Chapter 15 The Management of Capital

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 Learning Outcomes
• The Many Tasks Capital Performs
• Capital and Risk
– Key Risks in Banking and Financial Institution’s Management
– Defenses Against Risk
• Types of Capital in Use
• Reasons for Capital Regulation
• The Basel Agreement on International Capital Standards
• Choosing the Best Alternative for Raising Outside Capital

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Standby Letter of Credit (SLOC)
• https://youtu.be/KA_cgeRCnIQ

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 The Many Tasks Capital Performs

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Capital provides the
funds needed to
Capital provides a
charter, organize, and
cushion against the
operate a financial firm
risk of failure
before other sources of
funds come flowing in
Capital promotes
public confidence and
reassures creditors
concerning an
institution’s financial
strength.

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Capital regulation has
Capital serves as a
Capital provides funds become an
regulator of growth,
for the development of increasingly important
helping to ensure that
new services and tool to limit how much
growth is sustainable
facilities. risk exposure financial
in the long run.
firms can accept.

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 Capital and Risk
• Capital and risk are intimately related to each other.

• Capital itself is mainly the funds contributed by the owners of a financial

firm that have been placed in the firm at the owner’s risk – the risk that the
institution will earn less-than-statisfactory return on owner’s funds.
Key Risks in Banking and Financial Institution’s Management:

Liquid Intere
Credit
ity st rate
Risk
Risk Risk

Operati Excha
onal Crime
nge
Risk Risk
Risk

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 Types of Capital in Use

Subordinat
Common Preferred Undivide Equity
Surplus ed
Stock Stock d Profits Reserves
Debentures

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 The Basel Agreement on
International Capital Standards
• The regulatory community has taken important steps in recent years to
strengthen government’s role in assessing how much capital banks really
need and in making sure they comply with government-imposed capital
standards.

• In 1988 ,the Federal Reserve Board, representing the US and

representatives from other leading countries (such as Canada, France,
Germany, Italy, Japan, Spain, UK, Sweden, and others) announced
agreement on new capital standards – referred to as the Basel Agreement
for the city in Switzerland where this agreement was reached.

• The Basel standards were to be applied uniformly in their respective

countries (with some modifications for local conditions).

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 The Basel Agreement on International
Capital Standards (Cont.)
The Basel capital rules were designed to:

To encourage leading banks around the world to

keep their capital position strong.

To reduce inequalities in capital requirements

among different countries to promote fair
competition

To catch up with recent rapid changes in

financial services and financial innovation. *

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 The Basel Agreement on International
Capital Standards (Cont.)
Basel I
Under the terms of Basel I, the various sources of capital were divided into two
tiers:

 Tier 1 (core) capital includes:

Common stock and surplus, undivided profits (retained earnings), qualifying
noncumulative perpetual preferred stock

 Tier 2 (supplemental) capital includes:

The allowance (reserves) for loans and lease losses, subordinated debt capital
instruments, intermediate-term preferred stock, cumulative perpetual preferred
stock with unpaid dividends.

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 The Basel Agreement on International
Capital Standards (Cont.)
Basel I (Cont.)
•  
Basel I stipulated that 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

2. A ratio of total capital (the sum of Tier 1and Tier 2 capital) to total
risk-weighted assets of

What are 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-weighted factor designed to
reflect its credit risk exposure.

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 The Basel Agreement on International
Capital Standards (Cont.)
Basel I (Cont.)
To computer the bank’s risk-weighted assets under Basel I, a banker would:

1. Computer the credit-equivalent amount* of each off-balance-sheet item.

2. Multiply each balance sheet item and credit equivalent amount of each
OBS item by its risk weight, as determined by regulatory authorities. **

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 The Basel Agreement on International
Capital Standards (Cont.)
Example (1)
Suppose a bank has $4000 in Tier 1 capital and $2000 in Tier 2 capital,
$100,000 in total assets, and the following on-balance-sheet and off-
balance-sheet items, determine whether the bank qualifies as adequately
capitalized?

Bond 5

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 The Basel Agreement on International
Capital Standards (Cont.)
1. Computer the credit-equivalent amount of each off-balance-sheet item.

There are three categories of standby credit letters with different conversion
factors and credit risk weights (See Table on p. 499-500), we have assumed the
standby credit letters in this discussion question are backing the issue of state
and local government general obligation bonds.)
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 The Basel Agreement on International
Capital Standards (Cont.)
2. Multiply each balance
sheet item and credit
equivalent amount of each
OBS item by its risk weight.

3. Calculate the capital-to-

Risk-Weighted Asset Ratio:

Tier 1 risk-based capital

ratio = $4000 / $80,500 =
5.52%

Total risk-based capital

ratio = ($4000 + $2000) /
$80,500 = 7.45%

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 The Basel Agreement on International
Capital Standards (Cont.)
Basel II
• The next edition of the international bank capital accord was Basel II. The
concern to bankers, regulatory agencies, and industry analysts was how to
correct the weaknesses of Basel I.

• Smart bankers found ways around many of Basel I’s restrictions. Largest
banks discovered that the broad asset risk categories in Basel I actually
encompassed many different levels of risk exposure.*

• Moreover, Basel I represented a “one size fits all” approach to capital

regulation. Different banks have different risk exposures and, therefore,
should use different models to estimate risk and be subject to different
capital requirements.

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 The Basel Agreement on International
Capital Standards (Cont.)
Basel II
Base II set up a system in which capital requirements would be more sensitive
to risk and protect against more types of risk than with Basel I. Basel II
proposed to ensure that, consistently, low-risk assets would require less capital
than high-risk assets, as was often not the case with Basel I.
 Pillars of Basel II:
Minimum capital requirement for each
bank based on its own estimated risk
exposure from credit, market and
operational risks.

Supervisory review of each bank’s risk-

assessment procedures and the
adequacy of its capital to ensure they
are “reasonable”.

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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 Choosing the Best Alternative for
Raising Outside Capital
• The choice of which method to use in raising outside capital should be
made on the basis of a careful financial analysis of the alternatives and their
effects on a financial firm’s earnings per share.

Example (2)
Suppose a bank that needs to raise $20 million in external capital. The
institution currently has 8 million shares of common stock outstanding at
$4 per share par value. Income tax rate is 35%. The management has
three options for raising external capital:
1. Issuing 2 million new equity shares each as a price of $10.
2. Issuing preferred stock, bearing an 8 percent dividend, at $20 per
share.
3. Selling $20 million in debt capital notes bearing a 10 percent coupon
rate
If this bank can generate total revenues of about $100 million and hold
operating expenses to no more than $80 million, which option is best?
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Choosing the Best Alternative for
Raising Outside Capital

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 Learning Outcomes
• The Many Tasks Capital Performs
• Capital and Risk
– Key Risks in Banking and Financial Institution’s Management
– Defenses Against Risk
• Types of Capital in Use
• Reasons for Capital Regulation
• The Basel Agreement on International Capital Standards
• Choosing the Best Alternative for Raising Outside Capital

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