Capital Adequacy Ratio Wiki Requirements and Implementation

The Capital Adequacy Ratio (CAR) is a crucial metric for banks to ensure they have enough capital to absorb potential losses. It's a measure of a bank's ability to withstand financial stress.

To calculate the CAR, banks use a formula that takes into account their total capital and risk-weighted assets. The risk-weighted assets are determined by the type of assets held, with higher-risk assets given a higher weight.

Banks are required to maintain a minimum CAR of 8% to 10.5% depending on the jurisdiction. This requirement is set by regulatory bodies to ensure the stability of the financial system.

In practice, banks use a variety of methods to manage their CAR, including reducing risk-weighted assets, increasing capital, or using off-balance sheet items.

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A bank's risk-weighted assets are calculated by multiplying each exposure amount by the risk weight appropriate to the exposure based on the exposure type or counterparty. This is done to determine the risk-weighted asset amount for each exposure.

The total risk-weighted assets for general credit risk equals the sum of the risk-weighted asset amounts calculated under this section. This is a straightforward calculation that helps banks determine their overall risk exposure.

To calculate the risk-weighted asset amount for operational risk, a bank must first determine its dollar risk-based capital requirement for operational risk. This can be done using one of two methods, depending on whether the bank has qualifying operational risk mitigants or not. If it does, the risk-weighted asset amount is calculated by multiplying the dollar risk-based capital requirement by 12.5.

For global systemically important BHCs, the risk-weighted asset amount is calculated using a more complex formula that takes into account various systemic indicators and coefficients. The formula is as follows: CategorySystemic indicatorCoefficient value (%)SizeTotal exposures4.423InterconnectednessIntra-financial system assets12.007Intra-financial system liabilities12.490Securities outstanding9.056ComplexityNotional amount of over-the-counter (OTC) derivatives0.155Trading and available-for-sale (AFS) securities30.169Level 3 assets161.177Cross-jurisdictional activityCross-jurisdictional claims9.277Cross-jurisdictional liabilities9.926

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Minimum Requirements are crucial to ensuring the stability and security of financial institutions.

Tier 1 and Tier 2 capital requirements are closely linked, with a combined total that must be above 8%.

The exact amounts of Tier 1 and Tier 2 capital are not specified here, but we know they need to add up to meet this threshold.

To meet these requirements, financial institutions must carefully manage their capital structure to ensure they remain above this minimum threshold.

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A bank holding company's method 1 score is the sum of its systemic indicator scores for the twelve systemic indicators set forth in Table 1 of this section.

The method 1 score is calculated by determining the systemic indicator score for each of the twelve systemic indicators, which is done by dividing the amount of that systemic indicator by the aggregate global indicator amount for that systemic indicator.

The systemic indicator score is then multiplied by 10,000 and the indicator weight corresponding to the systemic indicator. For example, the indicator weight for total exposures is 20 percent.

The maximum substitutability score is 100 basis points, which is the sum of the systemic indicator scores for the indicators in the substitutability category.

The systemic indicators are categorized into five categories: Size, Interconnectedness, Substitutability, Complexity, and Cross-jurisdictional activity.

Here is a breakdown of the indicator weights for each category:

The Bank of England was in the process of implementing the Basel III framework on large exposures as of 2024.

This framework aims to limit large exposure to external and internal counterparties, a key aspect of operational counterparty risk.

In 2018, a framework for limiting large exposure to external and internal counterparties was already implemented.

Operational Counterparty Risk is a significant concern for many businesses. Limiting large exposure to external and internal counterparties is a crucial step in managing this risk.

In 2018, a framework for limiting large exposure to external and internal counterparties was implemented. This framework helps to mitigate the risk of significant financial losses due to counterparties.

The Bank of England is in the process of implementing the Basel III framework on large exposures in the UK. This framework aims to strengthen the regulation of banks and other financial institutions.

Derivative contracts can be treated in different ways depending on the regulatory framework used.

Under the IMA, a Board-regulated institution must hold risk-based capital against an equity derivative contract's counterparty credit risk, in addition to risk-based capital against the contract itself.

This means that the institution must consider the creditworthiness of the counterparty when determining the risk associated with the contract.

A Board-regulated institution using the SRWA, on the other hand, may choose not to hold risk-based capital against the counterparty credit risk of equity derivative contracts.

However, this choice must be applied consistently across all such contracts, and the institution must also consider the impact of qualified master netting agreements.

In cases where contracts are subject to a qualified master netting agreement, the institution must either include all or exclude all of the contracts from any measure used to determine counterparty credit risk exposure.

This highlights the importance of careful consideration and consistent application of regulatory frameworks when managing operational counterparty risk.

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Securitization and Off-Balance Sheet exposures are crucial components of a bank's balance sheet, requiring careful calculation and risk assessment to ensure compliance with regulatory standards.

A Board-regulated institution must calculate the exposure amount of an off-balance sheet exposure using the credit conversion factors (CCFs) in paragraph (b) of § 217.33.

The CCFs range from 0 to 100 percent, depending on the type of commitment, such as a guarantee, repurchase agreement, or credit-enhancing representation and warranty, which must be assigned a 100 percent CCF.

A Board-regulated institution may determine the risk-weighted asset amount of an eligible ABCP liquidity facility by multiplying the exposure amount by the highest risk weight applicable to any of the individual underlying exposures covered by the facility.

Securitization exposures to which the SSFA and gross-up approach do not apply are assigned a 1,250 percent risk weight, unless they meet specific requirements, such as being in a second loss position or better to an ABCP program.

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In securitization, collateralized transactions are often used to mitigate counterparty credit risk. A Board-regulated institution must hold risk-based capital against an equity derivative contract under this part.

Equity derivative contracts are treated as wholesale exposures, which means they're subject to a supplemental risk-weighted asset amount under § 217.132. This is an additional layer of capital requirement.

A Board-regulated institution may choose not to hold risk-based capital against the counterparty credit risk of equity derivative contracts under the SRWA, but only if it does so for all such contracts. This means a blanket approach is required.

If equity derivative contracts are subject to a qualified master netting agreement, a Board-regulated institution using the SRWA must either include all or exclude all of the contracts from any measure used to determine counterparty credit risk exposure.

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Securitization is a complex financial concept that can be tricky to grasp, but let's break it down. A Board-regulated institution must assign a 1,250 percent risk weight to all securitization exposures that don't apply the SSFA or gross-up approach.

To determine the risk-weighted asset amount of an eligible ABCP liquidity facility, a Board-regulated institution can multiply the exposure amount by the highest risk weight applicable to any of the individual underlying exposures.

Securitization exposures in a second loss position or better to an ABCP program can be risk-weighted differently. A Board-regulated institution can determine the risk-weighted asset amount by multiplying the exposure amount by the higher of 100 percent or the highest risk weight applicable to any of the individual underlying exposures of the ABCP program.

For a securitization exposure to qualify for this treatment, it must not be an eligible ABCP liquidity facility and must be economically in a second loss position or better. The first loss position must provide significant credit protection to the second loss position, and the exposure must qualify as investment grade.

A Board-regulated institution must calculate the exposure amount of an off-balance sheet exposure using the credit conversion factors (CCFs) in paragraph (b) of this section.

These CCFs are used to determine the risk associated with off-balance sheet items, and they vary depending on the type of item and its characteristics. The unused portion of a commitment that is unconditionally cancelable by the institution must be assigned a zero percent CCF.

For commitments with an original maturity of one year or less that are not unconditionally cancelable, a 20 percent CCF must be applied. This is also the case for self-liquidating, trade-related contingent items that arise from the movement of goods, with an original maturity of one year or less.

Commitments with an original maturity of more than one year that are not unconditionally cancelable require a 50 percent CCF. This also applies to transaction-related contingent items, including performance bonds, bid bonds, warranties, and performance standby letters of credit.

Guarantees, repurchase agreements, off-balance sheet securities lending transactions, and off-balance sheet securities borrowing transactions require a 100 percent CCF. This means the exposure amount for these items is equal to the maximum contractual amount of the commitment, repurchase agreement, or credit-enhancing representation and warranty, as applicable.

In the U.S., Basel III applies not only to banks but also to all institutions with more than $50 billion in assets. These institutions must meet stricter capital and leverage requirements, including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions.

Market liquidity is also a key focus in the U.S., with institutions required to conduct liquidity stress tests and set internal quantitative limits. The Federal Reserve Board itself conducts annual stress tests using three economic and financial market scenarios, and institutions are encouraged to use at least five scenarios reflecting improbable events.

Institutions are required to publish summaries of their internal company-run stress tests, which must be run each year. The Federal Reserve Board also sets single-counterparty credit limits to cut credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital.

The single-counterparty credit limits are tighter for credit exposure between the largest financial companies. Early remediation requirements are also in place to ensure that financial weaknesses are addressed at an early stage, with one or more triggers for remediation, such as capital levels, stress test results, and risk-management weaknesses.

Required actions vary based on the severity of the situation, but may include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.

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A hedge pair is two equity exposures that form an effective hedge as long as each equity exposure is publicly traded or has a return that is primarily based on a publicly traded equity exposure. This is a key concept in understanding how banks manage their risk.

The leverage ratio is a critical metric in banking, calculated by dividing Tier 1 capital by the bank's leverage exposure. The leverage exposure includes on-balance sheet assets, derivative exposures, and securities financing transactions.

In the EU, the minimum bank leverage ratio is 3%, as required by Basel III. The UK requires a minimum leverage ratio of 3.25% for banks with deposits greater than £50 billion.

Here's a brief overview of the leverage ratio timeline:

Banks must also consider capital requirements for equity investments in funds, which were introduced in 2017. This framework takes into account a fund's leverage when determining risk-based capital requirements.

The conservation and countercyclical buffer is a crucial aspect of maintaining stability in the financial system. It's a requirement for certain financial institutions to hold a certain amount of capital as a buffer against potential losses.

Regulations dictate that if a leverage buffer is less than its requirement, certain limits on distributions and discretionary bonus payments may apply. This is to ensure that institutions have sufficient capital to absorb losses and maintain stability.

Institutions are also required to maintain a leverage buffer, which serves as a cushion against potential losses. The specific requirements for the leverage buffer can be found in the relevant regulations.

For institutions that engage in certain activities, such as forward agreements, specific requirements and exemptions may apply. These requirements are designed to ensure that institutions have sufficient capital to manage their risks and maintain stability.

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A hedge pair is two equity exposures that form an effective hedge as long as each equity exposure is publicly traded or has a return that is primarily based on a publicly traded equity exposure.

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To calculate the leverage ratio, you divide Tier 1 capital by the bank's leverage exposure. The leverage exposure includes the sum of on-balance sheet assets, add-ons for derivative exposures, and credit conversion factors for off-balance sheet items.

The minimum leverage ratio is 3% as required by Basel III. The U.S. established another ratio, the supplemental leverage ratio, which is required to be above 3.0%. A minimum leverage ratio of 5% is required for large banks and systemically important financial institutions.

Here's a breakdown of the leverage ratio timeline:

In 2017, capital requirements for equity investments in hedge funds, managed funds, and investment funds were introduced. This framework requires banks to take account of a fund's leverage when determining risk-based capital requirements associated with the investment.

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Market risk is a key consideration for financial institutions, as it can have a significant impact on their capital adequacy ratio. The Basel Accords, a set of international banking regulations, require banks to maintain a minimum capital adequacy ratio to mitigate market risk.

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Banks must disclose their market risk exposure to regulators and investors, providing a clear picture of their potential losses. This includes disclosing their exposure to various asset classes, such as equities, commodities, and foreign exchange.

Market risk disclosure requirements are designed to ensure transparency and accountability in the financial sector.

A Board-regulated institution that elects to use the subpart to calculate its risk-based capital requirements must exclude certain risk-weighted asset amounts from its calculation.

A market risk Board-regulated institution must exclude the risk-weighted asset amounts of all covered positions, except foreign exchange positions that are not trading positions, over-the-counter derivative positions, cleared transactions, and unsettled transactions.

To calculate its risk-based capital requirements, a Board-regulated institution must use the same internal model(s) used to calculate its VaR-based measure to calculate a stressed VaR-based measure at least weekly.

A Board-regulated institution must calculate a stressed VaR-based measure for its covered positions using the same model(s) used to calculate the VaR-based measure, subject to the same confidence level and holding period, but with model inputs calibrated to historical data from a continuous 12-month period that reflects a period of significant financial stress.

The stressed VaR-based measure must be calculated at least weekly and be no less than the Board-regulated institution's VaR-based measure.

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Disclosures are a crucial part of market risk management. A Board-regulated institution must provide timely public disclosures each calendar quarter of the information in the applicable tables in § 217.63.

These disclosures must be made available on the institution's public Web site or in more than one public financial report or other regulatory reports, as long as a summary table is provided to indicate the location of all such disclosures. The institution's management must ensure that the disclosures are accurate and complete.

A Board-regulated institution must have a formal disclosure policy approved by the board of directors that addresses its approach for determining the disclosures it makes. This policy must also address the associated internal controls and disclosure controls and procedures.

The board of directors and senior management are responsible for establishing and maintaining an effective internal control structure over financial reporting, including the disclosures required by this subpart. One or more senior officers of the Board-regulated institution must attest that the disclosures meet the requirements of this subpart.

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If a Board-regulated institution concludes that specific commercial or financial information would be exempt from disclosure by the Board under the Freedom of Information Act, then the institution is not required to disclose that specific information. However, it must disclose more general information about the subject matter of the requirement, together with the fact that, and the reason why, the specific items of information have not been disclosed.