Chapter Fifteen The Management of Capital Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Topics The Many Tasks of Capital Capital and Risk Exposures Types of Capital In Use Reasons for Capital Regulation Basel I and Basel II Planning to Meet Capital Needs 15-2

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Regulatory tool to limit risk exposure Protects the government’s deposit insurance system 15-3

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Risks in Financial Institutions Management Credit Risk: probability of default on any promised payments of interest or principal or both Liquidity Risk: probability of being unable to raise cash when needed at reasonable cost Interest Rate Risk: probability that changes in interest rates will adversely affect the value of net worth Operational Risk: probability of adverse affect of earnings due to failures in computer systems, management errors, etc. Exchange Risk: probability of loss due to fluctuating currency prices 15-4

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Capital Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries 15-5

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Relative Importance of Different Sources of Capital 15-6

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Capital Regulation 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 15-7

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Basel 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 15-8

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Basel Agreement The Basel Agreement of 1988 includes risk-based capital standards for banks in 12 industrialized nations; designed to: ▫ Encourage banks to keep their capital positions strong ▫ Reduce inequalities in capital requirements between countries to promote fair competition ▫ Account for financial innovations (OBS, etc.) 15-9

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Minimum capital requirement increased to 8% total capital to risk-adjusted assets Capital is divided into Two Tiers 15-10

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Tier 1 Capital Common stock and surplus Undivided profits Qualifying noncumulative preferred stock Minority interests in the equity accounts of consolidated subsidiaries 15-11

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Tier 2 Capital (Reserve) Allowance for Loan and Lease Losses Subordinated Debt Capital Instruments Mandatory Convertible Debt Cumulative Perpetual Preferred Stock with Unpaid Dividends Other Long Term Capital Instruments that Combine Debt and Equity Features 15-12

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-13

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-14

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Risk-Weighted Assets The weights given to each item in the bank’s portfolio include : ▫ 0 percent for cash and government securities; ▫ 20 percent for deposits held at other banks and certain standby credit letters; ▫ 50 percent for home mortgage loans; ▫ And 100 percent for corporate loans, long-term credit commitments, and all other claims on the private sector as well as bank premises and other fixed assets

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Risk-Weighted Assets Suppose a bank has 6,000 in total capital, 100,000 in total assets, and the following on-balance-sheet and off-balance-sheet (OBS) items:

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Risk-Weighted Assets On-Balance-Sheet items (Assets) Cash 5000 U.S. treasury securities Deposit balances held at domestic banks 5000 Loans secured by first liens on 1-to-4 family residential properties 5000 Loans to private corporations Total balance sheet assets Off-balance-sheet (OBS) items Standby letters of credit backing municipal and corporate borrowings Long-term, legally binding credit commitments to private companies Total off-balance-sheet items 30000

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating Risk-Weighted Assets Compute the credit-equivalent amount of each off-balance-sheet item. This figure is supposed to translate each OBS item into the equivalent amount of a direct loan considered to be of equal risk to the bank. Off-balance-sheet (OBS) itemsFace value Conversion factor Standby letters of credit backing municipal and corporate borrowings Long-term, legally binding credit commitments to private companies

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The former bank would have the following risk-weighted assets: Risk-weighting categoryAmountRisk-weighted assets 0 percent Cash50000 U.S. treasury securities percent Deposits at domestic banks Credit-equivalent amounts of SLCs backing municipal and corporate borrowings percent Mortgage loans percent Loans to private corporations65000 Credit-equivalent amounts of long-term credit commitments to private corporations10000 Total risk-weighted assets held by this bank 80,500

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Calculating the Capital-to-Risk-Weighted Assets Ratio under Basel 1 For the bank whose risk-weighted assets we just calculated above at 80,500, which currently has 6,000 in total regulatory capital, its capital adequacy ratio would be as follows:

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Basel 1 represents a “ one size fits all” approach to capital regulation. In the U.S. banks can create their own In-House Models to measure their market risk exposure, VaR, to determine the maximum amount a bank might lose over a specific time period Regulators would then determine the amount of capital required based upon their estimate 15-21

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-22

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-23

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Basel II Aims to Correct the Weaknesses of Basle 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 public disclosure of each bank’s true financial condition so that market discipline can become a powerful force compelling excessively risky banks to lower their risk exposure 15-24

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 15-25

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Choosing the Best Alternative for Raising Outside Capital: an example of a bank that needs to raise 20mill. in external capital Income or expense item Sell common stock at 10 per share Sell preferred stock promising an 8% dividend at 20 per share Sell capital notes with a 10% coupon rate Estimated revenues 100mill. Estimated operating expenses 80 Net revenues 20 Interest expenses on capital notes n.a. 2 Estimated before-tax net income Estimated income tax(35%) Estimated after-tax net income Preferred stock dividends n.a.1.6n.a. Net income available to common stockholders Earnings per share of common stock 1.3(10mill. Shares)1.43(8mill. Shares) 1.46(8mill. Shares)