Overview: Capital Adequacy

The efficient functioning of markets requires participants to have confidence in each other's stability and ability to transact business. Capital rules help foster this confidence because they require each member of the financial community to have, among other things, adequate capital. This capital must be sufficient to protect a financial organisation's depositors and counterparties from the risks of the institution's on- and off-balance sheet risks. Top of the list are credit and market risks; not surprisingly, banks are required to set aside capital to cover these two main risks. Capital standards should be designed to allow a firm to absorb its losses, and in the worst case, to allow a firm to wind down its business without loss to customers, counterparties and without disrupting the orderly functioning of financial markets.

Minimum capital standards are thus a vital tool to reducing systemic risk. They also play a central role in how regulators supervise financial institutions. (see also systemic safety.) But capital requirements have so far tended to be simple mechanical rules rather than applications of sophisticated risk-adjusted models, although moves are afoot to change this by 2002. Further, there is a difference in the capital requirements of banks and securities houses, which could lead to competitive distortion in the long-run between these two main types of financial institutions.

I. Banks

Formulating relevant capital rules is the domain of the Basle Committee on Banking Supervision. Recognising that its seminal work, the 1988 Capital Accord, which set the minimum 8% capital standard for banks in the industrialised world, is outdated, the Committee has issued a "Consultative Paper on a New Capital Adequacy Framework" (1999) for comments from all interested parties. They have till 31st March 2000 to comment on a paper which represents the most far-reaching reforms to international banking standards for more than a decade.

The 1988 Accord covered primarily credit risk. "International Convergence of Capital Measurement and Capital Standards (1988) sets out the details of the risk-based capital framework. The document outlines how different asset classes (both on and off-balance sheet) are weighted according to their riskiness. There are five weights -0%, 10%, 20%, 50% and 100%. OECD-government debt or cash, for example, has a zero or low weight, loans on banks get 20% while loans fully secured by mortgages on residential property 50%. All claims on the private sector or on banks incorporated outside the OECD with a residual maturity of over one year are weighted 100%.

The Basle Committee recognises that a bank's capital ratio using the above risk weightings, are not always a good indicator of its financial condition. The 1988 weightings do not differentiate adequately borrowers' differing default risks. Another related and increasing problem with the existing Accord is the ability of banks to arbitrage their regulatory capital requirement and exploit divergences between true economic risk and risk measured under the Accord.

The new framework is designed to improve the way regulatory capital reflects underlying risk. It consists of three pillars. The first, minimum capital requirements, develops and expands on the standardised 1988 rules. The risk-weighting system described above will be replaced by a system that uses external credit ratings. So the debt of an OECD country rated single A will get a risk weighting of 20% while that of a triple-A will still enjoy the zero weighting. Corporate debt will also enjoy the graduated weightings so that a double-A rated corporate loan will be risk-weighted at 20% while a single-A 100%. The committee has also introduced a higher-than-100% risk weight for certain low quality exposures. A new scheme to address asset securitisation, is proposed. For example, securitisation tranches rated single A would be risk weughted at 50%, while those rated double B 150%. For some sophisticated banks, the Committee believes that an internal ratings-based approach could form the basis for setting capital charges, subject to supervisory approval and adherence to quantitative and qualitative guidelines.

The second pillar is the supervisory review of capital adequacy which will seek to ensure that a bank's position is consistent with its overall risk profile and strategy, and as such, will encourage early supervisory intervention. Supervisors want the ability to require banks which show a greater degree of risk to hold capital in excess of 8 % minimum. The third pillar, market discipline, will encourage high disclosure standards and enhance the role of market participants in encouraging banks to hold adequate capital.

The existing Accord specifies explicit capital charges for credit and market risks of the trading book. The Committee wants to extend specific charges to cover interest rate risk in the banking book where interest rate risk is significantly above average, and is developing a charge for operational risk

Under the 1988 Accord, off-balance sheet risks are converted to credit risk equivalents by multiplying the notional principal amounts by a credit conversion factor. The resulting amounts are then weighted according to the nature of the counterparty. For example, standby letters of credit serving as financial guarantees for loans carry a 100% credit risk conversion, while revolving underwriting facilities require 50%. These conversion factors remain the same under the 1999 proposals, except for commitments. Under the 1988 Accord, short-term commitments of 365 days or less did not carry any conversion factor. The Basle Committee proposes to change it to 20%.

The credit risk of derivatives is assessed by calculating the current replacement cost, plus an 'add-on' to account for potential exposure. The 'add-on' is based on the notional principal of each contract and varies depending on the volatility of the underlying asset and residual maturity of the contract. Foreign exchange contracts have higher weights than those of interest rates, and transactions with a residual maturity of more than one year bear higher weights than those under one year.

In assessing the credit risk on derivatives, the Capital Accord makes a distinction between exchange-traded and over-the-counter products. Since the outstanding credit risk at exchanges is eliminated by daily margin calls, exchange-traded contracts are exempt from credit risk capital. The original Accord recognised bilateral netting by novation with respect to forward obligations but not close-out netting. (see also netting and insolvency) In a "Consultative paper on on-balance sheet netting" (1998), the Basle Committee proposes to extend netting to on-balance sheet items, such as deposits and loans. It proposes to accept novation as a means of reducing gross exposures to a single net amount.

The Basle Committee considers that the key elements of capital requirements are equity capital and disclosed reserves. The former is the only element common to all countries' banking systems; it is wholly visible in the published accounts and it has a crucial bearing on profit margins and a bank's ability to compete. Equity capital and disclosed reserves form Tier 1 capital, and the Accord requires internationally active banks to have at least 4% Tier 1 capital and 8% total capital in relation to risk-weighted assets.In October 1998, the Committee clarified that innovative capital instruments should be limited to a maximum of 15% of Tier 1 capital and subject to a variety of conditions. In "Enhancing Bank Transparency" (1998), the BIS also puts forward the idea that banks should periodically publicly disclose each component of Tier 1 capital and its main features. Tier 2 capital is supplementary capital and includes other forms of reserves and hybrid debt capital requirements.

In April 1993, the Basle Committee announced that it recognised other forms of netting for capital adequacy purposes, (i.e. that capital would be based on the net marked-to-market). They confirmed their intention in a formal revision to the Capital Accord issued in July 1994. "The Treatment of the Credit Risk Associated with Certain Off-Balance Sheet Items" (1994) also proposed a new formula for add-ons, which took into account the risk reduction effects of netting on potential exposure. It also proposed an enlarged matrix of add-on factors. This document was superseded by "The Treatment of Potential Exposure for Off-Balance Sheet Items " (1995) which contains a new add-on formula for calculating capital requirements for potential exposure. The formula is as follows:

Add-on formula = (0.4 x notional x BIS%) + (0.6 x notional x BIS% x NGR)

Where BIS% is the proposed percentage factor for the contract type and remaining maturity, and NGR is the current netted market value divided by current grossed market value.

The expanded matrix includes three new columns to cover more accurately equity, precious metals and other commodity contracts; the old matrix only made a distinction between interest rate and foreign exchange contracts. The Basle Committee also decided to introduce a third maturity breakdown, over five years, with correspondingly higher capital charges. The former matrix only differentiated between maturities of less than one year and more than one year.

An attempt to take into account the effects of multilateral netting for forward value contracts was made in April 1996. "Interpretation of the Capital Accord for Multilateral Netting of Forward Value Foreign Exchange Transactions " contains the Basle Committee's approach. They suggested that a participant's capital requirement for current credit exposure be the sum of the participant's pro rata share of the clearing house exposure it would be required to absorb from a default by every other participant, individually, in the clearing system. For future exposure, the Basle Committee proposed using the add-on formula (as shown above).

Even when they issued the 1988 Capital Accord, banking regulators realised that minimum capital standards would eventually have to be broadened to take direct and explicit account of market risk. Changes in technology and banking trends made this even more imperative and in 1993 the Basle Committee proposed formulas for measuring market risk arising from foreign exchange positions and trading in debt, and equity securities.

The 1993 proposals were amended because industry comments pointed out the shortcomings of the way that the market risk of different instruments, particularly that of derivatives, were to be treated. These amendments were contained in "Planned Supplement to the Capital Accord to Incorporate Market Risks " (1995). This document is very important from the regulatory capital viewpoint because the Basle Committee agreed to banks using their internal models to calculate capital charges for market risk. This is the first time banking regulators have moved from simple percentages to sophisticated in-house models to determine regulatory capital. (see market risk for details of 1993 and 1995 documents.)

The "Amendment to the Capital Accord to Incorporate Market Risks (1996) " is the Basle Committee's definite pronouncement on capital charges for market risk. For banks which choose to use their internal models, the capital charge will be the higher of:

* the previous day's value-at-risk;
* three times the average of the daily value-at-risk of the preceding sixty business days.

The firm's value-at-risk must be computed on a price shock equivalent to a ten-day holding period with a confidence interval of 99% (one-tailed) and based on a historical observation period of at least one year. For options, banks will be permitted to scale up their one-day value-at-risk number by the square root of 10. This scaling- up method will be allowed for only a limited period. Financial institutions will also be allowed to use correlation offsets both within and across risk factors if they can convince their supervisory authority that they have a sound system for measuring correlations.

Banks in G-10 countries were required to maintain capital to cover market risk at the start of 1998. Eligible capital consists of Tiers 1 and 2 capital as defined in the 1988 Accord, and short-term subordinated debt (Tier 3 capital). Tier 3 capital will be subject to the following conditions:

* It should have an original maturity of at least two years and will be limited to 250% of the bank's Tier 1 capital that is allocated to support market risk
* It is only eligible to cover market risk, including foreign exchange risk and commodities risk.
* Insofar as the overall limits in the 1988 Accord are not breached, Tier 2 elements may be substituted for Tier 3 up to the same limit of 250%.
* It is subject to a "lock-in " provision, which stipulates that neither interest nor principal may be paid if such payment means that the bank's overall capital would then amount to less than its minimum capital requirement.

Banks which do not meet strict qualitative criteria set down by the Basle Committee are not allowed to use their internal models and must use the standardised measurement framework first proposed in 1993, albeit with a few changes. The capital for their option positions can be calculated on a 'simplified', 'delta-plus' or 'scenario' approach, depending on whether the firm buys or/and sells options.

Although the Basle Committee has accepted the validity of using internal models to calculate market risk capital, it feels that potential weaknesses in these models has to be provided for in the minimum capital calculations. So it requires all internal value-at-risk numbers to be multiplied by a minimum factor of three, provided the predicted value-at-risk numbers accurately reflect realised daily profits and losses. If there is a significant discrepancy between actual trading and model-generated numbers, then a plus factor will be added to the minimum number of three.

The criteria for avoiding the plus factor, and enjoying the minimum market risk capital, are set out in the three zones contained in the document titled "Supervisory Framework for the Use of "Backtesting" in conjunction with the Internal Models Approach to Market Risk Capital Requirements" (1996). The three zones are green (no plus factor), yellow (plus factor of 0.4 to 0.85) and red (plus factor of 1.0). An institution falls into the green zone if the actual figures exceed the predicted numbers 4 or less times (out of 250 observations); yellow five to nine times, and red 10 or more times.

The Basle Committee conducted a survey of 40 banks in nine countries for the third and fourth quarters of 1998 to assess whether the internal models approach generated sufficient capital cover for market risk. The survey results showed that for the period covered in the survey, a period of high market volatility, the internal models approach provided an adequate buffer against trading loss. In a report titled, "Performance of Models-Based Capital Charges for Market Risk (1999)", the Committee notes that none of the 40 institutions surveyed reported trading losses over any 10-day consecutive period that exceeded the capital requirement in force at the start of the period.

Capital adequacy

Regulators try to ensure that banks and other financial institutions have sufficient capital to keep them out of difficulty. This not only protects depositors, but also the wider economy, because the failure of a big bank has extensive knock-on effects.

The risk of knock-on effects that have repercussions at the level of the entire financial sector is called systemic risk.

Capital adequacy requirements have existed for a long time, but the two most important are those specified by the Basel committee of the Bank for International Settlements.

Basel 1

The Basel 1 accord defined capital adequacy as a single number that was the ratio of a banks capital to its assets. There are two types of capital, tier one and tier two. The first is primarily share capital, the second other types such as preference shares and subordinated debt. The key requirement was that tier one capital was at least 8% of assets.

Each class of asset has a weight of between zero and 1 (or 100%). Very safe assets such as government debt have a zero weighting, high risk assets (such as unsecured loans) have a rating of one. Other assets have weightings somewhere in between. The weighted value of an asset is its value multiplied by the weight for that type of asset.

Basel 2

The Basel 1 accord has largely been replaced by new rules. Basel 2 is based on three “pillars”: minimum capital requirements, supervisory review process and market forces.

The first "pillar" is similar to the Basel 1 requirement, the second is the use of sophisticated risk models to ascertain whether additional capital (i.e. more than required by pillar 1) is necessary.

The third pillar requires more disclosure of risks, capital and risk management policies. This encourages the markets to react to the taking of high risks.

In addition to specifying levels of capital adequacy, most countries (including the UK) have regulator run guarantee funds that will pay depositors at least part of what they are owed. It is also usual for regulators to intervene to prevent outright bank defaults.