Management of a Bank’s Equity capital Position

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Chapter: 16Peter Rose, Commercial Bank Management

Compiled By: Md. Lutfor RahmanPart Time Faculty

Jahangirnagar University

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1. An Overview of Basel III To strengthen global capital and liquidity rules with the goal of

promoting a more resilient banking sector, the Basel Committee on Banking Supervision (BCBS) issued “Basel III: A global regulatory framework for more resilient banks and banking systems” in December 2010.

The objective of the reforms was to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

Through its reform package, BCBS also aims to improve risk management and governance as well as strengthen banks’ transparency and disclosures.

These new global regulatory and supervisory standards mainly addressed the following areas:

• raise the quality and level of capital to ensure banks are better able to absorb losses on both a going concern and a gone concern basis

• increase the risk coverage of the capital framework • introduce leverage ratio to serve as a backstop to the risk-based

capital measure • raise the standards for the supervisory review process (Pillar 2) and • public disclosures (Pillar 3) etc.

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Minimum Capital Standards :Each bank is required to maintain a ratio of capital to risk weighted assets of not less than 10% with at least 5.5% in Core Capital.

Table 1: Phase-in arrangements for Basel III implementation in Bangladesh

2015 2016 2017 2018 2019Minimum Common Equity Tier 1 (CET1) Capital Ratio 4.50% 4.50% 4.50% 4.50% 4.50% Minimum T-1 Capital Ratio

5.50% 5.50% 6.00% 6.00% 6.00% Minimum Total Capital Ratio

10.00% 10.00% 10.00% 10.00% 10.00% Leverage Ratio 3% 3% 3%

Readjustment Migration to Pillar 1

Liquidity Coverage Ratio ≥100% (From Sep.)

≥100% ≥100% ≥100% ≥100%

Net Stable Funding Ratio > 100% (From Sep.)

>100% >100% >100% >100%

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2. General Instructions on Capital Adequacy FrameworkCapital to Risk-weighted Asset Ratio The Capital to Risk-weighted Asset Ratio (CRAR) is calculated by

taking eligible regulatory capital as numerator and total RWA as denominator.

CRAR = Total Eligible Capital Credit RWA + Market RWA + Operational RWA

Measurement of Risk-weighted AssetIn order to calculate Capital to Risk-weighted Asset Ratio (CRAR),

banks are required to calculate their Risk Weighted Assets (RWA) on the basis of credit, market, and operational risks. Total RWA will be determined by multiplying the amount of capital charge for market risk and operational risk by the reciprocal of the minimum CRAR and adding the resulting figures to the sum of risk weighted assets for credit risk. The methodologies to calculate RWA for each of these risk categories are described in detail in relevant chapters.

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Capital The long-term funds coming from debt & equity that support a bank’s long-term

assets & absorb its earnings losses.3. Constituents of Capital and Minimum Requirement Components of Capital For the purpose of calculating capital under capital adequacy framework, the

capital of banks shall be classified into two tiers. The total regulatory capital will consist of sum of the following categories:

1) Tier-I (Core Capital) (going-concern capital): comprise the highest quality capital elements

A) Common Equity Tier 1 B) Additional Tier 1 2) Tier-II (Supplementary Capital)(gone-concern capital) - represent other

capital elements which fall short of some of the characteristics of core capital but which contribute to the overall strength of a bank.

1) A) Common Equity Tier 1 Capital For the local banks, Common Equity Tier 1 (CET1) capital shall consist of sum of the

following items: a) Paid up capital b) Non-repayable share premium account c) Statutory reserve d) General reserve e) Retained earnings f) Dividend equalization reserve g) Minority interest in subsidiaries Less: Regulatory adjustments applicable on CET1

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1 A) Common Equity Tier 1 Capital For the foreign banks operating in Bangladesh, Common

Equity Tier 1 (CET1) capital shall consist of sum of the following items:

i. Funds from Head Office for the purpose of meeting the capital adequacy

ii. Statutory reserves kept in books in Bangladesh iii. Retained earnings iv. Actuarial gain/loss kept in books in Bangladesh v. Non-repatriable interest-free funds from Head Office for

the purpose of acquisition of property and held in a separate account and have the ability to absorb losses regardless of their source

Less: Regulatory adjustments applicable on CET1

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1 B) Additional Tier 1 Capital For the local banks, Additional Tier 1 (AT1) capital shall consist

of the following items: a) Instruments issued by the banks that meet the qualifying

criteria for AT1b) Minority Interest i.e. AT1 issued by consolidated

subsidiaries to third parties (for consolidated reporting only);

Less: Regulatory adjustments applicable on AT1 Capital

For the foreign banks operating in Bangladesh, Additional Tier 1 (AT1) capital shall consist of the following items:

i. Head Office borrowings in foreign currency by foreign banks operating in Bangladesh for inclusion in Additional Tier 1 capital which comply with the regulatory requirements

ii. Any other item specifically allowed by BB from time to time for inclusion in Additional Tier 1 capital

Less: Regulatory adjustments regulatory adjustments applicable on AT1 Capital

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2) Tier-II Capital (Supplementary Capital)Tier 2 capital, also called ‘gone-concern capital’,

represents other elements which fall short of some of the characteristics of the core capital but contribute to the overall strength of a bank.

For the local banks, Tier 2 capital shall consist of the following items:

a) General Provisions b) Subordinated debt / Instruments issued by the banks

that meet the qualifying criteria for Tier 2 capitalc) Minority Interest i.e. Tier 2 issued by consolidated

subsidiaries to third partiesLess: Regulatory adjustments applicable on Tier 2 capital

For the foreign banks operating in Bangladesh, Tier 2 capital shall consist of the following items:

i. General Provisions ii. Head Office (HO) borrowings in foreign currency

received that meet the criteria of Tier 2 debt capital Less: Regulatory adjustments applicable on Tier 2 capital

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4. Leverage Ratio In order to avoid building-up excessive on- and off-balance sheet leverage in the banking system, a simple, transparent, non-risk based leverage ratio has been introduced. The leverage ratio is calibrated to act as a credible supplementary measure to the risk based capital requirements. The leverage ratio is intended to achieve the following objectives: a) constrain the build-up of leverage in the banking sector which can damage the broader financial system and the economy b) reinforce the risk based requirements with an easy to understand and a non-risk based measure Definition and Calculation of Leverage Ratio A minimum Tier 1 leverage ratio of 3% is being prescribed both at solo and consolidated level. The banks will maintain leverage ratio on quarterly basis. The calculation at the end of each calendar quarter will be submitted to BB showing the average of the month end leverage ratios based on the following definition of capital and total exposure.

Leverage Ratio = Tier 1 Capital (after related deductions) Total Exposure (after related deductions)

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4.2 Capital Measure The capital measure for the leverage ratio will be based on the new definition of Tier 1 capital. Items which are deducted completely from capital do not contribute to leverage and will therefore also be deducted from the measure of exposure. This means that deductions from Tier 1 capital will also be made from the exposure measure.

4.3 Exposure Measure General Measurement Principles The exposure measure for the leverage ratio will generally follow the accounting measure of exposure. In order to measure the exposure consistently with financial accounts, the following will be applied by the bank:i. On balance sheet, non-derivative exposures will be net of specific provisions and valuation adjustments (e.g. surplus/ deficit on Available for sale (AFS)/ Held-for-trading (HFT) positions). ii. Physical or financial collateral, guarantee or credit risk mitigation purchased is not allowed to reduce on-balance sheet exposure. iii. Netting of loans and deposits is not allowed.

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5. Measurement of Risk Weighted Assets: Credit RiskCredit risk is the potential that a bank borrower or counterparty fails to meet its obligation in accordance with agreed term.Risk weight for balance sheet exposure Exposure wise risk weights against different rating grades of BB are given in Table 7. Where an exposure is secured by guarantee or eligible financial collateral, it may reduce its capital charge by taking benefit of credit risk mitigation.

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Bank Capital & RiskCredit or Default Risk.Liquidity Risk.Interest Rate Risk.Operating Risk.Exchange Risk.Crime Risk (The danger that a bank will lose funds as a

result of robbery or other crimes committed by its customers or employees)

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Bank Defense Against Risk1) Quality Management2) Diversification

i. Portfolio Diversification (spreading out a bank’s credit accounts & deposits among wide variety of customers)

ii. Geographical Diversification (seeking out customers located in different communities or countries)

3) Deposit Insurance4) Owners’ Capital

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Types of Bank Capital1. Common Stock2. Preferred Stock3. Surplus (excess of stock’s par value known as

premium)4. Undivided Profits (retained earnings)5. Equity Reserves (for contingencies purposes)6. Subordinated Debentures7. Minority Interest in consolidated subsidiaries.8. Equity Commitment Notes (debt securities

repayable only from the sale of stock)

How Could Bank Raise Capital?

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Raising Capital Internally- Dividend Policy (Retention and dividend payout ratio)

Raising Capital ExternallySelling Common Stock.Issuing Preferred StockIssuing Subordinated Notes & DebenturesSelling Assets & Leasing FacilitiesSwapping Stock for Debt Securities.

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Measuring the Size of Bank capital1) Book or GAAP Capital: Book or GAAP Capital = Book Value of bank Assets – Book Value of bank Liabilities. = Par value of Equity Capital + Surplus + Undivided Profits + Reserves for losses on loans & leases.

2) RAP Capital: Regulatory capital as spelled out by RAP (Regulatory Accounting Principles)

RAP Capital = Stockholders’ Equity + Perpetual Preferred Stock + Bad-debt reserves for losses on loans & leases + Subordinated debentures + Minority Interest

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Measuring the Size of Bank capital3) Market-Value Capital: Market-Value Capital (MVC) = Market value of bank assets (MVA) – Market value of bank liabilities (MVL) = Current market price per share of stock outstanding X Number of equity shares issued & outstanding

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How Much Capital Does a Bank Need?Reasons for Capital Regulations:

To limit the risk of bank failure.To preserve public confidence in banks.To limit losses to the government arising form deposit

insurance claims.Research Evidence

Private market place is probably more important than government regulation in the long run in determining the amount & type of capitals bank holds.

Background of Basel-IIWhat is BIS?The Bank for International Settlements (BIS) is an international

organization, which fosters international monetary and financial co-operation and serves as a bank for central banks. The BIS fulfils this mandate by acting as: i) a forum to promote discussion and policy analysis among central banks and within the international financial community; ii) a centre for economic and monetary research; iii) a prime counterparty for central banks in their financial transactions agent or trustee in connection with international financial operations.

The Head Office is in Basel, Switzerland, Established on 17 May 1930. The BIS strongly advises caution against fraudulent schemes.

What is BASEL-I ?Basel Committee on Banking Supervision (BCBS) brought out the

guidelines for calculation of capital charge on Loans & Advances and Investments based on the Risk Weights applicable to the counter –party / borrower- constituent.

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What is BASEL-II ?Basel –II is recommendatory framework for banking supervision,

issued by the Basel Committee on Banking Supervision in June June 2004. The objective of Basel-II is to bring about international convergence of capital measurement and standards in the banking system.

What are three pillars? Pillar-1: Minimum Capital Requirements- Deals with the

maintenance of regulatory capital calculated for three major components of risk that a bank faces: Credit Risk, Operational Risk and Market Risk.

Pillar-2: Supervisory Review Process- Deals with regulatory response to the first pillar, giving regulatory response to the first pillar, giving regulators much improved tools over those available to them under Basel-I.

Pillar-3: Market Discipline Requirements- The third pillar greatly increases the disclosures that the bank must make.

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How Much Capital Does a Bank Need?-----ContdA. The Judgment Approach: This requires viewing each bank

within the context of its own market environment & looking at several different dimensions of internal & external conditions surrounding the bank. Assessment is based on following parameters:

1. Management Quality2. Asset liquidity.3. Earnings history.4. Quality of ownership5. Occupancy of operating procedures.6. Deposit volatility.7. Local market conditions.

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How Much Capital Does a Bank Need?-----Contd

B. The Imposition of Minimum Capital Requirements: As per International Lending & Supervision Act of 1983, Imposition of minimum capital requirements upon all banks & called for special reserves behind their foreign loans. The centerpiece of this minimum capital program was the concept of:

1. Primary Capital (common stock, perpetual preferred stock, surplus, undivided profits, capital reserves, mandatory convertible debt, loan & lease losses reserves & minority interest in consolidated subsidiaries less equity commitment notes & intangible assets. )

2. Secondary Capital (limited preferred stock, subordinated notes & debentures, mandatory convertible debt instruments)

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How Much Capital Does a Bank Need?-----ContdC. Basel Agreement I (1988): An international treaty involving

the U.S., Canada, Japan & the nations of Western Europe to impose common capital requirements on all banks in those countries. Under the terms of this agreement, sources of bank capital were divided into two tiers:

Tier 1 Capital (core capital) includes common stock & surplus, undivided profits, qualifying noncummulative perpetual preferred stock, minority interest, selected identifiable intangible assets less goodwill & other intangible assets.

Tier 2 Capital (supplemental capital) includes the allowance for loan & lease losses, subordinated debt capital instruments, mandatory convertible debt, intermediate term preferred stock, cumulative perpetual preferred stock, equity notes & other long term capital instruments.

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How Much Capital Does a Bank Need?-----Contd Basel Agreement requires a banker to divide each contract’s

risk exposure to the bank into two categories:1. Potential Market Risk Exposure: The danger of bank

loss at some future time if the customer who entered into a market based contract with the bank fails to perform.

2. Current Market Risk Exposure: To measure the risk of loss to the bank should a customer default today on its contract, which would compel the bank to replace the failed contact with a new one.

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How Much Capital Does a Bank Need?-----Contd

D. Basel Agreement II (2004): The New Basel Capital Accord, often referred to as the Basel II Accord or simply Basel II, was approved by the Basel Committee on Banking Supervision of Bank for International Settlements in June 2004 and suggests that banks and supervisors implement it by beginning 2007, providing a transition time of 30 months. It is estimated that the Accord would be implemented in over 100 countries, including India. Basel II takes a three-pillar approach to regulatory capital measurement and capital standards –

Pillar1 (minimum capital requirements); Pillar 2 (supervisory oversight); and Pillar 3 (market discipline and disclosures).

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Basel II…………Contd.Pillar 1 spells out the capital requirement

of a bank in relation to the credit risk in its portfolio, which is a significant change from the “one size fits all” approach of Basel I. Pillar 1 allows flexibility to banks and supervisors to choose from among the Standardized Approach, Internal Ratings Based Approach, and Securitization Framework methods to calculate the capital requirement for credit risk exposures. Besides, Pillar 1 sets out the allocation of capital for operational risk and market risk in the trading books of banks.

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Basel II…………Contd.Pillar 2 provides a tool to supervisors to keep

checks on the adequacy of capitalization levels of banks and also distinguish among banks on the basis of their risk management systems and profile of capital. Pillar 2 allows discretion to supervisors to (a) link capital to the risk profile of a bank; (b) take appropriate remedial measures if required; and (c) ask banks to maintain capital at a level higher than the regulatory minimum.

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Basel II…………Contd.Pillar 3 provides a framework for the

improvement of banks’ disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, and the like. The pillar also indicates the remedial measures that regulators can take to keep a check on erring banks and maintain the integrity of the banking system. Further, Pillar 3 allows banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts.

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Problems to be done: Using this information for Caring Bank, calculate the Bank’s required level of capital based on new international capital standards. Does the bank have sufficient capital under the new international capital standards?

On Balance sheet items (assets)

BDT Off-balance-sheet items BDT

Loans secured by first lines on family residential property

50,000 Long-term commitments to corporate customers

200,000

Bangladesh Bank securities 200,000 Interest rate swaps 100,000Deposit balances due from other banks

50,000 Total off-balance sheet items 300,000

Cash 50,000Loans to private corporations

650,000

Total assets 1,000,000 Total capital 60,000