Chapter Fifteen The Management of Capital Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Topics The Many Tasks of Capital Capital and Risk Exposures Types of Capital In Use Capital as the Centerpiece of Regulation Basel I and Basel II Planning to Meet Capital Needs 15-2

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Tasks Performed By Capital Provides a Cushion Against Risk of Failure Provides Funds to Help Institutions Get Started Promotes Public Confidence (credit crisis showed importance) Provides Funds for Growth Regulator of Growth Role in Growth of Bank Mergers Regulatory Tool to Limit Risk Exposure Protects the Government’s Deposit Insurance System 15-3

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 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 Crime Risk ▫ Due to embezzlement, robbery, fraud, identity theft 15-4

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-5

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Capital Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes 15-6

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Relative Importance of Different Sources of Capital 15-7

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Capital Regulation The 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 15-8

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Basel Agreement on International Capital Standards An International Treaty Involving the U.S., Canada, Japan and the Nations of Western Europe to Impose Common Capital Requirements On All Banks Based in Those Countries 15-9

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Quick Quiz What forms of capital are in use today? What are the key differences between the different types of capital? What are the most important and least important forms of capital held by U.S.-insured banks? How do small banks differ from large banks in the composition of their capital accounts and in the total volume of capital they hold relative to their assets? What is the rationale for having the government set capital standards for financial institutions as opposed to letting the private marketplace set those standards? 15-10

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.) 15-11

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Basel Agreement A Bank’s Minimum Capital Requirement is Linked to its Credit Risk ▫ The greater the credit risk, the greater the required capital Stockholders' equity is deemed to be the most valuable type of capital Minimum capital requirement increased to 8% total capital to risk-adjusted assets Capital requirements were approximately standardized between countries to ‘level the playing field‘ Capital is divided into Two Tiers 15-12

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Tier 1 Capital Common Stock and Surplus Undivided Profits Qualifying Noncumulative Preferred Stock Minority Interests in the Equity Accounts of Consolidated Subsidiaries Selected Identifiable Intangible Assets Less Goodwill and Other Intangible Assets 15-13

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Combine Debt and Equity Features 15-14

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-15

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 See BHC’s Call report and RBC calculations: aspx aspx 15-16

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Regulatory Capital Calculations 15-17

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Global Credit Crisis 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 15-20

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Value at Risk (VAR) Models A Statistical Framework for Measuring a Bank Portfolio’s Exposure to Changes in Market Prices or Market Rates Over a Given Time Period Subject to a Given Probability 15-21

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-22

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-23

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Risk Models Parallel the Development of VaR Models 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 15-24

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Revised Framework for Basel II 15-25

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Capital Adequacy Categories Based on Prompt Corrective Action (PCA) Well Capitalized Adequately Capitalized Undercapitalized Significantly Undercapitalized Critically Undercapitalized 15-26

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Internal Capital Growth Rate = ROE X Retention Ratio = Profit Margin X Asset Utilization X Equity Multiplier X Retention Ratio 15-27

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Planning to Meet a Bank’s 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 15-28

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Quick Quiz What are the most popular financial ratios regulators use to assess the adequacy of bank capital today? First National Bank reports the following items on its balance sheet: cash, $200m; U.S. government securities, $150m; residential real estate loans, $300m; and corporate loans, $350m. Its off-balance sheet items include standby credit letters, $20m, and long-term credit commitments to corporations, $160m. What are First Nation’s total risk-weighted assets? If the bank reports Tier 1 capital of $30m and Tier 2 capital of $20m, does it have a capital deficiency? 15-29