Chapter Fifteen

The Management of Capital

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Key Topics•The Many Tasks of Capital

•Capital and Risk Exposures

•Types of Capital In Use

•Capital as the Centerpiece of Regulation

•Basel I and Basel II

•Planning to Meet Capital Needs

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Tasks Performed By Capital•Provides a Cushion Against Risk of

Failure•Provides Funds to Help Institutions Get

Started •Promotes Public Confidence (credit

crisis 2007-2009 showed importance)•Provides Funds for Growth•Regulator of Growth•Role in Growth of Bank Mergers •Regulatory Tool to Limit Risk Exposure•Protects the Government’s Deposit

Insurance System

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Key Risks in Financial Institutions Management• Credit Risk▫ Probability of default on any promised payments of

interest or principal or both• Liquidity Risk▫ Probability of being unable to raise cash when

needed at reasonable cost• Interest Rate Risk▫ Probability that changes in interest rates will

adversely affect the value of net worth• Operational Risk▫ Probability of adverse affect of earnings due to

failures in computer systems, management errors, etc.

• Exchange Risk▫ Probability of loss due to fluctuating currency prices

• Crime Risk▫Due to embezzlement, robbery, fraud, identity theft

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Defenses Against Risk•Quality Management•Diversification

▫Geographic▫Portfolio

•Deposit Insurance (increased from $100K to $250K in the Fall of 2008 through Dec 2009)

•Owners’ Capital

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Types of Capital

•Common Stock•Preferred Stock •Surplus•Undivided Profits•Equity Reserves

•Subordinated Debentures

•Minority Interest in Consolidated Subsidiaries

•Equity Commitment Notes

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Relative Importance of Different Sources of Capital

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Reasons for Capital Regulation

The underlying assumption is that the private marketplace does not correctly price the impact of systemic failures. Thus, the purpose of capital regulation is:

•To Limit the Risk of Failures•To Preserve Public Confidence•To Limit Losses to the Federal Government Arising from Deposit Insurance Claims

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The Basel Agreement on International Capital Standards

An International Treaty Involving the U.S., Canada, Japan and the Nations of Western Europe to Impose Common Capital Requirements On All Banks Based in Those Countries

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Quick Quiz•What forms of capital are in use today? What

are the key differences between the different types of capital?

•What are the most important and least important forms of capital held by U.S.-insured banks? How do small banks differ from large banks in the composition of their capital accounts and in the total volume of capital they hold relative to their assets?

•What is the rationale for having the government set capital standards for financial institutions as opposed to letting the private marketplace set those standards?

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The Basel Agreement•Historically, the minimum capital

requirements for banks were independent of the riskiness of the bank▫Prior to 1990, banks were required to maintain:

a primary capital-to-asset ratio of at least 5% to 6%, and

a minimum total capital-to-asset ratio of 6%• The Basel Agreement of 1988 includes risk-

based capital standards for banks in 12 industrialized nations; designed to:▫Encourage banks to keep their capital positions

strong▫Reduce inequalities in capital requirements

between countries▫Promote fair competition▫Account for financial innovations (OBS, etc.)

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The Basel Agreement•A Bank’s Minimum Capital Requirement is

Linked to its Credit Risk▫The greater the credit risk, the greater the

required capital•Stockholders' equity is deemed to be the

most valuable type of capital•Minimum capital requirement increased to 8%

total capital to risk-adjusted assets•Capital requirements were approximately

standardized between countries to ‘level the playing field‘

•Capital is divided into Two Tiers

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Tier 1 Capital

•Common Stock and Surplus•Undivided Profits•Qualifying Noncumulative Preferred Stock•Minority Interests in the Equity Accounts of

Consolidated Subsidiaries•Selected Identifiable Intangible Assets

Less Goodwill and Other Intangible Assets

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Tier 2 Capital

•Allowance for Loan and Lease Losses•Subordinated Debt Capital Instruments•Mandatory Convertible Debt•Cumulative Perpetual Preferred Stock with

Unpaid Dividends•Equity Notes•Other Long Term Capital Instruments that

Combine Debt and Equity Features

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Basel Agreement Capital Requirements

•Ratio of Core Capital (Tier 1) to Risk Weighted Assets Must Be At Least 4 Percent

•Ratio of Total Capital (Tier 1 and Tier 2) to Risk Weighted Assets Must Be At Least 8 Percent

•The Amount of Tier 2 Capital Limited to 100 Percent of Tier 1 Capital

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Calculating Risk-Weighted Assets

•Compute Credit-Equivalent Amount of Each Off-Balance Sheet (OBS) Item

• Find the Appropriate Risk-Weight Category for Each Balance Sheet and OBS Item

•Multiply Each Balance Sheet and Credit-Equivalent OBS Item By the Correct Risk-Weight

•Add to Find the Total Amount of Risk-Weighted Assets

•See BHC’s Call report and RBC calculations: https://cdr.ffiec.gov/public/ManageFacsimiles.aspx

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Total Regulatory Capital Calculations

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What Was Left Out of the Original Basel Agreement

• The Most Glaring Hole with the Original Basel Agreement is its Failure to Deal with Market Risk, Especially Problematic During the 2007-2009 Global Credit Crisis

• In 1995 the Basel Committee Announced New Market Risk Capital Requirements for Their Banks

• In the U.S. Banks Can Create Their Own In-House Models to Measure Their Market Risk Exposure, VaR, to Determine the Maximum Amount a Bank Might Lose Over a Specific Time Period

•Regulators Would Then Determine the Amount of Capital Required Based Upon Their Estimate

•Banks That Continuously Estimate Their Market Risk Poorly Would Be Required to Hold Extra Capital

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Value at Risk (VAR) Models

A Statistical Framework for Measuring a Bank Portfolio’s Exposure to Changes in Market Prices or Market Rates Over a Given Time Period Subject to a Given Probability

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Central Elements of VaR

•An Estimate of the Maximum Loss in a Bank’s Portfolio Value at a Specified Level of Risk Over 10 Business Days

•A Statement of the Confidence Level Management Attaches to its Estimate of the Probability of Loss

•An Estimate of the Time Period Over Which the Assets in Question Could be Liquidated Should the Market Deteriorate

•A Statement of the Historical Time Period Management Uses to Help Develop Forecasts of Market Value and Market Rates of Interest

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Basel II

•Aims to Correct the Weaknesses of Basle I•Three Pillars of Basel II:▫Capital Requirements For Each Bank Are

Based on Their Own Estimated Risk Exposure from Credit, Market and Operational Risks

▫Supervisory Review of Each Bank’s Risk Assessment Procedures and the Adequacy of Its Capital

▫Greater Disclosure of Each Bank’s True Financial Condition

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Credit Risk Models

•Parallel the Development of VaR Models• IF Adverse Situation Develops in the

Future, What Magnitude of Losses Can Be Expected?

•Model Generates Risk Estimates Based On▫Borrower Credit Rating▫Probability Credit Rating Will Change▫Probable Amount of Recovery▫The Possibility of Changing Interest Rate

Spreads

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Revised Framework for Basel II

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Capital Adequacy Categories Based on Prompt Corrective Action (PCA)

•Well Capitalized•Adequately Capitalized•Undercapitalized•Significantly Undercapitalized•Critically Undercapitalized

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Internal Capital Growth Rate

= ROE X Retention Ratio

= Profit Margin X Asset Utilization

X Equity Multiplier X Retention Ratio

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Planning to Meet a Bank’s Capital Needs•Raising Capital Internally▫Dividend Policy▫ Internal Capital Growth Rate

•Raising Capital Externally▫ Issuing Common Stock▫ Issuing Preferred Stock▫ Issuing Subordinated Notes and Debentures▫Selling Assets and Leasing Facilities▫Swapping Stock for Debt Securities▫Choosing the Best Alternative

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Quick Quiz•What are the most popular financial ratios

regulators use to assess the adequacy of bank capital today?

• First National Bank reports the following items on its balance sheet: cash, $200m; U.S. government securities, $150m; residential real estate loans, $300m; and corporate loans, $350m. Its off-balance sheet items include standby credit letters, $20m, and long-term credit commitments to corporations, $160m. What are First Nation’s total risk-weighted assets? If the bank reports Tier 1 capital of $30m and Tier 2 capital of $20m, does it have a capital deficiency?

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