1. Chapter 12: The Effective Use of Capital 1

2. Why Worry about Bank Capital? Capital reduces risk by cushioning earnings volatility and restricting growth opportunities. Reduces expected returns to shareholders as equity is more expensive than debt. Decreasing capital increases risk by increasing financial leverage and the risk of failure. Firms with greater capital can borrow at lower rates, make larger loans and expand faster through acquisition or internal growth. 2

3. Why Worry about Bank Capital? Regulators primary objective is to ensure safety and soundness of U.S. financial system. – Regulators specify minimum amounts of equity and other qualifying capital banks must maintain. Historically, minimum capital-to-total-assets were stipulated without regard to asset quality. – Equity-to-asset ratios are much higher in 2013 than 2007 for all but the smallest banks, demonstrating the problem that small bank face in exiting the recession. 3

4. 4

5. Risk-Based Capital Standards and The 1986 Basel Agreement Historically, bank capital requirements were independent of risk. In 1986, Basel Agreement proposed banks maintain minimum capital reflecting the riskiness of assets. – Minimum capital requirements linked to credit risk as determined by composition of assets. – Stockholders’ equity deemed most critical type of capital. – Minimum requirement 8% of risk-adjusted assets. – Capital requirements standardized between countries to level the playing field. 5

6. Risk-Based Elements of Basel I 1.Classify assets into one of four risk categories. 2.Classify off-balance sheet commitments into the appropriate risk categories. 3.Multiply the dollar amount of assets in each risk category by the appropriate risk weight to calculate risk-weighted assets. 4.Multiply risk-weighted assets by the minimum capital percentages, currently 4% for Tier 1 capital and 8% for total capital. 6

7. 7

8. 8

9. 9

10. 10

11. 11

12. 12

13. 13

14. 14

15. What Constitutes Bank Capital? Capital (Net Worth): – The cumulative value of assets minus the cumulative value of liabilities or ownership in the firm. Total Equity Capital: – Sum of common stock, surplus, retained earnings, capital reserves, net unrealized holding gains (losses) and perpetual preferred stock. Regulatory capital ratios focus on the book value of equity. 15

16. What Constitutes Bank Capital? Tier 1 (Core) Capital: – Common stockholders’ equity, noncumulative perpetual preferred stock and any related surplus. – Minority interest in consolidated subsidiaries, less intangible assets such as goodwill. Tier 2 (Supplementary) Capital: – Preferred stocks and any surplus. – Limited amounts of term-subordinated debt and a limited amount of the allowance for loan and lease losses (up to 1.25 percent of gross. risk-weighted assets) 16

17. 17

18. 18

19. Tier 3 Capital Requirements for Market Risk Under Basel I Leverage Capital Ratio: – Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets. Minimum of 3% required by regulation. Market Risk: – Risk of loss from interest rate fluctuations, equity prices, foreign exchange rates, commodity prices, and exposure to specific risk associated with debt and equity positions in the bank’s trading portfolio. – Banks with significant market risk must measure their exposure and hold sufficient capital to mitigate the risk. 19

20. Tangible Common Equity Equals a bank’s tangible assets minus its liabilities and any preferred stock outstanding. – Reflects what would be left over if a bank liquidated and used its proceeds to pay off debt and preferred stockholders. – Assigns no value to intangible assets. 20

21. Basel III Capital Standards Approved in July 2013 with intent to increase bank capital requirements and upgrade capital quality. – Imposes higher minimum capital ratios and places a greater emphasis on common equity as a preferred form of capital. – Rules apply differently to larger organizations vs. smaller. – Smaller organizations can count more items as capital and have more time to comply with the new requirements. – Stricter rules on what qualifies as capital and a new minimum capital ratio. 21

22. Basel III Capital Standards When implemented, banks must hold a capital conservation buffer plus old RBC minimums. Minimum capital requirements when implemented in 2019: 22

23. Weaknesses of the Risk-Based Capital Standards Standards only consider credit risk except for market risk at large banks with extensive trading. – Banks capital requirements is determined by asset composition. Banks subject to the advanced approaches of Basel II use internal models to assess credit risk and report results of their model to regulators. – Many large institutions’ dramatically understate risk. 23

24. What is the Function of Bank Capital? For regulators, bank capital serves to protect the deposit insurance fund in case of bank failures. Bank capital reduces bank risk by: – providing a cushion for firms to absorb losses and remain solvent. – providing ready access to financial markets, which guards against liquidity problems from deposit outflows. – constraining growth and limits risk taking. 24

25. What is the Function of Bank Capital? For regulators, bank capital serves to protect the deposit insurance fund in case of bank failures. Bank capital reduces bank risk by: – providing a cushion for firms to absorb losses and remain solvent. – providing ready access to financial markets, which guards against liquidity problems from deposit outflows. – constraining growth and limits risk taking. 25

26. 26

27. How Much Capital Is Adequate? Regulators prefer more capital which reduces the likelihood of failure and increases bank liquidity. Bankers prefer less capital as the smaller a bank’s equity base the greater its financial leverage and equity multiplier. – High leverage coverts a normal ROA into high ROE. Riskier banks should hold more capital while lower-risk banks should be allowed to increase financial leverage. 27

28. The Effect of Capital Requirements on Bank Operating Policies Limiting Asset Growth: – Minimum capital requirements restrict bank‘s ability to grow. Additions to assets mandate additions to capital to meet minimum capital-to- asset ratios. – Each bank must limit asset growth to some percentage of retained earnings plus new external capital. – Must determine growth strategy while meeting minimum capital requirements. Higher ROA is one option: 28

29. The Effect of Capital Requirements on Bank Operating Policies Limiting Asset Growth: – Relationship for internally generated capital: 29

30. 30

31. The Effect of Capital Requirements on Bank Operating Policies Changing the Capital Mix: – Internal versus external capital. Changing Asset Composition: – Shift from high-risk to lower-risk categories. Pricing Policies: – Raise rates on higher-risk loans. Shrinking the Bank: – Fewer assets requires less capital. 31

32. Characteristics of External Capital Sources Subordinated debt advantages: – Interest payments are tax-deductible. – Shareholders do not reduce proportionate ownership. – Generates additional profits as long as earnings before interest and taxes exceed interest payments. Subordinated debt disadvantages: – Does not qualify as Tier 1 or core capital. – Interest and principal payments are mandatory. – Many issues require sinking funds. – Fixed maturity and banks cannot charge losses against it. 32

33. Contingent Convertible Capital Common stock advantages: – No fixed maturity and thus a permanent source of funds. – Dividend payments are discretionary. – Losses can be charged against equity. Common stock disadvantages: – Dividends are not tax-deductible. – Transactions costs on new issues exceed new debt costs. – Shareholders sensitive to earnings dilution and possible loss of control in ownership. 33

34. Contingent Convertible Capital Preferred Stock: – Form of equity in which investors' claims are senior to those of common stockholders. – Dividends are not tax-deductible. – Corporate investors in preferred stock pay taxes on only 20 percent of dividends. – Most issues take the form of adjustable-rate perpetual stock. – Has the same disadvantages of common stock but the earnings dilution is less than with common stock. 34

35. Contingent Convertible Capital Trust Preferred Stock: – Hybrid form of equity capital at banks. – Effectively pays dividends that are tax deductible To issue the security, bank establishes a trust company. Trust company sells preferred stock to investors and loans the proceeds of the issue to the bank. Interest on the loan equals dividends paid on preferred stock. Interest on loan is tax deductible such that the bank deducts dividend payments. – Counts as Tier 1 capital. 35

36. Contingent Convertible Capital TARP Capital Purchase Program: – The Troubled Asset Relief Program’s Capital Purchase Program (TARP-CPP), allowed institutions to sell preferred stock that qualified as Tier 1 capital to the Treasury. Could issue senior preferred stock equal to not less than 1% of risk-weighted assets and not more than the lesser of $25 billion, or 3%, of risk-weight assets. Paid 5% per annum for five years and 9% afterwards. In 2014, many banks with outstanding TARP stock saw the required dividend payment rise to the higher price. – Many institutions repaid their TARP stock by 2014. 36

37. 37

38. Contingent Convertible Capital Leasing Arrangements: – Many banks enter into sale and leaseback arrangements as a source of immediate capital. – Most transactions involve selling bank-owned headquarters or other real estate and simultaneously leasing it back from the buyer. Terms can be structured to allow the bank to maintain complete control while receiving large amounts of cash at low cost. – Effectively converts the appreciated value of real listed on the bank’s book at cost to cash. 38

39. Capital Planning Process can be summarized in three steps: – Generate pro formal balance sheet and income statements for the bank. – Select a dividend payout. – Analyze the costs and benefits of alternative sources of external capital. 39

40. Capital Planning: Applications Bank exhibiting a deteriorating profit trend. – Classified assets and loan loss provisions are rising and earnings prospects are bleak, given the economy. – Federal regulators who examined bank indicated the primary capital-to-asset ratio should be increased from its current 7% to 8.5% within four years. – Following exhibit identifies different strategies for meeting the required increase. – In practice, bank will consider numerous other alternatives by varying assumptions until best plan is determined. 40

41. 41

42. Depository Institutions Capital Standards The Federal Deposit Insurance Improvement Act (FDICIA) was passed with the intent of revising bank capital requirements to: – emphasize the importance of capital. – authorize early intervention in problem institutions. – authorize regulators to measure interest rate risk at banks and require additional capital when deemed excessive. Focal point is the system of prompt regulatory action which divides banks into zones and mandates action when capital minimums not met. 42

43. Depository Institutions Capital Standards Five capital categories with first two representing: – Well-capitalized banks not subject to any directives. – Adequately capitalized banks but cannot obtain brokered deposits without FDIC approval. Banks in the bottom categories prompt action: – Undercapitalized banks do not meet at least one of the three minimum capital requirements. – Significantly undercapitalized banks have capital that falls below at least one of three standards. – Critically undercapitalized banks do not meet minimum threshold levels for the three capital ratios. 43

44. 44

45. 45

46. Changes to Capital Standards Under Basel III Basel Committee agreed on principles to “strengthen global capital and liquidity rules” known as Basel III. – Standards will be implemented over time by G20 countries and have the general impact of increasing capital requirements (decreasing financial leverage). – Formal standards that set minimum liquidity requirements, increase minimum capital requirements and redefine what constitutes regulatory capital. Focuses on common equity as the “best” form of capital. 46

47. 47

48. 48

49. Changes to Capital Standards Under Basel III Regulatory capital standards that put more emphasis on common equity required generally lower financial leverage. – Requirements will put pressure on bank returns on equity. – Lower returns will increase cost of capital making it more expensive and difficult to issue new stock to investors. – Banks will be forced to raise loan rates, cut expenses, or find new income to cover higher cost of capital. Impact is much broader than provisions suggest. 49