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Bank Financial Statements Analysis
Managing bank capital
FFAS 2009
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Session structure
FFAS 2009
Explain the four roles thatcapital plays in a bank
Explain the main componentsof Tier 1 and Tier 2 capital
Explain how risk-weightedassets are calculated under
the standardised approach
On completion of this session students should be able to:
Explain the key differencebetween the standardisedapproach and internal ratingsbased approach
Explain the key changes inmain measures of Basel 3 and
likely implications
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Equity as a funding source
No explicit cost free!
Required return
Hurdle rate - IRR approach
Equitytreated asfree funds
Balance sheet
Loan asset 10,000
Interest bearing funding (e.g. deposits) 9,600Equity 400
Income statement
Interest income (10,000 @ 9.5%) 950
Cost of interest bearing funds (9,600 @ 8.0%) (768)
Pre-tax cost of equity (@ 24%)Operating costs (100)
Operating profit 82
Economic profit
Return on equity 20.5%
ROE in excess of COE -3.5%
Equity charged atCOE
10,000
9,600400
950
(768)
(96)(100)
(14)
Example
Capital charged - NPV approach
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Transaction capital allocation
Capital allocation critical for exposure appraisal
How to determine the appropriate capital for an exposure?
Loan principal
Interest bearing funding
Allocated equity (4% of loan)
Operating profitInterest income (@ 9.5%)
Cost of interest bearing funds (@ 8.0%)
Pre-tax cost of equity (@ 24%)
Operating costs
Value added
Value added (% points above ROE)
4% equity
10,000
9,600
400
950
(768)
(96)
(100)
(14)
-3.5%
Example ($m)
10,000
9,800
200
950
(784)
(48)
(100)
18
9.0%
2% equity
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The Basel Accord Original and Basel 2/3
Bank InternationalSettlements (BIS)
Level playing field forinternationally active banks
Reduce scope for regulatoryarbitrage
Brought in (1988) followingcollapse of Bretton Woods
Volatile interest rates andfloating rate exchange ratesled many to believe thatrisks banks faced weregreater than in the past
General perception that
banks were undercapitalised
Covered credit, FX andinterest rate risk
Market risk amendment2000, revised 2009 (Basel2.5)
Basel 2 implementation 2007-2012
Standardised approach rule drivenand relatively straightforward toimplement
Internal rating based (IRB)approach suitable for banks withmore sophisticated systems andhistoric data on credit losses
Banks can opt for a mix ofapproaches
Basel 3 implementation 2012-18
Three pillars in Basel
Minimum capital requirements
Regulatory responsibilities
Bank risk disclosures Specifies minimum capital
requirements but many regulatorsimpose higher requirements
But many critics of both the need foran accord and its specific nature
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Basel Approach
RiskCapital
Major part of risk-weighted assets(RWAs) relates to credit risk
Assets given risk-weighting toreflect level of credit risk
Other risks (market, interest rate,FX and operational) translated into
RWA equivalents Risk capital comprises equity(less intangibles and otheradjustments) plus certain forms oflong-term debt
Minimum risk capital requiredspecified as % of total RWAs andRWA equivalents
Assets
Government
bonds
Deposits withother banks
Bonds (AAAthrough tounrated)
Residentialmortgages
Ratedcorporates
Credit cards,personal loans
Unrated &SMEs
Other
Other liabilities
Equity
Long term debt
Short andmedium termwholesalefunding
Deposits
Liabilities
RWAs andequivalents*
Operational
Interest rate
FX
Market
Credit
*Not to scale
Convertedinto
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Basel 2 Tier 1 Capital Equity
Core Tier 1 capitalshareholders equity
Less goodwill and intangible assets
Reversal of other comprehensive income (US GAAP)
Reversal of unrealised AFS gains/losses (net of deferred tax)
Reversal of fair value gains/losses on bonds issued by bank from
changing credit spreads (net of deferred tax)
Reversal of revaluation of premises
Reversal of reserves created from use of hedge accounting
Less dividends declared but not paid
Less 50% of excess of expected losses over impairment allowances
Plus minority interests in banking subsidiaries core Tier 1 equity
Less investments in insurance subsidiaries and associates
Less first loss positions in securitisation issues
Local regulators have discretion to amend BIS recommendations to comply withdomestic legislation, accounting standards need to check to be sure
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Basel 2 Tier 1 Capital
FFAS 2009
Preference shares fixed coupon, no tax relief
Senior only to equity holders
Bank restricted on return of capital and dividend payments to ordinary
shareholders
Must be non-cumulative payments missed are lost
Must be perpetual and irredeemable
May have trigger conditions on mandatory conversion to ordinary stock
Innovative Tier 1 securities
Non-cumulative preference shares with coupon step-up and call clauses
Coupon step-up and call clauses result in an economic term
As coupon rate increases incentive to call rises
Restrictions on conditions (number of years before step-up clauses kick in)
Limited to 15% of total Tier 1 capital
Minimum requirement for Tier 1 capital ratio 4%
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Basel 2 Tier 2 Capital
FFAS 2009
Preference shares fixed coupon, no tax relief
Senior only to equity and non-cumulative preference share holders
Cumulative missed payments accumulated
Must be perpetual and irredeemable
Can have step-up and call clauses
Subordinated debt May be term* or perpetual
If outstanding term greater than 5 years all eligible If term less than 5 years the proportion eligible falls
e.g. if 4 years remaining, 80%; if 1 year remaining 20%
Collective allowances/general provisions
Restricted to 1.25% of risk-weighted assets
Less 50% of excess of expected losses over impairment allowances
Plus 45% of any revaluation reserves and gains of securities AFS
* Term subordinated debt classified as lower Tier 2, rest all upper Tier 2
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Basel (2 and 3) Calculation of Risk-Weighted Assets
Three different approaches possible for credit risk
Standardised approach
Simplest approach
Credit risk RWAs calculated by use of standard weightings for differentasset classes
Use of credit ratings from external Credit Rating Agencies (CRAs)important aspect of weightings
Internal ratings based (IRB)
Allows banks to use own systems to estimate PD for exposures
EAD and LGD given as supervisory defaults and specified in Accorddepending on type of exposure
Used as inputs to Basel black-box formulae to generate value for RWAs
Advanced internal ratings based
Allows banks to use own systems to estimate PD and EAD and LGD
Still uses Basel black-box formulae to generate value for RWAs
Choice of standardised or IRB approach affects way in which eligibleTier 1 capital is calculated
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Operational, interest rate and market risk
Operational risk Crude capital charge equivalent to 15% of gross operating income
Converted into RWA equivalents by multiplying this capitalrequirement by 12.5 (= 1/8%) and added to other RWAs
Lower charge for more sophisticated banks based on business profile
Interest rate risk Assets and liabilities put into time buckets based on re-pricing date
Includes derivatives (e.g. interest rate swaps and FRAs)
Size of net position in each bucket calculated
Conversion factors applied to each net position (longer the date to re-pricing larger the factor)
Risk-weight equivalent asset value then calculated
Market Risk
Have covered how regulatory capital requirement was calculated inBasel 2 and the July 2009 (Basel 2.5) amendment
Converted into RWA equivalents by multiplying this capitalrequirement by 12.5 (= 1/8%) and added to other RWAs
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Credit risk - the Standardized Approach to calculating RWAs
Sovereign 0% 20% 50% 100% 150% 100%
Banks
Option 1 (National) 20% 50% ---- 100% ----- 150% 100%
Option 2 (Individual)
Short-term claims ------- 20% ----------- 50% 150% 20%
Other claims ------- 20% --------- 50% 100% 150% 20%
Corporates 20% 50% ----- 100% ---- 150% 100%
Commercial real estate --------------------- 100% ----------------------
Residential mortgages ---------------------- 35% ----------------------
Other retail ---------------------- 75% ----------------------
Past due loans (based on unsecured portion)
NPL cover < 20% ---------------------- 150% ----------------------
NPL cover 20%-50% ---------------------- 100% ----------------------
NPL cover > 50% -------------------- 50%-100% --------------------
Other assets ---------------------- 100% ----------------------
FFAS 2009
1 2 3 4 5 Unrated
Standard and Poors AAA toAA-
A+ toA-
BBB+to BBB-
BB+ toB-
BelowB-
Given 4% Tier 1 capital requirement for $100,000 mortgage riskweighted assets $35,000 (=$100,000 x 35%) 4% = $1,400 (i.e. 1.4%)
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Simplified example of Standardised Basel CAR* calculation
Assets
Cash and governmentsecurities 20,000 0% 0
Deposits with other banks 10,000 20% 2,000
Residential mortgages 45,000 35% 15,750
Other loans 15,000 75% 11,250
Fixed and other assets 8,000 100% 8,000
Goodwill 2,000 0% 0
Total 100,000 37,000
Other RWA equivalents 7,125
Total RWA 44,125
Liabilities
Customer accounts 70,000
Deposits with banks 21,500
Subordinated debt 2,000
Cumulative preference shares 1,000
Perpetual non-cumulativepreference shares 500
Shareholders' equity 4,500
Minority interests in banksubsidiaries 500
Total equity 5,000
Total 100,000
Tier 1 Tier 2
750
1,000
500
2,500
500
3,500 1,750
Tier 1 ratio 3,500 = 7.9%
44,125
Tier 2 ratio 1,750 = 4.0%
44,125
Total Capital Adequacy Ratio (CAR) (5,250/44,125) = 11.9%
* CAR = Capital Adequacy Ratio
Other RWA equivalents from market risk, FX, interest rate risk andoperational risk For sake of example ignoring regulatory reversals and deductions from
equity, expected losses, collective allowances etc.
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Advanced internal rating based (IRB)
Banks classify loans according to BIS classes
For each asset class Basel specifies a complex formula whoseinputs are PD, LGD and EAD
Calculate historic PD (probability of default), LGD (loss givendefault given as a % of exposure at default) and EAD (exposureat default) using historic data at least 5 years
Bank calculates regulatory capital requirement for each class Output from formula gives regulatory capital requirement
PD
LGD
EAD
Regulatorycapitalrequirement
Credit ratings /historic database
Baselformulae
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Banks Securities
firms
Assetbacked
financing
.Projectfinance
Commoditiesfinance
(structuredshort-term)
Real estate
investment
(incomegenerating)
Real estate
development
(high-volatilityfinance)
entities
Sovereign &foreign central
banks
Export CreditAgencies
BIS,IMF, ECB
& EC
Non-governmentpublic sector
Multi-lateraldevelopmentbanks
Residentialmortgages
Revolvingcredit
Other RealestateOther
Assetsecuritizationissues
Equities(includinghybrid &convertibles)
All other
assets
Purchased
receivables
Retail
Public sectorPrivate sector financial
institutions
Corporate Specialized corporate lending
All othercorporate
loans
SMEs
Off-balancesheet items
Other assets on-balance sheet
Internals Rating Based (IRB) Classes for Credit Risk
Regulatory defaults/ over-rides Internal historic databases
FFAS 2009
Each class has its own formula changes in parameters or differentform for formula
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IRB Basel 2 Exacerbates Cyclicality in Downturn
RWAs
EL
--- Tier 1 capital ---
Before After
50% of excess of EL overcollective impairment allowancesdeducted from Tier 1 capital
RWAs and EL driven by PD and
LGD
In a recession PD and LGD bothincrease higher RWAs and EL
Higher EL lowers eligible Tier1capital
Lower Tier 1 ratio results
RWAs
EL
Before After
--- Tier 1 capital ---
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Some general criticisms of Basel 2
Arbitrary absolute capital requirement may beevaded when going gets tough
Mandatory minimum requirements rule based vs. principles
Cyclicality capital & provisions Capital requirement at its lowest when credit losses low (IRBmodelling) Rises as credit-risk increases and rating deteriorate Likely to exacerbate a downturn Fails to encourage banks to build up reserves when earnings arestrong
Capital charge for operational risk does not reward banks for
taking action to reduce operational risk or punish those mostexposed to it
FFAS 2009
Gives competitive advantage to sophisticated banks(IRB versus standardised)
Not in fact a buffer to absorb losses
Nothing on liquidity risk
Some of these criticisms addressed in Basel 3
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Basel 3 Capital Requirements
Reduction in allowable Tier 1 capital Focus on core (eguity less deductions) capital (CET1)
More deductions (deferred tax assets, Tier 1 capital from minority
interests in consolidated bank subsidiaries; deductions in Basel 2that were taken 50% from Tier 1 and Tier 2 increased to 100%from Tier 1)
Move away from preference shares and hybrid equity
Permitted preference shares
Perpetual, i.e. there is no maturity date (and there are no step-upclauses or other incentives to redeem early)
Bank has discretion to suspend dividend payments
Non-cumulative
Can be called but only after 5 years and with supervisory approval
Other hybrid equity to be phased out
Allowable Tier 2 capital
Vanilla subordinated debt; loss absorbing before other creditors,minimum maturity 5 years at issue
Minority interests in consolidated bank subsidiaries
General provisions (Standardised approach)
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Basel 3 Capital Requirements (cont.)
Increase in risk-weighted assets Increases capital requirements for counterparty credit risk arising from
derivatives and repo type deals and central counterparties (settlement
agents) Tighter and higher capital requirements for securitisation issues
Higher capital requirements for trading book positions
Minimum BIS CET1 of 4.5%, Tier 1 6%, total CAR 8% at alltimes
Measures to reduce cyclical effects inherent in Basel 2 Capital Conservation Buffer (2.5% - effectively increases CET1 to 7%),
level banks expected to hold during good times may be drawn on atregulatory discretion
Countercyclical buffer regulators may impose additional 2.5%
requirement during periods of excessive credit growth BIS lobbying IASB on impairment allowances
Systematically important financial institutions Too big/connected to fail
Increase in CET1 by 1%-2.5%
l i
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Basel 3 Leverage ratio
Leverage ratio
Based on Tier 1 capital/Exposures
Exposures not risk-weighted On-balance sheet assets (less deductions included in
calculation of Tier 1 capital)
Off-balance sheet exposures (e.g. commitments, potentialfuture exposures from derivatives)
Minimum leverage ratio of 3% proposed
Long transition period
Parallel run through to January 2017, BIS to track banksdisclosures of calculations of ratio
Implementation January 2018
General acceptance that such a measure will be usefulcomplement to risk-weighted measures but nobody is surewhether 3% is an appropriate level
P d B l 3 I l i Ti bl
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Proposed Basel 3 Implementation Timetable
2013 2014 2015 2016 2017 2018 2019
Min. Core Tier 1 Capital Ratio(% of RWA) 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Conservation Buffer (%of RWA)
0.625% 1.25% 1.875% 2.5%
Min. Core Tier 1 plus CapitalConservation Buffer(% of RWA)
3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
Phase-in of deductions from
Core Tier 1
20% 40% 60% 80% 100% 100%
Min. Tier 1 Capital (% of RWA) 4.5% 5.5% 6% 6% 6% 6% 6%
Min. Total Capital (% of RWA) 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Min. Total Capital plus CapitalConservation Buffer(% of RWA)
8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5%
Capital instruments that nolonger qualify asNon-Core Tier 1 Capital or Tier2 Capital
Phased out over 10 year horizon beginning 2013 (reduction of 10%each year)
New leverage ratio 3.0% 3.0%
Many countries and banks moving at a much faster pace and
some meet requirements already
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Some implications of Basel 3
Impact will vary by region, country and bank
- More decisions on required levels and measures being taken by local regulators
- Common framework for calculating ratios and level playing fields?
- Wide and confusing mix of regulatory measures followed by banks increasingcomparability issues
- Lack of clarity in requirements and excessive complexity
Higher capital equity Tier 1 requirements
- Banks will look to raise equity; higher retained earnings lower dividends
- Shrinking of balance sheets (RWAs)
- Shift away from activities regarded as high-risk/requiring higher regulatory capitalunder Basel e.g. Lending to SMEs, some trading and market-making activities
Lower bank ROEs
- Lower leverage (gearing)
- Shift to lower yield assets (G5 bonds) to meet liquidity requirements and away fromhigher risk activities- Shift to funding from higher cost long-term bonds and away from cheap short-termcustomer deposits- Lower bank ROEs and weak growth prospects will make equity issues for some banksunattractive to investors
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Session structure
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Session structure
FFAS 2009
Explain the four roles thatcapital plays in a bank
Explain the main componentsof Tier 1 and Tier 2 capital
Explain how risk-weightedassets are calculated under
the standardised approach
On completion of this session students should be able to:
Explain the key differencebetween the standardisedapproach and internal ratingsbased approach
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A consensus means that everyone agrees to say collectively what no onebelieves individually.
Abba Eban, former Israeli ambassador to the UN
Managing Bank Capital