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Capital
One of the most important topics in banking Bankers and Regulators view capital differently Bankers like to use less capital, thus increase the equity multiplier, to increase returns to the stockholder. Regulators want more capital because they want the bank to survive. Regulators are interest in the safety and soundness of the bank. Capital for Financial Firms 1) stockholders common and preferred 2) owners of credit union or mutual savings banks may be their customers because of the mutual form of organization Owners contribute a part of their wealth
Differences in the viewing of the Distribution of Earnings: A. Regulators are concerned about the downside risk of banks. They focus on the lower end of the distribution of bank earnings. B. Shareholders are more concerned with the central part of the distribution of bank earnings. C. Regulators Viewpoint 1. From regulators view financial risk increases the probability of bank insolvency. 2. If a bank has insufficient capital to absorb losses, regulators must close the bank due to capital impairment. 3. Capital regulations decrease efficiency and competition 4. They know who foots the bill when banks fail, the Federal Government (FDIC). For them the optimal number of bank failures approaches zero.
Definition of Bank Capital A. Capital = Equity Plus Long-Term Debt B. Equity = Total Assets - Total Liabilities (looking at capital as a residual) C. For Banks, Capital also includes reserves that are set aside to meet anticipated bank operating losses from loans, leases, and securities. (Contra Asset) D. For Banks, Capital is heavily regulated.
Types of Capital
Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes
Equity
A. Equity Defined - Equity Capital consists of 1. Common Stock 2. Preferred Stock 3. Surplus or Paid In Excess of Par 4. Undivided Profits (Retained Earnings) B. Preferred and Common = Number of Shares times par C. Surplus = amount of paid in capital in excess of par value realized by the bank upon the initial sale of stock. Suppose when bank was started they issued 10 Shares of $4 par. These shares were sold for $5.50 a share. Therefore the total inflow of money to the bank was 10 times $5.50 for a total of $55.00 1. Common Stock Account = Par Value times Shares = $4 times 10 = $40 2. Surplus = (Issue Price Par Value) times Shares Surplus = ($5.50 - $4.00) times 10 = $1.50 times 10 = $15
Equity Continued
D. Undivided Profits = retained earnings - are the cumulative net profits of the bank not paid out in the form of dividends to shareholders. E When these items are summed you get the book value of equity. The market value of equity will differ from the book value of equity. F. Number of Shares of Preferred and Common times respective market values gives you market values.
Long-Term Debt (Subordinated Notes and Debentures are sources of long-term debt)
A. Banks use less long-term debt than do most nonfinancial firms (they are able to get interest free deposits). B. Debt is second in priority to deposits, therefore it is subordinated (like a first and second mortgage, depositors come first). C. Rules in 1960s allowed banks to count some debt as capital. Especially debt with maturities of greater than seven years. D. Debt can be substituted for common equity in certain areas of banking. Note, debt is NOT a perfect substitute for common equity. E. The beauty about debt is that interest is tax deductible whereas dividends on stock are paid after tax. F. Debt after tax is less expensive than common equity. G. Small banks use less debt than large banks.
Reserves
A. Banks set aside earnings for loan and lease loss reserves. B. When a loan defaults, the loss does not necessarily reduce current earnings because it can be deducted from the reserve account. C. To establish reserves to meet anticipated loan losses banks expense an account known as the PROVISION FOR LOAN LOSSES (PLL). By expensing PLL banks reduce their tax burden D. Since the passage of the Tax Reform Act of 1986, banks with assets greater than $500 M can only expense actual losses from pretax income. Thus banks were not able to tweak their financial statements like they did in the past. E. Another account is the Reserve for Loan and Lease Losses. This is a contra asset account. This account is a lot like the Allowance for Bad Debts Account that we used with Accounts Receivable in Basic Accounting and Finance.
Together then capital for certain purposes equals basic equity capital + subordinated debentures and the reserve for loan and lease losses Reserves for Loan and Lease Lossest = Reserve for Loan and Lease Lossest-1 Charge-Offst + Recoveriest + PLLt
Reserves for Loan Losses, Beginning of 200X Less: Charge-Offs During 200X Plus: Recoveries during 200X on Loans Previously Charged Off Plus: Provision for Loan Losses, 200X Reserve for Loan Losses, End of 200X 3,000,000 800,000 80,000 1,000,000 3,280,000
Because reserves absorb most losses in the banking industry, they are a key component of bank capital. Losses that exceed these reserves would have to be absorbed by stockholders equity.
Extended Definitions
Surplus-representing the excess amount above each share of stocks par value paid in by the institutions shareholders. Undivided profits-representing the net earnings that have been retained in the business rather than being paid out as dividends. Equity reserves-representing funds set aside for contingencies, such as legal action against the institution, as well as providing a reserve for dividends expected to be paid but not yet declared and a sinking fund to retire stock or debt in the future Minority interest in consolidated subsidiaries, where the financial firm holds ownership shares in other businesses. Equity commitment notes, which are debt securities repayable from the sale of stock
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.) Stockholders' equity is deemed to be the most valuable type of capital Minimum capital requirement increased to 8% total capital to risk-adjusted assets
Tier 1 Capital
Common Stock and Surplus Undivided Profits (Retained Earnings Qualifying Noncumulative Preferred Stock Minority Interests in the Equity Accounts of Consolidated Subsidiaries Selected Identifiable Intangible Assets Less Goodwill and Other Intangible Assets
Tier 2 Capital
Allowance (Reserves) for Loan and Lease Losses Subordinated Debt Capital Instruments Mandatory Convertible Debt Intermediate-term Preferred Stock Cumulative Perpetual Preferred Stock w/ Unpaid Dividends Equity Notes Other Long Term Capital Instruments that Combine Debt and Equity Features
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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 Tier 1 risk based capital ratio = Tier 1 capital Total risk weighted assets Total risk based = capital ratio Total capital = Total (Tier 1 + Tier 2) capital Risk weighted risk weighted + risk weighted assets on balance off balance sheet assets sheet assets
Total Capital Ratio = Tier 1 Capital + Tier 2 Capital Risk Adjusted Assets Tier 1 Capital Ratio = Tier 1 Capital Risk Adjusted Assets Leverage Ratio = Minimum Capital= Tier 1 Capital Ratio Total Assets
Total Capital = (Tier 1 Capital + Tier 2 Capital) .08 (Risk Adjusted Assets) Tier 1 Capital .04 (Risk Adjusted Assets) Tier 1 Capital .04 (Total Assets) >>>>> Leverage Ratio
A. Basel I dictated there should be 4 Risk Groups of Assets 1. .00 items A1 2. .20 itemsA2 3. .50 itemsA3 4. 1.00 itemsA4 B. As the credit risk increases so does the capital requirement. C. How do we get Risk Adjusted Assets (Risk Weighted Assets)? 0.00 A1 + .20 A2 + .50 A3 + 1.00 A4 D. How do we calculate minimum capital needed? K = Minimum Ratio 0.00 A1 + .20 A2 + .50 A3 + 1.00 A4 K = .080.00 A1 + .20 A2 + .50 A3 + 1.00 A4 K = Minimum Capital Amount. E. The same .00; .20; .50 and 1.00 apply to off-balance sheet items.
Cash and treasury Securities Repurchase Muni bonds Single family mortgages CMOs Commercial Loans Ag Loans Allow for Loan loss Bank Build Total
Book liability and equity Deposits Hot money Sub Debt Common stock RE Surplus
Amt
15000
Risk Assets = .00 (A1) + .20 (A2) + .50 (A3) + 1.00 (A4) From above A1 = 2,000 From above A2 = Securities + Repurchase Agreements + Municipal Bonds = 1,000 + 1,500 = 2,500 From above A3 = Single Family Mortgages + CMOs = 2,700 + 2,500 = 5,200 From above A4 = Commercial Loans + Agricultural Loans + Bank Building = 1,500 + 2,100 + 2,000 = 5,600 Risk Assets = .00 (2,000) + .20 (2,500) + .50 (5,200) + 1.00 (5,600) Risk Assets = 0.0 + 500 + 2,600 + 5,600 = 8,700
To satisfy capital requirements as dictated by the Risk Based Capital Rules the sum of Tier One Capital plus Tier Two Capital must be greater than or equal to .08 of Risk Adjusted Assets to be considered adequately capitalized . Total Capital = Tier One Capital + Tier Two Capital .08 Risk Adjusted Risk Adjusted Assets Assets Therefore (Tier One Capital + Tier Two Capital) .08 (Risk Adjusted Assets) Therefore for this example (Total Capital) must be .08 (8,700) = 696
Note Risk Adjusted Assets is just another name for Risk Weighted Assets
Risk Based Capital Rules also dictate that Tier One Capital/Risk Adjusted Assets be .04 (Tier One Capital) must be .04 (Risk Adjusted Assets). So (Tier One Capital) must be .04 (8,700) = 348. Leverage Ratio Minimum Capital Ratio = Tier One Capital/Total Assets Risk Based Capital Rules say that (Tier One Capital)/Total Assets be .04 We will assume that we are dealing with average risk banks, thus .04 is the appropriate number to use here For this example Tier One Capital .04 (15,000) = 600 Risk Based Capital Rules say that Tier 2 Capital Tier 1 Capital This means that Tier Two Capital must be 348
Tier one capital = Common stockholders equity 100 350 300 + perpetual preferred stock 0 + minority interest in equity accounts of considered subsidiaries 0 - Goodwill and other intangibles 0 Total Tier one 750
Therefore this bank satisfies the tier one capital requirement since 750 > than either the tier one capital amount of 348 (Amount Determined by the Tier 1 Capital Ratio) or 600/450 (Amount Determined by the Leverage Ratio/Minimum Capital Ratio)
Allowances for losses on loans and leases 300 + Cumulative perpetual, long term and convertible preferred stock 0 + perpetual debt 0 + other hybrid debt-equity instruments 0 + intermediate term preferred stock 0 + term subordinated debt 250 Total 550 Therefore this bank satisfies another requirement in that 550 < 750. Finally the sum of Tier One and Tier Two = 750 + 550 = 1300
Once again this bank meets another requirement. Actual total capital (1,300) is greater than the total capital dictated by risk assets (696)
Ratios
The banks core capital or leverage ratio (Tier 1 capital to total assets) would be: Leverage Ratio = $4,000 = .04 $100,000 The banks total capital to total balance sheet assets ratio would be: = $4,000 + $2,000 = $6,000 = .06 $100,000 $100,000 But international capital standards are base upon risk weighted assets, not total assets.
Compute the credit-equivalent amount of each off balance item. Off Balance Sheet Items Face Value Conversion Credit Equivalent Factor Amount Standby letters of credit $50,000 X 0.2 $10,000 (SLCs) backing muni obligation bonds Long term unused loan $20,000 X 0.5 $10,000 commitments made to private corporations
100 Percent Risk Weighting Category Loans to private corporations $65,000 Credit-Equivalent Amounts of $10,000 Long-term unused loan commitments $75000 x 1.00 = $75000 to private corporations Total Risk Weighted Assets Held by this Bank $80,500
Replacement Cost
Once the replacement cost of a contract is determined, the estimated potential market risk exposure amount is then added to the estimated current market risk exposure to derive the total credit equivalent amount of each derivative contract. This total is multiplied by the correct risk weight, to find the equivalent amount of risk weighted assets represented by each contract.
Previous example Entered into $100,000 five year interest rate swap agreement with one of its customers Entered into $50,000 three year currency swap with another of its customers Multiply the face amount (notional value) of these two contracts by the appropriate credit conversion factor for each instrument (.005 and .05) in order to find the banks potential market risk exposure from each instrument. Add the estimated replacement cost if suddenly the bank has to substitute new swap contracts at todays prices and interest rates for the original contracts. Assume these replacement costs amounted to $2,500 for the interest rate contract and $1,500 for the currency contract
Example
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5 year int $100000 X 0.005 rate swap contract 3 year $50000 X 0.05 currency swap contract
= $500
Credit equivale nt volume of int rate and currency contracts + $2,500 = $3,000
Final Steps
From last slide the total credit equivalent amount of these contracts is $7,000 The final step is to multiply this total by the correct risk weight, which is 50 percent or .50. This step yields: Credit equivalent x Volume of interest rate and currency contracts Credit Risk = Volume of risk-weighted Weight assets represented by off balance sheet interest and currency contracts
Example Continued
From previous work the bank has total regulatory capital of $6,000 and total risk-weighted assets of $80,500. Its total risk-weighted assets included total on-balance sheet assets of $68,500 and off-balance sheet standby credit letters and corporate loan commitments of $12,000. We now add to these other assets the $3,500 in risk-weighted currency and interest rate contracts that we determined. In this case the banks regulatory capital to risk-weighted assets would be:
The bank lies substantially below the minimum total regulatory capital requirement of .08 of total risk-weighted assets.
Problems With Risk Adjusted Assets A. Only deals explicitly with credit risk. B. The concept uses book values rather than market values. C. Other types of risk ignored (operating, liquidity, and legal) D. Portfolio diversification is ignored Positive of Risk Adjusted Assets A. Are sensitive to some extent to differences in bank risk taking B. Incorporate off-balance sheet activities into risk assessments C. Do not penalize banks for holding low-risk, liquid assets D. Increase the consistency of rules applied to large banks around the world.
If management determines that its VaR estimates are rising, the bank must consider either increasing the amount of regulatory define capital it holds in order to absorb the rising level of risk or take steps to reduce its risk exposure.
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 banks risk assessment procedures and the adequacy of its capital Greater disclosure of each banks true financial condition (market works)
Basel II
I. Minimum capital requirements Definition of capital is unchanged and the minimum capital requirement remains 8%, but risk-adjusted assets in the denominator will be calculated differently. Credit risk will be evaluated more precisely than before to get the weights to apply to different kinds of loans. Banks will have the choice between a standardized approach (similar in most respects to Basel I) and internal credit risk models of banks (similar to the way that market risk capital requirement was previously calculate). Also, operational risk will be taken into account computer failures, poor documentation, fraud, and risks external to the bank. Again different approaches will be available to banks that have varying degrees of complexity. II. Supervisory review process Supervisors will evaluate bank measurement techniques with respect to credit and operational risks. III. Market discipline Banks will be required to increase their information disclosure, especially on the measurement of credit and operational risks.
BASEL I: A. Focus on a single measure B. One size fits all C. Broad-brush approach BASEL II: A. More emphasis on banks own internal risk models, supervisory review and market discipline. B. Flexibility, menu of approaches, incentives for better risk management C. More risk sensitivity
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Technology of risk measurement has a long way to go. For some forms of risk (such as operational risk) have no generally accepted measurement scale. There is the problem of risk aggregation. How do you add up different forms of risk exposure? How do account for the business cycle? There is also concern about regulatory competence. Regulators must be trained to keep up so they can asses the effectiveness of the different risk models each bank has adopted. The regulatory community must change along with changes in the financial services industry
15-64
Capital Standards
Banks need to be in a good capital position before they will be approved to offer new services (investment banking or insurance underwriting) Banks with weak capital may face more regulatory pressure and may be more restricted in their activities until they improve their capital positions. FDIC Improvement Act (1991) mandated Prompt Corrective Action (PCA) when an insured depository institutions capital falls below acceptable levels. Regulators may impose tougher restrictions on an insured depository institution as its capital declines, such as prohibiting payment of stockholder dividends.
Banks are classified as being Well Capitalized, Adequately Capitalized, Under Capitalized, Significantly Undercapitalized and Critically Undercapitalized. A. Well Capitalized Total Capital to Risk Adjusted Assets .10 Tier 1 Capital to Risk Adjusted Assets .06 Tier 1 Capital to Total Assets .05 (Leverage Ratio) B. Adequately Capitalized Total Capital to Risk Adjusted Assets .08 Tier 1 Capital to Risk Adjusted Assets .04 Tier 1 Capital to Total Assets .04 (Leverage Ratio) C. Under Capitalized Total Capital to Risk Adjusted Assets .08
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In the fall of 1992 federal regulators created five capitaladequacy categories for depository institutions Well Capitalized .10, .06, .05 Adequately Capitalized .08, .04, 04 Undercapitalized-depository institution that fails to meet one or more of the capital minimums for an adequately capitalized institution Significantly Undercapitalized-total capital ratio < .06; Tier I Capital < .03. No pay raises for senior officers, limits on deposit interest rates. Critically Undercapitalized-has tangible equity capital to total assets is .02
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Internal Expansion 1. The rate at which a bank can internally expand its assets and still maintain its capital ratio is known as the sustainable growth rate. 2. Sustainable Growth Rate =
1 Capital Ratio
1 TE/TA TA TE = EM = = =
NPAT TA
NPAT TA NPAT TA ROA
ROE x Retention Ratio = g ROE x b = g = Sustainable Growth Rate Profit Margin x Asset Utilization x Equity Multiplier x Retention Ratio
EM times NPM times TA Turn times RR = ROE times RR = g = Sustainable Grow Rate A. A decreasing capital ratio (increasing equity multiplier) allows a more rapid expansion of bank assets, all other things being equal. B. Higher capital requirements increase the role of internally generated profits, as opposed to externally borrowed funds, in growing the asset base of the bank. C. Management's approach to financing asset growth is related to: 1. Sustainable Growth Rate 2. Regulatory rules concerning capital adequacy 3. Competitive pressures 4. Financial Market Conditions 5. Other factors (shareholder preferences for debt)
Best Alternative-Example
Bank needs to raise $20 million in external capital. Bank has 8 million shares of common stock outstanding at $4 par Bank has assets close to $1 billion, with 60 million in equity capital. If bank generates total revenue of about $100 million and holds operating expenses to no more than $80 million, the bank should have $10.8 million in earnings left after taxes. If management raises the needed $20 million in new capital by issuing 2 million of new shares, each at a net price of $10, common stock holders will receive $1.30 in earnings per share.
Solution to Problem
Cash $200,000,000 x 0 =$ 0 U.S. Gov Sec. $150,000,000 x 0 =$ 0 Residential Real Estate Loans $300,000,000 x .50 =$150,000,000 Corporate Loans $350,000,000 x 1 =$350,000,000 Stand by Credit $20,000,000 x .20 x .20=$ 800,000 Long-Term Credit Com $160,000,000 x .50 x 1 =$ 80,000,000 Risk Weighted Assets =$580,800,000
Total Capital .08 x $580,800,000 = $46,464,000 Tier One Capital .04 x $580,800,000 = $23,232,000 Total Capital = Tier 1 + Tier 2 = $30,000,000 + $20,000,000 = $50,000,000 Adequate Capital Good Tier One Capital = $30,000,000 Adequate Capital Good