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: 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 / 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 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 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 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 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 • 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 • 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 • 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