1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 16 Management of a Bank’s Equity Capital Position The purpose of this chapter is to discover why capital – particularly equity capital – is so important in banking, to learn how bankers and regulators assess the adequacy of a bank’s capital position, and to explain the ways that bank management can raise new capital.

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Tasks Performed By Bank Capital Provides a Cushion Against Risk of Failure Provides Funds to Help Banks 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

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Key Risks in Banking Credit Risk Liquidity Risk Interest Rate Risk Operating Risk Exchange Risk Crime Risk

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Bank Defenses Against Risk Quality Management Diversification Geographic Portfolio Deposit Insurance Owners’ Capital

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Types of Bank Capital Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. GAAP Capital

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. RAP or Regulatory Capital

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Market Value Capital

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Reasons for Capital Regulation To Limit the Risk of Bank Failures To Preserve Public Confidence in Banks To Limit Losses to the Federal Government Arising from Deposit Insurance Claims

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Imposition of Minimum Capital Requirements International Lending and Supervision Act of 1983 – Federal Law That Imposed Minimum Capital Requirements Upon All U.S. Banks and Called for Special Reserves Behind Their Foreign Loans

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Leverage Ratio Core Capital Includes: Book Value of Common Equity Capital Cumulative Preferred Stock Minority Interest in the Equity Accounts of Subsidiaries

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Basle 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

14. Copyright © 2002 by 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. Copyright © 2002 by 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

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Basle 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

17. Copyright © 2002 by 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

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. What is Left Out of the Original Basle Agreement The Most Glaring Hole with the Original Basle Agreement is its Failure to Deal with Market Risk In 1995 the Basle 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

19. Copyright © 2002 by 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

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. New Capital Standards Proposed to Follow Basle Growing International Awareness that the Old Capital Standards Have Too Many Weaknesses Some Proposed Changes Include Using New Risk Weights Based on External Credit Ratings It Also Calls for Simplifying Current Capital Requirements for Community Banks Another Proposal is to Require Money-Center Banks to Issue at Least a Minimum Amount of Subordinated Debt Capital

21. Copyright © 2002 by 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

22. Copyright © 2002 by 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

23. Copyright © 2002 by 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