Risk Measurement in Banks
- Capital adequacy
- The Basel Committee on Banking Supervision
- introduced a capital measurement system called Accord of 1998.
- Since 1998, the Basel Accord has been replaced with more complex capital adequacy measurement system known as Basel II
- Basel III is going to work alongside Basel I and Basel II, but the details are outside the scope
- Basel Accord
- Tier 1 capital: the bank’s core capital
- common stock
- retained earnings
- perpetual preferred stock (if it is non-redeemable and non-cumulative)
- Tier 2 capital: secondary capital
- undisclosed reserves
- revaluation reserves (increase in the value of an asset that has been reappraised)
- general provisions
- general loan-loss reserves
- hybrid debt capital instruments that combined characteristics of equity and debt
- subordinated term debt (debt that would be paid off in the event of default only after some other debt has been paid off)
- Capital Adequacy Ratio (CAR)
- The amount of capital a bank has is used to calculate each bank’s Capital Adequacy Ratio (CAR).
- Risk Weighted Assets (RWA) is an adjusted total assets figure that recognizes that the different assets held by banks have different risk profiles.
- Risk weighing allows banks to adjust their total assets for purposes of calculating their CAR by “discounting” assets that are less risky.
\( \displaystyle \bf CAR = \frac{Tier~1~Capital + Tier~2~Capital}{RWA} \)
Where:
CAR = Capital Adequacy Ratio
RWA = Risk Weighted Assets
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