Capital Requirements Ratio
- 05:27
Considers the different capital requirements ratios that banks are subject to, and provides an overview of how risk weighted assets (or RWAs) and regulatory capital can be calculated.
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Transcript
Risk weighted assets or RWA is positively correlated to the value of the assets on the balance sheet and the riskiness of the assets.
The more risky the assets that a bank holds, the more capital it needs to hold to provide an effective buffer against bankruptcy.
A bank with a balance sheet of more risky assets will have a higher RWA than a similarly sized bank with less risky assets.
The bank with the riskier assets will need to hold a relatively higher amount of regulatory capital to take account of the fact that there is a higher risk of losses with more risky assets.
This is the concept behind RWAs.
Regulators also govern what can be used as regulatory capital, what can't be used as regulatory capital.
And in the instance of qualifying capital, different levels of quality. Capital adequacy ratios are calculated by dividing the qualifying regulatory capital of a bank by its RWA.
There are many different categories of capital under the Basel banking regulations, and therefore there are many capital adequacy requirements a bank must comply with. At a high level, there are two approaches to calculating a bank's RWA under the Basel rules.
The first is the standardized approach where the bank applies risk weights given by their regulators to different types of assets.
The riskier the asset, the higher the weight, and the more regulatory capital the bank is required to hold.
The alternative approach is the advanced approach in which the bank uses their own internal models.
To assess the riskiness of their assets, they must demonstrate the robustness of these internal models to their regulators.
The advanced approach typically results in lower capital requirements.
Since the bank has been able to demonstrate the robustness of its own internal risk assessment, approaches to the regulator and having strong internal controls is also assumed to reduce the risk of bankruptcy within the bank.
For example, under the advanced approach to assess capital requirements for market risk, banks can use the internal models approach IMA, which is usually based on expected shortfall or value at risk.
An internal rating based approach or IRB can be used for credit risk.
While for counterparty credit risk, the bank can use the internal modeling method IMM approach.
This slide shows a selection of standard or standardized approach risk ratings for different types of assets using S&P credit ratings as determined by the Basel Committee on Banking Supervision and published under the Basel Accords, national regulators have scope for discretion on these risk weights through their local implementation of the Basel rules.
Under the Basel three framework, the government debt of highly rated countries such as the US has a risk weighting of 0%, meaning that no regulatory capital is required to be held by a bank which holds these bonds as assets on its balance sheet.
However, a weight of 150% is applied to the value of corporate bonds with a credit rating below B minus due to the increased risk of default for this asset type.
For residential mortgages, the standardized approach risk weighting is only 35% because the house purchased with a mortgage loan acts as collateral, therefore, reducing the risk of loss faced by the bank if the homeowner defaults on their mortgage loan.
Under the Basel Accord, there are various different tiers of qualifying capital.
Common equity, tier one or CET1 capital mainly consists of paid up share capital or common stock, and its associated share premium or additional paid in capital accounts retained earnings and accumulated other comprehensive income and other reserves.
However, a number of important deductions are made from these items, including goodwill and other intangible assets such as deferred tax assets.
CET1 capital is considered the highest quality regulatory capital.
Additional tier one AT1 capital consists of paid up capital instruments such as preference shares and hybrid debt instruments called contingent convertibles, which are able to be written down or converted to CET1 instruments.
If the CET1 ratio falls below a certain level, AT1 instruments must not have any features that could hinder the recapitalization of the institution through additional fundraising if the trigger event occurs.
Total tier one capital is the sum of its CET1 and 81 capital tier 2 capital includes certain capital instruments and subordinated loans, which are harder to liquidate than tier 1 capital. Tier two instruments must be wholly subordinated to the claims of all non subordinated creditors.
A bank's total capital is the sum of its tier 1 and tier 2 capital.