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MANAGEMENT
CAPITAL ADEQUACY
WEEK 8
Saunders and Cornett (2003)
Chp. 20
1
Overview
This chapter discusses
the functions of capital,
different measures of capital adequacy,
current and proposed capital adequacy
requirements, and
advanced approaches used to calculate
adequate capital according to internal
rating based models of credit risk.
2
Functions of Capital
1. The primary means of protection against
the risk of insolvency and failure is a FIs
capital. Capital absorb unanticipated
losses with enough margin to inspire
confidence.
2. To protect uninsured depositors
bondholders and creditors in the event of
insolvency and liquidation
3
Functions of Capital
3. To protect FI insurance funds and the
taxpayers.
4. To protect the FI owners against
increases in insurance premiums.
5. To fund the branch and other real
investments necessary to provide
financial services.
Example:
Assets (mill. $)
Long-term securities
Long-term loans
Liabilities (mill. $)
80
20
100
Assets
Long-term securities
Long-term loans
Liabilities
Net worth
90
10
100
Liabilities
80
12
100
Liabilities
Net worth
90
2
100
10
11
13
14
15
17
19
20
Zone
Total Risk-based Ratio
Well capitalized
10% or >
Adequately capitalized
8% or >
Undercapitalized
8%<
Singnificantly undercapitalized
6%<
Critically undercapitalized
2% <
21
23
24
26
Calculating Risk-based
Capital Ratios
Tier I includes:
book value of common equity, plus perpetual
preferred stock, plus minority interests of the
bank held in subsidiaries, minus goodwill.
Tier II includes:
loan loss reserves (up to maximum of 1.25%
of risk-adjusted assets) plus various
convertible and subordinated debt
instruments with maximum caps
28
29
>4%
32
Step Two:
Multiply credit equivalent amounts by appropriate
risk weights (dependent on underlying
counterparty)
34
Criticisms of
Risk-based Capital Ratio
Risk weight categories versus true credit risk.
Risk weights based on rating agencies
Portfolio aspects: Ignores credit risk portfolio
diversification opportunities.
May reduce incentives for banks to make
loans.
Other risks: Interest Rate, Foreign Exchange,
Liquidity
Competition and differences in standards
36