Chapter 15 Management of a Banks Equity capital

Chapter: 15 Management of a Bank’s Equity capital Position M. Morshed 1

Capital n The long-term funds coming from debt & equity that support a bank’s long-term assets & absorb its earnings losses. M. Morshed 2

Bank Capital & Risk n n n Credit or Default Risk. Liquidity Risk. Interest Rate Risk. Operating Risk. Exchange Risk. Crime Risk (The danger that a bank will lose funds as a result of robbery or other crimes committed by its customers or employees) M. Morshed 3

Bank Defense Against Risk Quality Management 2) Diversification 1) i. Portfolio Diversification (spreading out a bank’s credit accounts & deposits among wide variety of customers) ii. Geographical Diversification (seeking out customers located in different communities or countries) Deposit Insurance 4) Owners’ Capital 3) M. Morshed 4

Types of Bank Capital 1. 2. 3. 4. 5. 6. 7. 8. Common Stock Preferred Stock Surplus (excess of stock’s par value known as premium) Undivided Profits (retained earnings) Equity Reserves (for contingencies purposes) Subordinated Debentures Minority Interest in consolidated subsidiaries. Equity Commitment Notes (debt securities repayable only from the sale of stock) M. Morshed 5

How Could Bank Raise Capital? Raising Capital Internally - Dividend Policy (Retention and dividend payout ratio) n Raising Capital Externally n • • • Selling Common Stock. Issuing Preferred Stock Issuing Subordinated Notes & Debentures Selling Assets & Leasing Facilities Swapping Stock for Debt Securities. M. Morshed 6

Measuring the Size of Bank capital 1) Book or GAAP Capital: Book or GAAP Capital = Book Value of bank Assets – Book Value of bank Liabilities. = Par value of Equity Capital + Surplus + Undivided Profits + Reserves for losses on loans & leases. 2) RAP Capital: Regulatory capital as spelled out by RAP (Regulatory Accounting Principles) RAP Capital = Stockholders’ Equity + Perpetual Preferred Stock + Bad-debt reserves for losses on loans & leases + Subordinated debentures + Minority Interest M. Morshed 7

Measuring the Size of Bank capital 3) Market-Value Capital: Market-Value Capital (MVC) = Market value of bank assets (MVA) – Market value of bank liabilities (MVL) = Current market price per share of stock outstanding X Number of equity shares issued & outstanding M. Morshed 8

How Much Capital Does a Bank Need? n Reasons for Capital Regulations: – To limit the risk of bank failure. – To preserve public confidence in banks. – To limit losses to the government arising form deposit insurance claims. n Research Evidence – Private market place is probably more important than government regulation in the long run in determining the amount & type of capitals bank holds. M. Morshed 9

How Much Capital Does a Bank Need? -----Contd A. The Judgment Approach: This requires viewing each bank within the context of its own market environment & looking at several different dimensions of internal & external conditions surrounding the bank. Assessment is based on following parameters: 1. 2. 3. 4. 5. 6. 7. Management Quality Asset liquidity. Earnings history. Quality of ownership Occupancy of operating procedures. Deposit volatility. Local market conditions. M. Morshed 10

How Much Capital Does a Bank Need? -----Contd B. The Imposition of Minimum Capital Requirements: As per International Lending & Supervision Act of 1983, Imposition of minimum capital requirements upon all banks & called for special reserves behind their foreign loans. The centerpiece of this minimum capital program was the concept of: 1. Primary Capital (common stock, perpetual preferred stock, surplus, undivided profits, capital reserves, mandatory convertible debt, loan & lease losses reserves & minority interest in consolidated subsidiaries less equity commitment notes & intangible assets. ) 2. Secondary Capital (limited preferred stock, subordinated notes & debentures, mandatory convertible debt instruments) M. Morshed 11

How Much Capital Does a Bank Need? -----Contd C. Basel Agreement I (1988): An international treaty involving the U. S. , Canada, Japan & the nations of Western Europe to impose common capital requirements on all banks in those countries. Under the terms of this agreement, sources of bank capital were divided into two tiers: n n Tier 1 Capital (core capital) includes common stock & surplus, undivided profits, qualifying noncummulative perpetual preferred stock, minority interest, selected identifiable intangible assets less goodwill & other intangible assets. Tier 2 Capital (supplemental capital) includes the allowance for loan & lease losses, subordinated debt capital instruments, mandatory convertible debt, intermediate term preferred stock, cumulative perpetual preferred stock, equity notes & other long term capital instruments. M. Morshed 12

How Much Capital Does a Bank Need? -----Contd n Basel Agreement requires a banker to divide each contract’s risk exposure to the bank into two categories: 1. Potential Market Risk Exposure: The danger of bank loss at some future time if the customer who entered into a market based contract with the bank fails to perform. 2. Current Market Risk Exposure: To measure the risk of loss to the bank should a customer default today on its contract, which would compel the bank to replace the failed contact with a new one. M. Morshed 13

How Much Capital Does a Bank Need? -----Contd D. Basel Agreement II (2004): The New Basel Capital Accord, often referred to as the Basel II Accord or simply Basel II, was approved by the Basel Committee on Banking Supervision of Bank for International Settlements in June 2004 and suggests that banks and supervisors implement it by beginning 2007, providing a transition time of 30 months. It is estimated that the Accord would be implemented in over 100 countries, including India. Basel II takes a three-pillar approach to regulatory capital measurement and capital standards – Pillar 1 (minimum capital requirements); Pillar 2 (supervisory oversight); and Pillar 3 (market discipline and disclosures). M. Morshed 14

Basel II…………Contd. n Pillar 1 spells out the capital requirement of a bank in relation to the credit risk in its portfolio, which is a significant change from the “one size fits all” approach of Basel I. Pillar 1 allows flexibility to banks and supervisors to choose from among the Standardized Approach, Internal Ratings Based Approach, and Securitization Framework methods to calculate the capital requirement for credit risk exposures. Besides, Pillar 1 sets out the allocation of capital for operational risk and market risk in the trading books of banks. M. Morshed 15

Basel II…………Contd. n Pillar 2 provides a tool to supervisors to keep checks on the adequacy of capitalization levels of banks and also distinguish among banks on the basis of their risk management systems and profile of capital. Pillar 2 allows discretion to supervisors to (a) link capital to the risk profile of a bank; (b) take appropriate remedial measures if required; and (c) ask banks to maintain capital at a level higher than the regulatory minimum. M. Morshed 16

Basel II…………Contd. n Pillar 3 provides a framework for the improvement of banks’ disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, and the like. The pillar also indicates the remedial measures that regulators can take to keep a check on erring banks and maintain the integrity of the banking system. Further, Pillar 3 allows banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts. M. Morshed 17