Best Practices For BIS II Implementation
The regulatory capital determines the amount of capital required to cover the risk of losses by banks. For obvious reasons not all sources of capital qualify as a buffer against risk. For instance, bonds issued by a bank are burdened by a crippling obligation. The bank has to repay the loan. This means that this money cannot be used to absorb a loss, as eventually the money will have to be raised to repay the bond holders. Only capital without strings attached (or few strings attached) can be used as a buffer. Basically a bank should be able to consume the capital without failing subsequent obligations.
For this purpose the capital eligible as regulatory capital is divided into two types, according to the amount of strings attached.
Tier one capital is capital without any (or very few) strings attached.
Basically it contains the banks equity (Issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock, excluding cumulative preferred stock). Additionally some forms of mezzanine capital with properties like equity, can be recognised as tier one capital by your central bank.
Tier two capital is capital with either some string attached or some difficulties considering its value.
Basically it contains the banks undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt (with a minimum term to maturity of 5 years for BIS 2). There may not be more tier two capital than tier one capital. Excess tier two capital will not be excepted as an eligible buffer
Tier three capital consists of short term subordinated debt. A bank may only use for covering market risk after the central banks consent (it is a t the central banks discretion). The capital covering the market risk should consist of at least 28.5% tier one capital. The remainder may be tier two or three. Although the total tier two capital must remain equal or les than the tier one capital. Some central banks may require the sum of the tier two and three capital to be less or equal to the tier one capital. This is at the discretion of the central bank.
For BIS 1 the regulatory capital was defined as the buffer for absorbing all losses. In BIS 2 a split is made between expected losses and unexpected losses. Every year some loss can be expected and provisions are made to cover these losses. Besides the expected losses there is a probability that a certain amount of unexpected loss occurs. The regulatory capital for BIS 2 (if you use IRB) is calculated to cover the unexpected losses only. Therefore the general provisions/general loan-loss reserves are not included in the tier two capital for BIS 2. In other words, under BIS 2 the general provisions/general loan-loss reserves are subtracted from both the regulatory capital and the tier two capital. If for some reason you have more general provisions/general loan-loss reserves than your expected loss, the excess may be added to your tier two capital (up to 0.6% of risk weighed assets). If you have less, the difference must be subtracted. A subtraction must be done on both tier one and tier two capital (50% on both). The general provisions/general loan-loss reserves used for the calculation should not include general provisions/general loan-loss reserves for equity exposures
Certain balance sheet items have to be subtracted from the tier capital available. If an asset is placed on the balance sheet with a dubious high value it will most probably be reflected in the equity, as both the total assets and total liability must remain equal. However this increased equity does not represent real value on which the bank can rely. For this reason goodwill should be deducted from tier one capital. Secondly, if a bank has a banking subsidiary which has not been consolidated (and thus covers its own regulatory capital by its own tier capital), its value should be subtracted from the total capital of the bank. This is done because the extra equity created by the investment in the subsidiary is already used to cover the regulatory capital of that subsidiary. It should not be possible to also use this capital for the mother.
For BIS 2 an additional subtraction is necessary. If the expected loss for equity exposures is calculated using the PD/LGD method (see article on this site), this expected loss should be subtracted from the capital (50% from tier one and 50% of tier two).