banking principle - capital

8/12/2019 banking principle - capital

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Banks capitalChapter 15


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What is capital

Funds contributed by the owners of the firm

Investors who have stocks and preferred stock inthe 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 (optionalreading)

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 2007-

2009 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

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 valueof 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: absorb losses

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Types of Capital

Common stock

Preferred stock

Surplus

Undivided profits

Subordinateddebentures

Minority interest inconsolidatedsubsidiaries

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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 privatemarketplace does not correctly price the impact ofsystemic 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 InternationalCapital Standards

An International Treaty Involving the U.S.,Canada, Japan and the Nations of Western

Europe to Impose Common CapitalRequirements On All Banks Based in ThoseCountries

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The Basel Agreement

Historically, the minimum capital requirements forbanks 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-basedcapital standards for banks in 12 industrializednations; 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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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 combinedebt and equity features

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Capital adequacy ratio

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

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

The Amount of Tier 2 Capital Limited to 100 Percentof 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 eachbalance sheet and OBS item

Multiply each balance sheet and credit-equivalentOBS 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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https://cdr.ffiec.gov/public/ManageFacsimiles.aspxhttps://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 BaselAgreement

The most glaring hole with the original basel agreement is its failureto deal with market risk, especially problematic during the 2007-2009global credit crisis

In 1995 the basel committee announced new market risk capitalrequirements for their banks

In the U.S. Banks can create their own in-house models to measuretheir market risk exposure, var, to determine the maximum amount abank might lose over a specific time period

Regulators would then determine the amount of capital requiredbased upon their estimate

Banks that continuously estimate their market risk poorly would berequired 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 II15-23

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Capital Adequacy Categories Based onPrompt 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

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banking principle - capital

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