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Why Bank Capital?
A bank can finance its operations and carry out lendingand investment activity either with debt (borrowings anddeposits) or own funds (equity)
Borrowings (including primarily insured deposits)generate contractual liabilities, which if not paid whendue can cause the bank to fail.
In contrast, equity can gain or lose value without causingthe bank to default
The greater the proportion of equity relative to debt in abanks capital structure, the more likely the bank will beable to meet its obligations, especially during periods ofeconomic adversity
Thus, regulatory emphasis on Capital Adequacy as akey element of banks Safety and Soundness
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Why Bank Capital?
However, equity capital comes at a much higher cost
Higher regulatory requirements of equity capital canconstrain the banks capacity to lend and have broadermacroeconomic effects on availability of credit
Higher bank capital requirements can also reduce banksability to take advantage of higher financial leverage andtax benefits of debt capital to increase ROE
In a competitive market place, if banks ROE is
depressed, capital will migrate to other higher returnindustries / sectors
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How Much Bank Capital?
Prior to 1980s, there were no specific numerical capitaladequacy standards, only subjective, qualitativeregulatory assessments of banks
Equity capital to total assets ratio of some of the largest
banks in the US had reached a low of 4% In the 1970s and early 1980s, failures of large number of
banks in the US and Europe, including large banks,combined with economic recession in 1881 changedregulatory and supervisory perceptions of bank capital
Since the late 1980s, bank supervisors, stimulated inpart by concerns arising out of bank failures and bankingcrises attempted to precisely define numerical minimumcapital adequacy standards for banks
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How Much Bank Capital?
Issues
Banking business defined differently indifferent countries
Banks moving away from safe, low yieldassets to riskier on balance sheet assets andoff-balance activities which were difficult toquantify
Regulators in different countries set capitalstandards individually, without convergence toany common norms
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The Basel Capital Accord
In December 1987 International convergence of capitalmeasures and capital standards was achieved.
In July 1988,the Basel I Capital Accord was created andadopted by the Basel Committee for BankingSupervision (BCBS) comprising the Central Bankgovernors of the Group of Ten (G-10) countries
Key objectives of Basel I Set minimum regulatory capital adequacy requirements for
banks that reflect the risks of the banks
Define the components of regulatory capital, bearing in mind the
ability to absorb losses Applicable in its original version to large, internationally
active commercial and investment banks
Applicable, with suitable modifications by localregulators, to domestically operational banks
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Minimum Capital Adequacy
Standards
Capital Adequacy Ratio (CAR) =
Regulatory Capital Funds
--------------------------------------------Risk Weighted Assets (On B/S & Off B/S)
Minimum CAR under Basel I = 7.25% by 1990 and 8%
by 1992
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Components of Regulatory Capital
Common Equity &Retained earnings
Lower Tier IISubordinated debt (Dated)
Upper Tier IISubordinated debt(Dated & Perpetual)
Corecapital
Supplem
entarycapital
Tier I
Hybrid Tier I innovative
Cost/Riskfor investor
High
LowTier IIISubordinated debt (Dated)
Regulatory
Capital
Approved by BIS in 1996
Approved by BIS in 1988
Approved by BIS in 1988
Approved by BIS in 1998 Max up to 15% of Tier I
Max up to 50% of Tier I
Max up to 100% of Tier I(along with Lower Tier II
50% at least ofminimum capitalratio of 8%
LossAbsorption
High
Low
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Risk Weighted Assets
Basel I recommended risk weights to be assigned todifferent broad categories of assets or off balance sheetexposures based on the relative riskiness of thoseexposures
The risk weighted approach was preferred over a simplegearing ratio because: (i) it provides a fairer basis for making international comparisons
between banking systems whose structures may differ;
(ii) it allows off-balance-sheet exposures to be incorporated moreeasily into the measure;
(iii) it does not deter banks from holding liquid or other assetswhich carry low risk.
Broad brush, judgemental weights were applied todifferent types of assets and the framework of weightswas kept as simple as possible.
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Risk Weights Under Basel I
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Off Balance Sheet Exposures
Off-balance sheet contingent contracts, such as letters of
credit, loan commitments and derivative instruments,
which are traded over the counter, needed to be first
converted to a credit equivalent based on regulatory
specified credit conversion factors (CCF) and thenassigned appropriate risk weights
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Benefits of Basel I
Basel I acted as a stabilizing force in the internationalbanking systems
Measured on-balance-sheet capital ratios increasedsince the Accord's provisions took effect in 1992 to reachindustry average of 8% in 1993, without any evidentcontraction in credit availability as a result
Since the implementation of Basel I, banks equitycapital, and also reserves and income increased, furtherstrengthening banks total level of protection from creditlosses
Banks consciously held capital well in excess ofregulatory minimum requirements, to avoidconsequences of regulatory sanctions that could beimposed during times of adversity
There was a marked decline in bank failures
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Criticism of Basel I
Could not create a level playing field among banks fromdifferent countries due to differences in regulatoryactions, tax laws, disclosure requirements, insolvencylaws and others
Used a one-size-fit-all risk weight approach for allcategories of banks irrespective of their risk profile
Created incentives for regulatory capital arbitrage usingsecuritisation and off-balance sheet derivatives
Failed to recognize the loss reducing effects (riskmitigating effects) of collateralised exposures
Assigning favourable weights to claims on OECD banksand countries implied a biased treatment which was nottruly a reflection of the risks of such exposures
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1996 Amendment to Basel I
An explicit capital cushion for the price risks to whichbanks are exposed, particularly those arising from theirtrading activities.
The amendment introduced different approaches to the
measurement of market risks arising from banks openpositions in foreign exchange, traded debt securities,traded equities, commodities and options.
For the first time, banks were allowed to use, as analternative to the standardized risk weight approach,
their internal models for measuring the capital charge formarket risk
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Basel II
Basel Capital Accord II - International Convergence of
Capital Measurement and Capital Standards, June 2004
Initiation of revised framework in June 1999; additional
proposals in Jan 2001 and April 2003; latest version
endorsed by Central Bank Governors and heads of
Banking Supervision of G - 10 Countries
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Basel II
To align capital adequacy assessment more closely with
the key elements of banking risk
3 Pillars to ensure safety and soundness of the banking
system
Minimum Capital Requirements
Supervisory Review Process
Use of Market Discipline
Focus on internationally active banks but can be applied
suitably to all types of banks
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Basel II
Greater emphasis on banks own assessment of risks to
which they are exposed, with special importance to
credit and operational risk
Banks management ultimately responsibility for
managing risks & ensuring that CAR is consistent with
the banks risk profile
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Basel II
Capital Adequacy Ratio =
Regulatory Capital Funds
--------------------------------------------------
Risk Weighted Assets (On & Off B/S)= Minimum 8%
Total Risk Weighted Assets =
12.5 X [Capital Required for Mkt risk + Operationalrisk + Credit Risk]
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Credit Risk in Basel II
Applicable to credit exposures like loans and advances
in the banking book and investments in corporate bonds
Three Approaches for Credit Risk Capital Charge
Standardized approach based on external rating agency ratings
Foundation IRB approach based on bank specific internal ratings
and
Advanced IRB approach based on bank specific internal ratings
and measures of loss
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Credit Risk in Basel I
Provide incentives for banks to enhance their riskmeasurement and management techniques
Is more risk sensitive as compared to the previousstandardized approach
wider differentiation of risk weights wider recognition of credit risk mitigation techniques
Reduce incentives for capital arbitrage
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Standardized Approach Credit
Risk
AAA to
AA-
A+ to
A-
BBB+ to
BBB-
BB+ to
BB-
B+ to
B-
Below
B- Unrated
Corporates 20% 50% 100% 100% 150% 150% 100%
Sovereign 0% 20% 50% 100% 100% 150% 100%Banks Option I 20% 50% 100% 100% 100% 150% 100%
Banks Option IIa 20% 50% 50% 100% 100% 150% 50%
Banks Option IIb 20% 20% 20% 50% 50% 150% 20%
Risk weights based on external credit assessments
Banks Option I : Risk Weighting based on risk weighting of sovereign in which Bank is incorporated
Banks Option IIa: Risk weighting based on assessment of individual bank
Banks Option IIb: Risk weighting based on assessment of individual bank with claims of originalmaturity < 3 months
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Market Risk in Basel I
Applicable to Trading books of banks which are affected
by price and interest rate variations
Two Approaches for Market Risk Capital Charge
Standardized Measurement Method (SMM) based on
regulatory standards for price and interest rate
variations
Internal Models Approach (IMA) based on banks
internal Value at Risk Models for assessing market
risk related losses and capital requirements
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Operational Risk in Basel II
Operational risk has been defined as the risk of loss
resulting from inadequate or failed internal processes,
people and systems or from external events.
Three Approaches for Operational Risk Capital Charge
Basic Indicator Approach (BIA)
The Standardised Approach (TSA)
Advanced Measurement Approaches (AMA)
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Supervisory Review in Basel II
Banks must implement an Internal Capital AdequacyAssessment Process (ICAAP) in relation to their riskprofile
This includes stress testing for credit, market andoperational risk and aligning their capital to the stressed
requirements Banks must also outline a strategy for maintaining their
capital levels
Pillar 2 also requires the supervisory authorities tosubject all banks to an evaluation process and to impose
any necessary supervisory measures based on theevaluations.
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Market Discipline in Basel II
Market discipline is imposed by a set of
disclosure requirements included in the Basel II
framework to allow market participants assess
the capital adequacy of the bank based oninformation on the capital, risk exposures, risk
assessment processes etc.
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Basel III
In September 2010, the Basel Committee's
oversight body - the Group of Central Bank
Governors and Heads of Supervision (GHOS) -
agreed on the broad framework, measures andtransition to stronger capital adequacy measures
of Basel III
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Basel III: Greater Emphasis on
Common Equity Increase of the minimum common equity requirement to
4.5%, much higher than the minimum ratio of 2% underBasel II
The Tier 1 minimum capital requirement increased to 6%as compared to a minimum ratio of 4% under Basel II
Banks will also be required to hold an additional capitalconservation buffer of 2.5% of common equity towithstand future periods of stress.
The closer a banks capital level gets to the minimumrequirement, the more constrained its earnings
distribution (eg dividend payments, share buybacks andbonuses) will be until capital is replenished.
Thus, during normal periods the total common equityrequirements for banks will be effectively brought to atleast 7%.
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Basel III: RWA
Increased the capital required for trading book andcomplex structured products
The risk-based capital requirement measures will besupplemented by a non-risk-based leverage ratio,
That is, the risk based capital adequacy ratio will bebenchmarked to a non-risk based leverage ratio whichuses the banks total non-weighted assets plus offbalance sheet exposures
This is expected to help contain the build-up ofexcessive leverage in the system, serve as a backstop tothe risk-based requirements and address model risk.
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Basel III: Pro-cyclicality
Basel III will promote the build-up of capital buffers ingood times that can be drawn down in periods of stress.
The countercyclical capital buffer, which has beencalibrated in a range of 02.5%, would build up during
periods of rapid aggregate credit growth if, in thejudgment of national authorities, this growth isaggravating system-wide risk.
Conversely, the capital held in this buffer could bereleased in the downturn of the cycle. This would, for
instance, reduce the risk that available credit could beconstrained by regulatory capital requirements.
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Basel III
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