Bank Financial Statements Analysis

Managing bank capital

FFAS 2009

Session structure

On completion of this session students should be able to:

Explain the four roles that capital plays in a bank Explain the main components of Tier 1 and Tier 2 capital Explain how risk-weighted assets are calculated under the standardised approach

Explain the key difference between the standardised approach and internal ratings based approach Explain the key changes in main measures of Basel 3 and likely implications

FFAS 2009

Equity as a funding source

No explicit cost free! Required return
Example

Hurdle rate Capital charged

Equity treated as free funds 10,000 9,600 400

- IRR approach - NPV approach

Equity charged at COE

Balance sheet
Loan asset Interest bearing funding (e.g. deposits) Equity 10,000 9,600 400

Income statement
Interest income (10,000 @ 9.5%) Cost of interest bearing funds (9,600 @ 8.0%) Pre-tax cost of equity (@ 24%) Operating costs Operating profit Economic profit Return on equity ROE in excess of COE 20.5% -3.5%
3

950 (768) (100) 82

950 (768) (96)

(100)
(14)

Transaction capital allocation

Capital allocation critical for exposure appraisal
Example ($m)
Loan principal Interest bearing funding Allocated equity (4% of loan) Operating profit Interest income (@ 9.5%) 4% equity 10,000 9,600 400 2% equity 10,000 9,800 200 950 (784) (48) (100) 18 9.0%

Cost of interest bearing funds (@ 8.0%)

Pre-tax cost of equity (@ 24%) Operating costs

950 (768) (96)

(100) (14) -3.5%

Value added
Value added (% points above ROE)

How to determine the appropriate capital for an exposure?

The Basel Accord Original and Basel 2/3

Bank International Settlements (BIS) Level playing field for internationally active banks Reduce scope for regulatory arbitrage Brought in (1988) following collapse of Bretton Woods Volatile interest rates and floating rate exchange rates led many to believe that risks banks faced were greater than in the past General perception that banks were undercapitalised Covered credit, FX and interest rate risk Market risk amendment 2000, revised 2009 (Basel 2.5) Basel 2 implementation 2007-2012
Standardised approach rule driven and relatively straightforward to implement Internal rating based (IRB) approach suitable for banks with more sophisticated systems and historic data on credit losses Banks can opt for a mix of approaches

Basel 3 implementation 2012-18 Three pillars in Basel

Minimum capital requirements Regulatory responsibilities Bank risk disclosures

Specifies minimum capital requirements but many regulators impose higher requirements But many critics of both the need for an accord and its specific nature
5

Basel Approach
Assets
Government bonds Deposits with other banks Bonds (AAA through to unrated) Residential mortgages Converted into Rated corporates Credit cards, personal loans Unrated & SMEs Other *Not to scale

Liabilities

Major part of risk-weighted assets (RWAs) relates to credit risk

RWAs and equivalents*
Operational Interest rate FX Market Deposits

Assets given risk-weighting to reflect level of credit risk Other risks (market, interest rate, FX and operational) translated into RWA equivalents Risk capital comprises equity (less intangibles and other adjustments) plus certain forms of long-term debt Minimum risk capital required specified as % of total RWAs and RWA equivalents Risk Capital
6

Credit

Short and medium term wholesale funding Other liabilities Long term debt Equity

Basel 2 Tier 1 Capital Equity

Core Tier 1 capital shareholders 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 with domestic legislation, accounting standards need to check to be sure

Basel 2 Tier 1 Capital

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%

FFAS 2009

Basel 2 Tier 2 Capital

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

Plus 45% of any revaluation reserves and gains of securities AFS

Less 50% of excess of expected losses over impairment allowances
* Term subordinated debt classified as lower Tier 2, rest all upper Tier 2
FFAS 2009

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 different asset 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 Accord depending 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 eligible Tier 1 capital is calculated

10

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 capital requirement 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 repricing larger the factor) Risk-weight equivalent asset value then calculated

Market Risk
Have covered how regulatory capital requirement was calculated in Basel 2 and the July 2009 (Basel 2.5) amendment Converted into RWA equivalents by multiplying this capital requirement by 12.5 (= 1/8%) and added to other RWAs

11

Credit risk - the Standardized Approach to calculating RWAs

1 Standard and Poors AAA to AA2 A+ to A3 BBB+ to BBB4 BB+ to B5 Below BUnrated

Sovereign
Banks Option 1 (National) Option 2 (Individual) Short-term claims Other claims Corporates Commercial real estate Residential mortgages Other retail

0%
20%

20%
50%

50%

100%

150%
150% 150% 150% 150%

100%
100% 20% 20% 100%

---- 100% ----50% 50% 100%

------- 20% ----------------- 20% --------20% 50%

----- 100% ----

--------------------- 100% ------------------------------------------- 35% ------------------------------------------- 75% ----------------------

Past due loans (based on unsecured portion) NPL cover < 20% NPL cover 20%-50% NPL cover > 50% Other assets ---------------------- 150% ------------------------------------------- 100% ----------------------------------------- 50%-100% ----------------------------------------- 100% ----------------------

Given 4% Tier 1 capital requirement for $100,000 mortgage risk weighted assets $35,000 (=$100,000 x 35%) 4% = $1,400 (i.e. 1.4%)
FFAS 2009

12

Simplified example of Standardised Basel CAR* calculation

* CAR = Capital Adequacy Ratio

Assets Cash and government securities Deposits with other banks Residential mortgages Other loans Fixed and other assets Goodwill Total Other RWA equivalents Total RWA 20,000 10,000 45,000 15,000 8,000 2,000 100,000 0% 20% 35% 75% 100% 0% 0 2,000 15,750 11,250 8,000 0 37,000 7,125 44,125

Liabilities Customer accounts Deposits with banks Subordinated debt Cumulative preference shares Perpetual non-cumulative preference shares Shareholders' equity Minority interests in bank subsidiaries Total equity Total 70,000 21,500 2,000 1,000 500 4,500 500 5,000 100,000 1,750 44,125

Tier 1

Tier 2

750 1,000 500

2,500
500

3,500
= 4.0%

1,750

Tier 1 ratio

3,500 44,125

= 7.9%

Tier 2 ratio

Total Capital Adequacy Ratio (CAR)

(5,250/44,125) = 11.9%

Other RWA equivalents from market risk, FX, interest rate risk and operational risk For sake of example ignoring regulatory reversals and deductions from equity, expected losses, collective allowances etc.
13

Advanced internal rating based (IRB)

Banks classify loans according to BIS classes Calculate historic PD (probability of default), LGD (loss given default given as a % of exposure at default) and EAD (exposure at default) using historic data at least 5 years For each asset class Basel specifies a complex formula whose inputs are PD, LGD and EAD

Output from formula gives regulatory capital requirement

Bank calculates regulatory capital requirement for each class PD Basel formulae Regulatory capital requirement

Credit ratings / historic database LGD

EAD
14

Internals Rating Based (IRB) Classes for Credit Risk

Public sector
Sovereign & foreign central banks Nongovernment public sector entities Export Credit Agencies Multi-lateral development banks BIS, IMF, ECB & EC

Private sector financial institutions

Banks Securities firms

Corporate Specialized corporate lending

All other corporate loans Project finance

Real estate Real estate Commodities Asset investment development finance backed . (structured (income (high-volatility financing short-term) generating) finance)

Retail
Residential mortgages Revolving credit Other

SMEs
Other Real estate

Other assets on-balance sheet

Purchased receivables Asset securitization issues Equities (including hybrid & convertibles) All other assets

Off-balance sheet items

Internal historic databases

FFAS 2009

Regulatory defaults/ over-rides

15

Each class has its own formula changes in parameters or different

form for formula

IRB Basel 2 Exacerbates Cyclicality in Downturn

RWAs RWAs

--- Tier 1 capital --Before After

--- Tier 1 capital ---

Before

After

EL

EL In a recession PD and LGD both increase higher RWAs and EL Higher EL lowers eligible Tier1 capital Lower Tier 1 ratio results
16

50% of excess of EL over collective impairment allowances deducted from Tier 1 capital

RWAs and EL driven by PD and LGD

Some general criticisms of Basel 2

Arbitrary absolute capital requirement may be Not in fact a buffer to absorb losses

evaded when going gets tough Mandatory minimum requirements rule based vs. principles

Gives competitive advantage to sophisticated banks

(IRB versus standardised)

Capital charge for operational risk does not reward banks for
taking action to reduce operational risk or punish those most exposed to it

Cyclicality capital & provisions Capital requirement at its lowest when credit losses low (IRB

modelling) Rises as credit-risk increases and rating deteriorate Likely to exacerbate a downturn Fails to encourage banks to build up reserves when earnings are strong

Nothing on liquidity risk Some of these criticisms addressed in Basel 3

FFAS 2009

17

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 2 that 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-up

clauses 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)
18

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 all times 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 at regulatory 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%
19

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, potential future exposures from derivatives) Minimum leverage ratio of 3% proposed Long transition period Parallel run through to January 2017, BIS to track banks disclosures of calculations of ratio Implementation January 2018

General acceptance that such a measure will be useful complement to risk-weighted measures but nobody is sure whether 3% is an appropriate level
20

Proposed Basel 3 Implementation Timetable

2013
Min. Core Tier 1 Capital Ratio (% of RWA) Capital Conservation Buffer (% of RWA) Min. Core Tier 1 plus Capital Conservation Buffer (% of RWA) Phase-in of deductions from Core Tier 1 Min. Tier 1 Capital (% of RWA) Min. Total Capital (% of RWA) Min. Total Capital plus Capital Conservation Buffer (% of RWA) Capital instruments that no longer qualify as Non-Core Tier 1 Capital or Tier 2 Capital New leverage ratio

2014 4.0%

2015 4.5%

2016 4.5%

2017 4.5%

2018 4.5%

2019 4.5%

3.5%

0.625%
3.5% 4.0% 20% 4.5% 8.0% 8.0% 5.5% 8.0% 8.0% 4.5% 40% 6% 8.0% 8.0% 5.125% 60% 6% 8.0% 8.625%

1.25%
5.75% 80% 6% 8.0% 9.125%

1.875%
6.375% 100% 6% 8.0% 9.875%

2.5%
7.0% 100% 6% 8.0% 10.5%

Phased out over 10 year horizon beginning 2013 (reduction of 10% each year) 3.0% 3.0%

Many countries and banks moving at a much faster pace and some meet requirements already

21

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 increasing comparability 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 capital under 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 from higher risk activities - Shift to funding from higher cost long-term bonds and away from cheap short-term customer deposits - Lower bank ROEs and weak growth prospects will make equity issues for some banks unattractive to investors
22

Session structure

On completion of this session students should be able to:

Explain the four roles that capital plays in a bank Explain the main components of Tier 1 and Tier 2 capital Explain how risk-weighted assets are calculated under the standardised approach

Explain the key difference between the standardised approach and internal ratings based approach

FFAS 2009

23

Managing Bank Capital

A consensus means that everyone agrees to say collectively what no one believes individually.
Abba Eban, former Israeli ambassador to the UN

FFAS 2009

24