Bank Regulatory Capital

Banks are necessary for any modern economy. However, they pose risks to the economy that could propagate globally. As major sources of credit, they control the availability of money for consumers and businesses, who use that money to purchase the products and services offered by the economy.  Thus, the failure of banks can have major repercussions for the economy and can cost the government a significant amount of money, as evidenced by the 2007-2009 credit crisis. Moreover, the failure of major banks can cause failures of other financial institutions because banks generally lend and borrow from each other in the interbank market, so that banks with excess funds can lend to banks with insufficient funds, and banks usually invest in the securities of other banks or serve as counterparties in derivative transactions. So when one or more major banks fail, it can cause a failure of other financial institutions. For instance, prior to the recent credit crisis, American International Group (AIG) sold credit default swaps, many of which covered mortgage-backed securities that were based on subprime mortgages. In 2007, when subprime mortgages started to default in significant numbers, there was a danger that AIG was going to collapse, and with it, the many other financial institutions that bought the credit default swaps, since they would no longer be protected from the defaults of their own mortgage-backed securities. Consequently, the United States (US) government had to pay $85 billion to bail out AIG. For these reasons, banks are heavily regulated, and to make the failure of a bank less likely, virtually all governments impose capital adequacy requirements on their banks. So that consumers have confidence in the banks, most governments offer deposit insurance that reimburses depositors if the bank should fail. Additionally, because technology facilitates cross-border transactions, international banking has greatly increased, thus, necessitating rules that apply to the global banking system.

Global standards are generally set by the Basel Committee on Banking Supervision. A set of 3 standards have been developed since the 1990s. Basel I was enacted in 1992. The Basel II rules were published in 2004 and enacted in 2008. The current recommended regulations, Basel III, enacted as a response to the recent credit crisis, will be implemented over a 6-year period, from 2013 to 2019. The minimum amount of capital required by Basel III for assets with some risk is 10.5%, from the previous minimum of 8%.

The Basel rules were developed as a means to facilitate international banking, which greatly increased since 1988. Regulatory authorities from the major G-10 countries got together in 1988 in Basel, Switzerland to develop new rules to facilitate international banking and to set standards for controlling risk. The Basel rules are administered by the Bank for International Settlements (BIS). They do not have regulatory force, but they do set the global standards that most countries follow to facilitate international banking and to prevent the spread of risk. Domestic regulations plus cross-border regulations, such as that by the European Union's Capital Adequacy Directive, are based on the Basel accords. The primary protection against risk and a major focus of the Basel accords is the primary requirement that banks have adequate capital.

A bank's capital is simply the difference between its assets and liabilities, i.e., the value of what the bank owners actually own. Because banks use extensive leverage to augment profits, a small decrease in the value of its assets can wipe out the bank's capital, causing it to fail. To lessen the probability of failure, banks must maintain a minimum of capital, which is referred to as regulatory capital, because the amount that must be maintained, which varies according to the riskiness of the assets, is stipulated by law. Regulatory capital, which includes equity, preferred stock, subordinated debt, and general reserves, must be sufficient to repay depositors and senior debtholders in the event of a bankruptcy. In the aftermath of the credit crisis, banks have started to issue a new type of bond called contingent convertible bonds (CoCos), which convert to equity when a bank's common equity tier 1 ratio drops below 7%. Barclays has even issued total-loss bonds, so-called because bondholders lose the entire principal if financially triggered. These 10 year bonds were sold for a 7.625% interest rate. CoCos and total-loss bonds lower risk by eliminating the legal obligation to pay interest when the issuing bank becomes financially stressed.

Bank owners generally want lower capital ratios because they increase the return on assets and the return on equity. Banks earn a profit from the net interest margin, which is the difference between the interest rates received on loans and interest rates paid on deposits and short-term debt, so leverage increases profits for a given investment of bank capital.  But that also increases risk. Banks have various means of modifying the capital to assets ratio. Banks can reduce capital to assets by paying a higher dividend; buying back company shares, or increase lending that is financed by issuing CDs, bonds, commercial paper, or by attracting more deposits. Banks can increase the capital to assets by reducing dividends; selling new shares; reducing assets by borrowing less or selling off existing loans; by selling securities; or by reducing costs, such as pay, bonuses, and other costs.

Banks must also maintain a minimum liquidity, as measured by the liquidity coverage ratio. While increased capital helps to protect against insolvency, increased liquidity allows banks to weather runs on the bank, freezes in the short term debt markets, and higher credit demands from existing customers.

Liquidity Coverage Ratio = High-Quality Liquid Assets/Total Net Cash Outflows

Liquidity coverage ratios are required to be 60% by 2015, which will gradually increase to 100% by 2019. Of its liquid assets, 60% must be cash, central bank reserves, and government bonds; 40% may be corporate bonds, residential mortgage-backed securities, and stocks of creditworthy corporations, but RMBSs and stocks cannot compose more than 15% of liquid assets.

Capital adequacy requirements are based on a minimum ratio of capital to risk-weighted assets. For assets that are essentially risk free, such as Treasuries, the ratio is 0%. For risky assets, the ratio can be greater than 100%. If a bank buys $1 million worth of assets with a risk rating of 100%, then the bank must hold $1 million of capital to cover the risk of those assets. On the other hand, if a bank invests $1 million in Treasuries, which have a risk rating of 0%, then no additional capital must be maintained for that asset.

Cash instruments — instruments that must be paid for, such as stocks or bonds — have risk-weighted capital requirements based on the amount invested, the type of instrument, and the creditworthiness of the issuer. Derivatives have lower requirements because they generally do not have an initial cash flow. The notional principal is required to calculate subsequent cash flows, but is never exchanged, so the capital adequacy requirements are less for derivatives. The main risk associated with derivatives is counterparty risk, which can be lowered through the exchange of collateral. If there is a default, then the surviving party does not lose any principal, but may incur only the replacement cost. Thus, capital adequacy requirements only apply to potential losses incurred by the replacement cost, which is generally a small fraction of the notional principal. The creditworthiness of the counterparties is also pertinent to the riskiness of derivatives.

The Basel accords determine procedures that should be followed to ensure adequate capital for risky assets. All assets have a risk weighting proportional to their riskiness, requiring a proportional amount of capital to be set aside in case of default or loss. This proportional percentage is referred to as the capital charge. For purposes of determining capital adequacy requirements, a bank's business is divided into the banking book and the trading book. The banking book lists transactions by the bank's lending department that mostly consists of loans, which is the bank's normal business. The trading book lists transactions by the banks dealing desk, buying and selling securities so that either additional profits can be made from trading or to hedge held positions. Stricter capital adequacy requirements apply to the trading book, since trading is a greater risk.

Basel I defined 2 tiers of capital: Tier 1 and Tier 2. Tier 1 capital is composed of stockholders equity and noncumulative preferred stock, which allows the bank to suspend dividend payments, if necessary. Tier 2 was composed of all other assets. The required capital is based on the risk adjusted exposure:

Risk-Adjusted Exposure = Principal × Risk Weighting × Capital Charge

Based on the risk-adjusted exposure, the capital requirements are determined by the following:

Tier 1 Capital
Risk-Adjusted Exposure
>4%
Tier 1 + Tier 2 Capital
Risk-Adjusted Exposure
>8%

The total risk exposure is determined by adding the risk-adjusted exposure for each asset. However, banks may use netting or portfolio modeling to reduce the principal value. Because the notional principal of derivatives is not at risk, their capital requirements are considerably less than for cash instruments. For instance, there is no capital requirement for forward rate agreements with less than 1-year maturity, while long-term currency swaps may have a capital charge ratio of between 0.08% and 0.2% of the notional principal.

Basel II rules are based on 3 pillars, or approaches: minimum capital requirements, minimum supervision by regulators, and minimum disclosures.

The 1st pillar is minimum capital requirements based on risk that is more detailed than in Basil I. In determining the risk of assets, 3 different types of risk must be assessed separately: market risk, credit risk, and operational risk. The 3 risk numbers are then added together to determine the overall risk:

  1. Market risk is the risk that the market value of the bank's assets will fall.
  2. Credit risk is the risk that borrowers or counterparties to derivatives will default.
  3. Operational risk is the risk incurred because of faulty operational procedures, including the failure to detect risks posed by employees, fraud, general computer failures, IT deficiencies, and legal risk.

There are 2 methods for calculating the required capital to cover market risk: standardized approach and internal models approach. The standardized approach uses standard rules for assessing the risk of particular securities and positions. Capital adequacy requirements will be less for net positions, if netting reduces the overall risk. A minimum risk asset ratio (aka capital adequacy ratio) is required, based on a credit rating matrix with specific weights according to type of asset and its credit rating. So, for instance, a loan to a corporation with a credit rating of less than B- may have a risk weighting of 150%. Additionally, more types of assets are recognized as collateral, such as equities and gold. However, only a portion of the market value of the securities can serve as collateral, to reduce the effects of price volatility. The ratio of the bank's capital and reserves must meet or exceed a percentage of the risk-weighted assets:

Risk Asset Ratio=Bank's Shareholder Equity + Reserves
Risk-Weighted Assets

The internal models approach allows the bank to use its own value-at-risk models, if they are approved by a bank supervisor, and the following requirements are satisfied:

There are also 2 approaches for determining credit risk. The standardized approach requires an assessment of the creditworthiness of the counterparty, based on published ratings by credit rating agencies, such as Standard & Poor's, multiplied by the factor assigned for the type of transaction, based on the potential loss from the transaction. For instance, a forward rate agreement with a notional principal of $1 million is considerably less risky than a $1 million loan, because the FRA simply uses the notional principal to calculate interest payments — the notional principal is not lent. On the other hand, the entire principal of a loan is at stake, so its risk is higher. For derivative transactions that use a clearinghouse, where the clearinghouse acts as the counterparty to both the buyer and the seller and where margin requirements are marked to market daily, the credit risk rating is 0.

The other approach for determining credit risk is the internal ratings-based approach. The bank can use its own methods for the calculation, but only if they are approved by the relevant supervisory body and were used for at least 3 years. Loans must be categorized into buckets of probability-to-default (PD) bands, allocating greater amounts of capital to the higher risk bands. Additionally, the following items must be determined for each exposure:

The 2nd pillar is the supervisory approach to capital allocation. Banks must calculate their capital requirements according to their own risk profiles, such as calculating prepayment risk with mortgages. Supervisors will have the authority to review the capital allocation and set a higher amount if deemed necessary.

The 3rd pillar is increased disclosure. The purpose of increasing disclosure is so that the market can more readily assess the risk taken by financial institutions. Core disclosure rules dictate what must be reported by the banks, but supplementary disclosure rules apply to information that only has to be reported if the bank determines that they are relevant and material. The main elements that must be disclosed are the type of instruments that make up the bank's Tier 1 and Tier 2 capital, the capital adequacy requirements that apply to the bank, and the overall risk exposure, especially concerning the maturity of its loans, interest-rate risk, and other market risks.

The recent credit crisis demonstrated that capital adequacy requirements were not strong enough. Therefore, Basel III rules were published and will be enacted gradually, from 2013 until 2019. Basel III rules that will be enacted in 2015: