CAPITAL ADEQUACY

[scorpiomanoj]

Hi David,

Let us assume a bank X is having the following portfolio.

ASSETS

2 yr AAA BONDS USD 100 MIO

LIABILITIES

CAPITAL (tier I + tier II) USD 20 MIO
2 YR DEPOSITS USD 80 MIO


Let us assume the risk weight for the assets is 100 % and hence the RWA (risk weighted assets) is USD 100 MIO.
Now the capital adequacy ratio is capital/RWA, i.e., 20/100, i.e., 20 % which is consiered healthy vis-a-vis the regulatory norms of various countries being in the range of 9% to 13%.

Now let us assume that unfortunately, the issuer of the bond failed to repay at the time of maturity. I dont understand how the capital of usd 20 mio (which is considered as a readily available support against unexpected loses) play a role at this stage, ie., more generally, the real significane of capital. I feel very sorry for posing this very basic question given your current hectic schedule.
Thanks
Manoj Kumar Halan.

 

[David Harper CFA FRM]

Hi Manoj,

(Just to get into good habits: the RW for AAA will typically be 20%. It's a common test question: how much capital against $100 MM AAA? Answer: $100 * 20% RWA * 8% ratio = $1.6 MM).

To grossly round off to common equity, the capital is a residual; it is what's left over after you subtract liabilities from assets. So, A = L + E, but it may be more helpful to think of it as: E = A - L. Because common equity really is the solved-for residual; you can't count the common equity in isolation. It is not like cash in an account.

In a way, you could view the equity as "merely" excess or net assets; i.e., how many assets are "free and clear" above the claims by liabilities. The right hand side of the balance sheet is, really, a totem pole of claim: liabilities (those with prior claims) and then equity is the shareholder claims on "what's left over."

So, in your example, the bond may be downgraded (deterioration) before it defaults and losses value; say from $100 to $80. Now the common equity (highest portion of Tier 1) drops from 100-80 = 20 to 80-80=0. Immediately, that is a paper loss. The common equity on the right hand side of balance sheet isn't cash; the bank will have cash, but that will be an asset on the left hand side. But the "capital adequacy" is now zero on your sheet because: all of the assets are claimed by (owed to) creditors, nothing left over for shareholders. See how it's a measure of "excess assets?" The bank is likely to still have at least some assets to use to, say, pay depositors if they withdraw. But note it's really only a paper exercise and isn't the same thing as liquidity.

This whole capital adequacy business is pretty much another type of accounting, and therefore, may or may not speak to economic reality of the bank. This is one of the arguments against fair value accounting; e.g., assume your $100 AAA bond is the senior tranche of a structured vehicle (CDO) and it losses value from $100 to $50, yet the underlying bonds are still paying you coupon. From an economic (cash flow) standpoint, you are fine, but you (the bank) will have to sell assets or raise equity to restore capital adequacy.

In your original example, if those depositors, hypothetically, don't need to be paid (e.g., if the coupon income on deteriorated bond still funds the interest for depositors), the bank can have 0 or negative tier I account and still be meeting its obligations! Conversely, the bank can have positive Tier I but the assets are illiquid yet the deposits are short term (maturity mismatch) and the bank can still cash flow insolvent (what we call in the FRM funding liquidity risk).

I hope that helps, thank you for your kind consideration!

David

 

[scorpiomanoj]

Hi David,
Thanx very much for a well presented explanation.

 

[David Harper CFA FRM]

Manoj, sure, I found in my blog reader a *better* explanation at the excellent Baseline Scenario that you might find helpful - Cheers, David

 

[Liming]

Dear David，

The capital adequacy ratio in the example above should be 20/(100*20%*8%) = 1250%, right?

thanks.

Cheers!
Liming
03/10/09