Lecture Legal and regulatory aspects of banking supervision – Chapter 7

The following will be discussed in this chapter: Regulating bank capital adequacy, what is capital adequacy, regulations, 5C’s of credit, regulatory capital, tier 1 capital, tier 2 supplementary capital, revaluation reserves.

MBF-705 LEGAL AND REGULATORY ASPECTS OF BANKING

SUPERVISION

OSMAN BIN SAIF

Session:

SEVEN

Summary of Previous Session

• General Types of Bank Regulations

• Privacy Regulations

• Anti-money laundering and anti-terrorism regulation

• Community re-investment regulation

• Deposit account regulation

• Deposit insurance regulation

• Consumer protection

• Withdrawal limit and reserve requirement

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Summary of Previous Session

• Central bank regulations

• Regulation of bank affiliates and holding

Agenda of this session

Agenda of this session (Contd.)

• General Provisions

• Hybrid Debt Capital Instrument

• Sub-ordinated term debt

• Different international implementations

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• SECTION 2:

• REGULATING BANK CAPITAL ADEQUACY

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CAPITAL ADEQUACY

• Capital requirement (also known

as Regulatory capital or Capital

adequacy) is the amount of capital

a bank or other financial institution has to hold as required by its financial regulator

• This is usually expressed as a capital

adequacy ratio of equity that must be held

as a percentage of risk-weighted assets

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CAPITAL ADEQUACY (Contd.)

• These requirements are put into place to ensure that these institutions do not take

on excess leverage and become

insolvent

• Capital requirements govern the ratio of

equity to debt, recorded on the right side

of a firm's balance sheet

• They should not be confused with reserve requirements, which govern the left side of

a bank's balance sheet in particular, the proportion of its assets it must hold in

cash

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• A key part of bank regulation is to make

sure that firms operating in the industry

are prudently managed

• The aim is to protect the firms themselves, their customers and the economy, by

establishing rules to make sure that these institutions hold enough capital to ensure continuation of a safe and efficient market and able to withstand any foreseeable

Regulations (Contd.)

• The main international effort to establish rules around capital requirements has been the Basel Accords, published by

the Basel Committee on Banking

Supervision housed at the Bank for

International Settlements

• This sets a framework on

how banks and depository

institutions must calculate their capital

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Regulations (Contd.)

• In 1988, the Committee decided to

introduce a capital measurement system commonly referred to as Basel I

• This framework has been replaced by a significantly more complex capital

adequacy framework commonly known

as Basel II

• After 2012 it was replaced by Basel III

• Another term commonly used in the

context of the frameworks is Economic

Capital, which can be thought of as the

capital level bank shareholders would

choose in the absence of capital

regulation

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Regulations (Contd.)

• The capital ratio is the percentage of a

bank's capital to its risk-weighted assets

• Weights are defined by risk-sensitivity

ratios whose calculation is dictated under the relevant Accord Basel II requires that the total capital ratio must be no lower

than 8%

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Regulations (Contd.)

• Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the

common requirements within their

individual national legal framework

• Most developed countries implement Basel I and II and now III , stipulate

lending limits

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Regulations (Contd.)

• The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital- have

been replaced by one single criterion

• While the international standards of bank capital were laid down in the 1988 Basel

I accord, Basel II makes significant

alterations to the interpretation, if not the calculation, of the capital requirement

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Regulations (Contd.)

• Examples of national regulators

implementing Basel II include the FSA in the UK, BaFin in Germany, OSFI in

Canada, Banca d'Italia in Italy, State bank

in Pakistan

• In the European Union member states

have enacted capital requirements based

on the Capital Adequacy Directive CAD1 issued in 1993 and CAD2 issued in 1998

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Regulations (Contd.)

• In the United States, depository

institutions are subject to risk-based

capital guidelines issued by the Board of Governors of the Federal Reserve

System (FRB)

• These guidelines are used to evaluate

capital adequacy based primarily on the perceived credit risk associated

with balance sheet assets, as well as

certain off-balance sheet exposures such

as unfunded loan commitments, letters of credit, and derivatives and foreign

exchange contracts

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capital ratio of at least 4%, a combined

Tier 1 and Tier 2 capital ratio of at least

8%, and a leverage ratio of at least 4%,

and not be subject to a directive, order, or written agreement to meet and maintain

specific capital levels

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Regulations (Contd.)

• To be well-capitalized under federal bank

regulatory agency definitions, a bank

holding company must have a Tier 1

capital ratio of at least 6%, a combined

Tier 1 and Tier 2 capital ratio of at least

10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels

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Regulations (Contd.)

• These capital ratios are reported quarterly

on the Call Report or Thrift Financial

Report Although Tier 1 capital has

traditionally been emphasized, in the 2000s recession regulators and investors began to focus on tangible common

Late-equity, which is different from Tier 1 capital

in that it excludes preferred equity

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Regulatory capital

• In the Basel II accord bank capital has been divided into two "tiers" , each with some subdivisions

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Tier 1 capital

• Tier 1 capital, the more important of the

two, consists largely of shareholders'

equity and disclosed reserves This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the

amount those shares are currently trading for on the stock exchange), retained

profits subtracting accumulated losses,

and other qualifiable Tier 1 capital

securities

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Tier 1 capital (Contd.)

• In simple terms, if the original stockholders contributed $100 to buy their stock and

the Bank has made $10 in retained

earnings each year since, paid out no

dividends, had no other forms of capital

and made no losses, after 10 years the

Bank's tier one capital would be $200

Shareholders equity and retained earnings are now commonly referred to as "Core"

Tier 1 capital, whereas Tier 1 is core Tier 1 together with other qualifying Tier 1 capital securities

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Tier 2 (supplementary) capital

• Tier 2 capital, or supplementary capital,

comprises undisclosed reserves,

revaluation reserves, general provisions, hybrid instruments and subordinated term debt

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Revaluation reserves

• A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to

The increase would be added to a

revaluation reserve

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General provisions

• A general provision is created when a

company is aware that a loss may have occurred but is not certain of the exact

nature of that loss

• Under pre-IFRS accounting standards,

general provisions were commonly

created to provide for losses that were

expected in the future

• As these did not represent incurred

losses, regulators tended to allow them to

be counted as capital

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Hybrid debt capital

instruments

• They consist of instruments which

combine certain characteristics of equity

as well as debt They can be included in supplementary capital if they are able to support losses on an on-going basis

without triggering liquidation

• Sometimes, it includes instruments which are initially issued with interest obligation (e.g Debentures) but the same can later

be converted into capital 27

Subordinated-term debt

• Subordinated debt is classed as Lower

Tier 2 debt, usually has a maturity of a

minimum of 10 years and ranks senior to Tier 1 debt, but subordinate to senior debt

• To ensure that the amount of capital

outstanding doesn't fall sharply once a

Lower Tier 2 issue matures and, for

example, not be replaced, the regulator

demands that the amount that is

qualifiable as Tier 2 capital amortises (i.e reduces) on a straight line basis from

maturity minus 5 years (e.g a 1bn issue

would only count as worth 800m in capital

4 years before maturity)

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Subordinated-term debt

(Contd.)

• The remainder qualifies as senior

issuance For this reason many Lower Tier

2 instruments were issued as 10yr

non-call 5 year issues (i.e final maturity after 10yrs but callable after 5yrs) If not called, issue has a large step - similar to Tier 1 - thereby making the call more likely

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Different International

Implementations

• Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction

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Different International Implementations (Contd.)

• For example, it has been reported that

Australia's Commonwealth Bank is

measured as having 7.6% Tier 1 capital

under the rules of the Australian Prudential Regulation Authority, but this would be

measured as 10.1% if the bank was under the jurisdiction of the UK's Financial

Services Authority This demonstrates that international differences in implementation

of the rule can vary considerably in their

Summary of this session

Summary of this session

(Contd.)

• General Provisions

• Hybrid Debt Capital Instrument

• Sub-ordinated term debt

• Different international implementations

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THANK YOU

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