CHAPTER Equity Capital

CHAPTER
CHAPTER FOURTEEN
FOURTEEN
The
The Management
Management Of
Of Capital
Capital
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
• Regulatory Tool to Limit Risk Exposure
• Protects the Government’s Deposit Insurance
System
Key Risks in Financial
Institutions Management
• Credit Risk
• Liquidity Risk
• Interest Rate Risk
• Operating Risk
• Exchange Risk
• Crime Risk
Defenses Against Risk
• Quality Management: Ability of top notch
managers to move swiftly to deal with a a bank’s
problems before they overwhelm the institution.
• Diversification
– Geographic
– Portfolio
• Deposit Insurance
• Owners’ Capital
Types of Capital
• Common Stock • Subordinated
Debentures
• Preferred Stock
• Minority Interest in
• Surplus Consolidated
Subsidiaries
• Undivided Profits
• Equity Commitment
• Equity Reserves Notes
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
The Basle 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
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
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
Basle 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
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
Capital Requirements Attached
to Derivatives
• In determining the credit equivalent
amount of these off balance sheet
contracts, Basle 1 required a banker to
divide each contract’s risk exposure into
two categories.
– Potential Market Risk Exposure
– Current Market Risk Exposure
• Potential Market Risk: refers to the
danger of loss at some future time if
the customer who entered into a
market based contract with the bank
fails to perform.
• Current Market Risk: measures the

risk of loss to the bank should a
customer default today on its
contract.
Derivat Face Conversi Potential Current Credit
ives amount of on factor market market Equivalen
Contract for risk risk t amount
potential exposure exposure
market
risk
5 year $ 100000 0.005 $ 500 $ 2500 $3000
Interes
t rate
swap
contrac
t
3 year $50,000 0.05 $2500 $1500 $4000
Curren
cy swap
contrac
t
Limitations of Basle I
• One of the most glaring holes in the
original Basle Agreement is its failure to
deal with market risk.
• Market Risk: the losses a bank may

suffer due to adverse changes in
interest rates, security prices, currency
& commodity prices.
Value at Risk (VAR)
Models
• The revised Basle I rules allowed
the banks to use their own
preferred method to determine the
maximum loss they might sustain
over a designated period of time
known as Value at Risk (VAR) model.
Elements of VAR Model
• An estimate of the maximum amount of
loss in the bank’s asset value that can
occur at a specified level of risk.
• An estimate of the time period
• The confidence level

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

CHAPTER Equity Capital

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CHAPTER

• To Limit the Risk of Failures

• Ratio of Core Capital (Tier 1) to Risk

• Current Market Risk: measures the

• Market Risk: the losses a bank may

• An estimate of the time period

• The confidence level

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