Download Changing Times for Financial Institutions Chapter 1

6-1
Capital Regulations and Management
Chapter 6
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6-2
Defining Capital:
Market versus Book Values
Most Financial Institutions vs. Security Firms
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Most Financial Institutions – Book Value
Security Firms – Market Value
Difficulties in Calculating Market Values
Why Capital?
The Role of Capital as a Cushion against Losses
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6-3
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6-4
Preferences for Capital
by Different Agents
Preferences of Stockholders for higher Financial
Leverage
Moral Hazard Problems with Deposit Insurance
Purposes of Capital and Some Incentives for
Stockholders to Hold Capital
Preferences of Uninsured Debtholders, Managers,
and Regulators
The Optimal Capital Structure: Balancing
Shareholders’ and Regulators’ Interests
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6-5
Other Views on Bank Capital
Regulatory Capital Adequacy May not Be as
Necessary Today as in the Past Due to
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Greater Market Transparency
More Risks
Greater Reliance on Market Pricing
Greater Large Customer Dependence
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6-6
Changes in Regulatory Capital
Requirements over Time
Equity-to-Asset Declining Trends
Basel I and FDICIA as a Response
The BIS Market Risk Amendment and Basel II
Equity-to-Asset Trends Following Basel I
Is Basel II Needed?
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More credit risk?
More risk due to competition?
More risk due to derivatives, other off-balance sheet
items?
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6-7
Two Types of Capital
Tier 1: Core or Tangible Equity Capital
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Common stock accounts
Retained earnings
Qualifying perpetual preferred stock (up to 25% of
Tier 1 capital)
Minority interest in equity accounts of consolidated
subsidiaries
Less ineligible intangible assets (e.g., goodwill)
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6-8
Two Types of Capital (continued)
Tier 2: Supplemental Capital
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Any additional perpetual preferred stock not allowed
in Tier 1
Subordinated notes and debentures (up to 50
percent of Tier 2 capital)
Allowance for loan and lease losses (up to 1.25% of
risk-weighted assets)
Mandatory convertible subordinated debt
Immediate-term preferred stock (original weighted
average maturity of five years or more)
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6-9
Regulatory Capital Ratios and
Definitions of Capital Adequacy
Regulatory Capital Ratios (minimum)
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Tier 1 capital/Total assets ratio = 4%
Tier 1 capital/Total risk-based assets ratio = 4%
Tier 1 + Tier 2 capital/total risk-based assets ratio = 8%
Regulatory Definitions of Capital Adequacy
See Table 6.2, page 225
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6-10
Four Risk Categories
Category 1:
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0 percent weight
Federal Reserve balances
U.S. government securities
OECD government securities
Some U.S. agency securities
Category 2: 20 percent weight
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Cash items in the process of collection
OECD interbank deposits & guaranteed claims
Some non-OECD bank & government deposits & securities
Claims collateralized by U.S. Treasury & some agency securities
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6-11
Four Risk Categories (continued)
Category 3: 50 percent weight
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Other municipal revenue bonds
Secured mortgage loans on 1-4 family residential
properties, fully secured by first liens
Category 4: 100 percent weight
All other on-balance-sheet assets including
◦ Commercial loans
◦ Consumer loans
◦ Commercial paper
◦ All other assets
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6-12
Basel I Issues
Basel I does take into account
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Credit risk overall
Riskiness of various assets
Basel I does not take into account
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Interest rate risk
Operating risk
Credit risk variance between different loans
Information from risk management models
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Table 6.3 Calculating a Risk-Based
Capital Ratio for Mega Bank
6-13
Capital standards are based in part on the riskiness of an institution's assets and on the degree of its
off-balance-sheet involvement. Depositories with lower-risk assets and lower-risk off-balance-sheet
activities will have more favorable capital ratios than higher-risk institutions.
(1)
(2)
(3)
(2) X (3)
Risk Category
On-Balance-Sheet Assets
Cash and Treasury securities
Repos and Fed Funds
Mortgages
Commercial loans and fixed assets
Total on-balance-sheet items
Contingent Liabilities (Off-Balance Sheet Items)
Cancellable short-term loan commitments
Commercial letters of credit
Long-term loan commitments
Selected forward agreements
Total off-balance-sheet items
Total risk-weighted value
Core (Tier 1) capital
Risk-based total assets ($5,000/$75,000)
Amount '(000s)
Risk Weight
Risk-Based
$20,000
30,000
10,000
40,000
$100,000
0.00
0.20
0.50
1.00
$0
6,000
5,000
40,000
$51,000
$5,000
20,000
10,000
15,000
$50,000
0.00
0.20
0.50
1.00
$0
4,000
5,000
15,000
$24,000
$75,000
$5,000
6.67%
Page 228
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6-14
The Evolving Basel II Accord
Applies to
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very large international banks
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Top ten U.S. banks
Three Mutually Reinforcing “Pillars”
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Pillar 1: Capital Charges against Market Risk,
Operational Risk, and Credit Risk
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Pillar 2: Effective Supervisory Review Process
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Pillar 3: Market Discipline
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6-15
Minimum Capital Requirements
Minimum capital required for a $100 million commercial loan of quality
AAA
Pre-1982 All judgemental by Regulators
Basel I (Current Rules)
$8
Basel II Advanced IRB
$0.37 to $4.45
BBB-
B
$8
$1.01 to $14.13
$8
$3.97 to $41.65
Notes: The quality of loans refers to one-year default probabilities corresponding to the historical average for a
given credit rating, in this case an unsecured credit with an assumed loss given a default (LGD) of 45 percent.
The one-year probability of default used is 0.03 percent for AAA, 0.35 percent for BBB, 8.38 percent for B,
based on a maturity of 2.5 years. Lower bounds reflect an LGD of 10 percent for high recovery for a one-year
loan and 90percent for a five-year loan. All Basel II capital calculations (standardized and IRB) include an
operational risk charge (under the Basic Indicator Approach, the operational capital charge is equal to 15
percent of the institution's average gross income over the previous three years). As a proxy for gross income,
the calculations in this table use dthe current industry average ROA (1.41% X the amount of the loan, $100)
for an estimated operational risk charge of $0.21 (15 percent of $1.41).
Page 229
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6-16
The Evolving Basel II Accord
Very Large U.S. Bank Participation for Basel II:
Two Regulatory Systems
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Operations and Other Large Banks That Opt In
Advanced Internal Ratings-Based (A-IRB) Approach
for Credit Risk and Advanced Measurement
Approach (AMA) for Operational Risk
Advance Notice of Proposed Rulemaking (ANPR)
Guidelines
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6-17
Measuring Risks
Guidelines for Measuring Operational Risk
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Process Risk
People Risk
System Risk
External Risk
Guidelines for Measuring Credit Risk under an IRB Approach
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Probability of Default
Loss Given Default
Exposure at Default
Remaining Maturity (M) Based on the Weighted Average Remaining
Maturity
FDIC Study of the Expected Effects with Basel II and Other Criticisms
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6-18
Management of Capital and Growth
with RAROC
The Adequacy of Capital Depends on
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Regulatory Requirements
An Institution's risk Profile
Other Practical Consideration
Other Capital Allocation Techniques for RAROC
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6-19
Example: RAROC Pricing of Commrcial Loans for the Hard Rock Bank
Source
Component
Example
Funds Transfer Cost of Funds
Required Loan Loss Provision
5.00%
1.25%
Funds Transfer Pricing System
Credit Risk Model
Plus:
Direct Expense
Indirect Expense
Overhead
Total Charges before Capital Charge
0.80%
0.40%
0.50%
7.95%
Customer/Product Cost
Accounting System
Plus:
Capital Charge (RAROC)
*Assocated Equity/Asset = 12.00%
Total Required Loan Rate
3.00%*
10.95%
*RAROC: allocated equity/assets = 12%; opportunity cost of equity = 15%;
after-tax capital charge = 15% X 0.12 = 1,80%; marginal tax rate = 40%;
pre-tax capital charge = 1.80%/0.6 = 3.0%
Page 234
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6-20
A Practical Approach to Capital
Structure
Defining an Optimal (Minimum) Weighted Average
Cost of Capital
Dividend and Stock Repurchase Trends
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