Case 064Capital and regulationCore
A bank buys a Rs 5,000 crore loan portfolio for Rs 5,300 crore. It has CET1 of Rs 6,000 crore on RWA of Rs 50,000 crore, the loans carry a 100% risk weight and the premium is goodwill deducted from CET1. What is the CET1 ratio after the deal, and how much capital does it need to stay at 12%?
1The situation
Aurevan Bank has CET1 capital of Rs 6,000 crore against risk-weighted assets of Rs 50,000 crore, a CET1 ratio of 12.0%, which is its internal target. It agrees to buy a Rs 5,000 crore portfolio of small business loans from another lender for Rs 5,300 crore in cash, a Rs 300 crore premium for the customer relationships.
The purchased loans carry a 100% risk weight. The premium is recorded as goodwill, which is deducted from CET1. The cash Aurevan pays out was held in assets with a zero risk weight.
2Your task
Compute the CET1 ratio after the deal and the capital Aurevan needs to stay at 12%, and explain where that capital goes.
Quick check
Roughly where does the CET1 ratio land after the deal?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The CET1 ratio falls from 12.0% to about 10.4%, and Aurevan needs about Rs 900 crore of new capital to stay at 12%. The deal costs capital twice. The loans add Rs 5,000 crore of RWA, which needs Rs 600 crore at 12%, and the Rs 300 crore premium becomes goodwill that is deducted from CET1 rupee for rupee.
Step 1Why does buying assets at a fair price still cost capital?
A shopkeeper who swaps Rs 5,300 of cash for Rs 5,000 of stock plus a customer list has not lost money on paper, but the bank that lends to him will count the cash as safe and the stock as risky, and will count the customer list as nothing at all. Swapping zero-weight cash for 100% weighted loans raises RWA, and paying above book value creates goodwill that capital rules do not count as loss-absorbing. So Aurevan's ratio falls from both ends: the numerator shrinks and the denominator grows.
Step 2How much capital does it need, and where does it go?
At 12%, RWA of Rs 55,000 crore needs CET1 of Rs 6,600 crore; Aurevan will have Rs 5,700 crore. The gap is Rs 900 crore: Rs 600 crore to support the new loans at 12% and Rs 300 crore to replace the goodwill deduction. The second piece is the one people forget, and it is expensive: every rupee of premium costs a full rupee of capital, while every rupee of loans costs only twelve paise.
| Rs crore | Before | After |
|---|---|---|
| CET1 before deductions | 6,000 | 6,000 |
| Less goodwill | (300) | |
| CET1 | 6,000 | 5,700 |
| RWA | 50,000 | 55,000 |
| CET1 ratio | 12.00% | 10.36% |
| CET1 needed at 12% | 6,000 | 6,600 |
| Shortfall | 0 | 900 |
Step 3What would change the answer?
Two levers, each worth pricing. Paying par removes the goodwill: the ratio would be 10.91% and the need falls to Rs 600 crore. The asset mix matters too: if the portfolio were home loans at an illustrative 35% risk weight, RWA would rise only to Rs 51,750 crore, the ratio would be 11.01%, and the need would be about Rs 510 crore, most of it the goodwill. Actual risk weights and the treatment of intangibles depend on the current RBI capital rules, which the reader should confirm.
Close with the judgement a credit or capital committee wants. The question is not only whether Aurevan can afford the Rs 900 crore, but whether the portfolio earns enough on it. If the loans return 2% after losses and costs, Rs 100 crore a year, against Rs 900 crore of capital, the deal returns about 11% on the capital it consumes. Whether that clears Aurevan's cost of equity decides whether the premium was worth paying.
Where candidates lose it
The usual miss is counting only the new RWA, getting about 10.9%, and forgetting the goodwill deduction. Interviewers ask this question precisely to see whether you know that intangibles come off capital.
The second is forgetting that the cash paid out had a zero risk weight, so the whole Rs 5,000 crore of loans is new RWA, not a swap of one risky asset for another.
What the interviewer asks next
- What premium could Aurevan pay and still need less than Rs 700 crore of new capital?
- Would a rating agency treat the goodwill the same way the regulator does?
- How would buying the portfolio through a securitisation instead change the capital cost?
Company names and figures are illustrative.