Capital Management and Risk Mitigation in Financial Institutions

1. Chapter Fifteen The Management of Capital

2. Tasks Performed By Capital • Provides a Cushion Against Risk of Failure • Provides Funds to Help Institutions Get Started • Promotes Public Confidence • Provides Funds for Growth • Regulator of Growth • Role in Growth of Bank Mergers • Regulatory Tool to Limit Risk Exposure • Protects the Government’s Deposit Insurance System

3. Key Risks in Financial Institutions Management • Credit Risk • Liquidity Risk • Interest Rate Risk • Operational Risk • Exchange Risk • Crime Risk

4. Defenses Against Risk • Quality Management • Diversification • Geographic • Portfolio • Deposit Insurance • Owners’ Capital

5. Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes Types of Capital

6. Reasons for Capital Regulation • To Limit the Risk of Failures • To Preserve Public Confidence • To Limit Losses to the Federal Government Arising from Deposit Insurance Claims

7. The Basel Agreement on International Capital Standards An International Treaty Involving the U.S., Canada, Japan and the Nations of Western Europe to Impose Common Capital Requirements On All Banks Based in Those Countries

8. Tier 1 Capital • Common Stock and Surplus • Undivided Profits • Qualifying Noncumulative Preferred Stock • Minority Interests in the Equity Accounts of Consolidated Subsidiaries • Selected Identifiable Intangible Assets Less Goodwill and Other Intangible Assets

9. Tier 2 Capital • Allowance for Loan and Lease Losses • Subordinated Debt Capital Instruments • Mandatory Convertible Debt • Cumulative Perpetual Preferred Stock with Unpaid Dividends • Equity Notes • Other Long Term Capital Instruments that Combine Debt and Equity Features

10. Basel Agreement Capital Requirements • Ratio of Core Capital (Tier 1) to Risk Weighted Assets Must Be At Least 4 Percent • Ratio of Total Capital (Tier 1 and Tier 2) to Risk Weighted Assets Must Be At Least 8 Percent • The Amount of Tier 2 Capital Limited to 100 Percent of Tier 1 Capital

11. Calculating Risk-Weighted Assets • Compute Credit-Equivalent Amount of Each Off-Balance Sheet (OBS) Item • Find the Appropriate Risk-Weight Category for Each Balance Sheet and OBS Item • Multiply Each Balance Sheet and Credit-Equivalent OBS Item By the Correct Risk-Weight • Add to Find the Total Amount of Risk-Weighted Assets

12. What Was Left Out of the Original Basel Agreement • The Most Glaring Hole with the Original Basel Agreement is its Failure to Deal with Market Risk • In 1995 the Basel Committee Announced New Market Risk Capital Requirements for Their Banks • In the U.S. Banks Can Create Their Own In-House Models to Measure Their Market Risk Exposure • Regulators Would Then Determine the Amount of Capital Required Based Upon Their Estimate • Banks That Continuously Estimate Their Market Risk Poorly Would Be Required to Hold Extra Capital

13. Basel II • Aims to Correct the Weaknesses of Basle I • Three Pillars of Basel II: • Capital Requirements For Each Bank Are Based on Their Own Estimated Risk Exposure from Credit, Market and Operational Risks • Supervisory Review of Each Bank’s Risk Assessment Procedures and the Adequacy of Its Capital • Greater Disclosure of Each Bank’s True Financial Condition

14. Value at Risk (VAR) Models 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

15. Central Elements of VaR • An Estimate of the Maximum Loss in a Bank’s Portfolio Value at a Specified Level of Risk Over 10 Business Days • A Statement of the Confidence Level Management Attaches to its Estimate of the Probability of Loss • An Estimate of the Time Period Over Which the Assets in Question Could be Liquidated Should the Market Deteriorate • A Statement of the Historical Time Period Management Uses to Help Develop Forecasts of Market Value and Market Rates of Interest

16. Credit Risk Models • Parallel the Development of VaR Models • IF Adverse Situation Develops in the Future, What Magnitude of Losses Can Be Expected? • Model Generates Risk Estimates Based On • Borrower Credit Rating • Probability Credit Rating Will Change • Probable Amount of Recovery • The Possibility of Changing Interest Rate Spreads

17. Revised Framework for Basel II • New Framework Will Only Apply to About 20 of the Largest U.S. Banks • New Rules Will be Phased in Starting in 2008 • All Banks Will be Affected by Basel II Because of Competition • The Largest Banks May BE Able to Hold Less Capital Than is True form Smaller Banks

18. Capital Adequacy Categories Based on Prompt Corrective Action • Well Capitalized • Adequately Capitalized • Undercapitalized • Significantly Undercapitalized • Critically Undercapitalized

19. Internal Capital Growth Rate = ROE X Retention Ratio = Profit Margin X Asset Utilization X Equity Multiplier X Retention Ratio

20. Planning to Meet a Bank’s Capital Needs • Raising Capital Internally • Dividend Policy • Internal Capital Growth Rate • Raising Capital Externally • Issuing Common Stock • Issuing Preferred Stock • Issuing Subordinated Notes and Debentures • Selling Assets and Leasing Facilities • Swapping Stock for Debt Securities • Choosing the Best Alternative