Capital Management
• Outline
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Definition of bank capital
Role of bank capital
Capital adequacy
Shareholders’ viewpoint
Trends in bank capital
Definition of bank capital
• Equity
– Common stock, preferred stock, surplus, and undivided profits
equals the book value of equity.
– Market value of equity
• Long-term debt
– Subordinated notes and debentures
– Interest payments are tax deductible
• Reserves
– Provision for loan losses (PLL) is expensed on the income
statement
– Reserve for loan losses is a capital account on the right-hand-side
of the balance sheet
Definition of bank capital
As an example of what happens when banks charge off loans, assume
that a bank has a PLL equal to $1,000,000 and the reserve for loan
losses is $3,000,000. If the bank charged off $800,000 in loan losses
during the year, the reserves for loan losses is calculated as follows:
Reserves for loan losses, beginning of 199X $3,000,000
Less: Charge-offs during 199X
800,000
Plus: Recoveries during 199X on loans
previously charged off
80,000
Plus: Provision for loan losses, 199X
1,000,000
Reserves for loan losses, end of 199X
$3,280,000
Role of bank capital
• Source of funds
– Start-up costs
– Growth or expansion (mergers and acquisitions)
– Modernization costs
• Cushion to absorb unexpected operating losses
– Insufficient capital to absorb losses will cause insolvency
– Long-term debt can only absorb losses in the event of institution
failure
• Adequate capital
– Regulatory requirements to promote bank safety and soundness
– Mitigate moral hazard problems of deposit insurance by increasing
shareholders’ exposure to bank operating losses
– Market confidence is important to depositors and other bank
claimants
Capital adequacy
• Bank regulators and bank shareholders have different
views of capital adequacy
– Regulators are more concerned with the lower end of the
distribution of bank earnings.
– Shareholders focus more on the central part of the distribution, or
the expected return available to them.
– Regulators perceive that financial risk increases the probability of
insolvency, as greater variability of earnings makes it more likely
that negative earnings could eliminate bank capital.
– Regulators must close banks due to capital impairment.
– Excessive capital regulation could inhibit the competitiveness and
efficiency of the banking system.
Capital adequacy
• Capital standards
– Office of the Comptroller of the Currency (OCC) used a capital-deposit
rate to measure capital adequacy in the early 1900s. This ratio was
motivated by fears of bank runs.
– The Federal Reserve Board (FRB) began using the Form for Analyzing
Bank Capital (FABC) in the 1950s which classified assets into 6
different risk categories. By contrast, the OCC in the 1960s moved to a
subjective system of capital evaluation (i.e., management quality, asset
liquidity, operating expenses, deposit composition, etc.).
– Problems with early standards:
Different standards applied by different regulators (OCC, FRB,
and FDIC).
Not enforceable by law until the International Lending Act of 1983.
Fairness was questionable with small banks required to keep higher
capital requirements than large banks.
Capital adequacy
• Uniform capital requirements
– Minimum primary capital-to-assets ratios established in 1981 by
all three federal bank regulators (i.e., equity capital and reserves).
A ratio of 5% to 6% was required.
Some larger institutions increased their risk taking in response to this
uniform capital requirement approach.
– Risk-based capital requirements were established in 1988 under the
Basle Agreement among 12 industrialized nations under auspices
of the Bank for International Settlements (BIS).
Like the FABC approach of the Fed, bank assets are classified into 4
categories by risk level.
In 1998 an amendment was made to include rules for securities trading
of banks.
Two categories of capital: (1) Tier 1 or “core” capital and (2) Tier 2 or
“supplemental” capital.
:
Capital adequacy
Capital
Tier 1
Tier 1 + Tier 2 (Total Capital)
Risk-Adjusted Assets
Total Assets
4%
3%
8%
No Requirement
COMPONENTS AND RULES GOVERNING QUALIFYING CAPITAL UNDER RISKBASED CAPITAL RULES
COMPONENTS
MINIMUM REQUIREMENTS
TIER 1 (CORE) CAPITAL
Must equal or exceed 4% or
risk-weighted assets (RWAs)
Common shareholder's equity and
retained earnings
Qualifying noncumulative perpetual
preferred stock and related surplus
Minority interests in equity accounts
of consolidated subsidiaries
Less:
Goodwill and some intangible assets
Subsidiaries of S&Ls in some cases
No limit
No limit, but regulatory warning
against "undue reliance"
No limit, but regulatory warning
against "undue reliance"
Capital adequacy
TIER 2 (SUPPLEMENTARY) CAPITAL Limited to 100% of Tier 1
Allowance for Loan and Lease Losses
Perpetual Preferred Stock Not
Qualifying for Tier 1 Capital
Hybrid Capital Instruments and
Equity-Contract Notes3
Subordinated Debt and IntermediateTerm Preferred Stock
Limited to 1.25% of RWAs
No limit within Tier 2
No limit within Tier 2
Limited to 50% of Tier 1
Calculating Risk-Adjusted Assets:
Assets
Cash
FNMA securities
GO municipal bonds
Home loans
Commercial loans
Total assets
(1)
In Thousands
$ 100
1,000
1,500
3,000
5,000
$10,600
(2)
(1)x(2)
Risk
Risk-Adj.
Weight Assets
0.00
0.20
0.20
0.50
1.00
$
0
200
300
1,500
5,000
$7,000
Capital adequacy
• Risk-adjusted capital requirements for total capital:
K = 8%[0(A1) + .20(A2) + .50(A3) + 1.0(A4)]
K = 0.08[0($100) + .2($2,500) + .5($3,000) + 1.0 ($5,000)]
= 0.08 [$7,000] = $560.00
Catagories of assets by credit risk are A1, A2, A3, A4:
A1 -- Cash and U.S. government securities
A2 -- Mortgage-backed bonds and government obligation
(GO) municipal bonds
A3 -- Home loans and municipal revenue bonds
A4 -- Business, consumer, and other loans, other
securities, and bank premises
Off balance sheet rules: these items must first be converted to onbalance sheet “credit equivalent” amounts. Then these adjusted
amounts are assigned to the different asset categories above.
Example:
Performance standby
Conversion
Risk
Risk-adjusted
letters of credit
factor
weight assets
$1,000
x
0.50
0.20
$100
Capital adequacy
• Market risk capital requirements (January 1998)
– Institutions with more than 10% of total assets or $1 billion or more
in trading account positions.
– 8% risk-adjusted capital requirement on a daily basis based on
market-to-market values of trading account securities.
– Add to credit-risk-weighted assets or risk-adjusted assets after
removing these securities from the previous calculation.
Example:
Previous risk-adjusted assets
Remove GO munis trading account securities ($1,500 x 0.20)
Value-at-risk (VAR) over the last 60 business days
Risk-adjusted assets with market risk capital requirements
$7,000
(300)
200
$6,900
– Stress tests need to be regularly performed on VAR models by
experimenting with assumptions. These backtesting results allow
VAR models to be continuously updated and improved.
Capital adequacy
• General market risk (financial market as a whole)
– Value-at-risk (VAR) is normally calibrated to the 10-day 99th
percentile standard.
Example: over the past year records show there is a 1 in a 100 chance of
losing $66.57 in any 10-day period.
– VAR times a scaling factor (3 normally but it can be higher).
Example: $66.57 x 3 = $200
– Must use: (1) an average VAR over the last 60 business days times
3, or (2) the previous day’s VAR. Latter condition only relevant to
periods in which the financial markets are very volatile.
• Specific risk (other risk factors including credit risk of the
securities issuer and liquidity risk).
– Scaling factor of 4 normally.
– Add to risk-adjusted assets.
Capital adequacy
• Potential weakness of current risk-based capital
requirements:
– Differences in credit risk for most loans are not taken into account.
– Book values are used rather than market values for most of the
assets in the risk-adjusted assets calculations.
– Regulatory requirements may change banks’ behavior in terms of
allocation of loanable funds and investment decisions and possibly
channel savings to less than the best uses.
– Some kinds of bank risk are excluded, including operating risk and
legal risk.
– Portfolio diversification is not taken into account.
Capital adequacy
• FDIC has a vested interest in bank capital adequacy due to
its deposit insurance activities.
– Handling distressed banks:
Depositor payoff
Purchase and assumption (P&A via mergers and acquisitions)
Provision of financial aid
Charter of a Deposit Insurance National Bank (DINB or bridge bank)
Reorganization
– Variable-rate deposit insurance (in cents per $100 domestic
deposits) implemented in 1994:
Capital Level
Well capitalized 0
Adequately capitalized
Undercapitalized
Risk Group
A
B
3
17
3
10
10
24
C
24
27
Shareholders’ viewpoint
• Financial risk and share valuation
% Change in EPS = % Change in EBIT [EBIT/(EBIT – Interest)]
(in thousands of dollars)
Low Debt
Bad
Net earnings before $9,000
Interest expenses (7,000)
Net earnings
2,000
Taxes (@ 34%)
(680)
Earnings after taxes$1,320
High Debt
Expected
Good
Bad
$10,000
(7,000)
3,000
(1,040)
$1,960
$11,000
(7,000)
4,000
(1,360)
$2,640
$9,000
(9,000)
-0-0-0-
Expected
$10,000
(9,000)
1,000
340
$ 660
Good
$11,000
(9,000)
2,000
(680)
$1,320
Common shares outstanding = 1 million
Earnings per share
(EPS)
Percentage change
in net earnings
before interest
expenses relative to
expected outcome
Percentage change
in EPS relative to
expected outcome
$1.32
$1.96
-10%
0%
-33%
0%
$2.64
$0
$.66
$1.32
+10%
-10%
0%
+10%
+33%
-100%
0%
+100%
Shareholders’ viewpoint
• Debt and bank valuation:
VL
VL = VU + tD
Max VL
VL = VU + tD - C
VU
VL = Total value with debt
VU = Total value with no debt
t = Tax rate
D = Debt outstanding
C = Regulatory costs
Optimal
Debt Level
D
Shareholders’ viewpoint
• Corporate control
– Greater debt increases the concentration of ownership among
shareholders and thereby increases corporate control of the bank.
– In banks that are not closely held there is the potential for agency costs
related to conflicts of interest between owners and managers.
– Hostile takeovers of banks with undervalued shares is a potential threat
that tends to reduce agency costs.
– Link management compensation to performance (e.g., stock options) to
decrease agency costs.
– Preemptive rights of shareholders reduces shareholder dilution and
reduces agency costs to the extent that owner concentration is increased.
Shareholders’ viewpoint
• Market timing (debt versus equity usage, interest rate
levels, and stock market levels)
• Asset investment considerations (asset risk and capital
needs to absorb potential losses)
• Dividend policy (fixed dividend policy versus fixed payout
dividend payout policy)
• Debt capacity (financial slack or flexibility)
• Transactions costs (private and public sales of equity)
• Mergers and acquisitions (Financial Services
Modernization Act of 1999)
• Internal expansion (internal capital generation rate)
ICR = (1/capital ratio) x ROA x Earnings retention ratio
Rate at which a bank can expand its assets and still maintain its
capital ratio.