Solution manual bank management and financial services 9th edition by rose, peter chap015

Chapter 15 - The Management of Capital CHAPTER 15 THE MANAGEMENT OF CAPITAL Goal of This Chapter: The purpose of this chapter is to discover why capital—particularly equity capital—is so important for financial institutions, to learn how managers and regulators assess the adequacy of an institution’s capital position, and to explain the ways that management can raise new capital Key Topics in This Chapter • • • • • • • 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 Capital Regulation in the Wake of the Great Recession/Basel III Planning to Meet Capital Needs Chapter Outline I II III IV Introduction 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 Capital and Risk A Key Risks in Banking and Financial Institutions’ Management Credit Risk Liquidity Risk Interest Rate Risk Operational Risk Exchange Risk Crime Risk B Defenses against Risk Quality Management Diversification a Portfolio Diversification b Geographic Diversification Deposit Insurance Owners' Capital Types of Capital in Use 15-1 Chapter 15 - The Management of Capital V VI VII VIII 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 Relative Importance of 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 Reasons for Capital Regulation Research Evidence The Basel Agreement on International Capital Standards: A Continuing Historic Contract among Leading Nations A Basel I Tier (Core) Capital Tier (Supplemental) Capital Calculating Risk-Weighted Assets Calculating the Capital-to-Risk-Weighted Assets Ratio B Capital Requirements Attached to Derivatives Bank Capital Standards and Market Risk Value at Risk (VaR) Models Responding to Market Risk Limitations and Challenges of VaR and Internal Modeling C Basel II Pillars of Basel II Internal Risk Assessment Operational Risk Basel II and Credit Risk Models A Dual (Large-Bank, Small-Bank) Set of Rules Problems Accompanying the Implementation of Basel II D Basel III: Another Major Regulatory Step Underway, Born in Global Crisis Changing Capital Standards Inside the United States A FDIC Improvement Act B Prompt Corrective Action Well capitalized Adequately capitalized Undercapitalized Significantly undercapitalized Critically undercapitalized Planning to Meet Capital Needs A Raising Capital Internally Dividend Policy How Fast Must Internally Generated Funds Grow? B Raising Capital Externally Selling Common Stock 15-2 Chapter 15 - The Management of Capital IX Selling Preferred Stock Issuing Debt Capital Selling Assets and Leasing Facilities Swapping Stock for Debt Securities Choosing the Best Alternative for Raising Outside Capital Summary of the Chapter Concept Checks 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, equity reserves, surplus, and retained earnings, plus any long-term debt issued that qualifies under regulations 15-2 What crucial roles does capital play in the management and viability of a 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 Capital promotes public confidence and reassures creditors concerning an institution’s financial strength Also, capital provides funds for the development of new services and facilities Recently, capital has also played a key role in the rapid growth of mergers among financial firms 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, undivided profits, equity reserves, subordinated debentures, minority interest in consolidated subsidiaries, and equity commitment notes Common stock represents the par value of common equity shares outstanding, while surplus is the amount paid over par value for the stock when it is sold Preferred stock is a special type of ownership where dividends are fixed and stockholders generally not have a vote on major activities undertaken by the firm Retained earnings or undivided profits are the accumulated earnings of the firm kept to reinvest back in the company Subordinated debentures are long term debt instruments that not represent ownership claims and are contributed by outside investors Equity reserves represents the funds set aside for contingencies, such as legal action against the institution, reserve for dividend expected to be paid but not yet declared, or shrinking fund to retire stock or debt in the future Minority interests 15-3 Chapter 15 - The Management of Capital in consolidated subsidiaries are one in which financial firms hold ownership shares in other businesses Equity commitment notes are one in which debt securities are repaid from the sale of stock 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 you think this is so? The most important form of capital is surplus, accounting for about two-thirds of all long-term debt and equity capital This is followed by retained earnings and capital reserves representing about one-fifth of U.S banks’ capitalization The remainder is divided up among all other types of capital, including long-term debt (subordinated notes and debentures) at close to 10 percent and the par value of common stock at close to percent Preferred stock is relatively insignificant at less than percent of the U.S banking industry’s capital Bank holding companies have issued substantial quantities of subordinated debt in recent years because such notes are callable shortly after issue and carry either fixed or floating interest rates 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 is the true cushion against loss that capital represents 15-6 How 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 you think these differences exist? Small banks rely mainly on surplus value of their stock and retained earnings (undivided profits) and very little on long-term debt (subordinated notes and debentures), whereas large banks rely on surplus value of stock, retained earnings, and long term debt This is because, large institutions have the ability to sell their capital instruments in the open market, while the smallest institutions, have only limited access to the financial market Small banks have a difficult time placing their equity and debt securities in the market and thus, rely more heavily on internal capital (i.e retained earnings) Moreover, many authorities in the field believe that generally the smallest banks should maintain the thickest cushion of capital relative to their asset size because they are not as well diversified as their large counterparts, both geographically and by product line, and, therefore, run a greater risk of failing 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 set capital standards stems from its efforts to stabilize the financial system, limit risk of failures, preserve public confidence, 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 failures and also that the private market cannot adequately assess their need for capital 15-4 Chapter 15 - The Management of 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, recently government regulation appears to have become nearly as important as the private marketplace by tightening capital regulations and imposing minimum capital requirements, especially in the wake of the great credit crisis of 2007–2009 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 some 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? The prime capital-adequacy ratios, under Basel I, which the regulators use to assess are, Tier risk-based capital ratio, which is equals core capital to risk-weighted assets, and total risk-based capital ratio, which is equals total capital to risk-weighted 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 and surplus, undivided profits (retained earnings), qualifying noncumulative perpetual preferred stock, minority interest in the equity accounts of consolidated subsidiaries, and selected identifiable intangible assets less goodwill, and other intangible assets Supplemental capital (or tier 2) is a secondary form of bank capital, which includes the allowance (reserves) for loan and lease losses, subordinated debt capital instruments, mandatory convertible debt, intermediate-term preferred stock, cumulative perpetual preferred stock with unpaid dividends, and equity notes and other long-term capital instruments that combine both debt and equity features 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 capital? In Tier capital? Does the bank have too much Tier capital? The Tier capital items include: Common stock and surplus $27 million The Tier capital items include: Allowance for loan and lease losses 15-5 $42 million Chapter 15 - The Management of Capital Undivided profits Noncumulative perpetual preferred stock Identifiable intangible assets Minority interest in subsidiaries Total Tier capital 81 million Subordinated debt capital Mandatory convertible debt million million million Equity notes million million $120 million million Total Tier capital $52 million The bank does not have too much Tier capital Tier capital can be up to 100 percent of the amount of Tier capital and hence can still count toward meeting its 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? Capital requirements today are set by regulatory agencies and, for banks in leading countries today, under rules laid out in the Basel Agreement on International Bank Capital Standards These government agencies set minimum capital requirements and assess the capital adequacy of the financial firms they regulate Capital regulation aimed primarily at the largest international banks and formally began with a multinational agreement known as Basel I This set of international rules required many of the largest banks to separate their on-balance-sheet and off-balance-sheet assets into risk categories and to multiply each asset by its appropriate risk weight to determine total risk-weighted assets The ratio of total regulatory capital relative to risk-weighted assets and off-balance-sheet commitments was an indicator of the strength of each international bank’s capital position Weaknesses in Basel I led to a Basel II agreement to be gradually phased in This approach to capital regulation required the world’s largest banking firms to conduct a continuing internal assessment of their individual risk exposures, including stress testing Thus, each participating bank would calculate its own unique capital requirements based upon its own unique risk profile Smaller banks would use a simpler, standardized approach to determining their minimum capital requirements similar to the rules of Basel I 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 National's total risk-weighted assets? If the bank reports Tier capital of $30 million and Tier capital of $20 million, does it have a capital deficiency? (Note: There are three categories of standby credit letters with different conversion factors and credit risk weights (See Table on p 499-500), we have assumed the standby credit letters in this discussion question are backing the issue of state and local government general obligation bonds.) 15-6 Chapter 15 - The Management of Capital We first convert the off-balance-sheet items to their credit-equivalent amounts: Off-Balance-Sheet Items: Standby credit letters: $20 million × 0.20 = $4 million Long-term commitments to corporations: $160 million × 0.50 = 80 million Then we can risk-weight all assets as follows: Risk-Weighted Assets Cash $200 million × = U.S government securities: $150 million × = Standby credit letters: $4 million × 0.20 = Residential real estate loans: $300 × 0.50 = Corporate loans: $350 × 1.00 = Long-term credit commitments: $80 × 1.00 = Total risk-weighted assets = $ 0.00 million 0.00 million 0.80 million 150.00 million 350.00 million 80.00 million $580.80 million The bank has total capital of: Tier capital = $30 million Tier capital = $20 million $50 million The bank's capital to risk-weighted asset ratio is: $50 million = 0.086 or 8.6 percent $580.80 million The ratio exceeds the minimum requirement of percent Moreover, more than percent of the 8.6 percent in capital is Tier 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? Under the capital standards brought into being by the Basel Agreement, 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 and to reduce their credit risk exposure will move toward government securities and away from corporate loans and home mortgage loans They will also shift the 15-7 Chapter 15 - The Management of Capital proportion of investment in off-balance sheet items as they legally bind credit commitments made by the banks to their customers 15-16 What are the most significant differences among Basel I, II, and III? 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 bank’s 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 Capital requirements laid down in Basel I and II apparently were inadequate in the face of the latest credit crash Also, Basel II had resulted in less total capital and a weaker mix of capital, worsening what turned into a global credit catastrophe Basel III was hence designed to head off future financial crises Basel III calls for greater total capitalization (a higher percentage relative to assets) plus a stronger definition of what belongs and does not belong in a bank’s capital accounts Internal risk assessment refers to an innovation in Basel II which allows banks to measure their own risk exposure and determine how much capital they needed to meet that 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 bank’s 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 bank’s risk exposure The market’s collective actions of buying and selling a bank's securities (like subordinate debt) in the financial market provide an independent assessment of the bank's financial condition Since such debt is not guaranteed, the buyers of such securities would be very vigilant about the bank’s 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: Develop an overall financial plan Determine the amount of capital that is appropriate given the goals, planned service offerings, acceptable risk exposure, and state and federal regulations Determine how much capital can be generated internally through profits retained in the business Evaluate and choose that source of external capital best suited to the institution’s needs and goals 15-18 How does dividend policy affect the need for capital? Relying on the growth of earnings to meet capital needs means that a decision must be made concerning the amount of earnings retained in the business versus the amount paid out to stockholders in the form of dividends For this reason, the management decides an appropriate retention ratio 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 A retention ratio set too 15-8 Chapter 15 - The Management of Capital high can result in a cut in stockholders’ dividend income Other factors held constant, such a cut would reduce the market value of stock issued by a financial institution Hence, the optimal dividend policy is one that maximizes the value of the stockholders’ investment 15-19 What is the ICGR, and why is it important to the management of a financial firm? The Internal capital growth rate (ICGR) is ratio of retained earnings to the equity capital of the firm It shows that if we want to increase internally generated capital, we must increase earnings (through a higher profit margin, asset utilization ratio, and/or equity multiplier) or increase the earnings retention ratio, or both To illustrate, the ICGR indicates how fast a firm can allow its assets to grow and still keep its capital-to-asset ratio fixed If the assets grow by a percentage above the ICGR, there is a possibility of capital-to-assets ratio to fall If it falls far enough, the regulatory authorities may insist that capital be increased Thus, it makes ICGR an important factor to keep a check on the firm’s earnings and its retention ratio 15-20 Suppose that a bank has a return on equity capital of 12 percent and that 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 × Retention Ratio ICGR = 0.12 × 0.35 = 0.042 or 4.2 percent The bank’s assets can grow at a rate of 4.2% percent without reducing the capital-to-assets ratio If ROE unexpectedly drops to only two-thirds of the expected 12 percent figure, the ICGR becomes: ICGR = [ 0.12 × 0.667 ] × 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 through which a financial firm can raise external capital are by selling common stock, selling preferred stock, issuing debt capital, selling assets, leasing certain fixed assets, or swapping stock for debt securities 15-22 What factors should management consider in choosing among the various sources of external capital? The alternative that management should choose will depend primarily on the impact each source would have on returns to stockholders, usually measured by earnings per share (EPS) Other key 15-9 Chapter 15 - The Management of Capital factors to consider are the institution’s risk exposure, the impact on control by existing stockholders, the state of the market for the assets or securities being sold, and regulations The management while considering in choosing among the various sources of external capital should also consider following factors individually 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 to boost EPS due to the financial leverage, but debt also adds to failure and earnings risk and may make it more difficult to sell stock in the future Selling assets and leasing capital usually creates a substantial inflow of cash Swapping stock for debt securities strengthens its capital and saves the cost of future interest payments on the notes Problems and Projects 15-1 The management at Sage National Bank located in Key West, Florida, is calculating the key capital adequacy ratios for its third-quarter reports At quarter-end, the bank’s total assets are $95 million and its total risk-weighted assets including off-balance-sheet items are $75 million Tier capital items sum to $4 million, while Tier capital items total $2.5 million Calculate Sage National’s leverage ratio, total capital-to-total assets, core capital-to-total risk-weighted assets, and total capital-to-total risk-weighted assets Does Sage National meet the requirement stipulated for a bank to qualify as adequately capitalized? In which of the five capital adequacy categories created by U.S federal regulators for PCA purposes does Sage National fall? Is Sage National subject to any regulatory restrictions given its capital adequacy category? Total assets Total risk-weighted assets including offbalance-sheet items $95.00 million 75.00 million Tier capital Tier capital 4.00 million 2.50 million Leverage ratio = Tier capital Total asset Leverage ratio = $4 million = 0.0421or 4.21percent $95 million Total capital-to-total assets ratio = ( Tier capital + Tier capital ) Total assets 15-10 Chapter 15 - The Management of Capital Total capital-to-total assets ratio = ( $4 million + $2.5 million ) = 0.0684 or 6.84 percent $95 million Core capital-to-total risk-weighted assets = Tier 1capital Risk weighted assets including off-balance-sheet items Core capital-to-total risk-weighted assets = $4 million = 0.0533or 5.33percent $75 million ( Tier capital Total capital-to-total risk-weighted assets = + Tier capital ) Risk weighted assets including off-balance-sheet items ( $4 million + $2.5 million ) = 0.0867 or 8.67 percent Total capital-to-total risk-weighted assets = $75 million Yes, Sage National Bank meets the requirement of having a minimum ratio of total capital to risk weighted assets of at least percent, a ratio of Tier capital to risk-weighted assets of at least percent, and a leverage ratio of at least percent stipulated for a bank to qualify as adequately capitalized Sage National Bank falls in “adequately capitalized” category among the five capital adequacy categories created by U.S federal regulators for PCA purpose Sage National Bank is subject to a regulatory restriction of not accepting broker-placed deposits without regulatory approval 15-2 Please indicate which items appearing on the following financial statements would be classified under the terms of the regulatory requirement for ( a ) Tier capital or ( b ) Tier capital Allowance for loan and lease losses Subordinated debt under two years to maturity Intermediate-term preferred stock Qualifying noncumulative perpetual preferred stock Cumulative perpetual preferred stock with unpaid dividends Subordinated debt capital instruments with an original average maturity of at least five years Common stock Equity notes Undivided profits Mandatory convertible debt Minority interest in the equity accounts of consolidated subsidiaries 15-11 Chapter 15 - The Management of Capital Tier Qualifying noncumulative perpetual preferred stock Common stock Undivided profits Minority interest in the equity accounts of consolidated subsidiaries Tier Allowance for loan and lease losses Subordinated debt under two years to maturity Intermediate-term preferred stock Cumulative perpetual preferred stock with unpaid dividends Subordinated debt capital instrument with an original maturity of at least five years Equity notes Mandatory convertible debt 15-3 Under the terms of the Original Basel Agreement, what risk weights apply to the following on-balance-sheet and off-balance-sheet items? Residential real estate loans Cash Commercial loans U.S Treasury securities Deposits held at other banks GNMA mortgage-backed securities Standby credit letters for commercial paper Federal agency securities Municipal general obligation bonds Investments in subsidiaries FNMA or FHLMC issued or guaranteed securities Credit card loans Standby letters of credit for municipal bonds Long-term unused commitments to make corporate loans Currency derivative contracts Interest-rate derivative contracts Short-term (under one year) loan commitments Bank real property Bankers’ acceptances Municipal revenue bonds Reserves on deposit at the Federal Reserve banks The items which would appear in the percent (Zero credit risk), 20 percent (Low credit risk), 50 percent (Moderate credit risk) and 100 percent (Highest credit risk) risk weight categories are: percent Cash U.S Treasury securities 20 percent Deposits held at other banks Federal agency securities 50 percent Residential real estate loans Long-term unused commitments to make corporate 15-12 100 percent Commercial loans Standby credit letters for commercial paper Chapter 15 - The Management of Capital GNMA mortgagebacked securities Short- term (under one year) loan commitments Reserves on deposit at the Federal Reserve banks loans Currency derivative contracts Interest-rate derivative contracts Municipal general obligation bonds FNMA or FHLMC issued or guaranteed securities Standby letters of credit for municipal bonds Municipal revenue bonds Investments in subsidiaries Credit card loans Bank real property Bankers’ acceptances 15-4 Using the following information for Gold Star National Bank, calculate that bank’s ratios of Tier capital-to-risk-weighted assets and total-capital-to-risk-weighted assets Does the bank have sufficient capital according to Basel I? On-Balance-Sheet Items (Assets) Cash U.S Treasury securities Deposit balances due from other banks Loans secured by first liens on residential property (1- to 4- family dwellings) Loans to corporations Total assets Off-Balance-Sheet Items Standby letters of credit backing repayment of commercial paper $ 20.5 million Long-term unused loan commitments to corporate customers 25.5 million $ 4.0 million 30.6 million Total off-balance-sheet items 4.0 million 46.0 million 66.0 million Tier capital 7.5 million 105.3 million $209.9 million Tier capital 5.8 million Gold Star National Bank's required level of capital under the new international capital standards would be determined from: The credit-equivalent amount of each off-balance-sheet (OBS) items: Standby letters of credit backing repayment of commercial paper Long-term unused loan commitments to corporate customers $20.5 million × 1.00 = $20.5 million $25.5 million × 0.50 = 12.75 million On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items: 15-13 Chapter 15 - The Management of Capital Percent Risk-Weighting Category Cash U.S Treasury securities Total $4 million $30.6 million $34.6 million × 0.00 = $0.00 million 20 Percent Risk-Weighting Category Deposit balances due from other banks $4.0 million × 0.20 = $0.80 million 50 Percent Risk-Weighting Category Loans secured by first liens on residential property $66.0 million × 0.50 = $33.00 million 100 Percent Risk-Weighting Category Loans to corporations Standby letters of credit backing repayment of commercial paper Long-term unused loan commitments to corporate customers Total Total risk-weighted assets held by this bank $105.3 million $20.5 million $12.75 million $138.55 million ×1.00 = $138.55 million $172.35 million The bank's capital ratio is: Tier capital-to-total risk-weighted assets = Tier 1capital Risk-weighted assets including off-balance-sheet items Tier capital ÷ Risk-weighted assets = $7.5 million ÷ $172.35 million = 4.35 percent Total capital ÷ Risk-weighted Assets = $13.3 million ÷ $172.35 million = 7.72 percent The ratio of Tier capital-to-risk-weighted assets is just above the minimum rate of percent However, the combined Tier plus Tier capital of 7.72 percent of risk-weighted assets is below the d percent Hence, the bank will have to raise new capital or reduce its risky assets under Basel I 15-5 Please calculate Red River National Bank’s 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? 15-14 Chapter 15 - The Management of Capital Cash Domestic interbank deposits U.S government securities Residential real estate loans Commercial loans Total assets Total liabilities Total capital $ 75 million 130 million 250 million 375 million 520 million $1,350 million $1,250 million $100 million Off-balance-sheet items include: Standby credit letters that back municipal general obligation bonds Long-term unused loan commitments to private companies $ 87 million 145 million The risk-weighted assets of Red River National Bank would be calculated as follows: The credit-equivalent amount of each off-balance-sheet (OBS) items: Standby credit letters that back municipal general obligation bonds Long-term unused loan commitments to private companies $87 million × 0.20 = $17.4 million $145 million × 0.50 = $72.5 million On-Balance-Sheet Items and Credit-Equivalent Off-Balance Sheet Items: Percent Risk-Weighting Category Cash U.S government securities Total 20 Percent Risk-Weighting Category Domestic interbank deposits Standby credit letters that back municipal general obligation bonds Total $75.00 million $250.00 million $325.00 million × 0.00 = $0 million $130.00 million 17.40 million $147.40 million 50 Percent Risk-Weighting Category 15-15 × 0.20 = $29.48 million Chapter 15 - The Management of Capital Residential real estate loans $375.00 million 100 Percent Risk-Weighting Category Commercial loans Long-term unused loan commitments to private companies Total Total risk-weighted assets held by this bank × 0.50 = $187.50 million $520.00 million $72.50 million $592.50 million × 1.00 = $592.50 million $809.48 million Red River's overall capital-to-assets ratio is: Total Capital Total Risk-Weighted Assets = $100 million $809.48 million = 0.1235 or 12.35 percent Based on the risk weighted assets, it does not appear that Red River has a capital deficiency as the capital to risk-weighted assets ratio is above the minimum requirement of percent In fact Red River is in a position to generate more assets by utilizing some part of the extra capital of 4.35 percent 15-6 Suppose Red 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 Tier capital? Tier capital? Calculate the Tier capital-to-riskweighted- assets ratio, total capital-to-risk-weighted-asset ratio, and the leverage ratio According to the data given in Problems and 6, does Red River have a capital deficiency? What is its PCA capital adequacy category? Red River National Bank has the following Tier and Tier capital items and totals: Tier Capital Common stock (par value) Surplus Undivided profits Total Tier capital Tier Capital $5 million Allowance for loan losses $15 million Subordinated debt capital $30 million Intermediate-term preferred stock $50 million Total Tier capital $25 million $20 million $5 million $50 million Hence, the Tier capital-to-risk-weighted- assets ratio is calculated as follows: Tier capital Total risk-weighted assets = $50 million $809.48 million 15-16 = 0.0618 or 6.18 percent Chapter 15 - The Management of Capital Total capital-to-risk-weighted-asset ratio is calculated as follows: Total capital Total risk-weighted assets = $50 million + $50 million $809.48 million = 0.1235 or 12.35 percent The leverage ratio is calculated as follows: Tier capital Total assets = $50 million $1,350 million = 0.0370 or 3.70 percent This bank has sufficient Tier capital and since its Tier capital amount is exactly 100 percent of Tier capital amount, it satisfies the requirements of Basel I Also, its PCA capital adequacy category would be “well capitalized” as it has a ratio of capital to risk-weighted assets of more than 10 percent and a ratio of Tier (or core) capital to risk-weighted assets of more than percent However, its leverage ratio (Tier capital to average total assets) does not meet the required standard of at least percent 15-7 Richman Savings Association has forecast the following performance ratios for the year ahead How fast can Richman allow its assets to grow without reducing its ratio of equity capital to total assets, assuming its performance holds reasonably steady over the period? Profit margin of net income over operating revenue Asset utilization (operating revenue ÷ assets) Equity multiplier Net earnings retention ratio 16.00% 8.25% 10x 60.00% Internal capital growth rate = Profit margin of net income over operating revenue × Asset utilization × Equity multiplier × Net earnings retention ratio = 0.16 × 0.0825 × 10 × 0.60 = 0.0792 or 7.92 percent Its assets cannot grow any faster than 7.92 percent over the period without reducing its ratio of equity capital to total assets 15-8 Using the formulas developed in this chapter and in Chapter and the information that follows, calculate the ratios of total capital to total assets for the banking firms listed below What relationship among these banks’ return on assets, return on equity capital, and capital-toassets ratios did you observe? What implications or recommendations would you draw for the management of each of these institutions? 15-17 Chapter 15 - The Management of Capital Name of Bank First National Bank of Hopkins Safety National Bank Ilsher State Bank Mercantile Bank and Trust Company Lakeside National Trust Net Income ÷ Total Assets (or ROA) 1.25% Net Income ÷ Total Equity Capital (or ROE) 1.2% 0.9% 0.25% 13% 11% 3% −0.5% −7% 15% The basic relationship needed in this problem is: Net income after tax Equity capital Net income after tax Equity capital = ROE ROE = And, Net income after taxes Total Assets Net income after taxes Total Assets = ROA ROA= Hence, the capital-to-asset ratio can be calculated as follows: Capital-to-asset ratio = ROA ROE Therefore, the ratio of total capital to total assets for the banks named in the problem must be: Name of Bank First National Bank of Hopkins Safety National Bank Ilsher State Bank Mercantile Bank and Trust Company Lakeside National Trust Net Income ÷ Total Assets (or ROA) Net Income ÷ Total Equity Capital (or ROE) ROA ÷ ROE 1.25% 1.20% 0.90% 15.00% 13.00% 11.00% 8.33% 9.23% 8.18% 0.25% −0.50% 3.00% −7.00% 8.33% 7.14% 15-18 Chapter 15 - The Management of Capital If an institution’s ratio of equity capital to total assets drops to percent or less, a depository institution is considered “critically undercapitalized” In this case, 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 It implies that the negative earnings may be eroding the capital position of this bank 15-9 Over the Hill 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 5.4 million, each bearing a par value of $1 This thrift institution currently holds assets of nearly $2 billion, with $135 million in equity During the coming year, the thrift’s economist has forecast operating revenues of $180 million, of which operating expenses are $25 million plus 70% of operating revenues Among the options for raising capital considered by management are (a) selling $8 million in common stock, or 320,000 shares at $25 per share; (b) selling $8 million in preferred stock bearing a percent annual dividend yield at $12 per share; or (c) selling $8 million in 10year capital notes with a 10 percent coupon rate Which option would be of most benefit to the stockholders? (Assume a 34% tax rate.) What happens if operating revenues are more than expected ($225 million rather than $180 million)? What happens if there is a slower-thanexpected volume of revenues (only $110 million instead of $180 million)? Please explain (a) Sale of Common Stock at $25 per share Estimated operating revenues Estimated operating expenses (b) Sale of 9% Preferred Stock at $12 per share (c) Sale of 10% Capital Notes $180,000,000 $151,000,000 $180,000,000 $151,000,000 $180,000,000 $151,000,000 Net revenues Interest expense on capital notes $29,000,000 - $29,000,000 - $29,000,000 $800,000 Before-tax income Estimated income taxes $29,000,000 $9,860,000 $29,000,000 $9,860,000 $28,200,000 $9,588,000 After-tax income Preferred stock dividends $19,140,000 - $19,140,000 $720,000 $18,612,000 - Net income for common stockholders $19,140,000 $18,420,000 $18,612,000 Shares of common stock outstanding 5,720,000 5,400,000 5,400,000 Earnings per share of common stock $3.35 $3.41 $3.45 In this case, sale of capital notes with a coupon rate of 10 percent would generate the highest EPS for the bank's shareholders 15-19 Chapter 15 - The Management of Capital Because of the dilution effect of issuing stock, if operating revenues rise to $225 million, the situation will be as shown below: (a) Sale of Common Stock at $25 per share Operating revenues Operating expenses (b) Sale of 9% Preferred Stock at $12 per share (c) Sale of 10% Capital Notes $225,000,000 $182,500,000 $225,000,000 $182,500,000 $225,000,000 $182,500,000 Net revenues Interest on capital notes $42,500,000 - $42,5000,000 - $42,500,000 $800,000 Before-tax income Estimated income taxes $42,500,000 $14,450,000 $42,500,000 $14,450,000 $41,700,000 $14,178,000 After-tax income Preferred stock dividends $28,050,000 - $28,050,000 $720,000 $27,522,000 - Net income for common stockholders $28,050,000 $27,330,000 $27,522,000 Shares of common stock outstanding 5,720,000 5,400,000 5,400,000 $4.90 $5.06 $5.1 Earnings per share of common stock Again capital notes would be the best option, although the preferred stock can also be considered this time as it also generates a slightly less earnings per share 15-20 Chapter 15 - The Management of Capital If operating revenues drop to $110 million, then the situation will be as shown below: (a) Sale of Common Stock at $25 per share (b) Sale of 9% Preferred Stock at $12 per share (c) Sale of 10% Capital Notes Operating revenues Operating expenses Net revenues Interest on capital notes $110,000,000 $102,000,000 $8,000,000 - $110,000,000 $102,000,000 $8,000,000 - $110,000,000 $102,000,000 $8,000,000 $800,000 Before-tax income Estimated income taxes $8,000,000 $2,720,000 $8,000,000 $2,720,000 $7,200,000 $2,448,000 After-tax income Preferred stock dividends $5,280,000 - $5,280,000 $720,000 $4,752,000 - Net income for common Stockholders $5,280,000 $4,560,000 $4,752,000 Shares of common Stock outstanding 5,720,000 5,400,000 5,400,000 $0.92 $0.84 $0.88 Earnings per share of common stock In this case, to raise the required sum of $8 million, issuing common stock is the best alternative from the point of view of the common stockholders 15-21 ... capital to total assets for the banks named in the problem must be: Name of Bank First National Bank of Hopkins Safety National Bank Ilsher State Bank Mercantile Bank and Trust Company Lakeside National... 15-17 Chapter 15 - The Management of Capital Name of Bank First National Bank of Hopkins Safety National Bank Ilsher State Bank Mercantile Bank and Trust Company Lakeside National Trust Net Income... exist? Small banks rely mainly on surplus value of their stock and retained earnings (undivided profits) and very little on long-term debt (subordinated notes and debentures), whereas large banks rely