Risk, Capital Adequacy, and Basel III

Risk, Capital Adequacy, and Basel III

Dr. Patricia McGraw

FINANCIAL INTERMEDIATION

November 24, 2012

Vincent Pugliese 500474323

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Introduction

The Royal Bank of Canada (operating under the name RBC) is Canada's largest bank by market capitalization ($83.8 billion November, 2012) and among the largest 15 banks globally7. The bank was first established in Halifax, Nova Scotia in 1864. RBC is one of North America's leading diversified financial services companies, the entity provides personal and commercial banking, wealth management services, insurance, corporate and investment banking and transaction processing services on a global basis7. RBC employs approximately 74,000 full and part-time employees who serve close to 15 million personal, business, public sector and institutional clients1. Furthermore, the entity provides customized trust, banking, credit and investment solutions to clients in 21 countries globally.

During 2011, the Royal Bank of Canada completed the acquisition of Blue Bay Asset Management for an estimated $1.5 billion3. The international banking group underwent significant changes during the same period with the sale of US regional retail banking operations to PNC Financial Services Group for an estimated $3.6 billion1.

In terms of revenue, during 2011 the bank was able to grow its continuing operations by $918,000,000 predominantly from wealth management services, Canadian banking and insurance operations, and lower provisions for credit losses1. However, the unfavourable Canadian dollar will continue to affect capital market operations along with challenging market conditions in Europe and the United States. Net income fell for the second year in a row by $72 million to $1.58 billion. This was mainly attributed to lower fixed income trading revenue3.

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Risk Management

The entities business activities expose it to a wide variety of risks in essentially all operational activities. Risk is managed by seeking to ensure that business activities and transactions provide an appropriate balance of return for the amount of risk assumed - risk must remain in the firms risk appetite. The risk appetite is the amount and type of risk RBC is able and willing to accept. The risk appetite framework is comprised of the following four major components:

1. Risk Capacity - Identifying regulatory constraints that restrict the ability to accept risk.

2. Risk Appetite - Establish and confirm on a regular ongoing basis. Comprised of drivers that are the business objectives which include risks that must be taken to generate desired financial returns, and self-imposed constraints that limit or influence the amount of risk taken.

3. Setting risk limits and tolerances to ensure that risk taking activities are within the risk appetite.

4. Measurement and evaluation of the risk profile, representing the risk the firm is exposed to, relative to its risk appetite1.

RBC's Risk Committee oversight role is designed to ensure that risk management functions are independent from the entities operation from which it is reviewing. Furthermore, that policies, procedures and controls used by the firm are within the risk framework and appetite1.

Risk measurement is essential to the integrity of the firms risk appetite, while quantitative risk measurement is essential, the firm also relies on qualitative factors. Measurement models and techniques are continually subject to independent assessment. For risks that are difficult to quantify, RBC places greater emphasis on qualitative risk factors to ensure they are within the firms risk appetite1. Stress testing is one measurement tool deployed by RBC to ensure that risks taken remain within the risk appetite. It is a key component of the capital management and capital adequacy assessment process. The stress testing

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program utilizes a variety of assumptions for different plausible adverse market and economic events, and places great emphasis on the "Value at Risk"1. The program uses macroeconomic projections that are then transformed into stress impacts on various types of risk across the organization. In addition, RBC is engaged in a broad range of stress testing activities that are specific to a particular operation, portfolio or risk type including market risk, liquidity risk, structural interest rate risk, retail and wholesale credit risk and insurance risk1.

BASEL III

The third installment of the Basel accords, scheduled to be introduced in January 2013, has been developed in response to the lack of regulation in the global financial markets. The third accord sets a global regulatory standard for market liquidity risk, stress testing, and capital adequacy5.

Basel III will require banks to increase their tier 1 capital by 2% to 6% of risk weighted assets that was mandated by Basel II6. The new regulations introduce additional capital buffers, a mandatory capital conservation buffer of 2.5% and a discretionary countercyclical buffer that would allow for an additional 2.5% of capital during periods of high growth6. Basel III also introduces additional leverage and capital adequacy ratios. Notable additions are mandates for a "Liquidity coverage ratio" and a "Net Stable Funding Ratio". The liquidity coverage ratio is designed to ensure that financial institutions have the necessary assets on hand to meet short-term liquidity disruptions. Banks will be required to hold an amount of highly liquid assets equal or greater than their net cash over a 30-day period. The Liquidity coverage ratio will be mandatory in 2015. The "Net Stable Funding Ratio" is a mandate that requires

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stable funding over weighted long-term assets to be greater than 100%. The requirement will be mandatory in 2018.

Capital Structure

Capital structure is the composition of a firm's debt and equity financing for operations. Companies may choose to finance themselves through equity issues, issues of debt, and certain hybrid securities such as preferred shares, convertible bonds, etc. A common measure to indicate a firm capital structure is the debt to equity ratio. The ratio gives insight on how financially leveraged a firm may be. To achieve this ratio, one must divide total long-term debt by equity. During