15-2 Key Topics• The Many Tasks of Capital• Capital and Risk Exposures• Types of Capital In Use• Capital as the Centerpiece of Regulation• Basel I and Basel II• Planning to Meet Capital Needs
Tasks Performed By Capital1. Provides a Cushion Against Risk of Failure2. Provides Funds to Help Institutions Get Started3. Promotes Public Confidence4. Provides Funds for Growth5. Regulator of Growth• Role in Growth of Bank Mergers• Regulatory Tool to Limit Risk Exposure• Protects the Government’s Deposit Insurance System
Defenses Against Risk • Quality Management • Diversification – Geographic – Portfolio • Deposit Insurance • Owners’ Capital
Types of Capital• Common Stock • Subordinated• Preferred Stock Debentures • Minority Interest• Surplus (largest in Consolidated capital component) Subsidiaries• Undivided Profits • Equity• Equity Reserves Commitment Notes
15-7Relative Importance of Different Sources of Capital
Reasons for Capital Regulation The underlying assumption is that the private marketplace does not correctly price the impact of systemic 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
15-9 Quick Quiz• What forms of capital are in use today? What are the key differences between the different types of capital?• What are the most important and least important forms of capital held by U.S.- insured banks?• How do small banks differ from large banks in the composition of their capital accounts and in the total volume of capital they hold relative to their assets?
15-10 Quick Quiz• What is the rationale for having the government set capital standards for financial institutions as opposed to letting the private marketplace set those standards?
The Basel Agreement onInternational Capital StandardsAn international treaty involving theU.S., Canada, Japan and the Nationsof Western Europe to Imposecommon capital requirements on allbanks based in those countries
15-12 The Basel Agreement• 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 13 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.)
15-13 The Basel Agreement• A Bank’s Minimum Capital Requirement is Linked to its Credit Risk ▫ The greater the credit risk, the greater the required capital• Stockholders equity is deemed to be the most valuable type of capital• Minimum capital requirement increased to 8% total capital to risk-adjusted assets• Capital requirements were approximately standardized between countries to ‘level the playing field‘• Capital is divided into Two Tiers
Tier 1 Capital• Common stock and surplus• Undivided profits• 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 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 combine debt and equity features
Basel 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
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
Problem 15-3Under the terms of the Basel Agreement, whatrisk weights apply to the following on balancesheet and off balance sheet items?
Problem 15-3Residential real estate loans Credi t card loansCash Standby letters of credit for municipalCommercial loans bondsU.S. Treasury securities Long-term unused commitments toDeposits held at other banks make corporate loansGNMA mortgage-backed Currency derivative contractssecurities Interest-rate derivative contractsStandby credit letters for Short-term (under one year) loancommercial paper commitmentsFederal agency securities Bank real propertyMunici pal general obligation bonds Bankers’ acceptancesInvestments in subsidiaries Municipal revenue bondsFNMA or FHLMC issued Reserves on deposit at the Federalor guaranteed securi ties Reserve banks
Problem 15-3The items which would appear in the 0%, 20%, 50% and 100% risk weightcategories are the following: 0% 20 % 50 % 100 % Cash Deposits held at Other Residential Real Commercial Loans Domestic Banks Estate Loans Treasury Securities Federal Agency Long Term Standby Credit Letters Securities Commitments to Make for Commercial Paper Corporate Loans GNMA Mortgage Municipal General Currency Derivative Investments in Backed Securities Obligation Bonds Contracts Subsidiaries Short Term Loan FNMA or FHLMC Interest Rate Credit Card Loans Commitments Issued or Guaranteed Derivative Contracts SecuritiesReserves on Deposit at Standby Letters of Municipal Revenue Bank Real Estate the Federal Reserve Credit for Municipal Bonds Bonds Bankers’ Acceptances
Problem 15-4• Using the following information for Bright Star National Bank, calculate that bank’s ratio of Tier I capital-to-risk-weighted assets under the terms of the Basel I agreement. Does the bank have sufficient capital?
Problem 15-4 (continued)On Balance Sheet Items (Assets) Off Balance Sheet ItemsCash $ 4.5 million Standby letters of $ 17.5 million credit backing municipals and corporate borrowingU.S Treasury 25.6 Long term binding 30.5 commitments tosecurities corporate customersDeposit balances due 4.0 Total of all off balance $ 48 millionfrom other banks sheet itemsLoans secured by first 50.8 Tier I capital $ 7.5 millionlines on residentialproperty (1-4 familydwellings)Loans to corporations 105.3 Tier 2 capital $ 5.8 million Total assets $190.2 million
Problem 15-4 (continued)Bright Star National Banks required level of capital under the internationalcapital standards would be determined from:Standby Credit Letter: $17.5 million * 1.00 = $17.5 millionLong-Term Credit Commitments: $30.5 million * 0.50 = 15.25 million0% Risk-Weighting CategoryCash $ 4.5 millionU.S. Treasury Securities 25.6 million $ 29.1 * 0 = $0 million20% Risk Weighting CategoryBalances Due from Other Banks $ 4.0 millionCredit Equivalent Amounts of Standby Credits 17.5 million $ 21.5 million * 0.20 = $4.3 mil
Problem 15-4 (continued)50% Risk Weighting CategoryResidential Real Estate Loans $ 50.8 million x 0.50 = $25.4 million100% Risk Weighting CategoryLoans to Corporations $105.3 millionCredit Equivalents of Long-Term Commitments $15.25 million $120.55 million * 1.0 = $120.55 millionTotal Risk-Weighted Assets $150.25 milThe banks capital ratio is: Tier I Capital /Risk-Weighted Assets = $ 7.5 million = 4.99% $ 150.25 million Total Capital/Risk-Weighted Asset = $ 13.3 million = 8.85% $ 150.25 million which is just above the minimum Tier I capital requirement of 4 percent and totalcapital (Tier One + Tier Two) requirement of 8 percent.
What Was Left Out of the Original Basel Agreement• The most glaring hole with the original Basel agreement is its failure to deal with market risk• In 1995 the Basel committee announced new market risk capital requirements for their banks• In the U.S. banks can create their own in-house models to measure their market risk exposure, VaR• Regulators would then determine the amount of capital required based upon their estimate• Banks that continuously estimate their market risk poorly would be required to hold extra capital
Value at Risk (VaR) ModelsA statistical framework for measuringa bank portfolio’s exposure tochanges in market prices or marketrates over a given time period subjectto a given probability
Central Elements of VaR• An estimate of the maximum loss in a bank’s portfolio value at a specified level of risk over 10 business days• A statement of the confidence level management attaches to its estimate of the probability of loss• An estimate of the time period over which the assets in question could be liquidated should the market deteriorate• A statement of the historical time period management uses to help develop forecasts of market value and market rates of interest
Basel II• Aims to correct the weaknesses of Basel 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 bank’s risk assessment procedures and the adequacy of its capital – Greater disclosure of each bank’s true financial condition
Credit Risk Models• Parallel the development of VaR models• IF adverse situation develops in the future, what magnitude of losses can be expected?• Model generates risk estimates based on – Borrower credit rating – Probability credit rating will change – Probable amount of recovery – The possibility of changing interest rate spreads
Revised Framework for Basel II• New framework will only apply to about 20 of the largest U.S. Banks• New rules will be phased in starting in 2008• All banks will be affected by Basel II because of competition• The largest banks may be able to hold less capital than is true from smaller banks
Capital Adequacy Categories Basedon Prompt Corrective Action (PCA)• Well capitalized• Adequately capitalized• Undercapitalized• Significantly undercapitalized• Critically undercapitalized
Capital Adequacy Categories Basedon Prompt Corrective Action (PCA) Leverage Capital/risk weighted assets Tier 1/risk-weighted assets Tier 1 / avg total assetsWell Capitalized > 10% > 6% > 5%Adequately Capitalized > 8% > 4% > 4%Undercapitalized fails to meet one or more of the aboveSignificantly Undercapitalized < 6% < 3% < 3% Tangible Equity Capital / total assetsCritically Undercapitalized < 2%
Internal Capital Growth Rate ICGR = ROE X Retention Ratio = Profit Margin X Asset Utilization X Equity Multiplier X Retention Ratio
Planning to Meet a Bank’s 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
15-39 Quick Quiz• What are the most popular financial ratios regulators use to assess the adequacy of bank capital today?
15-40 Quick QuizFirst National Bank reports the following items on its balance sheet: cash, $200m; U.S. government securities, $150m; residential real estate loans, $300m; and corporate loans, $350m.Its off-balance sheet items include standby credit letters, $20m, and long-term credit commitments to corporations, $160m.• What are First Nation’s total risk-weighted assets?• If the bank reports Tier 1 capital of $30m and Tier 2 capital of $20m, does it have a capital deficiency?
15-41 Quick QuizOff-Balance-Sheet Items – convert to equivalent on-balance sheet items:Standby credit letters $20 mill. * 1.00 = $20 mill.Long-term commitments to corporations $160 mill. * 0.50 = 80 mill.Then we risk-weight all assets:Risk-Weighted AssetsCash $200 mill. * 0 = $0 mill.U.S. Government Securities: $150 mill. * 0 = 0Standby Credit Letters: $20 mill. * 0.20 = 4Residential Real Estate Loans: $300 * 0.50 =150Corporate Loans: $350 * 1.00 =350Long-Term Credit Commitments: $80 * 1.00 = 80 Total Risk-Weighted Assets = $584millThe bank has total capital of:Tier 1 capital = $30 mill.Tier 2 capital = $20 mill. $50 mill.The banks capital to risk-weighted asset ratio is:$50 mill./$584 mill.= 0.086 or 8.6%which exceeds the minimum requirement of 8 percent. Moreover, more than 4 percent of the 8.6 percent in capital is Tier 1 capital, so the bank satisfies the capital requirements.
15-42 Summary• Many tasks capital performs• Types of capital in use Common stock Equity reserves Preferred stock Subordinated debentures Surplus Minority interest in consolidated subsidiaries Undivided profits Equity commitment notes• Basel I – Tier I and Tier II capital – Capital-to-Risk-Weighted Assets Ratio• Value at Risk (VaR) Models• Basel II – Internal risk assessment – Dual (large-bank, small-bank) set of rules
Problem 15-5 Calculate New River National Bank’s total risk weighted assets, based on the following items that the bank reported on its latest balance sheet. Does the bank appear to have a capital deficiency?On balance sheet items include: Cash $115 million Domestic interbank deposi ts 130 million U.S. government securities 250 million Residential real estate loans 450 million Commercial loans 520 million Total assets $1,465 million Total liabilities $1,350 million Total capi tal $115 million
Problem 15-5Off balance sheet items include: Standby credi t letters that back munici pal general obligation bonds $ 87 million Long-term unused loan commitments to private companies 145 million The risk-weighted assets of New River National Bank would be calculated as follows: Off-Balance-Sheet Items: Standby Credit Letters = $87 mill. * 1.00 = $87 mill. Long-Term Corporate Credit Commitments = $145 mill. * 0.50 = 72.5 mill.
Problem 15-5 (continued)New Rivers overall capital-to-assets ratio is: Total Capital = $115 million = 0.1336 or 13.36 percent Total Risk-Weighted Assets $860.9 millionOverall, it does not appear from the information given above thatNew River has a capital deficiency.
Problem 15-7Colburn Savings Association has forecast the followingperformance ratios for the year ahead. How fast can Colburnallow its assets to grow without reducing its ratio of equitycapital to total assets, assuming its performance holdsreasonably steady over it planning period? Profit Margin of Net Income Over Operating Revenue 17.75% Asset Utilization 8.25% Equity Multiplier 9.5x Net Earnings Retention Ratio 45.00%
Problem 15-7 (continued)Internal Capital Growth Rate = Profit Margin Asset Utilization Equity Multiplier Retention Ratio= 0.1775 0.0825 9.5 0.450= 0.0626 or 6.26%Its assets cannot grow any faster than 6.26 percentin order to avoid reducing its ratio of equity capital tototal assets.