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CHAPTER 15

THE MANAGEMENT OF CAPITAL


particularly equity capital is so important for financial institutions, to learn how
managers and regulators assess the adequacy of an institutions capital position, and to
explain the ways that management can raise new capital.
The Many Tasks of Capital
Capital and Risk Exposures
Types of Capital In Use
Capital as the Centerpiece of Regulation
Basel I and Basel II
Planning to Meet Capital Needs
I. Introduction: What Is Capital?
II. The Many Tasks Capital Performs
A. Cushion Against Risk of Failure
B. Provides Funds Needed to Begin Operations
C. Promotes Public Confidence
D. Provides Funds for Future Growth and New Services
E. Regulator of Growth
F. Capital Plays a Role in Mergers
G. Limits How Much Risk Exposure Banks and Competing Firms Can Accept
H. Protects the Governments Deposit Insurance System
Ill. Capital and Risk
A. Key Risks in Banking and Financial Institutions Management
1. Credit Risk
2. Liquidity Risk
3. Interest-Rate Risk
4. Operating Risk
5. Exchange Risk
6. Crime Risk
B. Defenses against Risk
1. Quality Management
2. Diversification
a. Portfolio
b. Geographic
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IV.
V.
VI.
VII.
3. Deposit Insurance 4. Owners' Capital Types of Capital A. Common Stock B. Preferred
Stock C. Surplus D. Undivided Profits E. Equity Reserves F. Subordinated Debentures G.
Minority Interest in Consolidated Subsidiaries H. Equity Commitment Notes I. Relative
Importance of the Different Sources of Capital One of the Great Issues in the History of
Banking: How Much Capital Is Really Needed? A. Regulatory Approach to Evaluating
Capital Needs 1. Reasons for Capital Regulation 2. Research Evidence The Basle
Agreement on International Capital Standards: An Historic Contract among Leading

Nations A. Basel I 1. Tier One Capital 2. Tier Two Capital 3. Calculating Risk-Weighted
Assets Under Basle I 4. Calculating the Capital-to Risk-Weighted Assets Ratio Under
Basel I B. Capital Requirements Attached to Derivatives 1. Bank Capital Standards and
Market Risk 2. Market Risk and Value at Risk (VaR) Models 3. Value at Risk (VAR)
Models 4. Limitations and Challenges of VaR and Internal Modeling C. Basel II: A New
Capital Accord Unfolding 1. Pillars of Basel II 2. Internal Risk Assessment 3.
Operational Risk 4. Basel II and Credit Risk Models 5. A Dual (Large-Bank, Small-Bank)
Set of Rules 6. Problems Accompanying the Implementation of Basel II Changing
Capital Standards Inside the United States A. FDIC Improvement Act B. Prompt
Corrective Action 1. Well Capitalized 2. Adequately Capitalized 3. Undercapitalized
4. Significantly Undercapitalized 5. Critically Undercapitalized
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VIII. Planning To Meet Capital Needs
A. Raising Capital Internally
1. Dividend Policy
2. How Fast Must Internally Generated Funds Grow?
B. Raising Capital Externally
1. Issuing Common Stock
2. Issuing Preferred Stock
3. Issuing Subordinated Notes and Debentures
4. Selling Assets and Leasing Facilities
5. Swapping Stock for Debt Securities
6. Choosing the Best Alternative for Raising Outside Capital
IX. Summary of the Chapter
15-1. What does the term capital mean as it applies to financial institutions?
Funds contributed to a financial institution primarily by its owners, consisting mainly of
stock, reserves, and retained earnings, plus any long-term debt issued that qualifies under
regulations.
15-2. What crucial role does capital play in the management and viability of financial
firm?
Capital provides the long-term, permanent funding that is needed to construct facilities
and provide a base for the future expansion of assets. Capital also absorbs operating
losses until management has a chance to correct the institution's problems. From a
regulatory perspective capital limits the growth of risky assets.
15-3. What are the links between capital and risk exposure among financial service
providers?
Capital functions as a cushion to absorb losses until management can correct the
problems generating those losses. Institutions face many different kinds of risk: (1) crime
risk, (2) interest-rate risk, (3) credit risk, (4) liquidity risk, (5) exchange risk and (6)
operational risk. Capital represents the ultimate line of defense against these risks when
all other defenses fail.
15-4. What forms of capital are in use today? What are the key differences between the
different types of capital?
The principal forms of bank capital include common and preferred stock, surplus,
retained
earnings, and subordinated notes and debentures. Common stock represents the par value

paid by owners, while surplus is the amount paid over par value for the stock when it is
first sold. Preferred stock is a special type of ownership where dividends are fixed and
stockholders
generally do not have a vote on major activities undertaken by the firm. Retained
earnings are the accumulated earnings of the firm kept to reinvest back in the company.
Subordinated notes and debentures are long term debt instruments that don not represent
ownership claims.
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15-5. Measured by volume and percentage of total capital, what are the most important
and least important forms of capital held by U.S.-insured banks? Why do you think this
is so?
The most important form of capital is surplus, followed by retained earnings,
subordinated notes and debentures and preferred stock. Common stock represents what
owners contribute originally when they buy the stock to begin with. Retained earnings
represent the growth in earnings that accumulate in the firm over time. What the owners
contribute to the firm and the wealth that accumulates over time are the true cushion
against loss that capital represents.
15-6. How do small banks differ from large banks in the composition of their capital
accounts and in the total volume of capital they hold relative to their assets? Why do you
think these differences exist?
Small banks rely mainly on retained earnings and very little on long term debt, whereas
large banks rely on common stock, retained earnings and long term debt. Small banks
have a difficult time to place their equity and debt securities in the market and thus, rely
more heavily on internal capital (i.e. retained earnings)
15-7 What is the rationale for having the government set capital standards for financial
institutions, as opposed to letting the private marketplace set those standards?
The government's interest in capital stems from its efforts to stabilize the financial system
and avoid drains on the federal insurance system. Capital requirements have long been
subject to government regulation, though bankers frequently argue that the market, rather
than regulators, should determine how much capital a financial institution should hold.
The fear among regulators, however, is that financial institutions would hold too little
capital to avoid excessive numbers of failures and that the private market cannot
adequately assess their need for capital.
15-8. What evidence does recent research provide on the role of the private marketplace
in determining capital standards?
The results of recent studies are varied, but most find that the private marketplace is more
important than government regulation in determining the amount and type of capital
financial institutions must hold. However, government regulation apparently was at least
as important in the 1980s and early 1990s, with the tightening of capital regulations and
the imposition of minimum capital requirements.
15-9. According to recent research, does capital prevent a financial institution from
failing?
If capital is large enough to absorb operating losses it can prevent failure for a time, at
least until the capital is all used up. However, there is no solid, undisputed evidence of a
significant relationship between the size of the capital-to-asset ratio and the incidence of
failure.

15-10. What are the most popular financial ratios regulators use to assess the adequacy of
bank capital today?
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The prime capital-adequacy ratios are total capital to assets, equity capital to assets, total
capital to risk assets, and primary or core capital and supplementary or secondary capital
to total assets and to risk-adjusted assets.
15-11. What is the difference between core (or tier 1) capital and supplemental (or tier 2)
capital?
Core capital is the permanent capital of a bank, consisting mainly of common stock,
surplus, retained earnings, and equity reserves. Supplemental capital is secondary forms
of bank capital, such as debt securities and limited-life preferred stock and a few
qualified intangibles assets.
15-12. A bank reports the following items on its latest balance sheet: Allowance for Loan
and Lease Losses $42 million; Undivided Profits $81 million; Subordinated Debt Capital
$3 million; Common Stock and Surplus $27 million; Equity Notes $2 million; Minority
Interest in
Subsidiaries $4 million; Mandatory Convertible Debt $5 million; Identifiable Intangible
Assets $3 million; and Noncumulative Perpetual Preferred Stock $5 million. How much
does the bank hold in Tier 1 capital? In Tier 2 capital? Does the bank have too much Tier
2 capital?
The Tier 1 capital items include: The Tier 2 capital items include:
Common stock and surplus $27 mill. Allowance for Loan and $42 mill.
Lease Losses
Undivided Profits 81 Subordinated Debt Capital 3 Noncumulative Perpetual
Mandatory Convertible Debt 5
Preferred Stock 5 Equity Notes 2 Minority
interest in Identifiable Intangible Assets 3
Subsidiaries 4
Total Tier 1 Capital $117 mill.
Total Tier 2 Capital $55 mill.
The bank does not have too much Tier 2 capital. Tier 2 capital can be up to 100 percent
of the amount of Tier 1 capital and still count toward meeting capital requirements.
15-13. What changes in the regulation of bank capital were brought into being by the
Basel Agreement? What is Basel I? Basel II?
U.S. banks, along with international banks from other industrialized nations, must hold a
core or Tier 1 (permanent) capital ratio to risk-adjusted assets of 4 percent and an
additional 4 percent in supplementary or secondary capital, under the terms of the Basel
Agreement on international capital standards. Basel I refers to the capital standards that
are in effect today. Basel II is a new capital requirement accord that is supposed to
address the weaknesses of Basel I. It is scheduled to be phased in starting in 2008.
15-14. First National Bank reports the following items on its balance sheet: cash $200
million; U.S. government securities $150 million; residential real-estate loans $300
million; and corporate loans $350 million. Its off-balance-sheet items include: standby
credit letters, $20 million and long-term credit commitments to corporations, $160
million. What are First
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National's total risk-weighted assets? If the bank reports Tier I capital of $30 million and
Tier 2 capital of $20 million, does it have a capital deficiency?
We first convert the off-balance-sheet items to their credit-equivalent amounts:

Standby Credit Letters $20 mill. * 1.00 = $20 mill.


Long-Term Commitments to Corporations $160 mill. * 0.50 = 80 mill.
Then we risk-weight all assets:
Cash
$200 mill. * 0 = $0 mill.
U.S. Government Securities:
$150 mill. * 0 = 0
Standby Credit Letters:
$20 mill. * 0.20 = 4
Residential Real Estate Loans:
$300 * 0.50 = 150
Corporate Loans:
$350 * 1.00 = 350
Long-Term Credit Commitments:
$80 * 1.00 = Total Risk-Weighted Assets = $584
The bank has total capital of:
Tier 1 capital = $30 mill.
$50 mill.
The bank's capital to risk-weighted asset ratio is:
$584 mill.
which exceeds the minimum requirement of 8 percent. Moreover, more than 4 percent of
the 8.6 percent in capital is Tier 1 capital, so the bank satisfies the capital requirements.
15-15. How is the Basel Agreement likely to affect a bank's choices among assets it
would like to acquire?
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Under the capital standards brought into being by the BaselAgreement, differing risk
weights will apply to different kinds of bank assets. Each dollar of high-risk assets, such
as corporate loans and home mortgages, requires a greater proportion of bank capital
pledged behind it than a dollar of low-risk assets, such as government securities. Banks
desiring to keep their capital costs as low as possible will move toward government
securities and away from corporate loans and home
mortgage loans. They will also change the types of off-balance sheet items they hold for
the same reason.
15-16. What are the most significant differences between Basel I and Basel II? Explain
the importance of the concepts of internal risk assessment, VAR, and market discipline
Basel I used a one size fits all approach to determine a banks capital requirements. Basel
II recognizes that different banks have different risk exposures and should be subject to
different capital requirements. It also broadens the types of risk considered for
determining capital
requirements, including credit, market and operational risk. Internal risk assessment
refers to an innovation in Basel II which allows banks to measure their own risk
exposure. These
measurements are subject to review by the regulators to ensure that they are reasonable.
The VAR model is one of the models used to determine a banks risk exposure. It
measures the price or market risk of a portfolio of assets whose value may decline due to
adverse movements in the financial markets or interest rates. Market discipline refers to
the market determining the banks risk exposure. In order to achieve that a bank would

be required to issue subordinated debt. Since this debt is not guaranteed the buyers of
these notes would be very vigilant about the issuing banks financial condition.
15-17. What steps should be part of any plan for meeting a long-range need for capital?
The four key phases of planning to meet a bank's capital needs are as follows:
1. Develop an overall financial plan.
2. Determine the amount of capital that is appropriate given the goals, planned service
offerings, acceptable risk exposure, and state and federal regulations.
3. Determine how much capital can be generated internally through profits retained in
the business.
4. Evaluate and choose that source of external capital best suited to the institutions
needs and goals.
15-18. How does dividend policy affect the need for capital?
The retention ratio is of great importance to management. A retention ratio set too low
results in slower growth of internal capital, which may increase the failure risk and retard
the expansion of earning assets.
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15-19. What is the ICGR and why is it important the management of a financial firm?
The ICGR indicates how fast a firm can allow its assets to grow and still keep its capitalto-asset ratio fixed. The ICGR indicates how fast earnings must grow and what
proportion must be retained in the business to insure a constant capital-asset ratio.
15-20. Suppose that a bank has a rate of return on equity capital of 12 percent and its
retention ratio is 35 percent. How fast can this bank's assets grow without reducing its
current ratio of capital to assets? Suppose that the bank's earnings (measured by ROE)
drop unexpectedly to only two-thirds of the expected 12 percent figure. What would
happen to the bank's ICGR? The relevant formula is:
ICGR = ROE x Retention Ratio
= 0.12 * 0.35
= 0.042 or 4.2 percent
If ROE unexpectedly drops to only two-thirds of the expected 12 percent figure, the
ICGR becomes:
ICGR = [0.12 * 0.66] * 0.35
= 0.028 or 2.8 percent.
15-21. What are the principal sources of external capital for a financial institution?
The principal sources of external capital are: selling common stock, selling preferred
stock, issuing capital notes, selling assets, or leasing certain fixed assets.
15-22. What factors should management consider in choosing among the various sources
of external capital?
Drawing upon common and preferred stock increases the borrowing capacity and
provides
permanent capital, but it can result in ownership and earnings dilution. Debt capital is
generally cheaper to issue due to the leveraging effect, but creates greater risk of
variability in shareholder returns and increased risk failure.
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15-1. Carter Savings Association has forecast the following performance ratios for the
year ahead. How fast can Carter allow its assets to grow without reducing its ratio of
equity capital to total assets, assuming its performance holds reasonably steady over it

planning period?
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Internal Capital Growth Rate =
=
= Profit Margin * Asset Utilization * Equity Multiplier * Retention Ratio 0.0830 *
0.0925 * 15.22 * 0.450 0.0526 or 5.26%
Its assets cannot grow any faster than 5.26 percent in order to avoid reducing its ratio of
equity capital to total assets.
15-2. Using the formulas developed in this chapter and in chapter 6 and the information
that follows, calculate the ratios of total capital to total assets for the banking firm listed
below. What relationship among these institutions return on assets, return on equity
capital, and capital to assets ratios did you observe? What implications or
recommendations would you draw for the management of each of these institutions?
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The basic relationship needed in this problem is
ROE = Net Income After Taxes = Net Income After Taxes * Total Assets Equity Capital
Total Assets Equity Capital
= ROA * Total Assets
Equity Capital
in which case:
Total Assets = ROE and Equity Capital = ROA
Equity Capital ROA Total Assets ROE
Therefore the ratio of total capital to total assets for the banks named in the problem must
be:
First National Bank of Hopkins = 0.016/0.15 = 0.1067 or 10.67%.
Safety National Bank = 0.013/0.13 = 0.1000 or 10.00%
Ilsher State Bank = 0.0095/0.100 = 0.0950 or 9.50%
Mercantile Bank and Trust Company = 0.0083/0.09 = 0.0922 or 9.22%
Lakeside National Bank = -0.0043/-0.0500 = 0.086 = 8.60%
None of the banks appear to have a serious capital deficiency problem. However, the
bank with the lowest capital to total assets ratio is also the one with a negative return on
assets and return on equity. The negative earnings may be eroding the capital position of
this bank.
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15-3 Using the following information for Sun-Up National Bank, calculate that banks

ratio of total capital to risk weighted assets under the terms of the Basel I agreement.
Does the bank have sufficient capital?
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Sun-Up National Bank's required level of capital under the new international capital
standards would be determined from:
Standby Credit Letter: $18.1 million * 1.00 = $18.1 million
Long-Term Credit Commitments: $40.2 million * 0.50 = 20.1 million
Cash $ 3.5 million
U.S. Treasury Securities
$ 29.1 * 0 = $0 million
Balances at Domestic Banks $ 4.0 million
Credit Equivalent Amounts of
Standby Credits
$ 22.1 million * 0.20 = $4.42 million
Residential Real Estate Loans $ 19.7 million x 0.50 = $9.85 million
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Loans to Corporations $105.3 million
Credit Equivalents of
Long-Term Commitments
Total Risk-Weighted Assets
$139.67 million
The bank's capital ratio is:
Total Capital/Risk-Weighted Assets = $ 139.67 million
which is just above the minimum total capital (Tier One + Tier Two) requirement of 8
percent.
15-4 Top of the Mountain Savings has been told by examiners that it needs to raise an
additional $8 million in long-term capital. Its outstanding common equity shares total 7.5
million, each bears a par value of $1. This thrift institution currently holds assets of
nearly $2 billion, with $105 million in equity. During the coming year, the thrifts
economist has forecast operating revenues of $175 million, of which operating expenses
are $25 million plus 70 percent of operating revenue. 214
Among the options for raising capital considered by management are: (a) selling $8
million in new common stock, or 320,000 shares at $25 per share; (b) selling $8 million
in preferred stock bearing a 9 percent annual dividend yield at $12 per share; or (c)
selling $8 million worth of
10-year capital notes with a 10 percent coupon rate. Which option would be of most
benefit to the stockholders? (Assume a 35% tax rate) What happens if operating revenue
increases more than expected (200 million rather than 175 million)? What happens if
there is a slower than expected volume of revenues (only $125 million instead of $175
million). Please explain.
(a) (b) (c)
Sale of Sale of 9%
Common Stock Preferred Stock Sale of 10%
Operating Revenues $175,000,000 $175,000,000 $175,000,000 Operating Expenses Net
Revenues $ 27,500,000 $ 27,500,000 $ 27,500,000 Interest on Capital Notes

Before-Tax Income $27,500,000 $27,500,000 $26,700,000 Estimated Income Taxes


After-Tax Income $ 18,150,000 $ 18,150,000 $ 17,622,000
Preferred Stock Dividends Net Income for Common $
18,150,000 $ 17,430,000 $
17,622,000
Stockholders
Shares of Common 7,820,000 7,500,000 7,500,000 Stock
Outstanding
Earnings Per Share of $ 2.32 $ 2.32 $ 2.35
Common Stock
In this case sale of the debt would yield the highest EPS for the bank's shareholders
Because of the dilution effect of issuing stock.
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If operating revenue rose to $200 million the situation would be the following:
(a) (b) (c)
Sale of Sale of 9%
Common Stock Preferred Stock Sale of 10%
Operating Revenues $200,000,000 $200,000,000 $200,000,000 Operating Expenses Net
Revenues $ 35,000,000 $ 35,000,000 $ 35,000,000 Interest on Capital Notes
Before-Tax Income $35,000,000 $35,000,000 $34,200,000 Estimated Income Taxes
After-Tax Income $ 23,100,000 $ 23,100,000 $ 22,572,000
Preferred Stock Dividends Net Income for Common $
23,100,000 $ 22,380,000 $
22,572,000
Stockholders
Shares of Common 7,820,000 7,500,000 7,500,000 Stock
Outstanding
Earnings Per Share of $ 2.95 $ 2.98 $ 3.01
Common Stock
And again the capital notes would be the best option, although the preferred stock comes
closer this time.
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If operating revenues drop to $125 million, then the situation would be the following:
(a) (b) (c)
Sale of Sale of 9%
Common Stock Preferred Stock Sale of 10%
Operating Revenues $125,000,000 $125,000,000 $125,000,000 Operating Expenses Net
Revenues $ 12,500,000 $ 12,500,000 $ 12,500,000 Interest on Capital Notes
Before-Tax Income $12,500,000 $12,500,000 $11,700,000 Estimated Income Taxes
After-Tax Income $ 8,250,000 $ 8,250,000 $ 7,722,000
Preferred Stock Dividends Net Income for Common $
8,250,000 $ 7,530,000 $
7,722,000
Stockholders
Shares of Common 7,820,000 7,500,000 7,500,000 Stock
Outstanding
Earnings Per Share of $ 1.05 $1.00 $ 1.03
Common Stock
In this case issuing the common stock is the best alternative from the point of view of the
common stockholders.
15-5. Please calculate New River National Banks total risk weighted assets, based on the
following items that the bank reported on its latest balance sheet. Does the bank appear
to have a capital deficiency?
The risk-weighted assets of New River National Bank would be calculated as follows:
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Off-Balance-Sheet Items:
Standby Credit Letters = $95 mill. * 1.00 = $95 mill.
Long-Term Corporate Credit Commitments = $190 mill. * 0.50 = 95 mill.
On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items:
Cash
$95 miIl. * 0 = 0
U.S. Government Securities $320 mill. * 0 = 0
Domestic Interbank Deposits $240 mill. * 0.20 =
48 mill. Standby Credit Letters
$95 mill. * 0.20 =
19 mill. Residential Real Estate Loans $370 mill. * 0.50 =
185 mill. Commercial Loans $520 mill. * 100% =
520 mill. Long-Term
Corporate Credit
Commitments $95 mill. * 1.00 = Total Risk-Weighted Assets =
$867 mill.
Willow River's overall capital-to-assets ratio is:
Total Capital = $105 million = 0.1211 or 12.11 percent
Total Risk-Weighted Assets $867 million
Overall, it does not appear from the information given above that Willow River has a
capital deficiency.
15-6. Suppose that New River National Bank whose balance sheet is given in problem 5,
reports the forms of capital shown in the following table as of the date of its latest
financial statement. What is the total dollar volume of the banks Tier 1 capital? Tier 2
capital? According to the data given in problems 5 and 6, does New River have a capital
deficiency?
New River National Bank has the following Tier 1 and Tier 2 Capital items and totals:
Tier 1 Capital Tier 2 Capital
Common Stock (Par) $8 million Allowance for Loan Loss $25 million
Surplus $17 million Subordinated Debt Capital $15 million Undivided Profit $35 million
Intermediate Term Preferred Stock $5 million Total Tier 1 Capital $60 million Total Tier
2 Capital $45 million
Tier 1 Capital = $60 million = 0..0692 or 6.92 percent
Total Risk-Weighted Assets $867 million
This bank has sufficient Tier 1 capital and since its Tier 2 capital amount is less than its
Tier 1 capital amount it satisfies the requirements of Basel I.
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15-7. Please indicate which items appearing on the following inancial statements would
be classified under the terms of the Basel Agreement as Tier 1 capital and Tier 2 capital.
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15-8. Under the terms of the Basel Agreement, what risk weights apply to the following
on balance sheet and off balance sheet items?
The items which would appear in the 0%, 20%, 50% and 100% risk weight categories are
the following:
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