Chapter Fifteen

The Management of Capital

Capital• One of the most important topics in banking

• Bankers and Regulators view capital differently

• Bankers like to use less capital, thus increase the equity multiplier, to increase returns to the stockholder.

• Regulators want more capital because they want the bank to survive. Regulators are interest in the safety and soundness of the bank.

• Capital for Financial Firms

1) stockholders – common and preferred

2) owners of credit union or mutual savings

banks may be their customers because of

the mutual form of organization

• Owners contribute a part of their wealth

Differences in the viewing of the Distribution of Earnings:A. Regulators are concerned about the downside risk of banks.

They focus on the lower end of the distribution of bank earnings.

B. Shareholders are more concerned with the central part of the distribution of bank earnings.

C. Regulators’ Viewpoint 1. From regulator’s view financial risk increases the probability of bank insolvency. 2. If a bank has insufficient capital to absorb losses, regulators must close the bank due to capital impairment. 3. Capital regulations decrease efficiency and competition 4. They know who foots the bill when banks fail, the

Federal Government (FDIC). For them the optimal number of bank failures approaches zero.

Tasks Performed By Capital

• Provides a cushion against risk of failure (equity cushion function-absorbing financial and operating losses)

• Provides funds to help institutions get started (sometimes call this the “chartering function of capital”)

• Promotes public confidence (credit crisis 2007-2009 showed importance)

• Provides funds for development of new services and facilities• Regulator of growth• Role in growth of bank mergers • Regulatory tool to limit risk exposure• Protects the government’s deposit insurance system

Capital and Merger Growth• Smaller banks have disappeared via merger because of

burgeoning growth in large business loans (over $1 million each), which can only be made by bigger lenders with stronger capital positions.

• Both banks’ internal loan policies and federal regulations limit the maximum size of not fully secured loans made to a single borrower to no more than 15 percent of bank’s unimpaired capital and surplus, while fully collateralized loans are limited to no more than 25 percent of federally charter bank’s unimpaired capital and surplus.

• Lenders whose capital fails to grow fast enough or declines far enough may find themselves losing market share in the competition for the largest borrowing customers or, as in the case of the global credit crisis, may fail

Capital and Risk

• Capital and risk in banking are intimately related to each other.

• Capital itself is mainly the funds contributed by the owners of a financial firm that have been placed in the firm at the owners’ risk.

• Owners’ risk is the risk that the institution will earn a less than satisfactory return on the owners’ funds or may even fail, with the stockholders recovering littler or nothing. Thus the risks facing owners of a financial firm are substantial.

Key Risks in Financial Institutions Management• Credit Risk– Probability of default on payments of interest or principal

• Liquidity Risk– Probability of being unable to raise cash when needed at

reasonable cost. This cash needed to cover deposit withdrawals and to meet credit requests

• 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. The

world’s most tradable currencies float with changing market conditions today.

Defenses Against Risk• Quality Management-the ability of top-notch managers to

move swiftly to deal with problems before they overwhelm a financial firm.

• Diversification –diversifying financial institution’s sources and uses of funds has risk reducing benefits.– Geographic-seeking out customers located in different

communities or countries.– Portfolio-spreading out credit accounts and deposits

among a wide variety of customers, including large and small business accounts, different industries and households

• Deposit Insurance (increased from $100K to $250K in the Fall of 2008 through Dec 2009)

• Owners’ Capital

• Crime Risk• Due to embezzlement, robbery, fraud, identity theft

Definition of Bank CapitalA. Capital = Equity Plus Long-Term DebtB. Equity = Total Assets - Total Liabilities (looking at capital

as a residual)C. For Banks, Capital also includes reserves that are set aside

to meet anticipated bank operating losses from loans, leases, and securities. (Contra Asset)

D. For Banks, Capital is heavily regulated.

Types of Capital• Common Stock

• Preferred Stock

• Surplus

• Undivided Profits

• Equity Reserves

• Subordinated Debentures• Minority Interest in

Consolidated Subsidiaries• Equity Commitment Notes

A. Equity Defined - Equity Capital consists of 1. Common Stock 2. Preferred Stock 3. Surplus or Paid In Excess of Par 4. Undivided Profits (Retained Earnings)B. Preferred and Common = Number of Shares times parC. Surplus = amount of paid in capital in excess of par value

realized by the bank upon the initial sale of stock. Suppose when bank was started they issued 10 Shares of $4 par. These shares were sold for $5.50 a share. Therefore the total inflow of money to the bank was 10 times $5.50 for a total of $55.00

1. Common Stock Account = Par Value times Shares = $4 times 10 = $40

2. Surplus = (Issue Price – Par Value) times Shares Surplus = ($5.50 - $4.00) times 10 = $1.50 times 10 = $15

Equity

Equity Continued

D. Undivided Profits = retained earnings - are the cumulative net profits of the bank not paid out in the form of dividends to shareholders.E When these items are summed you get the book value of equity. The market value of equity will differ from the book value of equity. F. Number of Shares of Preferred and Common times respective market values gives you market values.

Long-Term Debt (Subordinated Notes and Debentures are sources of long-term debt)

A. Banks use less long-term debt than do most nonfinancial firms (they are able to get interest free deposits).

B. Debt is second in priority to deposits, therefore it is subordinated (like a first and second mortgage, depositors come first).

C. Rules in 1960s allowed banks to count some debt as capital. Especially debt with maturities of greater than seven years.

D.Debt can be substituted for common equity in certain areas of banking. Note, debt is NOT a perfect substitute for common equity.

E. The beauty about debt is that interest is tax deductible whereas dividends on stock are paid after tax.

F. Debt after tax is less expensive than common equity. G.Small banks use less debt than large banks.

Reserves

A.Banks set aside earnings for loan and lease loss reserves. B. When a loan defaults, the loss does not necessarily reduce

current earnings because it can be deducted from the reserve account.

C. To establish reserves to meet anticipated loan losses banks expense an account known as the PROVISION FOR LOAN LOSSES (PLL). By expensing PLL banks reduce their tax burden

D.Since the passage of the Tax Reform Act of 1986, banks with assets greater than $500 M can only expense actual losses from pretax income. Thus banks were not able to tweak their financial statements like they did in the past.

E. Another account is the Reserve for Loan and Lease Losses. This is a contra asset account. This account is a lot like the Allowance for Bad Debts Account that we used with Accounts Receivable in Basic Accounting and Finance.

Reserves for Loan and Lease Lossest = Reserve for Loan and Lease Lossest-1 – Charge-Offst + Recoveriest + PLLt

Reserves for Loan Losses, Beginning of 200X 3,000,000 Less: Charge-Offs During 200X 800,000 Plus: Recoveries during 200X on Loans Previously Charged Off 80,000 Plus: Provision for Loan Losses, 200X 1,000,000 Reserve for Loan Losses, End of 200X 3,280,000

Because reserves absorb most losses in the banking industry, they are a key component of bank capital. Losses that exceed these reserves would have to be absorbed by stockholder’s equity.

Together then capital for certain purposes equals basic equity capital + subordinated debentures and the reserve for loan and lease losses

Extended Definitions• Surplus-representing the excess amount above each share of

stock’s par value paid in by the institution’s shareholders.

• Undivided profits-representing the net earnings that have been retained in the business rather than being paid out as dividends.

• Equity reserves-representing funds set aside for contingencies, such as legal action against the institution, as well as providing a reserve for dividends expected to be paid but not yet declared and a sinking fund to retire stock or debt in the future

• Minority interest in consolidated subsidiaries, where the financial firm holds ownership shares in other businesses.

• Equity commitment notes, which are debt securities repayable from the sale of stock

Relative Importance of Different Sources of Capital

Trust Preferred Stock

• New form of preferred stock that has emerged recently.

• Stock is a hybrid form of equity capital that is issued to investors through a trust company and the funds raised are loaned to the financial firm using this capital raising device.

• Trust issued preferred stock generates dividends that are tax deductible for the issuing institution. As with other forms of preferred, the issuer can miss making dividend payments and still avoid bankruptcy. This form of preferred is considered to be Tier I capital

• Became less attractive in 2003 by FASB-requires companies to classify these shares as debt and their payments to investors as interest payments rather than stock dividends.

Reasons for Capital RegulationThe 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

More About Banks and Regulation• Large bank failures are a special problem.

• Big bank failures attract significant media attention which in turn causing depositors to raise questions about the soundness of banks

• The largest banking organizations generally have a high proportion of nondeposit liabilities and large-denomination deposits that are adequately covered by insurance

• The failure of a large bank can have a greater impact on the government’s deposit insurance fund than the failures of numerous small insured depository institutions.

Capital Ratio Research• Most research studies find little connection between capital

ratios and the incidence of failure.

• It is by no means certain that imposing higher capital requirements will reduce banking risk.

• Financial firms confronted with higher capital requirements may take on more risk in other aspects of their operations in order to keep from earning lower returns.

The Basel Agreement on International Capital Standards

• An international treaty to impose common capital requirements on all banks based in those countries

• Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, UK, US, Luxembourg

• Formally approved in July 1988- Basel capital rules were designed to encourage leading banks around the world to keep their capital position strong, reduce inequalities in capital requirements among different countries to promote fair competition, and catch up with recent rapid changes in financial services and financial innovation

• The full set of initial Basel standards went into effect in January 1993 and was adjusted in following years

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.)

• Stockholders' equity is deemed to be the most valuable type of capital

• Minimum capital requirement increased to 8% total capital to risk-adjusted assets

The Basel Agreement• This agreement classifies assets into four risk categories that have

different capital requirements• A Bank’s Minimum Capital Requirement is Linked to its Credit Risk– The greater the credit risk, the greater the required capital

• Capital requirements were approximately standardized between countries to ‘level the playing field‘

• Capital is divided into Two Tiers• Basel I required bankers to determine the current market value for a

contract that is similar to the contract they have actually made with a customer in order to figure out the latter’s replacement cost. Future cash flows expected under current contracts must be discounted back to their present values using current interest rates, currency, or commodity prices to determine the value of such a contract in today’s market

Tier 1 Capital

• Common Stock and Surplus

• Undivided Profits (Retained Earnings

• 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 Capital• Allowance (Reserves) for Loan and Lease Losses• Subordinated Debt Capital Instruments• Mandatory Convertible Debt• Intermediate-term Preferred Stock• Cumulative Perpetual Preferred Stock w/ Unpaid Dividends• Equity Notes• Other Long Term Capital Instruments that Combine Debt

and Equity Features

Total Regulatory Capital

Tier 1 Capital + Tier 2 Capital – Investments in Unconsolidated Subsidiaries – Capital Securities Held by the Bank that were Issued by other Depository Institutions and are held under a reciprocity agreement – other items

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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Tier 1 risk based capital ratio = Tier 1 capital Total risk weighted assets

Total capital = Total (Tier 1 + Tier 2) capitalRisk weighted risk weighted + risk weightedassets on balance off balance sheet assets sheet assets

Total risk based = capital ratio

Total Capital Ratio = Tier 1 Capital + Tier 2 Capital .08 Risk Adjusted Assets

Tier 1 Capital Ratio = Tier 1 Capital .04 Risk Adjusted Assets

Leverage Ratio = Minimum Capital= Tier 1 Capital .04 Ratio Total Assets

Total Capital = (Tier 1 Capital + Tier 2 Capital) .08 (Risk Adjusted Assets)

Tier 1 Capital .04 (Risk Adjusted Assets)

Tier 1 Capital .04 (Total Assets) >>>>> Leverage Ratio

A. Basel I dictated there should be 4 Risk Groups of Assets 1. .00 items A1 2. .20 itemsA2 3. .50 itemsA3 4. 1.00 itemsA4B. As the credit risk increases so does the capital requirement.C. How do we get Risk Adjusted Assets (Risk Weighted

Assets)?0.00 A1 + .20 A2 + .50 A3 + 1.00 A4

D. How do we calculate minimum capital needed?K = Minimum Ratio 0.00 A1 + .20 A2 + .50 A3 + 1.00 A4

K = .080.00 A1 + .20 A2 + .50 A3 + 1.00 A4 K = Minimum Capital Amount.E. The same .00; .20; .50 and 1.00 apply to off-balance sheet

items.

Book assets account Amt Risk Weight

Book liability and equity

Amt

Cash and treasury 2000 0% Deposits 8000

Securities Repurchase 1000 20% Hot money 6000

Muni bonds 1500 20% Sub Debt 250

Single family mortgages

2700 50% Common stock

100

CMOs 2500 50% RE 350

Commercial Loans 1500 100% Surplus 300

Ag Loans 2100 100%

Allow for Loan loss (300) 0%

Bank Build 2000 100%

Total 15000 15000

Risk Assets = .00 (A1) + .20 (A2) + .50 (A3) + 1.00 (A4)From above A1 = 2,000From above A2 = Securities + Repurchase Agreements + Municipal Bonds = 1,000 + 1,500 = 2,500From above A3 = Single Family Mortgages + CMOs = 2,700 + 2,500 = 5,200From above A4 = Commercial Loans + Agricultural Loans + Bank Building = 1,500 + 2,100 + 2,000 = 5,600Risk Assets = .00 (2,000) + .20 (2,500) + .50 (5,200) + 1.00 (5,600)Risk Assets = 0.0 + 500 + 2,600 + 5,600 = 8,700

To satisfy capital requirements as dictated by the Risk Based Capital Rules the sum of Tier One Capital plus Tier Two

Capital must be greater than or equal to .08 of Risk Adjusted Assets to be considered adequately capitalized .

Total Capital = Tier One Capital + Tier Two Capital ≥ .08Risk Adjusted Risk Adjusted AssetsAssets Therefore (Tier One Capital + Tier Two Capital) ≥ .08 (Risk

Adjusted Assets)Therefore for this example (Total Capital) must be ≥ .08

(8,700) = 696

Note Risk Adjusted Assets is just another name for Risk Weighted Assets

Risk Based Capital Rules also dictate that Tier One Capital/Risk Adjusted Assets be ≥ .04(Tier One Capital) must be ≥ .04 (Risk Adjusted Assets).So (Tier One Capital) must be ≥ .04 (8,700) = 348.

Leverage Ratio ≈ Minimum Capital Ratio = Tier One Capital/Total Assets

Risk Based Capital Rules say that (Tier One Capital)/Total Assets be ≥ .04

We will assume that we are dealing with average risk banks, thus .04 is the appropriate number to use here

For this example Tier One Capital ≥ .04 (15,000) = 600

Risk Based Capital Rules say that Tier 2 Capital ≤ Tier 1 Capital

This means that Tier Two Capital must be ≤ 348

Therefore this bank satisfies the tier one capital requirement since 750 > than either the tier one capital amount of 348 (Amount Determined by the Tier 1 Capital Ratio) or 600/450 (Amount Determined by the Leverage Ratio/Minimum Capital Ratio)

Tier one capital = Common stockholders’ equity 100

350 300

+ perpetual preferred stock 0+ minority interest in equity accounts of considered subsidiaries 0-Goodwill and other intangibles 0Total Tier one 750

Therefore this bank satisfies another requirement in that 550 < 750.Finally the sum of Tier One and Tier Two = 750 + 550 = 1300

Once again this bank meets another requirement. Actual total capital (1,300) is greater than the total capital dictated by risk assets (696)

Allowances for losses on loans and leases 300+ Cumulative perpetual, long term and convertible preferred stock 0+ perpetual debt 0+ other hybrid debt-equity instruments 0+ intermediate term preferred stock 0+ term subordinated debt 250Total 550

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

Calculating Risk Weighted Assets Under Basel I

Suppose a bank has $4,000 in Tier 1 Capital and $2,000 in Tier 2 Capital, $100,000 in total assets and the following on-balance-sheet and off-balance (OBS) items.

Ratios

• The bank’s core capital or leverage ratio (Tier 1 capital to total assets) would be:

Leverage Ratio = $4,000 = .04

$100,000

• The bank’s total capital to total balance sheet assets ratio would be:

= $4,000 + $2,000 = $6,000 = .06

$100,000 $100,000

• But international capital standards are base upon risk weighted assets, not total assets.

Compute the credit-equivalent amount of each off balance item.

Off Balance Sheet Items Face Value

Conversion Factor

Credit Equivalent Amount

Standby letters of credit (SLCs) backing muni obligation bonds

$50,000 X 0.2 $10,000

Long term unused loan commitments made to private corporations

$20,000 X 0.5 $10,000

Compute Risk Assets for Balance Sheet0 Percent Risk Weighting Category

Cash $ 5,000

US Treasury Securities $20,000

$25,000 x 0 =$ 0

20 Percent Risk Weighting Category

Deposits at Domestic Banks $ 5,000

Credit-Equivalent Amounts of $10,000

$15,000 x .20 =$3,000

50 Percent Risk Weighting Category

Mortgage loans secured by first liens $5,000 x .50 = $2,500

On 1 – 4 family residential properties

100 Percent Risk Weighting Category Loans to private corporations $65,000 Credit-Equivalent Amounts of $10,000 Long-term unused loan commitments $75000 x 1.00 = $75000to private corporationsTotal Risk Weighted Assets Held by this Bank $80,500

Compute Risk Assets for Balance Sheet Continued

Calculating the Capital To Weighted Assets Ratio under Basel I

Tier 1 Risk Based Capital Ratio = Tier 1 Capital

Total Risk Weighted Assets

Total Risk Based Capital Ratio = Tier 1 +Tier 2 Capital

Total Risk Weighted Assets

Tier 1 Risk Based Capital Ratio = $4,000 = .052 > .04 Good

$80,500

Total Risk Based Capital Ratio = $4,000+$2,000 = $6,000

$80,500 $80,500

= .0745 < .08 Bad

Capital Requirements Attached to Derivatives• Basel I adjusted to account for risk from derivatives-futures,

options, interest rate and currency swaps, interest cap and floor contracts and other instruments designed to hedge against changing currency prices, interest rates and positions in commodities

• Many of these derivatives exposed a bank to counterparty risk.

• Risk for many of these instruments is limited because they are traded in organized exchanges.

• Credit-conversion factors for interest rate derivatives are set lower than credit conversion factors for contracts tied to the value of foreign currencies

Off Balance Sheet• Basel I requires bank to divide each contract’s risk into two

categories:

1. Potential Market Risk Exposure-risk exposure refers to the danger of loss at some future time if the customer who earned into a market base contract with the bank fails to perform.

2. Current Market Risk Exposure-risk exposure is designed to measure the risk of loss should a customer default today on its contract, which would compel the bank to replace the failed contract with a new one.

Replacement Cost

• Once the replacement cost of a contract is determined, the estimated potential market risk exposure amount is then added to the estimated current market risk exposure to derive the total credit equivalent amount of each derivative contract. This total is multiplied by the correct risk weight, to find the equivalent amount of risk weighted assets represented by each contract.

Example• Previous example

• Entered into $100,000 five year interest rate swap agreement with one of its customers

• Entered into $50,000 three year currency swap with another of its customers

• Multiply the face amount (notional value) of these two contracts by the appropriate credit conversion factor for each instrument (.005 and .05) – in order to find the bank’s potential market risk exposure from each instrument.

• Add the estimated replacement cost if suddenly the bank has to substitute new swap contracts at today’s prices and interest rates for the original contracts. Assume these replacement costs amounted to $2,500 for the interest rate contract and $1,500 for the currency contract

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Int rate and currency contracts

Face amount of contract

Conversion factor for potential market risk exposure

Potential market risk exposure

Current market risk exposure (replacement cost)

Credit equivalent volume of int rate and currency contracts

5 year int rate swap contract

$100000 X 0.005 = $500 + $2,500 = $3,000

3 year currency swap contract

$50000 X 0.05 = $2,500 + $1,500 = $4,000 $7,000

Final Steps

• From last slide the total credit equivalent amount of these contracts is $7,000

• The final step is to multiply this total by the correct risk weight, which is 50 percent or .50. This step yields:

Credit equivalent x Credit Risk = Volume of risk-weighted

Volume of interest Weight assets represented by rate and currency off balance sheet contracts interest and

currency contracts

$7,000 x .50 = $3,500

Example Continued

From previous work the bank has total regulatory capital of $6,000 and total risk-weighted assets of $80,500. Its total risk-weighted assets included total on-balance sheet assets of $68,500 and off-balance sheet standby credit letters and corporate loan commitments of $12,000. We now add to these other assets the $3,500 in risk-weighted currency and interest rate contracts that we determined. In this case the bank’s regulatory capital to risk-weighted assets would be:

Formulas and Calculations

Total Capital = Total (Tier 1 + Tier 2) Capital Risk Weighted Risk-Weighted Risk Weighted Assets on-balance sheet + off-balance sheet Assets Assets

= $6,000 = $6,000 = .0714 ($68,500 + $12,000 + $3,500) $84,000

Tier 1 Capital = $6,000 = .0476Risk Weighted Assets ($68,500 + $12,000 + $3,500)

The bank lies substantially below the minimum total regulatory capital requirement of .08 of total risk-weighted assets.

Problems With Risk Adjusted Assets

A. Only deals explicitly with credit risk.

B. The concept uses book values rather than market values.

C. Other types of risk ignored (operating, liquidity, and legal)

D. Portfolio diversification is ignored

Positive of Risk Adjusted AssetsA. Are sensitive to some extent to differences in bank risk

takingB. Incorporate off-balance sheet activities into risk

assessmentsC. Do not penalize banks for holding low-risk, liquid assetsD. Increase the consistency of rules applied to large banks

around the world.

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.

• Market Risk =losses a bank may suffer due to adverse changes in interest rates, security prices, and currency and commodity prices.

• 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

Value at Risk (VAR) Models• Suppose a bank estimates its portfolio’s daily average value

at risk is $100 million over a 10-day interval with a 99 percent level of confidence. Then, if this VaR estimate of $100 million is correct, losses in portfolio value greater than $100 million should occur less than 1 percent of the time. More precisely, the bank’s management anticipates losing at most $100 million for 99 out of 100 ten-day intervals.• An analysis of the bank’s historical distribution of losses in

its trading portfolio will indicate whether this estimate is reasonable or not.• Management would want to compare the estimated future

loss to the bank’s current level of equity capital to make sure the institution is sufficiently capitalized in order to avoid failure.

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.

• If management determines that its VaR estimates are rising, the bank must consider either increasing the amount of regulatory define capital it holds in order to absorb the rising level of risk or take steps to reduce its risk exposure.

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 (market works)

I. Minimum capital requirements – Definition of capital is unchanged and the minimum capital requirement remains 8%, but risk-adjusted assets in the denominator will be calculated differently. Credit risk will be evaluated more precisely than before to get the weights to apply to different kinds of loans. Banks will have the choice between a standardized approach (similar in most respects to Basel I) and internal credit risk models of banks (similar to the way that market risk capital requirement was previously calculate). Also, operational risk will be taken into account - computer failures, poor documentation, fraud, and risks external to the bank. Again different approaches will be available to banks that have varying degrees of complexity.

II. Supervisory review process – Supervisors will evaluate bank measurement techniques with respect to credit and operational risks.

III. Market discipline – Banks will be required to increase their information disclosure, especially on the measurement of credit and operational risks.

Basel II – Internal Risk Assessment

• Big change, banks permitted to measure their own risk exposure and determine how much capital they need to meet that exposure.

• Participating banks are required to carry out their own repeated stress testing, using an internal-rating based (IRB) approach.

• The hope is that this gives each bank greater flexibility in responding to changing market conditions and continuing innovation in the financial services industry.

• The fundamental goal of Basel II is to create a better alignment of capital regulations with the risks international banks actually face in the modern world.

Basel II – Operational Risk• Another key change-requires banks to hold capital to deal with

operational risk.

• Operational Risk is risk of loss due to inadequate or failed internal processes, people and systems or due to adverse external events.

• Employee fraud, Product flaws, Accounting errors, Computer Breakdowns, Terrorism, Natural disasters and fires.

• These adverse events may not only damage a financial firm’s physical assets but also reduce its capacity to communicate with its customers.

• Need adequate insurance coverage, backup service capability, effective internal audits, quality contingency plans and effective management information systems.

BASEL I:A. Focus on a single measureB. One size fits allC. Broad-brush approach

BASEL II:A. More emphasis on banks’ own internal risk models,

supervisory review and market discipline.B. Flexibility, menu of approaches, incentives for better risk

managementC. More risk sensitivity

Credit Risk Models• Parallel the development of VaR Models

• These computer algorithms attempt to measure a lender’s exposure to default by its borrowing customers or to credit downgradings that result in lowering the value of some of the lender’s loans.

• 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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A Dual (Large-Bank, Small-Bank ) Set of Rules• Basel II will operate under one set of capital rules for the

handful of largest multinational banks and another set for the much more numerous smaller banking firms.

• Regulators concerned small banks could get overwhelmed by the heavy burdens of gathering risk-exposure information and performing complicated risk calculations.

Problems Accompanying the Implementation of Basel II

• Technology of risk measurement has a long way to go. For some forms of risk (such as operational risk) have no generally accepted measurement scale.

• There is the problem of risk aggregation. How do you add up different forms of risk exposure?

• How do account for the business cycle?

• There is also concern about regulatory competence. Regulators must be trained to keep up so they can asses the effectiveness of the different risk models each bank has adopted. The regulatory community must change along with changes in the financial services industry

Revised Framework for Basel II

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Capital Standards

• Banks need to be in a good capital position before they will be approved to offer new services (investment banking or insurance underwriting)

• Banks with weak capital may face more regulatory pressure and may be more restricted in their activities until they improve their capital positions.

• FDIC Improvement Act (1991) mandated Prompt Corrective Action (PCA) when an insured depository institution’s capital falls below acceptable levels. Regulators may impose tougher restrictions on an insured depository institution as its capital declines, such as prohibiting payment of stockholder dividends.

Banks are classified as being Well Capitalized, Adequately Capitalized, Under Capitalized, Significantly Undercapitalized and Critically Undercapitalized.A. Well Capitalized

Total Capital to Risk Adjusted Assets .10Tier 1 Capital to Risk Adjusted Assets .06Tier 1 Capital to Total Assets .05 (Leverage Ratio)

B. Adequately CapitalizedTotal Capital to Risk Adjusted Assets .08Tier 1 Capital to Risk Adjusted Assets .04Tier 1 Capital to Total Assets .04 (Leverage Ratio)

C. Under CapitalizedTotal Capital to Risk Adjusted Assets .08Tier 1 Capital to Risk Adjusted Assets .04Tier 1 Capital to Total Assets .04 (Leverage Ratio)

Go to next lower classification if any condition NOT met.

Capital Adequacy Categories Based on Prompt Corrective Action (PCA)

In the fall of 1992 federal regulators created five capital-adequacy categories for depository institutions

• Well Capitalized .10, .06, .05

• Adequately Capitalized .08, .04, 04

• Undercapitalized-depository institution that fails to meet one or more of the capital minimums for an adequately capitalized institution

• Significantly Undercapitalized-total capital ratio < .06; Tier I Capital < .03. No pay raises for senior officers, limits on deposit interest rates.

• Critically Undercapitalized-has tangible equity capital to total assets is ≤ .02

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Planning to Meet Capital Needs

• Most recent years principal source of capital is from earnings retained rather than paid out to stockholders.

• Internally generated capital has the advantage of not depending on the open market for funds, thus avoids flotation costs.

• This source is less expensive that selling new common stock and it avoids dilution of ownership and earnings per share.

• Want an optimal dividend policy – one that maximizes the value of the stockholders’ investment.

Planning to Meet a Bank’s Capital Needs

• Raising Capital Internally– Dividend Policy– Internal Capital Growth Rate

• Raising Capital Externally– Issuing Common Stock-most expensive– Issuing Preferred Stock– Issuing Subordinated Notes and Debentures– Selling Assets and Leasing Facilities-often creates a substantial

inflow of cash– Swapping Stock for Debt Securities-may get rid of sinking fund

provisions– Choosing the Best Alternative

15-69

Internal Expansion1. The rate at which a bank can internally expand its assets and still

maintain its capital ratio is known as the sustainable growth rate.

2. Sustainable Growth Rate =

1 x NPAT x NI – Pref Div – Com DivCapital Ratio TA Earnings Available to Common Stock Holders

1 x NPAT x NI – Pref Div – Com DivTE/TA TA Earnings Available to Common Stock Holders

TA x NPAT x Additions to Retained Earnings TE TA Earnings Available to Common Stock Holders

= EM x ROA x Retention Ratio

= ROE x Retention Ratio = g = ROE x b = g = Sustainable Growth Rate= Profit Margin x Asset Utilization x Equity Multiplier x Retention Ratio

EM times NPM times TA Turn times RR = ROE times RR = g = Sustainable Grow Rate

A. A decreasing capital ratio (increasing equity multiplier) allows a more rapid

expansion of bank assets, all other things being equal.

B. Higher capital requirements increase the role of internally generated profits,

as opposed to externally borrowed funds, in growing the asset base of the bank.

C. Management's approach to financing asset growth is related to:1. Sustainable Growth Rate2. Regulatory rules concerning capital adequacy3. Competitive pressures4. Financial Market Conditions5. Other factors (shareholder preferences for debt)

Best Alternative-Example• Bank needs to raise $20 million in external capital.

• Bank has 8 million shares of common stock outstanding at $4 par

• Bank has assets close to $1 billion, with 60 million in equity capital.

• If bank generates total revenue of about $100 million and holds operating expenses to no more than $80 million, the bank should have $10.8 million in earnings left after taxes.

• If management raises the needed $20 million in new capital by issuing 2 million of new shares, each at a net price of $10, common stock holders will receive $1.30 in earnings per share.

Is This A Good Deal?• No, not if the goal is to maximize earnings per share.

• For example, management finds that it could issue preferred stock, bearing an 8% dividend, at $20 per share. If the board of directors elects to declare an annual dividend on these preferred shares, this will drain $1.6 million ($20 million x .08) each year from yearnings that would normally flow to the common stockholders.

• But it will still leave $11.6 million for holders of the 8 million in common shares, or a dividend rate of $1.43 per share. Thus, the preferred stock route would yield the common stockholders $ 0.13 more in dividends per share than would the issue of additional common stock.

Is This A Good Deal Again?• Suppose management discovers that it could sell $20

million in debt capital notes bearing a 10% coupon rate. While the issuing institution must pay $2 million in interest annually on these notes, this still leaves almost $12 million left over after all expenses (including taxes). When distributed among the 8 million common shares, this will yield $1.46 per share. Clearly, the best of the three capital raising options in this example is issuing debt capital. Moreover, the capital notes carry no voting power, so the current stockholders retain control.

• See Table 15-2

Solution to Problem

Cash $200,000,000 x 0 =$ 0U.S. Gov Sec. $150,000,000 x 0 =$ 0Residential Real Estate Loans $300,000,000 x .50 =$150,000,000Corporate Loans $350,000,000 x 1 =$350,000,000Stand by Credit $20,000,000 x .20 x .20=$ 800,000Long-Term Credit Com $160,000,000 x .50 x 1 =$ 80,000,000Risk Weighted Assets =$580,800,000

Total Capital ≥ .08 Tier One Capital ≥ .04Risk Weighted Assets Risk Weighted Assets

Total Capital ≥ .08 x $580,800,000 = $46,464,000Tier One Capital ≥ .04 x $580,800,000 = $23,232,000Total Capital = Tier 1 + Tier 2 = $30,000,000 + $20,000,000 = $50,000,000 Adequate Capital GoodTier One Capital = $30,000,000 Adequate Capital Good