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it is a quiz with 80 multiple choices question related to bank management. start from UTC/GMT-6.00 4.00 p.m.to 5.20 p.m

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12 The Effective Use of Capital I n the early 1990s, the Federal Reserve Board of Governors (Fed), Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) imposed minimum risk-based capital (RBC) standards to help control commercial bank risk taking. These RBC standards required higher levels of capital against higher-risk bank assets. Thus, banks with more risky loans were required to operate with more capital. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) established a system of prompt regulatory action with sanctions for undercapitalized institutions. These requirements mandated specific regulatory responses, including bank closures where appropriate, for institutions whose capital fell short of regulatory minimums. Unfortunately, during the recent financial crisis, many banks found themselves in need of additional capital at a time when the markets did not allow equity issues. In 2008, Congress passed the Troubled Asset Relief Program (TARP) with the intended purpose of purchasing distressed assets from financial institutions. In November 2008, Treasury Secretary Paulson stated that the original purpose of purchasing assets was not the most effective use of TARP funds and created the Capital Purchase Program (TARP-CPP) in which the Treasury would take senior preferred stock positions in financial companies. This senior preferred stock would count as Tier 1 capital, the gold standard in a financial institution’s capital. The cost of the preferred stock was 5 percent per annum (dividend rate) plus warrants. After five years, the dividend rate increased to 9 percent. This unprecedented capital injection by the federal government dramatically changed the face of the industry. Congress’s original intention was that these funds would allow financial institutions to replace capital lost due to loan and trading losses and begin to free up credit. Near the end of 2008, however, most financial institutions that participated in the TARP-CPP used the funds to acquire other financial institutions or possibly to hoard cash. Those that were able to buy back the preferred stock did so as soon as possible. Many problem banks still have costly TARP preferred stock outstanding that is now paying 9 percent. In 2004, the Basel Committee on Bank Supervision, with U.S. bank regulators’ endorsement, proposed new capital standards with an implementation date of 2007. These capital standards were revised by U.S. regulators in July 2013, which will have the effect of increasing required equity capital beginning in 2015. These Basel III standards are discussed later in the chapter. 449 Why Worry about Bank Capital? Capital plays a significant role in the risk-return trade-off at banks. Increasing capital reduces risk by cushioning the volatility of earnings, restricting growth opportunities, and Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 450 Chapter 12 The Effective Use of Capital lowering the probability of bank failure. It also reduces expected returns to shareholders, as equity is more expensive than debt. Decreasing capital increases risk by increasing financial leverage and the probability of failure. Not surprisingly, it also increases potential returns. The fundamental decision regarding capital thus focuses on how much capital is optimal. Firms with greater capital can borrow at lower rates, make larger loans, and expand faster through acquisitions or internal growth. In general, they can pursue riskier investments. A second important decision concerns the form in which new capital is obtained, because regulators allow certain types of debt and preferred stock to qualify as capital to meet the requirements. These decisions are examined in this chapter in light of the regulatory definition of capital, its function, and its cost. The chapter also describes the nature of the new Basel III capital requirements and possible market impacts. Bank regulators’ primary objective is to ensure the safety and soundness of the U.S. financial system. A serious concern is that failures of individual banks, particularly large institutions, might erode public confidence in the financial system and lead to frozen markets in which transactions cannot be completed. The federal government attempts to limit the magnitude and scope of bank failures and ensure confidence by setting and enforcing regulations and by imposing minimum capital requirements for individual banks. Banks meet the requirements when they obtain an acceptable amount of financing in the form of qualifying equity capital and related long-term debt sources. Such capital requirements reduce the risk of failure by acting as a cushion against losses, providing access to financial markets to meet liquidity needs, and by limiting growth. Bank supervision has reached the point where regulators now specify minimum amounts of equity and other qualifying capital that banks must obtain to continue operations. 1 Historically, regulators stipulated minimum capital-to-total-asset ratios but did not worry about the quality of bank assets. While bank capital-to-asset ratios averaged near 20 percent at the turn of the century, comparable ratios today are closer to 8–10 percent. Recent equityto-asset ratios for commercial banks and savings institutions appear in Exhibit 12.1. Note that these ratios are much higher in 2013 versus 2007, the year just prior to the worst of the financial crisis, for all but the smallest banks. The decline at institutions under $100 million in assets demonstrates the problems that small community banks face in exiting the recession. Still, the ratios are highest for institutions with less than $100 million in assets in both years. Finally, the equity ratios are higher for savings institutions versus similarsize commercial banks, reflecting in part, the high capital ratios at mutual savings banks. Under the old capital regulation, two banks of the same size would have to operate with the same amount of capital, independent of their risk profiles. Specifically, it did not matter what type of assets a bank held, because the same percentage requirement applied to all assets equally. Thus, a bank that held only Treasury securities needed the same amount of capital as the same-sized bank that held speculative real estate loans. Does this seem reasonable? The answer depends on the role that capital serves and how regulators want to control bank risk. Equity to Asset Ratios for Different Size Commercial Banks and Savings Institutions: December 2007 versus December 2013 EXHIBIT 12.1 1 The International Lending Supervision Act of 1983 empowered the Fed, FDIC, OCC, and Federal Home Loan Bank Board to mandate legally binding minimum capital requirements. Most banks acceded to prior guidelines even though the legal requirement did not exist. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 12 18 16 14 12 10 8 6 4 2 0 The Effective Use of Capital 451 Com Banks-2007 Com Banks-2013 Savings Inst-2007 Savings Inst-2013 All figures are in millions of dollars. Capital-to-asset ratios at commercial banks and savings banks are below similar ratios at other types of financial institutions and well below capital ratios at nonfinancial businesses. This difference reflects the intermediation function of depository institutions and thus is not remarkable. High financial leverage, however, increases the relative riskiness of operations by providing less protection to creditors upon liquidation of the firm. Bankers also recognize that high leverage increases potential profitability, so they often attempt to minimize external equity financing. Regulators, by contrast, want to increase bank equity financing and focus on balancing solvency risks with an individual bank’s profit potential. This chapter introduces the risk-based capital requirements that banks have been subject to since the end of 1992. It then examines the functions of bank capital and its impact on commercial bank operations. The chapter addresses the following issues: (1) What constitutes bank capital? (2) What functions do capital accounts serve? (3) How much capital is adequate? (4) What is the impact of regulatory capital requirements on bank operating policies? (5) What are the advantages and disadvantages of various sources of internal and external capital? These issues are important because federal regulators appear intent on raising or maintaining high capital standards for banks and other institutions over time. The last section describes the framework for the new Basel III capital standards. Risk-Based Capital Standards Prior to the mid-1980s, bank capital requirements were generally established without regard to a bank’s asset quality, liquidity risk, interest rate risk, operational risk, and related risks. Thus, when banks fell under pressure to increase earnings, capital requirements imposed no constraints to risk taking other than limiting growth. Bank regulators did force banks to have more capital than the minimums when they perceived bank risk to be excessive, but this determination often occurred long after management made risky investment decisions. The 1986 Basel Agreement In 1986, U.S. bank regulators proposed that commercial banks be required to maintain minimum amounts of capital that reflect the riskiness of their assets. By the time it was Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 452 Chapter 12 The Effective Use of Capital implemented, the proposal, known as the Basel Agreement, included RBC standards for banks in 12 industrialized nations. U.S. bank regulators phased in the requirements starting in 1990, with the regulations fully in place by the end of 1992. Importantly, countries that are members of the Organization for Economic Cooperation and Development (OECD) attempt to enforce similar risk-based requirements on their home country financial institutions. Although the terms varied between nations, primarily in terms of what constitutes capital, the original Basel Agreement contained several important elements. First, a bank’s minimum capital requirement is linked, by formula, to its credit risk as determined by the composition of assets. The greater the credit risk, the greater the required capital. Second, stockholders equity is deemed the most critical type of capital. As such, each bank is expected to operate with a minimum amount of equity based on the amount of credit risk. Third, the minimum total capital requirement increased to 8 percent of risk-adjusted assets. Finally, the capital requirements were approximately standardized between countries to “level the playing field,” that is, to remove competitive advantages that banks in one country might have over banks in other countries because of regulatory or accounting differences. Risk-Based Elements of Basel I To determine minimum capital requirements for a bank under the general RBC requirement of Basel I, bank managers follow a four-step process. 1. Classify assets into one of four risk categories, appropriate to the obligor, collateral, orguarantor of the asset. 2. Convert off-balance sheet commitments and guarantees to their on-balance sheet“credit equivalent” values and classify them in the appropriate risk categories. 2 3. Multiply the dollar amount of assets in each risk category by the appropriate riskweight; this product equals risk-weighted assets. 4. For a U.S. bank to be adequately capitalized, multiply risk-weighted assets by theminimum capital percentages, either 4 percent for Tier 1 capital or 8 percent for total capital. The process ensures that assets with the highest perceived credit risk have the highest risk weights and require the most capital. In addition to these credit risk-based standards, the Fed, FDIC, and OCC adopted measures related to the supervisory treatment of interest rate risk and market risk capital requirements, which are described in general later in the chapter. Consider the data in Exhibit 12.2 for Regional National Bank (RNB). As indicated in the first column of data, total assets for the bank were just under $5 billion, and the bank had almost $656 million in off-balance sheet items. Under the former capital standards, RNB would have needed 6 percent total capital or approximately $299.7 million (0.06 × $4,994,849) in primary and secondary capital. The exhibit demonstrates that the RBC requirements are slightly higher for total capital. Exhibit 12.3 lists the four risk categories and the general types of assets that fall into each category for RNB. Exhibit 12.4 demonstrates the application of Step 2, above, which Regional National Bank (RNB), Risk-Based Capital (Millions of Dollars) EXHIBIT 12.2 Category 1: Zero percent 2 Assets $1,000 Risk Weight Risk-Weighted Assets Banks were required to hold capital against off-balance sheet activities long before the Enron collapse. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 12 Cash and reserve Trading Account U.S. Treasury and agency securities Federal Reserve stock Total Category 1 Category 2: 20 percent Due from banks/in process The Effective Use of Capital 453 104,525 0.00% 0 830 0.00% 0 45,882 0.00% 0 5,916 0.00% 0 157,153 303,610 0 20.00% 60,722 Interest-bearing depository/F.F.S. 497,623 20.00% 99,525 Domestic depository institutions 38,171 20.00% 7,634 Repurchase agreements (U.S. Treasury and agency) 329,309 20.00% 65,862 U.S. agencies (government sponsored) 412,100 20.00% 82,420 State and municipal’s secured tax authority 87,515 20.00% 17,503 C.M.O. backed by agency securities 90,020 29,266 0 20.00% 20.00% 20.00% 18,004 5,853 0 SBAs (government-guaranteed portion) Other Category 2 assets Total Category 2 Category 3: 50 percent C.M.O. backed by mortgage loans State and municipals/all other Real estate: 1–4 family Other Category 3 assets Total Category 3 Category 4: 100 percent Loans: commercial/agency/institution/leases 1,787,614 357,523 50.00% 10,000 5,000 68,514 50.00% 34,257 324,422 50.00% 162,211 0 50.00% 402,936 1,966,276 0 201,468 100.00% Real estate, all other 388,456 Allowance for loan and lease losses (70,505) 0.00% 0 Other investments 168,519 100.00% 168,519 Premises, equity other assets 194,400 100.00% 194,400 0 100.00% 0.00% 2,717,651 Other Category 4 assets Total Category 4 Total assets before off-balance sheet Off-balance sheet contingencies 0% collateral category 2,647,146 100.00% 1,966,276 388,456 0 4,994,849 3,276,642 0 0 20% collateral category 0 20.00% 0 50% collateral category 364,920 50.00% 182,460 290,905 100.00% 4.00% 290,905 100% collateral category Total contingencies Total assets and contingencies before allowance for loan and lease losses and ATR Less: Excess allowance for loan and lease losses Total assets and contingencies 655,825 5,650,674 $5,650,674 $199,794 473,365 3,750,007 (2,152) $3,747,855 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 454 Chapter 12 The Effective Use of Capital Capital requirements Tier I @ 4% $149,914 Total capital @ 8% 399,588 8.00% 299,828 General Description of Assets in Each of the Four Risk Categories EXHIBIT 12.3 Asset Category Risk Weight Effective Total Capital Requirement* 1 0% 0% Generally, direct obligations of OECD central government or the U.S. federal government (e.g., currency and coin, government securities, and unconditional government-guaranteed claims). Also, balances due or guaranteed by depository institutions. 20% 1.6% Generally, indirect obligations of OECD central government or the U.S. federal government (e.g., most federal agency securities, full faith and credit municipal securities, and domestic depository institutions). Also, assets collateralized by federal government obligations are generally included in this category (e.g., repurchase agreements [when Treasuries serve as collateral] and CMOs backed by government agency securities.) 3 50% 4% Generally, loans secured by 1–4 family properties and municipal bonds secured by revenues of a specific project (revenue bonds). 4 100% 8% All other claims on private borrowers (e.g., most bank loans, premises, and other assets). 2 Obligor, Collateral, or Guarantor of the Asset *Equals 8 percent of equivalent risk-weighted assets and represents the minimum requirement that must be met to be adequately capitalized. involves converting off-balance sheet activity into a balance sheet equivalent value. Exhibit 12.5 provides a summary list of the balance sheet items in each category. Note that the lowest-risk category carries a zero weight because there is no default risk (or very little) with direct obligations of the federal government, such as cash, Treasury securities, and U.S. agency securities issued by the Government National Mortgage Association (GNMA). 3 Default risk is assumed to increase for assets in each of the subsequent categories. Thus, assets in Category 2 are subject to a 20 percent risk weight and an effective total capital-to-total-assets ratio of 1.6 percent (0.2 × 8 percent). Category 2 assets are shortterm and often carry U.S. government agency guarantees (e.g., U.S. agency securities, general obligation municipal bonds, interest-bearing depository institution deposits, and federal funds sold, among other assets). Each type is low in default risk so that the risk weight is slightly above that for zero default-risk assets. First mortgages, collateralized mortgage obligations (CMOs), and municipal revenue bonds constitute the bulk of the 50 percent risk-weighted assets under Category 3, which carry a 4 percent effective total capital ratio (0.5 × 8 percent). The final category includes assets with the highest default risk, such as commercial loans and real estate loans other than first mortgages, and ...
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