5.3.1.1 Introduction
While the focus of industrial and utility companies is primarily on the generation of revenues and cash flows, for financial institutions the management of assets is of paramount importance. Traditionally, banks’
income statements and asset composition have been the primary focus of attention when assessing their credit strength. However, the high complex- ity of businesses and financial products has shifted the focus towards risk management. Off-balance sheet items and funding issues have become more important, therefore common metrics of credit risk are not able to reflect the complete risk profile of a bank. We would argue that the analysis of banks requires a completely different research process compared to industrial companies.
The importance of the banking sector results from the services it provides for the economy. In commercial banking, the main business is deposit taking and lending. According to Greenbaum and Thakor (1995) the role of commercial banks involves transformations with regard to dura- tion, divisibility, risk, numeraire currency and liquidity. Additionally, they provide transaction and payment services as well as services related to securities accounts. Investment banks act as financial intermediaries in a broader sense, as they promote the efficiency of financial markets through underwriting, issuance and distribution of securities.
5.3.1.2 Regulation in the banking sector
Banks generally have to hold adequate capital against all risks that arise from their business. This capital is intended to provide a cushion for depositors and creditors, if the bank is confronted with unexpected losses.
Thus, the probability that a bank is not able to repay its liabilities is minimized. Since 1988, the Basel Capital Accord defines the minimum capi- tal requirements for all banks (Figure 5.27). The agreement was put forward by the Basel Committee on Banking Supervision, an organization founded
in 1974, following the severe crises of Bankhaus Herstatt in Germany and Franklin National Bank in the US to improve cooperation between bank supervisors. With the adoption of the Basel Capital Accord in a directive, the EU has created the basis to transform the guidelines into national law.
Therefore, the capital requirements for banks are very similar across Europe. Essentially, they reflect the rules of the Basel Capital Accord, requiring banks to hold at least 4 percent of core capital and 8 percent of total capital against risk-weighted assets. In practice, however, most commercial banks target a Tier 1 ratio in the range of 8–9 percent. Still other banks carry even higher Tier 1 ratios, reflecting a steady earnings stream, hidden reserves, and a conservative dividend policy. Total capital consists of Tier 1 capital and Tier 2 capital, whereas the latter one is eligible only up to 100 percent of Tier 1 capital. Hence, the amount of Tier 1 capital determines the maximum total capital of a bank. Tier 2 capital consists of Upper Tier 2 and Lower Tier 2.
Banking crises generally lead to high losses for depositors. Since govern- ments often feel obliged to cover part of these losses, there is a strong political interest to minimize the risk of bank failure through regulation. The basic idea is that regulatory authorities act on behalf of the depositors. But the goal of bank regulators is not only to protect depositors, but also to pro- vide a stable environment for banks to operate in. In order to be allowed to take deposits, any authorized bank has to hold adequate capital. Generally,
Figure 5.27 Regulatory capital of a bank according to the Basel Capital Accord
Source: DZ Bank Total capital
Tier 2 capital (max. 100% of Tier 1 capital)
Lower Tier 2 (max. 50% of Tier 2 capital)
Upper Tier 2 Tier 1 capital
capital requirements depend on the size and type of risk associated with a bank’s assets. In order to calculate the amount of capital that has to be held the bank’s business has to be split up between its term lending and deposit- taking activities, classified as the “banking book,” and its trading activities, or the “trading book.” While the capital requirements for the banking book are laid out by the Basel Capital Accord, the Amendment to the Capital Accord sets out the guidelines for the trading book.
Trading book items comprise
■ proprietary positions in equities, debt securities, money market instru- ments, financial futures, forward rate agreements, interest rate, currency and equity swaps, and call or put options on the above instruments as well as commodities and commodity derivatives held to benefit from short-term price or interest rate fluctuations;
■ the above instruments held for hedging trading book items, repos and securities and commodities lending and reverse repos;
■ exposures due to unsettled transactions, OTC derivatives, commission, fees, dividends, interest and margin on exchange-related derivatives.
Any instrument not named above, not held for trading purposes and any instrument used to hedge a banking book position is included in the bank- ing book.
As pointed out before, regulators require banks to hold adequate capital against assets depending on the size and type of risk of the asset and in which book the risk arises in. Counterparty risk, currency risk and risk from positions in commodities, for example, are treated the same irrespective whether they arise in the banking or trading book. Items that are unique to the trading book like repos, require a special counterparty risk treatment.
The amount of capital that has to be held also depends on netting opportu- nities and collateralization.
Assets in the banking book are risk-weighted according to their type.
Generally, riskier assets require a higher amount of capital to be held.
Table 5.14 illustrates the current risk-weighting scheme.
Besides counterparty risk, capital requirements that are due to trading book items depend on foreign exchange risk, commodity position risk, interest rate position risk and large exposures risk. It would be beyond the scope of this book to present a detailed description of how to determine capital requirements for each type of trading book asset. Interested readers may refer to the 200 pages of guidance notes issued by the FSA. Apart from the methodology laid out in this description, regulators allow banks to use authorized internal models to calculate their capital requirements.
The minimum requirement for the total capital ratio is 8 percent, but many banks use their own trigger ratios that are somewhat higher as an
early warning signal. Each bank has to meet this requirement on an ongo- ing basis. A breach of the trigger ratio and of the target ratio that is defined 0.5 percent above the trigger ratio, has to be reported immediately and leads to intervention by the regulator. Trigger ratios and target ratios are set separately for the trading and banking book. The methodology of calculat- ing capital requirements differentiates both books. While capital require- ments in the banking book are set as a ratio of capital to risk-weighted assets, trading book requirements are set as an absolute level of capital
“haircut” that has to be multiplied by 12.5 to bring it on the same basis as the banking book. A bank must always fulfil its capital requirements. In other words, a bank’s supervisory capital position has to exceed 100 percent at any time.
The calculation of the trading book capital requirements follows the scheme displayed in Table 5.15. If the trading book trigger is X percent, trading book capital requirements are calculated in the described manner.
Assuming a trigger ratio of Y percent the banking book requirement is shown in Table 5.16.
Yet, capital adequacy requires not only a certain amount of capital, but certain types of capital in relationship to the bank’s assets. The different lay- ers of capital are called “tiers”. Tier 1 capital is the strongest form in that it offers depositors the highest degree of protection. It is followed by Upper Tier 2, then Lower Tier 2 and finally Tier 3 capital. Different types of subor- dinated debt represent only a part of bank capital. Besides perpetual noncu- mulative preferred securities, for example, Tier 1 capital is made up of common equity and retained earnings. In the following paragraphs we refer primarily to the debt components of capital.
Table 5.14 Risk-weighting scheme for banking book items
Risk weighting (%) Asset type
0 Cash, gold, claims on and claims generated by OECD
central governments
0, 10, 20 or 50 Claims on loans guaranteed by domestic public (according to national regulation) sector entities
20 Claims on multilateral development banks, claims on
banks incorporated in the OECD and claims on non- OECD banks with residual maturity up to 1 year
50 Residential mortgages
100 Claims on private sector, claims on non-OECD banks
over 1 year, claims on non-OECD central
governments, premises, other fixed assets, real estate and all other assets
Source:Basel Capital Accord
Tier 1 capital is also known as “core” capital. It is characterized by the following features.
■ The issuer holds an option to defer dividend or coupon payments. If cap- ital adequacy is threatened this option is transferred to the regulator. The cancellation of coupons is not considered a default.
■ Coupons are noncumulative, that is, interest or dividends are not repaid at a later date, even if the bank would be able to repay deferred coupons without falling below regulatory capital requirements.
■ Tier 1 capital is designed to absorb losses. Since it is subordinated to all other debt and senior only to common equity, it is able to absorb losses before or instead of creditors. In order to remain solvent, principal and interest may be written down.
■ Tier 1 preferred issues are perpetual. Yet, the regulator allows a limited step-up associated with a call after the tenth anniversary of the issue. The call option may only be exercised if there is sufficient capital to fullfil regulatory requirements, and if the regulator explicitly allows the bank to call the issue.
Table 5.15 Trading book capital requirements
Risk type Capital Notional risk- Capital
haircut weighted assets required
FX position risk A 12.5⫻A X% of (12.5⫻A)
Equity position risk B 12.5⫻B X% of (12.5⫻B)
Interest rate position risk C 12.5⫻C X% of (12.5⫻C)
Large exposures incremental capital D 12.5⫻D X% of (12.5⫻D) Trading book counterparty and E 12.5⫻E X% of (12.5⫻E) settlement risk
Commodity position risk F 12.5⫻F X% of (12.5⫻F)
Activities subject to internal models G 12.5⫻G X% of (12.5⫻G) Source:FSA’s Banking Supervisory Policy
Table 5.16 Banking book capital requirements
Risk Risk-weighted assets Capital required
Credit risk H Y% of H
Source:FSA’s Banking Supervisory Policy
■ Since 1998, Lower Tier 1 issues are accepted as core capital by the Basel Committee for Banking Supervision and the national authorities of Germany and Luxemburg. These dated, noncumulative structures, how- ever, are included in the calculation of core capital only up to a maximum of 15 percent.
■ Tier 1 issues may include an equity settlement option at the call date. If the bond is not called, the investor has the right to redeem his Tier 1 bonds via a put option, and in turn receives stocks of the bank. Like a step up, equity settlement features are used to make sure that the bank calls its Tier 1 debt at the first opportunity, thus avoiding to have to increase its equity.
Besides Tier 1 preferred stock, there are some further components that belong to core capital. Equity is considered the strongest form of capital, as shareholders are last to be paid in the event of liquidation. Retained earn- ings, certain types of reserves and minority interest are also core capital. To avoid regulatory pitfalls such as double-counting of capital or connected lending, banks deduct holdings of own shares, own Tier 1 paper, current year’s unpublished losses, goodwill and interim published net losses from Tier 1 capital. Further deductions have to be made from the sum of Tier 1 and Tier 2 capital, for example, in relation to investments in
■ unconsolidated subsidiaries and associates;
■ connected lending of a capital nature, including guarantees;
■ holdings of another bank’s capital over a maximum of the equivalent of 10 percent of a bank’s eligible Tier 1 and Tier 2 capital base;
■ investments in life assurance companies.
Upper Tier 2 debt securities differ from Tier 1 preferred in that they are not necessarily perpetual, but the repayment rather requires prior consent of the regulator. In response to the limited demand for straight perpetuals, most regulators allow issuers to include coupon step-ups as a signal that there is an economic incentive for the issuer to refinance. If the step-up is large enough, Upper Tier 2 issues can be compared to dated subordinated bonds. However, since the underlying is still a perpetual instrument and retains interest deferral and loss absorption features, a spread premium versus less subordinated bank securities is required. While coupon pay- ments are also deferrable, they are cumulative. In other words, the issuer has to pay deferred coupons at a later date. As with Tier 1 principal and interest may be written down to enable the bank to remain solvent. As men- tioned above, Upper Tier 2 is senior only to Tier 1 preferred and common equity. Besides qualifying debt instruments, general provisions and revaluation
reserves in relation to fixed assets and fixed investments also belong to Upper Tier 2.
Dated subordinated debt with a minimum maturity of 5 years and per- petual debt with no loss absorbency or interest deferral features make up Lower Tier 2. Generally, Lower Tier 2 capital is regarded as offering a lower degree of protection, because it is only able to absorb losses in the event of insolvency. Furthermore, deferral of coupons or write-downs of principal are considered an event of default. Consequently, Lower Tier 2 is subordi- nated only to senior debt. Regulation requires that Lower Tier 2 is amor- tized on a linear basis during the last 5 years to maturity. To avoid this, various banks have issued Lower Tier 2 debt instruments with a step-up and call 5 years before its maturity.
Tier 3 debt can exclusively support market risk in the trading book. It rankspari passuwith Lower Tier 2 and is dated with a minimum maturity of 2 years. There are generally no write-downs or loss absorbency features.
The specialty of Tier 3 capital is the “lock-in” clause. At the order of the reg- ulator, interest and principal payments can be deferred if payment would cause capital to fall below minimum capital adequacy requirements. Yet, in this case coupons and principal have to be paid at a later date. Because of its short maturity and limited use Tier 3 capital is regarded as a weak form of capital by most regulators. The Amendment to the Basel Capital Accord rec- ommends limiting the use of Tier 3 to the extent that the sum of Tier 2 plus Tier 3 should not exceed Tier 1 capital.
5.3.1.3 Risks associated with bank debt
Table 5.17 summarizes the major characteristics of the different layers of bank capital with an emphasis on the risks for investors. Please note that senior debt is no bank capital but is included here for reasons of completeness.
The three major rating agencies S&P, Moody’s and FitchIBCA apply slightly differing approaches to account for the risks associated with the different layers of bank capital. The senior debt rating essentially reflects a rating agency’s assessment of the fundamental creditworthiness of the bank. The ratings for subordinated bank debt clearly have to consider the probability of default and the loss severity given default. Subordinated debt and Tier 1 preferred are accordingly rated below senior debt. Table 5.18 shows the general notching methodology of the major rating agencies. Yet, it should be noted that the degree to which a specific issue is notched below senior debt also depends on a bank’s overall ability to meet its financial obligations.
Unlike Moody’s and FitchIBCA, S&P includes only part of Tier 1 pre- ferred in its calculation of certain measures of capital strength. As the rating agency considers Tier 1 preferred a weaker form of capital than common
Table 5.17 Risks of bank capital to investors
Type of debt Subordination Interest Principal Principal
deferral repayment write-down
Senior (no None None Failure is event of No
bank capital) default
Lower Tier 2 Subordinated None Failure is event of No default
Upper Tier 2 Junior At the option of Early usually Only after subordinated the bank, based requires Tier 1
on a test. authorization of capital is Cumulative. regulator. fully written off Tier 3 Subordinated If the bank falls Only if the bank Only in
below its complies with its liquidation regulatory regulatory capital
requirements. requirements.
Generally cumulative.
Tier 1 preferred Ahead of Payment of Requires Mechanism common stock. dividends is Non- varies. Usually Subordinated discretionary. authorization of only after to everything Non-Cumulative. regulator. common stock
else. is written off.
Source:Morgan Stanley
Table 5.18 Notching methodology of the three major rating agencies for bank capital
Senior rating Lower Tier 2 Upper Tier 2 Tier 1 Tier 3
S&P (Senior debt
above BBB-) ⫹1 notch ⫹2 notches ⫹2 notches ⫹3 notches Moody’s
Financial Strength
Rating C and above ⫹1 notch ⫹1 notch ⫹2 notches* ⫹2 notches FitchIBCA
Senior Debt above A- ⫹1 notch ⫹1 notch ⫹1 notch ⫹1–2 notches Senior Debt between
BBB⫹and BBB- ⫹1 notch ⫹2 notches ⫹2 notches ⫹2 notches Note:*for issuers with senior debt ratings of Ba2 or higher
Source:Morgan Stanley
equity it accepts innovative Tier 1 preferred only up to 10 percent of a bank’s tangible total equity. Straight preference shares and noninnovative Tier 1 are included up to 25 percent in the calculation of “adjusted tangible equity.” Yet it is not taken into account in S&P’s calculation of “adjusted common equity,” or core capital. S&P’s methodology comprises several dif- ferent definitions, ranging from “total tangible equity” which includes Tier 1 preferred completely to “adjusted common equity,” the narrowest defini- tion which gives no equity credit to Tier 1 preferred. An example may help to understand the methodology. A bank has 120 million Euro of Tier 1 capital, consisting of 60 million Euro common equity and 60 million Euro Tier 1 preferred. Assuming that the bank has only banking book risk- weighted assets of 1 billion Euro, its regulatory Tier 1 ratio would be 12 per- cent. S&P would only include Tier 1 preferred up to a maximum of 10 percent of overall Tier 1 capital in its calculation, that is 12 million Euro.
S&P would thus get a Tier 1 ratio of 7.2 percent. If the bank’s Tier 1 capital exclusively consists of common equity, the Tier 1 ratio would again equal 12 percent, reflecting S&P’s view that common equity is a stronger form of capital than Tier 1 preferred. Changes in the structure of Tier 1 capital rather than the structure itself are the relevant issue for investors in bank capital, because they may trigger actions by the rating agencies.
Although offering the highest spread of all bank debt instruments, invest- ments in Tier 1 preferred are clearly most risky. The key question is how much worse off would a creditor be in a liquidation scenario by holding a bank’s Tier 1 debt rather than its higher ranking subordinated bonds. From past experience, the answer is: not very much. Holders of subordinated debt have generally fared well when the viability of European banks has been in question, often because of protective government intervention or even bailouts. Therefore, the more relevant risk is probably the deferral of the coupon. However, throughout the history of the Tier 1 market, there has been no case in which a bank deferred its coupon payments or even declared bankruptcy, leaving investors with massive capital losses. Nevertheless, Tier 1 investors experienced significant mark-to-market losses during peri- ods of high risk aversion, for example, after the Asian crisis, Russia’s default and the collapse of Long-Term Capital Management in 1998, or in bank-spe- cific cases that undermined the credit quality of the issuer.
After the introduction of the Euro the Tier 1 market has become a fairly large and liquid market with an established investor base. Between 1998 and 2003, the volume of the Tier 1 universe has increased from 1.5 billion Euro to more than 60 billion Euro. European investor demand for Tier 1 product has been supported by a diminished ability to generate outperfor- mance by playing the differences in interest rates and currencies after the introduction of the Euro, falling government bond yields, and a recognition that credit will be the primary means by which to add value in fixed income portfolios. The inclusion of bank capital in major European credit indices in