1. Capital Regulations and Management Chapter 6
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2. Defining Capital: Market versus Book Values
Most Financial Institutions vs. Security Firms
Most Financial Institutions – Book Value
Security Firms – Market Value
Difficulties in Calculating Market Values
Why Capital?
The Role of Capital as a Cushion against Losses
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4. Preferences for Capital by Different Agents
Preferences of Stockholders for higher Financial Leverage
Moral Hazard Problems with Deposit Insurance
Purposes of Capital and Some Incentives for Stockholders to Hold Capital
Preferences of Uninsured Debtholders, Managers, and Regulators
The Optimal Capital Structure: Balancing Shareholders’ and Regulators’ Interests
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5. Other Views on Bank Capital
Regulatory Capital Adequacy May not Be as Necessary Today as in the Past Due to
Greater Market Transparency
More Risks
Greater Reliance on Market Pricing
Greater Large Customer Dependence
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6. Changes in Regulatory Capital Requirements over Time
Equity-to-Asset Declining Trends
Basel I and FDICIA as a Response
The BIS Market Risk Amendment and Basel II
Equity-to-Asset Trends Following Basel I
Is Basel II Needed?
More credit risk?
More risk due to competition?
More risk due to derivatives, other off-balance sheet items?
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Two Types of Capital
Tier 1: Core or Tangible Equity Capital
Common stock accounts
Retained earnings
Qualifying perpetual preferred stock (up to 25% of Tier 1 capital)
Minority interest in equity accounts of consolidated subsidiaries
Less ineligible intangible assets (e.g., goodwill)
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8. Two Types of Capital (continued)
Tier 2: Supplemental Capital
Any additional perpetual preferred stock not allowed in Tier 1
Subordinated notes and debentures (up to 50 percent of Tier 2 capital)
Allowance for loan and lease losses (up to 1.25% of risk-weighted assets)
Mandatory convertible subordinated debt
Immediate-term preferred stock (original weighted average maturity of five years or more)
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9. Regulatory Capital Ratios and Definitions of Capital Adequacy
Regulatory Capital Ratios (minimum)
Tier 1 capital/Total assets ratio = 4%
Tier 1 capital/Total risk-based assets ratio = 4%
Tier 1 + Tier 2 capital/total risk-based assets ratio = 8%
Regulatory Definitions of Capital Adequacy
See Table 6.2, page 225
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Four Risk Categories
Category 1: 0 percent weight
Federal Reserve balances
U.S. government securities
OECD government securities
Some U.S. agency securities
Category 2: 20 percent weight
Cash items in the process of collection
OECD interbank deposits & guaranteed claims
Some non-OECD bank & government deposits & securities
Claims collateralized by U.S. Treasury & some agency securities
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11. Four Risk Categories (continued)
Category 3: 50 percent weight
Other municipal revenue bonds
Secured mortgage loans on 1-4 family residential properties, fully secured by first liens
Category 4: 100 percent weight
All other on-balance-sheet assets including
Commercial loans
Consumer loans
Commercial paper
All other assets
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Basel I Issues
Basel I does take into account
Credit risk overall
Riskiness of various assets
Basel I does not take into account
Interest rate risk
Operating risk
Credit risk variance between different loans
Information from risk management models
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13. Table 6.3 Calculating a Risk-Based Capital Ratio for Mega Bank
Page 228
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14. The Evolving Basel II Accord
Applies to
very large international banks
Top ten U.S. banks
Three Mutually Reinforcing “Pillars”
Pillar 1: Capital Charges against Market Risk, Operational Risk, and Credit Risk
Pillar 2: Effective Supervisory Review Process
Pillar 3: Market Discipline
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15. Minimum Capital Requirements
Page 229
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16. The Evolving Basel II Accord
Very Large U.S. Bank Participation for Basel II: Two Regulatory Systems
Operations and Other Large Banks That Opt In
Advanced Internal Ratings-Based (A-IRB) Approach for Credit Risk and Advanced Measurement Approach (AMA) for Operational Risk
Advance Notice of Proposed Rulemaking (ANPR) Guidelines
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Measuring Risks
Guidelines for Measuring Operational Risk
Process Risk
People Risk
System Risk
External Risk
Guidelines for Measuring Credit Risk under an IRB Approach
Probability of Default
Loss Given Default
Exposure at Default
Remaining Maturity (M) Based on the Weighted Average Remaining Maturity
FDIC Study of the Expected Effects with Basel II and Other Criticisms
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18. Management of Capital and Growth with RAROC
The Adequacy of Capital Depends on
Regulatory Requirements
An Institution's risk Profile
Other Practical Consideration
Other Capital Allocation Techniques for RAROC
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Page 234
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20. A Practical Approach to Capital Structure
Defining an Optimal (Minimum) Weighted Average Cost of Capital
Dividend and Stock Repurchase Trends
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