Solution manual bank management and financial services 9th edition by rose, peter chap015

The prime capital-adequacy ratios, under Basel I, which the regulators use to assess are, Tier 1 risk-based capital ratio, which is equals core capital to risk-weighted assets, and total

CHAPTER 15 THE MANAGEMENT OF CAPITAL

Goal of This Chapter: The purpose of this chapter is to discover why capital—particularly equity capital—is so important for financial institutions, to learn how managers and regulators assess the adequacy of an institution’s capital position, and to explain the ways that management can raise new capital

Key Topics in This Chapter

• 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 Needs

Chapter Outline

I Introduction

II The Many Tasks Capital Performs

A Cushion Against Risk of Failure

B Provides Funds Needed to Begin Operations

C Promotes Public Confidence

D Provides Funds for Future Growth and New Services

E Regulator of Growth

F Capital Plays a Role in Mergers

G Limits How Much Risk Exposure Banks and Competing Firms Can Accept

III Capital and Risk

A Key Risks in Banking and Financial Institutions’ Management

G Minority Interest in Consolidated Subsidiaries

H Equity Commitment Notes

Relative Importance of Different Sources of Capital

V One of the Great Issues in the History of Banking: How Much Capital Is Really Needed?

A Regulatory Approach to Evaluating Capital Needs

1 Reasons for Capital Regulation

2 Research Evidence

VI The Basel Agreement on International Capital Standards: A Continuing Historic Contract

among Leading Nations

A Basel I

1 Tier 1 (Core) Capital

2 Tier 2 (Supplemental) Capital

3 Calculating Risk-Weighted Assets

4 Calculating the Capital-to-Risk-Weighted Assets Ratio

B Capital Requirements Attached to Derivatives

1 Bank Capital Standards and Market Risk

2 Value at Risk (VaR) Models Responding to Market Risk

3 Limitations and Challenges of VaR and Internal Modeling

C Basel II

1 Pillars of Basel II

2 Internal Risk Assessment

3 Operational Risk

4 Basel II and Credit Risk Models

5 A Dual (Large-Bank, Small-Bank) Set of Rules

6 Problems Accompanying the Implementation of Basel II

D Basel III: Another Major Regulatory Step Underway, Born in Global Crisis

VII Changing Capital Standards Inside the United States

A FDIC Improvement Act

B Prompt Corrective Action

A Raising Capital Internally

1 Dividend Policy

2 How Fast Must Internally Generated Funds Grow?

B Raising Capital Externally

1 Selling Common Stock

2 Selling Preferred Stock

3 Issuing Debt Capital

4 Selling Assets and Leasing Facilities

5 Swapping Stock for Debt SecuritiesChoosing the Best Alternative for Raising Outside Capital

IX Summary of the Chapter

Concept Checks

15-1 What does the term capital mean as it applies to financial institutions?

Funds contributed to a financial institution primarily by its owners, consisting mainly of stock, equity reserves, surplus, and retained earnings, plus any long-term debt issued that qualifies under regulations

15-2 What crucial roles does capital play in the management and viability of a financial firm?

Capital provides the long-term, permanent funding that is needed to construct facilities and provide a base for the future expansion of assets Capital also absorbs operating losses until management has a chance to correct the institution's problems From a regulatory perspective capital limits the growth of risky assets Capital promotes public confidence and reassures creditors concerning an institution’s financial strength Also, capital provides funds for the development of new services and facilities Recently, capital has also played a key role in the rapid growth of mergers among financial firms

15-3 What are the links between capital and risk exposure among financial-service providers?

Capital functions as a cushion to absorb losses until management can correct the problems generating those losses Institutions face many different kinds of risk: (1) crime risk, (2) interest rate risk, (3) credit risk, (4) liquidity risk, (5) exchange risk and (6) operational risk Capital represents the ultimate line of defense against these risks when all other defenses fail

15-4 What forms of capital are in use today? What are the key differences between the

different types of capital?

The principal forms of bank capital include common and preferred stock, surplus, undivided profits, equity reserves, subordinated debentures, minority interest in consolidated subsidiaries, and equity commitment notes Common stock represents the par value of common equity shares outstanding, while surplus is the amount paid over par value for the stock when it is sold

Preferred stock is a special type of ownership where dividends are fixed and stockholders

generally do not have a vote on major activities undertaken by the firm Retained earnings or undivided profits are the accumulated earnings of the firm kept to reinvest back in the company Subordinated debentures are long term debt instruments that do not represent ownership claims and are contributed by outside investors Equity reserves represents the funds set aside for contingencies, such as legal action against the institution, reserve for dividend expected to be paid but not yet declared, or shrinking fund to retire stock or debt in the future Minority interests

in consolidated subsidiaries are one in which financial firms hold ownership shares in other businesses Equity commitment notes are one in which debt securities are repaid from the sale of stock.

15-5 Measured by volume and percentage of total capital, what are the most important and least important forms of capital held by U.S.-insured banks? Why do you think this is so?

The most important form of capital is surplus, accounting for about two-thirds of all long-term debt and equity capital This is followed by retained earnings and capital reserves representing about one-fifth of U.S banks’ capitalization The remainder is divided up among all other types

of capital, including long-term debt (subordinated notes and debentures) at close to 10 percent and the par value of common stock at close to 3 percent Preferred stock is relatively

insignificant at less than 1 percent of the U.S banking industry’s capital

Bank holding companies have issued substantial quantities of subordinated debt in recent years because such notes are callable shortly after issue and carry either fixed or floating interest rates Common stock represents what owners contribute originally when they buy the stock to begin with Retained earnings represent the growth in earnings that accumulate in the firm over time What the owners contribute to the firm and the wealth that accumulates over time is the true cushion against loss that capital represents

15-6 How do small banks differ from large banks in the composition of their capital accounts and in the total volume of capital they hold relative to their assets? Why do you think these differences exist?

Small banks rely mainly on surplus value of their stock and retained earnings (undivided profits) and very little on long-term debt (subordinated notes and debentures), whereas large banks rely

on surplus value of stock, retained earnings, and long term debt This is because, large

institutions have the ability to sell their capital instruments in the open market, while the smallestinstitutions, have only limited access to the financial market Small banks have a difficult time placing their equity and debt securities in the market and thus, rely more heavily on internal capital (i.e retained earnings) Moreover, many authorities in the field believe that generally the smallest banks should maintain the thickest cushion of capital relative to their asset size because they are not as well diversified as their large counterparts, both geographically and by product line, and, therefore, run a greater risk of failing

15-7 What is the rationale for having the government set capital standards for financial

institutions as opposed to letting the private marketplace set those standards?

The government's interest in set capital standards stems from its efforts to stabilize the financial system, limit risk of failures, preserve public confidence, and avoid drains on the federal

insurance system Capital requirements have long been subject to government regulation, though bankers frequently argue that the market, rather than regulators, should determine how much capital a financial institution should hold The fear among regulators, however, is that financial institutions would hold too little capital to avoid failures and also that the private market cannot adequately assess their need for capital

15-8 What evidence does recent research provide on the role of the private marketplace in determining capital standards?

The results of recent studies are varied, but most find that the private marketplace is more

important than government regulation in determining the amount and type of capital financial institutions must hold However, recently government regulation appears to have become nearly

as important as the private marketplace by tightening capital regulations and imposing minimum capital requirements, especially in the wake of the great credit crisis of 2007–2009

15-9 According to recent research, does capital prevent a financial institution from failing?

If capital is large enough to absorb operating losses it can prevent failure for some time, at least until the capital is all used up However, there is no solid, undisputed evidence of a significant relationship between the size of the capital-to-asset ratio and the incidence of failure

15-10 What are the most popular financial ratios regulators use to assess the adequacy of bank capital today?

The prime capital-adequacy ratios, under Basel I, which the regulators use to assess are, Tier 1 risk-based capital ratio, which is equals core capital to risk-weighted assets, and total risk-based capital ratio, which is equals total capital to risk-weighted assets

15-11 What is the difference between core (or tier 1) capital and supplemental (or tier 2) capital?

Core capital is the permanent capital of a bank, consisting mainly of common stock and surplus, undivided profits (retained 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 Supplemental capital (or tier 2) is a secondary form of bank capital, which includes the allowance (reserves) for loan and lease losses, subordinated 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 features

15-12 A bank reports the following items on its latest balance sheet: allowance for loan and lease losses, $42 million; undivided profits, $81 million; subordinated debt capital, $3 million; common stock and surplus, $27 million; equity notes, $2 million; minority interest in

subsidiaries, $4 million; mandatory convertible debt, $5 million; identifiable intangible assets, $3million; and noncumulative perpetual preferred stock, $5 million How much does the bank hold

in Tier 1 capital? In Tier 2 capital? Does the bank have too much Tier 2 capital?

The Tier 1 capital items include: The Tier 2 capital items include:

Common stock and

surplus $27 million Allowance for loan andlease losses $42 million

Undivided profits 81 million Subordinated debt capital 3 millionNoncumulative

perpetual preferred

Mandatory convertible debt

5 millionIdentifiable

intangible assets 3 million Equity notes 2 millionMinority interest in

subsidiaries 4 million

Total Tier 1 capital $120 million Total Tier 2 capital $52 million

The bank does not have too much Tier 2 capital Tier 2 capital can be up to 100 percent of the amount of Tier 1 capital and hence can still count toward meeting its capital requirements

15-13 What changes in the regulation of bank capital were brought into being by the Basel Agreement? What is Basel I? Basel II?

Capital requirements today are set by regulatory agencies and, for banks in leading countries today, under rules laid out in the Basel Agreement on International Bank Capital Standards These government agencies set minimum capital requirements and assess the capital adequacy ofthe financial firms they regulate

Capital regulation aimed primarily at the largest international banks and formally began with a multinational agreement known as Basel I This set of international rules required many of the largest banks to separate their on-balance-sheet and off-balance-sheet assets into risk categories and to multiply each asset by its appropriate risk weight to determine total risk-weighted assets The ratio of total regulatory capital relative to risk-weighted assets and off-balance-sheet

commitments was an indicator of the strength of each international bank’s capital position.Weaknesses in Basel I led to a Basel II agreement to be gradually phased in This approach to capital regulation required the world’s largest banking firms to conduct a continuing internal assessment of their individual risk exposures, including stress testing Thus, each participating bank would calculate its own unique capital requirements based upon its own unique risk profile.Smaller banks would use a simpler, standardized approach to determining their minimum capital requirements similar to the rules of Basel I

15-14 First National Bank reports the following items on its balance sheet: cash, $200 million;U.S government securities, $150 million; residential real estate loans, $300 million; and

corporate loans, $350 million Its off-balance-sheet items include standby credit letters, $20 million, and long-term credit commitments to corporations, $160 million What are First

National's total risk-weighted assets? If the bank reports Tier 1 capital of $30 million and Tier 2 capital of $20 million, does it have a capital deficiency?

(Note: There are three categories of standby credit letters with different conversion factors and credit risk weights (See Table on p 499-500), we have assumed the standby credit letters in this discussion question are backing the issue of state and local government general obligation bonds.)

We first convert the off-balance-sheet items to their credit-equivalent amounts:

Off-Balance-Sheet Items:

Standby credit letters: $20 million × 0.20 = $4 million

Long-term commitments to corporations: $160 million × 0.50 = 80 million

Then we can risk-weight all assets as follows:

Risk-Weighted AssetsCash

Total risk-weighted assets = $580.80 million

The bank has total capital of:

Tier 1 capital = $30 million

Tier 2 capital = $20 million

$50 millionThe bank's capital to risk-weighted asset ratio is:

as low as possible and to reduce their credit risk exposure will move toward government

securities and away from corporate loans and home mortgage loans They will also shift the

proportion of investment in off-balance sheet items as they legally bind credit commitments made by the banks to their customers.

15-16 What are the most significant differences among Basel I, II, and III? Explain the

importance of the concepts of internal risk assessment, VaR, and market discipline

Basel I used a “one size fits all” approach to determine a bank’s capital requirements Basel II recognizes that different banks have different risk exposures and should be subject to different capital requirements It also broadens the types of risk considered for determining capital

requirements, including credit, market, and operational risk Capital requirements laid down in Basel I and II apparently were inadequate in the face of the latest credit crash Also, Basel II had resulted in less total capital and a weaker mix of capital, worsening what turned into a global credit catastrophe Basel III was hence designed to head off future financial crises Basel III callsfor greater total capitalization (a higher percentage relative to assets) plus a stronger definition ofwhat belongs and does not belong in a bank’s capital accounts

Internal risk assessment refers to an innovation in Basel II which allows banks to measure their own risk exposure and determine how much capital they needed to meet that exposure These measurements are subject to review by the regulators to ensure that they are reasonable The VaRmodel is one of the models used to determine a bank’s risk exposure It measures the price or market risk of a portfolio of assets whose value may decline due to adverse movements in the financial markets or interest rates Market discipline refers to the market determining the bank’s risk exposure The market’s collective actions of buying and selling a bank's securities (like subordinate debt) in the financial market provide an independent assessment of the bank's financial condition Since such debt is not guaranteed, the buyers of such securities would be very vigilant about the bank’s financial condition

15.17 What steps should be part of any plan for meeting a long-range need for capital?

The four key phases of planning to meet a bank's capital needs are as follows:

1 Develop an overall financial plan

2 Determine the amount of capital that is appropriate given the goals, planned service offerings, acceptable risk exposure, and state and federal regulations

3 Determine how much capital can be generated internally through profits retained in the business

4 Evaluate and choose that source of external capital best suited to the institution’s needs and goals

15-18 How does dividend policy affect the need for capital?

Relying on the growth of earnings to meet capital needs means that a decision must be made concerning the amount of earnings retained in the business versus the amount paid out to

stockholders in the form of dividends For this reason, the management decides an appropriate retention ratio A retention ratio set too low results in slower growth of internal capital, which may increase the failure risk and retard the expansion of earning assets A retention ratio set too

high can result in a cut in stockholders’ dividend income Other factors held constant, such a cut would reduce the market value of stock issued by a financial institution Hence, the optimal dividend policy is one that maximizes the value of the stockholders’ investment.

15-19 What is the ICGR, and why is it important to the management of a financial firm?The Internal capital growth rate (ICGR) is ratio of retained earnings to the equity capital of the firm It shows that if we want to increase internally generated capital, we must increase earnings (through a higher profit margin, asset utilization ratio, and/or equity multiplier) or increase the earnings retention ratio, or both

To illustrate, the ICGR indicates how fast a firm can allow its assets to grow and still keep its capital-to-asset ratio fixed If the assets grow by a percentage above the ICGR, there is a

possibility of capital-to-assets ratio to fall If it falls far enough, the regulatory authorities may insist that capital be increased Thus, it makes ICGR an important factor to keep a check on the firm’s earnings and its retention ratio

15-20 Suppose that a bank has a return on equity capital of 12 percent and that its retention ratio is 35 percent How fast can this bank's assets grow without reducing its current ratio of capital to assets? Suppose that the bank's earnings (measured by ROE) drop unexpectedly to onlytwo-thirds of the expected 12 percent figure What would happen to the bank's ICGR?

The relevant formula is:

ICGR ROE Retention Ratio= ×

ICGR = 0.12 × 0.35 = 0.042 or 4.2 percent

The bank’s assets can grow at a rate of 4.2% percent without reducing the capital-to-assets ratio

If ROE unexpectedly drops to only two-thirds of the expected 12 percent figure, the ICGR becomes:

ICGR = 0.12 0.667× ×0.35 = 0.028 or 2.8 percent

15-21 What are the principal sources of external capital for a financial institution?

The principal sources through which a financial firm can raise external capital are by selling common stock, selling preferred stock, issuing debt capital, selling assets, leasing certain fixed assets, or swapping stock for debt securities

15-22 What factors should management consider in choosing among the various sources of external capital?

The alternative that management should choose will depend primarily on the impact each source would have on returns to stockholders, usually measured by earnings per share (EPS) Other key

factors to consider are the institution’s risk exposure, the impact on control by existing

stockholders, the state of the market for the assets or securities being sold, and regulations.The management while considering in choosing among the various sources of external capital should also consider following factors individually Drawing upon common and preferred stock increases the borrowing capacity and provides permanent capital, but it can result in ownership and earnings dilution Debt capital is generally to boost EPS due to the financial leverage, but debt also adds to failure and earnings risk and may make it more difficult to sell stock in the future Selling assets and leasing capital usually creates a substantial inflow of cash Swapping stock for debt securities strengthens its capital and saves the cost of future interest payments on the notes

Problems and Projects

15-1 The management at Sage National Bank located in Key West, Florida, is calculating the key capital adequacy ratios for its third-quarter reports At quarter-end, the bank’s total assets are

$95 million and its total risk-weighted assets including off-balance-sheet items are $75 million Tier 1 capital items sum to $4 million, while Tier 2 capital items total $2.5 million Calculate Sage National’s leverage ratio, total capital-to-total assets, core capital-to-total risk-weighted assets, and total capital-to-total risk-weighted assets Does Sage National meet the requirement stipulated for a bank to qualify as adequately capitalized? In which of the five capital adequacy categories created by U.S federal regulators for PCA purposes does Sage National fall? Is Sage National subject to any regulatory restrictions given its capital adequacy category?

Total risk-weighted assets including

Tier 1 capitalLeverage ratio =

Total asset

$4 millionLeverage ratio = = 0.0421or 4.21percent

$95million

(Tier 1 capital + Tier 2 capital)Total capital-to-total assets ratio =

Total assets