Chapter: 15

Management of a Bank’s
Equity capital Position

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 Capital
 Thelong-term funds coming from
debt & equity that support a bank’s
long-term assets & absorb its
earnings losses.

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 Functions of Bank Capital
1) Capital provides a cushion against the risk of failure by
absorbing financial & operating losses until management
can address the bank’s problems & restore the
institution’s profitability.
2) Capital provides the funds needed to get the bank
chartered, organized & operating before deposits come
flowing in.
3) Capital promotes public confidence in a bank &
reassures its creditors of the bank’s financial strengths.
4) Capital provides funds for the organization’s growth &
the development of new services, programs & facilities.
5) Capital serves as a regulator of bank growth, helping to
ensure that the individual bank’s growth is held to a pace
that is sustainable in the long run
M. Morshed 3
 Bank Capital & Risk
 Credit or Default Risk.
 Liquidity Risk.
 Interest Rate Risk.
 Operating Risk.
 Exchange Risk.
 Crime Risk (The danger that a bank will lose
funds as a result of robbery or other crimes
committed by its customers or employees)

M. Morshed 4
 Bank Defense Against Risk
1) Quality Management
2) Diversification
i. Portfolio Diversification (spreading out a bank’s credit
accounts & deposits among wide variety of customers)
ii. Geographical Diversification (seeking out customers
located in different communities or countries)

3) Deposit Insurance
4) Owners’ Capital

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 Types of Bank Capital
1. Common Stock
2. Preferred Stock
3. Surplus (excess of stock’s par value known as
premium)
4. Undivided Profits (retained earnings)
5. Equity Reserves (for contingencies purposes)
6. Subordinated Debentures
7. Minority Interest in consolidated subsidiaries.
8. Equity Commitment Notes (debt securities
repayable only from the sale of stock)
M. Morshed 6
 Measuring the Size of Bank capital
1) Book or GAAP Capital:
Book or GAAP Capital = Book Value of bank Assets – Book Value

of bank Liabilities.
= Par value of Equity Capital + Surplus +
Undivided Profits + Reserves for losses
on loans & leases.
2) RAP Capital: Regulatory capital as spelled out by RAP
(Regulatory Accounting Principles)
RAP Capital = Stockholders’ Equity + Perpetual Preferred Stock +
Bad-debt reserves for losses on loans & leases +
Subordinated debentures + Minority Interest

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Measuring the Size of Bank capital
3) Market-Value Capital:
Market-Value Capital (MVC) = Market value of bank assets
(MVA)
– Market value of bank liabilities (MVL)
= Current market price per share of
stock outstanding X Number of
equity shares issued & outstanding

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 How Much Capital Does a Bank Need?
 Reasons for Capital Regulations:
– To limit the risk of bank failure.
– To preserve public confidence in banks.
– To limit losses to the government arising form deposit
insurance claims.
 Research Evidence
– Private marketplace is probably more important than
government regulation in the long run in determining the
amount & type of capitals bank holds.
– The financial markets do seem to react to the differential
risk positions of banks by downgrading the debt & equity
securities.
– Marker may make efficient use of all information it
possesses.
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How Much Capital Does a Bank Need?-----Contd

A. The Judgment Approach: This requires viewing each

bank within the context of its own market environment
& looking at several different dimensions of internal &
external conditions surrounding the bank. Assessment is
based on following parameters:
1. Management Quality
2. Asset liquidity.
3. Earnings history.
4. Quality of ownership
5. Occupancy of operating procedures.
6. Deposit volatility.
7. Local market conditions.

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How Much Capital Does a Bank Need?-----Contd

B. The Imposition of Minimum Capital Requirements:

As per International Lending & Supervision Act of
1983, Imposition of minimum capital requirements upon
all banks & called for special reserves behind their
foreign loans. The centerpiece of this minimum capital
program was the concept of:
1. Primary Capital (common stock, perpetual
preferred stock, surplus, undivided profits, capital
reserves, mandatory convertible debt, loan & lease
losses reserves & minority interest in consolidated
subsidiaries less equity commitment notes &
intangible assets. )
2. Secondary Capital (limited preferred stock,
subordinated notes & debentures, mandatory
convertible debt instruments)
M. Morshed 11
How Much Capital Does a Bank Need?-----Contd

C. Basel Agreement I (1988): An international treaty

involving the U.S., Canada, Japan & the nations of
Western Europe to impose common capital requirements
on all banks in those countries. Under the terms of this
agreement, sources of bank capital were divided into two
tiers:
 Tier 1 Capital (core capital) includes common stock & surplus,
undivided profits, qualifying noncummulative perpetual
preferred stock, minority interest, selected identifiable
intangible assets less goodwill & other intangible assets.
 Tier 2 Capital (supplemental capital) includes the allowance
for loan & lease losses, subordinated debt capital instruments,
mandatory convertible debt, intermediate term preferred stock,
cumulative perpetual preferred stock, equity notes & other long
term capital instruments.
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How Much Capital Does a Bank Need?-----Contd

 Basel Agreement requires a banker to divide each

contract’s risk exposure to the bank into two categories:
1. Potential Market Risk Exposure: The danger of
bank loss at some future time if the customer who
entered a market-based contract with the bank fails to
perform.
2. Current Market Risk Exposure: To measure the
risk of loss to the bank should a customer default
today on its contract, which would compel the bank
to replace the failed contact with a new one.

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How Much Capital Does a Bank Need?-----Contd

D. Basel Agreement II (2004): The New Basel

Capital Accord, often referred to as the Basel II Accord or
simply Basel II, was approved by the Basel Committee on
Banking Supervision of Bank for International Settlements in
June 2004 and suggests that banks and supervisors
implement it by beginning 2007, providing a transition time of
30 months. It is estimated that the Accord would be
implemented in over 100 countries, including India. Basel II
takes a three-pillar approach to regulatory capital
–
measurement and capital standards

Pillar1 (minimum capital requirements);

Pillar 2 (supervisory oversight); and
Pillar 3 (market discipline and disclosures).
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Basel II…………Contd.

 Pillar 1 spells out the capital requirement of a

bank in relation to the credit risk in its
portfolio, which is a significant change from
the “one size fits all” approach of Basel I.
Pillar 1 allows flexibility to banks and
supervisors to choose from among the
Standardized Approach, Internal Ratings
Based Approach, and Securitization
Framework methods to calculate the capital
requirement for credit risk exposures.
Besides, Pillar 1 sets out the allocation of
capital for operational risk and market risk in
the trading books of banks.

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Basel II…………Contd.

 Pillar 2 provides a tool to supervisors to keep

checks on the adequacy of capitalization
levels of banks and also distinguish among
banks on the basis of their risk management
systems and profile of capital. Pillar 2 allows
discretion to supervisors to (a) link capital to
the risk profile of a bank; (b) take appropriate
remedial measures if required; and (c) ask
banks to maintain capital at a level higher
than the regulatory minimum.

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Basel II…………Contd.
 Pillar 3 provides a framework for the
improvement of banks’ disclosure standards
for financial reporting, risk management,
asset quality and regulatory sanctions. The
pillar also indicates the remedial measures
that regulators can take to keep a check one
banks’ capital and maintain the integrity of the
banking system. Further, Pillar 3 allows banks
to maintain confidentiality over certain
information, disclosure of which could impact
competitiveness or breach legal contracts.

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 Capital Adequacy Categories
 It should be noted at the outset that the Prompt Corrective Action
(PCA) zone in which your bank falls is not the sole determinant of
capital adequacy. It is not at all unusual for a bank to have capital
ratios that would place it in a well-capitalized PCA zone and still have
less than satisfactory capital adequacy.
 PCA was established to help banks maintain sufficient capital, to
minimize abuses from brokered and other high-cost deposits and place
banks into receivership in a timely manner (to avoid significant
deposit insurance losses). Given restrictions placed on poorly
capitalized banks, strong efforts are made by bank management to
keep their banks well-capitalized for PCA purposes and, particularly,
to avoid the three undercapitalized categories. Consequently, it is very
unusual for a bank not to be well capitalized and even more unusual
for a bank to be in one of the three undercapitalized categories.

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Capital Adequacy Categories-----Contd
1) Well-Capitalized
To be considered well-capitalized, a bank will meet the following
conditions:
 total risk-based capital ratio is 10 percent or more,
 tier 1 risk-based capital ratio is 6 percent or more, and
 tier 1 leverage ratio is 5 percent or more.
 In addition to these ratio guidelines, to be well capitalized a bank
cannot be subject to an order, a written agreement, a capital directive
or a PCA directive.
A well-capitalized bank will be placed under the following
restrictions:
 cannot normally pay dividends or make any capital contributions
that would leave it undercapitalized; and
 cannot pay a management fee to a controlling person if, after paying
the fee, it would be undercapitalized.

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Capital Adequacy Categories-----Contd

2) Adequately Capitalized
To be considered well-capitalized, a bank will meet the following
conditions:
 Total risk-based capital ratio is at least 8 percent,
 tier 1 risk-based capital ratio is at least 4 percent, and
 tier 1 leverage ratio is at least 4 percent.
An adequately capitalized bank will be placed under the following
restrictions:
 cannot normally pay dividends or make any capital contributions
that would leave it undercapitalized;
 cannot pay a management fee to a controlling person if, after paying
the fee, it would be undercapitalized; and,
 cannot accept, renew or roll over any brokered deposit unless the
bank has applied for and been granted a waiver by the FDIC.
Waived banks are limited on rates they can pay.

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Capital Adequacy Categories-----Contd

3) Undercapitalized
To be considered undercapitalized, a bank will meet the following
conditions:
 Total risk-based capital ratio is less than 8 percent,
 tier 1 risk-based capital ratio is less than 4 percent, or tier 1 leverage
ratio is less than 4 percent.
An undercapitalized bank will be placed under the following
restrictions:
 must cease paying dividends;
 is generally prohibited from paying management fees to a
controlling person;
 must file and implement a capital restoration plan; and,
 cannot accept, renew or roll over any brokered deposit. Effective
yield on deposits solicited by the bank cannot be more than 75 basis
points or .75 percent over local market yields for comparable size
and maturity deposits.

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Capital Adequacy Categories-----Contd

4) Significantly Undercapitalized
To be considered significantly undercapitalized, a bank will meet the
following conditions:
 Total risk-based capital ratio is less than 6 percent,
 tier 1 risk-based capital ratio is less than 3 percent, or
 tier 1 leverage ratio is less than 3 percent.
A significantly undercapitalized bank will be placed under the
following restrictions:
 must cease paying dividends;
 is generally prohibited from paying management fees to a controlling
person;
 must file and implement a capital restoration plan;
 is restricted in transactions with affiliates; and,
 rates paid on its deposits are restricted to the prevailing rates paid on
deposits of similar size and maturity in the region where the bank is
located.
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Capital Adequacy Categories-----Contd
5) Critically Undercapitalized
To be considered critically undercapitalized, a bank will meet the
following condition:
 Tangible equity capital to total average assets (less intangibles) is 2
percent or less.
A critically undercapitalized bank faces the following conditions and
restrictions:
 entering into any material transaction not in the usual course of
business;
 extending credit for any highly leveraged transaction (any
transaction in which the borrower has very little equity);
 paying excessive compensation or bonuses;
 paying interest on new or renewed deposits that would increase the
bank’s weighted average cost of funds significantly above
prevailing interest rates in its normal markets.

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 How Could Bank Raise Capital?
 Raising Capital Internally
 Raising Capital Externally
• Selling Common Stock.
• Issuing Preferred Stock
• Issuing Subordinated Notes & Debentures
• Selling Assets & Leasing Facilities
• Swapping Stock for Debt Securities.

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