Financial Institutions

The three pillars of the Basel III framework are the maintenance of minimum levels of capital, liquidity, and stable funding

• Minimum required capital for a bank is based on the risk of the bank’s assets. The riskier a bank’s assets are, the higher its required capital

• Basel III specifies that a bank should hold enough liquid assets to meet demands under a 30-day liquidity stress scenario

• The Basel III framework requires stable funding relative to a bank’s liquidity needs over a one-year time horizon.

CAMELS approach to analysing a bank

The CAMELS approach is a six-factor analysis of a bank, including capital adequacy, asset quality, management, earnings, liquidity, and sensitivity.

Capital Adequacy

To prevent financial insolvency, a bank must maintain adequate capital to sustain business losses

Capital adequacy is based on risk-weighted assets (RWAs); more risky assets require a higher level of capital

Basel III defines a bank’s capital in a tiered, hierarchal approach:

1. Tier 1 capital

   • Common Equity Tier 1 capital: common stock, additional paid-in capital, retained earnings, and OCI less intangibles and deferred tax losses

   • Other Tier 1 capital: subordinated instruments with no specified maturity and no contractual dividends (like preferred stock with discretionary dividends)

2. Tier 2 capital: subordinated investments with original maturity of more than 5 years

Tier 1 capital plus Tier 2 capital makes up the total capital of a bank.

Basel III guidelines specify a minimum Common Equity Tier 1 capital of 4.5% of RWA, minimum total Tier 1 capital of 6% RWA, and minimum total capital of 8% of RWA

Asset Quality

current and potential credit risk associated with bank assets (such as bad loans)

Management capabilities

A bank’s internal control and governance systems (including an independent board) ensure that managers do not take undue risks or engage in self-serving behavior

Earnings

Earnings are considered high quality if they are adequate as well as sustainable

For a typical bank, major sources of earnings are:

1. Net interest income

2. Service income

3. Trading income (least sustainable/ volatile year-to-year)

Liquidity

Basel III framework introduced two minimum liquidity standards:

1. Liquidity coverage ratio (LCR): is calculated as the value of a bank’s highly liquid assets divided by its expected cash outflows.

LCR = highly liquid assets / expected cash outflows

LCR estimates liquidity needs in a stress scenario - 30 day horizon

1. Net stable funding ratio (NSFR): is the percentage of required stable funding that is sourced from available stable funding.

NSFR = available stable funding / required stable funding

NSFR relates the liquidity needs of a bank’s assets to the liquidity provided by the bank’s liabilities (funding sources) - one year horizon

The standards recommend a minimum NSFR of 100% and minimum LCR of 100%

Under liquidity, “concentration of funding” and “maturity mismatch” are issues

Sensitivity to Market Risk

A bank’s interest rate risk is the result of the differences in maturity, rates, and repricing frequency between the bank’s assets and its liabilities.

Other factors in analysing a bank

• Government support

• Government ownership

• Bank mission (global banks have a well-diversified asset base, community banks have a focus on a single industry)

• Culture (risk-taking or not)

P&C vs L&H Insurers

• P&C: lumpier claims, shorter float, longer hard pricing periods, shorter claim periods

• L&H: predictable claims, longer float, longer soft pricing periods, longer claim periods. The relative predictability of L&H insurers’ claims generally allows these companies to have lower capital requirements and to seek higher returns than P&C insurers.