2. CHAPTER FOURTEEN The Management Of Capital The purpose of this chapter is to discover why capital – particularly equity capital – is so important for financial institutions, to learn how managers and regulators assess the adequacy of an institution’s capital position, and to explain the ways that management can raise new capital.

3. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-3 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

4. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-4 Key Risks in Financial Institutions Management Credit Risk Liquidity Risk Interest Rate Risk Operating Risk Exchange Risk Crime Risk

5. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-5 Defenses Against Risk Quality Management Diversification Geographic Portfolio Deposit Insurance Owners’ Capital

6. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-6 Types of Capital Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes

7. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-7 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

8. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-8 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

9. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-9 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

10. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-10 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

11. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-11 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

12. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-12 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

13. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-13 What Was 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

14. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-14 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. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-15 Basle II Aims to Correct the Weaknesses of Basle I Three Pillars of Basle II: Capital Requirements For Each Bank Are Based on Their Own Estimated Risk Exposure Supervisory Review of Each Bank’s Risk Assessment Procedures and the Adequacy of Its Capital Greater Disclosure of Each Bank’s True Financial Condition

16. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-16 Capital Adequacy Categories Based on Prompt Corrective Action Well Capitalized Adequately Capitalized Undercapitalized Significantly Undercapitalized Critically Undercapitalized

17. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-17 Internal Capital Growth Rate = ROE X Retention Ratio = Profit Margin X Asset Utilization X Equity Multiplier X Retention Ratio

18. McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-18 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