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Capital Tiers revisited and in one place

fullofquestions

New Member
At first I was going to ask about the maturity stipulations on Tier 3 (i.e. that short term subordinated debt with original maturity > 2 years) but I decided against it because the more you read this stuff the more confused you get. As asja said in one of the postings below, what is the difference if original maturity of Bond A was 5 yrs while that of Bond B was 3 years but now, Bond A and Bond B, which are the exact same bond in all regards except for when they were issued, are only one month away from maturity? How are these different? If anyone has a clear answer please send it in, otherwise, please don't.

Anyway, my main question regards something that David wrote in the posting (http://www.bionicturtle.com/forum/viewthread/696/). He wrote "If total capital is a pie, the Tier II wedge can cannot be larger than Tier I wedge (Tier I must be 50%), Tier III cannot be more than 2.5X Tier I."

It seems contradictory to say that Tier I must be 50% of the total regulatory capital while Tier III cannot be more than 2.5 times that of Tier I. I must be missing something. This implies that Tier I + II + III can be more than 8% of risk weighted assets; in that case some of Tier III could be totally not necessary for regulatory purposes so it is idle money. Best put it to work... I tried going over the following posts to sort things out although it is clear that many people are confused. So now I try to resolve this issue in one post. Please confirm...

Tier I (http://www.bionicturtle.com/forum/viewthread/975/)
Tier II (http://www.bionicturtle.com/forum/viewthread/1976/)
Tier III (http://www.bionicturtle.com/forum/viewthread/696/)


As per my notes:

Tier I
- core measure of a Bank's financial strength
- Common Stock
- Preferred Stock (non-cummulative, non-redeemable)
- Disclosed reserves
-???until today I was not aware that tier I has to be 50% of total regulatory capital. Please confirm

Tier II
- second most reliable form of financial capital
- cannot be more than tier I
- Cumulative Preferred Stock
- ??Subordinated term debt (same as subordinated debt?)
- Hidden reserves (if they enter the regulatory capital measures, then they aren't hidden anymore, just kidding)
- ??Asset revaluation reserves (say bank owns properties, is this an example?)
- ??General provisions (letters of credit?)
- Hybrid debt capital
- ??Why aren't on the run senior bonds considered here? Wouldn't these be pretty good sources of money?

Tier III
- only to be used for Market Risk (capital charge calculated for Market Risk)
- ??Limited to 2.5X tier I capital.
- Short term subordinated debt with original maturity > 2 years (this makes no sense whatsoever)
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Hi FoQ,

Thanks for taking the time to summarize. Just to try and summarize the T1/T2/T3 based on my XLS @ http://www.bionicturtle.com/premium/spreadsheet/7.d.1_b2_adequacy/ (which is merely Jorion's from FRM handbook, except i added ORC)

Using the XLS example, MRC = 350, CRC = 600, ORC = 500

Market Risk Charge = $350
Tier 3 can be used for MRC (but T3 is only for MRC) but limited to 2.5x Tier 1 of MRC,
so Tier 3 (if we have it) can be used up to 2.5/3.5 of MRC; if MRC = X, then T3 can be used 2.5/3.5*X
e.g., in this case, MRC = 350 so we can use 250 Tier 3 + 100 Tier 1
...Tier 3 is done ... any excess does not contribute (MRC only)

For Credit & Ops, we can use Tier 2 but limited to one-half of ORC and CRC (i.e., so that T2 is not more than 100% of Tier 1)
CRC = 600 so the max Tier 2 = 300. So CRC = 300 T1 + 300 T2

OPR = 500 so max T2 = 250. Could be 250 T1+ 250 T2
but in my example, i only have 100 T2 left. So, ORC = 100 T2 + 400 T1 for the rest
..in this way, T2 is "capped" at 100% of T1 ... any excess is "unused"

In regard to the total T1, any remaining counts, it is good buffer ... in my example, I used:
100 T1 for MRC + 300 for CRC + 400 for ORC = 800 total T1
but 900 T1 was available and, unlike T2 and T3 which have restrictions on their qualification as buffer, all 900 T1 counts in the adequacy ratio.
...the rules are to limit the use of T3 (MRC only and only 2.5/3.5 of MRC) and T2 (no more than 1.0x of T1)...excess T2 & T3 does not count, but all T1 counts

(note: this is not the total set of restrictions; there are further details.)

David
 

fullofquestions

New Member
David,

The example is very clear, thank you. At the moment I still have just a few more questions. We are almost there.

1. For MRC I understand that Tier 3 cannot be more than 250% of Tier 1. Depending on how you look at it, this may imply that Tier 1 has to be necessarily applied to MRC. Could you please confirm whether or not it is true? Can Tier 3 be used to cover all of MRC, or, if you apply Tier 1 to MRC, then X comes from Tier 1 and then 2.5X comes from Tier 3?

2. I don't mean to confuse things, but can Tier 2 also be used for MRC? If so, I guess it cannot exceed Tier 1?

3. To summarize:
- Tier 3 cannot be more than 2.5 times Tier 1 in MRC
- Tier 3 can only be applied to MRC
- Tier 1 must be 50% of ORC and CRC
- The above implies that Tier 2 cannot be more than 50% of ORC and CRC
- ? Can Tier 2 be applied to MRC?

4. Just out of curiosity, I don't see Senior/Unsubordinated debt (probably on the run) as part of any Tier capital. Wouldn't this be a good source of capital? Any thoughts?

That is all for me. Thank you.
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
1. Yes, some Tier 1 must be required for MRC. Per the rule, at least 1.0/3.5*MRC must be Tier 1; otherwise, it will violate "T3 no more than 2.5 T1 for MRC" and/or "T2 no more than T1" (I didn't confirm that with research, it just seems to me logically necessary)

2. Yes, in regard to MRC, T2 can substitute for T3 (it's one of those details, but it's also perfectly consistent with the "quality hierarchy:" T1 > T2 > T3)

3. Yes, agree with your summary!

4. No, i think it's important to understand why senior debt is not included: if it were, essentially the entire capital structure would qualify. If the bank's asset losses impinge to the senior debt, the bank is insolvent. I would suggest a better question is, why does "lower" Tier 2 include any debt (i.e.., subordinated term debt enters into buffer)

Thanks, David
 

fullofquestions

New Member
One more question. For the 'common shares' tier 1 capital, does this refer to any common share be it from bank xyz, corporation 123 and shareholder equity (i.e. common shares of the bank itself)?

To be more specific, imagine we work at Bank A. Which of the following would qualify as tier 1 capital?

a. 1M shares of Microsoft common shares
b. 2M shares of Goldman Sachs
c. say Bank A is public and we have 1M shares of Bank A
d. say Bank A is private, is there a 'shareholder equity' equivalent in this case?

thanks
 
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