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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Capital Adequacy,*,Capital Adequacy,Session 9,1,Capital Adequacy,Capital AdequacySession 91Capi,Capital Adequacy,Why must the bank manager be concerned about managing the capital account?,Important,(but most expensive)source of funding,Adequate capital,necessary to maintain confidence in the bank,Regulatory,constraints,Moral:Too little capital will incur the wrath of the regulator;too much capital will incur the wrath of the shareholder,2,Capital Adequacy,Capital AdequacyWhy must the b,The Cost of Capital,Why is equity,the most expensive,form of funding?,Common stock is the,residual security,-it is entitled to whatever is left after the more senior claimants have been satisfied.,Because the returns to the common are not specified,they are the most volatile.,In finance,volatility,equates to risk!,The higher the risk,the higher the expected return,!,3,Capital Adequacy,The Cost of CapitalWhy is equi,Capital Adequacy:Measuring Shareholder Returns,Capital is the most expensive form of funding available to the bank.How do we measure the required return to the shareholder,Use the Gordon Growth Model of Stock Valuation,If P=,Div,1,r-g,Then r=,Div,1,+g,P,Use the CAPM,R,stock,=R,free,+Beta,stock,(R,Market,-R,free,),4,Capital Adequacy,Capital Adequacy:Measuring Sh,Regulatory Capital AdequacyIn Canada,OSFI establishes minimum capital guidelines for banks in its publication“Guidelines for Banks”,Federally regulated Financial Institutions must pass two capital adequacy tests,Assets-to-capital multiple,Risk-based capital adequacy,5,Capital Adequacy,Regulatory Capital AdequacyIn,Regulatory Capital Adequacy:Assets-to-Capital Multiple,Calculation:,Assets-to-capital multiple=,Total Assets,Capital,Where:Capital is Tier One plus Tier Two capital,Total Assets all on-BS assets plus off-BS credit substitutes,Must maintain an assets to capital multiple less than twenty,Problems as a measure of capital adequacy:,Based on book values,not market values,Ignores the different credit,interest and market risks embedded in the total assets figure,Ignores off-Balance Sheet activities which are not credit substitutes(i.e.most derivatives),6,Capital Adequacy,Regulatory Capital Adequacy:A,Risk-Based Capital Adequacy,=,Capital_,Risk-weighted assets,Where:Capital is both,Tier One&Tier Two,capital,Both on-BS and off-BS assets are risk weighted,Ratio must be greater than or equal to 8%,Cannot directly compare this ratio to the assets-to-capital multiple because;,In the assets-to-capital multiple,all assets and credit-substitute off-BS assets are simply added together,In the risk-based capital adequacy framework,each exposure is multiplied by a weighting factor before being added,Regulatory Capital Adequacy:Assets-to-Capital Multiple,7,Capital Adequacy,Risk-Based Capital Adequacy=,Regulatory Capital Adequacy:Tier One Capital,Tier One capital is comprised of:,Common shareholders equity,Common stock,contributed surplus&retained earnings,Noncumulative preferred shares,Minority interest in subsidiaries arising from consolidation(Tier one capital portion),Less Goodwill,8,Capital Adequacy,Regulatory Capital Adequacy:T,Regulatory Capital Adequacy:Tier Two(A)Capital,Tier Two(A)capital comprised of instruments with the following characteristics:,Unsecured,subordinated to deposits and senior debt and fully paid up,Not redeemable at the option of the holder,Redeemable only after five years(at the option of the FI)and with OSFIs permission,Available to participate in losses(dividend default gives no additional rights),Allows dividends to be deferred,Example:cumulative,convertible,callable preferred shares,9,Capital Adequacy,Regulatory Capital Adequacy:T,Regulatory Capital Adequacy:Tier Two(B)Capital,Limited life(Tier 2B)capital instruments have the following characteristics:,Subordinate to deposits and senior debt,Initial minimum term greater than ten years,Redemption in the first five years only at the option of the FI and with OSFIs permission,Example:10 year subordinate notes,10,Capital Adequacy,Regulatory Capital Adequacy:T,All of the following must be true:,Tier 1 capital+Tier 2 capital 8%of risk-adjusted assets,Tier 2 capital Tier 1 capital,Tier 2B capital 50%of Tier 1 capital,Regulatory Capital Adequacy:Risk Weighting of Assets,11,Capital Adequacy,All of the following must be t,Regulatory Capital Adequacy:Risk Weighting of Assets,On Balance Sheet ItemRisk Weight,1.Cash&deposits with CB0%,2.Deposits with other banks20%,3.Securities issued by/guaranteed by an OECD govnt0%,4.Other securities100%,5.Loans issued by/guaranteed by an OECD govnt0%,6.Residential mortgages50%,7.Other loans100%,8.Customer liability under Acceptances100%,9.Other assets100%,12,Capital Adequacy,Regulatory Capital Adequacy:R,Regulatory Capital Adequacy:Off-Balance Sheet Credit Substitutes,Credit InstrumentsCredit ConversionRisk,FactorWeight,1.Guarantees&SBLCs,a)Financi
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