Transcript Capital Adequacy

Capital Adequacy
Capital Adequacy

G & K Chp. 12
Definition and Role of Bank Capital
 Capital Adequacy Construction and
Standards
 Problems with Capital Adequacy

Definition and Role of Capital

Definition:
Equity + Capital Notes + %Loan Loss Reserves
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Role:
Source of start-up and growth funding
Absorb losses during unexpected times
Promote actual and perceived soundness
Mitigate Moral hazard of Deposit Insurance
Capital Adequacy Construction
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Capital / Deposits
Previews possibility of Bank Runs; early 1900s
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Risk Classification
Separate Assets only into 6 classes; 1950’s
Separate Functions and assign subjective risk
measures; 1960’s
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Problems:
Different stds across regulators, not legally
binding until 1983, unfair to small banks that
ended carrying more relative capital levels.
Capital Adequacy Construction
Standard Federal Capital /Assets became
5-6% in 1981.
 Large Banks that innovate in proprietary
activities began to take varying levels of
off-balance sheet risk
 BIS (Bank of International Settlements;
the International “Fed”) implemented, for
12 largest nations, risk based capital
requirements in 4 classes of assets in
1988
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Capital Adequacy Construction
Amendment to BIS in 1998 added
securities trading to these risk classes.
 Two types of capital

 Tier
1 (Core) C/S, R/E, P/S, Minority Interests
Less Goodwill and Intangibles
 Tier 2 (Supplementary) Allowances for LL,
Capital Notes, Hybrid Capital

Roughly 4% for Tier 1, 8% for Tier 1 + 2
Capital Adequacy Example
Catagories risk are:
A1: Cash and U.S. Gov’ts
A2: MBSs,Agencies & Muni GOs
A3: Mortgages & Muni ROs
A4: All rmg. loans, and bank prem
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Risk-adjusted capital requirements for total capital:
K = 8%[0(A1) + .20(A2) + .50(A3) + 1.0(A4)]
K = 0.08[0($100) + .2($2,500) + .5($3,000) + 1.0 ($5,000)]
= 0.08 [$7,000] = $560.00
SBG Capital Adequacy
FRB Capital
Adequacy Ratio
=
Total Qualifying Capital
Total Required Capital
Total Qlfy’g Cap = Total Eq + Cap Notes +
50% of Balance Sheet
Prov for Loan Loss
Total Required Capital
Sum $ Account Value * Req’d %
Letters of Credit
2.50%
Loan Commitments*
1.25%
Medium
6.00%
Cash & Due
1.50%
Real Estate
4.00%
Fed Funds Sold
1.50%
Consumer
8.00%
T-Bills
1.00%
Credit Card
8.00%
U.S. Notes
1.50%
Non-Accruing Loans
50.00%
Munis
3.00%
Net Premises
15.00%
Syndicated Loans
4.00%
Other Assets
8.00%
Prime
4.00%
Speculation Requirement
100.00%
High
5.00%
Interest Rate Risk
100.00%
Two Points

Speculative Requirement
 If
110% or more short of optimal short
futures hedge; or 10% or more long of same
number of contracts 15% (#cnts*.15) will be
designated Speculative Requirement and
100% of that held in reserve.

Interest Rate Risk Capital
 2%
of shortest term gap with 100% held in
reserve.
Problems using Capital Adequacy

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Differences in credit risk for most loans are not
taken into account.
Book values are used rather than market values
for most of the assets in the risk-adjusted assets
calculations.
Regulatory requirements may change banks’
behavior in terms of allocation of loanable funds
and investment decisions and possibly channel
savings to less than the best uses.
Some kinds of bank risk are excluded, including
operating risk and legal risk.
Portfolio diversification is not taken into account.
Deposit Insurance
and Capital Adequacy

FDIC “scores” deposits as to premiums to
be levied on insurance:
 Variable-rate
deposit insurance
(in cents per $100 domestic deposits)
implemented in 1994:
 Risk Group CAMELS A:1,2; B:3; C: 4,5
Risk Group
Capital Level
A
B
Well capitalized (10%)
0
3
Adequately capitalized (8%)
3
10
Undercapitalized (<8%)
10 24
C
17
24
27