BANK MANAGEMENT - UNIT 9-Chapter 12 The Effective Use of Capital - Adj

Unit 9:
Capital
Management
© 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in
whole or in part, except for use as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom use. 1
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.
© 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
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 banks face in exiting the recession.
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.
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.
Risk-Based Elements of Basel I
Risk Weight and Category Description
Category 1: 0% Cash, Government Securities,
Govt Guaranteed Debt
Category 2: 20% Municipal securities, Balances
due from US depositary
institutions
Category 3: 50% Residential Mortgages,

mortgage backed bonds,
municipal revenue securities
Category 4: 100% Commercial loans, Personal

loans, Fixed assets, Margin
accounts on futures contracts
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.
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)
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.
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.
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.
Basel III Capital Standards
• When implemented, banks must hold a capital
conservation buffer plus old RBC minimums.
• Minimum capital requirements when implemented

in 2019:
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.
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.
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.
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.
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:
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.
External Capital Sources: Sub-ordinated
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.
• 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.
Common Stock
• 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.
Preferred Stock
• 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 (US) (Zero in JA)
• 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.
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.
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 estate
listed on the bank’s book at cost to cash.
Capital Planning
• Process can be summarized in three steps:
• Generate pro forma balance sheet and income
statements for the bank.
• Select a dividend payout.
• Analyze the costs and benefits of alternative sources of
external capital.
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 banks 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.
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.
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 three 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.
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.
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.

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Unit 9:

Category 3: 50% Residential Mortgages,

Category 4: 100% Commercial loans, Personal

• Minimum capital requirements when implemented

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