Financial Institutions Flashcards
Three important highlights of Basel III
- minimum capital requirement: percentage of its risk-weighted assets that a bank must fund with equity capital
- minimum liquidity:a bank must hold enough high-quality liquid assets to cover its liquidity needs in a 30-day liquidity stress scenario
- stable funding: requires a bank to have a minimum amount of stable funding relative to the bank’s liquidity needs over a one-year horizon. Stability of funding is based on the tenor of deposits (e.g., longer-term deposits are more stable than shorter-term deposits) and the type of depositor (e.g., funds from consumers’ deposits are considered more stable than funds raised in the interbank markets).
The CAMELS Approach
“CAMELS” is an acronym for the six components of a widely used bank rating approach originally developed in the United States.12 The six components are Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position, and Sensitivity to market risk.
A bank examiner using the CAMELS approach to evaluate a bank conducts an analysis and assigns a numerical rating of 1 through 5 to each component. A rating of 1 represents the best rating, showing the best practices in risk management and performance and generating the least concern for regulators.
Each component is weighted by the examiner performing the study. The examiner’s judgment will affect the weighting accorded to each component’s rating. Two examiners could evaluate the same bank on a CAMELS basis and even assign the same ratings to each component and yet arrive at different composite ratings for the entire bank.
Capital Adequacy
Common Equity Tier 1 Capital must be at least 4.5% of risk-weighted assets.
Total Tier 1 Capital must be at least 6.0% of risk-weighted assets.
Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk-weighted assets.
Common Equity Tier 1 Capital includes common stock, issuance surplus related to common stock, retained earnings, accumulated other comprehensive income, and certain adjustments including the deduction of intangible assets and deferred tax assets. Other Tier 1 Capital includes other types of instruments issued by the bank that meet certain criteria. The criteria require, for example, that the instruments be subordinate to such obligations as deposits and other debt obligations, not have a fixed maturity, and not have any type of payment of dividends or interest that is not totally at the discretion of the bank. Tier 2 Capital includes instruments that are subordinate to depositors and to general creditors of the bank, have an original minimum maturity of five years, and meet certain other requirements.
The three “levels” of the fair value hierarchy pertain to the observability of the inputs used to establish the fair value.
Level 1 inputs are quoted prices for identical financial assets or liabilities in active markets.
Level 2 inputs are observable but are not the quoted prices for identical financial instruments in active markets. Level 2 inputs include quoted prices for similar financial instruments in active markets, quoted prices for identical financial instruments in markets that are not active, and observable data such as interest rates, yield curves, credit spreads, and implied volatility. The inputs are used in a model to determine the fair value of the financial instrument.
Level 3 inputs are unobservable. The fair value of a financial instrument is based on a model (or models) and unobservable inputs.
Earnings
Regarding sustainability of a bank’s earnings, it is important to examine the composition of earnings. Banks’ earnings typically comprise (a) net interest income (the difference between interest earned on loans minus interest paid on the deposits supporting those loans), (b) service income, and (c) trading income. Of these three general sources, trading income is typically the most volatile. Thus, a greater proportion of net interest income and service income is typically more sustainable than trading income. In addition, lower volatility within net interest income is desirable: Highly volatile net interest income could indicate excessive interest rate risk exposure.
Liquidity Position
Basel III thus introduced two minimum liquidity standards, both to be phased in over subsequent years.
The Liquidity Coverage Ratio (LCR) is expressed as the minimum percentage of a bank’s expected cash outflows that must be held in highly liquid assets. For this ratio, the expected cash outflows (the denominator) are the bank’s anticipated one-month liquidity needs in a stress scenario, and the highly liquid assets (the numerator) include only those that are easily convertible into cash. The standards set a target minimum of 100%.
The Net Stable Funding Ratio (NSFR) is expressed as the minimum percentage of a bank’s required stable funding that must be sourced from available stable funding. For this ratio, required stable funding (the denominator) is a function of the composition and maturity of a bank’s asset base, whereas available stable funding (the numerator) is a function of the composition and maturity of a bank’s funding sources (i.e., capital and deposits and other liabilities). Under Basel III, the available stable funding is determined by assigning a bank’s capital and liabilities to one of five categories presented in Exhibit 8, shown below. The amount assigned to each category is then multiplied by an available stable funding (ASF) factor, and the total available stable funding is the sum of the weighted amounts.2
