Chapter Fifteen

The Management of Capital

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 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
• Capital Regulation in the Wake of the Great
Recession/Basel III
• Planning to Meet Capital Needs

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 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

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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
5. Regulator of growth
6. Regulatory tool to limit risk exposure

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 Capital and Risks
• Key Risks in Banking and Financial Institutions’
Management
▫ Credit Risk
▫ Liquidity Risk
▫ Interest Rate Risk
▫ Operational Risk
▫ Exchange Risk
▫ Crime Risk

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 Capital and Risks (continued)
• Defenses against Risks
▫ Quality Management
▫ Diversification
▫ Geographic
▫ Portfolio
▫ Deposit Insurance
▫ Owners’ Capital

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 Types of Capital in Use
1. Common stock
2. Preferred stock
3. Surplus
4. Undivided profits
5. Equity reserves
6. Subordinated debentures
7. Minority interest in consolidated subsidiaries
8. Equity commitment notes

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 TABLE 15–1 Capital Accounts of FDIC-Insured U.S.
Commercial Banks, December 31, 2010

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 One of the Great Issues in the History of Banking:
How Much Capital Is Really Needed?
• Regulatory Approach to Evaluating Capital Needs
▫ Reasons for Capital Regulation
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

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 One of the Great Issues in the History of Banking:
How Much Capital Is Really Needed? (continued)
• Regulatory Approach to Evaluating Capital Needs
▫ 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
▫ Recently government regulation appears to have become
nearly as important as the private marketplace
▫ Especially in the wake of the great credit crisis of 2007-2009

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 One of the Great Issues in the History of Banking:
How Much Capital Is Really Needed? (continued)
• Regulatory Approach to Evaluating Capital Needs
▫ Research Evidence
▫ We are not at all sure market disciplining works as well for
small and medium-size insured depository institutions
▫ Some of the most pertinent information needed to assess a
bank’s risk exposure is known only to government
regulators
▫ Research has found that increased capital does not
materially lower a bank’s failure risk

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations
• The Basel Agreement
▫ An international agreement on new capital standards
▫ 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 on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• 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) 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
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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Basel I
▫ 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 percent
2. A ratio of total capital (the sum of Tier 1 and Tier 2
capital) to total risk-weighted assets of at least 8 percent,
with the amount of Tier 2 capital limited to 100 percent of
Tier 1 capital

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• 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

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)

• Calculating Risk-Weighted Assets

▫ To compute this bank’s risk-weighted assets:
1. Compute the credit-equivalent amount of each off-balance-
sheet (OBS) item

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Calculating Risk-Weighted Assets
▫ To compute this bank’s risk-weighted assets:
2. Multiply each balance sheet item and the credit-equivalent
amount of each OBS item by its risk weight

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Calculating the Capital-to-Risk-Weighted Assets Ratio
▫ 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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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Capital Requirements Attached to Derivatives
▫ The Basel I capital standards were adjusted to take
account of the risk exposure banks may face from
derivatives
▫ Futures, options, swaps, interest rate cap and floor contracts,
and other instruments
▫ Sometimes expose a bank to counterparty risk
▫ The danger that a customer will fail to pay or to perform,
forcing the bank to find a replacement contract with another
party that may be less satisfactory

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Capital Requirements Attached to Derivatives
(continued)
▫ Basel required a banker to divide each contract’s risk
exposure into two categories
1. Potential market risk exposure
2. Current market risk exposure
▫ Once the replacement cost of a contract is determined:
▫ The estimated potential market risk exposure amount is
added to the estimated current market risk exposure to
derive the total credit-equivalent amount of each derivative
contract
▫ This total is multiplied by the correct risk weight, to find the
equivalent amount of risk-weighted assets represented by
each contract
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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Capital Requirements Attached to Derivatives (continued)

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Capital Requirements Attached to Derivatives (continued)

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• 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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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Value at Risk (VaR) Models Responding to Market
Risk
▫ 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
▫ VaR Example
▫ A bank estimates its portfolio’s daily average value at risk is
$100 billion over a 10-day interval with a 99 percent level of
confidence
▫ If this VaR estimate of $100 billion is correct, losses in
portfolio value greater than $100 billion should occur less than
1 percent of the time
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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Limitations and Challenges of VaR and Internal
Modeling
▫ VaR estimates and internal modeling are not perfect
▫ Inaccurate VaR estimates can expose a bank to excessive risk so
that its capital position may turn out not to be large enough to
cover actual losses the bank faces
▫ The portfolios of the largest banks are so complex with thousands
of risk factors it may be impossible to consistently forecast VaRs
accurately
▫ Promote “backtesting”
▫ Even if an individual bank is a good forecaster, there may
still be trouble due to systemic risk
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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Basel II
▫ Bankers found ways around many of Basel I’s restrictions
▫ Capital arbitrage
▫ 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
▫ Basel II would be gradually phased in for the largest
international banks
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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• 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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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)

• Basel II and Credit Risk Models

▫ Credit risk models
▫ Computer algorithms that attempt to measure a lender’s
exposure to default by its borrowing customers or to credit
downgradings
▫ Most credit risk models develop estimates based upon:
▫ Borrower credit ratings
▫ The probability those credit ratings will change
▫ The probable amount of recovery should some loans
default
▫ The possibility of changing interest-rate spreads between
riskier and less risky loans

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)

• Basel II and Credit 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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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• A Dual (Large-Bank, Small-Bank) Set of Rules
▫ Basel II was designed to operate under one set of capital
rules for the handful of largest multinational banks and
another set for more numerous smaller banking firms
▫ Regulators were concerned that smaller banks could be
overwhelmed by:
▫ The heavy burdens of gathering risk-exposure information
▫ Performing complicated risk calculations
▫ Basel II anticipated that smaller institutions would be able
to continue to use simpler approaches in determining their
capital requirements and risk exposures, paralleling Basel
I rules

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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• 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
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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Basel III: Another Major Regulatory Step Underway,
Born in Global Crisis
▫ Basel II was never fully implemented
▫ Had to move toward Basel III in order to prevent future crises
▫ 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
▫ Capital requirements laid down in Basel I and II
apparently were inadequate in the face of the latest credit
crash
▫ Bankers found ways to hold both less capital in total and a
weaker mix of kinds of capital
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 The Basel Agreement on International Capital
Standards: A Continuing Historic Contract Among
Leading Nations (continued)
• Basel III: Another Major Regulatory Step Underway,
Born in Global Crisis
▫ Proponents of Basel III called for greater total
capitalization, stronger definition of what belongs in
banks’ capital accounts
▫ Volcker Rule was proposed in the U.S.
▫ Implementation of Basel III could take many years
▫ Implementation would be phased in slowly, beginning in 2012
and possibly be completed close to 2019
▫ Basel III covers the capital, liquidity, and debt positions of
individual international banks and also broader issues
associated with global business cycles and systemic risks

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 Changing Capital Standards Inside the
United States
• Several new capital rules created recently by U.S.
regulatory agencies were mandated by the FDIC
Improvement Act of 1991
▫ Requires federal regulators to take Prompt Corrective
Action (PCA) when an insured depository institution’s
capital falls below acceptable levels
• U.S. bank regulators created capital-adequacy
categories for implementing PCA:
1.Well capitalized
2.Adequately capitalized
3.Undercapitalized
4.Significantly undercapitalized
5.Critically undercapitalized
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 Planning to Meet Capital Needs
• Raising Capital Internally
▫ 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

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 Planning to Meet Capital Needs (continued)
• Raising Capital Internally
▫ Dividend Policy

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 Planning to Meet Capital Needs (continued)
• Raising Capital Externally
▫ If a financial firm does need to raise capital from outside
sources, it has several options:
1. Selling common stock
2. Selling preferred stock
3. Issuing debt capital
4. Selling assets
5. Leasing facilities
6. Swapping stock for debt securities

▫ The choice of which method to use is based on their

effects on a financial firm’s earnings per share

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 TABLE 15–2 Methods of Raising External Capital for a
Financial Firm

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 Quick Quiz
• What crucial roles does capital play in the management and
viability of a financial firm?
• What are the most important and least important forms of
capital held by U.S.-insured banks?
• What is the rationale for having the government set capital
standards for financial institutions as opposed to letting the
private marketplace set those standards?
• How is the Basel Agreement likely to affect a bank’s choices
among assets it would like to acquire?
• What are the differences among Basel I, II, and III?
• What are the principal sources of external capital for a financial
institution?

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