Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-1 Chapter 8 Capital Regulation and Management

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-2 Market Versus Book Value Definitions of Capital for Depository Institutions The book value of assets and liabilities is unaffected by changes in interest rates. The market value of assets and liabilities varies in response to interest rate changes. For an institution that finances long-term fixed rate assets with short-term liabilities: a rise in interest rates will result in a decline in the market value of equity; and a drop in interest rates will result in an increase in the market value of equity.

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-3 Why capital? To provide long-term funds for long-term investments and growth in assets. To build confidence for depositors and other debtholders. To provide a cushion against future losses.

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-4 Preference of Stockholders for Capital Stockholders prefer higher financial leverage, i.e., lower capital, because they can employ the funds of depositors and debtholders to generate a higher return for a small investment. The use of debt provides a tax subsidy. The use of debt provides an insurance subsidy for insured institutions since insured depositors don’t demand a risk premium on debt. Stockholder preference creates a moral hazard for the deposit insurer.

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-5 An institution is funded with $5 million in capital. The funds can be used to make loans with a 50% probability of default and a 50% probability of producing a $5 million profit. The expected dollar return on the investment is : 0.5(-$5m) + 0.5($5m) = 0 If instead the institution is funded with $4 million of insured deposits at a cost of 10% ($400,000 in interest expense) and $1 million in capital, the expected dollar return on the investment is: 0.5(- $1m) +.5( $5m- $0.4m) = $1.8m

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-6 Some Incentives for Stockholders to Hold Capital Increasing equity through retained earnings permits an institution to grow and acquire other firms without the use of external capital. Higher capital levels prevent greater regulatory interference concerning branching and merger decisions. Using capital to finance long-term assets or growth is less risky than financing with short- term deposits.

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-7 Preference of Uninsured Depositors and Managers for Capital Debtholders prefer higher capital ratios to protect against loss of the funds they lent to the bank. Undercapitalized institutions may have to offer higher risk premiums to attract uninsured debt. Managers generally prefer higher capital ratios for fear of losing their jobs if their institutions fail. Managers may demand higher salaries to work for undercapitalized banks.

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-8 Preference of Regulators for Capital Regulators prefer greater capital to protect: the deposit insurance fund; and taxpayers.

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-9 Components of Tier 1, Core Capital Common Stock Accounts and Retained Earnings (Common Equity) Perpetual Preferred Stock (up to 25% of Tier 1 Capital) Less Ineligible Intangible Assets

Copyright © 2000 by Harcourt, Inc. All rights reserved Tier 2 Capital, Supplementary Capital Any additional Perpetual Preferred Stock not allowed in Tier 1 Limited Life Preferred Stock Subordinate Notes and Debentures (up to 50% of Tier 2 Capital) original maturities of five years or more, amortized as they mature Reserves for loan and lease losses (up to 1.25% of risk-weight assets) Mandatory Convertible Subordinate Debt

Copyright © 2000 by Harcourt, Inc. All rights reserved Nationsbank Maryland 1994 Capital Tier 1 Capital Common Equity$1,880,937 Less Ineligible Intangible Assets 291,335 Net Tier 1 Capital$1,589,602 Tier 2 Capital Allowable Subordinate Debt $ 0 Cumulative Preferred Stock 0 Mandatory Convertible Securities 0 Allowable Loan & Lease Allowance 161,113 Net Eligible Tier Two Capital $161,113 Total Regulatory Capital = $1,750,715

Copyright © 2000 by Harcourt, Inc. All rights reserved Minimum Regulatory Capital Requirements Leverage Ratio: Minimum Tier 1 capital-to- total asset ratio = 3% Tier 1 capital-to-risk based asset ratio = 4% Tier 1 + Tier 2 capital-to-risk based asset ratio = 8%

Copyright © 2000 by Harcourt, Inc. All rights reserved Calculating Risk-Based Assets Assets are classified into four categories based on credit risk. Each category has a risk weight. Risk-based assets are equal to the sum of the total assets for each risk class times respective risk weights. Off-balance sheet assets are converted to credit equivalent assets. Credit equivalent assets are then placed in the respective risk-based categories.

Copyright © 2000 by Harcourt, Inc. All rights reserved Risk Categories for Calculating Risk-Based Assets Category 1 (0% weight): Federal Reserve balances, U.S. government securities and some U.S. agency securities. Category 2 (20% weight): Cash items in the process of collection, U.S. and OECD interbank deposits and guaranteed claims, some non-OECD bank and government deposits and securities, General Obligation Municipal Bonds, Fed Funds Sold, some mortgage- backed securities, claims collateralized by the U.S. Treasury, and some other government securities.

Copyright © 2000 by Harcourt, Inc. All rights reserved Category 3 (50% weight): Municipal revenue bonds, secured mortgage loans on 1-4 family residential properties, and other securitized assets. Category 4 (100% weight): Commercial and consumer loans, corporate bonds, commercial paper, and other assets not included in other categories

Copyright © 2000 by Harcourt, Inc. All rights reserved Risk-Based Categories for Off-Balance Sheet Items Category 1 (0% risk weight): for unused commitments with an original maturity of one year or less or conditionally cancelable commitments. Category 2 (20% risk weight): for commercial letters of credit, bankers acceptances conveyed and other short-term self-liquidating trade-related items.

Copyright © 2000 by Harcourt, Inc. All rights reserved Category 3 (50% risk weight): for standby letters of credit, other performance warranties and unused commitments with original maturities exceeding one year, and revolving underwriting facilities. Category 4 (100% risk weight): for direct credit substitutes including general guarantees, sale and repurchase agreements with recourse, and forward agreements to purchase assets.

Copyright © 2000 by Harcourt, Inc. All rights reserved. 8-18

Copyright © 2000 by Harcourt, Inc. All rights reserved NATIONSBANK, SEPTEMBER 1994 On Balance Sheet ($000) Assets in this CategoryRisk-weighted assets Category 1: 0 weight Category 2: 20% weight Category 3: 50% weight Category 4 100% weight $2,979,181 6,126, ,398 9,539,789 $ 0 1,225, ,199 9,539,784 Total On-Balance Sheet Risk-Based Assets $11,168,304 Example: Finding Risk-Based Assets

Copyright © 2000 by Harcourt, Inc. All rights reserved Risk Category Equivalent OBSWeight-Equivalent OBS Category 1: 0 weight Category 2: 20% weight Category 3: 50% weight Category 4 100% weight $ 12,139 73,180 27,252 1,983,830 $ 0 14,636 13,626 1,983,830 Total On-Balance Sheet Risk-Based Assets$2,012,092 NATIONSBANK EQUIVALENT (CONVERTED) OFF-BALANCE SHEET (OBS) ITEMS Total Risk-Based Assets = ( $11,168,304 + $2,012,092 = $13,180,397

Copyright © 2000 by Harcourt, Inc. All rights reserved Nationsbank Capital Ratios Tier 1 to Risk-Based Assets $1,589,602 ÷ $13,180,397 * = 12.06% Tier 1 + Tier 2 to Risk-Based Assets $ 1,750,715 ÷ $13,180,397 * = 13.28% Tier 1 to Total Assets $ 1,589,602 ÷ $19,351,968 * = 8.21% * Excludes special technical adjustments to asset base

Copyright © 2000 by Harcourt, Inc. All rights reserved Definition of Capital Adequacy The level of capital helps determine whether a bank is well-capitalized or undercapitalized. Undercapitalized banks are subject to intense scrutiny by regulators. Undercapitalized banks must: restrict growth; prepare plans to restore capital; and obtain regulatory approval before expanding operations, making acquisitions or opening branches.

Copyright © 2000 by Harcourt, Inc. All rights reserved Additional considerations in determining capital adequacy include: a bank's CAMELS rating; and the rate of growth in bank assets. Thrift institutions are subject to similar capital adequacy standards.

Copyright © 2000 by Harcourt, Inc. All rights reserved Capital for Federal Credit Unions Capital consists of retained earnings and reserves from past operations set aside each year to cover future losses. Capital adequacy standards are based on size and age. Institutions four years old or older with more than $500,000 in assets or those less than four years old must have a capital ratio of 10%.

Copyright © 2000 by Harcourt, Inc. All rights reserved Risk assets are defined as total assets minus cash, Treasury securities, and loans not considered subject to default risk. Credit unions are subject to CAMEL ratings, which affect how much capital they need.

Copyright © 2000 by Harcourt, Inc. All rights reserved Unresolved Issues in Capital Regulation Rules focus on book-value rather than market-value measures. Current ratios emphasize credit risk and ignore other types of risk. Rules ignore the impact of portfolio diversification on overall risk. Rules ignore the actual default risk of different types of assets and contingent liabilities

Copyright © 2000 by Harcourt, Inc. All rights reserved Factors Determining the Optimal Capital Structure Regulatory requirements An institution’s risk profile Practical considerations

Copyright © 2000 by Harcourt, Inc. All rights reserved Risk-Adjusted Return on Capital (RAROC) Each asset given a capital charge based on the amount of capital that needs to be held on the asset according to its risk. Higher equity-assets percentage is allocated to more risky assets. More risky assets require a higher return to cover the cost of the extra capital that has to be held for them. Requires detailed historic market data to determine equity-to-asset allocations.

Copyright © 2000 by Harcourt, Inc. All rights reserved Peer Approach for Capital Allocation Equity that needs to be held for a particular business line is allocated based on the average equity-to-asset ratio held by peer banks in that business. The overall equity-to-asset ratio for the bank is the total of the equity allocated to each line of business divided by total assets. Some business lines may have few peers for comparisons.

Copyright © 2000 by Harcourt, Inc. All rights reserved Overhead 0.40% Example: RAROC PRICING OF COMMERCIAL LOANS SourceComponent Funds Transfer Cost of Funds 5.45% Required Loan Loss Provision 1.25% Plus: Direct Expense 0.70% Indirect Expense 0.45% Total Charge before Capital Charge 8.25% Plus: Capital Charge (RAROC) 3.00% * * Allocated equity/asset ratio=12% Total Required Loan Rate 11.25% * RAROC: allocated equity/assets = 12%; opportunity cost of equity = 15%; after-tax capital charge = 15%×12% = 1.8%; marginal tax rate = 40%; pretax capital charge = 1.8%/.06 = 3.0%

Copyright © 2000 by Harcourt, Inc. All rights reserved Line of BusinessAssetsEquity Equity to Assets Credit Cards$20,261$2, % Mortgage Banking 11,314 1, % Subprime Lending 5,072 1, % Total$36,647 $5, % Peer Group Comparisons

Copyright © 2000 by Harcourt, Inc. All rights reserved Standard Deviation ROA Approach Approach is based on the standard deviation of ROA and a bank’s probability of insolvency ratio (Z). K * is the required capital-to-asset ratio to achieve a target Z-ratio that the bank desires for each of the bank’s operations and is defined as: K * = [Z * × Std (ROA)] - ROA *

Copyright © 2000 by Harcourt, Inc. All rights reserved Line of BusinessROA %Std (ROA) Ratio %Equity (mils) Equity/Asset Credit Cards $ 2,018 Mortgage Banking ,779 Subprime Lending ,827 Total Bank $10,624 + Required equity capital for a bank to achieve Z * = 13.80% K * = (13.80)(1.29) = 11.81% Equity Capital = (0.118)($36,647 assets) = $4,328 Standard Deviation Approach Assumes a Z * = for all areas of operations. + Ignores the benefits of diversification

Copyright © 2000 by Harcourt, Inc. All rights reserved Equity Allocation Taking Account of Diversification Line of BusinessAllocatedEquity per (mils) (mils) Assets (%) Equity New Equity Effects Allocated Credit Cards$2, $ Mortgage Banking 3, , Subprime Lending 4, , Total Bank $10, $4, New Equity = $4,328/$10,624

Copyright © 2000 by Harcourt, Inc. All rights reserved Raising Capital Internally Increases in Retained Earnings Reduction in Dividend Payout

Copyright © 2000 by Harcourt, Inc. All rights reserved What to do with excess capital? Increase dividends and stock repurchases Over-leveraging the balance sheet or increasing off-balance sheet activities Acquiring other banks or nonbanks with cash

Copyright © 2000 by Harcourt, Inc. All rights reserved Davis and Lee (1997) Steps to Capital Structure Conduct the economic risk analysis. Maintain a comfortable margin above regulatory “well-capitalized” level. Conduct a peer group comparison. Consider future prospects and needs. Consider rating agency requirements. Establish a desired optimal mix of capital.