Chapter 12
The Effective Use of Capital
Chapter Objectives
1. Explain the structure of risk-based capital standards at U.S. commercial banks.
2. Explain what the function of bank capital is both from the view of bank regulators and bank
managers.
3. Demonstrate the in”uence of regulatory capital requirements on bank operating policies.
4. Describe what balance sheet items constitute bank capital.
5. Explain how the FDIC Improvement Act (FDICIA) established capital categories and prompt
regulatory corrective actions associated with a bank’s capital pro.le.
6. Discuss the characteristics and advantages and disadvantages of different types of internal
and external capital.
7. Describe the role and impact of Federal Deposit Insurance and proposals to improve
current weaknesses of the system.
8. Introduce the basic features of Basel II, which will establish the new risk-based capital
standards for banks throughout the industrialized world.
Key Concepts
1. effective in 1992, U.S. commercial banks have been required to meet risk-based capital
standards that require i) at least 4% tier 1 capital, primarily stockholders’ equity, and ii) at
least 8% total capital (tier I + tier 2 capital), primarily stockholders’ equity, a portion of loan
loss reserves and qualifying subordinated debt, as a fraction of risk assets to be adequately
capitalized. These standards will soon change per the implementation of Basel II capital
requirements.
2. The importance of risk-based capital standards is that:
a. minimum capital requirements are linked to a bank’s credit risk. The greater is assumed
credit risk, the more capital is required.
b. stockholders’ equity is recognized as the most important type of capital.
c. minimum capital requirements for risky banks exceed the requirements for low risk
banks
d. capital requirements are now roughly equal across most of the industrialized countries
throughout the world.
e. capital is required in support of selected o0-balance sheet activities.
3. To determine minimum capital requirements, bank managers must follow a four-step
process:
a. classify assets into one of the four risk classes
b. classify o0-balance sheet commitments and guarantees into the appropriate risk class
c. multiply the dollar amount of assets in each risk class by the appropriate risk weight, and
sum across classes
d. multiply risk-weighted assets by the minimum capital percentages, 4% or 8% to be
adequately capitalized, to determine the dollar amount of required capital
4. Bank capital serves to reduce risk. It does so by 1) providing a cushion against losses, and
thus lowering the risk of failure, 2) providing access to .nancing via the money and capital
markets, and 3) limiting a bank’s ability to grow rapidly. Banks with limited amounts of
capital can grow only at low rates, which restricts risk taking.
5. Regulatory capital requirements affect bank operating policies by 1) limiting growth in
assets, 2) forcing banks that choose to grow to obtain capital externally when suffcient
internally-generated funds are not available, 3) changing asset composition, and 4)
changing the pricing of loans and certain securities.
6. Subordinated debt constitutes tier 2 capital. It has the advantage that the issuing bank can
deduct interest expense for tax purposes. Dividends paid to equity stockholders are not
deductible. In recent years, many banks have used trust preferred stock to help meet
capital requirements. Trust preferred stock is a hybrid form of equity that was created to
take advantage of the tax laws and thereby allows banks to deduct dividends paid on this
stock.
7. The Banking Act of 1933 established the FDIC and authorized federal deposit insurance for
certain bank deposits. During the late 1980s and early 1990s, the large number of bank
failures put pressure on the reserves that the FDIC had to close problem banks. FIRREA
created two insurance funds for banks (BIF) and for savings and loans (SAIF) and increased
deposit insurance premiums. The Deposit Insurance Funds Act of 1996 mandated the
eventual elimination of BIF and SAIF and combination into one insurance fund.
8. FDIC insurance premiums are based on perceived risk of the insured institution.
Well-capitalized banks paid no insurance premiums under the current system during the
late 1990s and early 2000s because the insurance fund was overfunded relative to
minimum funding requirements. In late 2002, estimates were that the insurance fund
would fall below the minimum requirement and that all banks would .nd that their deposit
insurance premiums (payments) would increase. Adequately and undercapitalized banks
pay much higher premiums than well-capitalized banks.
Teaching Suggestions
Bank regulators rely on the risk-based capital requirements to help control risk-taking by banks.
The presumption is that banks with the greatest amounts of capital relative to risk assets and
other risks associated with bank activities are the least likely to fail. It is useful to start a
discussion of bank capital by having students describe how a bank might fail. Make sure that
they understand how capital helps ‘prevent’ failure.
It is also useful to emphasize that what bank regulators call capital differ from what accountants
call capital. The role of loan loss reserves and subordinated debt as qualilfying capital oBen
confuses students until you link it to regulators’ interests in protecting the deposit insurance
fund. A bank fully .nanced via subordinated debt would not concern bank regulators like
traditional banks, regardless of the volume of risk assets, because any bank failure would be
absorbed by the debtholders and the insurance fund would be unaffected.
Use the example for Regional National Bank in Exhibit 12.2 to demonstrate the application of
risk-based capital requirements. Emphasize the fact that the risk classes are general in nature
and apply uniformly to all banks. Emphasize also the fact that certain o0-balance sheet activities
require a bank to hold capital in support of the associated risks. This ultimately raises the cost of
such activities.
Have students debate the following ideas:
1. Capital is king in today’s banking environment. Banks with adequate capital will
be the survivors in the competitive environment that exists today.
2. Subordinated debt is a reasonable form of capital from a bank regulator’s
perspective.
3. The risk-based capital standards are de.cient because they ignore interest rate
risk, operational risk, foreign exchange risk, etc.
4. Capital is like a cookie jar. Any time a bank needs funds, it can reach into its
capital account and use the proceeds to help bail the bank out of its problems.
5. A bank can have too much capital. If so, an acquirer can step in, buy the bank,
and increase overall pro.ts by increasing .nancial leverage.
It is important for students to understand the implications of the capital categories and prompt
corrective actions outlined in Exhibit 12.13. First, deposit insurance premiums are determined, in
part, by whether a bank is well-capitalized or not. Second, the mandatory provisions under
prompt corrective actions can be extremely restrictive. Consider a bank that is undercapitalized.
If it is part of a holding company and the bank cannot pay dividends or management fees, the
holding company may not have revenues to service its debt. The provision suspending dividends
and fees effectively forces the bank to quickly meet to minimum standards to be adequately
capitalized if it wants to remain independent. Finally, students should understand how the
capital requirements affect decisions about asset growth, asset composition, and loan pricing.
This is easily done using the examples in the text.
In order to help manage the market risk of large banking organizations, regulators have recently
focused on the S in the CAMELS system. S refers to the sensitivity to market risk. Market risk is
the risk of loss to the bank from “uctuations in interest rates, equity prices, foreign exchange
rates, commodity prices and exposure to trading positions in debt and equity markets. The rules
generally require banks with substantive exposure to have internally generated risk
measurement models.
Trust preferred stock is introduced in the section on external sources of capital. Trust preferred is
a hybrid of debt and equity in the sense that banks that issue this stock get the tax deductibility
of payments as if it were debt, yet get to report it as equity for capital purposes. As such, they
get the best of both worlds. In fact, the process of issuing trust preferred stock is the same
process that Enron and other corporations used to move debt o0-balance sheet. Conceptually,
banks are doing the same thing that Enron did. They create special purpose vehicles (SPVs) to
make the balance sheet look less risky. Ignoring the .nancial bene.ts, have students discuss the
ethical issues associated with issuing trust preferred stock. If it is misleading to the investing
public, is it ethical to issue such claims?
Bank regulators throughout the industrialized world have been working together to devise a new
risk based capital system. This system extends the prior standards that emphasized credit risk.
The new standards, when implemented, will emphasize market risk and operational risk in
addition to credit risk. Regulators will allow the largest institutions to use their own internal risk
assessment systems as inputs into the required capital calculations. Many analysts believe that
these new requirements will lower the largest banks’ required capital by a20% – 25%, on
average. If so, this reduction would offer a serious competitive advantage toward efficiently
allocating capital. Have students review the operational risk requirements and comment on the
difficulty of measuring and monitoring such risk.