What is capital?

Funds contributed by the owners of a financial institution

Form of the owners’ investment

• Purchases of stocks
• Retained earnings

The Many Tasks Capital Performs

1. Provide a cushion against the risk of failure
   • losses => capital decrease, undivided profit decrease
2. Provide funds to help institutions get started
3. Promote public confidence and reassure creditors and borrowers
4. Provide funds for growth
5. Regulator of growth
   • Asset & capital <=> keep ratio
6. Capital regulation--Regulatory tool to limit risk exposure
   • 监管部门 observe the capital to control risk

Capital and Risks

Key Risks in Banking and Financial Institutions’ Management

• Credit Risk
• Liquidity Risk
• Interest Rate Risk
• Operational Risk
• Exchange Risk
• Crime Risk
  • Fraud and embezzlement by employees or director

Defenses against Risks

• Quality Management—deal with problems before they overwhelm a financial firm
• Diversification
  • Geographic
  • Portfolio
• Deposit Insurance—promote and preserve public confidence
• Owners’ Capital—the last line of defense against failure

Types of Capital in Use

1. Common stock
2. Preferred stock
3. Surplus
4. Undivided profits
5. Equity reserves
6. Subordinated debentures ( convertible )
7. Minority interest in consolidated subsidiaries
8. Equity commitment notes
   偿债顺序：deposits creditor -> Subordinated debentures Investor -> preferred stock -> common stock

Reasons for Capital Regulation

1. To limit risk of failures
2. To preserve public confidence
3. To limit losses to the government and other institutions arising from deposit insurance claims

The Basel Agreement

An international agreement on new capital standards

• Designed to keep their capital positions strong
• Reduce inequalities in capital requirements among different countries
• Promote fair competition
• Catch up with recent changes in financial services and financial innovation.
  • In particular, the expansion of off-balance-sheet commitments
• Formally approved in July 1988

Basel I

The original Basel capital standards are known today as Basel I

Two tiers:

• Tier1(core)capital
• Tier 2 (supplemental) capital

Tier 1 (core) capital

• Common stock and surplus
• undivided profits (retained earnings)
• qualifying noncumulative perpetual preferred stock,
• minority interest in the equity accounts of consolidated subsidiaries
• selected identifiable intangible assets less goodwill and other intangible assets

Tier 2 (supplemental) capital

• Allowance (reserves) for loan and lease losses
• subordinated debt capital instruments
• mandatory convertible debt
• intermediate-term preferred stock
• cumulative perpetual preferred stock with unpaid dividends
• equity notes
• other long-term capital instruments that combine both debt and equity features

In order for a bank to qualify as adequately capitalized, it

must have:

1. A ratio of core capital (Tier 1) to total risk-weighted assets of at least 4%
2. A ratio of total capital (the sum of Tier 1 and Tier 2 capital) to total risk-weighted assets of at least 8%, with the amount of Tier 2 capital limited to 100% Tier 1 capital

Calculating Risk-Weighted Assets

• Each asset item on a bank’s balance sheet and each off- balance-sheet commitment it has made are multiplied by a risk-weighting factor
  • Designed to reflect its credit risk exposure
• The most closely watched off-balance-sheet items are standby letters of credit and long-term, legally binding credit commitments

CALC

1. Compute the credit-equivalent amount of each off-balance- sheet (OBS) item
2. Multiply each balance sheet item and the credit-equivalent amount of each OBS item by its risk weight (P385)
3. Calculating the Capital-to-Risk-Weighted Assets Ratio

Tier 1 =
Total =

Bank Capital Standards and Market Risk

• Basel I failed to account for market risk
  • The losses a bank may suffer due to adverse changes in interest rates, security prices, and currency and commodity prices
• The risk weights on bank assets were designed primarily to take account of credit risk (not market risk)
• In an effort to deal with these and other forms of market risk, in 1996 the Basel Committee approved a modification to the rules
  • Permitted the largest banks to conduct risk measurement and estimate the amount of capital necessary to cover mark

Value at Risk (VaR) Models Responding to Market Risk

A statistical framework for measuring a bank portfolio’s exposure to changes in market prices or market rates over a given time period, subject to a given probability

VaR measures the worst possible loss that a bank could expect to suffer over a given time interval, under normal market conditions, at a given confidence level.

Example

• A bank estimates its portfolio’s daily average value at risk is $100 billion over a 10-day interval with a 99 percent level of confidence
• If this VaR estimate of $100 billion is correct, losses in portfolio value greater than $100 billion should occur less than 1 percent of the time

Advantage:

• measure market risk in everyday, normal market conditions-- assumptions
• allow banks to measure statistically probable losses that their trading portfolios could incur over a certain period of time
• the maximum loss that a bank might experience to a given level of probability

Limitations and Challenges of VaR and Internal Modeling

• VaR estimates and internal modeling are not perfect
  • Inaccurate VaR estimates can expose a bank to excessive risk so that its capital position may turn out not to be large enough to cover actual losses the bank faces
  • The portfolios of the largest banks are so complex with thousands of risk factors it may be impossible to consistently forecast VaRs accurately
• Promote“backtesting”
• Even if an individual bank is a good forecaster, there may still be trouble due to systemic risk

Systemic Risk 系统风险

Market losses may occur at several banks simultaneously due to the interdependence of the financial system, magnifying each bank’s risk exposure and possibly presenting regulators with a major crisis

Planning to Meet Capital Needs

Raising Capital Internally: Dividend Policy

1. The board of directors and management must agree on the appropriate retention ratio and dividend payout ratio
2. Key factor - How fast the financial firm can allow its assets to grow so that its current ratio of capital to assets is protected from erosion

Internal capital growth, or retained earnings / Equity capital
= ROE * Retention ratio
= Net income / E.C. 
* Retained earnings / Net income

Dividend / Net income
+ retained earnings / Net income
= 1

ROE = Profit margin * Asset utilization * Equity multiplier 

Retained earnings / E.C.
= Net Income / Operating revenue
* Operating revenue / Total assets
* Total assets / Retained earnings  
* Retained earnings / Net income

Raising Capital Externally

1. Selling common stock
2. Selling preferred stock
3. Issuing debt capital
4. Selling assets
5. Leasing facilities
6. Swapping stock for debt securities

CALC => PDF Exercise P395 TABLE 13-2