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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
? Planning to Meet Capital Needs
Chapter Outline I. Introduction: What Is Capital? 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 H. Protects the Government’s Deposit Insurance System
Ill. Capital and Risk
A. Key Risks in Banking and Financial Institutions’ Management
1. Credit Risk 2. Liquidity Risk 3. Interest-Rate Risk 4. Operating Risk 5. Exchange Risk 6. Crime Risk
B. Defenses against Risk
1. Quality Management 2. Diversification
a. Portfolio b. Geographic
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IV.
V.
VI.
VII.
3. Deposit Insurance 4. Owners' Capital
Types of Capital A. Common Stock B. Preferred Stock C. Surplus D. Undivided Profits E. Equity Reserves F. Subordinated Debentures G. Minority Interest in Consolidated Subsidiaries H. Equity Commitment Notes I. Relative Importance of the Different Sources of Capital
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
The Basle Agreement on International Capital Standards: An Historic Contract among Leading Nations A. Basel I
1. Tier One Capital 2. Tier Two Capital 3. Calculating Risk-Weighted Assets Under Basle I 4. Calculating the Capital-to Risk-Weighted Assets Ratio Under Basel I
B. Capital Requirements Attached to Derivatives
1. Bank Capital Standards and Market Risk 2. Market Risk and Value at Risk (VaR) Models 3. Value at Risk (VAR) Models 4. Limitations and Challenges of VaR and Internal Modeling
C. Basel II: A New Capital Accord Unfolding 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
Changing Capital Standards Inside the United States A. FDIC Improvement Act B. Prompt Corrective Action 1. Well Capitalized 2. Adequately Capitalized 3. Undercapitalized 4. Significantly Undercapitalized 5. Critically Undercapitalized
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VIII. Planning To Meet Capital Needs
A. Raising Capital Internally
1. Dividend Policy 2. How Fast Must Internally Generated Funds Grow?
B. Raising Capital Externally
1. Issuing Common Stock 2. Issuing Preferred Stock 3. Issuing Subordinated Notes and Debentures 4. Selling Assets and Leasing Facilities 5. Swapping Stock for Debt Securities 6. Choosing 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, reserves, and retained earnings, plus any long-term debt issued that qualifies under regulations.
15-2. What crucial role does capital play in the management and viability of 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.
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, retained
earnings, and subordinated notes and debentures. Common stock represents the par value paid by owners, while surplus is the amount paid over par value for the stock when it is first 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 are the accumulated earnings of the firm kept to reinvest back in the company. Subordinated notes and debentures are long term debt instruments that don not represent ownership claims.
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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, followed by retained earnings, subordinated notes and debentures and preferred stock. 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 are 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 retained earnings and very little on long term debt, whereas large banks rely on common stock, retained earnings and long term debt. Small banks have a difficult time to place their equity and debt securities in the market and thus, rely more heavily on internal capital (i.e. retained earnings)
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 capital stems from its efforts to stabilize the financial system 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 excessive numbers of failures and 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, government regulation apparently was at least as important in the 1980s and early 1990s, with the tightening of capital regulations and the imposition of minimum capital requirements.
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 a 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?
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