Chapter Fifteen

The Management of Capital

Copyright 2010 by The McGraw-Hill Companies, I nc. All rights reserved. McGraw-Hill/I rwin
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

Capital as the Centerpiece of 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 (credit crisis
2007-2009 showed importance)
Provides Funds for Growth
Regulator of Growth
Role in Growth of Bank Mergers
Regulatory Tool to Limit Risk Exposure
Protects the Governments 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
Crime Risk
Due to embezzlement, robbery, fraud, identity theft
15-4
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Defenses Against Risk
Quality Management
Diversification

Geographic
Portfolio

Deposit Insurance (increased from
$100K to $250K in the Fall of 2008
through Dec 2009)

Owners Capital
15-5
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
Equity
Commitment
Notes
15-6
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
15-7
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Reasons for Capital Regulation
The underlying assumption is that the
private marketplace does not correctly price
the impact of systemic failures. Thus, 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
15-8
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
15-9
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Quick Quiz
What forms of capital are in use today? What
are the key differences between the different
types of capital?
What are the most important and least
important forms of capital held by U.S.-insured
banks? How do small banks differ from large
banks in the composition of their capital
accounts and in the total volume of capital they
hold relative to their assets?
What is the rationale for having the government
set capital standards for financial institutions
as opposed to letting the private marketplace
set those standards?
15-10
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Basel Agreement
Historically, the minimum capital requirements
for banks were independent of the riskiness of
the bank
Prior to 1990, banks were required to maintain:
a primary capital-to-asset ratio of at least 5% to 6%,
and
a minimum total capital-to-asset ratio of 6%
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
Promote fair competition
Account for financial innovations (OBS, etc.)


15-11
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Basel Agreement
A Banks Minimum Capital Requirement is
Linked to its Credit Risk
The greater the credit risk, the greater the
required capital
Stockholders' equity is deemed to be the most
valuable type of capital
Minimum capital requirement increased to 8%
total capital to risk-adjusted assets
Capital requirements were approximately
standardized between countries to level the
playing field
Capital is divided into Two Tiers

15-12
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
Selected Identifiable Intangible Assets Less
Goodwill and Other Intangible Assets
15-13
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
15-14
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
15-15
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
See BHCs Call report and RBC calculations:
https://cdr.ffiec.gov/public/ManageFacsimiles.
aspx
15-16
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Total Regulatory Capital Calculations
15-17
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-18
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
15-19
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,
Especially Problematic During the 2007-2009 Global
Credit Crisis
In 1995 the Basel Committee Announced New Market
Risk Capital Requirements for Their Banks
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
Banks That Continuously Estimate Their Market Risk
Poorly Would Be Required to Hold Extra Capital
15-20
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 Portfolios Exposure to
Changes in Market Prices or Market
Rates Over a Given Time Period
Subject to a Given Probability
15-21
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 Banks
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
A Statement of the Historical Time Period
Management Uses to Help Develop Forecasts of
Market Value and Market Rates of Interest
15-22
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 Banks Risk
Assessment Procedures and the Adequacy of
Its Capital
Greater Disclosure of Each Banks True
Financial Condition

15-23
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Credit Risk Models
Parallel the Development of VaR Models
IF Adverse Situation Develops in the Future,
What Magnitude of Losses Can Be Expected?
Model Generates Risk Estimates Based On
Borrower Credit Rating
Probability Credit Rating Will Change
Probable Amount of Recovery
The Possibility of Changing Interest Rate Spreads
15-24
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Revised Framework for Basel II
15-25
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Capital Adequacy Categories Based
on Prompt Corrective Action (PCA)
Well Capitalized
Adequately Capitalized
Undercapitalized
Significantly Undercapitalized
Critically Undercapitalized
15-26
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Internal Capital Growth Rate
= ROE X Retention Ratio

= Profit Margin X Asset Utilization
X Equity Multiplier X Retention
Ratio
15-27
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Planning to Meet a Banks 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
15-28
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Quick Quiz
What are the most popular financial ratios
regulators use to assess the adequacy of bank
capital today?
First National Bank reports the following items
on its balance sheet: cash, $200m; U.S.
government securities, $150m; residential real
estate loans, $300m; and corporate loans,
$350m. Its off-balance sheet items include
standby credit letters, $20m, and long-term
credit commitments to corporations, $160m.
What are First Nations total risk-weighted
assets? If the bank reports Tier 1 capital of
$30m and Tier 2 capital of $20m, does it have
a capital deficiency?
15-29