Regulatory Capital Questions Flashcards
What’s the basic idea behind Regulatory Capital, and how do you calculate it?
Regulatory Capital protects a bank against unexpected losses. The bank expects to lose something on its Loans, which it reflects in the Allowance for Loan Losses. Regulatory Capital absorbs losses for anything beyond that expected amount. The basic idea is:
Regulatory Capital / Some Types of Assets >= Certain Percentage
“Regulatory Capital” is related to Shareholders’ Equity or Tangible Common Equity (or variations), and “Some Types of Assets” usually means Tangible Assets or Risk-Weighted Assets.
The bank must maintain a “buffer” of Equity so that unexpected losses reduce its Equity rather than its
Deposits, Debt, or anything else on the L&E side.
What are Risk-Weighted Assets (RWAs), and how do you use them in models?
To calculate Risk-Weighted Assets, a bank assigns a “risk weight” to each on-Balance Sheet and off- Balance Sheet Asset, based on the Asset’s credit risk, and sums up everything.
For example, if the bank has $10 of Cash, $10 of Business Loans, and $10 worth of Subprime Mortgages, the Cash might get a risk weight of 0%, the Business Loans might get 50%, and the Subprime Mortgages might get 100%, producing total RWAs of $15.
Risk-Weighted Assets are often the denominator in Regulatory Capital Ratios such as the CET 1, Tier 1,
and Total Capital Ratio, and you project them based on the bank’s Interest-Earning Assets. These capital ratios limit a bank’s growth and ability to issue Dividends.
Why is it so important to calculate Regulatory Capital Ratios based on Risk-Weighted Assets (RWAs) in addition to ratios based on Tangible Assets (TA)?
Because neither one tells the whole story. Banks can “game the system” and assign unrealistically low Risk Weights to Assets if you only examine the bank’s Risk-Weighted Assets.
But if you only calculate Tangible Assets, you ignore off-Balance Sheet Assets and the fact that certain mortgages, business loans, and securities are riskier than others.
What’s the difference between Tier 1 Capital and Tier 2 Capital?
Tier 1 Capital is “Going Concern Capital” and is available to absorb unexpected losses when the bank is still up and running. It consists of Shareholders’ Equity – Goodwill & Other Intangibles +/- Other Adjustments.
You can also say that Tier 1 Capital = CET 1 + Preferred Stock +/- Other Adjustments.
Tier 2 Capital is “Gone Concern Capital” and can absorb unexpected losses only when the bank is shutting down in a bankruptcy/liquidation scenario.
It consists of Hybrid Instruments (e.g., Convertible Bonds), Subordinated Notes, a portion of the Allowance for Loan Losses, and various Reserves.
What’s the Leverage Ratio, and why might we look at that in addition to the CET 1, Tier 1, and Total Capital Ratios?
Leverage Ratio = Tier 1 Capital / Tangible Assets, but you may also adjust Tangible Assets for off- Balance Sheet items.
The Leverage Ratio is harder to manipulate than the other ratios since it uses numbers straight from
the bank’s Balance Sheet, so it’s useful as a way to cross-check everything.
It’s similar to the Tangible Common Equity (TCE) Ratio, but it’s a bit less conservative since it also
includes Preferred Stock and various adjustments.
What’s the difference between Common Equity Tier 1 (CET 1) and Tangible Common Equity (TCE)?
They’re similar since they’re both based on Common Shareholders’ Equity – Goodwill & Other Intangibles, but banks often make adjustments to CET 1, whereas TCE comes straight from the Balance Sheet.
For example, a portion of the bank’s Noncontrolling Interests may count toward CET 1, and some Deferred Tax Assets may be deducted from it. Also, the Goodwill and Other Intangibles you subtract to calculate the CET 1 must be net of the associated Deferred Tax Liabilities.
How are Noncontrolling Interests (NCI) treated in the Regulatory Capital calculations?
Under Basel III, banks can count a portion of the NCI toward CET 1, but only in relation to their Surplus CET 1.
For example, let’s assume that the bank’s NCI is $20, representing the 20% it does not own in another company, and the bank has Surplus CET 1 of $10 (e.g., its minimum CET 1 is $100, but it has $110 currently).
In this case, the bank can count NCI – Surplus CET 1 * (1 – Ownership %) toward its CET 1. That would be $20 – $10 * (1 – 80%) = $18 here.
The bank can do the same thing in its Tier 1 Capital, but it must subtract the amount it has already recognized within CET 1. So, in this example, the bank could recognize a maximum of $2 within the additional amount that contributes to its Tier 1 Capital.
For Tier 2 Capital, the bank must subtract the amounts it has already recognized within both CET 1 and Tier 1 Capital.
In practice, these rules mean that banks with huge amounts of Surplus CET 1 cannot count much of their Noncontrolling Interests toward Regulatory Capital.
How do you factor Deferred Tax Assets (DTAs) and Deferred Tax Liabilities (DTLs) into the Regulatory Capital calculations?
When you deduct Goodwill and Other Intangibles from CET 1 (and the other figures), they must be net of associated DTLs.
Also, you must deduct the net DTAs that arise from net operating loss (NOL) and tax credit carryforwards when calculating the same figures.
It’s extremely difficult to determine these numbers on your own, so you usually hold the bank’s “adjustments” in its filings constant or project them with simple percentages.
What’s the purpose of the Liquidity Coverage Ratio (LCR), and how do you calculate it?
The LCR ensures that the bank has enough high-quality Liquid Assets to cover 100% of net cash
outflows during a “stressed 30-day period.”
You calculate it with Liquid Assets / Stressed Net Cash Outflows, and the minimum is 100%.
Usually, you make Liquid Assets a percentage of Cash and Investments.
Then, you assume a “Run-Off Rate” on the bank’s Deposits, subtract scheduled Loan repayments, and add items like Derivatives Payable that might disappear in a panic, to calculate the Stressed Net Cash Outflows.
What’s the purpose of the Net Stable Funding Ratio (NSFR), and how do you calculate it?
The NSFR ensures that the bank has enough stable, long-term funding for its Assets (i.e., the bank should not be dependent on short-term borrowings that might disappear overnight).
You calculate it with Available Stable Funding / Required Stable Funding, and the minimum is 100%.
Available Stable Funding consists of longer-term, stable Deposits plus Total Capital (or a variation thereof) plus other Liabilities with maturities greater than 12 months.
Required Stable Funding consists of the sum of “Adjustment Factors” multiplied by the bank’s Interest- Earning Assets and off-Balance Sheet Assets, plus all the bank’s non-Cash, non-Interest-Earning Assets.
A bank’s CET 1 Ratio is 10.0%, its Liquidity Coverage Ratio (LCR) is 95.0%, and its Net Stable Funding Ratio (NSFR) is 95.0%. What’s the BEST way for this bank to solve this problem?
The bank’s CET 1 Ratio is acceptable, but its LCR and NSFR are below the minimum percentages. Therefore, the bank has no reason to raise Common Equity if it can boost its LCR and NSFR via other means.
This bank should raise additional Deposits and keep the proceeds in Cash. Deposits cost far less than Common Equity, Preferred Stock, or Long-Term Debt, and additional Deposits kept in Cash would boost the LCR and NSFR.
The LCR would increase because the bank’s Liquid Assets would go up, while its Stressed Net Cash
Outflows would rise by only a slight amount – since the Run-Off of Deposits is a low percentage.
The NSFR would increase because the bank’s Available Stable Funding would increase while its Required Stable Funding would stay the same.
Under Dodd-Frank in the U.S., how does the Federal Reserve “stress test” banks?
The two main tests are Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress
Testing (DFAST). Under CCAR, the Fed uses the bank’s plan for Dividends and Stock
Issuances/Repurchases and assess whether or not the bank could maintain its minimum capital ratios
and a CET 1 Ratio of 5% even if “stressful conditions” emerge.
To test these conditions, the Fed creates adverse scenarios based on lower Loan growth, higher default rates, lower interest rates, and so on.
Under DFAST, the Fed ignores the bank’s business plan and assumes Dividends at similar levels to those in past years. It assumes no other changes to Equity capital except for Stock-Based Compensation and Stock Issuances for planned M&A deals.
Large banks must pass these tests to receive approval for their Dividend and Stock Repurchase plans.
What happens if a bank does not comply with its Regulatory Capital requirements?
If a bank does not comply with these requirements, government regulators may impose restrictions on
the bank’s Dividends, Share Repurchases, Acquisitions, and other activities.
They might limit employee compensation, and the government might even take over the bank if its ratios fall too low.
How do you use Regulatory Capital in real-life models?
You usually use it to determine the Dividends a bank can issue. For example, if the bank’s targeted CET 1 Ratio is 10%, and it’s currently at 11%, it can only issue Dividends representing 1% of its Risk- Weighted Assets.
You also use these ratios to constrain a bank’s Loan/Deposit growth by ensuring that it has enough Tangible Common Equity. If the bank’s ratios drop too low, you might even assume that the bank has to issue Stock to boost its ratios.
These ratios are a critical part of all models for banks because banks can take action only in relation to their capital.
How are the Allowance for Loan Losses and Regulatory Capital related?
The Allowance covers expected losses, and Regulatory Capital covers unexpected losses.
If a bank suddenly experiences an unexpected loss, it will have to increase its Allowance for Loan Losses by increasing its Provision for Credit Losses.
If the Provision increases by $100, Net Income decreases by $60 at a 40% tax rate.
On the CFS, Net Income is down by $60, but you add back the $100 Provision, so Cash at the bottom is up by $40.
On the BS, Cash is up by $40 on the Assets side, and the Allowance for Loan Losses is down by $100, so the Assets side is down by $60. Gross Loans then decreases by $100, and the Allowance increases by
$100, but those changes cancel each other out.
On the L&E side, Retained Earnings is down by $60, so Equity is down by $60, and both sides balance. The Regulatory Capital here allowed the bank to absorb these unexpected losses because the after-tax
Provision flowed directly into the bank’s Common Shareholders’ Equity.
