Capital Requirement

Reserve Requirement

European Central bank

In late 1998, ECB implemented interest bearing reserve requirement.

The ECB requires a reserve ratio of 1.5 to 2.5 percent

Reserve balances are credited an interest rate equal to repo rate.

Reserve requirement as a tax to the banking system

Around the world RR

There has been a gradual reduction on RR around the world.

Canada, New Zealand, Australia, and Switzerland have eliminated the RR all together in 1990.

RR as a tax on banking system effectively raises cost of capital and can make banks less competitive in a global market.

RR in the United States is imposed on 10 to 30 percent of deposits (checking account).

RRR In Islamic Republic

RR is 17 percent of all deposit. This huge tax reduces bank intermediation

(lending) and raises the cost of fund and reduces money supply.

Banks; public or private pass this tax to the ultimate borrowers at a margin over the 17 percent.

Banks in New Zealand, Canada, Australia, and Switzerland have created lending facilities for conducting monetary policy.

Banks can borrow at lombard rate from the central bank

Central Banks have created another facility in which they pay interest rate on the reserve that banks wish to hold

RR in Japan and USA

This ratio is approximately 1 percent of all deposit.

RR is 10 percent of checking deposit and none on time deposits in the USA.

Under 30 percent of all deposits are checking deposit subject to the 10 percent RR.

Breakdown of Financial risks

Commercial Investment Treasury Retail Asset

Banking Banking Management Management Management

operational

Credit

Market

Source: Robert Gescke

Market Risk

Risk of sudden shock, which could damage the financial system that the wider economy would suffer is an example of systematic or market risk.

Contagious transmission of the shock due to actual or suspected exposure to a failing bank or banks. Followed by flight to quality.

Panicky behavior of depositors or investors or Interruption in the payment system

Capital Requirements for Banks

Tier 1 capital is related to common stocks, non-cumulative perpetual preferred stocks, and disclosed reserves

Tier 2 capital represents debts with fixed or cumulative costs, such as cumulative preferred stocks, convertible debts, redeemable preferred shares, subordinated debts, and general provisions; and,

Tier 3 capital represents short-dated subordinated debentures retained to support the trading desk and market risks associated with derivatives transactions.

Qualifying Capitals

The Basle Accord further imposes limits on the amount of qualifying capital for the banks, i.e.,

For example, Tier 2 capital may not exceed 100 percent of Tier 1 capital, and subordinated debt may not amount to more than 60 percent of Tier 1 capital.

Tier 3 capital that is retained to support the market risk associated with trading desk may not exceed 250 percent of a bank’s tier 1 capital.

Furthermore, general provisions included in Tier 2 capital should not be greater than 1.25 percent of risk weighted assets

Capital Ratio

A bank’s capital adequacy requirement for the assets held in the bank book is estimated by the ratio of total qualifying Tier 1 and Tier 2 capital over the risk-weighted value of assets, both on and off-balance sheet.

The risk-weighted value of the bank assets is calculated as the product of the principal amount of the asset weighted by the risk weighting of an associated counterparty.

Based on the Basle Accord, banks are required to maintain a minimum capital/risk asset ratio of eight percent

Historical Simulations

The historical simulation method takes historical movements in the risk factors to simulate potential future movements.

Assume that on December 31,1998, XYZ has a forward contract to buy £10 million in exchange for delivering $16.5 million in 3 month.

XYZ Bank One$1.65/£

Spot rate

Intermediation

Banks in the Islamic Republic of Iran are largely responsible to perform all functions of:

originating, servicing, credit risk taking investing.

Disintermediation through securitization

Loan Originator (Sponsor) Third Party Guarantor (Credit enhancer) Rating Agency Special Purpose Vehicle SPV Arranger (underwriter) Liquidity Enhancer (secondary market

provider) Swap Counterparty Investors

Over-collateralization

Establishes more collateral than the underlying ABS created from the pool, the amount of which depends on:

The coupon rates underlying the collateral The rates offered to investors, The type of rating sought, The psychology of the market at the time of

the issue, among other things.

Indication of over-collateralization levels for traditional

and defeasance mortgage backed bonds (percent of par)

Bond Type of collateral Traditional Defeasance

GNMA pass-through 120-140 110-120 FNMA/FHLMC MBSs 130-145 110-120 US Treasuries 110-130 105-120 Collateralized mortgage obligations 130-150 No standard Whole loans (fixed rate) 155-175 No standard Whole loans (floating rate) 160-190 No standard Corporate bonds (AAA-B) 135-200 No standard Source: Federal Reserve Board.

Senior/Subordinated Structure

This is a self-imposed structure by the issuer to provide protection for a class of senior bondholders at the expense of another (junior) class through prioritizing cash flow of the entire pool of the underlying collateral.

This is also the most widely used internal credit enhancement structure in securitization of credit here in the United States and elsewhere.

The senior class of bondholders is willing to sacrifice yield in securing priority of claims over subordinated class in the event of bankruptcy or default of the issuer.

Shifting Interest Structure

All securitization programs involving senior/subordinated structures have incorporated a shifting interest structure, which allows disproportionate redistribution of prepayments of the underlying collateral from subordinate class to senior class according to a well-defined pre-specified schedule.

Example: Shifting Interest Structure

Shifting Interest Structure Months Percentage of

Prepayments Directed to

Senior Class 1-60 70

61-72 60 73-84 40 85-96 20

97-108 12 109 + pro rata

Source: Frank J. Fabozzi, “Bond Markets, Analysis, and Strategies.” Fifth Edition, 2004, Prentice Hall P. 234.

Arranger fee Servicer fee Liquidity fee

Sponsor BankArranger

$12.5 million

Lender A$12.5 million

Lender B$12.5 million

Lender C$12.5 million

Post Novation: Regional bank sells $50 million loans to SPV

SPV

Clean sales/no recourse proceeds

Securitization Through Novation Process

Potential Achievements in Securitization

Improved return on assets and return on equity Credit risk is reduced as securitization spreads the

risk among the major players Interest rate risk is mitigated as securitization of the

assets improves asset/liability management, Concentration risk to particular obligor(s) and or

industry is mitigated through securitization as banks attempt to off-load credits to achieve regulatory compliance.

Strictly speaking, novation represents the cleanest form of transfer from legal standpoint. However it is rarely used.

Assignment

Under the Common Law, assets can be assigned through legal assignment and equitable assignment.

An assignment is a legal assignment that satisfies four criteria of the section 136 of the 1925 of the Law of Property Act, that the assignment is:

(a) an absolute assignment, (b) in writing, (c) of the full amount of debt, and (d) notified in writing to the underlying debt obligor. In the event any of the four criteria is not satisfied, the

assignment is termed as an equitable assignment. The method of assignment in transfer of assets to SPV in a

securitization is through an equitable assignment, as originator is unwilling to inform the customers that their assets are being sold.

Participation

This is an agreement where the originating bank (seller) transfers the right to the investors a pro rata share of interest and principal from the borrower.

Participation does not transfer voting rights and does not require the consent of the borrower.

It imposes limits on the ability of the originating bank to the changes in interest rates, principal, scheduled payments, guarantor, and collateral without approval of the buyers (investors).

Legal Framework

Common law governs the process of securitization in the United States, United Kingdom and Australia.

Civil Law is the governing principle in the most other nations in a securitization process.

Civil law restricts the assignment or transfer of assets (removing assets from balance sheet as true sale without recourse by the originator or obligor). Also, insolvency laws dictate that the original obligor is to give its express consent or be notified in advance of the transfer or assignment of loan. Otherwise, the transfer would not constitute a true sale.

True Sale

There are three basic principles that ensure that an originator has surrendered control of financial assets and can legally record a sale of the assets:

- Asset isolation, - Originator or SPV control, - Originator or seller non-control.

Problems for emerging market economies

1. Country legal issues as to whether assets can be assigned to an SPV,

2. Limits imposed by rating agencies (sovereign ratings ceilings),

3. Local customs, such as whether direct debits (automatic/electronic payment of debt servicing obligation by a financial institution on behalf of an obligor or borrower) may be used for receivables and thereby qualify for securitization,

4. Lack of availability of currency swaps if receivables are denominated in the local currency.

Four-Tranche Sequential-Pay Structure

Par amount Coupon RateMaturity in

Months

Principal Pay-down

Window In Months*

Average Life**

Tranche A 21,125,000,000 0.174 36 36 1.625 year

Tranche B 21,125,000,000 0.181 64 29 4.4 years

Tranche C 21,125,000,000 0.190 85 22 6.36 years

Tranche D 21,125,000,000 0.215 102 18 7.84 years

Total collateral

IR850 billion

Pass-through

Rate0.190 4.96 years

WAC of Collatera

l0.2052

WAM of Collateral 102 Months

Four-Tranche Sequential-Pay Structure

Par amountCoupon

RateMaturity in

Months

Principal Pay-down

Window In Months*

Average Life**

In year

Tranche A 21,500,000,000 0.174 24 23 1.04

Tranche B 21,500,000,000 0.181 43 20 2.82

Tranche C 21,500,000,000 0.190 61 18 4.40

Z Bonds 21,500,000,000 0.215

Total collateralIR850

billion

Pass-through Rate 0.190 102 4.96 years

WAC of Collateral 0.2052

WAM of Collateral 102 Months

Economic Capital

Economic capital is the amount of risk capital, which a firm requires to mitigate risks undertaken as a going concern.

It is estimated by the amount of capital that the firm needs to ensure its solvency, over a specific horizon, given a pre-specified probability.

It is prudent that financial services aim to hold risk capital of an amount equal at least to economic capital.

Regulatory Capital

"Regulatory Capital" is the mandatory capital the regulators require under Basle Committee in Banking Supervesion.

On the other hand economic capital is the institution’s best estimate of required capital needed for management of various risks, and for allocating the cost of maintaining regulatory capital among different units within the organization.

Economic Capital EC

EC = credit risk capital + market risk capital + operational risk capital.

Economic capital may exceed or fall short of regulatory capital.