1. Capital Adequacy

2. G & K Chp. 12 G & K Chp. 12 Definition and Role of Bank Capital Definition and Role of Bank Capital Capital Adequacy Construction and Standards Capital Adequacy Construction and Standards Problems with Capital Adequacy Problems with Capital Adequacy

3. Definition and Role of Capital Definition: Definition: Equity + Capital Notes + %Loan Loss Reserves Role: Role: Source of start-up and growth funding Absorb losses during unexpected times Promote actual and perceived soundness Mitigate Moral hazard of Deposit Insurance

4. Capital Adequacy Construction Capital / Deposits Capital / Deposits Previews possibility of Bank Runs; early 1900s Risk Classification Risk Classification Separate Assets only into 6 classes; 1950’s Separate Functions and assign subjective risk measures; 1960’s Problems: Problems: Different stds across regulators, not legally binding until 1983, unfair to small banks that ended carrying more relative capital levels.

5. Capital Adequacy Construction Standard Federal Capital /Assets became 5-6% in 1981. Standard Federal Capital /Assets became 5-6% in 1981. Large Banks that innovate in proprietary activities began to take varying levels of off-balance sheet risk Large Banks that innovate in proprietary activities began to take varying levels of off-balance sheet risk BIS (Bank of International Settlements; the International “Fed”) implemented, for 12 largest nations, risk based capital requirements in 4 classes of assets in 1988 BIS (Bank of International Settlements; the International “Fed”) implemented, for 12 largest nations, risk based capital requirements in 4 classes of assets in 1988

6. Capital Adequacy Construction Amendment to BIS in 1998 added securities trading to these risk classes. Amendment to BIS in 1998 added securities trading to these risk classes. Two types of capital Two types of capital Tier 1 (Core) C/S, R/E, P/S, Minority Interests Tier 1 (Core) C/S, R/E, P/S, Minority Interests Less Goodwill and Intangibles Tier 2 (Supplementary) Allowances for LL, Capital Notes, Hybrid Capital Tier 2 (Supplementary) Allowances for LL, Capital Notes, Hybrid Capital Roughly 4% for Tier 1, 8% for Tier 1 + 2 Roughly 4% for Tier 1, 8% for Tier 1 + 2

7. Capital Adequacy Example Catagories risk are: A1: Cash and U.S. Gov’ts A2: MBSs,Agencies & Muni GOs A3: Mortgages & Muni ROs A4: All rmg. loans, and bank prem Risk-adjusted capital requirements for total capital: Risk-adjusted capital requirements for total capital: K = 8%[0(A1) +.20(A2) +.50(A3) + 1.0(A4)] K = 0.08[0($100) +.2($2,500) +.5($3,000) + 1.0 ($5,000)] = 0.08 [$7,000] = $560.00 = 0.08 [$7,000] = $560.00

8. SBG Capital Adequacy FRB Capital Total Qualifying Capital Adequacy Ratio Total Required Capital Total Qlfy’g Cap = Total Eq + Cap Notes + 50% of Balance Sheet Prov for Loan Loss 50% of Balance Sheet Prov for Loan Loss =

9. Total Required Capital Sum $ Account Value * Req’d % Letters of Credit Loan Commitments* 2.50% 1.25%Medium6.00% Cash & Due1.50%Real Estate4.00% Fed Funds Sold1.50%Consumer8.00% T-Bills1.00%Credit Card8.00% U.S. Notes1.50%Non-Accruing Loans50.00% Munis3.00%Net Premises15.00% Syndicated Loans4.00%Other Assets8.00% Prime4.00%Speculation Requirement100.00% High5.00%Interest Rate Risk100.00%

10. Two Points Speculative Requirement Speculative Requirement If 110% or more short of optimal short futures hedge; or 10% or more long of same number of contracts 15% (#cnts*.15) will be designated Speculative Requirement and 100% of that held in reserve. If 110% or more short of optimal short futures hedge; or 10% or more long of same number of contracts 15% (#cnts*.15) will be designated Speculative Requirement and 100% of that held in reserve. Interest Rate Risk Capital Interest Rate Risk Capital 2% of shortest term gap with 100% held in reserve. 2% of shortest term gap with 100% held in reserve.

11. Problems using Capital Adequacy Differences in credit risk for most loans are not taken into account. Differences in credit risk for most loans are not taken into account. Book values are used rather than market values for most of the assets in the risk-adjusted assets calculations. Book values are used rather than market values for most of the assets in the risk-adjusted assets calculations. Regulatory requirements may change banks’ behavior in terms of allocation of loanable funds and investment decisions and possibly channel savings to less than the best uses. Regulatory requirements may change banks’ behavior in terms of allocation of loanable funds and investment decisions and possibly channel savings to less than the best uses. Some kinds of bank risk are excluded, including operating risk and legal risk. Some kinds of bank risk are excluded, including operating risk and legal risk. Portfolio diversification is not taken into account. Portfolio diversification is not taken into account.

12. Deposit Insurance and Capital Adequacy FDIC “scores” deposits as to premiums to be levied on insurance: FDIC “scores” deposits as to premiums to be levied on insurance: Variable-rate deposit insurance (in cents per $100 domestic deposits) implemented in 1994: Variable-rate deposit insurance (in cents per $100 domestic deposits) implemented in 1994: Risk Group CAMELS A:1,2; B:3; C: 4,5 Risk Group CAMELS A:1,2; B:3; C: 4,5 Risk Group Capital Level ABC Well capitalized (10%) 0317 Adequately capitalized (8%)31024 Undercapitalized (<8%)102427