McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Chapter Fifteen The Management of Capital

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 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 Liquidity Risk Interest Rate Risk Operational Risk Exchange Risk Crime Risk

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 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. Reasons for Capital Regulation To Limit the Risk of Failures To Preserve Public Confidence To Limit Losses to the Federal Government Arising from Deposit Insurance Claims

15-7 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

15-8 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

15-9 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

15-10 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

15-11 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

15-12 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 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 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

15-13 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

15-14 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

15-15 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

15-16 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

15-17 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Revised Framework for Basel II New Framework Will Only Apply to About 20 of the Largest U.S. Banks New Rules Will be Phased in Starting in 2008 All Banks Will be Affected by Basel II Because of Competition The Largest Banks May BE Able to Hold Less Capital Than is True form Smaller Banks

15-18 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 Well Capitalized Adequately Capitalized Undercapitalized Significantly Undercapitalized Critically Undercapitalized

15-19 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

15-20 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