Regulatory Capital (Updated)

In a previous article (link here), I referred that the risk of Unexpected Loss (UL) can be mitigated by holding sufficient equity capital:

In practice, the regulatory capital does not consist only by equity (even though it is its main component) but of three categories with specific criteria:

1. Common Equity Tier 1 (CET1)

2. Additional Tier 1?(AT1)

3. Tier 2 Capital?(T2)

Here I present you the main concepts and definitions that I will use in other articles and that I consider essential to understand the regulatory and financial dynamics of a bank:

Total regulatory capital = Common Equity Tier 1 (CET1) + Additional Tier 1 (AT1) + Tier 2 capital (T2) - regulatory adjustments

Where:

Common Equity Tier 1 = Common shares (equity) + stock surplus (share premium) of issues included Common Equity Tier 1 + Retained earnings + Accumulated other comprehensive income and other disclosed reserves

Regulatory Adjustments

The regulatory adjustments are usually required to be applied to a specific capital tier (e.g. Common Equity Tier 1) and here are the main ones:

1.Investments in TLAC: Global systemically important banks (G-SIBs) are required to have a minimum total loss-absorbing capacity (TLAC) requirement set in accordance with the Financial Stability Board’s (FSB) TLAC principles and term sheet. Bank that invests in TLAC instruments may be required to deduct them in the calculation of their own regulatory capital.

2. Shortfall of the stock of provisions to expected losses:?

Banks using IRB approach must compare:

a. The amount of total eligible provisions, including specific provisions, partial write-offs, portfolio-specific general provisions or general provisions.

b. The total expected loss amount (ELA=EL x EAD) as calculated within the IRB approach.

If the total ELA > eligible provisions (shortfall), banks must deduct the difference from Common Equity Tier 1.?

This shortfall may be recognised in Tier 2 capital up to a maximum of 0.6% of RWA calculated under the IRB approach.

3. Goodwill and all other intangibles: including any goodwill included in the valuation of significant investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation but excluding mortgage servicing rights.

4. Deferred tax assets (DTA): these rely on future profitability of the bank. DTA’s may be netted with associated Deferred tax liabilities only if both relate to taxes levied by the same taxation authority and offsetting is permitted by them.

5. Cash flow hedge reserve: Reserves (positive or negative) related to the hedging of items not at fair value on the balance sheet should be derecognised in the calculation of Common Equity Tier 1.

6. Gain on sale related to securitisation transactions

7. Cumulative gains and losses due to changes in own credit risk on fair valued liabilities

8. Defined benefit pension fund assets and liabilities

9. Investments in own shares own other capital instruments or own other TLAC liabilities

10. Reciprocal cross-holdings in the capital or other TLAC liabilities of banking, financial and insurance entities. These are designed to artificially inflate the capital position of banks and should be deducted in full

11. Investments in the capital or other TLAC liabilities of banking, financial and insurance entities that are outside the scope of regulatory consolidation

Additionally, the following items can only have a recognition of up to 10% of the bank’s common equity, after the application of all regulatory adjustments mentioned before:

1. Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities)

2. Mortgage servicing rights

3. DTAs that arise from temporary differences