In the business of taking risk on both sides of the balance sheet, holding capital is necessary to provide protection against unexpected losses. This is not the same as expected losses, which are covered by provisions, reserves and current year profits. Basel I map out the risk weights for any credit (counterparty) exposure for on-balance sheet assets, as well as further mapping it into off-balance sheet assets, namely derivatives (think a swap in default (e.g. swaps, options) and non-derivatives (credit lines like guarantees, loan commitments, banker’s acceptances), with conversion factors into credit equivalent on-balance sheet exposure. While Basel I address the shortcomings of bank’s capital-to-asset ratio as bank’s financial health, it does not account for risk taken in bank’s trading book and non-trading book (for hedging of postions in trading book). This is addressed and implemented 10 years later 1998 with a “1996 Amendments” or BIS98.
Each country’s banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation, because the legal framework varies in different legal systems. While some countries enforce the regulation rules faithfully, there are also some countries who always seek to exploit loopholes or construct new alternative ambigous, misleading structures or procedures. Paradoxically, such act is refuting the initial reason why BIS arranged for meetings among OECD member countries before 1988.
Before 1988… Banks were not as integrated before globalisation i.e. holding each other’s capital or borrowing from each other. Banks with more liberal lending standards or loose capital regulatory capital ratio requirements. This gave them an unfair competitive advantage which encouraged for a standardisation of minimum capital holdings among banks in OECB. Members of OECB who joined the BCBS had 0 risk weights on claims on their debt such as T-Bonds, as well as low 20% RW on their banks and public sector entities. However, it also creates a deterrence for investors holding assets from countries who did not adopt the Basel Accord, as they face a more restrictive capital requirement (e.g. developing countries assets have 100% RW).
Of course, since GFC 2008, things changed slightly to the risk adverse side. Policymakers reward banks who follow the guidelines such as paying smaller contributions to the FDIC if it keeps a higher capital reserve. Market being so transparent have all participants rewarding the financially healthy, while penalising the financial unsafe by shrinking their equity.
Below, I summarise the “need-to-know” definition of what constitutes the definition of inclusion into capital reserve tiers that banks constantly monitor and borrow/lend overnight in their group of banking association to meet the capital requirement.
Tier 1 Core Capital
- make up at least 50% of bank’s capital base <=> at least 4% of credit RWA
- disclosed, transparent, published reserves from post-tax retained earnings… common among all countries banking systems
- no contractual obligation to pay dividends or interest to Tier 1 holders with the deferral or substitution of a coupon usually being at the option of the issuer
- deferred coupons or dividends are non-cumulative (any backlog of dividend must be paid before dividends are paid out)
- liquid, able to absorb losses before debtholders (creditors) as soon as they occur
- preferred (more seniority to claims during loss recovery or on limited dividends, dividend is regular and fixed like fixed income, hence stronger relationship with interest rates), perpetual, non cumulative shares
- e.g. common shares (>= 2% credit RWA), disclosed reserves (increased with post-tax retained earnings and share premiums and other fully paid up surplus), non-cumulative preferred stocks => This explains why equities are more volatile and fluctuates more than fixed income, given they are the first in-line capital to aborb losses, whereas senior debt is need to be protect most as they are needed to cover liabilities in the event of liquidation.
Tier 2 Supplementary Capital
- Tier 1 at least 50% of bank’s capital base <==> Tier 2 at most 100% of Tier 1
- less liquid and hence less accurate measurement of fair value due to varying value of illiquid premium
- Upper level Tier 2 capital – perpetual, senior to preferred capital and equity, cumulative and deferrable coupons, interest and principal that can be written down
- Lower level Tier 2 capital – inexpensive for a bank to issue but coupons are not deferrable without triggering default. e.g. >= 5yr subordinated debt
- only 25% of a bank’s total capital can be lower Tier 2
1. Undisclosed reserves
- Similar to disclosed reserves, they are not encumbered by any liability hence should be freely and immediately available to absorb unforeseen future losses
- Though reserve is not in the bank’s published balance sheet, losses will pass through P/L accounting accepted by the bank’s supervisory authorities before charging on fund
- contituted in various ways according to differing legal and accounting regimes in member countries
- many countries do not recognise undisclosed reserves as an accepted accounting concept hence neither as a legitimate capital reserve. Lack of transparency exlcudes them from Tier 1 capital
2. Revaluation reverses
- substantial discount to current market value to reflect for market volatility and tax charges on forced sales i.e. 55% discount on (Currency MTM value – historic value)
3. Loan loss reserves
- ineligible for inclusion if used for protecting against identified losses or identified depreciation. Only as protection for unidentified loss or depreciation
- cap at a limit of a small ~ <1% of credit WRA (banks making risky loans to borrowers), depending on credit risk measurement approach
4. Hybird Debt capital reserves
- Not in core capital because it carries dual features of equities and debt. Generally, issued by companies in growth stage who seek cheaper financing by rewarding debtholders of convertibles debt in the event of leveraging their assets with more debt financing and are willing to dilute their equity capital. Worst case is that equity underperforms if company’s growth plans are unrealised and debthodlers continue receiving lower than vanilla bond yields e.g. Cumulative preference shares
- close similarities to equities – able to support losses on an on going basis without triggering liquidation
5. Long Term Subordinated term debt
- term to maturity >= 5 years
- long fixed maturity, unsecured, and its inabiliy to absorb losses except in liquidation penalises it to a max of 50% of Tier 1 capital + (but over time) cumulative discount (amortisation) factor of 20% per yeat as a sign of the company survival
- lowest seniority to other forms of debt, including ordinary deposits – risk adverse debtholders demand higher yields hence more expensive financing option for company – so why issue? Because earlier issues (at more needy times) have indentures that mandate their status as “senior” so the next have to be “junior”
During liquidation, the seqeuence of loss recovery means no 2 different bond issuance can have the seniority ranking. Ranks are unique! So further subsequent bond issuance, given a mounting unmatured obligations, means later issuance down the road are more junior and demand a higher yields than before. That said, when such bonds secured with collaterals reaches its limit of reusing the same collateral (aka 1st, 1nd, 3rd lien and so on… each subsequent lien secured by a small fraction of the same asset) for default loss recovery, the most junior would be unsecured debts that demand much higher yields. Think “consolidated” mortgage where issue is secured by “first” mortgage on some part of issuer’s asset, but the remaining are secured by “second” lien on other part of its assets
- policymakers liken this as “canary in a mine” given its the first to give a warning of its deteriorating financials, and bond of this kind had much attention from market observers w.r.t. the parent company
- E.g. ABS junior tranches, Mezzaninec capital in private placements (unsecured, more expensive financing, structured as debt or preferred equity with seniority claim only above common shares
Tier 3 (At discretion of national authority)
- No longer in Basel III
- only for protection against a portion of market risk, not credit not counterparty risk i.e. when you expect more market risk
- Tier 1 at least 50% of bank’s capital base <==> Tier 2 + Tier 2 <= Tier 1
- At most 250% of Tier 1 capital that is required to support market risk
- needs to be able to become part of a bank’s permanent capital and absorb losses in the event of insolvency i.e. prerequisites are… unsecured, subordinated, fully paid up, no early repayment before repayment date
- maturity >= 2 yrs
- if such payments means that bank falls or remains below its min capital requirement, its subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity)
For calculating risk-weighted capital ratio, deductions should be made from the Tier1 capital base.
- Goodwill (despite having intangible value, esp if asset is illiquid) i.e acquisition at premium to NAV
- Similar idea to the blanket mortage mentioned above, double-leveraging in equity capital from securitisation multiple layerings calls for deduction
- Besides securitisation on assets, investments in subsidiaries in banking and financial activities which are not consolidated, calls for deduction to prevent multiple use of the same capital resource in different parts of the group i.e. the assets representing the investments in subsidiary companies whose capital had been deducted from that of the parent would not be included in total assets for the purposes of computing the ratio. In other words, subsidiary bank has his own capital reserve to maintain, whereas the parent cannot include the subsidiary asset after deducting its reserve as a capital reserve.
- Beyond banks holding banks, the Basel Committee considered bank’s holdings of capital issued by other banks or deposit-taking institutions, in equity or other capital forms. Such double-leveraging can have systemic dangers for the banking system by making it more vulnerable to the rapid transmission of problems from one institution to another and some members insist full deduction of such holdings. But doing so would impede desirable changes in the structure of domestic banking systems (think of a shared resource pool in insurance, think of clearing members in an exchange, think of reinsurance… they provide a source of liquidity for daily operations but pose a threat when problems spreads through the counterparties). However, reciprocal holdings of bank capital designed to artifically inflate banks capital reserve will be deducted.
- Investments in banks’s capital, or unconsolidated banking and finance subsidiary companies will deduct 50% from Tier 1 and 50% from Tier 2 capital