Chapter 15
Chapter 15
Chapter 15
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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?
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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?
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Key Topics
The Many Tasks of Capital Capital and Risk Exposures
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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
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Probability that changes in interest rates will adversely affect the value of net worth
Probability of adverse affect of earnings due to failures in computer systems, management errors, etc. Probability of loss due to fluctuating currency prices Due to embezzlement, robbery, fraud, identity theft
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Exchange Risk
Crime Risk
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Geographic Portfolio
Deposit Insurance (increased from $100K to $250K in the Fall of 2008 through Dec 2009) Owners Capital
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Types of Capital
Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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 riskbased 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.)
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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The greater the credit risk, the greater the required capital
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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
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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
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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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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
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