Capital Management

1
Capital Management

• Outline
• Definition of bank capital
• Role of bank capital
• Capital adequacy
• Shareholders viewpoint
• Trends in bank capital

2
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

3
Definition of bank capital
4
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

5
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.

6
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.

7
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.

8
Capital adequacy
9
Capital adequacy
Calculating Risk-Adjusted Assets
10
Capital adequacy

• Risk-adjusted capital requirements for total
  capital
• K 80(A1) .20(A2) .50(A3) 1.0(A4)
• K 0.080(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 on- balance 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

11
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 7,000
• Remove GO munis trading account securities
  (1,500 x 0.20) (300)
• Value-at-risk (VAR) over the last 60 business
  days 200
• Risk-adjusted assets with market risk capital
  requirements 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.

12
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 days
  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.

13
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.

14
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 (PA 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
• Risk Group
• Capital Level A B C
• Well capitalized 0 3 17
• Adequately capitalized 3 10 24
• Undercapitalized 10 24 27

15
Shareholders viewpoint

• Financial risk and share valuation

16
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
D
Optimal Debt Level
17
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.

18
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.