Regulatory

Requirements & Capital

Adequacy
What’s the Point of Regulation?
• Enough Capital?

• …or do I need a bailout?

• Limit the risks a bank is taking…

• And updated for financial crises.

• Affects Model & Valuation!

 Basel I (1988)
• Risk-Weighted Assets
Risk Example Assets
Weight
0% Cash / government
securities
10% Certain public debt

20% Interbank loans

50% Residential mortgages

• Capital Requirements 100% Private sector debt

• Tier 1 Ratio >= 4%

• Total Capital Ratio >= 8%
• Tier 2 Capital Cannot Exceed Tier 1 Capital
• Leverage Ratio >= 3% (US only)
How Well Capitalized Are You?
Strength Total Capital Tier 1 Leverage Tangible
Ratio Ratio Ratio Equity
Ratio
Well capitalized >= 10% and >= 6% and >= 5%

Adequately capitalized >= 8% and >= 4% and >= 4%

Undercapitalized >= 6% and >= 3% and >= 3%

Significantly undercapitalized < 6% or < 3% or < 3% and > 2%

Critically undercapitalized <= 2%

• And if you don’t comply…

• Higher deposit insurance premiums
• Restrictions on dividends, acquisitions, share buybacks
• Government takeover
 Problems with Basel I
• All corporate loans are equally risky?

• Loan classification

• Securitizations / derivatives…

• Narrow focus on credit risk

• Is 8% always enough to save you?

 Basel II (2004)
• More complex RWA Risk
Weight
Example Assets

0% Cash and equivalents

35% Residential mortgages

• Different risks
75% Credit / auto loans

100% Commercial real estate

100% Other assets

By rating Government securities

• Supervisory review By rating Interbank loans

By rating Corporate loans

• Bank transparency
 The Financial Crisis
• Tier 1 Ratios – wrong?

• Is the Leverage Ratio better?

• No measures of liquidity

• Managed reporting required?

• Counterparty credit risk

 Basel III?
• Stricter definition of Tier 1 Capital

• Leverage Ratio requirement

• Counter-cyclical capital buffers

• Limits on counterparty credit risk

• Liquidity Ratios
Why Do These Rules Matter?
• We need them in our model

• Impact on valuation
The Truth About Capital Adequacy
• Calculation is tricky and bank-specific

• Differs significantly by country

• Have to rely on filings – no “standard”

• More control in valuations / simple

models