Document

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Chapter 8

Capital Regulation and Management

Copyright © 2000 by Harcourt, Inc.

All rights reserved.

Market Versus Book Value Definitions of Capital for Depository Institutions

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 The book value of assets and liabilities is unaffected by changes in interest rates.

 The market value of assets and liabilities varies in response to interest rate changes.

 For an institution that finances long-term fixed rate assets with short-term liabilities:

•

a rise in interest rates will result in a decline in the market value of equity; and

•

a drop in interest rates will result in an increase in the market value of equity .



Why capital?

 To provide long-term funds for long-term investments and growth in assets.

 To build confidence for depositors and other debtholders.

 To provide a cushion against future losses.

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Preference of Stockholders for Capital

 Stockholders prefer higher financial leverage, i.e., lower capital, because they can employ the funds of depositors and debtholders to generate a higher return for a small investment.

 The use of debt provides a tax subsidy.

 The use of debt provides an insurance subsidy for insured institutions since insured depositors don’t demand a risk premium on debt.

 Stockholder preference creates a moral hazard for the deposit insurer.



An institution is funded with $5 million in capital. The funds can be used to make loans with a 50% probability of default and a 50% probability of producing a $5 million profit. The expected dollar return on the investment is :

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0.5(-$5m) + 0.5($5m) = 0

If instead the institution is funded with $4 million of insured deposits at a cost of 10% ($400,000 in interest expense) and $1 million in capital, the expected dollar return on the investment is:

0.5(- $1m) + .5( $5m- $0.4m) = $1.8m



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Some Incentives for Stockholders to Hold Capital

 Increasing equity through retained earnings permits an institution to grow and acquire other firms without the use of external capital.

 Higher capital levels prevent greater regulatory interference concerning branching and merger decisions.

 Using capital to finance long-term assets or growth is less risky than financing with shortterm deposits.



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Preference of Uninsured Depositors and

Managers for Capital

 Debtholders prefer higher capital ratios to protect against loss of the funds they lent to the bank.

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Undercapitalized institutions may have to offer higher risk premiums to attract uninsured debt.

 Managers generally prefer higher capital ratios for fear of losing their jobs if their institutions fail.

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Managers may demand higher salaries to work for undercapitalized banks.



Preference of Regulators for Capital

 Regulators prefer greater capital to protect:

•

the deposit insurance fund; and

•

taxpayers .

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Components of Tier 1, Core Capital

 Common Stock Accounts and Retained

Earnings (Common Equity)

 Perpetual Preferred Stock (up to 25% of

Tier 1 Capital)

 Less Ineligible Intangible Assets



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Tier 2 Capital, Supplementary Capital

 Any additional Perpetual Preferred Stock not allowed in Tier 1

 Limited Life Preferred Stock

 Subordinate Notes and Debentures (up to 50% of

Tier 2 Capital)

• original maturities of five years or more, amortized as they mature

 Reserves for loan and lease losses (up to 1.25% of risk-weight assets)

 Mandatory Convertible Subordinate Debt



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Nationsbank Maryland 1994 Capital

Tier 1 Capital

Common Equity

Less Ineligible Intangible Assets

Net Tier 1 Capital

Tier 2 Capital

$1,880,937

291,335

$1,589,602

Allowable Subordinate Debt

Cumulative Preferred Stock

$ 0

0

Mandatory Convertible Securities 0

Allowable Loan & Lease Allowance 161,113

Net Eligible Tier Two Capital $161,113

Total Regulatory Capital = $1,750,715



Minimum Regulatory Capital Requirements

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 Leverage Ratio: Minimum Tier 1 capital-tototal asset ratio = 3%

 Tier 1 capital-to-risk based asset ratio = 4%

 Tier 1 + Tier 2 capital-to-risk based asset ratio = 8%



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Calculating Risk-Based Assets

 Assets are classified into four categories based on credit risk.

 Each category has a risk weight.

 Risk-based assets are equal to the sum of the total assets for each risk class times respective risk weights.

 Off-balance sheet assets are converted to credit equivalent assets.

 Credit equivalent assets are then placed in the respective risk-based categories.



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Risk Categories for Calculating Risk-Based

Assets

 Category 1 (0% weight): Federal Reserve balances, U.S. government securities and some U.S. agency securities.

 Category 2 (20% weight): Cash items in the process of collection, U.S. and OECD interbank deposits and guaranteed claims, some non-OECD bank and government deposits and securities, General Obligation

Municipal Bonds, Fed Funds Sold, some mortgagebacked securities, claims collateralized by the U.S.

Treasury, and some other government securities.



 Category 3 (50% weight): Municipal revenue bonds, secured mortgage loans on 1-4 family residential properties, and other securitized assets.

 Category 4 (100% weight): Commercial and consumer loans, corporate bonds, commercial paper, and other assets not included in other categories

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Risk-Based Categories for Off-Balance Sheet Items

 Category 1 (0% risk weight): for unused commitments with an original maturity of one year or less or conditionally cancelable commitments.

 Category 2 (20% risk weight): for commercial letters of credit, bankers acceptances conveyed and other short-term self-liquidating trade-related items.



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 Category 3 (50% risk weight): for standby letters of credit, other performance warranties and unused commitments with original maturities exceeding one year, and revolving underwriting facilities.

 Category 4 (100% risk weight): for direct credit substitutes including general guarantees, sale and repurchase agreements with recourse, and forward agreements to purchase assets.



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Example: Finding Risk-Based Assets

NATIONSBANK, SEPTEMBER 1994

On Balance Sheet ($000) Assets in this Category Risk-weighted assets

Category 1: 0 weight

Category 2: 20% weight


Category 4 100% weight

$2,979,181

6,126,605

806,398

9,539,789

Total On-Balance Sheet Risk-Based Assets

$ 0

1,225,321

403,199

9,539,784

$11,168,304

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NATIONSBANK EQUIVALENT (CONVERTED)

OFF-BALANCE SHEET (OBS) ITEMS

Risk Category

Category 1: 0 weight



Category 4 100% weight

Equivalent OBS

$ 12,139

73,180

27,252

1,983,830

Weight-Equivalent OBS

$ 0

14,636

13,626

1,983,830

Total On-Balance Sheet Risk-Based Assets $2,012,092

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Total Risk-Based Assets =

( $11,168,304 + $2,012,092 = $13,180,397



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Nationsbank Capital Ratios

Tier 1 to Risk-Based Assets

$1,589,602 ÷ $13,180,397 * = 12.06%

Tier 1 + Tier 2 to Risk-Based Assets

$ 1,750,715 ÷ $13,180,397 * = 13.28%

Tier 1 to Total Assets

$ 1,589,602 ÷ $19,351,968 * = 8.21%

* Excludes special technical adjustments to asset base



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Definition of Capital Adequacy

 The level of capital helps determine whether a bank is well-capitalized or undercapitalized.

 Undercapitalized banks are subject to intense scrutiny by regulators. Undercapitalized banks must:

• restrict growth;

• prepare plans to restore capital; and

• obtain regulatory approval before expanding operations, making acquisitions or opening branches.



 Additional considerations in determining capital adequacy include:

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a bank's CAMELS rating; and

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the rate of growth in bank assets.

 Thrift institutions are subject to similar capital adequacy standards.

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Capital for Federal Credit Unions

 Capital consists of retained earnings and reserves from past operations set aside each year to cover future losses.

 Capital adequacy standards are based on size and age.

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Institutions four years old or older with more than $500,000 in assets or those less than four years old must have a capital ratio of 10%.

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 Risk assets are defined as total assets minus cash, Treasury securities, and loans not considered subject to default risk.

 Credit unions are subject to CAMEL ratings, which affect how much capital they need.

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Unresolved Issues in Capital Regulation

 Rules focus on book-value rather than market-value measures.

 Current ratios emphasize credit risk and ignore other types of risk.

 Rules ignore the impact of portfolio diversification on overall risk.

 Rules ignore the actual default risk of different types of assets and contingent liabilities



Factors Determining the Optimal Capital

Structure

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 Regulatory requirements

 An institution’s risk profile

 Practical considerations



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Risk-Adjusted Return on Capital (RAROC)

 Each asset given a capital charge based on the amount of capital that needs to be held on the asset according to its risk.

 Higher equity-assets percentage is allocated to more risky assets.

 More risky assets require a higher return to cover the cost of the extra capital that has to be held for them.

 Requires detailed historic market data to determine equity-to-asset allocations.



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Peer Approach for Capital Allocation

 Equity that needs to be held for a particular business line is allocated based on the average equity-to-asset ratio held by peer banks in that business.

 The overall equity-to-asset ratio for the bank is the total of the equity allocated to each line of business divided by total assets.

 Some business lines may have few peers for comparisons.



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Example: RAROC PRICING OF COMMERCIAL LOANS

Source Component

Funds Transfer Cost of Funds

Required Loan Loss Provision

Plus:

Direct Expense

5.45%

1.25%

Indirect Expense

Overhead

0.70%

0.45%

0.40%

Total Charge before Capital Charge

Plus:

8.25%

Capital Charge (RAROC)

* Allocated equity/asset ratio=12%

3.00% *

Total Required Loan Rate 11.25%

*

RAROC: allocated equity/assets = 12%; opportunity cost of equity = 15%; after-tax capital charge = 15%×12% = 1.8%; marginal tax rate = 40%; pretax capital charge =

1.8%/.06 = 3.0%



Peer Group Comparisons

Line of Business

Credit Cards

Assets

$20,261

Mortgage Banking 11,314

Subprime Lending

Total

5,072

$36,647

Equity Equity to Assets

$2,018 9.90%

1,949 17.23%

1,666

$5,633

32.77%

15.37%

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Standard Deviation ROA Approach

 Approach is based on the standard deviation of ROA and a bank’s probability of insolvency ratio (Z).

 K * is the required capital-to-asset ratio to achieve a target Z-ratio that the bank desires for each of the bank’s operations and is defined as:

K * = [Z * × Std (ROA)] - ROA *


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Standard Deviation Approach

Assumes a Z * = 13.80 for all areas of operations.

Equity/Asset

Line of Business ROA % Std (ROA) Ratio % Equity (mils)

Credit Cards 4.94 1.08

9.96

$ 2,018

Mortgage Banking 4.96

2.78

33.40

3,779

Subprime Lending 14.67

Total Bank 5.99

7.96

1.29

95.18

28.99

4,827

$10,624 +

Required equity capital for a bank to achieve Z * = 13.80%

K * = (13.80)(1.29) - 5.99 = 11.81%

Equity Capital = (0.118)($36,647 assets) = $4,328

+ Ignores the benefits of diversification



Equity Allocation Taking Account of Diversification

Equity New Equity Effects Allocated

Line of Business Allocated Equity per (mils) (mils) Assets (%)

Credit Cards $2,018 0.4074 $ 822 4.06

Mortgage Banking 3,779 0.4074

1,539 13.61

Subprime Lending 4,827 0.4074

1,967

Total Bank $10,624 0.4074 $4,328

38.78

11.81

New Equity = $4,328/$10,624

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Raising Capital Internally

 Increases in Retained Earnings

 Reduction in Dividend Payout

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What to do with excess capital?

 Increase dividends and stock repurchases

 Over-leveraging the balance sheet or increasing off-balance sheet activities

 Acquiring other banks or nonbanks with cash

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Davis and Lee (1997)

Steps to Capital Structure

 Conduct the economic risk analysis.

 Maintain a comfortable margin above regulatory “well-capitalized” level.

 Conduct a peer group comparison.

 Consider future prospects and needs.

 Consider rating agency requirements.

 Establish a desired optimal mix of capital.



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