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Fin 464 Chapter-15

The document discusses the management of a bank's equity capital position, covering types of bank capital, risks faced by banks, and strategies for raising capital. It outlines the importance of capital regulations to limit bank failures and preserve public confidence, as well as the Basel Agreements which set international capital requirements. The document emphasizes the need for banks to assess their capital needs based on various internal and external factors.

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Rumon Tahmid
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8 views17 pages

Fin 464 Chapter-15

The document discusses the management of a bank's equity capital position, covering types of bank capital, risks faced by banks, and strategies for raising capital. It outlines the importance of capital regulations to limit bank failures and preserve public confidence, as well as the Basel Agreements which set international capital requirements. The document emphasizes the need for banks to assess their capital needs based on various internal and external factors.

Uploaded by

Rumon Tahmid
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Chapter: 15

Management of a Bank’s
Equity capital Position

M. Morshed 1
Capital
 Thelong-term funds coming from
debt & equity that support a bank’s
long-term assets & absorb its
earnings losses.

M. Morshed 2
Bank Capital & Risk
 Credit or Default Risk.
 Liquidity Risk.
 Interest Rate Risk.
 Operating Risk.
 Exchange rate 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
1) Quality Management
2) Diversification
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)

3) Deposit Insurance
4) Owners’ Capital

M. Morshed 4
Types of Bank Capital
1. Common Stock
2. Preferred Stock
3. Surplus (excess of stock’s par value known as
premium)
4. Undivided Profits (retained earnings)
5. Equity Reserves (for contingencies purposes)
6. Subordinated Debentures/Debt
7. Minority Interest in consolidated subsidiaries.
8. 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)
 Raising Capital Externally
• 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?
 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.
 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. Management Quality
2. Asset liquidity.
3. Earnings history.
4. Quality of ownership
5. Occupancy of operating procedures.
6. Deposit volatility.
7. 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:
 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

 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
Pillar1 (minimum capital requirements);
Pillar 2 (supervisory oversight); and
Pillar 3 (market discipline and disclosures).
M. Morshed 14
Basel II…………Contd.

 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.

 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.
 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

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