McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Transcription

1 Bank Capital Management

2 15-2 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

3 Introduction What is capital? Funds contributed by the owners of a financial institution 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

4 15-4 Tasks Performed By Capital Provides a Cushion Against Risk of Failure Provides Funds to Help Institutions Get Started Promotes Public Confidence (credit crisis showed importance) Provides Funds for Growth Regulator of Growth Regulatory Tool to Limit Risk Exposure Protects the Government s Deposit Insurance System

5 15-5 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

6 15-6 Defenses Against Risk Quality Management Diversification Deposit Insurance (increased from $100K to $250K in the Fall of 2008 through Dec 2009) Owners Capital

7 15-7 Types of Capital Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes

8 Capital Accounts of FDIC-Insured U.S. Commercial Banks, December 31, 2010

9 15-9 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

10 15-10 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

11 15-11 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.)

12 15-12 The Basel Agreement A Bank s 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

13 15-13 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

14 15-14 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 15-15 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

16 15-16 Total Regulatory Capital Calculations

17 Minimum Capital Requirements across Capital Categories Total Risk- Based Ratio Tier 1 Risk- Based Ratio Tier 1 Leverage Ratio Well capitalized 10% & 6% & 5% Adequately capitalized 8% & 4% & 4% Undercapitalized < 8% or < 4% or < 4% Capital Directive / Requirement Not subject to a capital directive to meet a specific level for any capital measure Does not meet the definition of well capitalized Significantly undercapitalized Critically undercapitalized < 6% or < 3% or < 3% Ratio of tangible equity to total assets is 2%

18 Provisions for Prompt Corrective Action Category Mandatory Provisions Discretionary Provisions Well capitalized None None Adequately capitalized Undercapitalized Significantly undercapitalized 1. No brokered deposits, except with FDIC approval 1. Suspend dividends and management fees 2 Require capital restoration plan 3. Restrict asset growth 4. Approval required for acquisitions, branching, and new activities 5. No brokered deposits 1. Same as for Category 3 2. Order recapitalization 3. Restrict interaffiliate transaction 4. Restrict deposit interest rates 5. Pay of officers restricted 1. Same as for Category 4 2. Receiver/conservator within 90 days d 3. Receiver if still in Category 5 four Critically undercapitalized quarters after becoming critically undercapitalized 4. Suspend payments on subordinated debt d 5. Restrict certain other activities None Order recapitalization 2. Restrict interaffiliate transactions 3. Restrict deposit interest rates 4. Restrict certain other activities 5. Any other action that would better carry out prompt corrective action 1. Any Zone 3 discretionary actions 2. Conservatorship or receivership if fails to submit or implement plan or recapitalize pursuant to order 3. Any other Zone 5 provision, if such action is necessary to carry out prompt corrective action

19 15-19

20 15-20

21 Example: Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 1 & 2 Assets $ 1,000 Risk Weight Risk Weighted Assets Category 1: Zero Percent Cash & reserve 104, % 0 Trading Account % 0 U.S. Treasury & agency secs. 45, % 0 Federal Reserve stock 5, % 0 Total category 1 157,153 0 Category 2: 20 percent Due form banks / in process 303, % 60,722 Int. bearing Dep./F.F.S. 497, % 99,525 Domestic dep. institutions 38, % 7,634 Repurchase agreements (U.S. Treas & agency) 329, % 65,862 U.S. Agencies (gov. sponsored) 412, % 82,420 State & Muni's secured tax auth 87, % 17,503 C.M.O. backed by agency secs. 90, % 18,004 SBAs (govt. guaranteed portion) 29, % 5,853 Other category 2 assets % 0 Total category 2 1,787, ,523

22 Example: Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 3 & 4 Assets $ 1,000 Risk Weight Risk Weighted Assets Category 3: 50 percent C.M.O. backed by mtge loans 10, % 5,000 State & Muni's / all other 68, % 34,257 Real estate: 1-4 family 324, % 162,211 Other category 3 assets % 0 Total category 3 402, ,468 Category 4: 100 percent Loans: comm/ag/inst/leases 1,966, % 1,966,276 Real estate, all other 388, % 388,456 Allowance for loan and lease losses (70,505) 0.00% 0 Other investments 168, % 168,519 Premises, eq. other assets 194, % 194,400 Other category 4 assets % 0 Total category 4 2,647,146 2,717,651 Total Assets before Off-Balance Sheet 4,994,849 3,276,642

23 Example: Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Off Balance Sheet Assets $ 1,000 Risk Weight Risk Weighted Assets Total Assets before Off-Balance Sheet 4,994,849 3,276,642 Off-Balance Sheet Contingencies 0% collateral category % 0 20% collateral category % 0 50% collateral category 364, % 182, % collateral category 290, % 290,905 Total Contingencies 655, ,365 Total Assets and Contingencies before allowance for loan and lease losses and ATR 5,650,674 3,750,007 Less: Excess allowance for loan and lease losses (2,152) Total Assets and Contingencies 5,650,674 3,747,855 Minimum Capital requirements Actual Capital Required Capital (%) Required Capital (Minimum) Tier 4% 199, % 149,914 Total 8% 399, % 299,828

24 Example: Regional National Bank (RNB), Off-balance Sheet Conversion Worksheet Credit Conversion Factor Credit Equivalent $ Amount $ Amount Contingencies 100% conversion factor Direct Credit substitutes 165, % 165,905 Acquisition of participations in BA, direct credit % 0 substitutes Assets sold w/ recourse % 0 Futures & forward contracts 50, % 50,000 Interest rate swaps 75, % 75,000 Other 100% collateral category % 0 Total 100% collateral category 290, ,905 Contingencies 50% conversion factor Transaction-related contingencies % 0 Unused commitments > 1 year 364, % 182,460 Revolving underwriting facilities (RUFs) % 0 Other 50% collateral category % 0 Total 50% collateral category 364, ,460 Contingencies 20% conversion factor Short-term trade-related contingencies % 0 Other 20% collateral category % 0 Total 20% collateral category 0 0 Contingencies 0% conversion factor Loan commitments < 1 year % 0 Other 0% collateral category % 0 Total 0% collateral category 0 0 Total off-balance sheet commitment 655, ,365 *BA refers to bankers acceptance.

25 What Was Left Out of the Original Basel Agreement Its Failure to Deal with Market Risk, Especially Problematic During the 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 15-25

26 15-26 Value at Risk (VAR) Models A Statistical Framework for Measuring a Bank Portfolio s Exposure to Changes in Market Prices or Market Rates Over a Given Time Period Subject to a Given Probability

27 15-27 Central Elements of VaR An Estimate of the Maximum Loss in a Bank s 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

28 15-28 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 Bank s Risk Assessment Procedures and the Adequacy of Its Capital Greater Disclosure of Each Bank s True Financial Condition

29 15-29 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

30 15-30 Revised Framework for Basel II

31 15-31 Planning to Meet a Bank s 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