Capital ratio under Basel

[iActuary]

In chapter 12 section 2.6 first paragraph, it says the capital ratio (tier 1 + tier 2 divided by risk weighted assets) increased from 9% to 11%. I think it's actual solvency level observed in banks.

Same chapter section 2.8 (1. Regulatory capital), the solvency ratio is defined as regulatory capital divided by risk weighted assets, with the requirements increasing from 2% to 7%.

Based on my reading (I'm not in the banking sector), the capital calculation is always 8% multipled by something / risk weighted assets. So my question in particular to the second paragraph above: how do we get the requirements of 2% (and also 7%)?

Can someone help please? Thanks!

 

[Colin McKee]

The way it works is that (risk wghted assets)*(8%) is a regulatory minimum. So banks can do this calc and compare it to their actual capital to see if they comply. Most banks are over this, and rather than state that they have X bn excess capital, they take their actual capital / risk weighted assets and report that as their "actual" ratio. Its just two ways of making the same regulatory comparison. Between 1988 and 1996, the actual ratio increased from 9 to 11, but the regulatory minimum was always 8%.
Many banks also looked at how they measured up when they included ONLY their top quality (Tier 1) capital in the ratio. The normally manage 7% just using that alone.

Basel III has changed things a bit, and the old ratios are redundant, mainly because the definition of what is allowable as Tier 1 capital has been significantly tightened, and the calculation of risk-weighted assets has also been strengthened. So banks that used to boast a 11.1% ratio using Tier 1 alone, now find that they have only 5.7% using Tier 1 alone. This Tier 1 ratio has to get to 7% by 2019, which is the big challenge and may mean rights issues.
This is my understanding of what the core reading is stating, but let me know if you have any other queries or questions. - its a good discussion thread to have because others out there may have input.

 

[iActuary]

Thanks Colin, I believe we have to define capital / solvency ratio in the context because it may mean numerator may include actual capital or just the Tier 1.

But back to section 2.8 (1. Regulatory capital), I am still struggling to see how that "old" requirement of 2% came about.. because even if we use only Tier 1, it is already 4% since at least half of the regulatory capital must be supported by Tier 1..

Not sure if my problem is clear?

 

[Colin McKee]

I do see your point. Under the existing Basel II system, the banks have a lot more than 2% tier 1, and there is no 2% minimum as far as I know, so I don't know where that 2% has come from. I will send off an email to the staff actuary and see if anything comes back, and do some research when I get a free minute to see if I can come up with anything.

 

[iActuary]

risk weighted asset

So far I only see the term risk weighted asset that is used in calculating capital required. How about risk on the liability side?

Solutions to Q&A3.6(i)(b) and Q&A3.11(iii) are confusing me, in that the former says contingent liabilities (written) will be converted into on-balance sheet equivalents whereas the latter says the current exposure method ignores the value of contingent liabilities (swap in the exercise) that might be a liability to the bank. So do we set aside capital for risk on the liability side?

Also on Q&A bank Q&A3.6(i)(b) solutions - how do we "load" the capital required for contingent liabilities actually? Just add on to the other RWA?