Capital Adequacy

1
Capital Adequacy
2
Capital Adequacy

• G K Chp. 12
• Definition and Role of Bank Capital
• Capital Adequacy Construction and Standards
• Problems with Capital Adequacy

3
Definition and Role of Capital

• Definition
• Equity Capital Notes Loan Loss Reserves
• Role
• Source of start-up and growth funding
• Absorb losses during unexpected times
• Promote actual and perceived soundness
• Mitigate Moral hazard of Deposit Insurance

4
Capital Adequacy Construction

• Capital / Deposits
• Previews possibility of Bank Runs early 1900s
• Risk Classification
• Separate Assets only into 6 classes 1950s
• Separate Functions and assign subjective risk
  measures 1960s
• Problems
• Different stds across regulators, not legally
  binding until 1983, unfair to small banks that
  ended carrying more relative capital levels.

5
Capital Adequacy Construction

• Standard Federal Capital /Assets became 5-6 in
  1981.
• Large Banks that innovate in proprietary
  activities began to take varying levels of
  off-balance sheet risk
• BIS (Bank of International Settlements the
  International Fed) implemented, for 12 largest
  nations, risk based capital requirements in 4
  classes of assets in 1988

6
Capital Adequacy Construction

• Amendment to BIS in 1998 added securities trading
  to these risk classes.
• Two types of capital
• Tier 1 (Core) C/S, R/E, P/S, Minority Interests
• Less Goodwill and Intangibles
• Tier 2 (Supplementary) Allowances for LL, Capital
  Notes, Hybrid Capital
• Roughly 4 for Tier 1, 8 for Tier 1 2

7
Capital Adequacy Example

• Catagories risk are
• A1 Cash and U.S. Govts
• A2 MBSs,Agencies Muni GOs
• A3 Mortgages Muni ROs
• A4 All rmg. loans, and bank prem
• Risk-adjusted capital requirements for total
  capital
• K 80(A1) .20(A2) .50(A3) 1.0(A4)
• K 0.080(100) .2(2,500) .5(3,000) 1.0
  (5,000)
• 0.08 7,000 560.00

8
SBG Capital Adequacy

• FRB Capital Total Qualifying Capital
• Adequacy Ratio    Total Required Capital
• Total Qlfyg Cap Total Eq Cap Notes
• 50 of Balance Sheet Prov
  for Loan Loss

9
Total Required Capital
Sum Account Value Reqd Sum Account Value Reqd Sum Account Value Reqd Sum Account Value Reqd
Letters of Credit Loan Commitments 2.50 1.25 Medium 6.00
Cash Due 1.50 Real Estate 4.00
Fed Funds Sold 1.50 Consumer 8.00
T-Bills 1.00 Credit Card 8.00
U.S. Notes 1.50 Non-Accruing Loans 50.00
Munis 3.00 Net Premises 15.00
Syndicated Loans 4.00 Other Assets 8.00
Prime 4.00 Speculation Requirement 100.00
High 5.00 Interest Rate Risk 100.00
10
Two Points

• Speculative Requirement
• If 110 or more short of optimal short futures
  hedge or 10 or more long of same number of
  contracts 15 (cnts.15) will be designated
  Speculative Requirement and 100 of that held in
  reserve.
• Interest Rate Risk Capital
• 2 of shortest term gap with 100 held in
  reserve.

11
Problems using Capital Adequacy

• Differences in credit risk for most loans are not
  taken into account.
• Book values are used rather than market values
  for most of the assets in the risk-adjusted
  assets calculations.
• Regulatory requirements may change banks
  behavior in terms of allocation of loanable funds
  and investment decisions and possibly channel
  savings to less than the best uses.
• Some kinds of bank risk are excluded, including
  operating risk and legal risk.
• Portfolio diversification is not taken into
  account.

12
Deposit Insurance and Capital Adequacy

• FDIC scores deposits as to premiums to be
  levied on insurance
• Variable-rate deposit insurance (in cents per
  100 domestic deposits) implemented in 1994
• Risk Group CAMELS A1,2 B3 C 4,5
• Risk Group
• Capital Level A B C
• Well capitalized (10) 0 3 17
• Adequately capitalized (8) 3 10 24
• Undercapitalized (lt8) 10 24 27