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