Capital Management and Adequacy
Capital Management and Adequacy Functions of capital:
Absorbing unanticipated losses Protect uninsured depositors (deposits > $250k), bondholders & creditors in case of insolvency and liquidation To protect FI insurance funds and taxpayers (who essentially pay the $250k guarantee) To protect FI owners against increases in insurance premiums and to lower cost of funds Partially fund FI’s investment activities
Using market value rather than book value is better because it gives you a better idea of your current position if an unexpected event arises. Market value gives an accurate picture of your net worth and solvency position. It is a better way to measure your ability to withstand losses. Book value doesn’t recognise losses in asset values due to adverse interest rate changes, and it tends to defer write-downs of bad loans. However, market value accounting can be difficult to implement and it introduces unnecessary variability into an FI’s earnings as any change in the asset’s value needs to be recorded, even when the gain/loss isn’t realised (only realised once sold). An FI is insolvent if the market value of its assets is less than that of its liabilities. Losses in asset values are borne first by the equity holders. Only if losses exceed the value of equity will liability holders be affected. Reasons for regulating capital:
To limit risk of failures To preserve public confidence To limit losses to the government which arise from deposit insurance claims
Regulation mitigates the moral hazard which is created by government insurance which leads to banks taking on bigger risks and depositors monitoring less. Therefore if implemented well, capital regulations can lower systemic risk. Total capital = Tier 1 capital + Tier 2 capital Tier 1 = common stock, surplus, retained earnings, noncumulative perpetual preferred stock. Tier 2 = reserves for loan and lease losses, various convertible and subordinated debt instruments. RAA = RAA include on AND off BS assets. Mortgage insurance will reduce the risk weight on mortgages. The loan valuation ratio is the value of the loan relative to the value of the property. They higher the ratio, the higher the probability of default, the higher the risk weight. With off BS activities, they need to be separated into market and non-market related transactions. Market related ones are loan commitments, LoCs, because the risk weight depends on the risk of the
counterparty. Non-market related ones are derivatives (carry no default risk) and OTCs (futures, swaps) which carry the counterparty’s default risk. For non-market related off BS transactions, multiply the face value by the conversion factor which gives the credit equivalent amount, and then multiply it by the relevant risk weight, sum them all up. For market related ones, the credit equivalent amount is potential exposure (risk that the counterparty to the securities contract will default in
Absorbing unanticipated losses Protect uninsured depositors (deposits > $250k), bondholders & creditors in case of insolvency and liquidation To protect FI insurance funds and taxpayers (who essentially pay the $250k guarantee) To protect FI owners against increases in insurance premiums and to lower cost of funds Partially fund FI’s investment activities
Using market value rather than book value is better because it gives you a better idea of your current position if an unexpected event arises. Market value gives an accurate picture of your net worth and solvency position. It is a better way to measure your ability to withstand losses. Book value doesn’t recognise losses in asset values due to adverse interest rate changes, and it tends to defer write-downs of bad loans. However, market value accounting can be difficult to implement and it introduces unnecessary variability into an FI’s earnings as any change in the asset’s value needs to be recorded, even when the gain/loss isn’t realised (only realised once sold). An FI is insolvent if the market value of its assets is less than that of its liabilities. Losses in asset values are borne first by the equity holders. Only if losses exceed the value of equity will liability holders be affected. Reasons for regulating capital:
To limit risk of failures To preserve public confidence To limit losses to the government which arise from deposit insurance claims
Regulation mitigates the moral hazard which is created by government insurance which leads to banks taking on bigger risks and depositors monitoring less. Therefore if implemented well, capital regulations can lower systemic risk. Total capital = Tier 1 capital + Tier 2 capital Tier 1 = common stock, surplus, retained earnings, noncumulative perpetual preferred stock. Tier 2 = reserves for loan and lease losses, various convertible and subordinated debt instruments. RAA = RAA include on AND off BS assets. Mortgage insurance will reduce the risk weight on mortgages. The loan valuation ratio is the value of the loan relative to the value of the property. They higher the ratio, the higher the probability of default, the higher the risk weight. With off BS activities, they need to be separated into market and non-market related transactions. Market related ones are loan commitments, LoCs, because the risk weight depends on the risk of the
counterparty. Non-market related ones are derivatives (carry no default risk) and OTCs (futures, swaps) which carry the counterparty’s default risk. For non-market related off BS transactions, multiply the face value by the conversion factor which gives the credit equivalent amount, and then multiply it by the relevant risk weight, sum them all up. For market related ones, the credit equivalent amount is potential exposure (risk that the counterparty to the securities contract will default in
