1 Bank Funding and Capital Management 2 Contents 1. Bank funding sources: overview 2. Costs of deposits 3. Cost of debt and equity 4. Funding sources and banking risks 5. Role of bank capital 6. Capital adequacy 3 Liquidity and Funding Sources ̶ Amount of cash a bank holds is influenced by bank’s liquidity requirements. ̶ Size and volatility of cash requirements affects liquidity position of bank. ̶ Transactions that reduce cash force bank to replenish cash assets by issuing new debt or selling assets. ̶ Transactions that increase cash provide new investible funds. ̶ Banks with ready access to borrowed funds can enter into more transactions as they can borrow quickly and at low cost to meet cash requirements. 4 Bank Funding Sources ̶ Retail funding is considered funding bank receives from consumers and non-institutional depositors. ̶ Stable deposits that customers are less likely to withdraw when interest rates on competing investments rise. ̶ Borrowed or wholesale funding consists of government funds purchased, repurchase agreements and other borrowings (e.g., institutional CDs in US) ̶ Equity-related funding consists of subordinated debt, common and preferred stock and retained earnings. ̶ Volatile (purchased) liabilities describe funds obtained from interest-sensitive investors. ̶ Investors will move their funds if other institutions are paying higher rates or hear rumors that the bank has financial difficulties. 5 Transaction Accounts ̶ Demand deposits accounts (DDA) are non-interest bearing accounts held by individuals, businesses and government units. ̶ Interest-bearing (term or time deposits) accounts are accounts that pay interest. ̶ In the US: checking and automatic transfers from savings (ATS) ̶ ATS customer has both a DDA and a savings account. ̶ Bank forces a zero balance in the DDA at the end of each day ̶ Often labeled as sweep accounts 6 Non-transactional Accounts ̶ Interest-bearing accounts with limited or no transaction privileges ̶ In the US: Money market deposit accounts (MMDA) are time deposits that limit depositors to six transactions per month. Attractive to banks because no required reserves and limited transaction processing reduce effective cost to bank. ̶ Savings accounts have fixed maturity 7 Estimating the Cost of Deposit Accounts ̶ Cost includes: ̶ Interest which may be as low as zero or a fraction of 1%. ̶ Legal reserve requirements which can equal as much as 10% of the outstanding balance ̶ Processing costs which are substantial when deposit customers have a large number of transactions ̶ Cost analysis data indicate demand deposits are the least expensive source of funds. ̶ Profitability depends on average balance, number of transactions and fees collected ̶ Additional fees include overdraft protection or nonsufficient funds fees (represent a risk charge). ̶ Overdrafts are an extension of credit 8 Euroarea Bank Deposit Rates Source: ECB around 2.95 at the beginn deposit rates two policy ra at around 1. then resume was cut incr 0.05% in Se period, and at around 0. rates has na zero lower b However, th rates for any Before the c in vulnerab countries. T Composite euro area bank deposit rates for the nonfinancial private sector (percentages per annum) 0 1 2 3 4 5 2007 2009 2011 2013 2015 euro area vulnerable countries less vulnerable countries MRO rate Source: ECB. Note: Composite rates are computed as averages of new business rates for different maturities, weighted by outstanding amounts. 9 Distribution of deposit rates 0.0 0.5 1.0 1.5 2.0 2.5 0 2 4 6 8 Sep. 2015 (median = 0.23) June 2012 (median = 0.88) Sep. 2008 (median = 3.58) b) Less vulnerable countries MRO June 2012 MRO Sep. 2008 MRO Sep. 2015 nt maturities, weighted by outstanding amounts. The chart shows the density approximation of s vulnerable countries. uro area bank deposit rates for the non-financial private sector an = 0.24) ian = 1.15) an = 2.86) tries MRO Sep. 2008 2 0.5 1.0 1.5 2.0 2.5 Sep. 2015 (median = 0.23) June 2012 (median = 0.88) Sep. 2008 (median = 3.58) b) Less vulnerable countries MRO June 2012 MRO Sep. 2015 Source: ECB 10 Euroarea Bank Deposit Rates Source: ECB 11 Estimating the Cost of Deposit Accounts ̶ Transaction-processing activities: ̶ Deposits or withdrawals: Electronic transactions occur through automatic deposits, Internet and telephone payments, ATMs and ACH transactions. Non-electronic transactions are handled in person or by mail. ̶ Transit checks deposited or cashed ̶ Check-processing activities: ̶ Accounts opened or closed ̶ “On-us” checks/transactions cashed: Checks/transactions drawn on the bank’s customers’ accounts ̶ General account maintenance: General record maintenance and preparing statements. With a truncated account checks/transactions are not returned to the customer. An official check would be issued for certified funds. ̶ Net indirect costs are costs not directly related to the product such as general overhead or manager salaries. 12 Estimating the Cost of Deposit Accounts Banks pay market rates on deposits and want customers to pay at least what the service costs. ̶ Has led to relationship pricing in which service charges decline and interest rates increase with larger balances. ̶ Banks have unbundled services and price each separately. ̶ Some charge for services once considered courtesies such as balance inquiry and in-person banking. ̶ Has led to a caste system of banking. ̶ Large depositors receive highest rates, pay the lowest fees and receive personal attention from their banker. ̶ Small depositors earn lower rates, if any, pay higher fees and receive less personal service. 13 Calculating the Average Net Cost of Deposit Accounts ̶ Average historical cost of funds - measure of average unit borrowing costs for existing funds. ̶ Average interest cost - calculated by dividing total interest expense by the average amount of liabilities outstanding. ̶ Average net cost of bank liabilities: ̶ Example: If a demand deposit account does not pay interest, has $18.69 a month in transaction costs charges, $10.15 in fees, an average balance of $8,750, 5% float and 10% reserve requirement, the average net cost would be: existing funds. Average interest cost for the total portfolio is calculated by dividing tota interest expense by the average dollar amount of liabilities outstanding; it measures th average percentage cost of a single dollar of debt. Average historical costs for a singl source of funds can be calculated as the ratio of interest expense by source to the averag outstanding debt for that source during the period. The interest cost rates presented i Chapter 3 represent such costs. To estimate the annual historical net cost of bank liabilities, simply add historica interest expense to on earning assets: noninterest expense (net of noninterest income and divide by the investable amount of funds to determine the minimum return require on earning assets: Average net cost of bank liabilities Interest expense noninterest expense noninterest income Average balance net of float 1 reserve requirement ratio 12 (10.1 The average net cost of the medium-balance, high-activity account from Exhibit 10.5 assuming 5 percent float and 10 percent reserve requirements, would be: Average annual net cost of medium–balance account $0 $18 69 $10 15 $8,750 0 95 0 90 12 1 37% 6 We multiply by 12 because the cost figures given in Exhibit 10.5 are monthly costs. ge dollar amount of liabilities outstanding; it measures the single dollar of debt. Average historical costs for a single ted as the ratio of interest expense by source to the average rce during the period. The interest cost rates presented in s. storical net cost of bank liabilities, simply add historical g assets: noninterest expense (net of noninterest income) mount of funds to determine the minimum return required ilities oninterest expense noninterest income of float 1 reserve requirement ratio 12 (10.1) medium-balance, high-activity account from Exhibit 10.5, 10 percent reserve requirements, would be: dium–balance account $0 $18 69 $10 15 $8,750 0 95 0 90 12 1 37%6 14 US: Certificate of Deposits (CDs) ̶ Large, negotiable certificates of $100,000 or more. ̶ Minimum maturity of 7 days. ̶ Interest rates quoted on a 360-day year basis. ̶ Insured up to $250,000 per investor per institution. ̶ Considered risky and traded accordingly. ̶ Can be issued directly or through dealers or brokers (brokered deposits). ̶ Brokers provide small banks access to purchased funds. ̶ Packaged in $250,000 increments so deposits are fully insured. ̶ When managers expect rates to rise, try to lengthen CD maturities prior to rate move. ̶ Opposite occurs when rates are expected to fall. ̶ Types of CDs: ̶ Fixed-rate: Typically 1, 3 or 6 month maturities. Today maturities of up to 5 years are common. ̶ Variable-rate: Longer maturities with rates renegotiated at specified intervals. ̶ Jump rate (bump-up) CD gives the depositor a one-time option until maturity to change the rate to the prevailing market rate. 15 Europe: Certificate of Deposits EBA: Certificates of Deposit (CDs) are to be treated as debt securities as long as they are negotiable and with the exception of those sold exclusively in the retail market and held in a retail account, in which case those instruments can be treated as the appropriate retail deposit category. Nonnegotiable CDs should be treated as deposits of the relevant category. 16 Foreign Office Deposits ̶ Eurocurrency - financial claim denominated in a currency other than that of the country where the issuing bank is located ̶ Example: Eurodollar deposits in the US: dollardenominated deposits at foreign banks or at the overseas branches of American banks 17 Borrowing Immediately Available Funds ̶ Security Repurchase Agreements (Repos): ̶ Short-term loans secured by government securities that are settled in immediately available funds. ̶ Sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest. ̶ Market value of collateral is set above the loan amount. This difference is the margin. ̶ Normal repos are bullet repos with a fixed rate over a set maturity with no options. ̶ Structured repo agreements: ̶ embeds an option (call, put, swap, cap, floor, etc.) in the instrument to either lower its initial cost to the borrower or better help the borrower match the risk and return profile of an investment. ̶ A callable repo allows the deposit holder to terminate (call) the CD prior to maturity. 18 Marginal Cost of Funds ̶ Marginal cost of debt - measure of the borrowing cost paid to acquire one additional unit of investable funds ̶ Marginal cost of equity - measure of the minimum acceptable rate of return required by shareholders ̶ Marginal cost of funds - the marginal costs of debt and equity. ̶ Difficult to measure marginal costs precisely. ̶ Must include both interest and noninterest costs expected to be paid and identify which portion of the acquired funds can be invested in earning assets. ̶ Formula for measuring explicit marginal cost of a single source of bank liability: a bank can set asset yields at some markup over marginal costs to lock in able spread. Presumably, the markup reflects default risk as well as the return to shareholders. Marginal costs also serve as indicators of the relative different funds, which banks can use to target the least expensive sources for f growth. Costs of Independent Sources of Funds Unfortunately, it is difficult to measure marginal costs precisely. Manageme include both interest and noninterest costs it expects to pay and identify which of the acquired funds can be invested in earning assets. There is also consider agreement on whether equity costs are relevant and, ultimately, how to measur costs. One formula for measuring the explicit marginal cost of a single source liabilities is: Marginal cost of liability j Interest rate servicing costs acquisition cost insurance Net investable balance of liability j 17 Banking terminology generally refers to the average or marginal cost of funds as the associated co ities without reference to equity financing. The cost of equity is incorporated as a required sprea 19 Cost of Debt ̶ Marginal cost of different types of debt varies according to the magnitude of each type of liability. ̶ High-volume transactions accounts have substantial servicing costs and highest reserve requirements and float. ̶ Purchased funds pay higher rates but smaller transaction costs and zero reserve requirements (greater investable balances). ̶ Cost of long-term non deposit debt equals effective cost of borrowing from each source. ̶ This is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue. 20 Bank bond yields insulated fro the sovereig costs for ba countries ha them also w of 2011 and year maturi forced delev market fund the OMT an since fallen countries. M most euro a APP, at leas observed in swap (CDS in the type a (percentages per annum) 0 2 4 6 8 10 2007 2009 2011 2013 2015 euro area vulnerable countries less vulnerable countries Sources: iBoxx and ECB. Note: Bank bond yields are averaged by outstanding amount of securities issued. Chart 11 Yields on bonds issued by eu (percentages per annum) 0 2 4 6 8 10 2007 2009 2011 euro area vulnerable countries less vulnerable countries Source: ECB 21 Cost of Debt - Bloomberg 22 Cost of Equity ̶ The marginal cost of equity equals the required return to shareholders. ̶ Not directly measurable because dividend payments are not mandatory but several methods are used: ̶ Dividend Valuation Model: The cost of equity equals the discount rate (required return) used to convert future cash flows to their present value equivalent ̶ Capital Asset Pricing Model (CAPM): Required return to shareholders equals the riskless rate of return plus a risk premium on common stock reflecting non-diversifiable market risk ̶ Targeted Return on Equity Model. Cost of debt plus a premium to evaluate the cost of equity. Assumes book value = market value. 23 Cost of bank equity wholesale m tensions in spreads for The cost of during the triggered by United State by banks in started to op sovereign c euro area b expected ra the beginnin collapse of to almost 10 half of 2012 (percentages per annum) 4 6 8 10 12 14 2007 2009 2011 2013 2015 euro area vulnerable countries less vulnerable countries Sources: Bloomberg, Thomson Reuters Datastream, Consensus Economics and ECB calculations. Source: ECB Chart 13 Cost of euro area bank (percentages per annum) 4 6 8 10 12 14 2007 2009 euro area vulnerable countries less vulnerable countries Sources: Bloomberg, Thomson Reut calculations. 24 Cost of bank equity Source: ECB 25 Cost of Equity - Bloomberg 26 Cost of Capital - Bloomberg 27 Weighted Marginal Cost of Total Funds ̶ Best cost measure for asset-pricing purposes. ̶ Recognizes both explicit and implicit costs associated with any single source of funds. ̶ Computed in three stages: ̶ Forecast desired dollar amount of financing to be obtained from each individual debt and equity sources. ̶ Estimate marginal cost of each source of funds. ̶ Combine the estimates to project the weighted cost: ing and processing costs among the different liability and equity com ject interest and dividend costs for each source, recognizing any pe in risk associated with changes in financial leverage. Each cost e also reflect management’s assignment of nonearning assets per Equati icates the percentage of investable funds. e the individual estimates to project the weighted cost, which equals t weighted component costs across all sources. Each source’s weight (wj ected dollar amount of financing from that source divided by the of total liabilities and equity. Thus, if kj equals the single-source j com l cost of financing, where there are m liabilities plus equity, the WMC : WMC m j 1 wjkj l Cost Analysis: an Application 28 Funding Sources and Banking Risks ̶ Banks face two fundamental problems in managing liabilities or uncertainty over: ̶ what rates they must pay to retain and attract funds. ̶ likelihood customers will withdraw money regardless of rates. ̶ Basic fear is vulnerability to a liquidity crisis from unanticipated withdrawals and depositors and lenders refusing to provide funds. ̶ Banks must have the capacity to borrow in financial markets to replace deposits outflows and remain solvent. 29 Funding Sources: Liquidity Risk ̶ Liquidity risk of deposit base is a function of: ̶ Number and location of depositors ̶ Average size of accounts ̶ Specific maturity and rate characteristics of each account ̶ Competitive environment ̶ Interest elasticity of customer demand for each funding source is equally important. ̶ How much can interest rates change before bank experiences deposit outflows? ̶ If a bank raises its rates, how many new funds will it attract? 30 Funding Sources: Interest Rate Risk ̶ Many depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates change. ̶ Banks must offer premiums to lengthen maturities. ̶ Many banks have chosen not to pay premiums and reprice liabilities more frequently than in the past. ̶ One strategy is to aggressively compete for retail core deposits. ̶ Once a bank attracts deposit business, many will maintain those balances as long as bank provides good service. 31 Definition of bank capital ̶ Equity ̶ Common stock, preferred stock, surplus, and undivided profits equals the book value of equity ̶ Market value of equity ̶ Long-term debt ̶ Subordinated notes and debentures ̶ Interest payments are tax deductible ̶ Reserves ̶ Provision for loan losses (PLL) is expensed on the income statement ̶ Reserve for loan losses is a capital account on the right-hand-side of the balance sheet 32 Role of bank capital ̶ Source of funds ̶ Start-up costs ̶ Growth or expansion (mergers and acquisitions) ̶ Modernization costs ̶ Cushion to absorb unexpected operating losses ̶ Insufficient capital to absorb losses will cause insolvency ̶ Long-term debt can only absorb losses in the event of institution failure ̶ Adequate capital ̶ Regulatory requirements to promote bank safety and soundness ̶ Mitigate moral hazard problems of deposit insurance by increasing shareholders’ exposure to bank operating losses ̶ Public confidence is important to depositors and other bank claimants 33 Bank Capital: Regulators ̶ Bank capital serves to protect the deposit insurance fund in case of bank failures. ̶ Regulatory capital is the minimum amount of capital that a bank must hold (for an individual deal or for the whole bank) according to the regulator. ̶ Bank capital reduces bank risk by: ̶ providing a cushion for firms to absorb losses and remain solvent. ̶ providing ready access to financial markets, which guards against liquidity problems from deposit outflows. ̶ constraining growth and limits risk taking. 34 Bank Capital: Shareholders ̶ Corporate control ̶ Greater debt increases the concentration of ownership among shareholders ̶ In banks that are not closely held there is the potential for agency costs related to conflicts of interest between owners and managers. ̶ Hostile takeovers of banks with undervalued shares is a potential threat that tends to reduce agency costs. ̶ Link management compensation to performance (e.g., stock options) to decrease agency costs. ̶ Preemptive rights of shareholders reduces shareholder dilution and reduces agency costs to the extent that owner concentration is increased. 35 Bank Capital: Shareholders ̶ Market timing (debt versus equity usage, interest rate levels, and stock market levels) ̶ Asset investment considerations (asset risk and capital needs to absorb potential losses) ̶ Dividend policy (fixed dividend policy versus fixed payout dividend policy) ̶ Debt capacity (financial slack or flexibility) ̶ Transactions costs (private and public sales of equity) ̶ Mergers and acquisitions ̶ Internal expansion (internal capital generation rate) ̶ ICR = (1/capital ratio) x ROA x Earnings retention ratio ̶ Rate at which a bank can expand its assets and still maintain its capital ratio. 36 Capital Adequacy ̶ Bank regulators and bank shareholders have different views of capital adequacy ̶ Regulators are more concerned with the lower end of the distribution of bank earnings. ̶ Shareholders focus more on the central part of the distribution, or the expected return available to them. ̶ Regulators perceive that financial risk increases the probability of insolvency, as greater variability of earnings makes it more likely that negative earnings could eliminate bank capital. ̶ Regulators must close banks due to capital impairment. ̶ Excessive capital regulation could inhibit the competitiveness and efficiency of the banking system. 37 Effective Use of Capital ̶ Capital reduces risk by cushioning earnings volatility and restricting growth opportunities. ̶ Reduces expected returns to shareholders as equity is more expensive than debt. ̶ Decreasing capital increases risk by increasing financial leverage and the risk of failure. ̶ Firms with greater capital can borrow at lower rates, make larger loans and expand faster through acquisition or internal growth. 38 Risk-Based Elements of Basel I 1. Classify assets into one of four risk categories. 2. Classify off-balance sheet commitments into the appropriate risk categories. 3. Multiply the dollar amount of assets in each risk category by the appropriate risk weight to calculate risk-weighted assets. 4. Multiply risk-weighted assets by the minimum capital percentages, 4% for Tier 1 capital and 8% for total capital. Residential mortgages Liquid deposits Liquid assets (T-Bill) Capital (CET1 + aT1 + T2) Assets Liabilities Bank Corporate loan 100 100 100 Amount EUR 50% 0% 100% Risk weights • 8% * (50%*8%*100 + 100%*8%*100+0%*8%*100)*12.5 ≤ Capital Risk-weighted assets (RWA) ó 8% ≤ Capital/ RWA Regulatory capital 39 What Constitutes Bank Capital? ̶ Capital (Net Worth) - the cumulative value of assets minus the cumulative value of liabilities or ownership in the firm. ̶ Total Equity Capital - sum of common stock, surplus, retained earnings, capital reserves, net unrealized holding gains (losses) and perpetual preferred stock. ̶ Tier 1 (Core) Capital: ̶ Common stockholders’ equity, noncumulative perpetual preferred stock and any related surplus. ̶ Minority interest in consolidated subsidiaries, less intangible assets such as goodwill. ̶ Tier 2 (Supplementary) Capital: ̶ Preferred stocks and any surplus. ̶ Limited amounts of term-subordinated debt and a limited amount of the allowance for loan and lease losses (up to 1.25 percent of gross. riskweighted assets) 40 Tier 1 EXHIBIT 12.7 Definition of Qualifying Capital Components Minimum Requirements Tier 1 (Core) Capital Common stockholders equity* Must equal or exceed 4 percent of risk-weighted assets. Noncumulative perpetual preferred stock and any related surplus No limit; regulatory caution against undue reliance. Minority interests in equity capital accounts of consolidated subsidiaries No limit; regulatory caution against undue reliance. Less: goodwill, other disallowed intangible assets, and disallowed deferred tax assets, and any other amounts that are deducted in determining Tier 1 capital in accordance with the capital standards issued by the reporting bank’s primary federal supervisory authority Tier 2 (Supplementary) Capital Cumulative perpetual preferred stock and any related surplus Total of Tier 2 is limited to 100 percent of Tier 1† . Long-term preferred stock (original maturity of 20 years or more) and any related surplus (discounted for capital purposes as it approaches maturity) No limit within Tier 2. Auction rate and similar preferred stock (both cumulative and noncumulative) No limit within Tier 2. Hybrid capital instruments (including mandatory convertible debt securities) Subordinated debt and intermediate-term preferred stock are limited to 50 percent of Tier 1, amortized for capital purposes as they approach maturity. Term subordinated debt and intermediate-term 50 percent of Tier 1 capital (and discounted for 460 Chapter 12 The Effective Use of Capital preferred stock (original weighted average maturity of five years or more) capital purposes as they approach maturity). Allowance for loan and lease losses Lesser of the balance of the allowance account or 1.25 percent of gross risk-weighted assets. Tier 3 (Capital Allocated for Market Risk) Applicable only to banks that are subject to the market risk capital guidelines May not be used to support credit risk. Tier 3 capital allocated for market risk plus Tier 2 capital allocated for market risk are limited to 71.4 percent of a bank’s measure for market risk. Deductions Deductions are made for: investments in banking and finance subsidiaries that are not consolidated for regulatory capital purposes; intentional reciprocal cross-holdings of banking organizations’ capital instruments; and other deductions as determined by the reporting bank’s primary federal supervisory authority As a general rule, one-half of aggregate investments would be deducted from Tier 1 capital and one-half from Tier 2 capital. Total Capital (Tier 1 + Tier 2 − Deductions) Must equal or exceed 8 percent of risk-weighted assets. For most banks, total risk-based capital will equal the sum of Tier 1 capital and Tier 2 capital. *For risk-based capital purposes, common equity capital includes any net unrealized holding losses on available-for-sale equity securities with readily determinable fair values, but excludes other net unrealized holding gains (losses) on available-for-sale securities. † Amounts in excess of limitations are permitted but do not qualify as capital. Source: Federal Financial Institutions Examination Council FFIEC Report Forms, available on the Internet at www.ffiec.gov. Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 41 Tier 2 EXHIBIT 12.7 Definition of Qualifying Capital Components Minimum Requirements Tier 1 (Core) Capital Common stockholders equity* Must equal or exceed 4 percent of risk-weighted assets. Noncumulative perpetual preferred stock and any related surplus No limit; regulatory caution against undue reliance. Minority interests in equity capital accounts of consolidated subsidiaries No limit; regulatory caution against undue reliance. Less: goodwill, other disallowed intangible assets, and disallowed deferred tax assets, and any other amounts that are deducted in determining Tier 1 capital in accordance with the capital standards issued by the reporting bank’s primary federal supervisory authority Tier 2 (Supplementary) Capital Cumulative perpetual preferred stock and any related surplus Total of Tier 2 is limited to 100 percent of Tier 1† . Long-term preferred stock (original maturity of 20 years or more) and any related surplus (discounted for capital purposes as it approaches maturity) No limit within Tier 2. Auction rate and similar preferred stock (both cumulative and noncumulative) No limit within Tier 2. Hybrid capital instruments (including mandatory convertible debt securities) Subordinated debt and intermediate-term preferred stock are limited to 50 percent of Tier 1, amortized for capital purposes as they approach maturity. Term subordinated debt and intermediate-term 50 percent of Tier 1 capital (and discounted for 460 Chapter 12 The Effective Use of Capital Common stockholders equity* Must equal or exceed 4 percent of risk-weighted assets. Noncumulative perpetual preferred stock and any related surplus No limit; regulatory caution against undue reliance. Minority interests in equity capital accounts of consolidated subsidiaries No limit; regulatory caution against undue reliance. Less: goodwill, other disallowed intangible assets, and disallowed deferred tax assets, and any other amounts that are deducted in determining Tier 1 capital in accordance with the capital standards issued by the reporting bank’s primary federal supervisory authority Tier 2 (Supplementary) Capital Cumulative perpetual preferred stock and any related surplus Total of Tier 2 is limited to 100 percent of Tier 1† . Long-term preferred stock (original maturity of 20 years or more) and any related surplus (discounted for capital purposes as it approaches maturity) No limit within Tier 2. Auction rate and similar preferred stock (both cumulative and noncumulative) No limit within Tier 2. Hybrid capital instruments (including mandatory convertible debt securities) Subordinated debt and intermediate-term preferred stock are limited to 50 percent of Tier 1, amortized for capital purposes as they approach maturity. Term subordinated debt and intermediate-term preferred stock (original weighted average maturity of five years or more) 50 percent of Tier 1 capital (and discounted for capital purposes as they approach maturity). Allowance for loan and lease losses Lesser of the balance of the allowance account or 1.25 percent of gross risk-weighted assets. Tier 3 (Capital Allocated for Market Risk) Applicable only to banks that are subject to the market risk capital guidelines May not be used to support credit risk. Tier 3 capital allocated for market risk plus Tier 2 capital allocated for market risk are limited to 71.4 percent of a bank’s measure for market risk. Deductions and noncumulative) Hybrid capital instruments (including mandatory convertible debt securities) Subordinated debt and intermediate-term preferred stock are limited to 50 percent of Tier 1, amortized for capital purposes as they approach maturity. Term subordinated debt and intermediate-term preferred stock (original weighted average maturity of five years or more) 50 percent of Tier 1 capital (and discounted for capital purposes as they approach maturity). Allowance for loan and lease losses Lesser of the balance of the allowance account or 1.25 percent of gross risk-weighted assets. Tier 3 (Capital Allocated for Market Risk) Applicable only to banks that are subject to the market risk capital guidelines May not be used to support credit risk. Tier 3 capital allocated for market risk plus Tier 2 capital allocated for market risk are limited to 71.4 percent of a bank’s measure for market risk. Deductions Deductions are made for: investments in banking and finance subsidiaries that are not consolidated for regulatory capital purposes; intentional reciprocal cross-holdings of banking organizations’ capital instruments; and other deductions as determined by the reporting bank’s primary federal supervisory authority As a general rule, one-half of aggregate investments would be deducted from Tier 1 capital and one-half from Tier 2 capital. Total Capital (Tier 1 + Tier 2 − Deductions) Must equal or exceed 8 percent of risk-weighted assets. For most banks, total risk-based capital will equal the sum of Tier 1 capital and Tier 2 capital. *For risk-based capital purposes, common equity capital includes any net unrealized holding losses on available-for-sale equity securities with readily determinable fair values, but excludes other net unrealized holding gains (losses) on available-for-sale securities. † Amounts in excess of limitations are permitted but do not qualify as capital. Source: Federal Financial Institutions Examination Council FFIEC Report Forms, available on the Internet at www.ffiec.gov. 42 Basel II concepts 3 Pillar concept 1 2 3 (i) Banking book (i) Banking book Assets Liabilities Equity (ii) Trading book (i) Banking book (ii) Trading book (ii) Trading book Other assets Deposits Loans Equity Securitised liabilities Liquidity Reserve addTier 1 CE Tier 2 OthersTradeable Assets Tradeable liabilities Other assets 43 Basel II concepts Deposits Loans Equity Securitised liabilities Liquidity Reserve 1. Credit Risk (CR) 2. Market Risk (MR) 3. Operational Risk (OpR) addTier 1 CE Tier 2 Tier 3 OthersTradeable Assets Tradeable liabilities 1.CreditRisk(CR) Other assets 2.MR 2.MR Assets Liabilities (i) Banking book (ii) Trading book 8% K (PDInternal, R, ...)* LGDEx-/Internal EaDEx-/ Internal 12.5 St‘ed Appr. IRBA RW1(regul. segment, ext. rating) x RWACR St‘ed Appr. RWAMR Internal RW1(regul. segment, instrument characteristics) 43}, 60 ;max{ 60 1 %,1,101%,1,1010%,99 ££×= å= -- c i it c t Internal d mVaR m VaRVaR Basic/ St‘ed RWAOpR Internal Risk weight (regulatory segment) ),(1%,9.99 frequencyseverityVaRVaRAMA Y = x x Gross incomex 3 Pillar concept 1 2 3 44 Basel II concepts RWAbank ≥ ! RWAbank ! ≥ 8% (8%) Tier 1- ratio Total Capital Ratio Regulatory Capital Adequacy RWAbank ≥ ! CE-capital ratio Deposits Loans Equity Securitised liabilities Liquidity Reserve Tier 3 addTier 1 CE Tier 2 Tier 3 Others Tier 2 Tier 1 - Capital Tier 1 - CapitalCE Tradeable Assets Tradeable liabilities Other assets Assets Liabilities 1. Credit Risk (CR) 2. Market Risk (MR) 3. Operational Risk (OpR) RWACR RWAMR RWAOpR + + 1.CreditRisk(CR) 2.MR 2.MR (i) Banking book (ii) Trading book Analysts/ Rating agencies To be quarterly reported to regulator 3 Pillar concept 1 2 3 4% (6%) 2% (4.5%) 45 Basel III Capital Standards ̶ When implemented, banks must hold a capital conservation buffer plus old RBC minimums. ̶ Minimum capital requirements ments impose higher minimum capital ratios and place a greater emphasis on common equity as a preferred form of capital. The Basel III rules apply differently to larger organizations versus smaller ones. Generally, smaller organizations can count more items as capital and have more time to comply with the new requirements. The increased capital requirements arise from stricter rules on what qualifies as capital, as well as the introduction of a new minimum capital ratio, common equity Tier 1 (CET1). When fully implemented, banks must hold a capital conservation buffer in addition to the old RBC minimums. CET1 Common Equity Tier 1 Capital Risk-weighted Assets Consider the RBC ratios introduced earlier. Under Basel III, the minimum capital requirements, when the final rules are implemented in 2019, are listed below. Current Minimum Final Rule Minimum Buffer Total Tier 1 capital/risk-weighted assets 4% 6.0% 2.5% 8.5% Total capital/risk-weighted assets 8% 8.0% 2.5% 10.5% Leverage ratio 4% 4.0% – – CET1 ratio – 4.5% 2.5% 7.0% In July 2013, federal regulators approved Basel III capital rules with the intent to increase bank capital requirements and upgrade the quality of bank capital. The new requirements impose higher minimum capital ratios and place a greater emphasis on common equity as a preferred form of capital. The Basel III rules apply differently to larger organizations versus smaller ones. Generally, smaller organizations can count more items as capital and have more time to comply with the new requirements. The increased capital requirements arise from stricter rules on what qualifies as capital, as well as the introduction of a new minimum capital ratio, common equity Tier 1 (CET1). When fully implemented, banks must hold a capital conservation buffer in addition to the old RBC minimums. CET1 Common Equity Tier 1 Capital Risk-weighted Assets Consider the RBC ratios introduced earlier. Under Basel III, the minimum capital requirements, when the final rules are implemented in 2019, are listed below. Current Minimum Final Rule Minimum Buffer Total Tier 1 capital/risk-weighted assets 4% 6.0% 2.5% 8.5% Total capital/risk-weighted assets 8% 8.0% 2.5% 10.5% Leverage ratio 4% 4.0% – – CET1 ratio – 4.5% 2.5% 7.0% For smaller banks, the biggest changes involve the calculation of risk-weighted assets because certain types of residential mortgages carry higher risk weights. FortuBasel II Basel III Rule 46 Risk capital requirements approaches CRSA Based on external ratings Supervisory risk weights No specific minimal requirements No permission needed IRBA Based on internal ratings (with exceptions) Individually calculated risk weights Minimal requirements Permission/approval required 47 Risk weights 2. Not risk-sensitive (same as in Basel I): Central governments Financials Covered bonds short-term long-termCorporates Multi-lateral development banks Mutual funds shares Regional governments/ local administrations 8% EaD 12.5*Risk-weighted assets: Capital charge Borrower segment Class External Rating Analog to I and II Analog to I and II, else 100% Other public entities Other positions International organisations Retail Participations Residential Mortgage Commercial mortgage Loans to property savers Cash Past due items Tangible assets AAA to AA- A+ to ABBB+ to BBB- Less than B- Unrated *RW * BB+ to BB- B+ to B- 1. Risk-sensitive (different to Basel I): (For comparison: RW=100% ó Basel I) 48 Risk weights short-term long-termCorporates 8% EaD 12.5*Risk-weighted assets: Capital charge Retail *RW * 75% 8% 100 Capital charge *20% * Corproate Loan, External Rating: AA Lia- bilities MB Bank AG Other assets Retail Loan Any score Lia- bilities MB Bank AG Other assets Retail 100 100 8% 100 Capital charge *75% * 1.60 €= 6.00 €= Capital charge Capital charge 6.00€ 1.60€ AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB www.... • Risk-bearing capacity/ Internal capital adequacy VaRGroup Aggregation • Own capital definition • Internal models (models do not need approval from regulator) • Diversification effects possible (aggregation) + Tier 2 capital + additional Tier 1 Core Equity Tier 1 RWACR + RWAMR + RWAOpR ≥ 8% + 2.5% + x%1 + y%2 Total capital- ratio • Finance department: regulatory reporting • Treasury: ensure compliance • Regulatory capital- and liquidity adequacy: • Internal capital- and liquidity adequacy: • Internal models for cash flows • For risk management and planning • Internal stress tests 4) OBS: Off-Balance sheet items 56 Capital Requirements and Bank Operating Policies Limiting Asset Growth: ̶ Minimum capital requirements restrict bank‘s ability to grow. Additions to assets mandate additions to capital to meet minimum capital-to-asset ratios. ̶ Each bank must limit asset growth to some percentage of retained earnings plus new external capital. ̶ Must determine growth strategy while meeting minimum capital requirements. Higher ROA is one option: ̶ The relationship for internally generated capital: Consider the $100 million bank in Exhibit 12.9 that just meets the minimum 8 percent total capital requirement. Initially, the bank has $8 million in capital, of which $4 million is undivided profits and $4 million is other capital. Various effects of planned asset growth are shown in the following columns of data, which represent projections of balance sheet and income statement data for the upcoming year. The bank’s initial plan, designated as Case 1, calls for 8 percent asset growth with a projected 1.07 percent ROA and 40 percent dividend payout rate. In this scenario, the bank would have $108 million in assets and $693,360 in retained earnings for the year. The 8 percent target capital ratio would just be met. Suppose that profitable credit opportunities are available to generate 12 percent asset growth within acceptable risk limits. The last three columns of data identify three distinct strategies for growing and still meeting minimum capital requirements. One option (Case 2) is for the bank to generate a higher ROA. This bank would need $1,075,200 in additional retained earnings to support the $112 million in assets: Undivided profits Total assets ROA 1 dividend payout rate $1,075,200 $112,000,000 0 016 1 0 40 Because competition prevents banks from raising yield spreads on high-quality loans, they can achieve higher returns only by acquiring riskier assets or generating greater fee income from services. This sample bank would have to increase its ROA by 53 basis points to 1.6 percent if it did not change its dividend policy or obtain additional capital externally. If banks substitute riskier loans for lower-yielding and less-risky assets, the ts Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. asset growth with new capital, such as new common stock or perpetual preferred stock. Here the growth in retained earnings would total $719,040, so $356,200 in new external capital would be needed. Such equity is considerably more expensive than debt if the bank actually has access to the stock market. In practice, a bank would likely pursue some combination of these strategies, or may simply choose not to grow. If the bank in this example decides not to alter its initial policies, asset growth is restricted to 12.5 (100/8) times the addition to retained earnings. In other words, each dollar of retained profits can support $12.50 in new assets. The relationship for internally generated capital can be summarized by the following constraints.11 Let: TA = total assets EQ = equity capital ROA = return on assets DR = dividend payout rate EC = new external capital and the subscripts refer to the beginning of the period (1) or the end of the period (2) Capital constraints require that the asset growth rate equal the rate of growth in equity capital: ΔTA TA1 ΔEQ EQ1 (12.1) Recall that new capital comes from two sources: internally, or retained earnings, and externally, such as via new stock issues. Equation 12.1 can be restated as providing the following sustainable growth rate in assets when there is no new external capital: ΔTA TA1 EQ2 EQ1 EQ1 EQ1 ROA 1 DR TA2 ΔEC EQ1 EQ1 ROA 1 DR ΔEC TA2 EQ2 ROA 1 DR TA2 ΔEC TA2 (12.2) Chapter 12 The Effective Use of Capital 469 asset growth with new capital, such as new common stock or perpetual preferred stock. Here the growth in retained earnings would total $719,040, so $356,200 in new external capital would be needed. Such equity is considerably more expensive than debt if the bank actually has access to the stock market. In practice, a bank would likely pursue some combination of these strategies, or may simply choose not to grow. If the bank in this example decides not to alter its initial policies, asset growth is restricted to 12.5 (100/8) times the addition to retained earnings. In other words, each dollar of retained profits can support $12.50 in new assets. The relationship for internally generated capital can be summarized by the following constraints.11 Let: TA = total assets EQ = equity capital ROA = return on assets DR = dividend payout rate EC = new external capital and the subscripts refer to the beginning of the period (1) or the end of the period (2) Capital constraints require that the asset growth rate equal the rate of growth in equity capital: ΔTA TA1 ΔEQ EQ1 (12.1) Recall that new capital comes from two sources: internally, or retained earnings, and externally, such as via new stock issues. Equation 12.1 can be restated as providing the following sustainable growth rate in assets when there is no new external capital: ΔTA TA1 EQ2 EQ1 EQ1 EQ1 ROA 1 DR TA2 ΔEC EQ1 EQ1 ROA 1 DR ΔEC TA2 EQ2 ROA 1 DR TA2 ΔEC TA2 ΔTA TA1 ROA 1 DR ΔEC TA2 EQ2 TA2 ROA 1 DR ΔEC TA2 (12.2) Chapter 12 The Effective Use of Capital 469 asset growth with new capital, such as new common stock or perpetual preferred stock. Here the growth in retained earnings would total $719,040, so $356,200 in new external capital would be needed. Such equity is considerably more expensive than debt if the bank actually has access to the stock market. In practice, a bank would likely pursue some combination of these strategies, or may simply choose not to grow. If the bank in this example decides not to alter its initial policies, asset growth is restricted to 12.5 (100/8) times the addition to retained earnings. In other words, each dollar of retained profits can support $12.50 in new assets. The relationship for internally generated capital can be summarized by the following constraints.11 Let: TA = total assets EQ = equity capital ROA = return on assets DR = dividend payout rate EC = new external capital and the subscripts refer to the beginning of the period (1) or the end of the period (2) Capital constraints require that the asset growth rate equal the rate of growth in equity capital: ΔTA TA1 ΔEQ EQ1 (12.1) Recall that new capital comes from two sources: internally, or retained earnings, and externally, such as via new stock issues. Equation 12.1 can be restated as providing the following sustainable growth rate in assets when there is no new external capital: Chapter 12 The Effective Use of Capital 469 ΔTA TA1 ΔEQ EQ1 Recall that new capital comes from two sources: internally, or reta externally, such as via new stock issues. Equation 12.1 can be restate following sustainable growth rate in assets when there is no new exter ΔTA TA1 EQ2 EQ1 EQ1 EQ1 ROA 1 DR TA2 ΔEC E EQ1 ROA 1 DR ΔEC TA2 EQ2 ROA 1 DR TA2 ΔEC T ΔTA TA1 ROA 1 DR ΔEC TA2 EQ2 TA2 ROA 1 DR ΔEC TA2 The above relationship can be approximated by: ΔTA TA1 ROA 1 DR ΔEC TA2 EQ1 TA1 The numerator equals the sum of internally generated capital, ROA retention rate, and additions to equity from external sources. Equation 12.3 demonstrates the effect of minimum equity capit growth, earnings requirements, dividend payout rates, and new stock ple, a bank that does not plan on issuing new stock and targets an 8 pe a 1.2 percent ROA, and a 35 percent dividend payout rate, can inc 57 Capital Requirements and Bank Operating Policies ̶ Changing the Capital Mix ̶ Internal versus external capital ̶ Changing Asset Composition ̶ Shift from high-risk to lower-risk categories ̶ Pricing Policies ̶ Raise rates on higher-risk loans ̶ Shrinking the Bank ̶ Fewer assets requires less capital 58 Characteristics of External Capital Sources ̶ Subordinated debt advantages: ̶ Interest payments are tax-deductible. ̶ Shareholders do not reduce proportionate ownership. ̶ Generates additional profits as long as earnings before interest and taxes exceed interest payments. ̶ Subordinated debt disadvantages: ̶ Does not qualify as Tier 1 or core capital. ̶ Interest and principal payments are mandatory. ̶ Many issues require sinking funds. ̶ Fixed maturity and banks cannot charge losses against it. 59 Contingent Convertible Capital ̶ Common stock advantages: ̶ No fixed maturity and thus a permanent source of funds ̶ Dividend payments are discretionary ̶ Losses can be charged against equity ̶ Common stock disadvantages: ̶ Dividends are not tax-deductible ̶ Transactions costs on new issues exceed new debt costs ̶ Shareholders sensitive to earnings dilution and possible loss of control in ownership ̶ Trust Preferred Stock: ̶ Hybrid form of equity capital at banks ̶ Effectively pays dividends that are tax deductible ̶ To issue the security, bank establishes a trust company ̶ Trust company sells preferred stock to investors and loans the proceeds of the issue to the bank. ̶ Interest on the loan equals dividends paid on preferred stock ̶ Interest on loan is tax deductible such that the bank deducts dividend payments. ̶ Counts as Tier 1 capital 60 Bank Optimal Capital Structure Gropp and Heider (2010): ̶ Capital regulation constitutes the overriding departure from the Modigliani and Miller propositions (theoretically) ̶ Determinants of firms’ capital structures also apply to large publicly traded banks, except for the banks close to the minimum capital requirement ̶ Banks that would face a lower cost of raising equity at short notice (profitable, dividend paying banks with high market to book ratios) tend to hold significantly more capital. ̶ Banks have stable capital structures at levels that are specific to each individual bank ̶ Banks’ capital structures are the outcome of pressures emanating from shareholders, debt holders and depositors ̶ Capital regulation and buffers may only be of second-order importance in determining the capital structure of most banks 61 Literature ̶ KOCH, T.W. and S.S. MacDONALD (2015). Bank Management. Chapters 10, 12. ̶ CHOUDRY M. (2022). The Principles of Banking, 2nd ed. – Chapter 3 ̶ HORVÁTOVÁ, Eva. Ekonomika a riadenie bánk. S. 3-26. ̶ ECB (2016). Recent developments in the composition and cost of bank funding in the euro area. ECB Economic Bulletin, 1, pp. 26-45. ̶ GROPP, R. and F. HEIDER (2010). The Determinants of Bank Capital Structure. Review of Finance, 14, pp. 587-622.