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Chapter FifteenChapter Fifteen

The Management of CapitalThe Management of Capital

Key TopicsKey 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 CapitalTasks Performed By Capital

1. Provides a Cushion Against Risk of Failure2. Provides Funds to Help Institutions Get

Started 3. Promotes Public Confidence4. Provides Funds for Growth5. Regulator of Growth• Role in Growth of Bank Mergers • Regulatory Tool to Limit Risk Exposure• Protects the Government’s Deposit

Insurance System

Key Risks in Financial Institutions Management

Key Risks in Financial Institutions Management

• Credit Risk• Liquidity Risk• Interest Rate Risk• Operational Risk• Exchange Risk• Crime Risk

Defenses Against RiskDefenses Against Risk

• Quality Management• Diversification

–Geographic–Portfolio

• Deposit Insurance• Owners’ Capital

Types of CapitalTypes of Capital

• Common Stock• Preferred Stock • Surplus (largest

capital component)

• Undivided Profits• Equity Reserves

• Subordinated Debentures

• Minority Interest in Consolidated Subsidiaries

• Equity Commitment Notes

Relative Importance of Different Sources of Capital

Relative Importance of Different Sources of Capital

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Reasons for Capital Regulation

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

Quick QuizQuick 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?

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•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 on International Capital

Standards

The Basel Agreement on International Capital

StandardsAn 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

The Basel AgreementThe 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 13 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 AgreementThe 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 CapitalTier 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

Tier 2 CapitalTier 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

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



Calculating Risk-Weighted Assets

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

Total Regulatory Capital Calculations

Total Regulatory Capital Calculations

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Problem 15-3Problem 15-3

Under the terms of the Basel Agreement, what risk weights apply to the following on balance sheet and off balance sheet items?


Residential real estate loans Credi t card loansCash Standby letters of credit for municipalCommercial loans bondsU.S. Treasury securities Long-term unused commitments to Deposits held at other banks make corporate loansGNMA mortgage-backed Currency derivative contractssecurities Interest-rate derivative contractsStandby credit letters for Short-term (under one year) loancommercial paper commitmentsFederal agency securities Bank real propertyMunici pal general obligation bonds Bankers’ acceptancesInvestments in subsidiaries Municipal revenue bondsFNMA or FHLMC issued Reserves on deposit at the Federalor guaranteed securi ties Reserve banks


0 % 20 % 50 % 100 %Cash Deposits held at Other

Domestic BanksResidential Real Estate

LoansCommercial Loans

Treasury Securities Federal Agency Securities

Long Term Commitments to Make

Corporate Loans

Standby Credit Letters for Commercial Paper

GNMA Mortgage Backed Securities

Municipal General Obligation Bonds

Currency Derivative Contracts

Investments in Subsidiaries

Short Term Loan Commitments

FNMA or FHLMC Issued or Guaranteed

Securities

Interest Rate Derivative Contracts

Credit Card Loans

Reserves on Deposit at the Federal Reserve

Standby Letters of Credit for Municipal

Bonds

Municipal Revenue Bonds

Bank Real Estate

Bankers’ Acceptances

The items which would appear in the 0%, 20%, 50% and 100% risk weight categories are the following:


• Using the following information for Bright Star National Bank, calculate that bank’s ratio of Tier I capital-to-risk-weighted assets under the terms of the Basel I agreement. Does the bank have sufficient capital?

Problem 15-4 (continued)Problem 15-4 (continued)On Balance Sheet Items (Assets) Off Balance Sheet ItemsCash $ 4.5 million Standby letters of

credit backing municipals and corporate borrowing

$ 17.5 million

U.S Treasury securities

25.6 Long term binding commitments to corporate customers

30.5

Deposit balances due from other banks

4.0 Total of all off balance sheet items

$ 48 million

Loans secured by first lines on residential property (1-4 family dwellings)

50.8 Tier I capital $ 7.5 million

Loans to corporations 105.3 Tier 2 capital $ 5.8 million

Total assets $190.2 million

Problem 15-4 (continued)Problem 15-4 (continued)

Bright Star National Bank's required level of capital under the international capital standards would be determined from:

Standby Credit Letter: $17.5 million * 1.00 = $17.5 millionLong-Term Credit Commitments: $30.5 million * 0.50 = 15.25 million

0% Risk-Weighting CategoryCash $ 4.5 millionU.S. Treasury Securities 25.6 million

$ 29.1 * 0 = $0 million20% Risk Weighting CategoryBalances Due from Other Banks $ 4.0 millionCredit Equivalent Amounts of Standby Credits 17.5 million

$ 21.5 million * 0.20 = $4.3 mil

Problem 15-4 (continued)Problem 15-4 (continued)50% Risk Weighting Category Residential Real Estate Loans $ 50.8 million x 0.50 = $25.4 million

100% Risk Weighting Category Loans to Corporations $105.3 millionCredit Equivalents of Long-Term Commitments $15.25 million

$120.55 million * 1.0 = $120.55 millionTotal Risk-Weighted Assets $150.25 mil

The bank's capital ratio is: Tier I Capital /Risk-Weighted Assets = $ 7.5 million = 4.99% $ 150.25 million Total Capital/Risk-Weighted Asset = $ 13.3 million = 8.85%

$ 150.25 million

which is just above the minimum Tier I capital requirement of 4 percent and total capital (Tier One + Tier Two) requirement of 8 percent.

What Was Left Out of the Original Basel AgreementWhat 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

• 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

• 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

Value at Risk (VaR) ModelsValue 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

Central Elements of VaRCentral 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

Basel IIBasel II

• Aims to correct the weaknesses of Basel 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

Credit Risk ModelsCredit 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

Revised Framework for Basel II

Revised Framework for Basel II

• New framework will only apply to about 20 of the largest U.S. Banks

• New rules will be phased in starting in 2008

• All banks will be affected by Basel II because of competition

• The largest banks may be able to hold less capital than is true from smaller banks

Capital Adequacy Categories Based on Prompt Corrective

Action (PCA)


Action (PCA)

• Well capitalized• Adequately capitalized• Undercapitalized• Significantly undercapitalized• Critically undercapitalized


Action (PCA)


Action (PCA)

Leverage

Capital/risk weighted assets Tier 1/risk-weighted assets Tier 1 / avg total assets

Well Capitalized > 10% > 6% > 5%

Adequately Capitalized > 8% > 4% > 4%

Undercapitalized fails to meet one or more of the above

Significantly Undercapitalized < 6% < 3% < 3%

Tangible Equity Capital / total

assets

Critically Undercapitalized < 2%

Internal Capital Growth RateInternal Capital Growth Rate

ICGR = ROE X Retention Ratio

= Profit Margin X Asset Utilization

X Equity Multiplier X Retention Ratio

Planning to Meet a Bank’s Capital Needs

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


•What are the most popular financial ratios regulators use to assess the adequacy of bank capital today?

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Quick QuizQuick QuizFirst 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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Off-Balance-Sheet Items – convert to equivalent on-balance sheet items:Standby credit letters $20 mill. * 1.00 = $20 mill.Long-term commitments to corporations $160 mill. * 0.50 = 80 mill.

Then we risk-weight all assets: Risk-Weighted AssetsCash $200 mill. * 0 = $0 mill.U.S. Government Securities: $150 mill. * 0 = 0Standby Credit Letters: $20 mill. * 0.20 = 4Residential Real Estate Loans: $300 * 0.50 = 150Corporate Loans: $350 * 1.00 = 350Long-Term Credit Commitments: $80 * 1.00 = 80 Total Risk-Weighted Assets = $584mill The bank has total capital of:Tier 1 capital = $30 mill. Tier 2 capital = $20 mill. $50 mill. The bank's capital to risk-weighted asset ratio is:$50 mill./$584 mill.= 0.086 or 8.6% which exceeds the minimum requirement of 8 percent. Moreover, more than 4 percent of the 8.6

percent in capital is Tier 1 capital, so the bank satisfies the capital requirements.

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SummarySummary15-42

• Many tasks capital performs• Types of capital in use

Common stock Equity reservesPreferred stock Subordinated debenturesSurplus Minority interest in consolidated subsidiariesUndivided profits Equity commitment notes

• Basel I– Tier I and Tier II capital– Capital-to-Risk-Weighted Assets Ratio

• Value at Risk (VaR) Models • Basel II

– Internal risk assessment– Dual (large-bank, small-bank) set of rules

Problem 15-5Problem 15-5Calculate New River National Bank’s total risk weighted assets, based on the following items that the bank reported on its latest balance sheet. Does the bank appear to have a capital deficiency?

Cash $115 millionDomestic interbank deposi ts 130 millionU.S. government securities 250 millionResidential real estate loans 450 millionCommercial loans 520 millionTotal assets $1,465 millionTotal liabilities $1,350 millionTotal capi tal $115 million

On balance sheet items include:


The risk-weighted assets of New River National Bank would be calculated as follows:

Off-Balance-Sheet Items:

Standby Credit Letters = $87 mill. * 1.00 = $87 mill.Long-Term Corporate Credit Commitments = $145 mill. * 0.50 = 72.5 mill.

Standby credi t letters that back munici palgeneral obligation bonds $ 87 millionLong-term unused loan commitments toprivate companies 145 million

Off balance sheet items include:


On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items: Asset Items Risk-Weight Cash $115 miIl. * 0 = 0U.S. Government Securities $250 mill. * 0 = 0Domestic Interbank Deposits $130 mill. * 0.20 = 26.0 mill.Standby Credit Letters $87 mill. * 0.20 = 17.4 mill.Residential Real Estate Loans $450 mill. * 0.50 = 225.0 mill.Commercial Loans $520 mill. * 1.00 = 520.0 mill.Long-Term Corporate Credit Commitments $72.5 mill. * 1.00 = 72.5 mill.

Total Risk-Weighted Assets = $860.9 mill.


Total Capital = $115 million = 0.1336 or 13.36 percentTotal Risk-Weighted Assets $860.9 million

New River's overall capital-to-assets ratio is:

Overall, it does not appear from the information given above that New River has a capital deficiency.


Colburn Savings Association has forecast the following performance ratios for the year ahead. How fast can Colburn allow its assets to grow without reducing its ratio of equity capital to total assets, assuming its performance holds reasonably steady over it planning period?

Profit Margin of Net Income Over Operating Revenue 17.75%

Asset Utilization 8.25%Equity Multiplier 9.5xNet Earnings Retention Ratio 45.00%

Problem 15-7 (continued)Problem 15-7 (continued)Internal Capital Growth Rate = Profit Margin ´ Asset Utilization ´ Equity Multiplier ´ Retention Ratio = 0.1775 ´ 0.0825 ´ 9.5 ´ 0.450= 0.0626 or 6.26% Its assets cannot grow any faster than 6.26 percent in order to avoid reducing its ratio of equity capital to total assets.

Economy & Finance

Ch15 bb