Presentation on theme: "The Effective Use of Capital Chapter 12"— Presentation transcript:
1 The Effective Use of Capital Chapter 12 S. Scott MacDonald, Ph.D.President and CEO, SW Graduate School of Banking FoundationDirector, Assemblies for Bank DirectorsAdjunct Professor, Dept. of Finance, Cox School of BusinessSouthern Methodist University
2 The Southwestern Graduate School of Banking Assemblies for Bank Directors Southern Methodist University Cox School of Business PO Box Dallas TX Phone Fax S. Scott MacDonald, Ph.D.S. Scott MacDonald is president and CEO, SW Graduate School of Banking (SWGSB) Foundation, director of the Assemblies for Bank Directors, and Adjunct Professor of Finance, Cox School of Business, Southern Methodist University. He received his B.A. degree in economics from the University of Alabama and his Ph.D. from Texas A&M University. Dr. MacDonald joined the Southern Methodist University faculty as a visiting professor of Finance in 1997 and was named director of the SWGSB Foundation in Dr. MacDonald is a frequent speaker at professional programs, banker associations and banking schools. He is a nationally sought after strategic planning facilitator and consultant to the financial services industry. He has served as an expert resource witness before the Texas state Senate and is a former Chairman of the Board of Directors of a Texas financial institution. Dr. MacDonald is the co-author of the best selling textbook on banking, Bank Management, and the author of numerous articles in professional academic journals.
3 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 growthBank capital-to-asset ratios have fallen from about 20% a hundred years ago to around 8% today
5 Risk-Based Capital Standards Historically, the minimum capital requirements for banks were independent of the riskiness of the bank
6 The 1986 Basel AgreementA bank’s minimum capital requirement is linked to its credit riskThe greater the credit risk, the greater the required capitalStockholders' equity is deemed to be the most valuable type of capitalMinimum capital requirement increased to 8% total capital to risk-adjusted assetsCapital requirements were approximately standardized between countries to ‘level the playing field'
7 Risk-Based Elements of Basel I Classify assets into one of four risk categoriesClassify off-balance sheet commitments into the appropriate risk categoriesMultiply the dollar amount of assets in each risk category by the appropriate risk weightThis equals risk-weighted assetsMultiply risk-weighted assets by the minimum capital percentages, currently 4% for Tier 1 capital and 8% for total capital
15 What Constitutes Bank Capital? Capital (Net Worth)The cumulative value of assets minus the cumulative value of liabilitiesRepresents ownership interest in a firmTotal Equity CapitalEquals the sum of:Common stockSurplusUndivided profits and capital reservesNet unrealized holding gains (losses) on available-for-sale securitiesPreferred stock
16 Regulatory Capital Definitions Tier 1 (Core) CapitalEquals the sum of:Common stockholders equityNon-cumulative perpetual preferred stockMinority interest in consolidated subsidiaries, less intangible assets such as goodwill and disallowed deferred tax assets.Tier 2 (Supplementary) Capital, limited to 100 percent of Tier 1 capitalCumulative perpetual preferred stockLong-term preferred stockLimited amounts of term-subordinated debtLimited amount of the allowance for loan loss reserves (up to 1.25 percent of risk-weighted assets)
17 Regulatory Capital Definitions (continued) Tier 3 Capital, applies only to larger institutions with consolidated trading activity is 10 percent or more of total assets for previous quarter.Minimum 8 percent ratio of total qualifying capital [the sum of Tier 1 capital, Tier 2capital, and Tier 3 capital allocated for market risk, net of all deductions] to risk weighted assets and market risk-equivalent assets
18 Leverage Capital Ratio Regulators are concerned that a bank could acquire practically all low-risk assets such that risk-based capital requirements would be virtually zeroTo prevent this, regulators imposed a 3 percent leverage capital ratio equal to:Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets
19 Tangible Common Equity In response to the financial crisis, bank regulators placed greater importance on how much tangible common equity a bank had.Tangible common equity equals a bank’s tangible assets minus its liabilities and any preferred stock outstanding.Regulators and analysts construct a tangible common equity ratio (TCE) defined as tangible common equity divided by tangible assets:It reflects what would be left over if a bank were to liquidate and use the proceeds to pay off claims from debtors and preferred stockholders.It assigns no value to intangible assets, such as goodwill, mortgage servicing assets, and deferred tax assets. Regulators and analysts construct a tangible common equity ratio (TCE) defined as tangible common equity divided by tangible assets:
22 Basel III Capital Standards In July 2013, federal regulators approved Basel III capital rules with the intent to increase bank capital requirements and upgrade the quality of bank capital.The new requirements impose higher minimum capital ratios and place a greater emphasis on common equity as a preferred form of capital.The Basel III rules apply differently to larger and small organizations.Generally, smaller organizations can count more items as capital and have more time to comply with the new requirements.The increased capital requirements arise from stricter rules on what qualifies as capital, as well as the introduction of a new minimum capital ratio, common equity Tier 1 (CET1).When fully implemented, banks must hold a capital conservation buffer in addition to the old RBC minimums.
23 Capital Conservation buffer Under Basel III, the minimum capital requirements, when the final rules are implemented in 2019 will be:The Capital conservation buffer (CET1) is:
24 Weaknesses of the Risk-Based Capital Standards Basel I standards only consider credit riskIgnores interest rate risk and liquidity riskBanks subject to the advanced approaches of Basel II use internal models to assess credit risk and the “results” are reported to the regulators94% of banks are considered “well capitalized” in 2007, not a binding constraint for most banks
25 What is the Function of Bank Capital For regulators, bank capital serves to protect the deposit insurance fund in case of bank failuresBank capital reduces bank risk by:Providing a cushion for firms to absorb losses and remain solventProviding ready access to financial markets, which provides the bank with liquidityConstraining growth and limits risk taking
26 Bank Capital Provides a Cushion for Absorbing Losses. Albeit not very well.Manufacturing firm, 60% debt, 40% equity.Commercial bank operates with very few fixed assets and 92% debt.
27 Bank Capital Provides Ready Access to Financial Markets. As long as a bank’s capital exceeds the regulatory minimums, it can stay open and has the potential to generate earnings to cover losses and expand.FDICIA demonstrates that banks with the greatest capital-to-risk asset ratios will have the greatest opportunities to operate without restraint and to enter new businesses.Capital enables the bank to borrow from traditional sources at reasonable rates.Consequently, depositors will not remove their funds and asset losses will be minimized.
28 Capital Constrains Growth and Reduces Risk. Capital constraints require that the asset growth rate equal the rate of growth in equity capital:TA /TA1 = EQ / EQ1If not, the capital asset ratio will change.The change in total bank assets is restricted by the amount of bank equitywhereTA = Total AssetsEQ = Equity CapitalROA = Return on AssetsDR = Dividend Payout RatioEC = New External Capital
31 The Effect of Capital Requirements on Bank Operating Policies Changing the Capital MixInternal versus External capitalChange Asset CompositionHold fewer high-risk category assetsPricing PoliciesRaise rates on higher-risk loansShrinking the BankFewer assets requires less capital
32 Characteristics of External Capital Sources TARP Capital Purchase ProgramThe Troubled Asset Relief Program’s Capital Purchase Program (TARP-CPP), allows financial institutions to sell preferred stock that qualifies as Tier 1 capital to the TreasuryQualified institutions may issue senior preferred stock equal to not less than 1% of risk-weighted assets and not more than the lesser of $25 billion, or 3%, of risk-weight assets
34 Depository Institutions Capital Standards The Federal Deposit Insurance Improvement Act (FDICIA) focused on revising bank capital requirements to:Emphasize the importance of capitalAuthorize early regulatory intervention in problem institutionsAuthorized regulators to measure interest rate risk at banks and require additional capital when it is deemed excessiveThe Act required a system for prompt regulatory actionIt divides banks into categories according to their capital positions and mandates action when capital minimums are not met