Chapter Fifteen

The Management of Capital

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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

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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 (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
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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
• Crime Risk
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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
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Types of Capital

• Common Stock • Subordinated

• Preferred Stock Debentures
• Surplus • Minority Interest
in Consolidated
• Undivided Profits Subsidiaries
• Equity Reserves • Equity
Commitment
Notes

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Relative Importance of Different Sources of

Capital

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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

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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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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?
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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.)

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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
• 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
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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
• Selected Identifiable Intangible Assets Less
Goodwill and Other Intangible Assets

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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

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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
• See BHC’s Call report and RBC calculations:
https://cdr.ffiec.gov/public/ManageFacsimiles.a
spx
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Total Regulatory Capital Calculations

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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,
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
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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
• A Statement of the Historical Time Period
Management Uses to Help Develop Forecasts of
Market Value and Market Rates of Interest
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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 Disclosure of Each Bank’s True
Financial Condition

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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

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Revised Framework for Basel II

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Capital Adequacy Categories Based

on Prompt Corrective Action (PCA)

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

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Internal Capital Growth Rate

= ROE X Retention Ratio

= Profit Margin X Asset Utilization

X Equity Multiplier X Retention
Ratio

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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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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?
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