CHAPTER FOURTEEN

The Management Of Capital

The purpose of this chapter is to discover why capital – particularly equity capital – is so important for financial institutions, to learn how managers and regulators assess the adequacy of an institution’s capital position, and to explain the ways that management can raise new 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

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

Liquidity Risk

Interest Rate Risk

Operating Risk

Exchange Risk

Crime Risk

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Defenses Against Risk

Quality ManagementDiversification

GeographicPortfolio

Deposit InsuranceOwners’ Capital

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Types of Capital

Common StockPreferred Stock SurplusUndivided ProfitsEquity Reserves Subordinated Debentures

Minority Interest in Consolidated Subsidiaries

Equity Commitment Notes

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Reasons for Capital Regulation

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 Basle 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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Tier 1 Capital

Common Stock and SurplusUndivided ProfitsQualifying Noncumulative Preferred StockMinority Interests in the Equity Accounts of Consolidated SubsidiariesSelected Identifiable Intangible Assets Less Goodwill and Other Intangible Assets

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Tier 2 Capital

Allowance for Loan and Lease LossesSubordinated Debt Capital InstrumentsMandatory Convertible DebtCumulative Perpetual Preferred Stock with Unpaid DividendsEquity NotesOther Long Term Capital Instruments that Combine Debt and Equity Features

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Basle 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

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What Was Left Out of the Original Basle Agreement

The Most Glaring Hole with the Original Basle Agreement is its Failure to Deal with Market RiskIn 1995 the Basle Committee Announced New Market Risk Capital Requirements for Their BanksIn the U.S. Banks Can Create Their Own In-House Models to Measure Their Market Risk ExposureRegulators Would Then Determine the Amount of Capital Required Based Upon Their EstimateBanks 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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Basle II

Aims to Correct the Weaknesses of Basle I

Three Pillars of Basle II:Capital Requirements For Each Bank Are Based on Their Own Estimated Risk Exposure

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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Capital Adequacy Categories Based on Prompt Corrective Action

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 InternallyDividend Policy

Internal Capital Growth Rate Raising Capital Externally

Issuing Common StockIssuing Preferred StockIssuing Subordinated Notes and DebenturesSelling Assets and Leasing FacilitiesSwapping Stock for Debt SecuritiesChoosing the Best Alternative