? To understand how and why the current regulatory regime came - - PDF document

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How Much Capital Is Enough

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Objectives

• To understand how and why the current

regulatory regime came into being

• To understand the changes in bank risk

profiles and banking market structure that provide momentum for new regulations

Capital Adequacy

• Key element to bank safety and soundness

Cost of holding capital

• Restricts banks ability to borrow
• Reduces ROE
• Ultimately reduces banks ability to lend

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Historical Context

• 1864, National Bank Act set static

minimum capital requirements based on population of banks service area

• Example: 1954 American Bankers

Association statement f principles rejected numerical formulas for determining capital adequacy

Historical Context

• Judgment based, subjective bank-by-

bank approach

• Franklin National bank (1974) and First

Pennsylvania Bank(1980) were relatively large banks that failed

80’s

• 1981, Federal banking agencies introduced

explicit numerical regulatory requirements

• Minimum primary capital adequacy ratio
• f 6 percent for community banks and 5

percent for larger regional institutions.

• Threshold capital-to-assets ratio of 6

percent and minimum ratio of 5 percent

80’s

• 1983, Congress passed International Lending and

Supervision Act (ILSA) directing federal banking agencies to issue regulations addressing capital adequacy.

• 1985 uniform capital requirements
• Minimum primary capital for:

–Large banking organizations increased from 5 percent to 5.5 percent of adjusted total assets –Community banks’ capital requirements fell from 6 percent to 5.5 percent

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• 1986, Concern that the primary capital

ratio failed to differentiate among risks and did not provide an accurate measure of the risk exposures

• Regulators began to study the risk-based

capital framework of other countries

– France-1979 – UK-1980 – West Germany-1985

80’s Cont. Basel Accord

• 1988, the central bank governors of the

Group of Ten (G-10) countries adopt the Basel Accord

• Under Accord, U.S. assets and off-balance-

items are “risk-weighted” based on their perceived credit risk using four categories

• Risked based capital framework remains

in effect today

Credit Risk Categories

• Most claims are weighted at 100 percent
• Residential mortgages are weighted at 50

percent

• Claims on or guarantees provided by

qualifying banks and other entities are weighted at 20 percent

• Very low risk, such as those guaranteed by

qualifying government are weighted at 0 percent

Basel I Capital Requirements

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Prompt Corrective Action

• U.S. depository institutions are subject to PCA

regulations, institutions are classified into categories based on their regulator capital ratios

• Highest capital ratios classified as “well

capitalized”

• Lower capital ratios assigned lower capital

categories

• Less than well capitalized have restrictions or

conditions on certain activates

• Minimum leveraged ratio for strong institutions

is 3 percent and 4 percent for other banks

Bank Capital Levels Results of “Risk-Weighted” Capital Requirements

• Measured on-balance-sheet capital ratios

have risen since Accord took effect in 1992 without evident contraction in credit availability

• Banks seen increase not only in equity

capital, but also revenues and income

Capital Growth

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The need for change

• Blunt instrument with respect to credit-risk

differentiation

• Measure tends to understate true degree of

credit risk in bank portfolio

• To enhance ability to enforce capital

adequacy bank supervisor’s need the ability to harness two tools:

– Market Discipline – Risk Metrics employed by banks

Change in Bank Asset Mix The need for change

• Need for Financial Transparency

– For market discipline to be effective,market participants must be adequately informed about the risks banks are taking

• Use of internal measures to set capital

requirements for credit risk

Reasons for New Accord

Regulators

• Keep pace with

financial innovation

• Better align capital

charges with underlying risk

• Promote better risk

management Financial Institutions

• Better aligns business

decisions with internal capital allocation methods

• Potential for lower

minimum capital charge

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Basel II Framework

Pillar 1: Minimum Capital Requirements Pillar 2: Supervisory Review Process Pillar 3: Market Discipline Three Pillars

• Credit Risk
• Operational Risk
• Market Risk
• Banks review
• wn capital

adequacy

• Supervisors

evaluate bank assessments

Increased disclosure given reliance on internal assessments

Basel II

• Will include more risk buckets to provide

enhanced risk sensitivity

• Will rely on on external ratings agencies to

help determine risks

• Internal ratings based (IRB) approach

AAA Credit Risk BBB- Credit Risk B Credit Risk Prior to 1981 Judgmental Judgmental Judgmental 1981 - 1988 (Prior to risk-based framework) $5.00 $5.00 $5.00 1988 - Present (Risk-based standards of Basel Accord) $8.00 $8.00 $8.00 Proposed Basel II Standards AAA Credit Risk BBB- Credit Risk B Credit Risk Proposed Basel II Standardizedb $1.81 $8.21 $12.21 Proposed Basel II Foundation IRBc $1.41 $5.01 $18.53 Proposed Basel II Advanced IRBd $0.37 to $4.45 $1.01 to $14.13 $3.97 to $41.65

Under Basel II, Capital Requirements Will Vary Much More With the Risk of the Borrower Minimum Capital Required for a $100 Commercial Loan of Quality:a

Capital Standards in Place 1981 - Present

Difference in Capital Requirements