Management of a Banks Equity Capital Position, Ch

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Management of Capital, Ch. 15, Rose & Hudgins, 9th ed., (F14)Why is bank capital so important? Bank deposits are supported by the FDIC. Banks also owe money to uninsured depositors and other debt holders, e.g., corporate bonds and mortgages. If a banks losses are so large that they cannot pay their debts then this situation may severely disrupt the financial and business markets, particularly as the size of the bank grows. The more common equity a bank has, the safer those bank debt holders are because the greater equity allows the bank to absorb larger losses before the debt holders are affected.

The key element here is to assess the risks of the bank, e.g., credit, interest rate, liquidity, and market risks, and require equity to offset those risks. On the other hand, if the bank has to have more common equity and if nothing else changes, the banks return on equity (ROE) will decrease. The banks will increase their prices for services and interest rates on loans or lower the interest rates on deposits to achieve the ROE required by the banks investors. These adjustments affect the customers and the economy.

The required capital may also affect a banks competitiveness within a local market, e.g., small vs. large banks, or globally. The Basel Accords 1 to 3 are an attempt to coordinate capital regulation across borders so banks are competing on a level landscape. The Accord also attempts to deal with the potential failures of systematically important financial institutions (SIFIs), also known as too big to fail banks. Given the importance of the SIFIs they are required to hold more capital to lower their risk to the national and global financial systems.

We will examine how large losses affect a banks balance sheet. We will examine current capital ratios and we will examine how regulators try to measure the different bank risks.

KNOW: Functions or Tasks of Capital, p. 4861. Acquire fixed assets to start bank

2. Provides for growth in new services and products

3. Absorbs losses so bank can continue to operate4. Instills confidence that bank can continue to provide for credit needs of community

5. Provides base for continued growth that may be restricted if regulators or market think

capital is not adequate

6. Instills confidence by protecting uninsured depositors, FDIC and taxpayers

Simple Balance Sheet and Effect of Losses see types of capital, p. 489-491, Assets

Liabilities + EquityCash & due

Insured deposits

Investments

Uninsured deposits

Gross loans

Long-term secured debt, e.g., mortgage

Loan loss reserves

Subordinated notes & debenturesNet loans

Senior Preferred StockFixed Assets

Preferred StockIntangible Assets

Common equity Goodwill, PMSRs, PCCRs

Common stock (par value)

Surplus (additional paid-in capital)

Undivided profits (retained earnings)

KNOW: If loan losses are large, what balance sheet accounts are affected and in what order, from first to last? Loan loss reserves, undivided profits, surplus, common stock, preferred stock, senior preferred stock, subordinated notes and debentures, uninsured deposits, FDIC for insured deposits, taxpayers.

As of 6/30/01 mergers must use purchasing accounting, where if you pay $100 for a company that has a book value of $90, the other $10 is goodwill. Under the new accounting standards, goodwill may remain on the balance sheet indefinitely but the company must perform annual tests to see if the goodwill has become impaired, i.e., suffered a permanent decline in value. Under the previous accounting treatment goodwill was amortized as an expense and lowered EPS. In another popular previous accounting treatment, pooling accounting, there was no goodwill. You merged assets at book value and there was no amortization of goodwill to decrease EPS. On 6/30/14 goodwill and other intangibles were 2.2%, 4.3%, and 23.8% of total equity for banks (