Case 1 Assignment: Financial Institutions and Markets

Case 1
Student’s Name
Institutional Affiliation
Case 1
C: "Chase Manhattan Bank is preparing its first asset-backed debt issue, becoming the last major consumer bank to plan to access the growing market. Asset-backed offerings enable banks to remove credit card or other loan receivables from their balance sheets, which helps them comply with capital requirements." Corporate Financing Week, October 29, 1990. What are the capital requirements referred to in this quotation?
The issue from the above quotation and reference refers to the capital requirements adopted after the implementation of the 1988 Basle Accord guidelines. The 1988 Basle Accord was meant to strengthen the reliability, soundness, dependability, and stability of the international banking system, allowing easy coordination of the regulation of capital adequacy. Adoption of the stricter risk-based capital requirements was to ensure that there was minimal competitive inequality among international banks (Hall, 1993). In accordance with the 1988 Basle Accord, the Federal Reserve Board endorsed the United State’s risk-based capital requirements, which took effect in March 1989 and were fully implemented starting December 1992 (Hall, 1992). The case above refers to the actions of Chase Manhattan Bank to securitize by issuing the first asset-backed debt issue, in compliance with the Basel Accord.
Implementation of the minimum capital requirements was aimed at pushing financial institutions to become better capitalized by raising their capital ratios and becoming less leveraged and encouraging companies to find alternative sources of capital. All the G10 countries, as well as Luxembourg and Switzerland, were the first countries to adopt the Basel Accord guidelines which were guided by two primary guidelines. The first purpose was to create a level playing ground for internationally active banks by raising the capital ratios. The guidelines intended to promote financial stability by promoting the adoption of a moderately simple approach to credit risk “with the potential to distort incentives for bank risk-taking” (Van Roy, 2005, p. 2). Having adequate capital levels ensured that commercial banks minimized the expected costs to the direct insurance system by lowering the likelihood of a financial institution from becoming insolvent (Hall, 1993). The minimum capital standards aimed at reducing risks exposed to banks in the course of their operations and ensured that commercial banks were able to access alternative sources of capital.
Before the adoption of the risk-based capital requirements, banks across the board were subjected to similar minimum capital ratio requirements, regardless of the risk levels of their portfolios. The traditional capital requirements were as follows: First, the primary capital, comprising of equity, loan-loss reserves, and some convertible debt and preferred stock, was set at least 5.5% of the assets. The second requirement, total capital, primarily disqualified subordinated debentures and the remaining preferred stock and was set at 6% if the total assets (Hall, 1993; Flannery & Rangan, 2007). The failure of the traditional capital requirements necessitated for the formulation of new, stricter capital standards to regulate the banking sector.
Adoption of the new risk-based standards indicated an explicit shift from the traditional capital standards, thus representing a fundamental change in the calculation of the riskiness of capital ratios. Saunders and Cornett (2018) posit that the Basel I Accord incorporated the varying credit risks of assets (both on and off the balance sheet) into capital adequacy measures. The two components of regulatory capital established in the new agreement included: Tier I which include “common equity, noncumulative preferred stock, and minority interests in consolidated subsidiaries” and Tier 2 which included the “loan loss allowance ( not exceeding 1.25% of risk-weighted assets), cumulative and limited-life preferred stock, subordinated debentures and certain hybrid securities (e.g. The mandatory convertible debt)” (Flannery & Rangan, 2007, p. 397; Hall, 1993, p. 414). Flannery and Rangan (2007) add that the United States regulators set the minimum acceptable level of Tier I capital, in accordance with the Basel I Accord, at 4% of the risk-weighted assets. Additionally, summing the capital of Tier 1 and Tier 2 should be more than 8% of the risk-weighted assets. Maintaining these regulatory restraints ensured that banks were exposed to minimal risks and alternative funding sources were available.
The reduction of profitability from traditional loaning prompted the US banks to opt for alternative financing methods, including securitization. According to Saunders and Cornett (2018), securitization involves packaging loans and other assets into new securities and trading the newly created asset-based securities to investors. Securitizing the loans and other assets reduce liquidity, interest rate, and credit from the asset portfolio of a financial institution. Securitization involves the selling of loans and other...