Capital Regulations and Management Chapter 6 Copyright © 2004 by Thomson Southwestern All rights reserved.

Defining Capital: Market versus Book Values Most Financial Institutions vs. Security Firms Most Financial Institutions – Book Value Security Firms – Market Value Difficulties in Calculating Market Values Why Capital? The Role of Capital as a Cushion against Losses Copyright © 2004 by Thomson Southwestern All rights reserved.

Copyright © 2004 by Thomson Southwestern All rights reserved.

Preferences for Capital by Different Agents Preferences of Stockholders for higher Financial Leverage Moral Hazard Problems with Deposit Insurance Purposes of Capital and Some Incentives for Stockholders to Hold Capital Preferences of Uninsured Debtholders, Managers, and Regulators The Optimal Capital Structure: Balancing Shareholders’ and Regulators’ Interests Copyright © 2004 by Thomson Southwestern All rights reserved.

Other Views on Bank Capital Regulatory Capital Adequacy May not Be as Necessary Today as in the Past Due to Greater Market Transparency More Risks Greater Reliance on Market Pricing Greater Large Customer Dependence Copyright © 2004 by Thomson Southwestern All rights reserved.

Changes in Regulatory Capital Requirements over Time Equity-to-Asset Declining Trends Basel I and FDICIA as a Response The BIS Market Risk Amendment and Basel II Equity-to-Asset Trends Following Basel I Is Basel II Needed? More credit risk? More risk due to competition? More risk due to derivatives, other off-balance sheet items? Copyright © 2004 by Thomson Southwestern All rights reserved.

Copyright © 2004 by Thomson Southwestern All rights reserved. Two Types of Capital Tier 1: Core or Tangible Equity Capital Common stock accounts Retained earnings Qualifying perpetual preferred stock (up to 25% of Tier 1 capital) Minority interest in equity accounts of consolidated subsidiaries Less ineligible intangible assets (e.g., goodwill) Copyright © 2004 by Thomson Southwestern All rights reserved.

Two Types of Capital (continued) Tier 2: Supplemental Capital Any additional perpetual preferred stock not allowed in Tier 1 Subordinated notes and debentures (up to 50 percent of Tier 2 capital) Allowance for loan and lease losses (up to 1.25% of risk-weighted assets) Mandatory convertible subordinated debt Immediate-term preferred stock (original weighted average maturity of five years or more) Copyright © 2004 by Thomson Southwestern All rights reserved.

Regulatory Capital Ratios and Definitions of Capital Adequacy Regulatory Capital Ratios (minimum) Tier 1 capital/Total assets ratio = 4% Tier 1 capital/Total risk-based assets ratio = 4% Tier 1 + Tier 2 capital/total risk-based assets ratio = 8% Regulatory Definitions of Capital Adequacy See Table 6.2, page 225 Copyright © 2004 by Thomson Southwestern All rights reserved.

Copyright © 2004 by Thomson Southwestern All rights reserved. Four Risk Categories Category 1: 0 percent weight Federal Reserve balances U.S. government securities OECD government securities Some U.S. agency securities Category 2: 20 percent weight Cash items in the process of collection OECD interbank deposits & guaranteed claims Some non-OECD bank & government deposits & securities Claims collateralized by U.S. Treasury & some agency securities Copyright © 2004 by Thomson Southwestern All rights reserved.

Four Risk Categories (continued) Category 3: 50 percent weight Other municipal revenue bonds Secured mortgage loans on 1-4 family residential properties, fully secured by first liens Category 4: 100 percent weight All other on-balance-sheet assets including Commercial loans Consumer loans Commercial paper All other assets Copyright © 2004 by Thomson Southwestern All rights reserved.

Copyright © 2004 by Thomson Southwestern All rights reserved. Basel I Issues Basel I does take into account Credit risk overall Riskiness of various assets Basel I does not take into account Interest rate risk Operating risk Credit risk variance between different loans Information from risk management models Copyright © 2004 by Thomson Southwestern All rights reserved.

Table 6.3 Calculating a Risk-Based Capital Ratio for Mega Bank Page 228 Copyright © 2004 by Thomson Southwestern All rights reserved.

The Evolving Basel II Accord Applies to very large international banks Top ten U.S. banks Three Mutually Reinforcing “Pillars” Pillar 1: Capital Charges against Market Risk, Operational Risk, and Credit Risk Pillar 2: Effective Supervisory Review Process Pillar 3: Market Discipline Copyright © 2004 by Thomson Southwestern All rights reserved.

Minimum Capital Requirements Page 229 Copyright © 2004 by Thomson Southwestern All rights reserved.

The Evolving Basel II Accord Very Large U.S. Bank Participation for Basel II: Two Regulatory Systems Operations and Other Large Banks That Opt In Advanced Internal Ratings-Based (A-IRB) Approach for Credit Risk and Advanced Measurement Approach (AMA) for Operational Risk Advance Notice of Proposed Rulemaking (ANPR) Guidelines Copyright © 2004 by Thomson Southwestern All rights reserved.

Copyright © 2004 by Thomson Southwestern All rights reserved. Measuring Risks Guidelines for Measuring Operational Risk Process Risk People Risk System Risk External Risk Guidelines for Measuring Credit Risk under an IRB Approach Probability of Default Loss Given Default Exposure at Default Remaining Maturity (M) Based on the Weighted Average Remaining Maturity FDIC Study of the Expected Effects with Basel II and Other Criticisms Copyright © 2004 by Thomson Southwestern All rights reserved.

Management of Capital and Growth with RAROC The Adequacy of Capital Depends on Regulatory Requirements An Institution's risk Profile Other Practical Consideration Other Capital Allocation Techniques for RAROC Copyright © 2004 by Thomson Southwestern All rights reserved.

Copyright © 2004 by Thomson Southwestern All rights reserved. Page 234 Copyright © 2004 by Thomson Southwestern All rights reserved.

A Practical Approach to Capital Structure Defining an Optimal (Minimum) Weighted Average Cost of Capital Dividend and Stock Repurchase Trends Copyright © 2004 by Thomson Southwestern All rights reserved.