Capital Adequacy

Capital Adequacy - Allocation for Market + Credit Risk + Operational Risk

KEYWORDS: Capital Adequacy, Basel I, Market Risk, Capital

---

---

Traditionally, global banking regulation has focused on capital adequacy. Simply put, this is the measurement as to whether a bank has enough capital to support the assets it has on its books. Given the complexity of “capital” and the differentiation of asset risk, capital adequacy has grown from the ratio of regulatory capital to buckets of risk weighted assets to ever more stringent definitions of that capital and much more complex and granular asset definition. The ratio driven capital adequacy measurement is captured – in hindsight - with the periodic reporting of banks to their supervisors. Going forward, higher capital to assets ratios will be required; even more stringent capital criteria; higher risk weights for some asset classes, and more forward looking examinations of capital adequacy will be required.

The Basel I and Basel II, as well as forthcoming Basel III, accords require the listing of assets and then allocation of risk weights to those positions by specific rules depending on the product and obligor/issuer/counterparty. The Market Risk calculation will be the same in Basel I and II and III. Credit risk is quite different for Basel I and the other two, while Operational Risk is only calculated for Basel II and III.

Credit Risk is the great differentiator between the Accords. With Basel I the category of obligor/issuer/counterparty is the differentiator while Basel II uses asset classes. This makes the mapping of banking book assets between Basel I and Basel II a monumental exercise in itself unless one is using Axiom. Then the reconciliation between the two is easy and supervisors can see that both approaches are using the same data.

Market Risk, though it does not vary between Basels, presents a different problem when the bank uses some types of VaR (Value at Risk). The simulation approach – which most banks use – requires the use of vectors when modeling. This does not translate into an easily identifiable input and output reconciliation. AxiomSL makes the process completely auditable and transparent.

For Basel II and beyond, banks must calculate their Operational Risk and this charge will be included in their “asset” charges along with market and credit risk. There are three approaches specified: Basic, Standardised, and Advanced. The first two are rather simple to calculate (based on income by either firm as whole or relevant business divisions) and append to respondent’s regulatory submission. The Advanced Measurement Approach (AMA) is much more complicated. It requires the depository institution to have its own operational risk management system and the AMA itself is subject to rigorous review by the firm’s supervisor. Axiom is well placed to aggregate the multitude of components, scenarios, internal and external data, models required for substantiating the bank’s estimate of its charge.

Using AxiomSL’s ControllerView® gives the client the distinctive advantage of:

• Calculating Regulatory Capital requirements under different approaches in parallel on the same
  source data
• Aggregating Regulatory Capital requirements, simultaneously, along regulatory reporting dimensions and Business Unit Allocation dimensions
• Formulating, calculating and allocating cost of capital measures to Business Units.
• Providing a seamless and completely transparent data and application environment which tracks data and process work flows, calculation formulas/rules and aggregation parameters, and underlying source data

One of these will be the annual ICAAP – Internal Capital Adequacy Assessment Process – which a bank will present to its supervisor for review and remedial action if required. AxiomSL has obvious strengths for use in this process: Auditable retention of all data inputs, calculations and aggregations plus an easy to use user interface for comparisons with earlier submissions. The ICAAP is a Pillar 2 requirement for Basel III, but various regulators are effectively mandating it already as part of the supervisor to bank interaction. Inasmuch as the economic capital calculation will include “interest rate risk in the banking book”, the tie-in with the Axiom database of such exposures would be an enormous time savings as well as reconciliation tool.

Even more suitable for use of Axiom is the U.S. Federal Reserve’s Comprehensive Capital Adequacy Review (CCAR). This quarterly and annual filing is a massive exercise in asset risk evaluation on a firm level. Estimated at more than 15,000 man hours per filing, the 31 banks that have to file will require enormous data base usage and retention.

ControllerView® gives the client the distinctive advantage of:

• Aggregating Regulatory Capital requirements, simultaneously, along regulatory reporting dimensions and Business Unit Allocation dimensions
• Providing a seamless and completely transparent data and application environment which tracks data and process work flows, calculation formulas/rules and aggregation parameters, and underlying source data

Internal Capital Adequacy Assessment Process

A major tool of banking supervisors is the annual ICAAP – Internal Capital Adequacy Assessment Process – which a bank presents to its supervisor for review and remedial action if required. Axiom has obvious strengths for use in this process: Auditable retention of all data inputs, calculations and aggregations plus an easy to use user interface for comparisons with earlier submissions. The ICAAP is a Pillar 2 requirement for Basel III, but various regulators are effectively mandating it already as part of the supervisor to bank interaction. Inasmuch as the economic capital calculation will include “interest rate risk in the banking book”, the tie-in with the Axiom database of such exposures would be both an enormous time saver as well as reconciliation tool. In the interaction with the institution’s supervisor, the Axiom report would be the most transparent solution.

SIFI

Systemically Important Financial Institutions (SIFIs) are a new buzz word in regulatory circles. The financial crises and particularly the bankruptcy of Lehman Brothers focused attention on “too big to fail” financial institutions – SIFIs. The Bank for International Settlements (BIS), the Group of 20 (G-20), U.S. Congress in the Dodd-Frank Act (DFA) and banking regulators everywhere are busy making up new rules for firms that are designated SIFIs. Basel III will impose a higher capital ratio for them, starting in 2016.

It is still undecided what further requirements globally and in particular jurisdictions are on tap.

In the meantime, regulators are proposing a substantial set of reports to 1) help regulators classify firms as SIFIs and 2) determine what the systemic risks of each firm are. Those filings begin in 2012. AxiomSL is uniquely qualified to be the collector, aggregator, and generator of these reports.