1、Chapter FifteenThe Management of CapitalKey Topics The Many Tasks of Capital Capital and Risk Exposures Types of Capital In Use Capital as the Centerpiece of Regulation Basel I and Basel II Capital Regulation in the Wake of the Great Recession/Basel III Planning to Meet Capital NeedsIntroduction Wha
2、t is capital?Funds contributed by the owners of a financial institution Raising and retaining sufficient capital to protect the interests of customers,employees,owners,and the general public is tough Why is capital so important in financial-services management?It provides a cushion of protection aga
3、inst risk and promotes public confidence Capital has become the centerpiece of supervision and regulation todayThe Many Tasks Capital Performs1.Provides a cushion against the risk of failure2.Provides funds to help institutions get started 3.Promotes public confidence 4.Provides funds for growth5.Re
4、gulator of growth6.Regulatory tool to limit risk exposureCapital and Risks Key Risks in Banking and Financial Institutions Management Credit Risk Liquidity Risk Interest Rate Risk Operational Risk Exchange Risk Crime RiskCapital and Risks(continued)Defenses against Risks Quality Management Diversifi
5、cation Geographic Portfolio Deposit Insurance Owners Capital Types of Capital in Use1.Common stock2.Preferred stock 3.Surplus4.Undivided profits5.Equity reserves 6.Subordinated debentures7.Minority interest in consolidated subsidiaries8.Equity commitment notesTABLE 151 Capital Accounts of FDIC-Insur
6、ed U.S.Commercial Banks,December 31,2010 One of the Great Issues in the History of Banking:How Much Capital Is Really Needed?Regulatory Approach to Evaluating Capital Needs Reasons for Capital Regulation 1.To limit risk of failures2.To preserve public confidence3.To limit losses to the government an
7、d other institutions arising from deposit insurance claimsOne of the Great Issues in the History of Banking:How Much Capital Is Really Needed?(continued)Regulatory Approach to Evaluating Capital Needs Research Evidence Research has been conducted on the issue of whether the private marketplace or go
8、vernment regulatory agencies exert a bigger effect on bank risk taking Most studies find that the private marketplace is probably more important than government regulation in the long run Recently government regulation appears to have become nearly as important as the private marketplace Especially
9、in the wake of the great credit crisis of 2007-2009One of the Great Issues in the History of Banking:How Much Capital Is Really Needed?(continued)Regulatory Approach to Evaluating Capital Needs Research Evidence We are not at all sure market disciplining works as well for small and medium-size insur
10、ed depository institutions Some of the most pertinent information needed to assess a banks risk exposure is known only to government regulators Research has found that increased capital does not materially lower a banks failure riskThe Basel Agreement on International Capital Standards:A Continuing
11、Historic Contract Among Leading Nations The Basel Agreement An international agreement on new capital standards Designed to keep their capital positions strong Reduce inequalities in capital requirements among different countries Promote fair competition Catch up with recent changes in financial ser
12、vices and financial innovation In particular,the expansion of off-balance-sheet commitments Formally approved in July 1988 Included countries such as:The United States,Belgium,Canada,France,Germany,Italy,Japan,the Netherlands,Spain,Sweden,Switzerland,the United Kingdom,and LuxembourgThe Basel Agreem
13、ent on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Basel I The original Basel capital standards are known today as Basel I Various sources of capital were divided into two tiers:Tier 1(core)capital Common stock and surplus,undivided profits(retained
14、 earnings),qualifying noncumulative perpetual preferred stock,minority interest in the equity accounts of consolidated subsidiaries,and selected identifiable intangible assets less goodwill and other intangible assets Tier 2(supplemental)capital Allowance(reserves)for loan and lease losses,subordina
15、ted debt capital instruments,mandatory convertible debt,intermediate-term preferred stock,cumulative perpetual preferred stock with unpaid dividends,and equity notes and other long-term capital instruments that combine both debt and equity featuresThe Basel Agreement on International Capital Standar
16、ds:A Continuing Historic Contract Among Leading Nations(continued)Basel I In order for a bank to qualify as adequately capitalized,it must have:1.A ratio of core capital(Tier 1)to total risk-weighted assets of at least 4 percent2.A ratio of total capital(the sum of Tier 1 and Tier 2 capital)to total
17、 risk-weighted assets of at least 8 percent,with the amount of Tier 2 capital limited to 100 percent of Tier 1 capitalThe Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Calculating Risk-Weighted Assets Each asset item on a banks bala
18、nce sheet and each off-balance-sheet commitment it has made are multiplied by a risk-weighting factor Designed to reflect its credit risk exposure The most closely watched off-balance-sheet items are standby letters of credit and long-term,legally binding credit commitmentsThe Basel Agreement on Int
19、ernational Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Calculating Risk-Weighted Assets To compute this banks risk-weighted assets:1.Compute the credit-equivalent amount of each off-balance-sheet(OBS)itemThe Basel Agreement on International Capital Standards:A Co
20、ntinuing Historic Contract Among Leading Nations(continued)Calculating Risk-Weighted Assets To compute this banks risk-weighted assets:2.Multiply each balance sheet item and the credit-equivalent amount of each OBS item by its risk weightThe Basel Agreement on International Capital Standards:A Conti
21、nuing Historic Contract Among Leading Nations(continued)Calculating the Capital-to-Risk-Weighted Assets Ratio Under Basel I,once we know a banks total risk-weighted assets and its Tier 1 and Tier 2 capital amounts,we can determine its required capital adequacy ratiosThe Basel Agreement on Internatio
22、nal Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Capital Requirements Attached to Derivatives The Basel I capital standards were adjusted to take account of the risk exposure banks may face from derivatives Futures,options,swaps,interest rate cap and floor contrac
23、ts,and other instruments Sometimes expose a bank to counterparty risk The danger that a customer will fail to pay or to perform,forcing the bank to find a replacement contract with another party that may be less satisfactoryThe Basel Agreement on International Capital Standards:A Continuing Historic
24、 Contract Among Leading Nations(continued)Capital Requirements Attached to Derivatives(continued)Basel required a banker to divide each contracts risk exposure into two categories1.Potential market risk exposure2.Current market risk exposure Once the replacement cost of a contract is determined:The
25、estimated potential market risk exposure amount is added to the estimated current market risk exposure to derive the total credit-equivalent amount of each derivative contract This total is multiplied by the correct risk weight,to find the equivalent amount of risk-weighted assets represented by eac
26、h contractThe Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Capital Requirements Attached to Derivatives(continued)The Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued
27、)Capital Requirements Attached to Derivatives(continued)The Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Bank Capital Standards and Market Risk Basel I failed to account for market risk The losses a bank may suffer due to adverse c
28、hanges in interest rates,security prices,and currency and commodity prices The risk weights on bank assets were designed primarily to take account of credit risk(not market risk)In an effort to deal with these and other forms of market risk,in 1996 the Basel Committee approved a modification to the
29、rules Permitted the largest banks to conduct risk measurement and estimate the amount of capital necessary to cover market risk Led to a third capital ratio(Tier 3)The Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Value at Risk(VaR)
30、Models Responding to Market Risk A statistical framework for measuring a bank portfolios exposure to changes in market prices or market rates over a given time period,subject to a given probability VaR Example A bank estimates its portfolios daily average value at risk is$100 billion over a 10-day i
31、nterval with a 99 percent level of confidence If this VaR estimate of$100 billion is correct,losses in portfolio value greater than$100 billion should occur less than 1 percent of the timeThe Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(cont
32、inued)Limitations and Challenges of VaR and Internal Modeling VaR estimates and internal modeling are not perfect Inaccurate VaR estimates can expose a bank to excessive risk so that its capital position may turn out not to be large enough to cover actual losses the bank faces The portfolios of the
33、largest banks are so complex with thousands of risk factors it may be impossible to consistently forecast VaRs accurately Promote“backtesting”Even if an individual bank is a good forecaster,there may still be trouble due to systemic riskThe Basel Agreement on International Capital Standards:A Contin
34、uing Historic Contract Among Leading Nations(continued)Basel II Bankers found ways around many of Basel Is restrictions Capital arbitrage Instead of making banks less risky,parts of Basel I seemed to encourage banks to become more risky Basel I represented a“one size fits all”approach to capital reg
35、ulation It failed to recognize that no two banks are alike in terms of their risk profiles Basel II set up a system in which capital requirements would be more sensitive to risk and protect against more types of risk than Basel I Basel II would be gradually phased in for the largest international ba
36、nksThe Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Pillars of Basel II 1.Minimum capital requirements for each bank based on its own estimated risk exposure from credit,market,and operational risks2.Supervisory review of each bank
37、s risk-assessment procedures and the adequacy of its capital to ensure they are“reasonable”3.Greater public disclosure of each banks true financial condition so that market discipline could become a more powerful force compelling excessively risky banks to lower their risk exposureThe Basel Agreemen
38、t on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Basel II and Credit Risk Models Credit risk models Computer algorithms that attempt to measure a lenders exposure to default by its borrowing customers or to credit downgradings Most credit risk model
39、s develop estimates based upon:Borrower credit ratings The probability those credit ratings will change The probable amount of recovery should some loans default The possibility of changing interest-rate spreads between riskier and less risky loansThe Basel Agreement on International Capital Standar
40、ds:A Continuing Historic Contract Among Leading Nations(continued)Basel II and Credit Risk Models Under Basel I,minimum capital requirements remained the same for most types of loans regardless of credit rating Under Basel II,minimum capital requirements were designed to vary significantly with cred
41、it qualityThe Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)A Dual(Large-Bank,Small-Bank)Set of Rules Basel II was designed to operate under one set of capital rules for the handful of largest multinational banks and another set for
42、 more numerous smaller banking firms Regulators were concerned that smaller banks could be overwhelmed by:The heavy burdens of gathering risk-exposure information Performing complicated risk calculations Basel II anticipated that smaller institutions would be able to continue to use simpler approach
43、es in determining their capital requirements and risk exposures,paralleling Basel I rulesThe Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Problems Accompanying the Implementation of Basel II Basel II was not perfect Some forms of r
44、isk had no generally accepted measurement scale Operational Risk How do we add up the different forms of risk exposure in order to get an accurate picture of a banks total risk exposure?What should we do about the business cycle?Most banks are more likely to face risk exposure in the middle of an ec
45、onomic recession than they will in a period of economic expansion For example,the Global credit crisis of 2007-2009 Some have expressed concern about improving regulator competenceThe Basel Agreement on International Capital Standards:A Continuing Historic Contract Among Leading Nations(continued)Ba
46、sel III:Another Major Regulatory Step Underway,Born in Global Crisis Basel II was never fully implemented Had to move toward Basel III in order to prevent future crises Key issue in Basel III Determining the volume and mix of capital the worlds leading banks should maintain if their troubled assets
47、generate massive losses Capital requirements laid down in Basel I and II apparently were inadequate in the face of the latest credit crash Bankers found ways to hold both less capital in total and a weaker mix of kinds of capitalThe Basel Agreement on International Capital Standards:A Continuing His
48、toric Contract Among Leading Nations(continued)Basel III:Another Major Regulatory Step Underway,Born in Global Crisis Proponents of Basel III called for greater total capitalization,stronger definition of what belongs in banks capital accounts Volcker Rule was proposed in the U.S.Implementation of B
49、asel III could take many years Implementation would be phased in slowly,beginning in 2012 and possibly be completed close to 2019 Basel III covers the capital,liquidity,and debt positions of individual international banks and also broader issues associated with global business cycles and systemic ri
50、sksChanging Capital Standards Inside the United States Several new capital rules created recently by U.S.regulatory agencies were mandated by the FDIC Improvement Act of 1991 Requires federal regulators to take Prompt Corrective Action(PCA)when an insured depository institutions capital falls below
