The Management of capital

7/23/2019 The Management of capital

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Chapter Fifteen

The Management of Capital

Copyright © 2013 The McGraw-Hill Companies, nc! "ermission re#$ire% for repro%$ction or %isplay!



McGraw-Hill/Irwin

Bank Management and Financial © 2008 !e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts'eserved%

&ey Topics

• The Many Tas's of Capital

• Capital an% (is' )*pos$res

•

Types of Capital n +se• Capital as the Centerpiece of (eg$lation

• asel an% asel

• Capital (eg$lation in the a'e of the Great

(ecession.asel

• "lanning to Meet Capital /ee%s

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McGraw-Hill/IrwinBank Management and Financial © 2008 !e McGraw-Hill "#m$anies, Inc%, &ll 'ig!ts

'eserved%

ntro%$ction

• hat is capital▫ F$n%s contri$te% y the owners of a financial instit$tion

• (aising an% retaining s$fficient capital to protect the

interests of c$stomers, employees, owners, an% thegeneral p$lic is to$gh

• hy is capital so important in financial-sericesmanagement▫ t proi%es a c$shion of protection against ris' an% promotes

p$lic confi%ence• Capital has ecome the centerpiece of s$perision an%

reg$lation to%ay

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The Many Tas's Capital "erforms

1! "roi%es a c$shion against the ris' of fail$re

2! "roi%es f$n%s to help instit$tions get starte%

3! "romotes p$lic confi%ence

! "roi%es f$n%s for growth4! (eg$lator of growth

5! (eg$latory tool to limit ris' e*pos$re

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Capital an% (is's

• &ey (is's in an'ing an% Financial nstit$tions6Management▫ Cre%it (is'

▫ 7i#$i%ity (is' ▫ nterest (ate (is'

▫ 8perational (is'

▫ )*change (is'

▫ Crime (is'

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Capital an% (is's 9contin$e%:

• ;efenses against (is's▫ <$ality Management

▫ ;iersification

▫ Geographic▫ "ortfolio

▫ ;eposit ns$rance

▫ 8wners6 Capital

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Types of Capital in +se

1! Common stoc'

2! "referre% stoc'

3! =$rpl$s

! +n%ii%e% profits4! )#$ity reseres

5! =$or%inate% %eent$res

>! Minority interest in consoli%ate% s$si%iaries

?! )#$ity commitment notes

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T@7) 14A1 Capital @cco$nts of F;C-ns$re% +!=!

Commercial an's, ;ecemer 31, 2010

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8ne of the Great ss$es in the History of an'ingB

How M$ch Capital s (eally /ee%e%• (eg$latory @pproach to )al$ating Capital /ee%s

▫ (easons for Capital (eg$lation1! To limit ris' of fail$res2! To presere p$lic confi%ence

3! To limit losses to the goernment an% other instit$tionsarising from %eposit ins$rance claims

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How M$ch Capital s (eally /ee%e% 9contin$e%:• (eg$latory @pproach to )al$ating Capital /ee%s

▫ (esearch )i%ence▫ (esearch has een con%$cte% on the iss$e of whether the

priate mar'etplace or goernment reg$latory agencies

e*ert a igger effect on an' ris' ta'ing▫ Most st$%ies fin% that the priate mar'etplace is proaly

more important than goernment reg$lation in the longr$n

▫ (ecently goernment reg$lation appears to hae ecomenearly as important as the priate mar'etplace▫ )specially in the wa'e of the great cre%it crisis of 200>-200

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How M$ch Capital s (eally /ee%e% 9contin$e%:• (eg$latory @pproach to )al$ating Capital /ee%s

▫ (esearch )i%ence▫ e are not at all s$re mar'et %isciplining wor's as well for

small an% me%i$m-siDe ins$re% %epository instit$tions

▫ =ome of the most pertinent information nee%e% to assess aan'6s ris' e*pos$re is 'nown only to goernmentreg$lators

▫ (esearch has fo$n% that increase% capital %oes notmaterially lower a an'6s fail$re ris'

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The asel @greement on nternational Capital

=tan%ar%sB @ Contin$ing Historic Contract @mong

7ea%ing /ations

• The asel @greement▫ @n international agreement on new capital stan%ar%s

▫ ;esigne% to 'eep their capital positions strong▫ (e%$ce ine#$alities in capital re#$irements among %ifferent

co$ntries▫ "romote fair competition▫ Catch $p with recent changes in financial serices an%

financial innoation▫

n partic$lar, the e*pansion of off-alance-sheet commitments▫ Formally approe% in E$ly 1??▫ ncl$%e% co$ntries s$ch asB

▫ The +nite% =tates, elgi$m, Cana%a, France, Germany, taly,Eapan, the /etherlan%s, =pain, =we%en, =witDerlan%, the+nite% &ing%om, an% 7$*emo$rg

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7ea%ing /ations 9contin$e%:• asel

▫ The original asel capital stan%ar%s are 'nown to%ay asasel

▫ ario$s so$rces of capital were %ii%e% into two tiersB▫ Tier 1 9core: capital

▫ Common stoc' an% s$rpl$s, $n%ii%e% profits 9retaine%earnings:, #$alifying nonc$m$latie perpet$al preferre% stoc',minority interest in the e#$ity acco$nts of consoli%ate%s$si%iaries, an% selecte% i%entifiale intangile assets lessgoo%will an% other intangile assets

▫ Tier 2 9s$pplemental: capital▫ @llowance 9reseres: for loan an% lease losses, s$or%inate%

%et capital instr$ments, man%atory conertile %et,interme%iate-term preferre% stoc', c$m$latie perpet$alpreferre% stoc' with $npai% %ii%en%s, an% e#$ity notes an%other long-term capital instr$ments that comine oth %et

an% e#$ity feat$res

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7ea%ing /ations 9contin$e%:

• asel ▫ n or%er for a an' to #$alify as a%e#$ately capitaliDe%, it

m$st haeB1! @ ratio of core capital 9Tier 1: to total ris'-weighte%

assets of at least percent2! @ ratio of total capital 9the s$m of Tier 1 an% Tier 2

capital: to total ris'-weighte% assets of at least ? percent,with the amo$nt of Tier 2 capital limite% to 100 percent of

Tier 1 capital

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• Calc$lating (is'-eighte% @ssets▫ )ach asset item on a an'6s alance sheet an% each off-

alance-sheet commitment it has ma%e are m$ltiplie% y aris'-weighting factor▫ ;esigne% to reflect its cre%it ris' e*pos$re

▫ The most closely watche% off-alance-sheet items arestan%y letters of cre%it an% long-term, legally in%ingcre%it commitments

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• Calc$lating (is'-eighte% @ssets▫ To comp$te this an'6s ris'-weighte% assetsB

1! Comp$te the cre%it-e#$ialent amo$nt of each off-alance-sheet 98=: item

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7ea%ing /ations 9contin$e%:• Calc$lating (is'-eighte% @ssets

▫ To comp$te this an'6s ris'-weighte% assetsB2! M$ltiply each alance sheet item an% the cre%it-e#$ialent

amo$nt of each 8= item y its ris' weight

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• Calc$lating the Capital-to-(is'-eighte% @ssets (atio▫ +n%er asel , once we 'now a an'6s total ris'-weighte%

assets an% its Tier 1 an% Tier 2 capital amo$nts, we can%etermine its re#$ire% capital a%e#$acy ratios

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• Capital (e#$irements @ttache% to ;eriaties▫ The asel capital stan%ar%s were a%$ste% to ta'e

acco$nt of the ris' e*pos$re an's may face from%eriaties▫ F$t$res, options, swaps, interest rate cap an% floor contracts,

an% other instr$ments▫ =ometimes e*pose a an' to co$nterparty ris'

▫ The %anger that a c$stomer will fail to pay or to perform,

forcing the an' to fin% a replacement contract with anotherparty that may e less satisfactory

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• Capital (e#$irements @ttache% to ;eriaties9contin$e%:▫

asel re#$ire% a an'er to %ii%e each contract6s ris'e*pos$re into two categories1! "otential mar'et ris' e*pos$re2! C$rrent mar'et ris' e*pos$re

▫ 8nce the replacement cost of a contract is %etermine%B▫ The estimate% potential mar'et ris' e*pos$re amo$nt is

a%%e% to the estimate% c$rrent mar'et ris' e*pos$re to%erie the total cre%it-e#$ialent amo$nt of each %eriatiecontract

▫ This total is m$ltiplie% y the correct ris' weight, to fin% thee#$ialent amo$nt of ris'-weighte% assets represente% yeach contract

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7ea%ing /ations 9contin$e%:• Capital (e#$irements @ttache% to ;eriaties 9contin$e%:

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• Capital (e#$irements @ttache% to ;eriaties 9contin$e%:

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• an' Capital =tan%ar%s an% Mar'et (is' ▫ asel faile% to acco$nt for mar'et ris'

▫ The losses a an' may s$ffer %$e to a%erse changes ininterest rates, sec$rity prices, an% c$rrency an% commo%ityprices

▫ The ris' weights on an' assets were %esigne% primarily tota'e acco$nt of cre%it ris' 9not mar'et ris':

▫ n an effort to %eal with these an% other forms of mar'et

ris', in 15 the asel Committee approe% a mo%ificationto the r$les▫ "ermitte% the largest an's to con%$ct ris' meas$rement an%

estimate the amo$nt of capital necessary to coer mar'et ris' ▫ 7e% to a thir% capital ratio 9Tier 3:

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• al$e at (is' 9a(: Mo%els (espon%ing to Mar'et(is' ▫

@ statistical framewor' for meas$ring a an' portfolio6se*pos$re to changes in mar'et prices or mar'et rates oera gien time perio%, s$ect to a gien proaility

▫ a( )*ample▫ @ an' estimates its portfolio6s %aily aerage al$e at ris' is

100 illion oer a 10-%ay interal with a percent leel ofconfi%ence

▫ f this a( estimate of 100 illion is correct, losses inportfolio al$e greater than 100 illion sho$l% occ$r less than1 percent of the time

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• 7imitations an% Challenges of a( an% nternalMo%eling▫

a( estimates an% internal mo%eling are not perfect▫ nacc$rate a( estimates can e*pose a an' to e*cessie ris' so

that its capital position may t$rn o$t not to e large eno$gh tocoer act$al losses the an' faces

▫ The portfolios of the largest an's are so comple* with tho$san%sof ris' factors it may e impossile to consistently forecast a(s

acc$rately▫ "romote Iac'testingJ

▫ )en if an in%ii%$al an' is a goo% forecaster, there maystill e tro$le %$e to systemic ris'

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• asel ▫ an'ers fo$n% ways aro$n% many of asel 6s restrictions

▫ Capital aritrage▫ nstea% of ma'ing an's less ris'y, parts of asel seeme% to

enco$rage an's to ecome more ris'y▫ asel represente% a Ione siDe fits allJ approach to capital

reg$lation▫ t faile% to recogniDe that no two an's are ali'e in terms of

their ris' profiles

▫ asel set $p a system in which capital re#$irementswo$l% e more sensitie to ris' an% protect against moretypes of ris' than asel ▫ asel wo$l% e gra%$ally phase% in for the largest

international an's

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• "illars of asel

1! Minim$m capital re#$irements for each an' ase% on

its own estimate% ris' e*pos$re from cre%it, mar'et,an% operational ris's

2! =$perisory reiew of each an'6s ris'-assessmentproce%$res an% the a%e#$acy of its capital to ens$rethey are IreasonaleJ

3! Greater p$lic %isclos$re of each an'6s tr$e financialcon%ition so that mar'et %iscipline co$l% ecome amore powerf$l force compelling e*cessiely ris'yan's to lower their ris' e*pos$re

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• asel an% Cre%it (is' Mo%els▫ Cre%it ris' mo%els

▫

Comp$ter algorithms that attempt to meas$re a len%er6se*pos$re to %efa$lt y its orrowing c$stomers or to cre%it%owngra%ings

▫ Most cre%it ris' mo%els %eelop estimates ase% $ponB▫ orrower cre%it ratings▫ The proaility those cre%it ratings will change▫ The proale amo$nt of recoery sho$l% some loans

%efa$lt▫ The possiility of changing interest-rate sprea%s etween

ris'ier an% less ris'y loans

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• asel an% Cre%it (is' Mo%els▫ +n%er asel , minim$m capital re#$irements remaine%

the same for most types of loans regar%less of cre%itrating▫ +n%er asel , minim$m capital re#$irements were

%esigne% to ary significantly with cre%it #$ality

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• @ ;$al 97arge-an', =mall-an': =et of ($les▫ asel was %esigne% to operate $n%er one set of capital

r$les for the han%f$l of largest m$ltinational an's an%

another set for more n$mero$s smaller an'ing firms▫ (eg$lators were concerne% that smaller an's co$l% e

oerwhelme% yB▫ The heay $r%ens of gathering ris'-e*pos$re information▫ "erforming complicate% ris' calc$lations

▫asel anticipate% that smaller instit$tions wo$l% e aleto contin$e to $se simpler approaches in %etermining theircapital re#$irements an% ris' e*pos$res, paralleling asel r$les

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• "rolems @ccompanying the mplementation of asel ▫ asel was not perfect

▫ =ome forms of ris' ha% no generally accepte% meas$rement

scale▫ 8perational (is'

▫ How %o we a%% $p the %ifferent forms of ris' e*pos$re inor%er to get an acc$rate pict$re of a an'6s total ris'e*pos$re

▫ hat sho$l% we %o ao$t the $siness cycle▫ Most an's are more li'ely to face ris' e*pos$re in the mi%%le

of an economic recession than they will in a perio% of economice*pansion

▫ For e*ample, the Gloal cre%it crisis of 200>-200▫ =ome hae e*presse% concern ao$t improing reg$lator

competence


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• asel B @nother Maor (eg$latory =tep +n%erway,orn in Gloal Crisis▫ asel was neer f$lly implemente%

▫ Ha% to moe towar% asel in or%er to preent f$t$re crises

▫ &ey iss$e in asel ▫ ;etermining the ol$me an% mi* of capital the worl%6s

lea%ing an's sho$l% maintain if their tro$le% assetsgenerate massie losses

▫

Capital re#$irements lai% %own in asel an% apparently were ina%e#$ate in the face of the latest cre%itcrash▫ an'ers fo$n% ways to hol% oth less capital in total an% a

wea'er mi* of 'in%s of capital


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• asel B @nother Maor (eg$latory =tep +n%erway,orn in Gloal Crisis▫ "roponents of asel calle% for greater total

capitaliDation, stronger %efinition of what elongs inan's6 capital acco$nts

▫ olc'er ($le was propose% in the +!=!▫ mplementation of asel co$l% ta'e many years

▫ mplementation wo$l% e phase% in slowly, eginning in 2012

an% possily e complete% close to 201▫ asel coers the capital, li#$i%ity, an% %et positions of

in%ii%$al international an's an% also roa%er iss$esassociate% with gloal $siness cycles an% systemic ris's


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Changing Capital =tan%ar%s nsi%e the

+nite% =tates• =eeral new capital r$les create% recently y +!=!

reg$latory agencies were man%ate% y the F;Cmproement @ct of 11▫ (e#$ires fe%eral reg$lators to ta'e "rompt Correctie

@ction 9"C@: when an ins$re% %epository instit$tion6scapital falls elow acceptale leels

• +!=! an' reg$lators create% capital-a%e#$acycategories for implementing "C@B

1!ell capitaliDe%

2!@%e#$ately capitaliDe%

3!+n%ercapitaliDe%

!=ignificantly $n%ercapitaliDe%

4!Critically $n%ercapitaliDe%


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"lanning to Meet Capital /ee%s

• (aising Capital nternally▫ ;ii%en% "olicy

▫ The oar% of %irectors an% management m$st agree on theappropriate retention ratio an% %ii%en% payo$t ratio▫

&ey factor - How fast the financial firm can allow its assets togrow so that its c$rrent ratio of capital to assets is protecte%from erosion


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"lanning to Meet Capital /ee%s 9contin$e%:

• (aising Capital nternally▫ ;ii%en% "olicy


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"lanning to Meet Capital /ee%s 9contin$e%:

• (aising Capital )*ternally▫ f a financial firm %oes nee% to raise capital from o$tsi%e

so$rces, it has seeral optionsB1! =elling common stoc'

2! =elling preferre% stoc' 3! ss$ing %et capital! =elling assets4! 7easing facilities5! =wapping stoc' for %et sec$rities

▫ The choice of which metho% to $se is ase% on theireffects on a financial firm6s earnings per share


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T@7) 14A2 Metho%s of (aising )*ternal Capital for a

Financial Firm


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M G Hill/I i

<$ic' <$iD

• hat cr$cial roles %oes capital play in the management an%

iaility of a financial firm

• hat are the most important an% least important forms of

capital hel% y +!=!-ins$re% an's

• hat is the rationale for haing the goernment set capital

stan%ar%s for financial instit$tions as oppose% to letting the

priate mar'etplace set those stan%ar%s

• How is the asel @greement li'ely to affect a an'6s choices

among assets it wo$l% li'e to ac#$ire• hat are the %ifferences among asel , , an%

• hat are the principal so$rces of e*ternal capital for a financial

instit$tion

Documents

The Management of capital