©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Thirteen Regulation of Commercial Banks

©2009, The McGraw-Hill Companies, All Rights Reserved 13-2 McGraw-Hill/Irwin Specialness of Commercial Banks Commercial banks provide many unique services –information, liquidity, price-risk reduction, transaction cost, maturity intermediation, and payment services –money supply transmission, credit allocation, intergenerational wealth transfers, and denomination intermediation Failure to provide these services can be costly to both users and suppliers of funds Accordingly, commercial banks are regulated at the federal (and sometimes state) level Commercial banks provide many unique services –information, liquidity, price-risk reduction, transaction cost, maturity intermediation, and payment services –money supply transmission, credit allocation, intergenerational wealth transfers, and denomination intermediation Failure to provide these services can be costly to both users and suppliers of funds Accordingly, commercial banks are regulated at the federal (and sometimes state) level

©2009, The McGraw-Hill Companies, All Rights Reserved 13-3 McGraw-Hill/Irwin Types of CB Regulations Safety and soundness regulation –assets must be diversified: cannot make loans greater than 15% of their equity capital to any one borrower –must maintain adequate equity capital levels to protect against insolvency risk – TARP’s Capital Purchase Program. –provision of guarantee funds such as the Deposit Insurance Fund (DIF) protects depositors in the event of default and prevents bank runs –monitoring and surveillance: banks must submit (publicly accessible) quarterly reports and are subject to on-site examinations Safety and soundness regulation –assets must be diversified: cannot make loans greater than 15% of their equity capital to any one borrower –must maintain adequate equity capital levels to protect against insolvency risk – TARP’s Capital Purchase Program. –provision of guarantee funds such as the Deposit Insurance Fund (DIF) protects depositors in the event of default and prevents bank runs –monitoring and surveillance: banks must submit (publicly accessible) quarterly reports and are subject to on-site examinations

©2009, The McGraw-Hill Companies, All Rights Reserved Layers of Regulation 13-4 McGraw-Hill/Irwin Regulate by Monitoring & Surveillance Diversify Assets Guarantee Funds Hold Sufficient Capital LoansCashInvestments

©2009, The McGraw-Hill Companies, All Rights Reserved Wall Street Reform & Consumer Protection Act, 2010 Promote robust supervision and regulation of financial firms –Financial Services Oversight Council –New authority to Fed to supervise all financial firms (non-banks) posing a threat to financial stability –Stronger capital and prudential standards –National Bank Supervisor –Elimination of loopholes; BHCs and thrifts not in mortgages –Registration of hedge funds and private pools – 13-5 McGraw-Hill/Irwin

©2009, The McGraw-Hill Companies, All Rights Reserved Dodd–Frank Act Comprehensive supervision of financial markets –Regulation of securitization markets; transparency, credit rating agencies, financial interest requirement of securitized loans originators –Regulation of OTC derivatives –Authority to FED to oversee payment, clearing and settlement systems McGraw-Hill/Irwin

©2009, The McGraw-Hill Companies, All Rights Reserved Protect consumers and investors –Consumer Financial Protection Agency –Transparency, fairness and appropriateness of financial products –Higher standards for providers of consumer financial products 13-7 McGraw-Hill/Irwin Dodd–Frank Act – cont.

©2009, The McGraw-Hill Companies, All Rights Reserved Provide tools to manage financial crisis –New regime to resolve crisis involving non- banks –Revision to FED’s emergency lending powers to improve accountability 13-8 McGraw-Hill/Irwin Dodd–Frank Act – cont.

©2009, The McGraw-Hill Companies, All Rights Reserved Raise international regulatory standards and improve cooperation –Strengthening capital framework –Oversight of financial markets –Coordination supervision of internationally active firms –Enhancing crisis management tools 13-9 McGraw-Hill/Irwin Dodd–Frank Act – cont.

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Commercial Bank Regulation Monetary policy regulation –the Central Bank (the Federal Reserve) directly controls the quantity of notes and coin (i.e., outside money) in the economy –however, the bulk of the money supply is held as bank deposits, called inside money –regulators require cash reserves to be held against deposits at commercial banks Monetary policy regulation –the Central Bank (the Federal Reserve) directly controls the quantity of notes and coin (i.e., outside money) in the economy –however, the bulk of the money supply is held as bank deposits, called inside money –regulators require cash reserves to be held against deposits at commercial banks

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Commercial Bank Regulation Credit allocation regulation –regulators encourage (and often require) lending to socially important sectors of the economy (e.g., housing and farming) –QLT requiremement, usury laws cap interest rates that can be charged on loans Credit allocation regulation –regulators encourage (and often require) lending to socially important sectors of the economy (e.g., housing and farming) –QLT requiremement, usury laws cap interest rates that can be charged on loans

©2009, The McGraw-Hill Companies, All Rights Reserved Commercial Bank Regulation Consumer Protection Regulations –Community reinvestment Act (CRA) CRA ratings, demographic data & lending patterns Credit approval and denial decisions –Home Mortgage Disclosure Act (HMDA) – 1975 –Consumer Financial Protection Agency, 2010 –Credit card abuses – fees, rates, universal default Consumer Protection Regulations –Community reinvestment Act (CRA) CRA ratings, demographic data & lending patterns Credit approval and denial decisions –Home Mortgage Disclosure Act (HMDA) – 1975 –Consumer Financial Protection Agency, 2010 –Credit card abuses – fees, rates, universal default McGraw-Hill/Irwin

©2009, The McGraw-Hill Companies, All Rights Reserved Commercial Bank Regulation Investor protection regulation –protects investors against insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility –Securities Act, 1933 & 1934 –Investment Company’s Act, Investor protection regulation –protects investors against insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility –Securities Act, 1933 & 1934 –Investment Company’s Act, McGraw-Hill/Irwin

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Commercial Bank Regulation Entry and chartering regulation –the entry of commercial banks is regulated –the permissible activities of commercial banks are defined by regulators –the barriers to entry and the scope of permissible activities allowed affects the charter values of banks and the size of the net regulatory burden The net regulatory burden is the difference between the costs of regulations and the benefits for the producers of financial services Entry and chartering regulation –the entry of commercial banks is regulated –the permissible activities of commercial banks are defined by regulators –the barriers to entry and the scope of permissible activities allowed affects the charter values of banks and the size of the net regulatory burden The net regulatory burden is the difference between the costs of regulations and the benefits for the producers of financial services

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Commercial Bank Regulation Regulators –the Federal Deposit Insurance Corporation (FDIC) –the Office of the Comptroller of the Currency (OCC) –the Federal Reserve System (FRS) –state agencies The four facets of regulatory structure –regulation of product and geographic expansion –provision and regulation of deposit insurance –balance sheet regulation –off-balance-sheet regulation Regulators –the Federal Deposit Insurance Corporation (FDIC) –the Office of the Comptroller of the Currency (OCC) –the Federal Reserve System (FRS) –state agencies The four facets of regulatory structure –regulation of product and geographic expansion –provision and regulation of deposit insurance –balance sheet regulation –off-balance-sheet regulation

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Product Segmentation Regulation Commercial banking vs. investment banking –commercial banking involves deposit taking and lending –investment banking involves underwriting, issuing, and distributing securities –the Glass-Steagall Act of 1933 imposed a rigid separation between commercial and investment banks –by 1987 commercial banks were allowed to engage in limited investment banking activity through Section 20 affiliates –the Financial Services Modernization Act (FSMA) of 1999 repealed Glass-Steagall Commercial banking vs. investment banking –commercial banking involves deposit taking and lending –investment banking involves underwriting, issuing, and distributing securities –the Glass-Steagall Act of 1933 imposed a rigid separation between commercial and investment banks –by 1987 commercial banks were allowed to engage in limited investment banking activity through Section 20 affiliates –the Financial Services Modernization Act (FSMA) of 1999 repealed Glass-Steagall

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Product Segmentation Regulation Commercial banking vs. insurance underwriting –the Bank Holding Company Act (BHCA) of 1956 restricted insurance companies from owning or being affiliated with commercial banks –the FSMA of 1999 now allows bank holding companies to open insurance underwriting affiliates and also allows insurance companies to open banks Commercial banks and commerce –the BHCA of 1956 restricts commercial firms from acquiring banks –the 1970 Amendment to the BHCA requires banks to divest nonbank related subsidiaries Commercial banking vs. insurance underwriting –the Bank Holding Company Act (BHCA) of 1956 restricted insurance companies from owning or being affiliated with commercial banks –the FSMA of 1999 now allows bank holding companies to open insurance underwriting affiliates and also allows insurance companies to open banks Commercial banks and commerce –the BHCA of 1956 restricts commercial firms from acquiring banks –the 1970 Amendment to the BHCA requires banks to divest nonbank related subsidiaries

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Geographic Expansion Regulation Restrictions on intrastate banking –most banks used to be unit banks—i.e., banks with single offices –by 1997 only six states restricted intrastate branching Restrictions on interstate banking –the McFadden Act of 1927 (amended in 1933) restricted national banks from branching across state lines as a result, the largest banks were set up as multibank holding companies (MBHCs) an MBHC is a parent banking organization that owns a number of individual bank subsidiaries Restrictions on intrastate banking –most banks used to be unit banks—i.e., banks with single offices –by 1997 only six states restricted intrastate branching Restrictions on interstate banking –the McFadden Act of 1927 (amended in 1933) restricted national banks from branching across state lines as a result, the largest banks were set up as multibank holding companies (MBHCs) an MBHC is a parent banking organization that owns a number of individual bank subsidiaries

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Geographic Expansion Regulation –the Douglas Amendment to the BHCA of 1956 let states regulate MBHC expansion subsidiaries established prior to the passage of the amendment were considered grandfathered and not subject to the law –the 1970 Amendment to the BHCA of 1956 restricted the nonbank activities that one bank holding companies (OBHCs) could engage in a OBHC is a parent banking organization that owns one bank subsidiary and nonbank subsidiaries –the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allows consolidation of out-of-state bank subsidiaries into a branch network and allows interstate mergers and acquisitions –the Douglas Amendment to the BHCA of 1956 let states regulate MBHC expansion subsidiaries established prior to the passage of the amendment were considered grandfathered and not subject to the law –the 1970 Amendment to the BHCA of 1956 restricted the nonbank activities that one bank holding companies (OBHCs) could engage in a OBHC is a parent banking organization that owns one bank subsidiary and nonbank subsidiaries –the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allows consolidation of out-of-state bank subsidiaries into a branch network and allows interstate mergers and acquisitions

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Guarantee Funds The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to maintain the stability of the U.S. banking system –worked well until 1979 –from October 1979 to October 1982 the Fed targeted bank reserves and let interest rates rise dramatically –led to disintermediation—i.e., the withdrawal of deposits from depository institutions and their reinvestment elsewhere –problems were exacerbated by a policy of regulatory forbearance—i.e., a policy of not closing economically insolvent depository institutions, but allowing their continued operation The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to maintain the stability of the U.S. banking system –worked well until 1979 –from October 1979 to October 1982 the Fed targeted bank reserves and let interest rates rise dramatically –led to disintermediation—i.e., the withdrawal of deposits from depository institutions and their reinvestment elsewhere –problems were exacerbated by a policy of regulatory forbearance—i.e., a policy of not closing economically insolvent depository institutions, but allowing their continued operation

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Guarantee Funds The FDIC Improvement Act (FDICIA) of 1991 restructured the Bank Insurance Fund (BIF) The demise of the Federal Savings and Loan Insurance Corporation (FSLIC) –the FSLIC insured savings institutions from 1934 to 1989 –savings institutions failures in the 1980s led to an insolvent FSLIC by 1989 The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 –dissolved the FSLIC and transferred its management to the FDIC –created the Savings Association Insurance Fund (SAIF) The FDIC Improvement Act (FDICIA) of 1991 restructured the Bank Insurance Fund (BIF) The demise of the Federal Savings and Loan Insurance Corporation (FSLIC) –the FSLIC insured savings institutions from 1934 to 1989 –savings institutions failures in the 1980s led to an insolvent FSLIC by 1989 The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 –dissolved the FSLIC and transferred its management to the FDIC –created the Savings Association Insurance Fund (SAIF)

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Guarantee Funds The FDIC introduced risk-based deposit insurance premiums in January of 1993 –by 1996 the safest institutions insured by the BIF paid no deposit insurance premiums –by 1997 the safest institutions insured by the SAIF paid no deposit insurance premiums –by the early 2000s over 90% of depository institutions were in the “safe” category that paid no deposit insurance premium In March 2005 the BIF and the SAIF were merged into one Deposit Insurance Fund (DIF) In January 2007 the FDIC began a more aggressive insurance system where all institutions pay into the fund The FDIC introduced risk-based deposit insurance premiums in January of 1993 –by 1996 the safest institutions insured by the BIF paid no deposit insurance premiums –by 1997 the safest institutions insured by the SAIF paid no deposit insurance premiums –by the early 2000s over 90% of depository institutions were in the “safe” category that paid no deposit insurance premium In March 2005 the BIF and the SAIF were merged into one Deposit Insurance Fund (DIF) In January 2007 the FDIC began a more aggressive insurance system where all institutions pay into the fund

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Risk CategoryAnnual Rate in BP# Institutions% Total I – Minimum52, % I – Middle , % I – Middle , % I – Maximum % II % III % IV4370.1% The FDIC Assessment Rate Schedule for the quarter ending September 30, 2007

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Balance Sheet Regulation Liquidity regulation –banks must hold minimum levels of reserves against net transaction accounts –ensures that banks can meet required payments on liability claims such as deposit withdrawals –see Appendix 13c for more details Capital adequacy regulation –since 1987 U.S. commercial banks have faced two different capital requirements Tier I capital risk-based ratio Total capital (Tier I + Tier II) risk-based ratio Liquidity regulation –banks must hold minimum levels of reserves against net transaction accounts –ensures that banks can meet required payments on liability claims such as deposit withdrawals –see Appendix 13c for more details Capital adequacy regulation –since 1987 U.S. commercial banks have faced two different capital requirements Tier I capital risk-based ratio Total capital (Tier I + Tier II) risk-based ratio

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The first $10.7 million of net transaction accounts carry a 0% reserve requirement, amounts from $10.7 million to $55.2 million carry a 3% reserve requirement and all amounts over $55.2 million require a 10% reserve requirement. Suppose that a bank has average daily gross transaction deposits of $1,650 million, including $150 million in its own deposits elsewhere and in currency in the process of collection (CIPC) so that net transaction accounts are $1,500 million. The minimum average reserves the bank must hold is: Regulations on Commercial Bank Liquidity Net Transaction Accounts % Reserve RequiredAmount Daily Avg. Required Less than % to % more than % Total:

©2009, The McGraw-Hill Companies, All Rights Reserved Since 1987 U.S. commercial banks have faced two different capital requirements Capital-to-Assets (i.e., leverage) ratio –capital-to-assets ratio = core capital ÷ total assets –does not account for market values, riskiness of assets, or off-balance-sheet activities Risk weighted capital requirement –Tier I capital risk-based ratio –Total capital (Tier I + Tier II) risk-based ratio McGraw-Hill/Irwin Capital Adequacy Regulation

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Balance Sheet Regulation Since December 1992 regulators must take Prompt Corrective Action (PCA) if and when a bank falls outside of the “well capitalized” zone Risk-based capital ratios were phased in by Bank for International Settlement (BIS) countries (the U.S. included) by 1993 under the Basel Accord Since December 1992 regulators must take Prompt Corrective Action (PCA) if and when a bank falls outside of the “well capitalized” zone Risk-based capital ratios were phased in by Bank for International Settlement (BIS) countries (the U.S. included) by 1993 under the Basel Accord

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Capital Adequacy Regulation Tier I capital is composed of the book value of common equity plus an amount of perpetual preferred stock plus minority equity interests held by the bank in subsidiaries minus goodwill Tier II capital includes secondary capital resources such as loan loss reserves and convertible and subordinated debt risk-adjusted assets include both on- and off-balance-sheet assets whose values are adjusted for approximate credit risk the total risk-based capital ratio is equal to the sum of Tier I and Tier II capital divided by risk-adjusted assets the Tier I (core) capital ratio is equal to Tier I capital divided by risk-adjusted assets Tier I capital is composed of the book value of common equity plus an amount of perpetual preferred stock plus minority equity interests held by the bank in subsidiaries minus goodwill Tier II capital includes secondary capital resources such as loan loss reserves and convertible and subordinated debt risk-adjusted assets include both on- and off-balance-sheet assets whose values are adjusted for approximate credit risk the total risk-based capital ratio is equal to the sum of Tier I and Tier II capital divided by risk-adjusted assets the Tier I (core) capital ratio is equal to Tier I capital divided by risk-adjusted assets

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Off-Balance-Sheet Regulation Banks earn fee income with off-balance-sheet (OBS) activities By engaging in OBS activities, banks can avoid regulatory costs such as reserve requirements, deposit insurance premiums, and capital adequacy requirements Banks must report notional values of OBS activity on Schedule L OBS activity is incorporated into the total risk-based capital ratio and the Tier I capital ratio, but not the leverage ratio Banks earn fee income with off-balance-sheet (OBS) activities By engaging in OBS activities, banks can avoid regulatory costs such as reserve requirements, deposit insurance premiums, and capital adequacy requirements Banks must report notional values of OBS activity on Schedule L OBS activity is incorporated into the total risk-based capital ratio and the Tier I capital ratio, but not the leverage ratio

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Regulations on Capital Adequacy (Leverage) The FDICIA requires banks and thrifts to meet identical risk based capital requirements. FDICIA requires regulators to mandate prompt corrective actions (PCA) if a bank falls below the well capitalized criteria. The 1989 Basle Accord did three things: 1.Defined what banks could count as capital. 2.Increased the amount of capital a bank is required to hold by requiring stricter minimum capital/asset ratios. 3.Made the required capital levels reflect the risk of the institution.

©2009, The McGraw-Hill Companies, All Rights Reserved Basle Accord I defined two types of capital: Tier 1 (Core) capital: “No Contractual Obligated Payments” Common Equity, including Retained Earnings (Must be  4% of Risk Weighted Assets (RWA). Subject to regulatory approval: Qualifying cumulative and noncumulative perpetual preferred stock (and surplus) {No more than 25% of the sum of the other Tier 1 elements} Tier 2 or Supplemental Capital (major components) Allowance for loan and lease losses - Up to 1.25% of RWA Perpetual preferred stock not counted in Tier 1. Subordinated debt and finite lived preferred stock maturing no sooner than 5 years.{Maximum amount is 50% of Tier 1} Total Capital (TC) or Allowable Capital = Tier 1 + Tier 2

©2009, The McGraw-Hill Companies, All Rights Reserved Summary of the Risk Weights for On Balance Sheet Items Risk WeightAsset Category 1 0%Cash; Securities backed by U.S. and OECD govt. and some U.S. govt. agencies Reserves at Fed (central banks) GNMA mortgage backed securities Loans to sovereigns with an S&P rating of AA- or better Category 2 20%Mortgage backed non-govt. agency sponsored securities such as FNMA and FHLMC backed securities Most securities issued by govt. agencies; GO municipals U.S. and OECD interbank deposits and guaranteed claims Repos collateralized by U.S.G.S. Loans to sovereigns with an S&P rating of A+ to A- Loans to banks and corporates with an S&P rating of AA- or better Category 3 50%Single or multi-family mortgages (fully secured, first liens); Revenue bonds Loans to sovereigns with an S&P rating of BBB+ to BBB- Loans to banks and corporates with an S&P rating of A+ to A- Category 4 100%Loans to sovereigns with an S&P rating of BB+ to B- Loans to banks with an S&P rating of BBB+ to B- Loans to corporates with an S&P rating of BBB+ to BB- All other loans to private entities and all consumer loans Physical assets Corporate Bonds and other unclassified investments All other assets, including intangibles Category 5 150%Loans to sovereigns, banks and securities firms with an S&P rating below B- Loans to corporates with an S&P rating below BB-

©2009, The McGraw-Hill Companies, All Rights Reserved XYZ Bank (Millions) ASSETSLIABILITIES & EQUITY Cash & Reserves$ 5Deposits$113 Investments in Treasuries$ 1010 year Sub. Debt$ 16 Commercial loans BB+$ 12Perpetual Noncum. PS$ 1 Single family mortgages$ 45Common stock$ 2 Consumer loans$ 35Retained Earnings$ 5 Commercial loans CCC+$ 25 Allowance for loan losses($ 10 ) Physical assets$ 15 Total Assets$137 Total$137 Off Balance Sheet: Banker’s Acceptances $20 million to entities with an A+ rating. Three year fixed-for-floating interest rate swap with notional value of $75 million and a replacement cost of $3 million. Three year forward contract to sell euros for $10 million. The contract has a replacement cost of $1 million.

©2009, The McGraw-Hill Companies, All Rights Reserved XYZ Bank (Millions $) ASSETSRisk Weight RWALIABILITIES & EQUITY Capital Cash & Reserves$ 50% $0.0 Deposits$113- Investments in Treasuries$ 100% $ year Sub. Debt$ 16Tier 2 Commercial Loans BB+$ 12100% $12.0 Perpetual Noncum. PS$ 1Tier 1 Single family mortgages$ 4550% $22.5 Common stock$ 2Tier 1 Consumer loans$ 35100% $35.0 Retained Earnings$ 5Tier 1 Commercial loans CCC+$ 25150% $37.50 Allowance for loan losses ($ 10)N/A Physical assets$ 15100% Total Assets$137$ Total$137 The on balance sheet risk weighted asset total is calculated as the sum of the amount of each asset times the risk weight. Total on balance sheet risk weighted assets are thus $122 million. The reserve for loan losses is ignored in this calculation.

©2009, The McGraw-Hill Companies, All Rights Reserved Total Risk Weighted Assets (RWA) On Balance Sheet RWA$122,000,000 Off-Balance Sheet Assets Banker’s Acceptances$ 2,000,000 Swap$ 3,375,000 Forward$ 1,500,000 Total RWA$128,875,000 The risk weighted equivalent asset amounts for the off balance sheet items are calculated as follows:

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Calculations for the risk weighted equivalent asset amounts for the off balance sheet items: Banker’s Acceptance $20 million to entities with an A+ rating. 20% conversion factor; risk weight is 50% $20 million  0.20  50% = $2 million. Three year fixed for floating interest rate swap with notional value of $75 million and a replacement cost of $3 million. Potential exposure: Amount x conversion factor : $75 million  = $375,000 Current exposure: = replacement cost = $3 million. The total credit equivalent amount = $3, 375,000

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Three year forward contract to sell euros for $10 million; replacement cost of $1 million. Potential exposure: $10 million  0.05 = $500,000 Current exposure: The current exposure is the replacement cost of $1 million. The total credit equivalent amount = $1,500,000 Risk weight = 100% Equivalent on balance sheet risk weighted amount =$1,500,000  1.00 = $1,500,000

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Tier 1 Capital = $8,000,000 Tier 2 Capital = $5,610,937 million = $4 million + $1,610,937 Tier 2 Capital is calculated as follows: Only $4 million in 10 year subordinated debt can be counted because this category is limited to no more than 50% of Tier 1 Capital. Only part of the $10 million loan loss reserve can be counted; (maximum amount of loan loss reserves that can be counted as capital is 1.25% of risk weighted assets or $1,610,937 = $128,875,000 * in this case.

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Minimum capital requirements per category are as follows: Well Capitalized: (Zone 1) TC/RWA  10%, AND Tier 1/RWA  6%, AND TC/TA  5% Adequately Capitalized: (Zone 2) TC/RWA  8%, AND Tier 1/RWA  4%, AND TC/TA  4% Undercapitalized: (Zone 3) TC/RWA < 8%, OR Tier 1/RWA < 4%, OR TC/TA < 4% Significantly Undercapitalized: (Zone 4) TC/RWA < 6%, OR Tier 1/RWA < 4%, OR TC/TA < 3% Critically Undercapitalized:(Zone 5) TC/RWA  2% OR Tier 1/RWA  2%, OR TC/TA  2%

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Is the bank “well capitalized”? Total Capital or Allowable capital = Tier 1 + Tier 2 = $13,610,937 Total Capital/ RWA=$13,610,937 / $128,875,000 = 10.56% Tier 1 Capital / RWA=$8,000,000 / $128,875,000 = 6.21% Total Capital / Total Assets=$13,610,937 / $137,000,000 = 9.94% This bank is well capitalized: Well Capitalized: (Zone 1) Total Capital /RWA  10%, AND Tier 1 Capital /RWA  6%, AND Total Capital/TA  5%

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Basel II has three main pillars to help ensure the safety and soundness of the financial system: Pillar 1: Maintain and update regulatory capital requirements for credit, market and operational risk. The addition of capital requirements for operational risk is new. Pillar 2: Promote disclosure of the institution’s capital structure, risk exposure and capital adequacy.{Much of this is new}. Pillar 3: Stress the continued importance of the regulatory evaluation process in addition to capital requirements. In particular ensuring that the bank has valid internal control procedures.

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Foreign vs. Domestic Regulation Regulation of U.S. banks in foreign countries –the Overseas Direct Investment Control Act of 1964 restricted U.S. banks’ ability to lend to U.S. corporations to make foreign investment –the North American Free Trade Agreement (NAFTA) of 1994 enabled U.S. banks to expand to Mexico and Canada –a 1997 agreement between 100 countries (under the World Trade Organization (WTO)) began dismantling barriers inhibiting foreign direct investment into emerging countries Regulation of U.S. banks in foreign countries –the Overseas Direct Investment Control Act of 1964 restricted U.S. banks’ ability to lend to U.S. corporations to make foreign investment –the North American Free Trade Agreement (NAFTA) of 1994 enabled U.S. banks to expand to Mexico and Canada –a 1997 agreement between 100 countries (under the World Trade Organization (WTO)) began dismantling barriers inhibiting foreign direct investment into emerging countries

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Foreign vs. Domestic Regulation Regulation of foreign banks in the U.S. –the International Banking Act (IBA) of 1978 declared foreign banks are to be regulated the same as national domestic banks foreign banks are subject to Federal Reserve examinations –the Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave additional powers to the Federal Reserve Fed must approve new subsidiary, branch, agency, or representative offices of foreign banks in the U.S. Fed has the authority to close foreign banks operating in the U.S. only foreign banks with access to the FDIC can accept consumer deposits state-licensed foreign branches are regulated as national branches Regulation of foreign banks in the U.S. –the International Banking Act (IBA) of 1978 declared foreign banks are to be regulated the same as national domestic banks foreign banks are subject to Federal Reserve examinations –the Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave additional powers to the Federal Reserve Fed must approve new subsidiary, branch, agency, or representative offices of foreign banks in the U.S. Fed has the authority to close foreign banks operating in the U.S. only foreign banks with access to the FDIC can accept consumer deposits state-licensed foreign branches are regulated as national branches