Fin 464

Chapter 16: The

Management of Capital
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Introduction
• What is capital?
▫ Funds contributed by the owners of a financial institution
▫ The long-term funds coming from debt & equity that support a
bank’s long-term assets & absorb its earnings losses.
• Raising and retaining sufficient capital to protect the interests of
customers, employees, owners, and the general public is tough
• Why is capital so important in financial-services management?
▫ It provides a cushion of protection against risk and promotes
public confidence
• Capital has become the centerpiece of supervision and regulation
today
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The Many Tasks Capital Performs

1. Provides a cushion against the risk of failure

2. Provides funds to help institutions get started
3. Promotes public confidence
4. Provides funds for growth, i.e. new services & facilities
5. Regulator of growth, i.e. it must rise with the growth of risky
assets
6. Regulatory tool to limit risk exposure
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Key Risks in Banking Management

 Credit Risk: When borrowing customers failed in payments, defaulted loans
& securities result losses than erode capital.
 Liquidity Risk: Danger of running out of cash during the time of deposit
withdrawal and to meet good credit requests.
 Interest Rate Risk: Danger that revenues from earning assets will decline or
that interest expenses will rise, squeezing the margin.
 Operational Risk: Risk due to weather damage, old technology, breakdowns
in quality control, inefficiencies in services, error in judgment by management ,
fluctuations in the economy, etc.
 Exchange Risk: Risk face from dealings in foreign currency where the
institution run the risk of adverse price movements on both the buying &
selling sides of this market.
 Crime Risk: The danger that a bank will lose funds as a result of robbery or
other crimes committed by its customers or employees
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Banks Defense against Risk

1. Quality Management: Ability of the top-notch management to react swiftly
with the problems.
2. Diversification: Diversification of sources and uses of funds has risk-reducing
benefits.
▫ Geographic Diversification: customers located in different communities or
countries to experience different economic condition.
▫ Portfolio Diversification: wide variety of customers, large or small business
accounts, different industries, households with variety of sources of income &
collateral.
3. Deposit Insurance: Protect deposit up to a certain amount by FDIC or any
insured depository institution which are examining the bank and taking actions
against the bank’s mismanagement.
4. Owners’ Capital: When all fails, it is owners’ capital (net worth) that forms the
ultimate defense against risk. It absorbs losses from bad loans, poor securities
investments, crime, and misjudgment to recover the losses.
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Types of Bank Capital

1. Common stock: measured by the par value of common equity shares outstanding
2. Preferred stock: measured by the par value of shares outstanding that promise to pay fixed
rate of return (dividend rate)
3. Surplus: representing the excess amount above each share of stock’s par value paid by the
shareholders.
4. Undivided profits: net earnings that have been retained in the business rather than being paid
out as dividends
5. Equity reserves: funds set aside for contingencies such as legal action against the institution
or dividends expected to be paid but not yet declared, and sinking fund to retire stock/bond in
future.
6. Subordinated debentures/junior debt: debt instruments/loans that ranks below other loans
(or securities) with regard to claims on assets or earnings. In the case of default, creditors with
subordinated debt wouldn't get paid out until after the senior debt holders were paid in full.
Therefore, subordinated debt is more risky.
7. Minority interest in consolidated subsidiaries: where the financial firm holds
ownership shares in other business.
8. Equity commitment notes: debt securities repayable from the sale of stock. A type of
mandatory convertible bond issued by a bank or other lending institution that qualifies as
regulated capital.
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How Much Capital Is Really Needed?

□ How much capital a financial firm should hold has been the evolved around two
questions:
• Who should set capital standards, market or regulatory agencies?
• What is a reasonable standard for the proper amount of capital?
▫ Reasons for Capital Regulation
─ Bank must meet minimum capital requirement before they can be chartered,
and they must hold at least the minimum required level of capital throughout
their corporate life
1. To limit risk of failures
2. To preserve public confidence
3. To limit losses to the government and other institutions arising from deposit
insurance claims
▫ Research Evidence
─ Research has been conducted on the issue of whether the private marketplace
or government regulatory agencies exert a bigger effect on bank risk taking
─ Most studies find that the private marketplace is probably more important than
government regulation in the long run in determining the amount & type of
capitals bank holds.
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The Basel Agreement

An international treaty involving the U.S., Canada, Japan & the nations of
Western Europe to impose common capital requirements on all banks in those
countries.
▫ Designed to keep their capital positions strong
▫ Reduce inequalities in capital requirements among different
countries
▫ Promote fair competition
▫ Catch up with recent changes in financial services and financial
innovation
▫ In particular, the expansion of off-balance-sheet commitments
▫ Formally approved in July 1988
▫ Included countries such as:
▫ The United States, Belgium, Canada, France, Germany, Italy,
Japan, the Netherlands, Spain, Sweden, Switzerland, the United
Kingdom, and Luxembourg
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The Basel Agreement

 Basel I : The original Basel capital standards are known today as Basel I
 Various sources of capital were divided into two tiers:
▫ Tier 1 (core/primary) capital
Common stock and surplus, undivided profits (retained earnings), qualifying
noncumulative perpetual preferred stock, minority interest in the equity
accounts of consolidated subsidiaries, and selected identifiable intangible
assets less goodwill and other intangible assets
▫ Tier 2 (supplemental) capital
Allowance (reserves) for loan and lease losses, subordinated debt capital
instruments, mandatory convertible debt, intermediate-term preferred stock,
cumulative perpetual preferred stock with unpaid dividends, and equity notes
and other long-term capital instruments that combine both debt and equity
features
 In order for a bank to qualify as adequately capitalized, it must have:
1. A ratio of core capital (Tier 1) to total risk-weighted assets of at least 4 %
2. A ratio of total capital (the sum of Tier 1 and Tier 2 capital) to total risk-
weighted assets of at least 8 %, with the amount of Tier 2 capital limited to
100 percent of Tier 1 capital.
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Calculating Risk-Weighted Assets

▫ Each asset item on a bank’s balance sheet and each off-balance-sheet

commitment it has made are multiplied by a risk-weighting factor
▫ Designed to reflect its credit risk exposure
▫ The most closely watched off-balance-sheet items are standby letters
of credit and long-term, legally binding credit commitments
▫ Under Basel I, once we know a bank’s total risk-weighted assets and its
Tier 1 and Tier 2 capital amounts, we can determine its required capital
adequacy ratios
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Basel 1

• Bank Capital Standards and Market Risk

▫ Basel I failed to account for market risk
▫ The losses a bank may suffer due to adverse changes in interest
rates, security prices, and currency and commodity prices

▫ The risk weights on bank assets were designed primarily to take

account of credit risk (not market risk)
▫ In an effort to deal with these and other forms of market risk, in
1996 the Basel Committee approved a modification to the rules
▫ Permitted the largest banks to conduct risk measurement and
estimate the amount of capital necessary to cover market risk
▫ Led to a third capital ratio (Tier 3)
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Basel II
▫ Bankers found ways around many of Basel I’s restrictions
▫ Instead of making banks less risky, parts of Basel I seemed to encourage banks to
become more risky
▫ Basel I represented a “one size fits all” approach to capital regulation
▫ It failed to recognize that no two banks are alike in terms of their risk profiles
▫ Basel II set up a system in which capital requirements would be more
sensitive to risk and protect against more types of risk than Basel I
▫ Low risk assets would require less capital than high risk assets
▫ Under Basel I, minimum capital requirements remained the same for most
types of loans regardless of credit rating
▫ Under Basel II, minimum capital requirements were designed to vary
significantly with credit quality
 Basel Accord Summary
 Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%

 Commercial loans, for example, were assigned to the 100% risk weight category
 50% weight attributed to mortgage loans
 To calculate required capital, a bank would multiply the assets in each risk category by the
category’s risk weight and then multiply the result by 8%

 Thus a $100 commercial loan would be multiplied by 100% and then by 8%, resulting in a
capital requirement of $8
● Basel-I accord was criticized i) for taking a too simplistic approach to setting credit risk weights
and ii) for ignoring other types of risk

● Banks developed techniques to avoid compliance with the capital requirements known as
Capital Arbitrage.
□ If a bank were managing and holding mortgages on houses, it would have to maintain a capital
requirement of 4%. Instead, it sells the mortgages and uses the proceeds to buy US government
bonds, then under the rules, US government bonds produce no capital requirement and the bank
would thus have no capital maintenance. Securitization is the main means used especially by
U.S. banks to engage in regulatory capital arbitrage as it involves reducing the measures of risk.
 Basel Accord Summary (cont)
 Assume a bank has a portfolio of commercial loans with the following ratings
and internally generated capital requirements
 AA-A: 3%-4% capital needed
 B+-B: 8% capital needed
 B- and below: 12%-16% capital needed
 Under Basel-I, the bank has to hold 8% risk-based capital against all of these
loans
 To ensure the profitability of the better quality loans, the bank engages in
capital arbitrage--it securitizes the loans so that they are reclassified into a lower
regulatory risk category with a lower capital charge
 Lower quality loans with higher internal capital charges are kept on the bank’s
books because they require less risk-based capital than the bank’s internal
model indicates
 By the late 1990s, growth in the use of regulatory capital arbitrage led the Basel
Committee to begin work on a new capital regime (Basel-II)
▫ Effort focused on using banks’ internal rating models and internal risk models
▫ Under Basel I, minimum capital requirements remained the same for most types of
loans regardless of credit rating
▫ Under Basel II, minimum capital requirements were designed to vary significantly
with credit quality
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Basel II (contd…)
Problems Accompanying the Implementation of Basel II
▫ Basel II was not perfect
▫ Some forms of risk had no generally accepted measurement scale
▫ Operational Risk
▫ How do we add up the different forms of risk exposure in order to get an
accurate picture of a bank’s total risk exposure?
▫ What should we do about the business cycle?
▫ Most banks are more likely to face risk exposure in the middle of an economic
recession than they will in a period of economic expansion
▫ For example, the Global credit crisis of 2007-2009
▫ Some have expressed concern about improving regulator competence
▫ Basel III: Another Major Regulatory Step Underway, Born in Global Crisis
▫ Key issue in Basel III: Determining the volume and mix of capital the
world’s leading banks should maintain if their troubled assets generate
massive losses
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Pillars of Basel II

1. Minimum capital requirements for each bank based on its

own estimated risk exposure from credit, market, and
operational risks
2. Supervisory review of each bank’s risk-assessment
procedures and the adequacy of its capital to ensure they
are “reasonable”
3. Greater public disclosure of each bank’s true financial
condition so that market discipline could become a more
powerful force compelling excessively risky banks to
lower their risk exposure
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How Could Bank Raise Capital?

 Raising Capital Internally

─ Internally generated capital avoid floatation costs and doesn’t require to depend on the open market for
funds. Less threaten to existing stockholders with loss of control.
─ Dividend Policy: The board of directors and management must agree on the appropriate retention ratio
and dividend payout ratio
─ Key factor - How fast the financial firm can allow its assets to grow so that its current ratio of capital to
assets is protected from erosion

 Raising Capital Externally

 Selling Common Stock.

 Issuing Preferred Stock
 Issuing Subordinated Notes & Debentures
 Selling Assets & Leasing Facilities
 Swapping Stock for Debt Securities.