banking principle - capital
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Banks capitalChapter 15
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What is capital
Funds contributed by the owners of the firm
Investors who have stocks and preferred stock inthe bank
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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 (optionalreading)
Basel I and Capital adequacy ratio
Basel II (optional reading) Planning to Meet Capital Needs (optional reading)
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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
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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 valueof 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 Due to embezzlement, robbery, fraud, identity theft
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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: absorb losses
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Types of Capital
Common stock
Preferred stock
Surplus
Undivided profits
Subordinateddebentures
Minority interest inconsolidatedsubsidiaries
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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 privatemarketplace does not correctly price the impact ofsystemic 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 InternationalCapital Standards
An International Treaty Involving the U.S.,Canada, Japan and the Nations of Western
Europe to Impose Common CapitalRequirements On All Banks Based in ThoseCountries
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The Basel Agreement
Historically, the minimum capital requirements forbanks 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-basedcapital standards for banks in 12 industrializednations; 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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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 combinedebt and equity features
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Capital adequacy ratio
Ratio of Core Capital (Tier 1) to Risk Weighted AssetsMust Be At Least 4 Percent
Ratio of Total Capital (Tier 1 and Tier 2) to RiskWeighted Assets Must Be At Least 8 Percent
The Amount of Tier 2 Capital Limited to 100 Percentof 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 eachbalance sheet and OBS item
Multiply each balance sheet and credit-equivalentOBS item by the correct risk-weight
Add to find the total amount of risk-weighted assets See bhcs call report and RBC calculations:
https://cdr.Ffiec.Gov/public/managefacsimiles.Aspx
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Total Regulatory Capital Calculations
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What Was Left Out of the Original BaselAgreement
The most glaring hole with the original basel agreement is its failureto deal with market risk, especially problematic during the 2007-2009global credit crisis
In 1995 the basel committee announced new market risk capitalrequirements for their banks
In the U.S. Banks can create their own in-house models to measuretheir market risk exposure, var, to determine the maximum amount abank might lose over a specific time period
Regulators would then determine the amount of capital requiredbased upon their estimate
Banks that continuously estimate their market risk poorly would berequired to hold extra capital
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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 Banks Risk Assessment
Procedures and the Adequacy of Its Capital
Greater Disclosure of Each Banks True Financial Condition
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Revised Framework for Basel II15-23
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Capital Adequacy Categories Based onPrompt Corrective Action (PCA)
Well Capitalized
Adequately Capitalized Undercapitalized
Significantly Undercapitalized
Critically Undercapitalized
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Planning to Meet a Banks 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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