Regulatory Capital and Capital under German GAAP. Comparison and Implications

Structure

List of abbreviations

1 Introduction

2 Basics
2.1 Definitions
2.1.1 Capital under German GAAP
2.1.2 Regulatory Capital
2.2 Functions
2.2.1 Capital under German GAAP
2.2.2 Regulatory Capital

3 Analysis
3.1 Comparison
3.2 Implications

4 Analysis including deductions

5 Conclusion

6 Bibliography

Abstract

This paper provides an overview of equity according to the HGB and regulatory capital as defined by Basel III and also its functions. In the comparison, it becomes clear that regulatory capital is defined much broader than balance sheet equity, since hybrid and debt capital is also included in the regulatory capital. The functions are also different. Similarities are found mainly in the liability function, which distinguishes between the going and gone-concern perspective. It is examined whether a synchronization of the equity concepts is possible and useful. Furthermore the extent to which the results change if the regulatory capital deductions are included is described. Both analyzes (with deductions and without) show that synchronization is not possible. This is due to the differences in the quantities and qualities of equity according to their legal regulation.

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

The concept of equity is used in different contexts. While there are no regulatory provisions on capital adequacy for non-banks other than the capital stock, the legislature of credit institutions and insurance companies considered it to be necessary to regulate the amount and adequacy of equity due to the particular risks of the banking and insurance business . In the German Banking Act (KWG), the definition of liable capital creates a bank-specific equity concept that differs from the one of the balance sheet equity according to the German GAAP (German Commercial Code (HGB)). On 16 December 2010, the Basel Committee on Banking Supervision published its framework "Basel IN" in response to the banking crisis, and over the years it has been supplemented and revised.¹ At the European level, the implementation of the Basel III framework is carried out through the so-called CRD IV package, which consists of a regulation which is directly applicable and a directive which is to be transposed into national law. These measures represent a major step towards a sustainable strengthening of the resilience of the banking system.²

In this paper, an overview is given of the balance sheet equity and the regulatory capital under Basel III and their functions. In addition, both capital concepts are compared, whereby similarities and opposites become clear. The resulting implications are then presented and the question clarified whether a synchronization of both concepts would be useful. In addition, a brief look will be given on how the situation will change if the Basel III deductions are included in the analysis.

2 Basics

As already mentioned in the introduction, the capital concepts either based on regulatory capital or equity pursuant to the HGB differ quite a lot. The functions also have different objectives. In order to compare regulatory capital and equity according to the HGB, these must be clarified first.

2.1 Definitions

2.1.1 Capital under German GAAP

Capital under German GAAP includes the funds made available temporary unlimited by the owners of the company. These funds flow to the company from the outside or through the waiver of profit distributions. Equity can be financially seen as the difference between assets and loan capital.³ Commercial law defines the components of equity for the balance sheet as presented in Art. 266 III HGB. According to Article 266 III HGB, the balance sheet equity includes subscribed capital, capital reserve, retained earnings, profit brought forward/ loss carried forward and net profit/ loss. As a general standard, Art. 272 I 1 HGB defines the subscribed capital as the capital to which the responsibility of the shareholders for the liabilities of the capital company is limited to the creditors. Therefore, the designation "subscribed capital” is not permissible for equity components of individual companies and partnerships with personally liable companies. The liability mass of the company against its creditor obtains all components of the equity capital. For limited partnerships and open trading companies in purpose of Art. 264a of the HGB, companies in which not at least one natural person or an OHG or KG or other persons of a natural person as a personally liable shareholder is involved, there is in Art. 264c II HGB a more precise statement of the equity. Thereafter, capital shares, reserves, profit brought forward/ loss brought forward and net income/ loss are recognized as equity capital.⁴

Despite the rules laid down in the HGB under the section "Third Book of Trading Books" for the presentation of equity capital, there is no clear legal concretization of the concept of equity capital. In its opinion HFA 1/1994, the main committee of the IdW (German institute of public auditors) set cumulative requirements for the recognition of participation rights as equity and therefore providing a practically relevant assessment aid. The equity criteria include the subordination, loss participation, performance-related remuneration and long-term capital lease.⁵

2.1.2 Regulatory Capital

The Basel Committee on Banking Supervision (BCBS) has published criteria catalogs, which have largely been adopted by the European Commission in the CRR. The regulatory capital is broken down into hard core capital, additional core capital and supplementary capital.⁶

The hard core capital (Common Equity Tier 1 (CET 1)), defined in Art. 26 to 50 CRR, is the capital with the best quality. The definition of the CET 1 according to the BCBS primarily ensures that the instruments bear losses of the banking business that it is available indefinitely and is only to be remunerated subordinated to receivables from credit institution. For equity banks, it essentially consists of share capital, the premium and retained earnings (profit reserves and fund for general banking risks). In the case of cooperative banks and savings banks, etc., it appears problematic that the paid-up capital is not always permanently available because repayment possibilities are provided. In order to qualify as CET 1, repayment must be refused or restricted (Art. 29 CRR). The hard core capital ratio is at least 4.5% (Art. 92 I a CRR).

The additional core capital (Additional Tier 1 (AT 1)), defined in Art. 51 to 61 CRR, essentially consists of hybrid capital without repayment incentives (for example interest rate hikes), such as contingent convertible bonds. These are long-term subordinated convertible bonds with a fixed coupon, which are automatically converted into shares of the issuer and therefore into CET 1 capital if the CET1-ratio falls below a minimum threshold of 5.125% (Art. 54 CRR). This measure also links the additional core capital to the CET 1 and is involved in the loss absorption. The CET-1 ratio, which takes into account both CET 1 and AT 1, is at least 6% (Art. 92 I b CRR).

Supplementary capital (Tier 2 Capital), defined in Art. 62 to 71 CRR, consists of subordinated debt or hybrid capital without repayment incentives with a maturity of five years. Capital repayments are only possible with the consent of the supervisory authority (Art. 77 CRR). If the capital instruments are only available for a period of less than 5 years, the creditable amount will be reduced by zero against the residual term (Art. 64 CRR). In addition, standard approach banks can apply general credit risk adjustments of up to 1.25% of the credit risk RWA and IRB banks from the valuation allowance (overhang of the valuation adjustments over the expected loss amount) to a maximum of 0.6% RWA as supplementary capital. Impairment losses are adjustment items on the liabilities side, which are formed on a precautionary basis and according to the principle of prudence for expected credit losses. They lead to a reduction in hard core capital to the same level.⁷

The total capital ratio is the sum of the core capital ratio and the supplementary capital ratio and is at least 8% (Article 92 I c CRR). In addition, there is a capital conservation buffer, a countercyclical capital buffer, a capital buffer for systemic risks, a capital buffer for globally system-relevant institutions, and a capital buffer for institutions which are otherwise system-relevant. They are applied individually to the institutions.⁸

2.2 Functions

2.2.1 Capital under German GAAP

Equity according to the German GAAP in credit institutions fulfils six functions. The first function is the founding function. According to Art. 33 I no. 1 KWG, the establishment of the bank requires "sufficient initial capital, consisting of hard core capital”, which must amount to at least 5 million euro for CRR credit institutions (Art. 33 I d KWG). According to Art. 2 I no. 1 of the German Pfandbriefgesetz, mortgage banks must have at least a core capital of 25 million euro. The initial foundation capital is used to finance the first investments. The financing function describes, that equity, on the one hand, finances long-term fixed assets as well as the shares of credit institutions within the scope of the golden balance sheet rule. On the other hand, these balance items are included in the central concept of the risk position that has to be backed with capital.⁹

Another function is the liability function. Own funds are intended for the absorption of inter-temporary losses and the protection of depositors. Arising losses are absorbed by the capital. The higher the equity capital, the longer a company is able to cope with sustained losses, without entering into a corporate crisis.¹⁰ Since equity "is at the very end of the liquidation or insolvency-related repayment status”¹¹, it is liable to the creditors and thus provides the basis for creditor protection. The balance sheet equity capital is confronted with a bank's going concern perspective as it only absorbs ongoing losses.

The limiting function describes, that the amount of own funds limits the risk positions and the possible volume of business of a bank in general. The establishment of a credit portfolio is only permissible up to a limit of the core capital ratio, which is dependent on the equity. A specific limitation applies to large loans: their amount cannot exceed 25% of the eligible capital according to Art. 395 CRR. Pursuant to Art. 4 of the German Pfandbrief Act (PfandBG), at least 100% of the outstanding covered bonds must be guaranteed by means of "ordinary cover values". Since these cover values are again bound to own resources, this also results in a limiting function.

The assessment function for profit distribution says that the equity ratio of a single shareholder is the calculation basis for the distribution of profits and losses. Particularly in the case of corporations, the amount of dividends is based on share capital.

The capital under German GAAP also has a representation and advertising function. The absolute amount of capital as a risk capital can be presented to the public with the help of publicity and create confidence in the solvency of the institute. The existing own funds are an essential criterion for creditworthiness and rating.¹²

[...]

¹ C.f. Basel III Press release, 2010, URl and access see annex

² C.f. Deutsche Bundesbank, Monthly report 06/2013, URL and access see annex

³ C.f. Coenenberg, 2000, p.269

⁴ C.f. Ewig, 2006,p. 66f

⁵ C.f. IDW Stellungnahmen zur Rechnungslegung, 1994

⁶ C.f. Basel III: A global regulatory framework for more resilient banks and banking systems, 2010, URL and access see annex

⁷ C.f. Cech, 2017, p.75f

⁸ C.f. Bafin-Website: Bankenaufsicht, URL and last access see sources

⁹ C.f. Grill et al., 1995, p.495ff

¹⁰ C.f. Wöhe et al., 2013, p.542

¹¹ Werner, 2006, p.23

¹² C.f. Grill et al., 1995, p.495ff