IMPACT ON BANKS: CAPITAL RATIOS, TIER 1 CAPITAL AND RISK WEIGHTED ASSETS

Transcription

1 SG Analytics Solve. Synergise. Surpass. IMPACT ON BANKS: CAPITAL RATIOS, TIER 1 CAPITAL AND RISK WEIGHTED ASSETS By Manish Jalan April 19, 2016 Investment Research Business Research Data Analytics Market Research

2 2 Table of Content Abstract The Macro Level Stress Tests Methodologies for calculation of Tier 1 Capital Methodologies for calculation of Risk Weighted Assets Conclusion

3 3 Abstract Stress testing is an evolving discipline that is playing an increasingly important role in the risk management at banks as well as in supervisors assessments of capital and liquidity buffers especially with the introduction of the Basel 3 norms. The number of scenarios and assumptions made during stress testing makes it increasingly difficult at times to cater to all the disciplines and at the same time, build a comprehensive risk framework which can convince regulators from all ends. Many banks are concerned about how much time stress tests now take and the frequency with which they are being requested. There are also concerns over the relevance of the requested tests, with supervisors seen by some banks as focusing on fighting the last war rather than looking closely enough at new and emerging threats. The workload is certainly considerable and has a direct bearing on capital and distributions. In the US, banks need to pass a stress test hurdle before they are allowed to make dividend and bonus payments. The purpose of this paper is to walk past all the forms and levels of stress testing, which is mandated by the regulator on both the micro level and macro level views. The paper will also identify methodologies and practices that banks can adapt for testing their capital adequacy, ratios, etc. which are mandated by the Basel 3 norms. The Macro Level Stress Tests The macro level stress tests focuses on macro factors like sudden drop in the GDP rate, rise in unemployment data, rise in jobless claims, house market collapse, etc. and how these shocks are perceived by the banks. Basel 2 and 3 outlines capital adequacy norms and ratios which each banks are supposed to meet in order to sustain through these stressed times. A Federal Reserve macroeconomic scenario outlines a list of 16 macroeconomic variables, which needs to be stress tested for. Some of these scenarios are as under: The regulators also go on to specify some specific numbers that these tests might have. For example, the Fed s severely adverse scenario in the US results in unemployment hitting 10% in mid- 2016, real gross domestic product falling about 4.5% by the end of 2015 and a 25% decline in house prices. In addition, the test s severely adverse scenario assumes a jump in oil prices to about $110 a barrel. The table below outlines some of the macro stress test scenarios and numbers, which have been specified by the federal reserve going into Q4 of 2016 and However, this table has only got indicative numbers and regulators can change the numbers during the stress testing to figure out if banks are adequately capitalized to manage their balance sheets during severely stressed conditions. So the next logical question is what are the Basel 3 norm which gets impacted due to these scenarios? The capital ratio norms in Basel 3, involves Tier 1 capital in the numerator and risk weighted assets in the denominator. We next outline the methodologies, which a bank can use and build models around for calculation of their Tier 1 Capital under scenarios of severely stressed conditions. Methodologies for calculation of Tier 1 Capital The biggest impact of stress tests occurs in the bank s Tier 1 capital values. This value might get significantly reduced to an extent of 200 to 500 basis points or even more during the period of severely stressed conditions. Every bank has been mandated to run stress tests and identify the amount of impact, which each component of Tier 1 capital of the bank would have during these stressed conditions. We outline some of the common methods which banks can adapt to estimate the changes in their Tier 1 capital values. Net Interest Income from loans like corporate loans, mortgages, credit card interests, etc. (Interest Risk) Fed interest rates cycle Mortgage interest rates Regression against changes in macro data Historical analysis of stressed conditions with bank s past records Usage of QRM software Projection of reduced assets volume in the balance sheet by forecasting rates, unemployment, etc. Fee Income from Mortgage banking, payment services, etc. (Fees Risk) 30 Year Mortgage rate House price index 10 Year treasury Real GDP growth More then 50% of the fees projected through regression modeling Tool-driven analytics with management inputs Scenarios from recessionary and non-recessionary periods Fees not correlated to macroeconomic factors are projected by using regular business tools Expenses: Increase in collection, legal, mortgage foreclosures, etc. House Price Index Rates Claims No regression used Usage of historical relation between expenses and credit related charge offs Charge offs increase in stressed conditions Mortgage-related expenses projected by gross delinquency rates (delinquency and foreclosure model)

4 4 Operational Expenses: Inadequate/Failed internal process, strong legal actions, customer attrition due to banks reputation and negative publicity S&P 500 Index levels Real GDP Establishing statistical linkages between expected loss and relevant macroeconomic factors. Regression of historical quarterly loss frequency and severity with macro factors Data can be both banks internal and unscaled external data sources Credit Losses and Risks: Risk of not collecting interest/principal balance of a loan, investment or derivative contract, counter party default Decline in GDP, S&P Index levels Significant increase in unemployment Sharp decline in commercial and real estate values Portfolios segregated based on loan type as: commercial loans, commercial real estate loans, housing mortgage loans, credit card loans, derivative contracts, auto loans, auto leases, etc. Individual macroeconomic factors applied where correlations are high. For example, the S&P index level has high correlation with derivatives contracts, while home loan default has high correlation with real estate values Losses forecasted on account level / portfolio level Forecast done for each quarter separately Models followed: Benchmark models, past portfolio performance, current portfolio composition, management inputs Key assumption: Past experience indicative of future performance Methodologies for calculation of Risk Weighted Assets The second important factor which gets impacted due to macro level stress tests are risk-weighted assets (RWA). Under the Basel 3 norms, the total Tier 1 capital must be 6% of the riskweighted assets (RWA). The calculation of RWA might sometime becomes qualitative as different banks perceive risks in different ways. When severely stressed conditions of macro scenarios are applied the RWA might increase disproportionately causing banks to keep aside their addition Tier 1 capital to meet the required ratios. We outline the various risk weighted assets which the banks might have and their risk percentage keeping in mind the stressed conditions. hold can be tricky (for example, Mortgage CDO during period) and during those times digging deeper into the risk exposure of the bank becomes a necessity. As specified under the Basel norms risk exposures which cannot be clearly explained by the bank would be calculated at a whopping 1,250% of the asset value. This would significantly increase the risk weighted assets of banks and hence deplete their capital ratio. Conclusion As per the Basel norms the capital adequacy ratio is defined as: Capital Adequacy Ratio = Tier 1 Capital / Risk Weighted Assets (RWA) During the period of severely stressed conditions the bank s capital adequacy ratio gets depleted as the Tier 1 Capital erodes dramatically. The Basel 3 norms specify that the total Tier 1 capital ratio should be 6% of the RWA. An additional capital conservation buffer of 2.5% needs to be kept aside by the banks to meet conditions of severely stressed macroeconomic situations. Hence, a total of 8.5% is the minimal requirement of capital adequacy ratio under the Basel 3 norms. Stress tests run by the regulators use various paths and scenarios where they check if the requirement of 8.5% capital adequacy ratio is met under all circumstances or not. If the model fails to meet the criteria and the total Tier 1 capital comes below 8.5% watermark, then regulators can take extreme steps like withholding dividend distributions and share buyback, which can adversely impact the valuation of the bank. Hence an accurate stress testing model which is able to map various macroeconomic scenarios and at the same time, ensure that the forecasted Tier 1 Capital and risk weighted assets are calculated with accuracy and takes into account all the major scenarios would are highly appreciated by banks and regulators alike. In this white paper we show that mapping right loans, interest payments, banks fees, credit portfolio, etc. to the right macroeconomic indicator is the key to building such a model. For example, mortgage interest payments should be best mapped to housing price index and mortgage interest rates rather than to S&P Index levels. At the same time, using banks own past historical data, benchmark models, management inputs on the behavior of their loan portfolios during adverse conditions can add an extra edge to the model laying deeper insights into the bank s capital during the macro level severely stress situations. The bank first has to devise a methodology to break their assets into various heads like cash, equity, mortgage exposures, etc. Then depending on which category the risk asset belongs to, they have to assign an appropriate risk weighted percentage. Sometimes the risk heads and exposures which the banks

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