The Solvency Ratio

Introduction

The purpose of the Basel agreements is to provide guidance to banks in the restructuring of their balance sheets. The McDonough ratio (formerly Cooke ratio), which we will explain below, is the benchmark, not by force of law but by its implementation via local regulatory authorities and regulations. In Europe, the EU is responsible for applying the Basel Committee recommendations via the CAD (Capital Adequacy Directive).

The new ratio of the Basel agreements, called the McDonough ratio, does not change the spirit of the initial agreement but strengthens it. This ratio may also be referred to as a solvency or capital adequacy ratio. The negotiating process, termed Basel II (or Basel 2), lasted for several years and was covered extensively by the financial media.

What is a company balance sheet?

A company balance sheet may be broken down as follows:

• On one side, you have financing sources including equity and liabilities:
  • Owner's equity
  • Long-term debt (normally, one year and over)
• On the asset side, we find everything of value generated from the financing sources:
  • Fixed tangible (property, plant and equipment) and intangible assets (equity investments in other companies)
  • Inventory (or stocks)
  • Trade receivables

The balance sheet is presented as Total Assets = Total Liabilities + Equity

The company's capital includes all resources subject to business risk, that is, they may be recovered only at the time of the company's liquidation (equity) or after a very long period of time (quasi-equity).

Net assets are the totality of a company's assets minus all existing or potential commitments.

Net Assets = Fixed Assets + Current and Financial Assets - Total Debt

The solvency of any business, regardless of the type, consists in its ability to pay back the entirety of its commitments in case of total liquidation. It therefore depends on the quality of its assets, particularly the ease with which they may be liquidated, and the amount of its commitments (debt).

Since Assets = Liabilities + Equity

and

Equity + Debt = Fixed Assets + Current and Financial Assets

Equity = Net Assets

Conclusion: solvency, which amounts to debt/net assets, may also be measured by debt/equity.

Application to the case of a bank

For a bank, debt consists essentially of sight deposits. The financial assets are the loans granted. After all, the purpose of a bank is to distribute loans!

A bank's solvency therefore consists of its ability to fulfil the withdrawal demands of its depositors. And that is where the regulatory authorities come in: to ensure that banks are indeed capable of meeting their obligations. This is a matter that affects the economic stability of an entire country.

As we saw in the equation above, the bank must collect more deposits to be able to distribute more credit. Otherwise, it will be unable to meet withdrawal demands, unless it increases its equity.

As it turns out, a business entity is more secure if part of its current assets is not financed by sources that must be repaid within the year. Such assets always have an uncertain and thus risky character (especially when essentially composed of loans, as is the case for banks!), while debt itself is inevitable. That is why it is important that a portion of assets be financed by equity capital and not just debt.

However, if we require a bank to increase its equity capital, it will have more to lose in case of bankruptcy. As such, it will have a tendency to be more risk-averse in the granting of loans.

The level of equity capital is the guarantee of the entity's financial soundness. Equity acts to preserve the bank's solvency against the risk of loss engendered in the course of its operations.

For all these reasons, the solvency ratio for banks was initially expressed as total equity over distribution credit, weighted according to their level of risk. In its new version, the ratio factors in other risk categories than credit risk, such as market risk and operational risk, as expressed below:

We will review the ratio's different items in the following paragraphs. The summary that follows is meant to give you an idea of the complexity of the Basel agreement provisions and the capital adequacy directives.

Definition of regulatory capital

The provisions incorporate the following balance sheet items in equity capital. We have included only the most significant items. For a fuller list, please see the quoted documents in the appendix.

In the European directive, tier-one capital must represent a minimum of 50% of the total capital required to cover the institution's credit risk, with coverage of the remainder limited to tier-two capital. A minimum two-sevenths of capital must be available to cover market risk, with a minimum of 2/7 of capital required to cover market risk, the remainder of which may be provided by tier-two and tier-three capital

Measuring credit risk

Credit risk is the risk that a borrower will default or that his financial situation will worsen to the point of devaluing the bank's loan to him. To measure credit risk, we will therefore weight the total amount of the loan, referred to as the outstanding balance, by the quality of the borrower.

The Basel Committee thus defines several categories of credit risk exposure, with a weighting for each category to be applied to outstanding loan balances. This weighting extends from 0% for sovereign governments, which amounts to saying that sovereign debt is risk-free, to 150% for counterparties with the worst credit ratings.

In effect, in the standardised approach (see below), the weightings to apply depend on the ratings assigned by the credit rating agencies (Moody's, Standard & Poor's, etc.) to the counterparty.

Measuring market risk

Market risk is the risk of a partial or total devaluation of positions taken due to changes in market conditions (share prices, interest rates). This risk applies to the following instruments: interest rate products (bonds, interest-rate derivatives), equities, currencies and commodities.

Interest rate risk is measured on the basis of the trading portfolio, i.e. the positions held by the financial institution for its own account to make short-term gains, as opposed to “normal” financing and investment activities.

However, the capital required to cover currency and commodity positions is applied to all these positions wherever they may be held in the bank.

Each financial instrument category requires a different calculation method, which always consists of first evaluating a position, then calculating the capital required by applying a weighting of 0% to 8% to the position.

Measuring operational risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

In the standardised approach, the banking operation is spread among several fields or business lines. Market authorities assign a weighting factor to the "average" gross revenue of each business line, which is supposed to reflect the operational risk incurred by each line.

Calculation of the new capital ratio

To keep the calculation consistent, the equity amounts required to cover market and operational risk must be multiplied by 12.5 (the inverse of 8%) before they are incorporated into the final calculation.

Credit risk = Assets weighted according to their risk.

Market risk = Capital required to cover market risk x 12.5.

Operational risk = Capital required to cover market risk x 12.5.

Ratio (as a reminder):

Multiple approach to risk calculation

For each risk category (credit, market, operational risks), financial institutions have the choice of using either the standardised approach or more sophisticated methods based on their own figures and procedures.

For credit risk, there are three possible approaches: the standardised approach, the IRB (Internal Ratings-Based) approach or advanced IRB. In the standardised approach, the reliability of the counterparties is measured by the ratings attributed by ratings agencies. The IRB approach enables financial institutions to use their own internal rating methods. Financial institutions are encouraged to have their own internal ratings systems by the fact that their usage results in the reduction of the capital requirement.

The use of an internal method may also be used for market risk.

Three methods may be used to measure operational risk: the baseline indicator based solely on the institution's net banking income, the standardised approach described above and Advanced IRB.

Banks are encouraged to use an advanced method for each risk category, but it must be submitted to regulatory authorities for approval. Above all, a financial institution does not have the right to return to the standardised approach once it has adopted an advanced method.

The three pillars of the new Basel agreement

Aside from the mathematical aspect of calculating equity capital, the Basel Commission wanted to define more precisely the proper functioning of the banking market. Therefore, the new Basel agreement is based on three pillars:

The prudential oversight process reinforces the power of regulatory authorities and, among other powers, grants them latitude to increase the regulatory capital requirement if need be.

Market discipline describes all documents that banks are required to make public in order to comply with regulations (market disclosure). These documents mainly relate to the calculation of equity capital and the institution's risk exposure. The use of advanced methods is predicated on the publication of this information.

On the Web

This presentation is meant to provide an overview and express the spirit of the Basel agreements. For more information, the best source is the definitive document which can be found on the Bank for International Settlements (BIS) web site.