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Management of Capital, Ch. 15, Rose & Hudgins, 9th ed., (F14)
Why is bank capital so important? Bank deposits are supported by the FDIC. Banks also owe
money to uninsured depositors and other debt holders, e.g., corporate bonds and mortgages. If a
banks losses are so large that they cannot pay their debts then this situation may severely disrupt
the financial and business markets, particularly as the size of the bank grows. The more common
equity a bank has, the safer those bank debt holders are because the greater equity allows the bank
to absorb larger losses before the debt holders are affected.
The key element here is to assess the risks of the bank, e.g., credit, interest rate, liquidity, and
market risks, and require equity to offset those risks. On the other hand, if the bank has to have
more common equity and if nothing else changes, the banks return on equity (ROE) will
decrease. The banks will increase their prices for services and interest rates on loans or lower the
interest rates on deposits to achieve the ROE required by the banks investors. These adjustments
affect the customers and the economy.
The required capital may also affect a banks competitiveness within a local market, e.g., small vs.
large banks, or globally. The Basel Accords 1 to 3 are an attempt to coordinate capital regulation
across borders so banks are competing on a level landscape. The Accord also attempts to deal
with the potential failures of systematically important financial institutions (SIFIs), also known as
too big to fail banks. Given the importance of the SIFIs they are required to hold more capital
to lower their risk to the national and global financial systems.
We will examine how large losses affect a banks balance sheet. We will examine current capital
ratios and we will examine how regulators try to measure the different bank risks.
KNOW: Functions or Tasks of Capital, p. 486
1. Acquire fixed assets to start bank
2. Provides for growth in new services and products
3. Absorbs losses so bank can continue to operate
4. Instills confidence that bank can continue to provide for credit needs of community
5. Provides base for continued growth that may be restricted if regulators or market think
capital is not adequate
6. Instills confidence by protecting uninsured depositors, FDIC and taxpayers

Simple Balance Sheet and Effect of Losses see types of capital, p. 489-491,
Assets
Liabilities + Equity

Cash & due

Investments
Gross loans
Loan loss reserves
Net loans
Fixed Assets
Intangible Assets
Goodwill, PMSRs, PCCRs

Insured deposits
Uninsured deposits
Long-term secured debt, e.g., mortgage
Subordinated notes & debentures
Senior Preferred Stock
Preferred Stock
Common equity
Common stock (par value)
Surplus (additional paid-in capital)
Undivided profits (retained earnings)

KNOW: If loan losses are large, what balance sheet accounts are affected and in what order,
from first to last? Loan loss reserves, undivided profits, surplus, common stock, preferred stock,
senior preferred stock, subordinated notes and debentures, uninsured deposits, FDIC for insured
deposits, taxpayers.
As of 6/30/01 mergers must use purchasing accounting, where if you pay $100 for a company
that has a book value of $90, the other $10 is goodwill. Under the new accounting standards,
goodwill may remain on the balance sheet indefinitely but the company must perform annual tests
to see if the goodwill has become impaired, i.e., suffered a permanent decline in value. Under
the previous accounting treatment goodwill was amortized as an expense and lowered EPS. In
another popular previous accounting treatment, pooling accounting, there was no goodwill. You
merged assets at book value and there was no amortization of goodwill to decrease EPS. On
6/30/14 goodwill and other intangibles were 2.2%, 4.3%, and 23.8% of total equity for banks
(<$100M TA), ($100M-<1B TA), and (>= $1B TA), respectively. This amount is usually reduced
from an equity measure to determine tangible equity. Since the goodwill is not likely to have
much value when a bank is performing poorly or in a failure, many use the tangible measure as a
more legitimate measure of equity.
Source: http://www2.fdic.gov/SDI/SOB/
Types of Bank Capital and Importance of Each (6/30/14)
Subordinate Notes and Debentures/TA < 0.5% for small and medium banks, 2.67% for large
banks
Preferred Stock/TA is small (<0.1% for all bank sizes)
Common Equity Capital/Total Assets is 11.71% for small banks ($100M TA), 10.74% ($100M
to $1B), and 11.21% for large banks ($1B TA). NOTE: (CE-GW)/TA for small, medium, and
large banks = 11.45%, 10.28%, and (11.21 X (1-.238)) = 8.54%.
Market Value of Common Equity Capital = MVAssets - MVLiabilities
MVC = (current market price/share) X (# of shares outstanding)
Note: MVC is difficult to measure for small banks because their stock is not actively traded.

Basel Accord 1 (approved in 1988, fully effective in 1993) developed capital standards for US,

Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, UK,
Luxembourg to promote strong capital positions and reduce inequalities among different countries
to promote fair competition. The current (2014) 27 Basel Committees members come from
Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India,
Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia,
Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the
United States. The Committee's Secretariat is located at the Bank for International Settlements
(BIS) in Basel, Switzerland. However, the BIS and the Basel Committee remain two distinct
entities.
The Basel Committee formulates broad supervisory standards and guidelines and recommends
statements of best practice in banking supervision (see bank regulation or "Basel III Accord", for
example) in the expectation that member authorities and other nations' authorities will take steps
to implement them through their own national systems, whether in statutory form or otherwise.
The purpose of BCBS is to encourage convergence toward common approaches and standards.
BCBS does not issue binding regulation; rather, it functions as an informal forum in which policy
solutions and standards are developed.
KNOW: General Description of Regulatory Measures of Capital, pp. 494
1. Tier 1 Leverage ratio = [tier 1 (core) capital]/total assets (U.S. ratio but has not been a Basel
ratio until recent Basel 3 Accord)
= [common equity + qualified noncumulative perpetual pref. stk. + minority interests
in the equity accounts of consolidated subsidiaries + identified
intangible assets - (goodwill and other intangible assets] / total assets
Note that the Leverage ratio does not adjust for the risk levels of different assets held by the bank.
The Federal Reserve Board on Oct. 16, 2008, announced the adoption of an interim final
rule to be effective on Oct. 17, 2008, that will allow bank holding companies to include in their
Tier 1 capital without restriction the senior perpetual preferred stock issued to the Treasury
Department under the capital purchase program announced by the Treasury on October 14, 2008.
Treasury established the capital purchase program under the Emergency Economic Stabilization
Act of 2008, which became law on October 3, 2008. Many banks have repaid the funds but the
TARP funds (capital purchase program) had to be considered when analyzing capital ratios.
Details about the capital purchase program are available on the Treasury's website.

2. Tier 1 RBC (risk-based capital) ratio = [tier 1 (core) capital]*/risk-weighted assets

*Core capital here limits qualifying noncumulative perpetual pref. stk. to 1/4 of
Tier 1 capital with remainder over the limit, referred to as non-qualifying,
counting towards Tier 2 capital. Identified intangible assets such as purchased
mortgage servicing rights (PMSRs) and purchased credit card relationships
(PCCRs) may be included, subject to certain limits but also must be included in

risk-weighted assets. Risk-weighted assets include on- and off-balance sheet

items.
3. Tier 1 Common Equity Ratio = (common equity goodwill)/risk-weighted assets
4. Total RBC (risk-based capital) ratio = [Tier 1 (core) capital + Tier 2 (supplemental)
capital]/risk-weighted assets, where
Tier 2 capital = loan and lease loss reserves, subordinated notes & debentures,
non-qualifying perpetual pref. stk., mandatory convertible debt, intermediate-term
pref. stk., cumulative pref. stk. with unpaid dividends, and long-term capital notes
that combine both debt and equity features. Tier 2 is limited to 50% of Total
Capital. Risk-weighted assets include on- and off-balance sheet items.
Categories of Capitalization and the Ratios (6/30/11),

As of 6/30/13, 97.6% of the 6,939 FDIC-insured commercial banks and savings institutions
(99.7% of $14,409B of assets) are well-capitalized, 1.2% (0.2% of dollar assets) are adequatelycapitalized, 0.6% are undercapitalized, 0.5% are significantly undercapitalized, and 0.1% are
critically undercapitalized. [Source: FDIC Quarterly Banking Profile Graph Book, p.77]
According to FDICIA (1991) guidelines, regulatory authorities must or may take restrictive
actions as banks move from well-capitalized to lower categories. (p. 507)

KNOW new standards

Total RBC
Tier 1 RBC
Basel 3 (B3) (July 2, 2013)
B3 minimums
8%
6%
US bank minimum
New regulation (April 8, 2014)
B3 capital conservation 2.5%CE buffer 10.5%
8.5%
B3 counter cyclical buffer
B3 global SIFI buffer (Updated in November, see below)

Tier 1 Lev.

Tier 1 CE

3% global 4.5%
(4% US)
(5% Largest US BHCs)
NA
7.0%
0-2.5%
1-2.5%

Dodd-Frank domestic SIFI buffer (not determined yet but may be up another 2%)
The FED has regulated (April 8, 2014) that eight BHCs (BAC, JPM, C, GS, MS, WFC, BK,
STT) would have to increase their minimum tier 1 leverage ratios to 5% and 6% for their bank
deposit-insured subsidiaries to be considered well-capitalized. Only JPM and BK do not meet
the 5% but expect to in the future.
Standards will be phased in over time. Although the new standards will be higher for some
countries most U.S. banks current ratios (see below) will meet the new standards. Since the end
of 2008 capital ratios have been rising. For example, on 6/30/13 the levels for the industry were:
Total RBC = 14.93%; Tier 1 RBC = 13.0%, Tier 1 leverage = 9.34%, and Equity/Assets =
11.19%. Source: FDIC Quarterly Banking Profile Color Graph Book, 6/30/13, p. 17.
SIFI means systematically important financial institutions. The problem is balancing a higher
capital requirement with a higher cost of credit for borrowers. In other words, as the level of the
equity is increased, the return on that equity in the form of higher interest rates must also be
increased to provide the same return (ROE) to investors. The higher interest rates may have a
negative effect on economic growth. SMITH COMMENT: Some have argued that being a sifi
(or too big to fail) provides a subsidy to these banks by allowing them to obtain funds at a lower
cost. A higher equity requirement may offset that subsidy by requiring a higher ROE for
investors. Another approach that has been discussed by Congress and President Obama is to
apply an additional tax, e.g., 0.035% on total assets, on financial firms with assets more than $500
billion. This tax approach is criticized by bankers because its major purpose appears to be to raise
revenues rather than lower the banks ability to absorb losses like the additional sifi requirement
does.
On Nov. 11, 2013, the annual update of G-SIBs (globally systematically important banks)
were provided and the buckets were determined. Examples of US banks are 2.5% (JP Morgan
Chase), 2.0% (Citigroup), 1.5% (Bank of America, Goldman Sachs, Morgan Stanley), and 1.0%
(Bank of NY Mellon, State Street and Wells Fargo). These requirements will be phased in from
January 2016 to January 2019.
Common equity is considered the highest form of loss absorbing capital because then only the
common stockholders are wiped out. Big bailouts in the past have sometimes limited losses to the
common stockholders and not the others with preferred stock or other debt. The Group of
Governors and Heads of Supervision also agreed that the capital conservation buffer above the
regulatory minimum requirements be calibrated at 2.5% and be met with common equity, after the
application of deductions. The purpose of the conservation buffer is to ensure that banks maintain
a buffer of capital that can be used to absorb losses during periods of financial and economic
stress. While banks are allowed to draw on the buffer during such periods of stress, as the banks
fall into the buffer, the greater the constraints on earnings distributions such as discretionary
bonuses and high dividends.
The countercyclical buffer (0-2.5% common equity to RWA) may be added when authorities
judge credit growth is resulting in an unacceptable build up of systematic risk.

KNOW risk relationships reflected in credit risk and market risk weights, i.e., different
loans vs. ABS, revenue vs. GOs, different SLCs, different maturities, currency vs. interest
rate derivatives.
Risk Weights applied to bank assets and off-balance sheet items under Basle I Agreement,
pp. 495-500. These apply only to credit risk.
Examples of Assets on Balance Sheet - see p.496
Weight (Level of
Credit Risk)
Examples
1. 0% (zero)

Cash & due; Treasury securities of all maturities; GNMA mortgagebacked securities

2. 20% (low)

Items in process of collection (float), interbank deposits, general

obligation municipals, U.S. agency securities, FNMA & FHLMC
mortgage-backed securities

3. 50% (moderate)

Residential 1-4 family loans, selected multifamily housing loans, revenue

municipals

4. 100% (highest)

Commercial loans, consumer loans and all other assets not listed above.

Calculating Risk-Weighted Assets (RWA) Assume the following amount of assets in each
category, 1 = $10, 2 = $20, 3 = $40, and 4 = $30. The total assets = $100. The RWA = (0.0 x
$10) + (0.2 x $20) + (0.5 x $40) + (1.0 x $30) = $54. This simple example only considers onbalance sheet activities. Off-balance sheet activities below also have to be considered.
Examples of Off-Balance Sheet Items and Derivatives not shown on a balance sheet - see pp.497500

Off-Balance Sheet Activities

Conversion
Factor**

Weight (Level of
Credit Risk)

1. 0.0

0% (zero or lowest)

Unused loan commitments < 1 year maturity; guarantees of

federal or central government borrowings

2. 0.2

20% (low)

SLCs for general obligation municipals

3. 0.2

100% (modest)

Trade-based commercial letters of credit and bankers

acceptances

Examples

4. 0.50

100% (moderate)

5. 1.00

100% (highest)

SLCs guaranteeing performance; Unused loan

commitments with a maturity > 1 year
SLCs to back repayment of commercial paper

Derivatives Conversion Weight (Level of

Factor**
Credit Risk)

Examples

1. 0.0

50% (lowest)

Interest-rate contracts 1 year

2. 0.005

50% (modest)

Interest-rate contracts > 1 year

3. 0.01

50% (moderate)

Currency contracts 1 year

4. 0.05

50% (highest)

Currency contracts > 1 year

**Conversion Factor for converting Off-BS items into equivalent amounts of On-BS items. The
conversion factor is multiplied times the notional value to obtain the potential market risk
exposure. This amount is added to the current market risk exposure (replacement cost) and the
weight is multiplied times the sum of the two risk exposures.
Comment: To the extent that regulator-required capital is greater than the amount that the
market would require, then the difference is considered a tax by bankers. The weights may also
affect bank portfolio decisions, e.g., residential 1-4 family loans have a lower capital requirement
than commercial loans or consumer loans and may encourage banks to make more of the lowercapital requirement loans.
Bank Capital Standards and Market/Interest Rate Risk - The above weights only reflect
credit risk. A major risk that is not considered is market risk. The Basle Capital Accord in 1995
passed new market risk capital requirements that became effective January 1, 1998. In the U.S.
banks and bank holding companies whose trading activities in securities, currencies, and/or
commodities are greater than or equal to 10% of total assets or $1Billion must hold some capital
aimed at protecting their market risk exposure. These banks are allowed to develop their own inhouse models for risk assessment. The model must determine the maximum loss it might sustain
over a 10-day period (under a 99-percent statistical confidence standard) known as the Value at
Risk (VaR) approach. Regulators then will determine the amount of capital the bank needs to
cover its market risk exposure. Example of VAR approach: Take all of the 10- trading day returns
over some time period, e.g., the last five years, i.e., if periods overlap then one would have about
250 periods per year using trading days. Take the standard deviation of the returns and calculate
a 99% 2-tail confidence interval around the mean, e.g., Z = 2.567, which leaves 0.5% in each
tail. The lowest return at the (mean -2.567 standard deviation) would be the estimated maximum
loss for the next two-week period. Potential problems with this approach are (1) estimates will
vary by time period, e.g., estimates based on periods with low volatility will underestimate the
potential losses when periods have more volatility, and (2) losses may last longer than 10 days so

that the 10-day window may underestimate potential losses, e.g., R1-10 days = -10% and R11-20 days =
-11% show losses of -10 and -11%, however, the 20-day loss is 21%, much more than the 10-day
window estimates. The current multiplier for VaR is three but the multiplier depends on how
accurate the loss estimates are over the last 250 trading days. If the number of daily exceptions is
greater than four, then the multiplier is increased. If the number of exceptions is ten or more then
the multiplier increases to four and the risk assessment model must be explicitly improved. For an
example of recent use of VaR see excerpt from 2008 Q2 Bank Derivatives Report at the end of
the notes.
3 Pillars p. 502
1. Minimum capital requirement ( regulatory capital/risk-weighted assets) but more advanced
treatment of credit risk and market risk (see above examples). Explicitly take into account
operational risk (p. 503), the risk of loss resulting from inadequate or failed internal processes,
people, systems, or from external events.
2. Supervisory oversight - The internal process by which bank management assesses and sets
capital should be subject to supervisory review.
3. Stronger market discipline require banks to publicly disclose key information that enables
market to assess a banks risk profile and level of capitalization because internal ratings of an
individual bank could be used to set regulatory capital requirements; however, many difficulties,
e.g., data availability and model validation, must be dealt with. This should permit better
monitoring by private investors. (Other proposals related to market discipline would require the
largest banks in the U.S. to issue a minimal amount of subordinated debt that would not be
insured. This approach would provide market discipline.)
Operational Risk, the risk of loss resulting from inadequate or failed internal processes, people,
systems, or from external events, is newest risk factor. Other risk factors include credit and
market risk. The basic capital charge for operational risk would be a specified percentage of the
banks average annual gross income over the preceding three years. The standardized approach
would be calculated for each of eight business lines. The advanced measurement approaches
(AMA) would allow banks to use their own methods for assessing their exposure.
Scope of Application of Basel II
As of 7/20/07 only the 11 largest U.S. banks will use the Basel II capital rules using the
advanced approach where they set capital according to internal rated base models. Others will
use the standardized approach. The impact of the new rules on levels of capital will be studied
for two years after implementation which will probably occur in 2008. Under advanced
approach for measuring credit risk, a bank would be required to estimate for each credit
exposure, the probability of borrower default, likely size of loss in default, the amount of
exposure at time of default, and the remaining maturity of the exposure.
National discretion is built into the framework so that adopting countries have some flexibility in

implementing rules that are most appropriate to their own circumstances. It is also important to
have competitive equity across countries.
COMMENT: Small banks in U.S. and other countries are worried that new system will give
biggest banks a new advantage if they are allowed to lower the largest banks level of capital.
Large U.S. banks were worried about international competitive equality, particularly related to
the tier 1 leverage ratio that was not used in other countries until Basel 3.
VaR Example from OCCs Quarterly Report on Bank Trading and Derivatives
Activities Second Quarter 2008
Market Risk
Banks control market risk in trading operations primarily by establishing limits against potential
losses. Value at Risk (VaR) is a statistical measure that banks use to quantify the maximum loss
that could occur, over a specified horizon and at a certain confidence level, in normal markets. It
is important to emphasize that VaR is not the maximum potential loss; it provides a loss estimate
at a specified confidence level. A VaR of $50 million at 99% confidence measured over one
trading day, for example, indicates that a trading loss of greater than $50 million in the next day
on that portfolio should occur only once in every 100 trading days under normal market
conditions. Since VaR does not measure the maximum potential loss, banks stress test their
trading portfolios to assess the potential for loss beyond their VaR measure.
The large trading banks disclose their average VaR data in published financial reports. To provide
perspective on the market risk of trading activities, it is useful to compare the VaR numbers over
time and to equity capital and net income.
As shown in the table below, market risks reported by the three largest trading banks, as measured
by VaR, are small as a percentage of their capital.
$ in millions
JPMorgan & Co. Citigroup Inc.
Bank of America Corp.
Average VaR Q2 '08
$150
$255
$88
Average VaR 2007
$107
$142
$53
06-30-08 Equity Capital $133,176
$136,405
$162,691
2007 Net Income
$15,365
$3,617
$14,982
Avg VaR Q2 '08/Equity
0.11%
0.19%
0.05%
Avg VaR Q2 '08/
2007 Net Income
0.98%
7.05%
0.58%
Data Source: 10K & 10Q SEC Reports.
To test the effectiveness of their VaR measurement systems, trading institutions track the number
of times that daily losses exceed VaR estimates. Under the Market Risk Rule that establishes
regulatory capital requirements for U.S. commercial banks with significant trading activities, a
banks capital requirement for market risk is based on its VaR measured at a 99% confidence level
and assuming a 10-day holding period. Banks back-test their VaR measure by comparing the
actual daily profit or loss to the VaR measure. The results of the back-test determine the size of
the multiplier applied to the VaR measure in the risk-based capital calculation. The multiplier adds
a safety factor to the capital requirements. An exception occurs when a dealer has a daily loss in

10

excess of its VaR measure. Some banks disclose the number of such exceptions in their
published financial reports. Because of the unusually high market volatility and large write-downs
in CDOs in the recent quarters, as well as poor market liquidity, a number of banks experienced
back-test exceptions and therefore an increase in their capital multiplier. Concentrations in illiquid
ABS CDOs, as well as non-normal market conditions, have caused several large dealer institutions
(both bank and non-bank) to incur significant trading losses in the past four quarters. Historically,
these ABS CDOs had not exhibited significant price variability given their super senior position
in the capital structure, so measured risk in VaR models was very low. However, rapidly
increasing default and loss estimates for subprime mortgages caused abrupt and significant
reassessments of potential losses, in these super senior ABS CDOs, that continue to play out.
Because VaR models rely on historical price movements and assume normal market conditions,
this particular risk measurement tool may not have fully captured the effect of severe market
dislocations. As such, the OCC advocates the use of complementary risk measurement tools such
as stress testing and scenario analysis.