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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 Role:

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capital adequacy1
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 and Role of Capital
  • Definition:

Equity + Capital Notes + %Loan Loss Reserves

  • 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
Capital Adequacy Construction
  • Capital / Deposits

Previews possibility of Bank Runs; early 1900s

  • Risk Classification

Separate Assets only into 6 classes; 1950’s

Separate Functions and assign subjective risk measures; 1960’s

  • Problems:

Different stds across regulators, not legally binding until 1983, unfair to small banks that ended carrying more relative capital levels.

capital adequacy construction1
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
capital adequacy construction2
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
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

  • 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
SBG Capital Adequacy

FRB Capital Total Qualifying Capital

Adequacy Ratio    Total Required Capital

Total Qlfy’g Cap = Total Eq + Cap Notes +

50% of Balance Sheet Prov for Loan Loss

=

two points
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
Problems using Capital Adequacy
  • 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
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 C

Well capitalized (10%) 0 3 17

Adequately capitalized (8%) 3 10 24

Undercapitalized (<8%) 10 24 27