1、Capital AdequacySession 91Capital Adequacy4Why must the bank manager be concerned about managing the capital account?4Important(but most expensive)source of funding4Adequate capital necessary to maintain confidence in the bank4Regulatory constraints4Moral:Too little capital will incur the wrath of t
2、he regulator;too much capital will incur the wrath of the shareholder2The Cost of Capital4Why is equity the most expensive form of funding?4Common stock is the residual security-it is entitled to whatever is left after the more senior claimants have been satisfied.4Because the returns to the common
3、are not specified,they are the most volatile.4In finance,volatility equates to risk!4The higher the risk,the higher the expected return!3Capital Adequacy:Measuring Shareholder Returns4 Capital is the most expensive form of funding available to the bank.How do we measure the required return to the sh
4、areholder4Use the Gordon Growth Model of Stock ValuationIf P=Div1 r-gThen r=Div1 +g P 4 Use the CAPM Rstock=Rfree+Betastock(RMarket-Rfree)4Regulatory Capital AdequacyIn Canada4OSFI establishes minimum capital guidelines for banks in its publication“Guidelines for Banks”4Federally regulated Financial
5、 Institutions must pass two capital adequacy tests4Assets-to-capital multiple4Risk-based capital adequacy 5Regulatory Capital Adequacy:Assets-to-Capital Multiple4 Calculation:4Assets-to-capital multiple=Total Assets Capital4Where:Capital is Tier One plus Tier Two capital Total Assets all on-BS asset
6、s plus off-BS credit substitutes4 Must maintain an assets to capital multiple less than twenty4 Problems as a measure of capital adequacy:4Based on book values,not market values4Ignores the different credit,interest and market risks embedded in the total assets figure4Ignores off-Balance Sheet activ
7、ities which are not credit substitutes(i.e.most derivatives)64 Risk-Based Capital Adequacy=Capital_ Risk-weighted assets4 Where:Capital is both Tier One&Tier Two capitalBoth on-BS and off-BS assets are risk weighted4 Ratio must be greater than or equal to 8%4 Cannot directly compare this ratio to th
8、e assets-to-capital multiple because;4In the assets-to-capital multiple,all assets and credit-substitute off-BS assets are simply added together4In the risk-based capital adequacy framework,each exposure is multiplied by a weighting factor before being added Regulatory Capital Adequacy:Assets-to-Cap
9、ital Multiple7Regulatory Capital Adequacy:Tier One Capital4Tier One capital is comprised of:4Common shareholders equity4Common stock,contributed surplus&retained earnings4Noncumulative preferred shares4Minority interest in subsidiaries arising from consolidation(Tier one capital portion)4Less Goodwi
10、ll8Regulatory Capital Adequacy:Tier Two(A)Capital4 Tier Two(A)capital comprised of instruments with the following characteristics:4Unsecured,subordinated to deposits and senior debt and fully paid up4Not redeemable at the option of the holder4Redeemable only after five years(at the option of the FI)
11、and with OSFIs permission4Available to participate in losses(dividend default gives no additional rights)4Allows dividends to be deferred4Example:cumulative,convertible,callable preferred shares9Regulatory Capital Adequacy:Tier Two(B)Capital4Limited life(Tier 2B)capital instruments have the followin
12、g characteristics:4Subordinate to deposits and senior debt4Initial minimum term greater than ten years4Redemption in the first five years only at the option of the FI and with OSFIs permission4Example:10 year subordinate notes104All of the following must be true:4Tier 1 capital+Tier 2 capital 8%of r
13、isk-adjusted assets4Tier 2 capital Tier 1 capital4Tier 2B capital 50%of Tier 1 capital11Regulatory Capital Adequacy:Risk Weighting of Assets4 On Balance Sheet ItemRisk Weight1.Cash&deposits with CB0%2.Deposits with other banks20%3.Securities issued by/guaranteed by an OECD govnt0%4.Other securities1
14、00%5.Loans issued by/guaranteed by an OECD govnt0%6.Residential mortgages50%7.Other loans100%8.Customer liability under Acceptances100%9.Other assets100%12Regulatory Capital Adequacy:Off-Balance Sheet Credit Substitutes4 Credit InstrumentsCredit ConversionRiskFactorWeight1.Guarantees&SBLCs a)Financi
15、al100%100%b)Non-financial50%100%2.Securities lending100%100%3.Documentary&commercial L/Cs20%100%4.Commitments to extend credit a)Term less then 1 year0%0%b)Term more than 1 year50%100%5.Note issuance/Revolving under-writing facility50%100%13Regulatory Capital Adequacy:Off-Balance Sheet Items-Derivat
16、ives4First partition into exchange traded and OTC derivatives.No counterparty risk to exchange traded derivatives.4OTC derivatives4First multiply the notional amount by a conversion factor to create a credit equivalent amount4Then multiply the credit equivalent amount by the appropriate risk weights
17、14Regulatory Capital Adequacy:Off-Balance Sheet Items-DerivativesDerivative SecurityRisk WeightInterest Rate Contracts:a)Forward Rate Agreements20%b)Futures contracts0%c)Swap contracts20%d)Options purchased20%e)Options written0%Foreign Exchange contracts:a)Sport&forward contracts20%b)Futures contrac
18、ts0%c)Swap contracts20%d)Options purchased20%e)Options written0%15Regulatory Capital Adequacy:Problems with the BIS Rules4 Differential treatment between OECD&non-OECD borrowers4 100%risk weighting applied to all loans(even if the borrower has a higher risk rating than a bank,which attracts only a 2
19、0%risk weighting4 Inter-country differences in the calculation of Tier 2 capital4Japanese banks allowed to include a portion of unrealized capital gains on real estate and securities4UK banks allowed to include a portion of the unrealized gain on real estate assets 16Regulatory Capital Adequacy:Problems with the BIS Rules4Does not include various forms of market risk:4foreign exchange risk4interest rate risk4position risk in traded-equity securities4Does not capture large exposures to a single borrower(which perhaps should have more than a 100%risk weighting)17
