Since 1833

Regulatory Capital Thematic

September 2013

The Banks are suffering from a tug of war, with political pressure to increase leverage on one side and capital requirements forcing a deleverage on the other; This conundrum is further intensified by the fact that the rationale behind both forces is justifiable; With traditional methods to increase capital buffers less accessible, we ask whether an innovative funding opportunity exists.

Gregory Perdon, Eren Osman & Daniel Williams T. +44 (0)20 7012 2522 E. investment@arbuthnot.co.uk

Intentionally left blank

Regulatory Capital Thematic - September 2013

Introducing a Financial Conundrum

Many banks are finding themselves in a difficult dilemma. On the one hand, politicians and shareholders are putting pressure on these institutions to increase lending and profits by expanding leverage, whilst on the other hand regulators are putting intense pressure on banks to increase their capital buffers by reducing leverage. This presents a conundrum, which at first glance appears unresolvable due to the simple fact that one cannot increase leverage to appease politicians and shareholders whilst simultaneously respecting the prudent requirements set out by regulators. This conundrum is further intensified by the fact that both sides are right in their own respect. Institutions need to deliver profits to shareholders, lend more to banking customers but also put in place measures to promote trust and help safeguard the banking system. In this paper we investigate this conundrum and make the case that there exists a financial solution to this challenge. This technique is called Regulatory Capital Relief (RCR), a strategy implemented when a bank essentially buys insurance protection from a third party to help reduce various types of risks. When executed properly it reduces the capital required to be held by banks and can potentially offer high Income1 to third party investors, however this comes with a higher level of risk.

Why are there Regulatory Capital Requirements?

Banks serve as intermediaries between depositors and borrowers and make their revenue (spread) from standing in-between them. All assets of a bank carry an inherent risk (see bank terminology refresher, found overleaf in Box 1). If certain borrowers are unable to repay their loans, then lenders need capital of their own as a buffer to protect their depositors from the risk of losing their principal. Bank capital thus acts as a cushion to absorb unexpected losses. Regulators suggest that this capital buffer should be significant enough to weather extreme market stress. This is important because if depositors lack faith in the capital soundness or lending practices of the firm, then they may withdraw their funds. To strengthen the publics confidence in the markets amongst other reasons, regulators impose minimum levels of capital that banks must hold on the balance sheets; these are referred to as Regulatory Capital Requirements. Insulating banks from losses also reduces the potential burden on Governments (and ultimately tax payers) as they often play the role of white knight (or lender of last resort) by backstopping a banking institution in the event of insolvency. Needless-to-say steps are being taken to help strengthen the system and this is clearly a positive in the longer term. However, the efficacy of these requirements largely depends on the ability to successfully assess the default risk of the banks asset base.

Intentionally left blank

Assuming relatively low losses are incurred. Returns are subject to counterparty risk with the potential for all the capital to be lost.

Regulatory Capital Thematic - September 2013

Box 1: Bank Terminology Refresher

Banks borrow funds from one group of customers (depositors) and lend these funds to another group of customers (borrowers). Banks assets are the loans it makes and the Banks liabilities are the deposits it takes. This concept is a bit confusing, in the sense that a bank considers a loan as an asset. It makes these loans to governments by buying treasury bills/bonds (which in essence is lending to sovereigns); to corporations (in the form of loans and credit facilities) and to individuals (through mortgages, loans, overdrafts or credits cards). It would then logically follow that Bank assets are considered a liability on the balance sheet of the borrower (because the customer or sovereign must repay these loans at some point in the future). The important take-away is that each asset of a bank carries an inherent risk of the borrower failing to satisfy their obligation(s) and that some borrowers are riskier than others.

Method by which Regulatory Capital Ratios are calculated

Banks run their business based on the principle described in the old adage a bird in the hand is worth two in the bush. Uncertainty reduces the merit of an asset. When making loans to a risky borrower, banks require in exchange more collateral and a higher projected return to compensate them for the higher risk. Regulators simply want to replicate this logic when determining minimum capital requirements. Banks that hold a high percentage of risky assets should be considered higher-risk institutions and therefore would be obliged to maintain stronger capital buffers. A loan granted to the US government is more likely to be re-paid (with interest) than a loan extended to a troubled homeowner who suffers from a chequered credit history. This immediately translates into a lower back-stop capital requirement for loans granted to the former and a higher capital requirement for the latter. Regulators keep this feature in mind2 when determining the level of Risk-Based Capital (RBC) required for safeguarding investors against losses through a capital ratio3. This ratio expresses the banks total capital (not assets) against the risk-weighted average of its assets:

Ratio of Capital Safety=

(Amount of high quality capital) (Risk adjusted asset base)

Put simply, the greater amount of high quality capital a bank possesses relative to its asset base (adjusted for risk) should in theory indicate the banks degree of safety (which is a gross over-simplification). In contemplating this equation one should carefully consider the fact that not all capital on a banks balance sheet can be used in calculating the ratio under Basel III (see Appendix 1). A banks capital can be classified4 into Tier 1, Tier 2 and others. Tier 1 is the nucleus of total capital, which the bank has full control over, to deploy immediately in the event of losses. Tier 2 is a form of capital that may convert into Tier 1 at a point in the future. Another feature of this type of capital is that there is little obligation to return it immediately to investors. If push were to come to shove and the losses were to exacerbate beyond the level that can be met by Tier 1, then the bank may look to Tier 2 capital for additional buffer. All other forms of capital are classified under others category. Regulators (under Basel III) only consider Tier 1 and Tier 2 as eligible capital when computing the banks capital ratio.

Based on OECDs country risk classification the US has a lowest rating of 0 (on scale of 0-7), US T-Bills are considered the high quality liquid asset as per Basel III, and are risk weighted at 0% in the Basel II standardised approach. It should also be noted that because a US T-Bill is a short-term, zero-coupon obligation maturing in less than one year, the duration of the security will be very low in light of the fact the weighted average time until all the related cash flows are received is low. Duration is a measure of how sensitive the price of a bond is to the movements in interest rates. Thus a short maturity T-Bill is considered less risky than a comparatively longer duration bond. Low price volatility signifies low risk to Net Asset Value of the bond portfolio. 3 Also known as Capital Adequacy Ratio (CAR): Capital ratio=(Total Capital (Tier 1+Tier2))
2

Additional details on the components of Total capital and its placement on the balance sheet are provided in Section XX

(Risk weighted assets)

Regulatory Capital Thematic - September 2013 But merely holding higher total capital is not the only measure of the stability and the solvency of a bank. If this were the case, then the biggest banks with the largest capital bases would be considered the safest and we all know this is not true. The riskiness of the banks asset base is equally important. This is represented by the denominator of the capital ratio. Assets that are more risky are assigned a higher weight and the assets that are less risky are assigned a lower weight. Assets are respectively multiplied by their risk-weighting and then summed to determine the overall riskweighting of the portfolio. Thus, in effect, a portfolio with more risky assets would result in a bigger denominator. It would then follow that banks could improve their capital ratios by either a) holding more regulatory capital (raising the numerator) or b) shedding risky loans and thus reducing the denominator. From the illustration found in Box 2 overleaf, we quickly realise that regardless of Bank A holding less capital than Bank B, the former maintains a higher Capital Adequacy Ratio because it is assuming less risk. Its loan book relative to Bank B is comprised of lower risk-weighted assets, whilst Bank Bs loan book contains higher risk assets (such as Sovereign debt of a previously defaulted nation). This approach of risk-weighting assets helps investors and regulators make fairer and easier comparisons between banks that are operating across different geographies and national structures.

Intentionally left blank

Regulatory Capital Thematic - September 2013

Box 2: Case Study: Calculation of capital ratio from the Balance sheet of two banks
Assets US T-bills Mortgages AA Corporate Bond BB Sovereign (Defaulted) Total Assets Preferred stock + Shareholders equity Bank A 300 300 200 100 900 40 Bank B 100 200 300 400 1000 50 Liabilities Deposits Senior debt Subordinate debt Hybrids Total Liabilities Bank A 600 250 10 860 Bank B 600 340 5 5 950

As per the Balance sheet the two banks have different assets and liabilities. Bank A has lower total assets and lower shareholders equity than Bank B. In order to determine their capital ratio we need to estimate their Total capital and Risk weighted assets. Total capital = Tier 1 capital + Tier 2 capital, and in this example: Tier 1 capital = Shareholders equity + Preferred stock Tier 2 capital= Subordinate debt + Hybrids Bank As Total capital = 40 + 10 = 50 Bank Bs Total Capital = 50 + 5 + 5 = 60 Risk weighting of assets

Assets Risk weights

US T-Bill 0%

Mortgages 50%

Corp Bonds 100%

Sovereign (default) 150%

Risk weighted assets are calculated by multiplying assets with their respective risks. US T-bills which is one of the least risky assets is assigned a risk weight of 0%. The weights increase as the risk increases. A risk weight of 150% (>100%) for sovereigns that have defaulted in the past signifies that the regulators want banks to keep reserve capital far more than their original investment in such countries. It is also a way to desist banks from holding such investments. We calculate the Risk weighted assets: Bank As RWA = (300 x 0%) + (300 x 50%) + (200 x 100%) + (100 x 150%) = 500 Bank Bs RWA = (100 x 0%) + (200 x 50%) + (300 x 100%) + (400 x 150%) = 1000 Having calculated both the total capital and the risk weighted assets, the capital ratio can be determined for these two banks:

Ratio of Capital Safety=

Bank As Capital ratio = 50 / 500 = 10% Bank Bs Capital ratio = 60 / 1000 = 6%

(Amount of high quality capital) (Risk adjusted asset base)

Source: Arbuthnot Latham & Co, Limited

Regulatory Capital Thematic - September 2013

Why are the Regulatory Capital Requirements Increasing?

Banks deal with other banks both domestically and internationally. Similarly to customers, banks too should have credence in the soundness of their counterparty. Since different countries have different regulations, an International convergence of common capital standards is required. The Bank for International Settlements (BIS) has led efforts on this front for many years; it has put forward agreements between members on banking regulation. The capital requirements under the second accord, Basel II have been criticised as being too weak and is said to have helped to exacerbate the Global Financial Crisis (GFC). The BIS has worked hard to amend the accord and the latest version Basel III, raises capital requirements significantly with the objective of ring-fencing the banking sector from potential fallouts. Basel III regulations are designed to enhance supervision at both the macro and micro prudential levels (see Appendix 2). These regulations seek to raise the resilience of individual banks during periods of stress as well as keep at bay the system wide risks that can build across the banking sector due to pro-cyclical amplification. Basel III proposes to strengthen the three pillars of Basel II (See Figure 1).

BASEL II
Pillar I Pillar II Pillar III Pillar I

BASEL III
Pillar II Pillar III

Minimum Capital Requirements

Supervisory Review Process

Disclosure & Market Discipline

Enhanced Minimum Capital & Liquidity Requirements

Enhanced Supervisory Review Process for Firm-wide Risk Management and Capital Planning

Enhanced Risk Disclosure & Market Discipline

(Figure 1) Source: Moodys analytics, Basel III New Capital and Liquidity standards The benefits yielded by these additional capitalisation requirements are widely debated. The proponents argue that there are significant macroeconomic benefits from raising equity. More equity/Tier 1 capital will lower the leverage of the banking sector and thus reduce the risk of bankruptcies. But critics highlight the cost of implementing these increased capital requirements. This cost may in turn increase the price of their lending and if the cost for customers to borrow increases then this could potentially postpone important spending or hiring decisions (especially by SMEs5) which may hurt much needed economic growth.

Introducing Regulatory Capital Relief Strategies

If capital requirements are increasing then banks need to take action and one way banks can reduce their capital requirements is to engage in Regulatory Capital Relief transactions. In simple words, there are strategies which bundle together highly weighted risk assets and in turn lay-off some or all of the risk to a third-party investor in exchange for a fee.

Small and Medium Enterprises

Regulatory Capital Thematic - September 2013 There are a small number of specialist managers (representing investors) that can offer this solution. The idea behind the strategy is that a group of investors sell loss protection against parts of a banks asset book. As a result of the bank buying this protection against potential losses, they are able to carve out and genuinely re-assign part of their risk to an unrelated party. The rationale behind such an initiative is to reduce the amount of assets, which are eating disproportionately into their capital buffers. Typically, these risk-sharing transactions work by repackaging parcels of assets, such as corporate loans or counterparty risk and by transferring a portion of this risk, to a non-bank investor. This new entity then agrees to absorb the first or second tranche of losses should the loans go bad or counterparties default. As discussed earlier, capital ratios are a function of eligible capital divided by risk weighted assets. If the denominator (amount of risk weighted assets) decreases, the overall ratio will increase (all else held constant). If a bank needs to increase its capital ratio this represents a viable solution for consideration and helps to reconcile the high cost of holding these assets with the need to continue lending money to clients, which is often crucial to winning other parts of their business.

Reinsurance & Securitisation

The regulatory capital relief process is not dissimilar to reinsurance. Reinsurers are the insurers for the insurance industry and their business models are widely used by high profile investors such as Warren Buffett. A reinsurance transaction begins when an individual or company takes out an insurance policy and pays their premiums to an insurer. The Insurer then continues to sell additional policies to diversify its client base. But an insurers ability to diversify is often constrained6. This then encourages the insurer to enter into a contract with a reinsurer to share some of the risks. The two parties enter into a legal agreement, which triggers when losses go beyond a certain pre-defined threshold. For example, in a hurricane prone area the insurer may negotiate a contract with the reinsurer such that damages of up to 5bn (first-loss and most risky) will be covered by the original insurer, but should damages rise to between 5 - 10bn (the second loss and in theory less risky), then the contract would activate and the second-loss protection would be paid out by the reinsurer to the original insurer. The original insurer would then pay out the full 10bn to its policyholders. In reality the insurer has only paid out 5bn minus premiums collected plus premiums paid to reinsurers. The reinsurer diversifies its risks by entering into contracts with various other originating insurers in different geographies, countries, demography etc. One of the ways reinsurance and regulatory capital solutions diverge is that the process of laying off risk in an insurance sense tends to protect against very specific perils (such as a hurricane in a specific area) whereas regulatory relief tends to refer to potential liabilities arising from hundreds if not thousands of potential individual losses but is rarely linked to the same event. It is for this reason a few words on securitisation might be appropriate. In a securitisation process, the sponsor bank forms a special purpose vehicle, which issues securities7 to investors. These securities are backed by the loans made by the bank. Tranches or slices8 of these securities are created from the pool of assets, based on seniority. The incoming cash flows (repayment of interest) first pay the most senior (least risky) tranche, then the next one down and so on in a waterfall fashion. This way most of the credit risk is left to the bottom few tranches (confusingly referred to as the equity tranche). These tranches offer the highest yield but of course carry the highest risk.

Asset-backed securities (ABS) All of which combine to create the capital stack

Regulatory Capital Thematic - September 2013 Securitisation allows banks to bundle together assets into one structure and stack them in decreasing order of their inherent risks. This stack is analogous to a tall building, comprising of say ten floors. Assuming the sole tenant only uses the tall building for the warehousing of goods and the structure is located in a flood prone area, the occupier would probably store their least valuable goods9 on the ground floor and most valuable goods10 on the top floors. In the hypothetical event of a modest flood only the goods on the ground floor would be damaged or washed away, whilst goods stored on higher floors (more expensive to replace) would probably remain undamaged. If the calamity prolongs and water continues to rise to subsequent floors, the accumulated losses would grow. This is where the reinsurance example is complimented by a securitisation illustration, in that the occupier might agree with their business partners that they could weather a modest flood themselves (selfinsure with their own reserves) but if the flood were to be significant, their reserves would not be deep enough to keep them in business (even though their most valuable goods were stored high up top). In order to protect their business, they may decide to accept the first loss (ground and first floor) and lay off the second loss (say, 2nd, 3rd and 4th floors) to a third party in exchange for a fee paid by the occupier. The theory says that in this scenario the business strengthens due to its risk reduction strategy, which in turn offers the management team the option of either remaining conservative or embarking on an aggressive growth strategy.

Intentionally left blank

10

Highest credit risk Lowest credit risk

Regulatory Capital Thematic - September 2013

Bank A currently complying with a regulatory capital requirement of 10%

1bn Portfolio of Loans held by Bank A

1bn x 75% =

750m in Risk weighted assets

750m x 10% =

Bank holds 75m required capital

Bank As Risk weight = 75%

Capital Ratio = 10%

Consider Bank A, which holds a loan portfolio of 1bn. The composition of its assets is such that after a risk weighted assessment its total Risk weighted assets are calculated as 750mn. In order to comply with a simplified capital ratio of 10%, the bank should maintain a capital base of at least 75mn. In the case of Bank A, the capital requirement has been satisfied. Bank B has a similar quality asset base also holding 1bn in loans and 750mn in Risk weighted assets. Under the same regulatory requirement Bank B would also be required to maintain a 10% capital ratio, i.e. hold 75mn of eligible capital. Unfortunately Bank B recently faced several external problems and now holds a reduced capital base of only 30mn. With a capital ratio of only 4%, it stands well below the regulatory requirement of 10%. Regulators rightfully put pressure on Bank B to increase its buffers, but existing shareholders prefer to avoid diluting their holdings via further equity issuance and Bank B would prefer not to limit itself with potential legal covenants by funding through debt. Bank B seeks to explore a regulatory capital relief strategy.

Bank B currently not complying with a regulatory capital requirement maintaining a Capital Ratio of 4%

1bn Portfolio of Loans held by Bank B

1bn x 75% =

750m in Risk weighted assets

750m x 10% =

Bank holds only 30m in Eligible Capital which is far below the 75m required, with a short-fall of circa 45m.

Bank As Risk weight = 75%

Capital Ratio = 4%

Regulatory Capital Thematic - September 2013

Regulatory relief transactions:

In preparation for a Regulatory Relief Transaction, Bank B segregates its asset base into pools and stacks them in order of seniority with the most senior tranche containing the least risky paper (top floor). In this example the senior paper is rated AA and carries the low risk weighting of 8%. The highest risk tranches (ground and first floors) carry a high risk weighting of 1250%11. Out of the total asset base of 1bn only 80mn are classified into this category (15mn on the ground and 65mn on the first floor). The Bank seeks to reinsure most of the first floor (65mn x 95%) with an outside capital relief provider. In light of the fact that this first floor tranche is heavily risk weighted, the process of transferring a large part of it to a third party (in exchange for a premium), assists the bank in significantly reducing its risk weighted asset base. But why are they only transferring 19/20 of the first floor and retaining 5% of the risk? In this transaction the bank signals to the market that it too will lose capital if the loans default, the objective is to demonstrate a degree of risk sharing. As a result, of the risk transfer the risk weighted assessment of its assets is reduced to just shy of 302mn and the banks current level of capital 30mn is just about sufficient to meet the simplified 10% regulatory capital ratio requirement in this simulation.

Bank B through a capital relief transaction, the simplified regulatory requirement of 10% is now satisfied.
The senior tranche is AA rated with a risk weight of only 8%. 1bn-65m15m-920m

The Regulatory Capital Relief strategy provides reinsurance for 19/20 or 95% of the rst oor

920m stacked portfolio of AA rating

1/20 of 65m of rst oor is still with Bank B. Its risk weight is 1250%

A risk-based assessment of the assets: 920m x 8% = 73.6m 65m x (1/20) x 1250% = 40.6m 15m x 1250% = 187.5m Total RWA = 73.6 + 40.62 + 187.5 = 301.7m

Relief 19/20 of 65m

19/20 of 65m of risk 15m rst loss

Ground oor: Unrated and completely retained by Bank B. Risk weight 1250%

30.2m in risk-weighted assets after capital solution transactions

302m x 10% =

30.2m required Capital Ratio = 10%

Bank As Risk weight = 30%12

Weighted average of first loss, senior tranche and retained vertical slice, this retained slice represents 1/20 of the second tranche. Bank Bs risk weight = 920 x 8% + 3.25 x 1250% + 15 x 1250% = 302mn 12 Unrated first loss positions in securitisation transactions have to be risk weighted a 1250%
11

Regulatory Capital Thematic - September 2013

Why should banks seek relief, why not raise capital the old fashion way?
Regulators want banks to prop up their balance sheets and retain adequate capital to meet future unexpected liabilities. Theoretically, banks should just recapitalise using the typical ways (equity or debt issuance). Pedants could even argue that it is the best way to capitalise, will make the banking system most robust and should improve the general welfare of society. Sceptics have argued that capital relief strategies are akin to patching a tyre; whilst raising capital the old fashion way is simply replacing the punctured tyre. We side-line ourselves from this belief and consider a banks route to increasing its capital base as a purely economic decision. Even if we ignore the fact that in the current economic environment banks are challenged to raise capital at a price close to their appropriate valuations; banks need to consider the cost and returns of each method before making a final decision. The direct cost of issuing additional equity is the compensation (dividend pay-out) that investors demand, in the immediate year and/or through the increased growth of dividends in the future, in exchange for holding the assets of the company and bearing the risk of ownership. However, from the existing shareholders perspective, additional equity issuance13 has an indirect cost as it dilutes their ownership in the firm. Shareholders understand this and commonly, when firms issue additional equity, the market penalises it by de-rating and selling the companys shares. Alternatively, raising capital by issuing bonds safeguards shareholders from relinquishing their share of the company and lowers a firms tax base14 but debt issuance can present other challenges to both the firm and its investors. An institution that is highly leveraged is more prone to cash flow difficulties as it has to meet interest payments irrespective of income and could find itself in a more vulnerable position during an economic or financial market shock. Additionally, if the debt is issued with strict covenants, the firms freedom to operate may be constrained. Regulatory capital relief strategies can in some cases help improve the capital ratio of the bank but can also impact other performance measures of the firm such as Net Income and Return on Equity15 in light of the costs associated with these transactions. A detailed analysis of these remains outside the scope of this report but banks need to carefully analyse the trade-off before committing to a strategy. At times, patching a punctured tyre until a future date may best serve the objectives of the company at that point in time.

10

If unaccompanied by an equivalent increase in assets As debt payments are tax-deductible Net Income) 15 A measure of firms profitability, i.e. the amount of profits a firm generates with the money that shareholders have invested. ROE= Shareholders sequity
13 14

Regulatory Capital Thematic - September 2013

Engaging in Regulatory Capital Relief Strategies carries Risks

Several risks16 exist which are worth consideration before committing investor funds to these strategies. For example, were the regulators to believe that the scale, scope or spirit of these strategies were becoming overly aggressive, they might quickly enforce stricter regulation making the strategy impractical. Another risk relates to the information asymmetry inherent in these transactions, whereby the bank selling the risk would normally have better knowledge of the assets than the buyer and as a result may only make available the higher risk loans for the transfer whilst preserving the low-risk assets for themselves. Investors need protection against this eventuality and a second round of re-underwriting could serve as a credible defence. Investors should also be aware that certain market participants may abuse the strategy. This could be achieved by appearing to enter into a transaction but not genuinely shedding the risk to a third party, or the selling bank seeking to achieve ultra-high returns by deliberately using the released capital to increase risk disproportionally. However, these two risks tend to affect the bank more than the investor being compensated to assume a specific risk. And finally the greatest risk resides in the potential for deterioration in the insured loan portfolio. This could be due to poor underwriting or exogenous factors such as weak economic conditions that could negatively impact the value of these investments.

Conclusion
Politicians are seeking to expand credit by urging banks to lend more freely. In the UK we are seeing country-wide initiatives such as the help to buy and funding for lending scheme as means which are designed to help the economy recover. On the other hand, we are witnessing increased regulation, which require banks to strengthen their capital buffers. From a banks point of view this has created a dilemma, which appears unresolvable. However by utilising genuine risk transfer practices, banks can unearth additional capital to meet their regulatory capital requirements and in some cases free up capital to facilitate additional lending. This strategy offers obvious advantages such as having to avoid selling prized assets at undesirable prices and/or being forced to reduce their core lending businesses but the window of opportunity may not last forever. The fact still remains whether the institution is raising capital or risk transferring, neither solution is easy or risk-free but when executed properly investors can potentially benefit from above market returns assuming they are prepared to accept the risks.

The authors wish to acknowledge and thank Mr. Jayant Yadav for his valuable contributions to this report.
16

By no means an exhaustive list

11

Regulatory Capital Thematic - September 2013

APPENDIX I Where do Tier 1 and Tier 2 capital feature on Bank Balance sheets?
Not all assets are equally risky; similarly we need to consider that not all capital is equally liquid. The effectiveness of a capital instrument in buffering against a negative event depends on the ease with which the capital can be put to use if and when required. Capital is classified on the basis of its ability to absorb losses and is divided into various tiers.

Tier 1 is the highest form of bank capital, it is permanent, fully paid up, and the bank has these funds at its disposal. Besides common equity, the other forms of Tier 1 capital like Preferred Stock, are capable of absorbing losses and can help the institution continue trading in the event of losses up to the value of this capital. But Goodwill, an asset on the balance sheet, is not liquid enough to be capitalised in the hour of need, so it is excluded from the Tier 1 capital.

Tier 2 is the other form of capital, it may not be completely available at the banks disposal, but its structure does not impose any restrictions on the bank to use it as a secondary cushion. 1) Hybrids (with characteristics of equity and debt), 2) Subordinated debt (opposite of senior debt) and 3) Loss provisions (allowances made for an expected loss) etc. are not owned by the bank but if the expected losses go beyond the Tier 1 cover then the institution may put them into use. We have devised a particular case to help illustrate the calculation of eligible capital. See Case 1.

Case XX: Placement of capital on a banks Balance sheet

Assets Cash Interbank loans Loans Mortgages Credit card Corp Loan AAA Corp Loan BB Allowance for loss (AL) Goodwill Other assets Total assets 200 100 1250 500 200 500 100 -50 50 50 1650 Liabilities Deposit Senior debt Subordinated debt (SD) Borrowings Convertibles Total Liabilities Preferred stock Common Stockholders equity (SE) Total Liabilities + S.E 1000 200 50 150 25 1425 25 200 1650 Calculation of Capital Tier 1 Capital (Core) = Common Equity (CE) - Goodwill = 200 - 50 = 150 Tier 1 Capital (Total) = CE + Preferred - Goodwill = 200 + 25 - 50 = 175 Tier 2 Capital (Total) = SD + Convertible - AL = 50 + 25 + 50 = 125 Total Capital = Tier 1 + Tier 2 = 175 + 125 = 300

Capital ratios are calculated by dividing the capital with risk-weighted average of assets.

12

Regulatory Capital Thematic - September 2013

Appendix II Why did Basel III replace Basel II?

Basel III was launched to address the deficiencies of financial regulation that were exposed in the Global Financial Crisis. The Basel Committee on Banking Supervision17 (BCBS) aims to fill this gap through better regulation and macro prudential supervision. Basel III proposes measures to further strengthen the regulation, supervision and risk measurement of the banking sector.

What has changed in Basel III?

Basel III proposed new capital, leverage and liquidity standards to strengthen the regulation, supervision and risk management of the banking sector. The capital standards and new capital buffers will require banks to hold more capital and higher quality of capital than under current Basel II rules. The new leverage ratio introduces a non-risk based measure to supplement the risk-based minimum capital requirements. The new liquidity ratios ensure that banks are adequately funded in the short and long run and are in a better position to negotiate acute liquidity stress at the time of crisis.

Basel II vs Basel III capital ratios

14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

+0 2.5% +0 to 2.5% +0 to 2.5% +2.5% +2.5% 4% 2% Core Tier 1 ratio Tier 1 ratio Tier 1 + Tier 2 ratio +2.5% +2% 8% +2.5% Basel III countercylical buer Basel III conservation buer Basel III min. Add-on Basel III min.

Source: BIS, Moodys analytics

The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. The committee however has no legal force in implementing those standards. http://www.bis.org/bcbs/about.htm
17

13

Arbuthnot Latham & Co., Limited Registered Office Arbuthnot House 20 Ropemaker Street London EC2Y 9AR t +44 (0)20 7012 2500 f +44 (0)20 7012 2501 banking@arbuthnot.co.uk www.arbuthnotlatham.co.uk Exeter 17 Southernhay West Exeter Devon EX1 1PJ t +44 (0)1392 496061 f +44 (0)1392 495313 banking@arbuthnot.co.uk www.arbuthnotlatham.co.uk

IMPORTANT INFORMATION: The information given in this document is for information only and does not constitute investment, legal, accounting or tax advice, or a representation that any investment or service is suitable or appropriate to your individual circumstances. You should seek professional advice before making any investment decision. The value of investments and the income from them can fall as well as rise. An investor may not get back the amount of money invested. Past performance is not a guide to future performance. The facts and opinions expressed are those of the author of the document as of the date of writing and are liable to change without notice. We do not make any representations as to the accuracy or completeness of the material and do not accept liability for any loss arising from the use hereof. We are under no obligation to ensure that updates to the document are brought to the attention of any recipient of this material. Arbuthnot Latham & Co., Limited is authorised and regulated by the Financial Services Authority. Arbuthnot House, 20 Ropemaker Street, London EC2Y 9AR.

Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Regulated by the Dubai Financial Services Authority.