RISK ANALYSIS AND

MANAGENT

LECTURE:10

TOPIC: CAPITAL ADEQUACY

THE PURPOSE OF CAPITAL
A FI must safeguard the institution from insolvency risks, ensuring its survival and protecting it from significant risks that could lead to its failure.

The primary means of protection against the risk of insolvency and failure is a FI’s capital. This leads to the first function of capital, namely:

1. The goal is to manage anticipated losses with sufficient margin to maintain confidence and sustain the FI as a viable business. Capital safeguards nonequity
liability holders, particularly those not insured by external guarantors like the FDIC, against losses, thereby fulfilling its second function:

2. The purpose of this policy is to safeguard uninsured depositors, bondholders, and creditors from potential insolvency and liquidation. When FIs fail, regulators
such as the FDIC must intervene to protect insured claimants. The capital of a FI offers protection to insurance funds and ultimately the taxpayers who bear the
cost of insurance fund insolvency. This leads to the third function of capital:

3. To protect FI insurance funds and the taxpayers.

ü During the financial crisis, the FDIC's DIF suffered losses, leading to a special assessment fee and 13 quarters of deposit insurance premiums for insured FIs.
By holding capital and reducing the risk of insolvency, a FI protects the industry from larger insurance premiums. Such premiums are paid out of the net
profits of the FI. Thus, a fourth function of capital is as follows:

4. To protect the FI owners against increases in insurance premiums.

ü Financial institutions (FIs) rely on equity or capital for financing new projects and business expansion, subject to regulatory constraints. Traditional factors
like tax deductibility and private costs of failure or insolvency influence a business firm's capital structure decision, leading to a fifth function of capital.

5. The purpose is to fund the branch and other real investments required to provide financial services.
CAPITAL AND INSOLVENCY RISK

Capital

The problem is there are several definitions for capital, an economist's definition of capital may differ from an accountant's definition, which
in turn may differ from the definition used by regulators. Economists define a FI's capital or owners' equity stake as the difference between its
assets and liabilities, also known as its net worth. The economic meaning of capital is derived from market value accounting, with regulatory
definitions deviating by a lesser degree from economic net worth, except in the investment banking industry which are based in whole or in
part on historical or book value accounting concepts.

Economic capital, or net worth, serves as an insulation against credit risk. The market value concept and book value of capital can be
misleading to managers, owners, liability holders, and regulators due to their potential to distort a FI's true solvency position.
 The Market Value of Capital
Table 1: A FI’s Market Value Balance Sheet(in millions of dollars)
To see how economic net worth or equity insulates a FI against risk,
Panel A: Beginning Market Value Balance Sheet consider the following example. Panel A of Table 1 presents a simple
balance sheet where all the assets and liabilities of a FI are valued in
Assets $ Liabilities $
market value terms at current prices on a mark-to-market basis
LT Securities 80 Liabilities ( ST, 90 (allowing balance sheet values to reflect current rather than historical
Floating Rate prices).
Deposits The FI's equity is economically solvent, with a market value of $10
LT Loans 20 Net Worth 10 million, which is the difference between the market value of its assets
and liabilities, indicating no failure costs for depositors or regulators
100 100 if liquidated today. Let’s consider the impact of a classic type of FI
risk on this FI’s net worth: credit risk.
Panel B: Market Value Balance Sheet after a $12 million Decline in Loan Portfolio Value

LT Securities 80 Liabilities 90
Market Value of Capital and Credit Risk
LT Loans 8 Net Worth −2
In Panel A, a FI has $20 million in long-term loans. Suppose that A
88 88
recession causes borrowers to face cash flow issues, lowering the market
value of their loan portfolio below 20. If loans are worth only 8 (the price the
FI would receive if it could sell these loans in a secondary market at today’s
prices). Thus, the market value has fallen from 20 to 8, as shown in Panel B.
The Market Value of Capital

This loss renders the FI insolvent; the market value of its assets is $88 which is less than the value of its liabilities of $90. The owners’ net
worth stake has been completely wiped out (reduced from $10 to −$2), making net worth negative. As a result, liability holders are hurt, but
only a bit. Specifically, the first 10 of the 12 loss in value of the loan portfolio is borne by the equity holders. Only after the equity holders are
wiped out do the liability holders begin to lose. In this example, the economic value of their claims on the FI has fallen from 90 to 88, or a loss
of 2.

The example illustrates the concept of net worth as an insurance fund, protecting liability holders against insolvency risk. Larger net worths
provide more protection, leading regulators to focus on capital requirements in assessing insolvency risk exposure.
The Book Value of Capital

Book value capital and capital rules based on book values are most used by FI regulators.

Table 2: Book Value of a FI’s Assets and Liabilities (in millions of In Table 2 , we use the same initial balance sheet we used in Table 1 but assume that assets and liabilities are
dollars) now valued at their historical book values. That is, they reflect the values when the loans were made, the
securities were purchased, and the liabilities were issued which may have been many years ago. The net worth
Beginning Book Value Balance Sheet or equity is now the book value of the stockholders’ claims rather than the market value of those claims. The
book value of capital equals 10, but equity value does not equal market value (the difference between the market
value of assets and that of liabilities). This inequality can be explained by credit risk shocks on capital position
Assets $ Liabilities $ using book value accounting methods.

LT 80 ST 90
Securities Liabilities Book Value of Capital and Credit Risk
LT Loans 20 Net Worth 10
Suppose that some of the 20 in loans are in difficulty regarding repayment schedules. We assumed in Panel B of
Table 1 that the revaluation of cash flows leads to an immediate downward adjustment of the loan portfolio’s
100 100 market value from 20 to 8, a market value loss of 12. By contrast, under historic book value accounting methods
such as generally accepted accounting principles (GAAP), FIs have greater discretion in reflecting or timing
problem loan loss recognition on their balance sheets and thus on the impact of such losses on capital. The
market value balance sheet is reflected in Panel B of Table 1, and the book value balance sheet is reflected in
Table 2. Notice the book value balance sheet continues to list 10 as the value of net worth, yet the true value is -
2.
The Discrepancy between the Market and Book Values
of Equity
These preceding examples show that market valuation of balance sheets provides a more accurate
picture of a FI's net worth than book value accounting. Equity holders bear losses in asset market
value, while liability holders and regulators are protected against insolvency risk as long as the
owners’ capital or equity stake is adequate, or sufficiently large. Many academics and analysts
advocate for market value accounting and market value of capital closure rules for all FIs.
CAPITAL ADEQUACY IN THE COMMERCIAL
BANKING AND THRIFT INDUSTRY
• The FDIC Improvement Act of 1991 mandated banks and thrifts to adopt risk-based capital requirements. The Bank for International Settlements (BIS) agreed to
implement these ratios in 1993, known as Basel I. The 1993 agreement included credit risks of assets into capital adequacy measures. This was followed with a
revision in 1998 in which market risk was incorporated into risk-based capital in the form of an add-on to the 8% ratio for credit risk exposure.

• In 2001, the BIS proposed operational risk inclusion in capital requirements and updated the credit risk assessments in the 1993 agreement called the 2006 Basel
II agreement which included three pillars, which together contribute to the safety and soundness of the financial system.

• Pillar 1 covers regulatory minimum capital requirements for credit, market, and operational risk. The measurement of market risk did not change from that
adopted in 1998. The 2006 Accord allowed for two options for measuring both credit risk and operational risk: the Standardized Approach and an Internal
Ratings-Based Approach.

• The Standardized Approach was like that of the 1993 agreement but was more risk-sensitive. Under the IRB Approach, DIs were allowed to use their internal
estimates of borrower creditworthiness to assess credit risk in their portfolios (using their own internal rating systems and credit scoring models) subject to strict
methodological and disclosure standards, as well as explicit approval by the DI’s supervising regulator. Three different options were available to measure
operational risk: the Basic Indicator, Standardized, and Advanced Measurement approaches.
Basel II and Basel III Pillars of Capital Regulation
Basel II
Pillar 1 Pillar 2 Pillar 3

Calculation of regulatory minimum capital Regulatory supervisory review to complement and Requirements on rules for disclosure of capital
requirements enforce minimum capital requirements calculated structure, risk exposures, and capital adequacy
under Pillar 1 to increase FI transparency and enhance
market/investor discipline

1. Credit risk: on-balance- sheet and off-balance-sheet

(Standardized vs. Internal Ratings–Based Approach)

2. Market risk (Standardized vs. Internal Ratings–

Based Approach)

Operational risk (Basic Indicator vs.

Standardized vs. Advanced Measurement
Approach)

Basel III
Enhanced minimum capital and liquidity requirements Enhanced supervisory review for firmwide risk Enhanced risk disclosure and market discipline
management and capital planning

1. Liquidity Risk
Basel II and Basel III Pillars of Capital Regulation

• The BIS emphasizes the regulatory supervisory review process as a complement to minimum capital requirements in Pillar 2, while Pillar 3 encourages market
discipline by requiring disclosure of capital structure, risk exposures, and capital adequacy, allowing market participants to assess critical information.

• The 2008-09 financial crisis exposed weaknesses in Basel II, including private companies rating credit risk on securities without regulatory oversight. Further, the
Basel II capital adequacy formula for credit risk was procyclical. Thus, as the financial crisis developed, the probability of borrower default and loss on default
both increased, which meant increased regulatory capital requirements and reliance on central banks for capital injections and liquidity support.

• Basel 2.5, passed in 2009, updated capital requirements on market risk from banks' trading operations, effective in 2013 and Basel III was passed in 2010 fully
effective in 2019, addressing regulatory issues.

• Basel III aims to enhance the quality, consistency, and transparency of banks' capital base to mitigate credit risk and enhance the risk coverage of the capital
framework. Pillar 1 of Basel III proposes improvements to the Standardized and IRB Approaches for calculating adequate capital, focusing on common equity,
capital conservation, countercyclical buffers, higher trading and derivatives requirements, and strengthening counterparty credit risk calculations in determining
required minimum capital. Pillar 2 advocates for improved bank governance and risk management, including long-term incentives, stress testing, and sound
compensation practices to enhance long-term risk and return management. Pillar 3 advocates for increased risk disclosure, including those related to
securitization exposures and sponsorship of off-balance-sheet vehicles.
Basel II and Basel III Pillars of Capital Regulation

• All other depository institutions use the Standardized Approach for calculating capital adequacy. Under Basel III, depository institutions must calculate and
monitor four capital ratios: common equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, total risk-based capital ratio, and Tier I leverage
ratio.

• The innovation involves using risk-adjusted assets denominator in capital adequacy ratios to differentiate between on- and off-balance sheet credit risks, and to
account for additional capital charges against market and operational risk. A DI’s capital adequacy is assessed according to where its capital ratios are placed in
one of the five target zones listed in Table 4. Under Basel III, the capital ratios used include:

• Common equity Tier I risk-based capital ratio = Common equity Tier I capital / Credit risk-adjusted assets
ü Common equity Tier I risk-based capital ratio - The ratio of the common equity Tier I capital to the risk-adjusted assets of the DI.

• Tier I risk-based capital ratio = Tier I capital (Common equity Tier I capital + Additional Tier I capital) / Credit risk-adjusted assets
ü Tier I risk-based capital ratio - The ratio of the Tier I capital to the risk-adjusted assets of the DI.

• Total risk-based capital ratio = Total capital (Tier 1 + Tier II) / Credit risk-adjusted assets
ü Total risk-based capital ratio - The ratio of the total capital to the risk-adjusted assets of the DI.

• Tier I leverage ratio = Tier I capital / Total exposure

Table 3 Phase-in of Basel III Capital Levels Basel II and Basel III Pillars of
Capital Regulation

Once the ratios are fully phased in (in 2019,

see Table 3 ), to be adequately capitalized, a
DI must hold a minimum ratio of common
equity Tier I capital to credit risk-adjusted
assets of 4.5%, Tier I capital to credit risk-
adjusted assets of 6%, total capital to credit
risk-adjusted assets of 8%, and Tier I capital
to total exposure of 4%.
Table 4 Specifications of Capital Categories for Prompt Corrective Action Basel II and Basel III Pillars
of Capital Regulation

Capital ratios under the FDICIA define five zones in

Table 4: adequately capitalized, well capitalized,
undercapitalized, significantly undercapitalized, and
critically undercapitalized. Since 1992, regulators
must take prompt corrective action (PCA) when a DI
falls outside the zone 1, or well-capitalized, category.
A receiver is appointed when a DI's tangible equity
(Tier I + Non-Tier I perpetual preferred stock) to total
assets ratio falls to 2% or less. Between 1994 and
2008, less than 0.5% of depository institution industry
assets were critically undercapitalized.
Table 5 Summary of Prompt Corrective Action Provisions
Basel II and Basel III Pillars of
Capital Regulation

The mandatory and discretionary actions of regulators

in capital adequacy zones aim to enforce minimum
capital requirements and restrict their ability to show
forbearance to the worst capitalized DIs.

Not required if primary supervisor determines action would not serve purpose of prompt corrective action
or if certain other conditions are met.
Table 6 Summary Definition of Qualifying Capital for Depository Institutions
Capital
In the measurement of a DI’s capital adequacy, its capital is the standard
by which each of these risks is measured. Under Basel III, a DI’s capital
is divided into common equity Tier I (CET1), additional Tier I, and Tier
II. CET1 is primary or core capital of the DI; Tier I capital is the primary
capital of the DI plus additional capital elements; Tier II capital is
supplementary capital. The total capital that the DI holds is defined as
the sum of Tier I and Tier II capitals.

Common Equity Tier I Capital (CET1)

Common equity Tier I capital (CET1 capital) is a crucial component of a

company's core capital contribution, comprising the book value of
common equity, minority equity interests, and goodwill, reflecting the
company's ability to absorb losses.

Tier 1 Capital

Tier I capital comprises CET1 capital and additional Tier I capital. Tier I
capital includes noncumulative perpetual preferred stock, with no
maturity dates or redemption incentives, available for bank losses
beyond common equity, which are callable after 5 years only if they are
replaced with better capital.

Tier II Capital

Tier II capital comprises secondary equity-like capital resources,

including a DI's loan loss reserves and convertible and subordinated debt
instruments with maximum caps.
 Table 7 Summary of the Risk-Based Capital Standards for On-Balance-Sheet Items under Basel II
CAPITAL
ADEQUACY
Credit Risk–Adjusted Assets
Under Basel III capital adequacy rules, risk-adjusted assets represent the denominator of
the risk-based capital ratios. Two components make up credit risk–adjusted assets : (1)
credit risk–adjusted on-balance-sheet assets, and (2) credit risk–adjusted off-balance-
sheet assets.

Calculating Risk-Based Capital Ratios; Credit Risk–Adjusted On-Balance-Sheet Assets

under Basel III
Critics criticized the Basel Agreement's risk weights, which depended on borrowers like
sovereigns, banks, or corporates. For example, under Basel I all sovereign loans had a
risk weight of 100% regardless of the borrowing country’s credit risk. Basel II and III
Standardised Approach aligns regulatory capital requirements with DI's risk elements by
introducing a wider differentiation of credit risk weights.
Basel III's Standardized Approach includes more exposure categories for purposes of
calculating total risk-weighted assets. Provides for greater financial collateral
recognition, and a wider range of eligible guarantors, aiming to produce capital ratios
more aligned with actual economic risks faced by DIs, this is compared to Basel I and II.
The Basel III risk-based capital plan assigns DI assets to credit risk exposure categories,
with cash assets, U.S. T-bills, notes, bonds, and GNMA mortgage-backed securities
being zero risk-based, while 20% class includes U.S. agency-backed securities,
municipal bonds, and interbank deposits. (Table 7)
Multifamily mortgage loans and municipal bonds fall in the 50% risk category, while
commercial loans, consumer loans, and other assets are in the 100% risk category.
CAPITAL ADEQUACY
• Residential 1-4 family mortgages are categorized into two risk categories: Category 1 (traditional, first-lien, prudently underwritten loans) and Category 2 (junior
liens and non-traditional mortgage products).

• The risk weight for residential mortgage exposure is determined by the mortgage's loan-to-value ratio, with category 1 mortgages having a 35% risk weight,
category 2 mortgages having a 200% risk weight, and 90-day past due mortgages having a 150% risk weight.

• The OECD uses country risk classifications (CRCs) to determine risk weights for sovereign exposures, which are determined by assessing a country's credit risk
using a quantitative model, country risk assessment model (CRAM) and a qualitative assessment of the CRAM results.

• Countries in categories 0-1 have the lowest risk assessment and a risk weight of 0%, while those in category 7 have the highest risk assessment and a risk weight
of 150% (see Table 7).

• Countries without CRC assessments have a 100% credit risk weight, while sovereign exposures are assigned a 150% risk weight upon sovereign default or
previous five-year default.

• Risk weights for foreign bank exposures are determined by the CRC assessment for the bank's home country, with banks in 0-1 countries assigned a 0% risk
weight, and 4-7 countries assigned a 150% risk weight. Banks in countries without CRC assessments are assigned 100% credit risk weight, while sovereign
exposures are assigned 150% risk weight upon sovereign default or previous five-year default.

• To figure the credit risk–adjusted assets, the DI multiplies the dollar amount of assets it has in each category by the appropriate risk weight.
 Table 8 Bank’s Balance Sheet under Basel III (in millions of dollars)
Calculation of On-Balance- Sheet
Credit Risk-Adjusted Assets under
Basel III: Example 1

Consider Table 8 Bank’s Balance Sheet under Basel III (in

millions of dollars)

Under Basel III, the credit risk–adjusted value of the bank’s on-balance-
sheet assets would be:

Credit risk-adjusted on-balance-sheet assets = 0 (8M + 13M + 60M + 50M

+ 42M) + 0.2 (10M + 10M + 20M + 55M + 10M) + 0.5 (34M + 308M +
75M) + 1(390M + 108M + 22M) + 1.5 (10M) = $765.5M

The simple book value of on-balance-sheet assets is $1,215M; its credit

risk-adjusted value under Basel III is $764.5M
CAPITAL Credit Risk–Adjusted Off-Balance-Sheet Activities

The capital ratio denominator includes both on-balance-sheet assets

and off-balance-sheet activities of a financial institution, which are
ADEQUACY contingent claims rather than actual claims against depository
institutions. Regulations mandate capital holding for securities
against potential on-balance-sheet credit risk for depository
institutions, not against the full-face value of these items. To
calculate credit risk-adjusted asset values of OBS items, they must be
TABLE 9 Conversion Factors for Off-Balance- Sheet Contingent or converted into credit equivalent amounts, which are equivalent to
Guaranty Contracts, Basel III
an on-balance-sheet item.

The calculation of credit risk-adjusted values for off-balance sheet

activities involves initial segregation, focusing on contingent or
guaranty contracts, foreign exchange and interest rate forward,
option, and swap contracts, and derivative or market contracts. We
first consider the credit risk–adjusted asset value of OBS guaranty-type
contracts and contingent contracts and then derivative or market contracts.
CAPITAL ADEQUACY
The Credit Risk–Adjusted Asset Value of Off-Balance-Sheet Contingent Guaranty Contracts

Table 8 outlines conversion factors for direct credit substitute standby letters of credit guarantees (100% conversion factor rating) , sale and
repurchase agreements, and assets sold with recourse (a 100% conversion factor rating) under Basel III.

Performance-related SLCs and unused loan commitments have a 50% conversion factor, while loan commitments with one year or less have a
20% credit conversion factor.

Credit ratings assign credit risk weights for on-balance-sheet assets and OBS activities (listed in Table 7), such as issuing a two-year loan
commitment to a foreign bank located in a country with a 4 OECD CRC assessment would result in a risk weight of 150%.
CAPITAL ADEQUACY: Calculating Off- Balance-Sheet Contingent
or Guaranty Contracts’ Credit Risk–Adjusted Assets
To see how OBS activities are incorporated into the risk-based ratio, we can extend Example 1 for the bank in Table 8 . Notice that in addition
to having $764.5 million in credit risk– adjusted assets on its balance sheet, the bank also has the following off- balance-sheet contingencies or
guarantees:
1. $80 million two-year loan commitments to a U.S. corporations.

2. $10 million direct credit substitute standby letters of credit issued to a U.S. corporation.

3. $50 million commercial letters of credit issued to a U.S. corporation.

To find the risk-adjusted asset value for these OBS items, we follow a two-step process.

Step 1. Convert OBS Values into On-Balance-Sheet Credit Equivalent Amounts. In the first step, we multiply the dollar amount outstanding of
these items to derive the credit equivalent amounts using the conversion factors (CFs) listed in Table 9 .
CAPITAL ADEQUACY: Calculating Off- Balance-Sheet Contingent or Guaranty
Contracts’ Credit Risk–Adjusted Assets: Example 2

OBS item Face Value $ Conversion Factor Credit Equivalent

Amount (Face Value Thus, the credit equivalent amounts of loan commitments,
× Conversion standby letters of credit, and commercial letters of credit
Factor) $
are, respectively, $40, $10, and $10 million. These
Two-year loan 80M 0.5 40M conversion factors convert an OBS item into an
commitment equivalent credit or on-balance-sheet item.
Standby letter of 10M 1.0 10M
credit

Commercial letter of 50M 0.2 10M

credit
CAPITAL ADEQUACY: Calculating Off- Balance-Sheet Contingent or Guaranty
Contracts’ Credit Risk–Adjusted Assets

Step 2. Assign the OBS Credit Equivalent Amount to a Risk Category. In the second step we multiply these credit equivalent amounts by their
appropriate risk weights. In our example, because each of the contingent guaranty contracts involves a U.S. corporation, each is assigned a
risk weight of 100%.

OBS Item Credit Equivalent Risk weight (𝒘𝒊 ) Risk-Adjusted Asset

Amount $ Amount $ (Credit
Equivalent Amount Thus, the bank’s credit risk–adjusted asset value of
× (𝒘𝒊 ) ) its OBS contingencies and guarantees is
$60 million.
Two-year loan 40 1.0 40
commitment
Standby letter of 10 1.0 10
credit
Commercial letter of 10 1.0 10
credit
60
Capital Adequacy: Adjusted Asset Value of Off-Balance-Sheet Market
Contracts or Derivative Instruments
The Credit Risk–Adjusted Asset Value of Off-Balance-Sheet Market Contracts or Derivative Instruments

• In addition to having OBS contingencies and guarantees, FIs engage heavily in buying and selling OBS futures, options, forwards, swaps,
caps, and other derivative securities contracts for interest rate risk, credit risk, and foreign exchange risk management and hedging reasons,
as well as buying and selling such products on behalf of their customers.

• Positions expose DIs to counterparty credit risk, where counterparties default on large losses, forcing DIs to replace contracts at less
favourable terms.

• Risk-based capital ratio rules differentiate between exchange-traded derivative security contracts and over-the-counter instruments like
forwards, swaps, caps, and floors. Exchange-traded derivatives have almost zero credit or default risk due to the full adoption of
counterparty obligations by the exchange, unlike bilateral over-the-counter contracts traded outside organized exchanges.

• Basel III mandates banks to hold capital equal to 2% times the margin requirement on exchange-traded derivatives, reflecting low default
risk. Hence, most OBS futures and options positions have virtually no capital requirements for a DI, while most forwards, swaps, caps, and
floors do.

• The calculation of risk-adjusted asset values in OBS market contracts involves a two-step process (like that with contingent or guaranty
contracts) : calculating a conversion factor and multiplying credit equivalent amounts by appropriate risk weights.
Capital Adequacy: Adjusted Asset Value of Off-Balance-Sheet Market
Contracts or Derivative Instruments
Step 1. Convert OBS Values into On-Balance-Sheet Credit Equivalent Amounts

• We first convert the notional or face values of all non-exchange-traded swap, forward, and other derivative contracts into credit equivalent
amounts. The credit equivalent amount itself is divided into a potential exposure element and a current exposure element. That is:
ü Credit equivalent amount of OBS derivative security items ($) = Potential exposure ($) + Current exposure ($)

• The potential exposure component indicates the risk of future contract default, influenced by future interest rate, credit, or exchange rate volatility. Table 10
reveals larger potential exposure conversion factors for credit contracts compared to interest rate contracts, and greater exposure risk for longer-term contracts of
both types.

• In addition to calculating the potential exposure of an OBS market instrument, a DI must calculate its current exposure with the instrument. This reflects the cost
of replacing a contract if a counterparty defaults today. The DI calculates replacement cost or current exposure by replacing initial contract rate or price with
current rate or price, recalculating current and future cash flows.

• So, the DI discounts any future cash flows to give a current present value measure of the contract’s replacement cost. Regulations mandate setting the replacement
cost to zero if the contract's replacement cost is negative, meaning the DI profits on the replacement if the counterparty defaults.

• The current exposure is measured by the positive replacement cost, which represents the loss of the DI on contract replacement if the counterparty defaults.
 Capital Adequacy: Adjusted Asset Step 2. Assign the OBS Credit Equivalent Amount to a
Value of Off-Balance-Sheet Risk Category.
Market Contracts or Derivative The credit equivalent amount for each contract is
Instruments calculated by summing current and potential exposure
amounts, and then multiplied by a risk weight to create
the final credit risk-adjusted asset amount.
Table 10 Credit Conversion Factors for OBS Derivative Contracts Used in Calculating
Potential Under Basel III, the appropriate risk weight is generally
Exposure 1.0, or 100%. That is:
ü Credit risk-adjusted value of OBS market
contracts = Total credit equivalent amount × 1.0
(risk-weight)

11/15/23 SAMPLE FOOTER TEXT 26

 Calculating Off-Balance-Sheet Market Contract Credit Risk– Adjusted
Assets: Example 3
The bank in Examples 1 and 2 has taken one interest rate hedging position in the fixed floating interest rate swap market for four years with a
notional dollar amount of $100 million and one 2-year forward foreign exchange contract for $40 million (see Table 8 ).

Step 1. We calculate the credit equivalent amount for each item or contract as:
For the four-year, fixed–floating interest rate swap, the notional value (contract face value) of the
Potential Exposure + Current Exposure swap is $100M. Since this is a long-term (one to five years to maturity) interest rate market contract,
its face value is multiplied by 0.005 to get a potential exposure or credit risk equivalent value of
$0.5M (see row 2 of Table 10 ). We add this potential exposure to the replacement cost (current
Type of Notional/ Potential Potential Replacement Current Credit exposure) of this contract to the bank. The replacement cost reflects the cost of having to enter into a
contract Principal (a) Exposure Exposure (a Cost $ Exposure (d) Equivalent new four-year, fixed–floating swap agreement at today’s interest rates for the remaining life of the
(remaining $ Conversion × b) (c)$ Amount (c + swap should the counterparty default. Assuming that interest rates today are less favourable, on a
maturity factor (b) d) present-value basis, the cost of replacing the existing contract for its remaining life would be $3M.
Thus, the total credit equivalent amount, current plus potential exposures, for the interest rate swap is
Four-year 100 0.005 0.5M 3M 3M 3.5M $3.5M.

fixed– Next, look at the foreign exchange two-year forward contract of $40M face value. Since this is a
floating foreign exchange contract with a maturity of one to five years, the potential (future) credit risk is
interest $40M × 0.05, or $2M (see row 2 in Table 10 ). However, its replacement cost is minus $1M. That is,
in this example our bank actually stands to gain if the counterparty defaults. Exactly why the
rate swap counterparty would do this when it is in the money is unclear. However, regulators cannot permit a
DI to gain from a default by a counterparty since this might produce all types of perverse risk-taking
incentives. Consequently, as in our example, current exposure has to be set equal to zero (as shown).
Two-year 40M 0.050 2M −1𝑀 0 2M Thus, the sum of potential exposure ($2M) and current exposure ($0) produces a total credit
forward equivalent amount of $2M for this contract. Since the bank has just two OBS derivative contracts,
summing the two credit equivalent amounts produces a total credit equivalent amount of $3.5M +
foreign $2M = $5.5M for the bank’s OBS market contracts.
exchange
contract
Calculating Off-Balance-Sheet Market Contract Credit
Risk– Adjusted Assets
Step 2.

The next step is to multiply this credit equivalent amount by the appropriate risk weight. Specifically, to calculate the risk-adjusted asset value
for the bank’s OBS derivative or market contracts, we multiply the credit equivalent amount by the appropriate risk weight, which is generally
1.0, or 100%:

ü Credit risk-adjusted asset value of OBS derivatives = Credit equivalent Amount × Risk weight

= $5.5M × 1.0

= $5.5M
CAPITAL ADEQUACY
Under Basel III, the total credit risk-adjusted assets are $830 million ($764.5 million from on-balance-sheet activities, plus $60 million for the
risk-adjusted value of OBS contingencies and guarantees, plus $5.5 million for the risk-adjusted value of OBS derivatives).

Calculating the Overall Risk-Based Capital Position

After calculating the risk-weighted assets for a DI, the final step is to calculate the Tier I and total risk-based capital ratios.

Example 4:
From Table 8, the bank’s CET1 capital (common stock and retained earnings) totals $70 million; additional Tier I capital (qualifying perpetual preferred stock) totals
$10 million; and Tier II capital (convertible bonds, subordinate bonds, nonqualifying perpetual preferred stock, and reserve for loan losses) totals $35 million. We can
now calculate our bank’s capital adequacy under the Basel III risk-based capital requirements as:
#$%
ü CET1 risk-based ratio = = 8.43%
&'$%
#$%()$%
ü Tier I risk-based capital ratio = = 9.64%
&'$% To be adequately capitalized, the minimum CET1 risk-based capital ratio is 4.5 % (see Table 3 ),
#$%()$%('*% the minimum Tier I capital ratio is 6 %, and the minimum total risk-based capital ratio required is
ü Total risk-based capital ratio = = 13.86% 8%. Thus, the bank in our example has more than adequate capital under all three capital
&'$%
requirement formulas.
 Table 11 Capital Conservation Buffer, Capital Ratio Levels, and Maximum Payout Ratios

CAPITAL ADEQUACY

Capital Conservations Buffer

• Basel III revised credit risk minimum capital ratio requirements, introduced a capital conservation buffer to help DIs build a capital surplus buffer outside
financial stress, reducing losses.

• The buffer requirements provide incentives for DIs to build up a capital surplus [e.g., by reducing discretionary distributions of earnings (reduced dividends, share
buybacks, and staff bonuses)] to reduce the risk that their capital levels would fall below the minimum requirements during periods of stress. The capital
conservation buffer must be composed of CET1 capital and is held separately from the minimum risk-based capital requirements.

• Basel III mandates a DI to maintain a capital conservation buffer exceeding 2.5% ((the capital buffer is being phased in between 2016 and 2019, when it will be
set a 2.5%, see Table 2 ) of total risk-weighted assets to avoid limitations on capital distributions and executive officer bonuses.

• Table 11 outlines the maximum dividend payout ratio allowed when the conservation buffer falls below 2.5%. A DI with a buffer between 1.875% and 2.5% ie;
the smaller the conservation buffer, the greater the constraint on a DI’s discretionary payout of earnings. What this means is, a CET1 capital ratio of 6.75 percent,
a Tier I capital ratio of 8.2 percent, or a total capital ratio of 10.2 percent) can distribute no more than 60% of eligible retained income in the current quarter, but
must conserve at least 40% of its retained earnings to build up its capital conservation buffer.
 Table 12 Countercyclical Buffer, Capital Ratio Levels, and Maximum Payout Ratios

CAPITAL ADEQUACY

Countercyclical Capital Buffer

• Basel III also introduced a countercyclical capital buffer that may be declared by any country experiencing excess aggregate credit growth. The countercyclical
capital buffer, set at a maximum of 2.5% between 2016 and 2019, can vary between 0% and 2.5% of risk-weighted assets (see Table 2). This buffer must be met
with CET1 capital, and DIs are given 12 months to adjust to the buffer level.

• If a DI's capital levels fall below the countercyclical capital buffer, restrictions on earnings payouts are applied, with international banks paying a weighted
average buffer charge based on their credit exposures to each country. Thus, if a bank has 60% of its assets in country A with an imposed countercyclical buffer of
2% and 40% of its assets in country B with a countercyclical buffer requirement of 1% the countercyclical buffer for the bank is 1.6% [(0.60 × 2%) + (0.40×
1%)], (see Table 11).

• The countercyclical capital buffer protects the banking system from economic downturns by reducing systemic exposures. It helps maintain the system's health
during declining asset prices and weakening credit conditions. Accumulated buffers absorb abnormal losses, allowing DIs to access funding, meet obligations, and
serve as credit intermediaries.
CAPITAL ADEQUACY
Global Systemically Important Banks

• As part of Basel III, the BIS imposed an additional common equity Tier I surcharge (“loss absorbency requirement”) on global systemically
important banks (G-SIBs):

• Banking groups that are in distress or in disorder would significantly disrupt the financial system and economic activity.

• G-SIBs, as too-big-to-fail banks (that would have to be bailed out by central governments and taxpayers) , must increase their tangible
capital requirements even more than other banks. The surcharges ranging from 1% to 3.5%, to be held over and above the 7 percent
minimum CET1 plus conservation buffer requirement, to lower risk and avoid government bailouts.

• The additional capital requirement aims to decrease the likelihood of a G-SIB's failure by increasing its going-concern loss absorbency and
enhancing global recovery and resolution frameworks.
CAPITAL ADEQUACY
Leverage Ratio

• The 2008-09 financial crisis was the accumulation of extreme on- and off-balance-sheet leverage in the banking system, forcing DIs to
reduce leverage, causing asset prices to fall, losses to DIs, and reduced credit availability.

• Basel III introduced a leverage ratio requirement to prevent recurring cycles and discourage excess leverage use, acting as a backstop to
risk-based capital requirements.

• The Basel III leverage ratio, defined under the Standardized Approach, is the ratio of Tier I capital to on-balance sheet assets, with a
minimum of 5% for well-capitalized DIs and 4% for adequately-capitalized DIs, (see Table 2). Under the Advanced Approach, Basel III
leverage ratio is defined as the ratio of Tier I capital to a combination of on- and off-balance sheet assets:
#$%& ' ()*$+),
ü Leverage ratio =
#-+), %.*-/0&% 123144 5),)26% 78%%+

• Total exposure is equal to the DI’s total assets plus off-balance-sheet exposure. For derivative securities, off-balance-sheet exposure is
current exposure plus potential exposure as described earlier. For off-balance-sheet credit (loan) commitments, a conversion factor of 100
% is applied unless the commitments are immediately cancellable. In this case, a conversion factor of 10 % is used.
CAPITAL ADEQUACY
Interest Rate Risk, Market Risk, and Risk-Based Capital
• A credit risk-based capital ratio is considered adequate by regulatory standards if a depository institution is not exposed
to excessive interest rate or market risk. The risk-based capital ratio only considers a DI's capital's adequacy to meet both
its on- and off-balance-sheet credit risks, not insolvency risk from interest rate and market risks.
• In 1993, the Federal Reserve and the Bank for International Settlements developed additional capital requirement
proposals for interest rate risk and market risk. Since 1998, Deposit Insurance Companies (DIs) have had to calculate an
add-on to the 8% risk-based capital ratio to reflect their exposure to market risk. Two approaches were available: the
standardized model proposed by regulators and the DI's own internal market risk model. The financial crisis exposed
shortcomings in the standardized approach in Basel II to measuring market risk, including a lack of risk sensitivity,
limited recognition of hedging and diversification benefits, and inability to capture risks associated with more complex
instruments. Basel III proposes a revised partial risk factor and fuller risk factor approach.
CAPITAL ADEQUACY
Operational Risk and Risk-Based Capital

• Basel II introduced an additional capital requirement for operational risk, addressing the increased visibility of operational risks in recent
years. The BIS now believes operational risks are important enough for DIs to quantify and incorporate them separately into their capital
adequacy assessment. Basel III continued to use the Basic Indicator Approach, Standardized Approach, and Advanced Measurement
Approach.

• The Basic Indicator Approach targets DIs to hold 12% of their total regulatory capital for operational risk, focusing on net profits. To
achieve this target, the Basic Indicator Approach focuses on the gross income of the DI, that is, its net profits. This equals a DI’s net
interest income plus net noninterest income:
ü Gross income = Net interest income + Net noninterest income

• BIS calculations show that a DI holding 15% of gross income for operational risk capital (α) generates enough capital to cover 12% of its
total regulatory capital holdings against all risks. For example, under the Basic Indicator Approach:
ü Operational capital = α × Gross Income or Operational risk = 0.15 × Gross Income
 CAPITAL ADEQUACY
The Basic Indicator Approach is problematic as it is overly aggregative and fails to differentiate between different operational risk areas, such as Payment and Settlement may have a
very different operational risk profile from Retail Brokerage. The BIS provides a Standardized Approach for operational capital calculation, dividing activities into eight major
business units and lines to better differentiate operational risks across different activity lines.

Within each business line, there is a specified broad indicator (β) that reflects the scale or volume of a DI’s activities in that area. The indicator represents gross income for a business
line, indicating operational risk. A capital charge is calculated by multiplying he for each line by the indicator assigned to the line and then summing these components. The betas
reflect the importance of each activity in the average DI, which are set by regulators and are calculated from average industry figures from a selected sample of DIs.

Table 10 BIS Standardized Approach Business Units and Lines

Business Line Indicator Capital Factors Suppose the industry β for Corporate Finance is 18% and gross income from the Corporate Finance line
of business (the activity indicator) is $30 million for the DI. Then, the regulatory capital charge for this
Corporate Finance Gross Income 𝛽! = 18%
line for this year is:
Trading and Sales Gross Income 𝛽" = 18%
Capital )*+,*+-./ 012-23/ 4 β × Gross income from the Corporate Finance line of business for the DI
Retail Banking Gross Income 𝛽# = 12%
= 18% × $30M = $5.4M
Commercial Banking Gross Income 𝛽$ = 15%
The total capital charge is calculated as the three-year average of the simple summation of the regulatory
Payment and Settlement Gross Income 𝛽% = 18% capital charge across each of the eight business lines.
Agency Services and Custody Gross Income 𝛽& = 15%
Retail Brokerage Gross Income 𝛽' = 12%
Asset Management Gross Income 𝛽( = 12%
CAPITAL ADEQUACY
The Advanced Measurement Approach allows DIs to use internal data for regulatory capital
purposes, subject to supervisory approval. Supervisors calculate regulatory capital requirements by
combining expected and unexpected loss for each event type. Internally generated risk measures
must be comprehensive and based on a minimum three-year observation period. A DI’s internal loss
data must be comprehensive in that the data capture all material activities and exposures from all
appropriate subsystems and geographic locations. Risk measures for different operational risk
estimates are added for purposes of calculating the regulatory minimum capital requirement.
RISK ANALYSIS
AND
MANAGEMENT

THE END