31 May 2011

Illusory Part of Core Tier 1 Capital

As a result of the financial crisis 2007-2009 and the ongoing regulatory initiatives (Basel III), the focus has moved from the banks’ total capital and total capital ratios to the core capital (share capital and retained earnings) and core tier 1 ratios. The obvious reason is that subordinated loans and every kind of other hybrid instruments included in capital base turned out to be ineffective in absorbing losses. But attention: there is a trick with the regulatory deductions which possibly undermines the reliability of core capital and core tier 1 ratios as presented by banks and monitored by regulators.

Namely, when calculating the available regulatory capital, certain (reasonable) deductions must be made from own funds. For example, the following items are subtracted from capital base:
* Intangible assets, incl. goodwill
* Holdings in other credit and financial institutions amounting to more than 10% of their capital
* Expected losses over provisions
* Deferred tax assets
* Certain securitisation positions
* Shares in insurance companies
Part of these deductions, such as intangible assets, is made straight and in full amount from the common equity. Regarding other deductions like expected losses over provisions, the current Basel II framework requires that at least 50% of them are made from tier 1 capital; the rest can be made from tier 2 capital. Some deductions (e.g. subtracting shares in insurance companies) are applicable to total capital base, i.e. first the total capital base is calculated and then these deductions are made.

The thing is that all applicable deductions are reflected only in the total capital ratio. When banks calculate and present their core tier 1 ratios, the later deductions from the tier 2 capital and from the total capital base are not reflected. Thus strong core tier 1 ratios may easily be illusory just because of the expected losses that are not taken into account. Also it’s difficult to compare core tier 1 ratios of different banks: those with substantial tier 2 and total capital deductions look relatively better capitalised than the others although they don’t certainly need to be. Furthermore, note the Basel III phase-in of deductions from Common Equity Tier 1 (CET1) capital will affect the first ones more.

As an example, consider the capital ratio calculations for Royal Bank of Scotland (RBS) Group as of 31 December 2010 (see Tables 1-a and 1-b).

In Table 1-a there are summarised the Group’s regulatory capital, risk-weighted assets and capital ratios according to Basel II framework (the detailed items from the original report are summed up for overview purposes). As can be seen, when deriving the core tier 1 ratio (row no (15)) later deductions on rows no (6), (9) and (12) are being ignored. More specifically, row no (9) consists of the following items: excess of expected losses over provisions (GBP 2,658m), securitisation positions (GBP 2,321m), material holdings (GBP 310m) and first loss of Asset Protection Scheme (GBP 4,225m). Unconsolidated investments on row (10) under deductions from total capital mainly refer to RBS Insurance (GBP 3,962m). The resulting core tier 1 ratio that is being presented by RBS is 10.7%.

When we now adjust the core tier 1 capital (to remove the illusory part) in a way that all regulatory deductions are excluded from the capital base defined as core tier 1 capital (see Table 1-b below), we see that the resulting recalculated core tier 1 ratio is 7.5%. This is quite a substantial difference compared to the reported 10.7%.

To summarise, the core tier 1 capital and the core tier 1 ratio normally reported by the banks are misleading as primary indicators of a bank’s capitalisation. Core tier 1 capital was defined only as an intermediate stage in the calculation of the total eligible capital in Basel II framework and its use is limited by that. If we want to see the bank’s capital ratio based on the strongest capital, we should exclude all necessary deductions from the core tier 1 capital.

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