─ increase its capital

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PILLAR 2 - RISK MANAGEMENT AND SUPERVISION

Note that under Pillar 2, banks might be required by the

regulator to hold additional capital.

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PILLAR 3 – MARKET DISCIPLINE

▪ More risky firms face higher risk premiums when they

raise funds in the market. So if a bank takes more risk,
its cost of funds will rise because its risk premium will
rise, too.
▪ This discourages banks from taking more risk.
▪ It only works, however, if the market has information that
is - it only works if the market knows the bank is taking
more risk.
▪ Basel III introduces a dashboard of banks’ key
prudential metrics.

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LECTURE OUTLINE

▪ Capital and insolvency risk

▪ Basel accords: the evolution of ADI capital regulation
▪ Measuring ADI capital adequacy
▪ Summary

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BASEL III REVISIONS

▪ Improving bank capital quality by placing a greater focus on CET1

▪ Increasing the level of capital requirements to ensure banks’
resilience to losses
▪ Improving risk sensitivity in standardised risk weightings models
▪ Reducing mechanistic reliance on credit ratings, by requiring
banks to conduct sufficient due diligence
▪ Constraining the use of internal model approaches to reduce
unwarranted variability in banks’ calculations
▪ Introducing macroeconomic factors such as capital buffers and a
large exposures regime
▪ Specifying a minimum non-risk-based leverage ratio to constrain
excess leverage
▪ Introducing new liquidity requirements
▪ https://www.bis.org/bcbs/publ/d424_inbrief.pdf

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APRA ON BENEFITS FROM BASEL III

▪ Many banking systems in other countries will become stronger in both

capital and liquidity terms. This reduces Australia’s exposure to foreign
economic disasters.
▪ Australia’s banking system will become moderately stronger in capital
terms, and a lot stronger in liquidity terms.
▪ Australia remains in global ‘A’ league of well regulated banks.
▪ Over time, it will reduce Australia’s strategic vulnerability to offshore
money markets.
▪ Depositors get better deals.
▪ All of the above benefits add up to a reduced chance of Australia
experiencing a financial crisis.

Source: Charles Littrell (2011), “APRA’s Basel III implementation – Rationale and
impacts”, 23 November

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