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The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted (see Risk-weighted asset). Internationally, the Basel Committee on Banking Supervision housed at the Bank for International Settlements influence each country's banking capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Accord. This framework is now being replaced by a new and significantly more complex capital adequacy framework commonly known as Basel II. While Basel II significantly alters the calculation of the risk weights, it leaves alone the calculation of the capital. The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord.

Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework.

Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate.

The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital, have been replaced by one single criterion. While the international standards of bank capital were laid down in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement.

Examples of national regulators implementing Basel II include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy.

An example of a national regulator implementing Basel I, but not Basel II, is in the United States. Depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB). These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report. Although Tier 1 capital has traditionally been emphasized, in the Late-2000s recession regulators and investors began to focus on tangible common equity, which is different from Tier 1 capital in that it excludes preferred equity.[1]

Contents

Regulatory capital

In the Basel I accord bank capital was divided into two "tiers", each with some subdivisions.

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Tier 1 capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits subtracting accumulated losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in retained earnings each year since, paid out no dividends, had no other forms of capital and made no losses, after 10 years the Bank's tier one capital would be $200. Shareholders equity and retained earnings are now commonly referred to as "Core" Tier 1 capital, whereas Tier 1 is core Tier 1 together with other qualifying Tier 1 capital securities.

Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. One of these instruments is referred to Tier 1 capital securities.

Apart from a few minor issues, these began to gain momentum from 1998 and usually consisted of a perpetual security (ie no final maturiy)with a fixed coupon for 10 years. After 10 years the issue would be callable at par (ie 100% of original notional amount). If not called, the coupon would step up usually to 100bp (1bp=0.01%) above the initial launch spread (eg if launched at LIBOR+60, issue would step to LIBOR+160bp). As with equity, their coupons (dividends) were not guaranteed and usually could only be paid provided the bank had sufficient distributable reserves. If the coupon was not paid, the coupon would never be paid (ie was non-cumulative). They were also loss absorbing to provide a further buffer for depositors. Until the credit crunch of 2007-2009, 99% of all issues were called as they could be refinanced at cheaper levels to their post-step coupon. However, even though many issues were trading wider than their step level during the credit crunch most were still called much to the annoyance of the regulators. Holders of the securities (eg pension funds, asset managers) argued that they needed these issues to be called and coupons paid as, unlike shareholders, they do not benefit in the upside of a bank's equity price (ie they buy the bonds at 100% and hopefully receive 100% 10years later even though equity could have rallied by 300%). They also hold no voting rights (again, unlike shareholders). The only benefit of holding the securities is the coupon and getting paid back your initial outlay after 10 years. If they weren't called, or coupons paid, the holders argued that this would therefore considerably affect the cost of issuing other Lower Tier 2 or senior issues. Due to the fact that senior issuance vastly outweighed Tier 1 capital issuance, the banks therefore mostly decided to call these issues at the first call/step date and continued to pay coupons, even though it was un-economic to do so. In certain countries, eg Germany, the regulator took a strong line and forbade these issues to be called. Similarly for the state-owned banks that had restrictions imposed on them by the EU. This therefore has led to calls that such issues need to be stronger in language in the original prospectus and that coupons can ONLY be called or coupons paid provided there is sufficient distributable reserves. This will be part of future bank capital requirements which are in the process of being decided as part of Basel 3.

Tier 2 (supplementary) capital

There are several classifications of tier 2 capital, which is composed of supplementary capital. In the Basel I accord, these are categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results.

Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.

General provisions

A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.

Subordinated-term debt

Subordinated debt is classed as Lower Tier 2 debt, usually has a maturity of a minimum of 10years and ranks senior to Tier 1 debt, but subordinate to senior debt. To ensure that the amount of capital outstanding doesn't fall sharply once a Lower Tier 2 issue matures and, for example, not be replaced, the regulator demands that the amount that is qualifiable as Tier 2 capital amortises (ie reduces) on a straight line basis from maturity minus 5 years (eg a 1bn issue would only count as worth 800m in capital 4years before maturity). The remainder qualifies as senior issuance. For this reason many Lower Tier 2 instruments were issued as 10yr non-call 5 year issues (ie final maturity after 10yrs but callable after 5yrs). If not called, issue has a large step - similar to Tier 1 - thereby making the call more likely.

Different International Implementations

Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction.

For example, it has been reported[2] that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Financial Services Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.

Common capital ratios

  • Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6%
  • Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets >=10%
  • Leverage ratio = Tier 1 capital / Average total consolidated assets >=5%
  • Common stockholders’ equity ratio = Common stockholders’ equity / Balance sheet assets

Example

Listed below are the capital ratios in Citigroup at the end of 2003 [1].

Ratios
At year-end 2003
Tier 1 capital 8.91%
Total capital (Tier 1 and Tier 2) 12.00%
Leverage (1) 5.56%
Common stockholders’ equity 7.67%
(1) Tier 1 capital divided by adjusted average assets.
Components of Capital Under Regulatory Guidelines
In millions of dollars at year-end 2003
Tier 1 capital
Common stockholders’ equity $ 96,889
Qualifying perpetual preferred stock 1,125
Qualifying mandatorily redeemable securities of subsidiary trusts 6,257
Minority interest 1,158
Less: Net unrealized gains on securities available-for-sale (1) (2,908)
Accumulated net gains on cash flow hedges, net of tax (751) (1,242) (751)
Intangible assets: (2)
Goodwill (27,581)
Other disallowed intangible assets (6,725)
50% investment in certain subsidiaries (3) (45)
Other (548)
Total Tier 1 capital 66,871
Tier 2 capital
Allowance for credit losses (4) 9,545
Qualifying debt (5) 13,573
Unrealized marketable equity securities gains (1) 399
Less: 50% investment in certain subsidiaries (3) (45)
Total Tier 2 capital 23,472
Total capital (Tier 1 and Tier 2) $ 90,343
Risk-adjusted assets (6) $750,293
(1) Tier 1 capital excludes unrealized gains and losses on debt securities available-for-sale in accordance with regulatory risk-based capital guidelines. The federal bank regulatory agencies permit institutions to include in Tier 2 capital up to 45% of pretax net unrealized holding gains on available-for-sale equity securities with readily determinable fair values. Institutions are required to deduct from Tier 1 capital net unrealized holding losses on available-for-sale equity securities with readily determinable fair values, net of tax.
(2) The increase in intangible assets is primarily due to the acquisition of the Sears credit card portfolio in November 2003.
(3) Represents unconsolidated banking and finance subsidiaries.
(4) Includable up to 1.25% of risk-adjusted assets. Any excess allowance is deducted from risk-adjusted assets.
(5) Includes qualifying subordinated debt in an amount not exceeding 50% of Tier 1 capital.
(6) Includes risk-weighted credit equivalent amounts, net of applicable bilateral netting agreements, of $39.1 billion for interest rate, commodity and equity derivative contracts and foreign exchange contracts, as of December 31, 2003, compared to $31.5 billion as of December 31, 2002. Market risk-equivalent assets included in risk-adjusted assets amounted to $40.6 billion and $30.6 billion at December 31, 2003 and 2002, respectively. Risk-adjusted assets also includes the effect of other “off-balance sheet” exposures such as unused loan commitments and “letters of credit” and reflects deductions for certain intangible assets and any excess allowance for credit losses.

See also

References

  1. ^ Stress Test for Banks Exposes Rift on Wall St.. NYTimes.
  2. ^ Boyd, Tony, "A Capital Idea", 21 October 2008

External links


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