Loans & Finances Experts

Unlike Moody’s and FitchIBCA, S&P includes only part of Tier 1 preferred in its calculation of certain measures of capital strength. As the rating agency considers Tier 1 preferred a weaker form of capital than common 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 different definitions, ranging from “total tangible equity” which includes Tier 1 preferred completely to “adjusted common equity,” the narrowest definition 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 riskweighted assets of 1 billion Euro, its regulatory Tier 1 ratio would be 12 percent. 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.

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. We see 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.

Tier 3 debt can exclusively support market risk in the trading book. It ranks pari passu with 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 regulator, 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 recommends limiting the use of Tier 3 to the extent that the sum of Tier 2 plus Tier 3 should not exceed Tier 1 capital.

Dated subordinated debt with a minimum maturity of 5 years and perpetual 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 subordinated only to senior debt. Regulation requires that Lower Tier 2 is amortized 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.

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 payments 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 mentioned 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.

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 earnings, 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.

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 capital 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.

The calculation of the trading book capital requirements follows the scheme displayed in the previous post. 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 the previous post.

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 layers 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 subordinated debt represent only a part of bank capital. Besides perpetual noncumulative 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.

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 ongoing 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 calculating capital requirements differentiates both books. While capital requirements 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.

Trading book items comprise:

Proprietary positions in equities, debt securities, money market instruments, 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 banking 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 opportunities and collateralization.