1. Chapter Fifteen
The Management of Capital

2. 15-2
Key Topics
• The Many Tasks of Capital
• Capital and Risk Exposures
• Types of Capital In Use
• Capital as the Centerpiece of Regulation
• Basel I and Basel II
• Planning to Meet Capital Needs

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

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

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

6. Types of Capital
• Common Stock • Subordinated
• Preferred Stock Debentures
• Minority Interest
• Surplus (largest in Consolidated
capital component) Subsidiaries
• Undivided Profits • Equity
• Equity Reserves Commitment
Notes

7. 15-7
Relative Importance of Different Sources of
Capital

8. Reasons for Capital Regulation
The underlying assumption is that the
private marketplace does not correctly
price the impact of systemic failures. Thus,
the purpose of capital regulation is:
• To limit the risk of failures
• To preserve public confidence
• To limit losses to the federal government
arising from deposit insurance claims

9. 15-9
Quick Quiz
• What forms of capital are in use today?
What are the key differences between the
different types of capital?
• What are the most important and least
important forms of capital held by U.S.-
insured banks?
• How do small banks differ from large
banks in the composition of their capital
accounts and in the total volume of capital
they hold relative to their assets?

10. 15-10
Quick Quiz
• What is the rationale for having the
government set capital standards for
financial institutions as opposed to letting
the private marketplace set those
standards?

11. 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

12. 15-12
The Basel Agreement
• Historically, the minimum capital requirements
for banks were independent of the riskiness of the
bank
▫ Prior to 1990, banks were required to maintain:
 a primary capital-to-asset ratio of at least 5% to 6%, and
 a minimum total capital-to-asset ratio of 6%
• The Basel Agreement of 1988 includes risk-based
capital standards for banks in 13 industrialized
nations; designed to:
▫ Encourage banks to keep their capital positions strong
▫ Reduce inequalities in capital requirements between
countries
▫ Promote fair competition
▫ Account for financial innovations (OBS, etc.)

13. 15-13
The Basel Agreement
• A Bank’s Minimum Capital Requirement is
Linked to its Credit Risk
▫ The greater the credit risk, the greater the required
capital
• Stockholders' equity is deemed to be the most
valuable type of capital
• Minimum capital requirement increased to 8%
total capital to risk-adjusted assets
• Capital requirements were approximately
standardized between countries to ‘level the
playing field‘
• Capital is divided into Two Tiers

14. 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

15. 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

16. 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

17. Basel Agreement Capital Requirements

18. 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

19. Total Regulatory Capital
Calculations

20. 15-20

21. 15-21

22. Problem 15-3
Under the terms of the Basel Agreement, what
risk weights apply to the following on balance
sheet and off balance sheet items?

23. Problem 15-3
Residential real estate loans Credi t card loans
Cash Standby letters of credit for municipal
Commercial loans bonds
U.S. Treasury securities Long-term unused commitments to
Deposits held at other banks make corporate loans
GNMA mortgage-backed Currency derivative contracts
securities Interest-rate derivative contracts
Standby credit letters for Short-term (under one year) loan
commercial paper commitments
Federal agency securities Bank real property
Munici pal general obligation bonds Bankers’ acceptances
Investments in subsidiaries Municipal revenue bonds
FNMA or FHLMC issued Reserves on deposit at the Federal
or guaranteed securi ties Reserve banks

24. Problem 15-3
The items which would appear in the 0%, 20%, 50% and 100% risk weight
categories are the following:
0% 20 % 50 % 100 %
Cash Deposits held at Other Residential Real Commercial Loans
Domestic Banks Estate Loans
Treasury Securities Federal Agency Long Term Standby Credit Letters
Securities Commitments to Make for Commercial Paper
Corporate Loans
GNMA Mortgage Municipal General Currency Derivative Investments in
Backed Securities Obligation Bonds Contracts Subsidiaries
Short Term Loan FNMA or FHLMC Interest Rate Credit Card Loans
Commitments Issued or Guaranteed Derivative Contracts
Securities
Reserves on Deposit at Standby Letters of Municipal Revenue Bank Real Estate
the Federal Reserve Credit for Municipal Bonds
Bonds
Bankers’ Acceptances

25. Problem 15-4
• Using the following information for Bright
Star National Bank, calculate that bank’s
ratio of Tier I capital-to-risk-weighted
assets under the terms of the Basel I
agreement. Does the bank have sufficient
capital?

26. Problem 15-4 (continued)
On Balance Sheet Items (Assets) Off Balance Sheet Items
Cash $ 4.5 million Standby letters of $ 17.5 million
credit backing
municipals and
corporate borrowing
U.S Treasury 25.6 Long term binding 30.5
commitments to
securities corporate customers
Deposit balances due 4.0 Total of all off balance $ 48 million
from other banks sheet items
Loans secured by first 50.8 Tier I capital $ 7.5 million
lines on residential
property (1-4 family
dwellings)
Loans to corporations
105.3 Tier 2 capital $ 5.8 million
Total assets $190.2 million

27. Problem 15-4 (continued)
Bright Star National Bank's required level of capital under the international
capital standards would be determined from:
Standby Credit Letter: $17.5 million * 1.00 = $17.5 million
Long-Term Credit Commitments: $30.5 million * 0.50 = 15.25 million
0% Risk-Weighting Category
Cash $ 4.5 million
U.S. Treasury Securities 25.6 million
$ 29.1 * 0 = $0 million
20% Risk Weighting Category
Balances Due from Other Banks $ 4.0 million
Credit Equivalent Amounts of
Standby Credits 17.5 million
$ 21.5 million * 0.20 = $4.3 mil

28. Problem 15-4 (continued)
50% Risk Weighting Category
Residential Real Estate Loans $ 50.8 million x 0.50 = $25.4 million
100% Risk Weighting Category
Loans to Corporations $105.3 million
Credit Equivalents of
Long-Term Commitments $15.25 million
$120.55 million * 1.0 = $120.55 million
Total Risk-Weighted Assets $150.25 mil
The bank's capital ratio is:
Tier I Capital /Risk-Weighted Assets = $ 7.5 million = 4.99%
$ 150.25 million
Total Capital/Risk-Weighted Asset = $ 13.3 million = 8.85%
$ 150.25 million
which is just above the minimum Tier I capital requirement of 4 percent and total
capital (Tier One + Tier Two) requirement of 8 percent.

29. 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, VaR
• 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

30. 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

31. 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

32. Basel II
• Aims to correct the weaknesses of Basel 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

33. 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

34. 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 from smaller banks

35. Capital Adequacy Categories Based
on Prompt Corrective Action (PCA)
• Well capitalized
• Adequately capitalized
• Undercapitalized
• Significantly undercapitalized
• Critically undercapitalized

36. Capital Adequacy Categories Based
on Prompt Corrective Action (PCA)
Leverage
Capital/risk weighted assets Tier 1/risk-weighted assets Tier 1 / avg total assets
Well Capitalized > 10% > 6% > 5%
Adequately Capitalized > 8% > 4% > 4%
Undercapitalized fails to meet one or more of the above
Significantly Undercapitalized < 6% < 3% < 3%
Tangible Equity Capital / total
assets
Critically Undercapitalized < 2%

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

38. 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

39. 15-39
Quick Quiz
• What are the most popular financial ratios
regulators use to assess the adequacy of
bank capital today?

40. 15-40
Quick Quiz
First National Bank reports the following items on
its balance sheet: cash, $200m; U.S. government
securities, $150m; residential real estate loans,
$300m; and corporate loans, $350m.
Its off-balance sheet items include standby credit
letters, $20m, and long-term credit commitments
to corporations, $160m.
• What are First Nation’s total risk-weighted assets?
• If the bank reports Tier 1 capital of $30m and Tier
2 capital of $20m, does it have a capital
deficiency?

41. 15-41
Quick Quiz
Off-Balance-Sheet Items – convert to equivalent on-balance sheet items:
Standby credit letters $20 mill. * 1.00 = $20 mill.
Long-term commitments to corporations $160 mill. * 0.50 = 80 mill.
Then we risk-weight all assets:
Risk-Weighted Assets
Cash $200 mill. * 0 = $0 mill.
U.S. Government Securities: $150 mill. * 0 = 0
Standby Credit Letters: $20 mill. * 0.20 = 4
Residential Real Estate Loans: $300 * 0.50 =150
Corporate Loans: $350 * 1.00 =350
Long-Term Credit Commitments: $80 * 1.00 = 80
Total Risk-Weighted Assets = $584mill
The bank has total capital of:
Tier 1 capital = $30 mill.
Tier 2 capital = $20 mill.
$50 mill.
The bank's capital to risk-weighted asset ratio is:
$50 mill./$584 mill.= 0.086 or 8.6%
which exceeds the minimum requirement of 8 percent. Moreover, more than 4 percent of the 8.6 percent in
capital is Tier 1 capital, so the bank satisfies the capital requirements.

42. 15-42
Summary
• Many tasks capital performs
• Types of capital in use
Common stock Equity reserves
Preferred stock Subordinated debentures
Surplus Minority interest in consolidated subsidiaries
Undivided profits Equity commitment notes
• Basel I
– Tier I and Tier II capital
– Capital-to-Risk-Weighted Assets Ratio
• Value at Risk (VaR) Models
• Basel II
– Internal risk assessment
– Dual (large-bank, small-bank) set of rules

43. Problem 15-5
Calculate New River National Bank’s total risk weighted assets,
based on the following items that the bank reported on its latest balance
sheet. Does the bank appear to have a capital deficiency?
On balance sheet items include:
Cash $115 million
Domestic interbank deposi ts 130 million
U.S. government securities 250 million
Residential real estate loans 450 million
Commercial loans 520 million
Total assets $1,465 million
Total liabilities $1,350 million
Total capi tal $115 million

44. Problem 15-5
Off balance sheet items include:
Standby credi t letters that back munici pal
general obligation bonds $ 87 million
Long-term unused loan commitments to
private companies 145 million
The risk-weighted assets of New River National Bank would be calculated
as follows:
Off-Balance-Sheet Items:
Standby Credit Letters = $87 mill. * 1.00 = $87 mill.
Long-Term Corporate Credit Commitments = $145 mill. * 0.50 = 72.5 mill.

45. Problem 15-5 (continued)
On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items:
Asset Items Risk-Weight
Cash $115 miIl. * 0 = 0
U.S. Government Securities $250 mill. * 0 = 0
Domestic Interbank Deposits $130 mill. * 0.20 = 26.0 mill.
Standby Credit Letters $87 mill. * 0.20 = 17.4 mill.
Residential Real Estate Loans $450 mill. * 0.50 = 225.0 mill.
Commercial Loans $520 mill. * 1.00 = 520.0 mill.
Long-Term Corporate Credit
Commitments $72.5 mill. * 1.00 = 72.5 mill.
Total Risk-Weighted Assets = $860.9 mill.

46. Problem 15-5 (continued)
New River's overall capital-to-assets ratio is:
Total Capital = $115 million = 0.1336 or 13.36 percent
Total Risk-Weighted Assets $860.9 million
Overall, it does not appear from the information given above that
New River has a capital deficiency.

47. Problem 15-7
Colburn Savings Association has forecast the following
performance ratios for the year ahead. How fast can Colburn
allow its assets to grow without reducing its ratio of equity
capital to total assets, assuming its performance holds
reasonably steady over it planning period?
Profit Margin of Net Income
Over Operating Revenue 17.75%
Asset Utilization 8.25%
Equity Multiplier 9.5x
Net Earnings Retention Ratio 45.00%

48. Problem 15-7 (continued)
Internal Capital Growth Rate
= Profit Margin Asset Utilization
Equity Multiplier Retention Ratio
= 0.1775 0.0825 9.5 0.450
= 0.0626 or 6.26%
Its assets cannot grow any faster than 6.26 percent
in order to avoid reducing its ratio of equity capital to
total assets.