Chapter 5 - Capital Flashcards
What is capital management in banking?
The process of managing a bank’s capital requirements, available capital, and capital adequacy.
What are the two components of a bank’s total capital requirements (TCR)?
- Pillar 1 minimum capital requirements
- Pillar 2 additional capital requirements
How are Pillar 1 minimum capital requirements calculated?
Using prescribed methodologies for credit risk, market risk, and operational risk.
What is ICAAP?
Internal Capital Adequacy Assessment Process, a bank’s internal assessment of its capital needs.
What types of capital are included in a bank’s capital available?
- Common Equity Tier 1 (CET1) capital
- Additional Tier 1 (AT1) capital
- Tier 2 (T2) capital
What is the purpose of capital buffers?
To absorb losses in severe adverse stress scenarios.
Under Basel III, what is the minimum total capital requirement for banks?
At least 8% of total risk-weighted assets (RWAs).
What is the capital conservation buffer under Basel III?
2.5% of total RWAs.
True or False: CET1 capital can be used immediately to cover losses.
True
What is the point of non-viability under Basel III?
The point at which AT1 and T2 capital can be written off or converted.
Fill in the blank: A bank’s capital must exceed its total capital requirements at all times, including under _______ conditions.
stress
What factors influence the capital management strategy of a bank?
- Capital adequacy
- Economic environment
- Risk appetite
- Acquisition considerations
What is the relationship between expected credit losses and capital resources?
Provisions for expected credit losses reduce banks’ retained earnings and capital resources.
What are the three pillars of the Basel regulations?
- Pillar 1: Quantification of capital requirements
- Pillar 2: Supervisory review process
- Pillar 3: Public disclosures
What is the role of stress testing in capital management?
To determine the capital buffer needed to absorb losses in adverse scenarios.
What is the capital buffer determined by stress testing?
The larger of the capital buffer from stress testing and the sum of regulatory capital buffers.
What should a bank do if its capital available falls close to its total capital requirements?
Move into recovery and potentially into resolution if requirements cannot be restored.
True or False: Economic capital assessments are less nuanced than regulatory capital assessments.
False
What is the expected structure of an ICAAP submission?
Influenced by the three pillars of Basel regulations.
What is a systemic risk buffer?
An additional buffer that large banks may need to hold.
What is the ‘use test’ in the context of internal models for capital requirements?
Evidence that the bank is using its own internal models for risk management.
How often must a bank carry out its ICAAP?
Once a year, and additionally in the event of a change in circumstances.
What is the impact of macro-economic forecasts on provisions for expected credit losses?
They heavily influence the amount of provisions that banks must make.
What does the term ‘TCR’ stand for?
Total Capital Requirements.
What is the significance of Tier 1 capital in a bank’s capital structure?
It must be at least 6% of total risk-weighted assets.
What is the primary function of a bank’s capital buffer?
To exceed the sum of its total capital requirements and its capital buffer at all times
A bank may dip into its capital buffer under stress conditions, but must take management actions to restore capital levels.
What is CET1 capital?
Common Equity Tier 1 capital, which must cover the required portion of total capital requirements and 100% of the capital buffer
It is a key measure of a bank’s financial strength.
What does ICAAP stand for?
Internal Capital Adequacy Assessment Process
A process that banks must undertake to assess their capital adequacy.
Who is responsible for the prudential regulation and supervision of banks in the UK?
Prudential Regulatory Authority (PRA)
A part of the Bank of England.
What are some key components that a bank must assess in its ICAAP?
- Amounts of capital
- Types of capital
- Distribution of capital
- Major sources of risks
- Stress testing and scenario analysis
The assessment must not just replicate PRA methodologies.
Define risk register in the context of banking.
A record of all material risks faced by the bank, including identified ‘risk owners’
It is often referred to as a risk taxonomy.
What are the traditional main sources of losses for banks?
- Credit risk
- Market risk
Recent years have seen substantial losses from operational risks like IT failures.
List the event-type categories of operational risk defined in Article 324 of the Capital Requirement Regulation (CRR).
- Internal fraud
- External fraud
- Employment Practices and Workplace Safety
- Clients, Products & Business Practices
- Damage to Physical Assets
- Business Disruption and System Failures
- Execution, Delivery and Process Management
These categories highlight various operational risks banks face.
True or False: The risk appetite statement is developed solely by the board of a bank.
False
It is typically developed by the board risk committee with input from the Chief Risk Officer.
What does a bank’s risk appetite statement contain?
A series of risk statements supported by triggers and limits for a range of indicators
These indicators help monitor and control risks specific to the bank.
What are the capital and liquidity indicators that banks must monitor?
- CET1 capital ratio
- Tier 1 capital ratio
- Total capital ratio
- Leverage ratio
- Liquidity Coverage Ratio
- Net Stable Funding Ratio
These indicators have regulatory limits that must not be breached.
What is the difference between the base case forecast and adverse scenario forecast?
Base case forecast reflects normal conditions, while adverse scenario forecast prepares for negative economic conditions
Adverse scenarios include higher credit and operational risk losses.
What is the standardised approach for quantifying capital requirements for credit risk?
A method that prescribes risk weights for various categories of loan assets
Risk weights vary based on credit ratings and loan types.
What is the internal ratings-based (IRB) approach?
An alternative to the standardised approach that allows banks to use their internal estimates for risk components
It consists of foundation and advanced levels.
What is the Basel III output floor requirement?
Limits the extent to which banks can benefit from internal models compared to the standardised approach
The output floor will be phased in from 2023 to 2028.
What is market risk in the context of banks?
Risk related to positions held in banks’ trading books
It can be quantified using either the standardised approach or the internal-models approach.
What are the two approaches banks may use for market risk?
Standardised approach and internal-models approach (IMA)
What document set out the revised methodologies for market risk from 1 January 2023?
Minimum requirements for market risk
What is a key feature of the revised standardised approach for market risk?
More risk-sensitive and appropriate as a fallback measure
What does the revised internal models-based approach (IMA) require?
A more rigorous model approval process
What measure of risk must banks use under stress according to the revised IMA?
Expected shortfall (ES)
What assumption must banks make regarding liquidity under the revised market risk framework?
A sudden and severe reduction in liquidity across markets
What is the difference between assets in the banking book and the trading book?
Banking book assets are held to maturity and not marked to market; trading book assets must be marked to market
How many approaches to operational risk are currently permitted?
Four approaches
What is the basic indicator approach (BIA) for operational risk?
Capital requirement is 15% of average income over the last 3 years
What new standardised approach for operational risk must banks use from 1 January 2023?
A new standardised approach that considers operational risk increases with size and past losses
How is a bank’s operational risk capital calculated under the new standardised approach?
Product of business indicator component (BIC) and internal loss multiplier (ILM)
What is the purpose of Pillar 2 in the capital requirements framework?
To assess additional capital requirements based on principles
What types of risks are not fully captured under Pillar 1, requiring additional capital under Pillar 2?
Credit risk, market risk, operational risk
What is the risk of losses arising from the default of counterparties known as?
Counterparty credit risk
What types of risks must banks consider under Pillar 2 for credit concentration risk?
Single name, industrial sectors, and geographic areas
What types of risk can arise from changes in interest rates in the banking book?
Duration risk, basis risk, optionality risk
What is the capital conservation buffer required by Basel regulations?
2.5% of total RWAs, comprised of CET1 capital
What is the purpose of a bank’s stress-testing assessment?
To quantify the capital buffer needed for adverse scenarios
What is included in the evaluation of a system-wide stress scenario?
An adverse macro-economic stress scenario
What is the capital requirement for operational risk under Pillar 2 based on?
The sum of non-conduct and conduct operational risk elements
Under what circumstances may banks need to hold additional capital for operational risk under Pillar 2?
If using a standardised approach and risks are not adequately covered
What is the loss component (LC) in calculating operational risk capital?
15 times the bank’s average historical operational losses over the preceding 10 years
What is the expected behavior of operational risk as a bank grows?
Increases at an increasing rate with size
What must banks consider when assessing their capital needs for pension obligation risk?
Possible impact of their pension fund going into deficit
What is the systemic buffer that large systemically important banks must hold?
Up to 3.5% of their RWAs, comprised of CET1 capital
What is meant by ‘business risk’ in the context of banks?
The risk of not being able to meet running costs due to a contraction in business volume
What is the approach banks must take towards the assessment of their capital requirements under Pillar 2?
Judgment-based and not prescriptive
What kind of stress test evaluates a range of severe but possible adverse scenarios?
Stress-testing assessment
What does the internal loss multiplier (ILM) relate to in operational risk capital calculation?
A function of the BIC and historical operational losses
What are the three types of risks identified under interest rate risk in the banking book?
- Duration risk
- Basis risk
- Optionality risk
What must banks do if they identify shortcomings in their market risk systems?
Hold a capital add-on under Pillar 2
What is a common scenario evaluated by larger banks in stress testing in some countries?
A common macro-economic stress scenario prescribed by authorities
What is the risk associated with a bank’s pension scheme that has an accounting deficit?
The deficit must be deducted from CET1 capital
What is the purpose of macro-economic stress scenarios in banking?
To test the effect of economic stress across the banking system as a whole.
Authorities prescribe these scenarios for larger banks to evaluate their resilience.
What does the Bank of England publish annually regarding stress testing?
A baseline economic scenario (BES) and an annual cyclical scenario (ACS).
The ACS indicates severity levels for other banks’ stress test calibrations.
What are banks expected to define in their stress tests?
Their own vulnerabilities, including operational risks such as IT failures or cyberattacks.
Banks must consider non-financial risks alongside credit and market risks.
What is a combined stress scenario?
An evaluation of simultaneous macro-economic stress and bank-specific stress.
This scenario is typically the most challenging for banks.
What is the goal of a reverse stress test?
To explore business model vulnerabilities that could lead to bank failure.
It identifies factors that might cause a bank to breach regulatory requirements.
What management actions should banks identify during stress scenarios?
Realistic and credible actions to mitigate negative impacts on capital adequacy.
Historical actions during crises, like the global financial crisis, are particularly useful.
How should the results of stress tests be presented?
Forecast total and CET1 capital levels and capital requirements in currency amounts and percentages.
This aids in understanding capital adequacy under various scenarios.
What must a bank’s capital buffer exceed in adverse scenarios?
The regulatory capital buffers required by Basel regulations.
This includes the capital conservation buffer and countercyclical buffer.
What defines a good ICAAP?
It enables understanding of risks, supports regulatory clarity, and provides a comprehensive management document.
A good ICAAP meets objectives for both the bank and regulators.
What are the principal ICAAP requirements according to the SARB?
Process for capital adequacy assessment, supervisory review, and rapid remedial action requirements.
This ensures banks maintain sufficient capital levels.
What are the seven principles outlined by the ECB for ICAAP?
- Sound governance
- Integral to management framework
- Ensures capital adequacy
- Identifies all material risks
- High-quality internal capital
- Adequate risk quantification methodologies
- Regular stress testing
These principles guide effective ICAAP implementation.
What should the ICAAP document be like for regulatory approval?
Factually correct, well-structured, and easy to understand.
Clear documentation helps facilitate board engagement and regulatory review.
What content structure is suggested for an ICAAP document?
- Summary of business plan
- Financial forecasts
- Risk register
- Risk appetite statement
- Assessment of capital requirements
- Evaluation of stress test scenarios
- Appendices
This structure aids in clarity and comprehensiveness.
What factors can influence a bank’s capital buffer determination?
Stress testing results, regulatory requirements, and potential future distributions.
A bank may set higher buffers to limit restrictions on distributions to stakeholders.
What is the role of stress testing in capital management?
To capture the range of risks and support capital planning.
It is crucial for determining adequate capital levels under various scenarios.
In ICAAP, what should be included in the assessment of capital adequacy?
Base-case conditions and various adverse stress scenarios.
This includes both regulatory (Pillar 1) and economic (Pillar 2) assessments.
What is the purpose of presenting financial information in a consistent format?
To facilitate the assessment of capital adequacy under various stress scenarios
This includes base-case conditions and adverse stress scenarios.
What are the components of Pillar 1 capital requirements?
- Credit risk
- Market risk
- Operational risk
These components are essential for calculating the minimum capital requirements for banks.
What additional risks are included in Pillar 2 capital requirements?
- Credit risk
- Market risk
- Operational risk
- Counterparty credit risk
- Credit concentration risk
- IRRBB
- Business risk
- Other
Pillar 2 requirements address risks that are not fully covered under Pillar 1.
What does TCR stand for?
Total Capital Ratio
TCR is the maximum of Pillar 1 and Pillar 2 capital requirements.
What is a capital buffer in the context of stress testing?
- Pillar 1 stress buffer
- Pillar 2 stress buffer
Capital buffers are additional capital reserves held to absorb losses during stress scenarios.
What does the term ‘capital available’ refer to?
Total capital resources that a bank can utilize
It can be assessed in relation to TCR and capital buffers.
Fill in the blank: Different banks will have different mixes of _____, AT1 capital, and T2 capital.
CET1 capital
CET1 refers to Common Equity Tier 1 capital, which is a key measure of a bank’s financial strength.
True or False: Regulators may require banks to provide tables showing monetary amounts and percentages of total RWAs.
True
This helps in understanding the capital adequacy in relation to the bank’s risk-weighted assets.
What is meant by ‘risk appetite framework’ in banking?
The strategy and guidelines that define the level of risk a bank is willing to take
This framework is crucial for determining required capital levels.
List the years covered in the capital adequacy assessment scenario.
- Year 1
- Year 2
- Year 3
- Year 4
- Year 5
This timeframe is typically used to project capital requirements and stress testing outcomes.
What is the purpose of a formal dividend policy statement for a bank?
To reflect the bank’s overall risk appetite and support capital management.
Why are dividend payments important in the capital management process?
They limit the bank’s internal capital generation.
What does a high proportion of after-tax profits paid as dividends suggest about a bank’s focus?
It suggests a lack of focus on internal capital generation for future growth.
How do start-up and mid-sized ‘challenger’ banks typically approach dividend payments?
They likely pay little or no dividends to build capital for lending growth.
What are the progressive restrictions on dividend distributions when a bank’s capital dips into its combined capital buffer?
Restrictions on dividends, variable remuneration, and discretionary pension benefits.
What is the maximum distributable amount (MDA) based on?
It is based on percentages (60%, 40%, 20%, or 0%) of interim and year-end profits.
Which organizations are responsible for regulating the banking industry in various jurisdictions?
PRA (UK), EBA (Europe), Federal Reserve (USA), SARB (South Africa).
What is stress testing in banking?
A tool to evaluate the resilience of banks under severe but plausible scenarios.
What types of risks are considered in stress testing?
Credit risk, operational risk, market risk, liquidity risk, and more.
What major risks were highlighted during the 2007–2008 banking crisis?
Concentration risk, securitisation risk, liquidity risk, credit risk.
In South Africa, how does the SARB conduct stress testing?
Through the ICAAP process and under the Banks’ Act Regulation.
What actions can the SARB take based on its review of banks’ ICAAP?
Require additional capital, remedial action, or prevent dividend payments.
What is included in the common scenario stress test conducted by the SARB?
Estimation of potential losses and capital shortfalls in systemically important banks.
What does the EBA do in terms of stress testing?
Initiates and coordinates EU-wide stress tests for financial institutions.
What is the aim of the Bank of England’s stress testing?
To assess tail risk events and the resilience of banks.
What are the three types of stress tests expected by the PRA?
- Severe macro-economic stress scenario
- Idiosyncratic stress scenario
- Combined stress scenario
What does the Federal Reserve’s CCAR require from banks?
To develop their own stress scenarios and assess capital adequacy.
What do CCAR requirements ensure for bank holding companies?
- Effective capital planning processes
- Sufficient capital to absorb losses
- Continuation as credit intermediaries
What is the main objective of a bank’s stress-testing exercise?
To assess capital adequacy over the next few years under various scenarios.
Fill in the blank: The _____ process requires banks to set scenarios that are approved by the board.
ICAAP
What types of risks are banks required to stress test according to the EBA?
- Credit risk
- Market risk
- Operational risk
True or False: The stress test scenario and modelling performed by the Federal Reserve Board is intended to illustrate likely outcomes.
False
What is a significant consideration for banks specializing in higher-risk lending during stress tests?
Potential credit losses in severe adverse macro-economic scenarios.
What is the purpose of stress tests for banks?
To assess risks and ensure capital adequacy under adverse scenarios
Stress tests help banks identify potential vulnerabilities in their financial health.
What specific risks do banks specializing in higher-risk lending focus on during stress tests?
Possible level of credit losses in severe adverse macro-economic scenarios
What is CET1 capital?
Common Equity Tier 1 capital, the highest quality capital for banks
Why is the assessment period for capital adequacy important in stress testing?
It affects how well management actions can be implemented and capital can recover after stress
What is a key consideration when determining the stress testing framework?
Whether to show outcomes before and after management actions
True or False: Management actions should be linked directly to breaches of thresholds in the bank’s risk appetite statement.
False
What are some examples of management actions that banks might take during stress scenarios?
- Cost savings
- Reductions in new lending
- Sales of loan portfolios
- Delaying distributions
What is the primary focus of ABC Bank’s ICAAP submission?
Identification of material risks, quantification of capital requirements, and assessment of capital buffer
What types of loans does ABC Bank primarily offer?
- Retail loans
- Corporate loans (mainly commercial real estate)
What methodology did ABC Bank use to assess its Pillar 1 minimum capital requirements?
Mixed approach and Standardised approach
What is the Pykhtin approach used for?
To quantify single name credit concentration risk
What is the expected capital surplus for ABC Bank by 2022?
£1,244 million
How does ABC Bank quantify its total capital requirements over time?
By using a forecast balance sheet and applying uplifts for Pillar 2A risks
Fill in the blank: The capital buffer should be the larger of (i) the capital buffer determined by _______ and (ii) the sum of its capital conservation buffer and its countercyclical capital buffer.
[stress testing]
What percentage of total capital requirements can be met by Tier 2 capital under Basel regulations?
Up to 25%
What is the capital ratio for ABC Bank’s CET1 capital in 2022?
17.5%
What might regulators ask ABC Bank regarding its assessment of capital for geographic credit concentration risk?
Why it was not assessed
What is the expected change in ABC Bank’s CET1 capital available from 2018 to 2022?
Increase from £1,518 million to £2,532 million
What types of risks are considered material for ABC Bank?
- Credit risk
- Counterparty credit risk
- Operational risk
- Credit concentration risk
- Non-traded market risk
What does the term ‘excess capital’ refer to?
CET1 and total capital available less total capital requirements
How does ABC Bank assess its capital requirements for operational risk?
By applying a scaling factor based on peer banks’ economic capital requirements
What does RWAs stand for?
Risk-Weighted Assets
RWAs are used to determine the minimum capital requirements for banks.
What is the Total Capital Requirements (TCR) for ABC Bank in 2018?
£1,438 million
What is the CET1 capital for ABC Bank in 2022?
£1,178 million
What is the CET1 capital surplus available for buffer in 2019?
£238 million
Under a severe adverse macro-economic scenario, what happens to ABC Bank’s capital requirements?
Increased by the need to apply higher PDs in 2019 and 2020
What is the CET1 capital surplus forecasted for ABC Bank in 2021?
£878 million
What is the capital conservation buffer as a percentage of total RWAs?
2.5%
What is the regulatory capital buffer amount for ABC Bank in 2022?
£362 million
What is the capital buffer determined by stress testing for ABC Bank?
£202 million
What does a recovery plan aim to support?
The recovery of a bank from near failure
True or False: All banks must prepare a recovery plan and a resolution plan.
True
What is a key element in addressing liquidity pressures in a recovery plan?
The bank’s liquidity contingency plan
What must banks have access to under the MREL requirements?
Sufficient equity and debt resources
What is the objective of a resolution plan?
To ensure orderly resolution without systemic risk
What may happen to parts of a bank under a resolution plan?
They may be sold or recapitalised
Fill in the blank: The decline in CET1 surplus from 2018 to 2019 is ______.
–£202 million
What should management actions in a recovery plan consider?
Management actions already taken under the ICAAP governance framework
What is the maximum amount of the capital conservation buffer for ABC Bank in 2018?
£316 million
What is the risk associated with the failure of one bank highlighted by the Lehman Brothers collapse?
Systemic risk due to inter-connectedness
What is the Bank Recovery and Resolution Directive (BRRD)?
Regulations requiring banks to meet minimum requirements for own funds and eligible liabilities
What is the maximum guaranteed deposit amount in the UK?
£85,000
What could a regulator ask ABC Bank to do due to optimistic growth in capital available?
Carry out an additional stress test
What is one of the management actions ABC Bank could take to maximise capital?
Cease all new business lending
What happens to retail depositors during a resolution plan?
Their position and potential losses are a major concern
What is the limit for deposit insurance in the UK?
£85,000
This is the maximum amount covered by deposit insurance schemes in the UK.
What is the limit for deposit insurance in South Africa?
R100,000
This amount protects retail depositors per bank.
What does ‘pari passu’ mean in the context of deposits?
Treated on equal footing with unsecured debt
What is the role of the Financial Stability Board in relation to deposits?
Suggests flexibility for greater protection of deposits than unsecured debt
What essential services must a bank provide during resolution?
Current accounts and deposit accounts
What are critical functions that need to remain in place during a bank’s resolution?
Critical functions, shared services, outsourced services
What are the implications of a bank entering resolution on financial contracts?
Termination of contracts may negatively impact financial stability
What can authorities impose during a bank’s resolution to protect financial stability?
Temporary bans on termination rights and collateral seizure
What must banks submit to regulators in preparation for possible resolution?
Resolution packs with comprehensive information
What is the purpose of the Financial Sector Laws Amendment Bill in South Africa?
To provide the SARB with powers for orderly resolution of designated institutions
When was the Corporation for Deposit Insurance (CoDI) established?
2023
What is the primary function of the CoDI?
To establish and maintain a deposit insurance fund
What is the Internal Capital Adequacy Assessment Process (ICAAP)?
A process for assessing capital adequacy in relation to risk profiles
What are the components of Pillar II in the supervisory review process?
- Identification and measurement of balance-sheet risks
- Appropriate level of internal capital
- Development of risk management systems
What does the recovery plan relate to in the ICAAP?
It is invoked during significant stress events
Define expected loss in the context of banking.
Average level of loss expected based on historical experience and current outlook
What are unexpected losses?
Losses that exceed expected loss rates due to unforeseen events
What is required to absorb unexpected losses?
A buffer of capital above the regulatory minimum
What should a bank’s capital management policy include?
- Roles and responsibilities of finance, risk, and treasury teams
- Processes for strategic business plans and capital demand
- Escalation procedures for risk events
What is the purpose of capital stress testing in a bank?
To assess potential capital impact of business conditions changes
What is the relationship between risk-weighted assets and capital management?
A subset of capital management policy focusing on adherence to standards
SREP Definition
Supervisory and Review Evaluation Process
