INTRODUCTION  The countries that members of Organization for WHAT IS THE FUNCTION OF BANK CAPITAL?

 Capital plays a significant role in the risk- Economic Cooperation and Development  It provides a cushion that allows firms to absorb
return trade-off at banks. (OECD) attempt to enforce similar risk-based losses and remain solvent.
 Increase the capital reduces risk by requirements on their home country FIs.  The role of capital as a buffer against loan
cushioning the volatility of earnings,  Based on BASEL agreement and OECD the losses. In the case of defaults, banks operating
restricting growth opportunities, and capital must contain several elements: cash inflows will be immediately affected
lowering the probability of bank failure.  Banks minimum capital requirement is because the banks do not receive any interest
 It also reduces expected return to linked by formula to its credit risk as and principal payments.
shareholders as equity is more expensive determine by the composition of assets. (^  The bank remains operationally solvent as long
than debt. risk ^ capital required) as the cash inflows is more than cash outflows.
 Decrease capital increases risk by  Stockholders equity is deemed the most  Capital serves as buffer because banks may
increase the financial leverage and the critical type of capital. As such each bank is defer the dividends on preferred and common
probability of failure. expected to operate with minimum amount stocks.
 The fundamental decision regarding of equity based on the amount of credit risk.  Thus the greater a bank’s equity capital, the
capital thus focuses on how much capital  The minimum total capital requirement greater magnitude of asset that can default
is optimal. increased to 8% of risk-adjusted assets. before the firm is technically insolvent and the
 The capital requirements were lower the bank risk.
approximately standardized between
WHAT CONSTITUTES BANK CAPITAL
countries to “level the playing field” that is
 Prior to the mid-1980’s, bank capital
to remove competitive advantages that
requirements were generally established CHAPTER 15
banks in 1 country might have over banks in
without regard to bank’s asset quality,
other countries because of regulatory CAPITAL MANAGEMENT
liquidity risk, interest rate risk, operational
differences.
risk, and related risks.
 In banking, the regulators include certain forms
 Thus when banks fell pressure to increase
of debt and loan loss reserves when measuring
earnings, capital requirements imposed no
capital adequacy.  Bank capital provides ready access to financial markets.
constraints to risk taking other than  Adequate bank capital minimizes operating problems
 Common item include are:
limiting growth. by providing ready access to the financial markets. As
 Common stock
 The regulators dis force the banks to have long as the bank’s capital exceeds the regulatory
 Surplus
more capital than the minimums when minimums, it can stay open and has the potential to
 Retained earnings
they perceived bank risk to be excessive, generate earnings to cover losses and expand.
 Capital reserves for contingencies
but this determination often occurred long
 Net unrealized holding gain / loss on  When depositors withdraw their funds, a bank must
after mgt made risky investment decision. either liquidate assets from its portfolio or replace the
available-for-sale securities
 In 1986, bank regulators proposed that  Preferred stock deposit outflows with new borrowings.
commercial banks be required to maintain  Book value equity  This will have forced bank to sell assets and it can only
minimum amounts of capital that reflect be accomplished through lowering asset prices.
 Subordinated debt
the riskiness of their assets.  Capital serves as a guarantees to the federal.
 Capital constrains growth and reduces WHAT IS THE IMPACT REGULATORY CAPITAL  Pricing policies
risk. REQUIREMENTS ON BANK OPERATING POLICIES?  Advantages of RBC requirements is it
 By limiting the amount of new assets  Limiting asset growth recognizes that some investments are riskier
that a bank can acquire through debt  Minimum capital requirements restrict a than others.
financing, capital constrain growth. bank’s ability to grow.  The riskier investments require the greatest
 Regulator impose equity capital  Additions to asset mandate additions to equity capital support.
requirements as a fraction of capital for a bank to continue to meet  As regards to that, the banks are forced to
aggregate bank assets. minimum capital-to-asset ratios imposed by reprice assets to reflect these mandatory
 If a bank chooses to expand loans or regulators. equity allocations.
acquire other assets, they must  Each bank must limit its asset growth to  For example, bank has to hold capital in
support the growth with additional some percentage of retained earnings plus support of a loan commitment, so it should
equity financing. This is because, new new external capital. raise the fee it charges to compensate for the
equity is expensive, expected asset greater cost of providing the services.
returns must be high to justify the  Shrinking the bank
financing.  Historically, banks tried to circumvent capital
 Rigid capital requirements reduce the CHAPTER 15 requirements by moving assets off the books.
likelihood that banks will expand  Interest rate and product deregulation
CONTINUED
beyond their ability to manage their encouraged banks to transfer risks off the
assets successfully and thus serve to balance sheet by creating contingent liabilities
reduce risk. that produce fee income but do not show up
as assets in financial reports.
HOW MUCH CAPITAL IS ADEQUATE?  Changing the capital mix  Off-balance sheet activity increases risk, the
 The regulators primarily concern with the  Bank that choose to grow faster than the rate greater are its capital requirements.
safety of banks, the viability of funds, and the allowed with internally generated capital alone  Alternatively, banks can meet the new
stability of financial markets, prefer more must raise additional capital externally. standards by shrinking in size.
capital.  Large banks can obtain capital nationally  The problem is that, a shrinking bank has
 However, bankers prefer to operate with less through public offerings of securities. difficulty generating earnings growth and
capital because the smaller equity base, the  Small banks only issue capital securities to paying shareholders a reasonable risk-
greater financial leverage and equity limited number of investors, such as existing adjusted return.
multiplier. shareholders, bank customers, upstream
 ^ leverage converts a normal ROA into ^ ROE. correspondent banks.
 The regulatory agencies periodically assess  Changing asset composition
specific banks risk through on-site  Banks may respond to the RBC requirements
examination. by changing their asset composition.
 FDIC rates bank according to Financial  When RBC declines, potential profitability also
Institutions Rating System which will be declines.
encompasses six general categories of
performance (CAMELS).