1、Capital AdequacySession 91Capital AdequacyCapital AdequacySession 91CapiCapital AdequacyWhy must the bank manager be concerned about managing the capital account?Important (but most expensive) source of fundingAdequate capital necessary to maintain confidence in the bankRegulatory constraintsMoral:

2、Too little capital will incur the wrath of the regulator; too much capital will incur the wrath of the shareholder2Capital AdequacyCapital AdequacyWhy must the bThe Cost of CapitalWhy is equity the most expensive form of funding?Common stock is the residual security - it is entitled to whatever is l

3、eft after the more senior claimants have been satisfied.Because the returns to the common are not specified, they are the most volatile.In finance, volatility equates to risk!The higher the risk, the higher the expected return!3Capital AdequacyThe Cost of CapitalWhy is equiCapital Adequacy:Measuring

4、 Shareholder ReturnsCapital is the most expensive form of funding available to the bank. How do we measure the required return to the shareholderUse the Gordon Growth Model of Stock ValuationIf P = Div1 r - gThen r = Div1 + g P Use the CAPM Rstock = Rfree + Betastock(RMarket - Rfree)4Capital Adequac

5、yCapital Adequacy:Measuring ShRegulatory Capital AdequacyIn CanadaOSFI establishes minimum capital guidelines for banks in its publication “Guidelines for Banks”Federally regulated Financial Institutions must pass two capital adequacy testsAssets-to-capital multipleRisk-based capital adequacy 5Capit

6、al AdequacyRegulatory Capital AdequacyInRegulatory Capital Adequacy:Assets-to-Capital MultipleCalculation:Assets-to-capital multiple = Total Assets CapitalWhere:Capital is Tier One plus Tier Two capital Total Assets all on-BS assets plus off-BS credit substitutesMust maintain an assets to capital mu

7、ltiple less than twentyProblems as a measure of capital adequacy:Based on book values, not market valuesIgnores the different credit, interest and market risks embedded in the total assets figureIgnores off-Balance Sheet activities which are not credit substitutes (i.e. most derivatives)6Capital Ade

8、quacyRegulatory Capital Adequacy:ARisk-Based Capital Adequacy = Capital_ Risk-weighted assetsWhere:Capital is both Tier One & Tier Two capitalBoth on-BS and off-BS assets are risk weightedRatio must be greater than or equal to 8%Cannot directly compare this ratio to the assets-to-capital multiple be

9、cause;In the assets-to-capital multiple, all assets and credit-substitute off-BS assets are simply added togetherIn the risk-based capital adequacy framework, each exposure is multiplied by a weighting factor before being added Regulatory Capital Adequacy: Assets-to-Capital Multiple7Capital Adequacy

10、Risk-Based Capital Adequacy = Regulatory Capital Adequacy:Tier One CapitalTier One capital is comprised of:Common shareholders equityCommon stock, contributed surplus & retained earningsNoncumulative preferred sharesMinority interest in subsidiaries arising from consolidation (Tier one capital porti

11、on)Less Goodwill8Capital AdequacyRegulatory Capital Adequacy:TRegulatory Capital Adequacy:Tier Two (A) CapitalTier Two (A) capital comprised of instruments with the following characteristics:Unsecured, subordinated to deposits and senior debt and fully paid upNot redeemable at the option of the hold

12、erRedeemable only after five years (at the option of the FI) and with OSFIs permissionAvailable to participate in losses (dividend default gives no additional rights)Allows dividends to be deferredExample: cumulative, convertible, callable preferred shares9Capital AdequacyRegulatory Capital Adequacy

13、:TRegulatory Capital Adequacy:Tier Two (B) CapitalLimited life (Tier 2B) capital instruments have the following characteristics:Subordinate to deposits and senior debtInitial minimum term greater than ten yearsRedemption in the first five years only at the option of the FI and with OSFIs permissionE

14、xample: 10 year subordinate notes10Capital AdequacyRegulatory Capital Adequacy:TAll of the following must be true:Tier 1 capital + Tier 2 capital 8% of risk-adjusted assetsTier 2 capital Tier 1 capitalTier 2B capital 50% of Tier 1 capitalRegulatory Capital Adequacy:Risk Weighting of Assets11Capital

15、AdequacyAll of the following must be tRegulatory Capital Adequacy:Risk Weighting of AssetsOn Balance Sheet ItemRisk Weight1. Cash & deposits with CB0%2. Deposits with other banks20%3. Securities issued by/guaranteed by an OECD govnt0%4. Other securities100%5. Loans issued by/guaranteed by an OECD go

16、vnt0%6. Residential mortgages50%7. Other loans100%8. Customer liability under Acceptances100%9. Other assets100%12Capital AdequacyRegulatory Capital Adequacy:RRegulatory Capital Adequacy:Off-Balance Sheet Credit SubstitutesCredit InstrumentsCredit ConversionRiskFactorWeight1. Guarantees & SBLCs a) F

17、inancial100%100% b) Non-financial50%100%2. Securities lending100%100%3. Documentary & commercial L/Cs20%100%4. Commitments to extend credit a) Term less then 1 year0%0% b) Term more than 1 year50%100%5. Note issuance/Revolving under- writing facility50%100%13Capital AdequacyRegulatory Capital Adequa

18、cy:ORegulatory Capital Adequacy:Off-Balance Sheet Items - DerivativesFirst partition into exchange traded and OTC derivatives. No counterparty risk to exchange traded derivatives.OTC derivativesFirst multiply the notional amount by a conversion factor to create a credit equivalent amountThen multipl

19、y the credit equivalent amount by the appropriate risk weights14Capital AdequacyRegulatory Capital Adequacy:ORegulatory Capital Adequacy:Off-Balance Sheet Items - DerivativesDerivative SecurityRisk WeightInterest Rate Contracts:a) Forward Rate Agreements20%b) Futures contracts0%c) Swap contracts20%d

20、) Options purchased20%e) Options written0%Foreign Exchange contracts:a) Sport & forward contracts20%b) Futures contracts0%c) Swap contracts20%d) Options purchased20%e) Options written0%15Capital AdequacyRegulatory Capital Adequacy:ORegulatory Capital Adequacy:Problems with the BIS RulesDifferential treatment between OECD & non-OECD borrowers100% risk weighting applied to all loans (even if the borrower has a higher risk rating than a