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Chapter 6 The capital play an important role in both starting a bank and insuring its survival. Directors and managers of banks, customers and regulatory.

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Presentation on theme: "Chapter 6 The capital play an important role in both starting a bank and insuring its survival. Directors and managers of banks, customers and regulatory."— Presentation transcript:

1 Chapter 6 The capital play an important role in both starting a bank and insuring its survival. Directors and managers of banks, customers and regulatory authorities are all concerned about banks ability to attract and maintain adequate capital. Bank capital management has become as much a matter of legal requirement in the public interest as it is a matter of management discretion.

2 Why Worry About Bank Capital? Capital requirements reduce the risk of failure by acting as a cushion against losses, providing access to financial markets to meet liquidity needs, and limiting growth Bank capital-to-asset ratios have fallen from about 20% a hundred years ago to around 8% today

3 Determining Capital Adequacy How much capital is appropriate for individual bank?. Three Primary factor affect the appropriate amount of capital for an individual bank. 1- The function of bank capital. 2- the advantage of leverage to owners 3- capital adequacy as measured by regulators.

4 1- Function of bank capital Its difficult to quantify how much capital is needed to fulfill the functions capital is supported to perform?. - the primary functions of bank capital is to support or absorb risk. Losses are absorbed by capital. Banks that operate at higher level of risk, for example, those that conduct aggressive lending programs, should have more capital than low risk institution. If risk reserve creditors realize that a bank has insufficient capital for the degree of risk it takes, they will avoid lending to the bank.

5 What is the Function of Bank Capital? For regulators, bank capital serves to protect the deposit insurance fund in case of bank failures Bank capital reduces bank risk by: 1-Providing a cushion for firms to absorb losses and remain solvent 2-Providing ready access to financial markets, which provides the bank with liquidity 3- Constraining growth and limits risk taking

6 How Much Capital is Adequate? Regulators prefer more capital Reduces the probability of bank failures and increases bank liquidity Bankers prefer less capital Lower capital increases ROE, all other things the same Riskier banks should hold more capital while low- risk banks should be allowed to increase financial leverage. Example p.323

7 Risk-Based Capital 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%

8 Risk-Based Capital Primary Capital Common stock Perpetual preferred stock Surplus Undivided profits Contingency and other capital reserves Mandatory convertible debt Allowance for loan and lease losses

9 Risk-Based Capital Secondary Capital Long-term subordinated debt Limited-life preferred stock Total Capital Primary Capital + Secondary Capital Capital requirements were independent of a bank’s asset quality, liquidity risk, interest rate risk, operational risk, and other related risks

10 2- The need for leverage to improve the returns to equity. Commercial bank must have the financial leverage resulting from low level of equity in relation to assets. From the owners “point of view “: the appropriate amount of equity capital is an amount that is small enough to produce at least an adequate return on equity capital (ROE) and yet to have enough to absorb risk. Look to example p.325

11 Three factors keep bank owners from using excessive financial leverage to increase their bank return on capital 1- Market constraints keep creditors from lending excessive amount to banks in relation to the money providing by bank owners 2- Excessive leverage may be inconsistent with the goal of maximizing the market value of stock. 3- regulatory capital rules force banks to keep amounts of capital that these rules deem adequate to protect depositors and the banking system. The regulatory constraints often are the most common factors that limit the use of financial leverage by commercial banks. If a debt or preferred stock issue is accepted as capital by regulatory authorities, then the issue increases the bank capital position.However The same debt or preferred stock issue also increases financial leverage and resulting leverage multiplier of the bank.

12 Table 9.2 p. 326 show the effect of financial leverage on a typical small bank and a typical large bank Small bank usually has a higher return on assets, and a higher percentage of equity to assets. And it has more equity and lower than average leverage multiplier. Large bank usually has a lower than average return on assets and lower than average percentage of equity to assets, which produces a higher leverage multiplier and higher (ROE) because greater leverage.

13 3- Regulatory capital adequacy Criteria and concern The third affecting appropriate amount of capital for the bank is, amount of capital a bank regulators believe is adequate. Bank regulators are responsible for protecting depositors funds and the safety of the banking system. Federal and state laws prescribe the minimum amount of capital amount for the organization of new bank.

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