Bank Fund Management

Chapter
The Management of Capital

1 Md. Taslim Uddin Yousuf, PhD

American International University
Bangladesh

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 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, Basel II and Basel III

 Planning to Meet Capital Needs

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 3
What is Capital?
 Capital represents the contribution of the owners ( shareholders) of a
financial institutions), consisting mainly stocks, reserves and those
earnings that are ratained in the bank.

 In every level from the inception to liquidation, a bank requires

capital of different extent.

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 4 Types of Capital
Primary capital Secondary capital
1. Common Stock 1. Subordinated Debentures
2. Perpetual Preferred Stock 2. Minority Interest in
3. Capital Surplus (Share Consolidated Subsidiaries
premium) 3. Equity Commitment
4. Undistributed Profits Notes
5. Equity Reserves (mandatory convertible
6. Mandatory convertible instrument not eligible for
bonds primary capital)
Sum of the above mentioned elements of primary and seceondary capital must
be 8% of the weighted risky assets. Secondary capital can never be more than
50% of total capital.
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 5 Tasks Performed By Capital
 Provides a Cushion Against Risk of Failure
 Provides Funds to Help Institutions Get Started
 Promotes Public Confidence (credit crisis 2007-2009 showed
importance)
 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

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 6 Key Risks in Financial Institutions Management
• Credit Risk
▫ Probability of default on any promised payments of interest or principal or both
▫ Owner’s capital is usually less than 10 percent of the volume of loans and risky securities.
▫ Too many default, erode capital and may financially fail (bankrupted).
• Liquidity Risk
▫ Probability of being unable to raise cash when needed at reasonable cost
• Interest Rate Risk
▫ Probability that changes in interest rates will adversely affect the value of net worth
• Operational Risk
▫ Probability of adverse affect of earnings due to failures in computer systems, management errors, etc.
• Exchange Risk
▫ Probability of loss due to fluctuating currency prices
• Crime Risk
▫ Due to embezzlement, robbery, fraud, identity theft
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 7 Defenses Against Risk
• Quality Management
• Diversification
▫ Geographic
▫ Portfolio
• Deposit Insurance ("Bank Amanat Bima Ain” 2000, ceiling
amount max BDT 100 thousand)
• Owners’ Capital

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 8
Relative Importance of Different Sources of
Capital

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 9 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

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 10
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

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 11 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 12 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.)
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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
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Tier 1 Capital (Core 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

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 14
Tier 2 Capital (Supplement 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

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 15 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

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 16
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
• See BHC’s Call report and RBC calculations:
https://cdr.ffiec.gov/public/ManageFacsimiles.aspx

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 Total Regulatory Capital Calculations
17

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 20 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, Especially Problematic During the 2007-
2009 Global Credit Crisis
❑ 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, to Determine the Maximum Amount
a Bank Might Lose Over a Specific Time Period
❑ 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
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 21
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.

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 22 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
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 23
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

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 24
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

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 25 Revised Framework for Basel II

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 26 Capital Adequacy Categories Based
on Prompt Corrective Action (PCA)

 Well Capitalized
 Adequately Capitalized
 Undercapitalized
 Significantly Undercapitalized
 Critically Undercapitalized

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 27 Internal Capital Growth Rate

= ROE X Retention Ratio

= Profit Margin X Asset Utilization

X Equity Multiplier X Retention
Ratio

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 28 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
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