Chapter Fifteen

The Management of Capital

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
15-2

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

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-3

Tasks Performed By Capital

• Provides a Cushion Against Risk of Failure
• Provides Funds to Help Institutions Get
Started
• Promotes Public Confidence (credit crisis
2007-2009 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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-4

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
McGraw-Hill/Irwin
▫ Due to embezzlement, robbery, fraud,
© 2008 The McGraw-Hill
Bank Management and Financial Services, 7/e identity
Companies, theft
Inc., All Rights Reserved.
15-5

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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-6

Types of Capital

• Common Stock • Subordinated

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

Relative Importance of Different Sources of

Capital

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

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

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-9

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

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-10

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

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.)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-12

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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-13

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

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

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

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

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

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-16

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:
https://
cdr.ffiec.gov/public/ManageFacsimiles.aspx
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-17

Total Regulatory Capital Calculations

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-18

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-19

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

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 2007-2009 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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-21

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

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

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

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

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-24

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

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

Revised Framework for Basel II

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-26

Capital Adequacy Categories Based

on Prompt Corrective Action (PCA)

• Well Capitalized
• Adequately Capitalized
• Undercapitalized
• Significantly Undercapitalized
• Critically Undercapitalized

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-27

Internal Capital Growth Rate

= ROE X Retention Ratio

= Profit Margin X Asset Utilization

X Equity Multiplier X Retention
Ratio

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

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

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-29

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