BU7056 Credit, Lending and Risk Management

Pillars of Capital

SESSION 3c
 Session 12: Objectives

• Understand the three Pillars of Capital

• Discuss Operational, Market risks, Risk of Insolvency
• Calculate Capital Adequacy Ratio and various leverage ratios
• Explain other types of risks (Liquidity, Reputational,
Regulatory)

BU7056 Credit, Lending and Risk Management

 Pillars of Capital
The "Pillars of Capital" typically refer to the regulatory framework
known as Basel III.
Basel III is an international set of banking regulations developed by
the Basel Committee on Banking Supervision (BCBS), aimed at
improving the stability and risk management of the banking industry.
It prescribes minimum capital requirements for financial institutions,
with the goal of minimizing credit risk.
The framework includes three pillars, which are key components of
capital and risk management for banks.

BU7056 Credit, Lending and Risk Management

BU7056 Credit, Lending and Risk Management
 Pillar 1 - Minimum Capital Requirements
This pillar sets the minimum capital requirements
that banks must maintain to cover credit,
operational, and market risk.
It establishes the minimum capital-to-risk-weighted-
assets ratio, which helps ensure that banks have an
adequate capital buffer to absorb potential losses.
It also includes the leverage ratio, which sets a
minimum level of Tier 1 capital to total exposure.

BU7056 Credit, Lending and Risk Management

 Operational Risk
Operational risk summarizes the uncertainties and
hazards a company faces when it attempts to do its
day-to-day business activities within a given field or
industry.
It can result from breakdowns in internal procedures.
They can be classified by a variety of unsystematic
risk, which is unique to a specific company or
industry.
Operational risk is usually caused by four different
avenues: people, processes, systems, or external
events.
BU7056 Credit, Lending and Risk Management
 Operational Risk
People
• Operational risk caused by people
can arise due to employee
deficiencies or employee shortages.
E.g.: staff with insufficient
knowledge base, human-error, etc.
BU7056 Credit, Lending and Risk Management
Process
• Operational risk arises when due steps
with a process which must be
performed in sequential order are
deviated from, causing inevitable
detrimental outcomes.
• It could also occur when gaps within a
process are taken advantage of through
collusion and failed internal controls to
put the bank at risk of losing money
through theft.
 Operational Risk
Systems
• Operational risks relating to the
technical aspects of a system due to
reliance on software and systems for
business operations.
• Outdated, inadequate, overstretched,
or not property set up systems could
result in inefficiencies that could affect
performance. Issues such as system
bugs or technical deficiencies lead to
more exposure to cybercrime.
BU7056 Credit, Lending and Risk Management
External Events
• These are external to the organisation.
They cut across from natural disasters
that impede the process of a financial
institution to political changes that
could restrict operations.
• Some of these types of risk may be
classified on their own (i.e.: geopolitical
risk). Others are simply a nature of
business such as a third-party
defaulting on a contract agreement.
 Market Risk
Marketing risk is the potential for failures or losses
during any marketing activity, from production to
promotion.
Marketing risks could include any of the following
examples:
• Pricing a product incorrectly (equity or stock
prices).
• interest rate movements
• foreign exchange fluctuations

BU7056 Credit, Lending and Risk Management

 Market Risk
There are four main forms of market risk capable of
impacting performance of banks across the entire
financial industry:
• Exchange rate
• inflation
• interest rate
• Commodity pricing
It is determined by different factors which affect the
whole economy hence this makes it is somewhat outside
the control of most commercial banks.
BU7056 Credit, Lending and Risk Management
 Capital-to-risk weighted-assets ratio
The capital-to-risk weighted assets ratio, also known as
the capital adequacy ratio (CAR), is one of the most
important financial ratios used by investors and analysts
to determine a bank’s risk of insolvency.
The ratio measures a bank's financial stability by
measuring its available capital as a percentage of its risk-
weighted credit exposure.
The capital adequacy ratio is calculated by dividing a
bank's capital by its risk-weighted assets.
Currently, the minimum ratio of capital to risk-weighted
assets is 8% under Basel II and 10.5% (which includes a
2.5% conservation buffer) under Basel III.
BU7056 Credit, Lending and Risk Management
 Capital-to-risk weighted-assets ratio
To calculate capital adequacy ratio:

Tier 1 Capital: Core capital of the bank on hand to absorb and cushion losses
suffered by a bank without it being required to stop operations. It consists of equity
capital, ordinary share capital, intangible assets and audited revenue reserves.
Tier 2 Capital: a secondary supply of funds available from the sale of assets once a
bank winding up. It comprises of unaudited retained earnings, unaudited reserves,
and general loss reserves.
Risk-weighted assets are used to determine the minimum amount of capital that
must be held by banks and other institutions to reduce the risk of insolvency.
 Calculation of Capital adequation ratio video
BU7056 Credit, Lending and Risk Management
 Leverage ratio
These ratios provide an indication of how the
company’s assets and business operations are
financed, using either debt or equity.
Debt-to-Assets Ratio = Total Debt / Total Assets
Debt-to-Equity Ratio = Total Debt / Total Equity
Debt-to-Capital Ratio = Today Debt / (Total Debt +
Total Equity)
Debt-to-EBITDA Ratio = Total Debt / Earnings Before
Interest Taxes Depreciation & Amortization (EBITDA)
Asset-to-Equity Ratio = Total Assets / Total Equity
BU7056 Credit, Lending and Risk Management
 Case Study
Abbey Bank Group, a new subsidiary of the Zenial Finance Group, is an online bank that
depends on a sound IT software system for its operations which are run web-based
platforms. In the past two years, it has been 2nd on the IPSOS rating carried out by
customers. In the current financial year, the following occurrences have been observed:
1. Abbey Bank has given out about 60% of its loans in foreign currency, with the balance
40% across various other sector portfolios.
2. The bank’s Core capital is £400,000, Tier 2 Capital is £100,000 and its risky loans and
their assigned riskiness are as follows: £15m @ 15%, £60m @ 8%, £20m @ 10%.
3. Oje, a new staff in the IT team, has been given the responsibility to cover for a key staff
who had an emergency, and was forced to resign.
You are required as a financial analyst to advise the bank about its inherent risk exposure,
and make suggestions on what can be done to mitigate these?

BU7056 Credit, Lending and Risk Management

 Pillar 2 - Supervisory Review Process
• The Pillar 2 expands on the rules for minimum capital requirements as provided
Basel I.
• The main focus was to provide a regulatory framework for supervision and set new
disclosure requirements for assessing the capital adequacy of the banks.
• So three main tenets:
• Consider ways to ensure minimum capital requirements that cannot be easily eroded by risks
• Carried out regulatory supervision by stating disclosure requirements related to risk
management strategies
• Market discipline which encouraged sharing of specific information that could confirm the
bank’s transparency and soundness.

It sought to provide a unified way of evaluating banks across boarders irrespective of

country or geographic location

BU7056 Credit, Lending and Risk Management

 Pillar 2 - Supervisory Review Process

It involves regulatory authorities (such as
central banks and financial regulators)
assessing the specific risks (outside Basel I),
capital adequacy of individual banks and
accessing and distributing risk management
information.
Banks are expected to conduct their internal
assessments of capital adequacy and risk
management, and regulators work with them
to ensure they are adequately prepared to
withstand various risks.

Video  Basel II explained

BU7056 Credit, Lending and Risk Management
 Pillar 3 - Market Discipline and Disclosure
It was an improvement of Basel 1 and 2.
It sought to ensure transparency and market discipline
by requiring individual banks to disclose relevant
information about their risk exposures, capital, and risk
management practices.
The goal is to provide stakeholders, including investors
and the public, with sufficient information to assess a
bank's financial health and risk profile.

BU7056 Credit, Lending and Risk Management

 Pillar 3 - Market Discipline and Disclosure
Its focus on specific ratios would shows a banks soundness.
1. Liquidity Coverage Ratio
2. Net Stable Funding Ratio
3. Establishing liquidity Risk Management Supervision
Principles
4. And its iterative process of ensuring monitoring
This disclosure enhances market discipline by allowing
market participants to make informed decisions about a
bank's risk.
Video  Basel III explained
BU7056 Credit, Lending and Risk Management
 Think about this…. What will be a disclosure
document that all banks must
produce to ensure
compliance with this
requirements of BASEL 3?

Audited Financial statement which shows full details of

the banks financial position, risk exposure, capital,
corporate governance, etc. Usually gives a “view”
about the firm. Used by investors to make decisions.
BU7056 Credit, Lending and Risk Management
BU7056 Credit, Lending and Risk Management
 Other Types of Risks

BU7056 Credit, Lending and Risk Management

 Liquidity Risk • arises from our potential inability to meet short-
term payment obligations when they come due or
only being able to meet these obligations at
excessive costs.
This could occur when:
• over-reliance on short-term sources of funds ,
• having a balance sheet concentrated in illiquid
(non-current) assets,
• loss of confidence in the bank on the part of
customers.
• mismanagement of asset-liability duration can also
cause funding difficulties.
Introduction
BU7056 Credit,
to Banking
Lending and Risk Management
 Liquidity Risk cont’d
Banks employ a range of strategies to ensure
adequate liquidity:
• including maintaining reserves with the
central bank,
• borrowing in the interbank market,
• leveraging intra-group borrowing,
• investing in readily marketable assets like
government bonds.

BU7056 Credit, Lending and Risk Management

Introduction to Banking
 Reputational Risk
- Risk of damage to the bank’s reputation
- leads to the degeneration of the bank’s
goodwill
- not capable of failing a bank, but too many
incidences coming after such could trigger loss
of trust, confidence in the bank
E.g.: mistreatment of a customer, some kind of
dishonesty, etc

BU7056 Credit, Lending and Risk Management

 Reputational Risk Cont’d
Another example:
Midland Bank’s disclosure of some high profile
account details caused their slogan to change from
“the listening bank” degenerate to “the whispering
bank”. Within the same period the bank’s mgt
made a bad acquisition decision in the US,
increasing the perception of poor management.
Eventually leading to their takeover by HSBC.

Croxford, Abramson, & Jablonowski (2005:82)

BU7056 Credit, Lending and Risk Management
 Regulatory Risk
- is the risk of failing to meet the requirements as
stipulated by the regulators.
- simply “non-compliance with regulations”
- could also refer to the risk that a change to the
laws or regulations will hurt a business or
investment by affecting that business, sector, or
market.
- brings about bad publicity and huge fines arising
from the regulatory breach

BU7056 Credit, Lending and Risk Management

 Regulatory Risk
Some of such breaches could be:
• Where an increase in (CRR) capital reserve
ratio cannot be fulfilled as a result of poor
management of the bank
• Failure to implement anti-money laundering
legislations
• Inadequate internal controls
• Failure to meet the require corporate
governance
• Production of audit report
BU7056 Credit, Lending and Risk Management
 Class Activity

What can be done What can be done

to mitigate the to mitigate the
Liquidity Risk? Market Risk?

What can be done What can be done

to mitigate to mitigate
Regulatory Risk? Reputational Risk?

BU7056 Credit, Lending and Risk Management

 References
Croxford, H., Abramson, F., & Jablonowski, A. (2005). The art of better
retail banking: Supportable predictions on the future of retail
banking. John Wiley & Sons Ltd.
Hayes, A., Kindness, D., & Munichiello, K. (2023, November 2).
Leverage ratios: What it is, what it tells you, how to calculate.
https://www.investopedia.com/terms/l/leverageratio.asp
Hayes, A., James, M., & Velasquez, V. (2023, August 22). What the
capital adequacy ratio (CAR) measure, with formula.
https://www.investopedia.com/terms/c/capitaladequacyratio.asp

BU7056 Credit, Lending and Risk Management