CHAPTER Three The Management Of Capital

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 Regulator of Growth Regulatory Tool to Limit Risk Exposure Protects the Government’s Deposit Insurance System

Key Risks in Financial Institutions Management Credit Risk Liquidity Risk Interest Rate Risk Operating Risk Exchange Risk Crime Risk

Defenses Against Risk Quality Management: Ability of top notch managers to move swiftly to deal with a a bank’s problems before they overwhelm the institution. Diversification –Geographic –Portfolio Deposit Insurance Owners’ Capital

Types of Capital Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes

Reasons for Capital Regulation To Limit the Risk of Failures To Preserve Public Confidence To Limit Losses to the Federal Government Arising from Deposit Insurance Claims

The Basle 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

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

Basle 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

Capital Requirements Attached to Derivatives In determining the credit equivalent amount of these off balance sheet contracts, Basle 1 required a banker to divide each contract’s risk exposure into two categories. – Potential Market Risk Exposure – Current Market Risk Exposure

Potential Market Risk: refers to the danger of loss at some future time if the customer who entered into a market based contract with the bank fails to perform. Current Market Risk: measures the risk of loss to the bank should a customer default today on its contract.

Derivat ives Face amount of Contract Conversi on factor for potential market risk Potential market risk exposure Current market risk exposure Credit Equivalen t amount 5 year Interes t rate swap contrac t $ $ 500$ 2500$ year Curren cy swap contrac t $50, $2500$1500$4000

Limitations of Basle I One of the most glaring holes in the original Basle Agreement is its failure to deal with market risk. Market Risk: the losses a bank may suffer due to adverse changes in interest rates, security prices, currency & commodity prices.

Value at Risk (VAR) Models The revised Basle I rules allowed the banks to use their own preferred method to determine the maximum loss they might sustain over a designated period of time known as Value at Risk (VAR) model.

Elements of VAR Model An estimate of the maximum amount of loss in the bank’s asset value that can occur at a specified level of risk. An estimate of the time period The confidence level

Basle II Aims to Correct the Weaknesses of Basle I Three Pillars of Basle II: –Capital Requirements For Each Bank Are Based on Their Own Estimated Risk Exposure –Supervisory Review of Each Bank’s Risk Assessment Procedures and the Adequacy of Its Capital –Greater Disclosure of Each Bank’s True Financial Condition