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1、15-1 CHAPTER 15 THE MANAGEMENT OF CAPITAL Goal of This Chapter:The purpose of this chapter is to discover why capitalparticularly equity capitalis so important for financial institutions,to learn how managers and regulators assess the adequacy of an institutions capital position,and to explain the w
2、ays 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 Nee
3、ds 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 Muc
4、h Risk Exposure Banks and Competing Firms Can Accept III.Capital and Risk A.Key Risks in Banking and Financial Institutions Management 1.Credit Risk 2.Liquidity Risk 3.Interest Rate Risk 4.Operational Risk 5.Exchange Risk 6.Crime Risk B.Defenses against Risk 1.Quality Management 2.Diversification a.
5、Portfolio Diversification b.Geographic Diversification 3.Deposit Insurance 4.Owners Capital IV.Types of Capital in Use 15-2 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
6、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 Stand
7、ards: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
8、.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 Imple
9、mentation 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 1.Well capitalized 2.Adequately capitalized 3.Undercapitalized 4.Significantly undercapitalized 5.C
10、ritically undercapitalized 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.Selling Common Stock 15-3 2.Selling Preferred Stock 3.Issuing Debt Capital 4.Selling Assets and Leasing Facilit
11、ies 5.Swapping Stock for Debt Securities 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 mai
12、nly 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 facili
13、ties and provide a base for the future expansion of assets.Capital also absorbs operating losses until management has a chance to correct the institutions problems.From a regulatory perspective capital limits the growth of risky assets.Capital promotes public confidence and reassures creditors conce
14、rning an institutions 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 p
15、roviders?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 th
16、e 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
17、,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 w
18、here 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 re
19、present 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.Minori
20、ty interests 15-4 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
21、 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
22、.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
23、.banking industrys 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
24、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 th
25、e 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
26、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 smallest institutions,have only limited access to the financial market.Small bank
27、s 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 asse
28、t 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 mark
29、etplace set those standards?The governments 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 regulati
30、on,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 ade
31、quately assess their need for capital.15-5 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 deter
32、mining 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 c
33、risis 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 signi
34、ficant 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 r
35、isk-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 o
36、f 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.S
37、upplemental 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 n
38、otes 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
39、 million;equity notes,$2 million;minority interest in subsidiaries,$4 million;mandatory convertible debt,$5 million;identifiable intangible assets,$3 million;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
40、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 and lease losses$42 million Undivided profits 81 million Subordinated debt capital 3 million 15-6 Noncumulative perpetual preferred stock 5 million Mandatory c
41、onvertible debt 5 million Identifiable intangible assets 3 million Equity notes 2 million Minority 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
42、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 countrie
43、s 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 of the financial firms they regulate.Capital regulation aimed primarily at the largest international banks and formal
44、ly 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
45、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 banks capital position.Weaknesses in Basel I led to a Basel II agreement to be gradually phased in.This approach to capital regulatio
46、n required the worlds 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 simple
47、r,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
48、,$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 Nationals 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 capi
49、tal 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 bo
50、nds.)15-7 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 Assets C