Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Six – The awkward squad
financial assets to their net realisable value; (ii) hidden reserves, created when
loans or investment securities are written down without specific reasons or risks;
(iii) generic reserves for possible loan losses or for latent losses which have not
yet been identified; and (iv) reserve for general banking risk, created explicitly to
protect against the cyclicality of the banking business.
Some hybrid instruments (preferred shares and subordinated debt) can qualify as
Upper Tier 2 under specific conditions. Banks are continuously developing new
financing instruments which might simultaneously satisfy investors’ interests and
regulators’ requirements. Therefore, it is not possible to compile an exhaustive
list of qualifying instruments, which is applicable across different countries.
However, to contribute to Upper Tier 2 such instruments must have certain
features:
• They must be unsecured, subordinated and fully paid-up.
• They must be perpetual, or, at least, not redeemable at the investor’s
discretion.
• Default on interest/dividend payments does not automatically oblige the
bank to stop trading, i.e. the instruments must be available to participate in
losses.
Total capital
Total capital is calculated simply as the sum of Tier 1 and Tier 2 (Upper and
Lower), less a deduction for investments in unconsolidated banking associates.
This deduction is not an explicit requirement of the Basle Accord, although it is
implemented by most national regulators to avoid double-counting of capital
across the financial system. Basle II has recently proposed a more stringent
requirement relating to the deduction of unconsolidated insurance associates
from consolidated capital.
Banks are obliged to publish their Tier 1, Tier 2 and Total Capital but they do not
have to disclose a reconciliation of their calculation with the information
contained in the balance sheet. However, many banks show a break-down of the
calculation of capital in the directors’ report.
Total capital is aimed at covering credit risk in the bank’s so-called ‘banking
book’, essentially the loan portfolio, measured by risk weighted assets (see
below).
Tier 3
Total capital does not provide cover for market risk which affects the value and
profits of the bank’s trading securities, i.e. the so-called ‘trading book’. Cover for
market risk has been introduced in the form of Tier 3 capital by the Capital
Adequacy Directive of the European Commission.
283