Banks capital

Chapter 15

What is capital
Funds contributed by the owners of the firm Investors who have stocks and preferred stock in the bank

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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 (optional reading) Basel I and Capital adequacy ratio Basel II (optional reading) Planning to Meet Capital Needs (optional reading)

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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 20072009 showed importance) Provides funds for growth Regulator of growth Role in growth of bank mergers Regulatory tool to limit risk exposure

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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 Probability of being unable to raise cash when needed at reasonable cost Probability that changes in interest rates will adversely affect the value of net worth Probability of adverse affect of earnings due to failures in computer systems, management errors, etc.

Liquidity risk

Interest rate risk

Operational risk
Exchange risk Crime risk

Probability of loss due to fluctuating currency prices

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: absorb losses

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Types of Capital
Common stock Preferred stock Surplus Undivided profits Subordinated debentures Minority interest in consolidated subsidiaries

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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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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 Banks 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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Capital adequacy ratio

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 offbalance 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 bhcs 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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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 Banks Risk Assessment Procedures and the Adequacy of Its Capital Greater Disclosure of Each Banks True Financial Condition

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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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Planning to Meet a Banks 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