FINC 4320

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• FINC 4320
• Managing Bank Capital
• Fall 2004

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Tasks performed by bank capital

• Provides a cushion against risk of failure
• Promotes public confidence
• Provides funds for growth
• Regulator of growth
• Role in bank mergers
• Regulatory tool to limit risk exposure
• Protects the governments deposit insurance system

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What constitutes bank capital?
according to an accounting definition, capital
or net worth equals the cumulative value of
assets minus the cumulative value of liabilities,
and represents ownership interest in a firm.

• Other items
• Subordinated Debentures
• Minority Interest in Consolidated Subsidiaries
• Equity Commitment Notes

• Total Equity
• Common Stock
• Preferred Stock
• Surplus
• Undivided Profits
• Unrealized Gains
• Equity Reserves

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The Basle agreement

• In 1986, U.S. bank regulators proposed that U.S.
  banks be required to maintain capital that
  reflects the riskiness of bank assets.
• By 1988, the proposal had grown to include
  risk-based capital standards for banks in 12
  industrialized nations according to the terms of
  the Basle Agreement.
• Regulations were fully in place by the end of
  1992.

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Terms of the Basle Agreement

• Minimum capital requirement is linked to credit
  risk as determined by the composition of assets.
• Stockholders' equity is deemed to be the most
  critical type of capital.
• Minimum capital requirement increased to 8 for
  total capital.
• Capital requirements were approximately
  standardized between countries to 'Level the
  playing field.'

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Risk-based elements of the plan

• To determine minimum capital requirements, bank
  managers follow a four-step process
• Classify assets into one of four risk categories
• Classify off-balance sheet commitments and
  guarantees into the appropriate risk categories
  that is, compute credit-equivalent amount of each
  off balance sheet item
• Multiply the dollar amount of assets in each risk
  category by the appropriate risk weight and sum -
  this equals risk-weighted assets and
• Multiply risk-weighted assets by the minimum
  capital percentages, currently either 4 percent
  or 8 percent.

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General descriptions of the four risk categories
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Regional National Bank (RNB), risk-based capital
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Regional National Bank (RNB), risk-based capital
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Regional National Bank (RNB), risk-based capital
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Tier 1 Capital

• Common stock and surplus
• Undivided profits
• Qualifying non-cumulative preferred stock
• minority interests in the equity accounts of
  consolidated subsidiaries
• Selected indentifiable intangible assets less
  goodwill and other intangible assets

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Tier 2 Capital

• Allowance for loan and lease losses (up to 1.25
  of RAA)
• Subordinated debt capital instruments
• Mandatory convertible debt
• Intermediate-term preferred stock
• Cumulative perpetual preferred stock with unpaid
  dividends
• Equity notes
• Other long-term capital instruments that combine
  debt and equity features

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Basle Agreement Capital Requirements

• Ratio of Tier 1 Capital to Risk-Weighted Assets
  must be at least 4 percent
• Ratio of Total Capital (Tier 1 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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The Leverage Ratio

• Regulators are also concerned that a bank could
  acquire so many low-risk assets that risk-based
  capital requirements would be negligible, so they
  have imposed an alternative minimum capital
  level, defined as

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FDICIA and bank capital standards

• Effective December 1991, Congress passed the
  Federal Deposit Insurance Improvement Act
  (FDICIA) with the intent of revising bank capital
  requirements to
• emphasize the importance of capital and
• authorize early regulatory intervention in
  problem institutions, and
• authorized regulators to measure interest rate
  risk at banks and require additional capital when
  it is deemed excessive.
• A focal point of the Act was the system of prompt
  corrective actions, which divides banks into
  categories or zones according to their capital
  positions and mandates action when capital
  minimums are not met.

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Capital categories under FDICA
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Prompt regulatory action under FDICIA
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Tier 3 capital requirements for market risk

• Many large banks have dramatically increased the
  size and activity of their trading accounts,
  resulting in greater exposure to market risk.
• Market risk is the risk of loss to the bank from
  fluctuations in interest rates, equity prices,
  foreign exchange rates, commodity prices, and
  exposure to specific risk associated with debt
  and equity positions in the banks trading
  portfolio.
• Market risk exposure is, therefore, a function of
  the volatility of these rates and prices and the
  corresponding sensitivity of the banks trading
  assets and liabilities.

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Tier 3 capital requirements for market risk

• In response to the FDICIA stipulation that
  regulators systematically measure and monitor a
  banks market risk position, risk-based capital
  standards require all banks with significant
  market risk to measure their market risk exposure
  and hold sufficient capital to mitigate this
  exposure.
• A bank is subject to the market risk capital
  guidelines if its consolidated trading activity,
  defined as the sum of trading assets and
  liabilities for the previous quarter, equals 10
  percent or more of the banks total assets for
  the previous quarter, or 1 billion or more in
  total dollar value.
• Banks subject to the market risk capital
  guidelines must maintain an overall minimum 8
  percent ratio of total qualifying capital to
  risk-weighted assets and market risk equivalent
  assets.
• Tier 3 capital allocated for market risk plus
  Tier 2 capital allocated for market risk are
  limited to 71.4 percent of a banks measure for
  market risk.

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Value-at-risk

• Market risk exposure is a function of the
  volatility of rates and prices and the
  corresponding sensitivity of the bank's trading
  assets and liabilities.
• The largest banks use a value-at-risk (VAR) based
  capital charge, estimated by using an internally
  generated risk measurement model.

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Weakness of the risk-based capital standards

• The current formal standards do not account for
  any risks other than credit risk, except for
  market risk at large banks with extensive trading
  operations.
• Although the new Basel II does account for
  operational risk.
• Book value of capital is not the most meaningful
  measure of soundness.
• It ignores changes in the market value of assets,
  the value of unrealized gains or losses on
  held-to-maturity bank investments, the value of a
  bank charter, and the value of federal deposit
  insurance.
• Trading account securities must be
  marked-to-market and unrealized gains and losses
  reported on the income statement but other bank
  assets and liabilities are generally listed at
  book value
• The contra asset account, Loan Loss Allowance, is
  a crude measure of anticipated default losses but
  does not generally take into account the change
  in value of the loans from changes in interest
  rates.

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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 (credit, market, and
  operational) risk exposure
• Supervisory review of each banks risk assessment
  procedures and the adequacy of its capital
• Greater disclosure of each banks true financial
  condition, to enhance market discipline

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Operational Risk

• is the risk of loss resulting from inadequate
  or failed internal processes, people, and
  systems, or from external events.
• By 2005, a banks regulatory capital needs could
  increase significantlyup to 20 percent of total
  risk-based capitalas a result of its exposure to
  operational risk.

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Functions of bank capital

• Provides a cushion for firms to absorb losses and
  remain solvent.
• Provides ready access to financial markets,
  guards against liquidity problems.
• Constrains growth and limits risk-taking, because
  ?TA / TA ?EQ / EQ

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Example

• Recall ?TA / TA ?EQ / EQ
• Assume ROA1.1, 7 equity, DR40

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The effect of capital requirements on bank
operating policies limiting growth
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Planning to Meet a Banks Capital Needs

• Develop an Overall Financial Plan for Bank
• Determine Amount of Capital Appropriate for
  Goals, Planned Service Offerings, Acceptable Risk
  Exposure and Regulations
• Determine Amount of Capital Which Can be
  Generated Internally
• Evaluate and Choose Source of Capital Best Suited
  to Banks Needs and Goals

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Internal Capital Growth Rate

• ROE Retention Ratio

• Profit Margin Asset Utilization
• Equity Multiplier Retention Ratio