Outline April 13

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Outline April 13

• Credit Risk
• Exam
• Capital adequacy

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Capital AssetComparisons to Other Industries
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Maintenance of Capital

• Rationale
• cushion for loan losses or other problems
• funds for internal needs and expansion
• added security
• depositors
• deposit insurance system
• Fed. Deposit Insurance Corp. Improvement Act. of
  1991
• prompt corrective action
• timely and nondiscretionary mechanism for
  regulators
• more severe as as banks capital declines

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Role of Capital
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Prompt Corrective Action

• Each bank is assigned category
• 1. well-capitalized
• 2. adequately capitalized
• 3. undercapitalized
• 4. significantly undercapitalized
• 5. critically undercapitalized
• Top 2 do not pose supervisory problem
• Others face mandatory enforcement steps

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What is capital of bank?
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Definitions of Capital Categories

• Three basic ratios
• total capital to risk-weighted assets
• tier 1 capital to risk-weighted assets
• tier 1 capital to total average assets
• Tier 1 (core capital)
• stock holders equity
• noncumulative perpetual preferred stock
• minority interests in equity accounts of
  consolidated subsidiaries
• Less goodwill and some intangible assets

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Definitions of Capital Categories

• Tier 2 capital (main items)
• allowance for loan and lease loss (up to 1.25 of
  risk weighted assets)
• cumulative perpetual or long-term preferred stock
• mandatory convertible debt securities and other
  capital instruments
• subordinated debt
• last 2 items can not be more than 50 of tier 1
  capital
• Total of Tier 2 is limited to 100 of Tier 1.

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Definitions of Capital Categories

• Total capital (Tier 1 Tier 2 capital
• Capital compared to risk-weighted assets

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Risk Weighted Assets

• See link

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Requirements of regulators

• See link

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Problems with this approach

• Market values vs. book value
• Interest rate risk
• Risk weights appropriate?
• Differences in credit risk among loans in 100
  category
• Ignores portfolio diversification
• Reduce banks incentives to loan
• Competition with other institutions
• Incentives for balance sheet games

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Sample problem
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Growth and Capital

• Internal capital generation rate (ICGR)

Desired
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Example
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Capital Requirements of Other FI

• Securities firms (brokers and dealers)Net
  worth/Assets gt 2

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Life Insurance

• Life Insurance companies
• C1 Asset risk
• see chart
• C2 Insurance risk
• C3 Interest rate risk--classify liabilities
  into
• Low risk (0.5 capital)
• Medium risk (1 capital)
• High risk (2 capital)
• C4 Business risk
• Required risk based capital

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Property Casualty

• Risk
• R0 Asset risk for investments in p/c affiliates
• R1 Asset risk for fixed income investments
• R2 Asset risk for equity (stocks) and real
  estate
• R3 Credit Risk for reinsurance recoverables
• R4 Underwriting risk for loss and loss
  adjustment
• R5 Underwriting risk for written premiums

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Examples