Chapter Fifteen

The Management of Capital

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 Key Topics

• The Many Tasks of Capital

• Types of Capital In Use
• Capital as the Centerpiece of Regulation
• Basel I, Basel II, Basel III
• Planning to Meet Capital Needs

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 Introduction
• What is capital?
▫ Funds contributed by the owners of a financial institution

• Raising and retaining sufficient capital to protect the

interests of customers, employees, owners, and the general
public

• Why is capital so important in financial-services

management?
▫ It provides a cushion of protection against risk and promotes
public confidence

• Capital has become the centerpiece of supervision and

regulation today
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 The Many Tasks Capital Performs
1. Provides a cushion against the risk of failure

2. Provides funds to help institutions get started

3. Promotes public confidence

4. Provides funds for growth/development

5. Serves a regulator of growth

6. Regulatory tool to limit risk exposure

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 Capital and Risks
• Key Risks in Banking Management
▫ Credit Risk

▫ Liquidity Risk

▫ Interest Rate Risk

▫ Operational Risk

▫ Exchange Risk

▫ …
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 Capital and Risks (continued)
• Defenses against Risks
▫ Quality Management
 The ability of managers to deal with problems before they
overwhelm the bank
▫ Diversification (of uses and sources of funds)
▫ Portfolio (verity of customers, different industries)
▫ Geographic (customers from different communities/countries)

▫ Deposit Insurance
 implemented in many countries to protect bank depositors
▫ Owners’ Capital
 When all else fails, it is owner’s capital that forms the ultimate
defense’ against risk
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 Types of Capital in Use
1. Common stocks
2. Preferred stocks
3. Surpluses
4. Retained earnings (Undivided profits)
5. Equity reserves
6. Subordinated debentures
7. Minority interests in consolidated subsidiaries
8. Equity commitment notes

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 One of the Great Issues in the History of Banking:
How Much Capital Is Really Needed?
• Regulatory Approach to Evaluating Capital Needs
▫ Reasons for Capital Regulation

1. To limit risk of failures

2. To preserve public confidence

3. To limit losses to the government and other institutions

arising from deposit insurance claims

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 The Basel Agreement on International Capital
Standards
• The Basel Agreement
▫ Approved in July 1988 among leading countries

▫ Has strengthened government’s role in assessing how much

capital banks need

▫ Rules were designed to

▫ Encourage banks to keep their capital positions strong
▫ Reduce inequalities in capital requirements among different
countries
▫ Promote fair competition
▫ Catch up with recent changes in financial services and financial
innovation
▫ In particular, the expansion of off-balance-sheet commitments

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 The Basel Agreement on International Capital
Standards
• Basel I
▫ The original Basel capital standards are known today as
Basel I
▫ Various sources of capital were divided into two tiers:
▫ Tier 1 (core) capital

▫ Common stock and surplus

▫ Retained earnings (undivided profits)

▫ Qualifying noncumulative perpetual preferred stock

▫ Minority interest

▫ Identifiable intangible assets less goodwill and other intangible

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 The Basel Agreement on International Capital
Standards
• Basel I
▫ Various sources of capital were divided into two tiers:
▫ Tier 2 (supplemental) capital

▫ Allowance (reserves) for loan losses (ALL)

▫ Subordinated debt capital instruments

▫ Mandatory convertible debt

▫ Intermediate-term preferred stock

▫ Equity notes and other long-term capital instruments that

combine both debt and equity features

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 The Basel Agreement on International Capital
Standards
• Basel I Capital Requirements
▫ In order for a bank to qualify as adequately capitalized, it
must have:

with the amount of Tier 2 capital limited to 100

percent of Tier 1 capital

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 The Basel Agreement on International Capital
Standards
• Calculating Risk-Weighted Assets
▫ Each asset item on a bank’s balance sheet and each off-balance-sheet
commitment it has made are multiplied by a risk-weighting factor
▫ Designed to reflect its credit risk exposure

▫ Off-balance-sheet items are usually standby letters of credit and long-

term credit commitments

▫ The Basel I capital standards were adjusted to take account of the risk
exposure banks may face from derivatives (futures, options, swaps, …)
and from counterpart risk (replacement costs)

▫ Basel required a banker to divide each contract’s risk exposure into

two categories
1. Potential market risk exposure
2. Current market risk exposure
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 The Basel Agreement on International Capital
Standards
• Problems with Basel I
▫ [1] Basel I failed to account for market risk
▫ The losses a bank may suffer because of adverse changes in
interest rates, security prices, and currency and commodity
prices

▫ The risk weights on bank assets were designed primarily to

take account of credit risk (not market risk)

▫ In 1996 the Basel Committee approved a modification to

the rules
▫ Permitted the largest banks to conduct risk measurement and
estimate the amount of capital necessary to cover market risk
▫ Led to a third capital ratio (Tier 3)

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 The Basel Agreement on International Capital
Standards
• Value at Risk (VaR) – measuring market risk
• A statistical framework for measuring a bank portfolio’s exposure to
market risk

• It shows the maximum amount a bank might lose over a specific

time period
▫ VaR Example
▫ A bank estimates its portfolio’s daily average value at risk is
$100 billion over a 10-day interval with a 99 percent level of
confidence
▫ So VaR=$100 billion, suggesting that with probably of 99% the banks
will not lose more than $100b over the next 10 days

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 The Basel Agreement on International Capital
Standards
• Problems with Basel I (Continued)

▫ [2] Smart bankers found ways around many of Basel I’s restrictions

▫ [3] Basel I represented a “one size fits all” approach to capital

regulation

▫ It failed to recognize that no two banks are alike in terms of their

risk profiles

▫ Basel II set up a system in which capital requirements would be

more sensitive to risk and protect against more types of risk than
Basel I

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 The Basel Agreement on International Capital
Standards
• Pillars of Basel II
1. Minimum capital requirements for each bank based on its own
estimated risk exposure from credit, market, and operational risks

2. Supervisory review of each bank’s risk-assessment procedures

3. Greater public disclosure of each bank’s true financial condition

• Under Basel II, minimum capital requirements were

designed to vary significantly with credit quality

• Note also that Basel II requires banks to hold capital to

address operational risk

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 The Basel Agreement on International Capital
Standards
• Problems with Basel II
• Defining operational risk
• Resulted in less total capital and a weak mix of capital

• Basel III Born in Global Crisis

• Basel III Capital Requirements

1. , the same as Basel I

2. , base capital=common equity

With 2.5% extra capital buffer ratio. The buffer ratio would absorbs losses
when the economy is in serious trouble.
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• Implementation would be phased©in slowly,
2008 beginning
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 Capital Standards Inside the United States
• U.S. bank regulators created capital-adequacy categories as
follows:
1. Well capitalized

2. Adequately capitalized

3. Undercapitalized

4. Significantly undercapitalized

5. Critically undercapitalized

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 Planning to Meet Capital Needs
• Raising Capital Internally
• Dividend Policy

• Raising Capital Externally

• Selling Common Stock
• Selling Preferred Stock
• Issuing Debt Capital
• Selling Assets and Leasing Facilities
• Swapping Stock for Debt Securities

The choice of which method to use is based on their effects on a

financial firm’s earnings per share

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 Quick Quiz
• What crucial roles does capital play in the management of a banking
firm?

• What is the rationale for having the government set capital

standards for banks as opposed to letting the private marketplace set
those standards?

• How is the Basel Agreement likely to affect a bank’s choices among

assets it would like to acquire?

• What are the differences among Basel I, II, and III?

• What are the principal sources of external capital for a banking

firm?
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