#11148 - Safety And Soundness - Federal Banking Regulation

Safety and Soundness

1. In General

   1. keeping banks safe and sound represents the central concern of bank regulation and the overriding objective of bank regulators

2. Capital

   1. Leverage Limit (MUST BE 4%)

      1. Leverage Ratio = Tier 1 Capital/Total Assets

         • Tier 1 Capital = Common Shareholders' Equity + Noncumulative Perpetual Preferred + Minority Interests in Consolidated Subsidiaries

      2. Leverage Ratio MUST BE 4%

   2. Risk-Based Capital Ratio (MUST BY 8%)

      1. Risk-Based Capital Ratio = Total Capital (Tier 1 + Tier 2)/Risk-Weighted Assets

         • Total Capital - SEE CHART ON pg. 265

           • Total Capital = Tier 1 Capital + Tier 2 Capital

           • Tier 1 Capital = Common Shareholders' Equity + Noncumulative Perpetual Preferred + Minority Interests in Consolidated Subsidiaries

           • Tier 2 Capital

             • NO LIMIT:

               • Cumulative preferred (perpetual or long term), long-term preferred, and convertible preferred)

             • ONLY UP TO 50% OF TIER 1:

               • Intermediate-term preferred

               • Subordinated Debt

               • Debt-equity hybrids, including perpetual debt

             • TIER 2 CAPITAL IS ONLY INCLUDABLE UP TO THE AMOUNT OF TIER 1 CAPITAL

         • Risk-Weighted Assets

           • Step 1: Sort assets (on balance sheet) into risk-weight categories

             • (1) 0% for assets having essentially no credit risk

               • cash, foreign currency, obligations of the U.S. government and certain foreign governments, balances kept at the Federal Reserve or certain foreign central banks, and gold bullion

             • (2) 20% for assets having slightly more credit risk

               • U.S. state and local government obligations, obligations conditionally guaranteed by the U.S. government, claims against U.S. banks, and Mortgage-backed securities backed by Fannie Mae or Freddie Mac

             • (3) 50% for certain assets having additional credit risk

               • first-mortgage loans on one- to four- family residences and revenue bonds issued by state and local governments

             • (4) 100% for all other assets

               • loans to private borrowers, the bank's own premises and equipment, and real property acquired by foreclosure or otherwise in satisfaction of a debt

           • Step 2: Take each class of the bank's off-balance sheet items and multiply the face value by the appropriate "credit-conversion factor" to produce the "credit-equivalent amount."

             • a 100% factor applies to "direct credit substitutes"

               • financial-guarantee-type standby letters of credit, assets sold with recourse, and legally binding commitments to purchase assets on specified future dates

             • a 50% factor applies to "transaction-related contingencies"

               • performance-based standby letters of credit (such as those backing labor and materials contracts and subcontractors' and suppliers' performance), the unused portion of lines of credit (including home-equity lines of credit) made for more than one year.

             • a 20% factor applies to commercial letters of credit

             • a 0% factor applies to

               • the unused portion of lines of credit expiring within one year if the bank regularly reviews such lines and cancel them at any time and the unused portion of retail credit card lines of credit that the bank has the unconditional right to cancel at any time

           • Step 3: Sort the "credit-equivalent amounts" above and sort them into risk-weight categories

           • Step 4: Multiply the dollar total for each of the four risk-weight categories by the relevant percentage for that category

           • Step 5: Total all four risk-weight categories. The sum = the bank's "risk-weighted assets"

      1. Risk-Based Capital Ratio MUST BE 8%

   3. Tier 1 Risk-Based Capital Ratio = Tier 1 Capital/Risk-Weighted Assets

   4. Basel II

      1. Reform to Basel II prompted by limitations of Basel I:

         • (1) Simple risk-weighting approach did not adequately differentiate between assets that have different risk levels

         • Although the simple risk-weighted approach is an adequate capital framework for most banks, it has proven to be inadequate with respect to the larger, more complex banking institutions.

         • Basel I's risk-weighting categories lacked accuracy and failed to accurately reflect certain banks' risk profile

           • e.g. all commercial loans were assigned to the 100% risk-weighted category.

           • This led banks to structure their activities to take advantage of the limitations in the regulatory capital framework (regulatory capital arbitrage)

             • This led to banks increasing their actual risk exposure without a commensurate increase in capital

         • (2) Basel I only offered a limited recognition of credit risk mitigation techniques (e.g. hedging with derivatives)

         • (3) Basel I did not explicitly address all the risks faced by banking organizations

         • Basel I did not recognize all the various risk categories (it only focused on credit risk and later market risk)

           • Categories of Risk:

             • Credit risk: potential for loss from borrower or counterparty's failure to perform on an obligation

             • Market risk: potential for loss from movements in market prices, including interest rates, commodity prices, stock prices, and foreign exchange rates

             • Interest rate risk: potential for loss from adverse movements in interest rates (a type of market risk)

             • Operational risk: potential for loss from inadequate or failed internal processes, people, or systems or from external events

             • Liquidity risk: risk that a bank will not be able to meet its obligations as they come due because it cannot liquidate assets or obtain adequate outside funding

             • Concentration risk: risk arising from any single exposure or group of exposures with the potential to produce losses large enough to threaten the bank's health or ability to maintain its core operations

             • Reputational risk: potential for loss from negative publicity about the bank's business practices

             • Compliance risk: potential for loss from violating law, internal policies, or ethical standards

             • Strategic risks: potential for loss from adverse business decisions or poor implementations

           • Basel II sought to remedy this by adding an explicit capital charge for operational risk and by using supervisory review (already a part of U.S. regulatory practice) to address all other risks

         • (4) Also, significant financial innovations occurred between the implementation of Basel I and Basel II

           • This includes the creation of advanced risk measurement techniques, including economic capital models, of which regulators encourage the use of both as a an element of strong risk management and as such techniques may provide useful input to the supervisory process

             • Economic Capital Models seek to value a bank's assets and liabilities at market price, take account of the full range of risks the bank faces, and make sure the bank has enough capital to handle its risk exposure.

             • Basel II sought to better align regulatory capital (standards for solvency that support the safety and soundness of the overall banking system) and economic capital (defined by management for internal business purposes)

      2. By more closely aligning regulatory capital methodologies with the banks' internal capital methodologies, Basel II aimed to encourage large banks to develop and maintain a more disciplined approach to risk management

         • Three Pillars of Basel II to address risk:

           • (1) Minimum Capital Requirements

             • Uses the advanced approach for credit risk (known as the advanced internal ratings-based approach) which uses risk parameters determined by a bank's internal systems for calculating minimum regulatory capital

               • This approach increases both the risk sensitivity and the complexity of such calculations

           • Under the advanced approach for operational risk (known as the advanced measurement approaches), a bank is to use its internal operational risk management systems and processes to assess its need for capital to cover operational risk

             • This method provides banks with substantial flexibility and does not prescribe specific methodologies or assumptions, but it does specify several qualitative and quantitative standards

           • (2) Supervisory Review

             • Explicitly recognizes the role of supervisory review, which includes the assessment of capital adequacy relative to a bank's overall risk profile and early supervisory intervention that is already a part of the U.S. regulatory scheme

           • (3) Market Discipline in the form of increased public disclosure

             • Establishes disclosure requirements that aim to inform market participants about banks' capital adequacy in a consistent framework that enhances comparability

   5. Basel III

      1. Key Terms (Upon Full implementation of which will take place over a couple years in order to mitigate against harm to credit availability)

         • (1) Tier 1 Capital

           • Tier 1 Capital Ratio = 6%

Core Tier 1 Capital Ratio (Common Equity after deductions) = 4.5%

• This is in contrast to Basel II of which only requires Tier 1 capital ratio = 4%
  Core Tier 1 capital ratio = 2%

• (2) Capital Conservation Buffer

  • Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.

  • Capital Conservation Buffer of 2.5 percent, on top of Tier 1 capital, will be met with common equity, after the application of deductions.

    • This is in contrast to Basel II, of which has no capital conservation requirements

    • The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.

• (3) Countercyclical Capital Buffer

  • A countercyclical buffer within a...