TIER 1 CAPITAL
1. Tier 1 capital consists of shareholders' equity and retained earnings. Tier 1 capital is intended to measure a bank's financial health and is used when a bank must absorb losses without ceasing business operations. Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank's tier 1 capital by its total risk-based assets.
2. Tier 1 capital, under the Basel Accord, measures a bank's core capital. The tier 1 capital ratio measures a bank's financial health, its core capital relative and its total risk-weighted assets. In 2015, under Basel III, the minimum tier 1 capital ratio is 6%.
3. Calculate a bank's tier 1 capital ratio by dividing its tier 1 capital by its total risk-weighted assets. Tier 1 capital includes a bank's shareholders' equity and retained earnings. Risk-weighted assets are a bank's assets weighted according to their risk exposure. Can be calculated by looking at a bank's loans, evaluating the risk and then given a weight.
4. Examples
i. For example, bank ABC has shareholders' equity of $3 million and retained earnings of $2 million, so its tier 1 capital is $5 million. Bank ABC has risk-weighted assets of $50 million. Consequently, its tier 1 capital ratio is 10% ($5 million/$50 million), and it is considered to be well-capitalized compared to the minimum requirement.
ii. bank DEF has retained earnings of $600,000 and stockholders' equity of $400,000. Thus, its tier 1 capital is $1 million. Bank DEF has risk-weighted assets of $25 million. Therefore, bank DEF's tier 1 capital ratio is 4% ($1 million/$25 million), which is undercapitalized because it is below the minimum tier 1 capital ratio under Basel III.
iii. Bank GHI has tier 1 capital of $5 million and risk-weighted assets of $83.33 million. Consequently, bank GHI's tier 1 capital ratio is 6% ($5 million/$83.33 million), which is considered to be adequately capitalized because it is equal to the minimum tier 1 capital ratio.
TIER 2 CAPITAL
1. Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves.
2. Tier two capital comprises unaudited retained earnings, unaudited reserves and general loss reserves. This capital absorbs losses in the event of a company winding up or liquidating.
3. Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. In 2017, under Basel III, the minimum total capital ratio is 12.5%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 10.5% for the tier 1 capital ratio.
TIER 3 CAPITAL
1. The Tier 3 capital consisting of short-term subordinated debt would be solely for the purpose of meeting a proportion of the capital requirements for market risk.
BASEL III CAPITAL ADEQUACY RATIO MINIMUM REQUIREMENT
1. Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%. The capital adequacy ratio measures a bank's capital in relation to its risk-weighted assets.
2. The capital adequacy ratio is calculated by adding tier 1 capital to tier 2 capital and dividing by risk-weighted assets.
3. a bank's tier 1 and tier 2 capital must be at least 8% of its risk-weighted assets. The minimum capital adequacy ratio (including the capital conservation buffer) is 10.5%.
4. Simple Example
i. Assume Bank A has $5 million in tier 1 capital and $3 million in tier 2 capital. Bank A loaned $5 million to ABC Corporation, which has 25% riskiness, and $50 million to XYZ Corporation, which has 55% riskiness.
ii. Bank A risk-weighted assets of $28.75 million, or ($5 million * 0.25 + $50 million * 0.55). It also has capital of $8 million, or ($5 million + $3 million). Its resulting capital adequacy ratio is 27.83%, or ($8 million/$28.75 million * 100%). Therefore, Bank A attains the minimum capital adequacy ratio, under Basel III.
5. Regulators use this ratio to determine whether a bank is well capitalized, undercapitalized or adequately capitalized relative to the minimum requirement.
BNM ICAAP GL FOR INSURERS ON CAPITAL ADEQUACY
1. The total amount of Tier 2 capital must not exceed the amount of Tier 1 capital.
2. Tier 1 capital of an insurer is the aggregate of the following:
i. issued and fully paid-up ordinary shares (or working fund, in the case of a branch of a foreign insurer);
ii. share premiums;
iii. paid-up non-cumulative irredeemable preference shares;
iv. capital reserves;
v. retained profits;
vi. the valuation surplus maintained in the insurance funds; and
vii. 50% of future bonuses
3. Capital instruments which qualify as Tier 2 capital include:
i. cumulative irredeemable preference shares;
ii. mandatory capital loan stocks and other similar capital instruments;
iii. irredeemable subordinated debts;
iv. available-for-sale reserves;
v. revaluation reserves for self-occupied properties and other assets;
vi. general reserves; and
vii. subordinated term debts.
- Subordinated term debts are subject to the prior approval of the Bank on a case-to-case basis, include term debt and limited life redeemable preference shares which satisfy the following conditions:
- unsecured, subordinated and fully paid-up;
- a minimum original fixed term to maturity of five years;
- early repayment or redemption shall not be made without prior consent of the Bank;
- the instruments should be subjected to straight line amortisation over the last five years of their life;
- there should be no restrictive covenants; and
- the amount eligible for inclusion shall not exceed 50% of Tier 1 capital. In exceptional cases, this limit may be exceeded with the prior written consent of the Bank.
REQUIRED DEDUCTIONS FROM AGGREGATED TIER 1 & 2
1. Goodwill and other intangible assets (e.g. capitalised expenditure);
2. Deferred tax income/(expenses) and deferred tax assets;
3. Assets pledged to support credit facilities obtained by an insurer or other specific purposes;
4. Investment in subsidiaries; and
5. All credit facilities granted by an insurer and secured by its own shares.
KEY CALCULATIONS OF CAPITAL REQUIRED FOR MAJOR RISKS
1. 1 The TCR is the higher of the aggregate of capital charges for credit, market, insurance and operational risks faced by an insurer or surrender value capital charges, where applicable.
2. The credit risk capital charges (CRCC) aim to mitigate risks of losses resulting from asset defaults, related losses of income and the inability or unwillingness of a counterparty to fully meet its contractual financial obligations.
3. The market risk capital charges (MRCC) aim to mitigate risks of financial losses arising from:
(i) the reduction in the market value of assets due to exposures to equity, interest rate, property and currency risks;
(ii) non-parallel movements between the value of liabilities and the value of assets backing the liabilities due to interest rate movements (i.e. the interest rate mismatch risk);
Note: The MRCC for interest rate mismatch risks is applicable only for life insurance funds and general insurance funds with discounted liabilities.
4. The general insurance liabilities risk capital charges (GCC) aim to address risks of under-estimation of the insurance liabilities and adverse claims experience, over and above the amount of reserves already provided for at the 75% level of confidence.
Note: To arrive at the GCC, the risk charges are applied on the claims liabilities and unexpired risk reserves computed at the 75% level of confidence for each class of business after allowing for diversification.
5. The life insurance liabilities risk capital charges (LCC) aim to address the risk of under-estimation of the insurance liabilities and adverse claims experience, over and above the amount of reserves already provided for at the 75% level of confidence.
Note:
-V*’ is the adjusted value of life insurance liabilities
-‘V’ is the best estimate value of life insurance liabilities
-‘PRAD’ is the Provision of Risk Margin for Adverse Deviation
(Source: Investopedia, BNM)
