Bank Capital Management - College of...
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McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Capital Management
Transcript of Bank Capital Management - College of...
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Capital Management
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
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Introduction
• What is capital?
▫ Funds contributed by the owners of a financial institution
• Raising and retaining sufficient capital to protect the interests of customers, employees, owners, and the general public is tough
• Why is capital so important in financial-services management?
▫ It provides a cushion of protection against risk and promotes public confidence
• Capital has become the centerpiece of supervision and regulation today
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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
• 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
• 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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Capital Accounts of FDIC-Insured U.S. Commercial Banks,
December 31, 2010
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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 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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Total Regulatory Capital Calculations
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Minimum Capital Requirements across Capital Categories
Total Risk-
Based
Ratio
Tier 1 Risk-
Based Ratio
Tier 1
Leverage
Ratio
Capital Directive / Requirement
Well capitalized 10% & 6% & 5%
Not subject to a capital
directive to meet a specific level
for any capital measure
Adequately capitalized 8% & 4% & 4% Does not meet the definition of
well capitalized
Undercapitalized < 8% or < 4% or < 4%
Significantly
undercapitalized < 6% or < 3% or < 3%
Critically
undercapitalized Ratio of tangible equity to total assets is 2%
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Provisions for Prompt Corrective Action
Category Mandatory Provisions Discretionary Provisions
Well capitalized None None Adequately capitalized
1. No brokered deposits, except with FDIC approval
None
Undercapitalized
1. Suspend dividends and management fees
2 Require capital restoration plan 3. Restrict asset growth 4. Approval required for acquisitions,
branching, and new activities 5. No brokered deposits
Order recapitalization 2. Restrict interaffiliate transactions 3. Restrict deposit interest rates 4. Restrict certain other activities 5. Any other action that would better
carry out prompt corrective action
Significantly undercapitalized
1. Same as for Category 3 2. Order recapitalization 3. Restrict interaffiliate transaction 4. Restrict deposit interest rates 5. Pay of officers restricted
1. Any Zone 3 discretionary actions 2. Conservatorship or receivership if
fails to submit or implement plan or recapitalize pursuant to order
3. Any other Zone 5 provision, if such action is necessary to carry out prompt corrective action
Critically undercapitalized
1. Same as for Category 4 2. Receiver/conservator within 90
daysd
3. Receiver if still in Category 5 four quarters after becoming critically undercapitalized
4. Suspend payments on subordinated debt
d
5. Restrict certain other activities
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Example: Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 1 & 2
Assets $ 1,000
Risk Weight
Risk Weighted
Assets
Category 1: Zero Percent
Cash & reserve 104,525 0.00% 0
Trading Account 830 0.00% 0
U.S. Treasury & agency secs. 45,882 0.00% 0
Federal Reserve stock 5,916 0.00% 0
Total category 1 157,153 0
Category 2: 20 percent
Due form banks / in process 303,610 20.00% 60,722
Int. bearing Dep./F.F.S. 497,623 20.00% 99,525
Domestic dep. institutions 38,171 20.00% 7,634
Repurchase agreements (U.S. Treas & agency) 329,309 20.00% 65,862
U.S. Agencies (gov. sponsored) 412,100 20.00% 82,420
State & Muni's secured tax auth 87,515 20.00% 17,503
C.M.O. backed by agency secs. 90,020 20.00% 18,004
SBAs (govt. guaranteed portion) 29,266 20.00% 5,853
Other category 2 assets 0 20.00% 0
Total category 2 1,787,614 357,523
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Example: Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 3 & 4
Assets $ 1,000
Risk Weight
Risk Weighted
Assets
Category 3: 50 percent
C.M.O. backed by mtge loans 10,000 50.00% 5,000
State & Muni's / all other 68,514 50.00% 34,257
Real estate: 1-4 family 324,422 50.00% 162,211
Other category 3 assets 0 50.00% 0
Total category 3 402,936 201,468
Category 4: 100 percent
Loans: comm/ag/inst/leases 1,966,276 100.00% 1,966,276
Real estate, all other 388,456 100.00% 388,456
Allowance for loan and lease losses (70,505) 0.00% 0
Other investments 168,519 100.00% 168,519
Premises, eq. other assets 194,400 100.00% 194,400
Other category 4 assets 0 100.00% 0
Total category 4 2,647,146 2,717,651
Total Assets before Off-Balance Sheet 4,994,849 3,276,642
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Example: Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Off Balance Sheet
Assets $ 1,000
Risk Weight
Risk Weighted
Assets
Total Assets before Off-Balance Sheet 4,994,849 3,276,642
Off-Balance Sheet Contingencies
0% collateral category 0 0.00% 0
20% collateral category 0 20.00% 0
50% collateral category 364,920 50.00% 182,460
100% collateral category 290,905 100.00% 290,905
Total Contingencies 655,825 473,365
Total Assets and Contingencies before allowance for loan and lease losses and ATR
5,650,674 3,750,007
Less: Excess allowance for loan and lease losses (2,152)
Total Assets and Contingencies 5,650,674 3,747,855
Capital requirements Actual Capital
Minimum Required Capital
(%)
Required Capital
(Minimum)
Tier I @ 4% 199,794 4.00% 149,914
Total capital @ 8% 399,588 8.00% 299,828
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Example: Regional National Bank (RNB), Off-balance Sheet Conversion Worksheet
$ Amount
Credit
Conversion
Factor
Credit
Equivalent
$ Amount
Contingencies 100% conversion factor
Direct Credit substitutes 165,905 100.00% 165,905
Acquisition of participations in BA, direct credit substitutes
0 100.00% 0
Assets sold w/ recourse 0 100.00% 0
Futures & forward contracts 50,000 100.00% 50,000
Interest rate swaps 75,000 100.00% 75,000
Other 100% collateral category 0 100.00% 0
Total 100% collateral category 290,905 290,905
Contingencies 50% conversion factor
Transaction-related contingencies 0 50.00% 0
Unused commitments > 1 year 364,920 50.00% 182,460
Revolving underwriting facilities (RUFs) 0 50.00% 0
Other 50% collateral category 0 50.00% 0
Total 50% collateral category 364,920 182,460
Contingencies 20% conversion factor
Short-term trade-related contingencies 0 20.00% 0
Other 20% collateral category 0 20.00% 0
Total 20% collateral category 0 0
Contingencies 0% conversion factor
Loan commitments < 1 year 0 0.00% 0
Other 0% collateral category 0 100.00% 0
Total 0% collateral category 0 0
Total off-balance sheet commitment 655,825 473,365
*BA refers to bankers acceptance.
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What Was Left Out of the Original Basel Agreement
• 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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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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