Chapter Fifteen The Management of Capital Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.

Chapter Fifteen

The Management of Capital

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

McGraw-Hill/IrwinBank Management and Financial Services, 7/e

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Key Topics

•The Many Tasks of Capital

•Capital and Risk Exposures

•Types of Capital In Use

•Reasons for Capital Regulation

•Basel I and Basel II

•Planning to Meet Capital Needs

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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

•Regulatory tool to limit risk exposure

•Protects the government’s deposit insurance system

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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

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Types of Capital

•Common Stock

•Preferred Stock

•Surplus

•Undivided Profits

•Equity Reserves

•Subordinated

Debentures

•Minority Interest in

Consolidated

Subsidiaries

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Relative Importance of Different Sources of Capital

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Reasons for Capital Regulation

• 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

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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

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The Basel Agreement

• 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 to promote fair competition

▫Account for financial innovations (OBS, etc.)

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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

•Minimum capital requirement increased to 8% total

capital to risk-adjusted assets

•Capital is divided into Two Tiers

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Tier 1 Capital

• Common stock and surplus

• Undivided profits

• Qualifying noncumulative preferred stock

• Minority interests in the equity accounts of consolidated

subsidiaries

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Tier 2 Capital

• (Reserve) Allowance for Loan and Lease Losses

• Subordinated Debt Capital Instruments

• Mandatory Convertible Debt

• Cumulative Perpetual Preferred Stock with Unpaid Dividends

• Other Long Term Capital Instruments that Combine Debt and

Equity Features

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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

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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

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Calculating Risk-Weighted Assets

• The weights given to each item in the bank’s portfolio include :

▫ 0 percent for cash and government securities;

▫ 20 percent for deposits held at other banks and certain standby credit

letters;

▫ 50 percent for home mortgage loans;

▫ And 100 percent for corporate loans, long-term credit commitments,

and all other claims on the private sector as well as bank premises

and other fixed assets

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Calculating Risk-Weighted Assets

•Suppose a bank has 6,000 in total capital, 100,000 in

total assets, and the following on-balance-sheet and

off-balance-sheet (OBS) items:

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Calculating Risk-Weighted Assets

On-Balance-Sheet items (Assets) 　Cash 5000

U.S. treasury securities 20000

Deposit balances held at domestic banks 5000

Loans secured by first liens on 1-to-4 family residential properties 5000

Loans to private corporations 65000

Total balance sheet assets 100000

Off-balance-sheet (OBS) items 　Standby letters of credit backing municipal and corporate borrowings 10000

Long-term, legally binding credit commitments to private companies 20000

Total off-balance-sheet items 30000

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Calculating Risk-Weighted Assets

• Compute the credit-equivalent amount of each off-balance-sheet

item. This figure is supposed to translate each OBS item into the

equivalent amount of a direct loan considered to be of equal risk to

the bank.

Off-balance-sheet (OBS) items Face valueConversion

factor

Standby letters of credit backing municipal and corporate borrowings 10000 1.00

Long-term, legally binding credit commitments to private companies 20000 0.50

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The former bank would have the following risk-weighted assets:

Risk-weighting category Amount Risk-weighted assets

0 percent 　 　Cash 5000 0

U.S. treasury securities 20000 0

20 percent 　 　Deposits at domestic banks 5000 1000

Credit-equivalent amounts of SLCs backing municipal and corporate borrowings 10000 2000

50 percent 　 　Mortgage loans 5000 2500

100 percent 　 　Loans to private corporations 65000 65000

Credit-equivalent amounts of long-term credit commitments to private corporations 10000 10000

Total risk-weighted assets held by this bank 　 80,500

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Calculating the Capital-to-Risk-Weighted Assets Ratio under Basel 1

• For the bank whose risk-weighted assets we just calculated

above at 80,500, which currently has 6,000 in total

regulatory capital, its capital adequacy ratio would be as

follows:

6 000= =7.45%

80 500

Total regulatory capital

Total risk weighted assets，，

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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

• Basel 1 represents a “ one size fits all” approach to capital

regulation.

• 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

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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

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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

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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 public disclosure of each bank’s true financial condition so

that market discipline can become a powerful force compelling

excessively risky banks to lower their risk exposure

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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

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Choosing the Best Alternative for Raising Outside Capital: an example of a bank that needs to raise 20mill. in external capital

Income or expense item

Sell common stock at 10 per share

Sell preferred stock promising an 8% dividend at 20 per share

Sell capital notes with a 10% coupon rate

Estimated revenues 100mill. 100mill. 100mill.

Estimated operating expenses 80 80 80

Net revenues 20 20 20

Interest expenses on capital notes n.a. n.a. 2

Estimated before-tax net income 20 20 18

Estimated income tax(35%) 7 7 6.3

Estimated after-tax net income 13 13 11.7

Preferred stock dividends n.a. 1.6 n.a.

Net income available to common stockholders 13 11.4 11.7

Earnings per share of common stock

1.3(10mill. Shares) 1.43(8mill. Shares)

1.46(8mill. Shares)