Safety And Soundness Outline

Safety and Soundness

1. In General

   1. keeping banks safe and sound represents the central concern of bank regulation and the overriding objective of bank regulators

2. Capital

   1. Leverage Limit (MUST BE 4%)

      1. Leverage Ratio = Tier 1 Capital/Total Assets

         • Tier 1 Capital = Common Shareholders' Equity + Noncumulative Perpetual Preferred + Minority Interests in Consolidated Subsidiaries

      2. Leverage Ratio MUST BE 4%

   2. Risk-Based Capital Ratio (MUST BY 8%)

      1. Risk-Based Capital Ratio = Total Capital (Tier 1 + Tier 2)/Risk-Weighted Assets

         • Total Capital - SEE CHART ON pg. 265

           • Total Capital = Tier 1 Capital + Tier 2 Capital

           • Tier 1 Capital = Common Shareholders' Equity + Noncumulative Perpetual Preferred + Minority Interests in Consolidated Subsidiaries

           • Tier 2 Capital

             • NO LIMIT:

               • Cumulative preferred (perpetual or long term), long-term preferred, and convertible preferred)

             • ONLY UP TO 50% OF TIER 1:

               • Intermediate-term preferred

               • Subordinated Debt

               • Debt-equity hybrids, including perpetual debt

             • TIER 2 CAPITAL IS ONLY INCLUDABLE UP TO THE AMOUNT OF TIER 1 CAPITAL

         • Risk-Weighted Assets

           • Step 1: Sort assets (on balance sheet) into risk-weight categories

             • (1) 0% for assets having essentially no credit risk

               • cash, foreign currency, obligations of the U.S. government and certain foreign governments, balances kept at the Federal Reserve or certain foreign central banks, and gold bullion

             • (2) 20% for assets having slightly more credit risk

               • U.S. state and local government obligations, obligations conditionally guaranteed by the U.S. government, claims against U.S. banks, and Mortgage-backed securities backed by Fannie Mae or Freddie Mac

             • (3) 50% for certain assets having additional credit risk

               • first-mortgage loans on one- to four- family residences and revenue bonds issued by state and local governments

             • (4) 100% for all other assets

               • loans to private borrowers, the bank's own premises and equipment, and real property acquired by foreclosure or otherwise in satisfaction of a debt

           • Step 2: Take each class of the bank's off-balance sheet items and multiply the face value by the appropriate "credit-conversion factor" to produce the "credit-equivalent amount."

             • a 100% factor applies to "direct credit substitutes"

               • financial-guarantee-type standby letters of credit, assets sold with recourse, and legally binding commitments to purchase assets on specified future dates

             • a 50% factor applies to "transaction-related contingencies"

               • performance-based standby letters of credit (such as those backing labor and materials contracts and subcontractors' and suppliers' performance), the unused portion of lines of credit (including home-equity lines of credit) made for more than one year.

             • a 20% factor applies to commercial letters of credit

             • a 0% factor applies to

               • the unused portion of lines of credit expiring within one year if the bank regularly reviews such lines and cancel them at any time and the unused portion of retail credit card lines of credit that the bank has the unconditional right to cancel at any time

           • Step 3: Sort the "credit-equivalent amounts" above and sort them into risk-weight categories

           • Step 4: Multiply the dollar total for each of the four risk-weight categories by the relevant percentage for that category

           • Step 5: Total all four risk-weight categories. The sum = the bank's "risk-weighted assets"

      1. Risk-Based Capital Ratio MUST BE 8%

   3. Tier 1 Risk-Based Capital Ratio = Tier 1 Capital/Risk-Weighted Assets

   4. Basel II

      1. Reform to Basel II prompted by limitations of Basel I:

         • (1) Simple risk-weighting approach did not adequately differentiate between assets that have different risk levels

         • Although the simple risk-weighted approach is an adequate capital framework for most banks, it has proven to be inadequate with respect to the larger, more complex banking institutions.

         • Basel I's risk-weighting categories lacked accuracy and failed to accurately reflect certain banks' risk profile

           • e.g. all commercial loans were assigned to the 100% risk-weighted category.

           • This led banks to structure their activities to take advantage of the limitations in the regulatory capital framework (regulatory capital arbitrage)

             • This led to banks increasing their actual risk exposure without a commensurate increase in capital

         • (2) Basel I only offered a limited recognition of credit risk mitigation techniques (e.g. hedging with derivatives)

         • (3) Basel I did not explicitly address all the risks faced by banking organizations

         • Basel I did not recognize all the various risk categories (it only focused on credit risk and later market risk)

           • Categories of Risk:

             • Credit risk: potential for loss from borrower or counterparty's failure to perform on an obligation

             • Market risk: potential for loss from movements in market prices, including interest rates, commodity prices, stock prices, and foreign exchange rates

             • Interest rate risk: potential for loss from adverse movements in interest rates (a type of market risk)

             • Operational risk: potential for loss from inadequate or failed internal processes, people, or systems or from external events

             • Liquidity risk: risk that a bank will not be able to meet its obligations as they come due because it cannot liquidate assets or obtain adequate outside funding

             • Concentration risk: risk arising from any single exposure or group of exposures with the potential to produce losses large enough to threaten the bank's health or ability to maintain its core operations

             • Reputational risk: potential for loss from negative publicity about the bank's business practices

             • Compliance risk: potential for loss from violating law, internal policies, or ethical standards

             • Strategic risks: potential for loss from adverse business decisions or poor implementations

           • Basel II sought to remedy this by adding an explicit capital charge for operational risk and by using supervisory review (already a part of U.S. regulatory practice) to address all other risks

         • (4) Also,...

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