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Management of Capital, Ch. 15, Rose & Hudgins, 8th ed., (09F)

Functions or Tasks of Capital
      1. Acquire fixed assets to start bank
      2. Provides for growth in new services and products
      3. Absorbs losses so bank can continue to operate
      4. Instills confidence that bank can continue to provide for credit needs of community
      5. Provides base for continued growth that may be restricted if regulators or market think
              capital is not adequate
      6. Instills confidence by protecting uninsured depositors, FDIC and taxpayers

Simple Balance Sheet and Effect of Losses – see types of capital, p. 483-484
      Assets                                      Liabilities + Equity
      Cash & due                                  Insured deposits
      Investments                                 Uninsured deposits
      Gross loans                                 Subordinated Notes & debentures
        Loan loss reserves                        Senior Preferred Stock, then Pref. Stock
      Net loans                                   Common equity
      Fixed Assets                                  Common stock (par value)
      Intangible Assets                             Surplus (additional paid-in capital)
        Goodwill, PMSRs, PCCRs                      Undivided profits (retained earnings)

KNOW: If loan losses are large, what balance sheet accounts are affected and in what order,
from first to last? Loan loss reserves, undivided profits, surplus, common stock, preferred stock,
subordinated notes and debentures, uninsured deposits, FDIC for insured deposits, taxpayers.

As of 6/30/01 mergers must use purchasing accounting, where if you pay $100 for a company
that has a book value of $90, the other $10 is goodwill. Under the new accounting standards,
goodwill may remain on the balance sheet indefinitely but the company must perform annual
tests to see if the goodwill has become “impaired,” i.e., suffered a permanent decline in value.
Under the previous accounting treatment goodwill was amortized as an expense and lowered
EPS. In another popular previous accounting treatment, pooling accounting, there was no
goodwill. You merged assets at book value and there was no amortization of goodwill to
decrease EPS.

Types of Bank Capital and Importance of Each (12/31/07), see p. 484
Subordinate Notes and Debentures < 1% for small and medium banks, 14.7% for large banks
Preferred Stock is small (<= 0.4% for all bank sizes)
Common Equity Capital/Total Assets is 13.4% for small banks (≤$100M TA), 10.3% ($100M to
$1B), and 10.2% for large banks (≥$1B TA).

Market Value of Common Equity Capital = MVAssets - MVLiabilities
       MVC = (current market price/share) X (# of shares outstanding)
Note: MVC is difficult to measure for small banks because their stock is not actively traded.

General Description of Regulatory Measures of Capital, pp. 489-91
      1. Tier 1 Leverage ratio = [tier 1 capital]/ total assets (Not Basel ratio but is U.S. ratio)
   = [common equity + cumulative perpetual pref. stk. + minority interests
     in the equity accounts of consolidated subsidiaries + identified
     intangible assets - (goodwill and other intangible assets] / total assets

        The Federal Reserve Board on Oct. 16, 2008, announced the adoption of an interim final
rule to be effective on Oct. 17, 2008, that will allow bank holding companies to include in their
Tier 1 capital without restriction the senior perpetual preferred stock issued to the Treasury
Department under the capital purchase program announced by the Treasury on October 14, 2008.
Treasury established the capital purchase program under the Emergency Economic Stabilization
Act of 2008, which became law on October 3, 2008. Details about the capital purchase program
are available on the Treasury's website.

       2. Tier 1 capital ratio = [tier 1 capital]*/ risk-weighted assets

               *Core capital here limits qualifying cumulative perpetual pref. stk. to 1/4 of
       Tier 1 capital with remainder over the limit, referred to as non-qualifying,
       counting towards Tier 2 capital. Identified intangible assets such as purchased
       mortgage servicing rights (PMSRs) and purchased credit card relationships
       (PCCRs) may be included, subject to certain limits but also must be included in
       risk-weighted assets. Risk-weighted assets include on- and off-balance sheet items.

       3. Total capital ratio = [Tier 1 (core) capital + Tier 2 (supplemental) capital]
                                / risk-weighted assets, where

               Tier 2 capital = loan and lease loss reserves, subordinated notes & debentures,
       non-qualifying perpetual pref. stk., mandatory convertible debt, intermediate-term
       pref. stk., cumulative pref. stk. with unpaid dividends, and long-term capital notes
       that combine both debt and equity features. Tier 2 is limited to 50% of Total
       Capital. Risk-weighted assets include on- and off-balance sheet items.

Categories of Capitalization and the Ratios (3/31/09),

As of 3/31/09, 97.0% of the 7,998 DIF-insured commercial and savings institutions (98.6% of
dollar assets) are well-capitalized, 1.8% (0.9% of dollar assets) are adequately-capitalized, 53
banks are undercapitalized, 30 banks are significantly undercapitalized, and 20 banks are
critically undercapitalized. [Source: FDIC Quarterly Banking Profile] According to FDICIA
(1991) guidelines, regulatory authorities must or may take restrictive actions as banks move from
well-capitalized to lower categories.

Risk Weights applied to bank assets and off-balance sheet items under Basle I Agreement,
pp. 485-490. These apply only to credit risk.

Examples of Assets on Balance Sheet - see p.490
Weight (Level of
Credit Risk)         Examples

1. 0% (zero)          Cash & due; Treasury securities of all maturities; GNMA mortgage-
                      backed securities

2. 20% (low)          Items in process of collection (float), interbank deposits, general
                      obligation municipals, U.S. agency securities, FNMA & FHLMC
                      mortgage-backed securities

3. 50% (moderate)     Residential 1-4 family loans, selected multifamily housing loans, revenue

4. 100% (highest)     Commercial loans, consumer loans and all other assets not listed above.

Calculating Risk-Weighted Assets (RWA) Assume the following amount of assets in each
category, 1 = $10, 2 = $20, 3 = $40, and 4 = $30. The total assets = $100. The RWA = (0.0 x
$10) + (0.2 x $20) + (0.5 x $40) + (1.0 x $30) = $54. This simple example only considers on-
balance sheet activities. Off-balance sheet activities below also have to be considered.

Examples of Off-Balance Sheet Items and Derivatives not shown on a balance sheet - see p.493-
Off-Balance Sheet Activities

Conversion     Weight (Level of
Factor**       Credit Risk)          Examples

1. 0.0         0% (zero or lowest)   Loan commitments < 1 year maturity; guarantees of federal
                                     or central government borrowings

2. 0.2         20% (low)              SLCs for general obligation municipals

3. 0.2         100% (modest)          Trade-based commercial letters of credit and bankers
4. 0.50        100% (moderate)        SLCs guaranteeing performance; Unused loan
                                      commitments with a maturity > 1 year
5. 1.00        100% (highest)         SLCs to back repayment of commercial paper

Derivatives -
Conversion Weight (Level of
Factor**      Credit Risk)            Examples

1. 0.0         50% (lowest)           Interest-rate contracts ≤ 1 year

2. 0.005       50% (modest)           Interest-rate contracts > 1 year

3. 0.01        50% (moderate)         Currency contracts ≤ 1 year

4. 0.05        50% (highest)          Currency contracts > 1 year

**Conversion Factor for converting Off-BS items into equivalent amounts of On-BS items. The
conversion factor is multiplied times the notional value to obtain the potential market risk
exposure. This amount is added to the current market risk exposure (replacement cost) and the
weight is multiplied times the sum of the two risk exposures.

Comment: To the extent that regulator-required capital is greater than the amount that the
market would require, then the difference is considered a tax by bankers. The weights may also
affect bank portfolio decisions, e.g., residential 1-4 family loans have a lower capital requirement
than commercial loans or consumer loans and may encourage banks to make more of the lower-
capital requirement loans.

Bank Capital Standards and Market/Interest Rate Risk - The above weights only reflect
credit risk. A major risk that is not considered is market risk. The Basle Capital Accord in 1995
passed new market risk capital requirements that became effective January 1, 1998. In the U.S.
banks and bank holding companies whose trading activities in securities, currencies, and/or
commodities are greater than or equal to 10% of total assets or $1Billion must hold some capital
aimed at protecting their market risk exposure. These banks are allowed to develop their own in-
house models for risk assessment. The model must determine the maximum loss it might sustain
over a 10-day period (under a 99-percent statistical confidence standard) known as the Value at
Risk (VaR) approach. Regulators then will determine the amount of capital the bank needs to
cover its market risk exposure. Example of VAR approach: Take all of the 10- trading day
returns over some time period, e.g., the last five years, i.e., if periods overlap then one would

have about 250 periods per year using trading days. Take the standard deviation of the returns
and calculate a 99% 2-tail confidence interval around the mean, e.g., Z = ± 2.567, which leaves
0.5% in each tail. The lowest return at the (mean -2.567 standard deviation) would be the
estimated maximum loss for the next two-week period. Potential problems with this approach are
(1) estimates will vary by time period, e.g., estimates based on periods with low volatility will
underestimate the potential losses when periods have more volatility, and (2) losses may last
longer than 10 days so that the 10-day window may underestimate potential losses, e.g., R1-10 days
= -10% and R11-20 days = -11% show losses of -10 and -11%, however, the 20-day loss is 21%,
much more than the 10-day window estimates. The current multiplier for VaR is three but the
multiplier depends on how accurate the loss estimates are over the last 250 trading days. If the
number of daily exceptions is greater than four, then the multiplier is increased. If the number of
exceptions is ten or more then the multiplier increases to four and the risk assessment model
must be explicitly improved. For an example of recent use of VaR see excerpt from 2008 Q2
Bank Derivatives Report at the end of the notes.

Basel II (agreed upon 6/26/04) starting p. 492 (selected features)

1. Expand risk weights from four (0%, 20%, 50%, 100% ) to five (0%, 20%, 50%, 100%, 150%)

2. Weights on assets will now depend on external credit ratings provided by commercial credit
rating agencies such as Moody’s, S&P, Fitch, and other NRSROs . For example, the current 0%
weight on claims on sovereigns could vary from 0% to 150% and the current 100% weight on
corporate claims could vary from 20% to 150%, depending on ratings. Unrated claims would
receive a 100% weight. Residential mortgages and unsecured consumer loans would continue at
a 50% and a 100% weight, respectively. The proposed process considers that the credit risk of
one type of financial instrument may vary considerably depending on the issuer, whereas, the
current process assumes that all issuers of one type have the same credit risk. The current
approach encourages capital arbitrage (invest in the higher-risk and -yielding assets within a
class). Banks with more credit risk will have higher capital requirements. The recent external
and internal ratings for subprime mortgage-backed securities and their unexpected deterioration
in 2007 and 2008 should cause regulators to question the validity of the ratings for calculating

Basel II Capital Accord (selected features)

3 Pillars

Minimum capital requirement ( regulatory capital/risk-weighted assets) but more advanced
treatment of credit risk and market risk (see above examples). Explicitly take into account
operational risk (p. 481), the risk of loss resulting from inadequate or failed internal processes,
people, systems, or from external events.

Supervisory oversight - The internal process by which bank management assesses and sets capital
should be subject to supervisory review.

Stronger market discipline – require banks to publicly disclose key information that enables
market to assess a bank’s risk profile and level of capitalization because internal ratings of an
individual bank could be used to set regulatory capital requirements; however, many difficulties,
e.g., data availability and model validation, must be dealt with. This should permit better
monitoring by private investors. (Other proposals related to market discipline would require the
largest banks in the U.S. to issue a minimal amount of subordinated debt that would not be
insured. This approach would provide market discipline.)

Operational Risk, the risk of loss resulting from inadequate or failed internal processes, people,
systems, or from external events, is newest risk factor. Other risk factors include credit and
market risk. The basic capital charge for operational risk would be a specified percentage of the
bank’s average annual gross income over the preceding three years. The standardized approach
would be calculated for each of eight business lines. The advanced measurement approaches
(AMA) would allow banks to use their own methods for assessing their exposure.

Scope of Application of Basel II

As of 7/20/07 only the 11 largest U.S. banks will use the Basel II capital rules using the advanced
approach where they set capital according to internal rated base models. Others will use the
standardized approach. The impact of the new rules on levels of capital will be studied for two
years after implementation which will probably occur in 2008. Under advanced approach for
measuring credit risk, a bank would be required to estimate for each credit exposure, the
probability of borrower default, likely size of loss in default, the amount of exposure at time of
default, and the remaining maturity of the exposure.

National discretion is built into the framework so that adopting countries have some flexibility in
implementing rules that are most appropriate to their own circumstances. It is also important to
have “competitive equity” across countries.

COMMENT: Small banks in U.S. (and Denmark) are worried that new system will give biggest
banks a new advantage if they are allowed to lower the largest banks’ level of capital. Large U.S.
banks are worried about international competitive equality, particularly related to the tier 1
leverage ratio that is not used in other countries.

Excerpts from FED press release on 11/02/07

The Federal Reserve Board on Friday approved final rules to implement new risk-based capital
requirements in the United States for large, internationally active banking organizations.

For banking organizations that meet the relevant qualifying criteria, Basel II would replace the
current U.S. rules implementing the Basel Capital Accord of 1988 (Basel I). Basel II would be
mandatory for large, internationally active banking organizations (so-called “core” banking

organizations with at least $250 billion in total assets or at least $10 billion in foreign exposure)
and optional for others. Under Basel II, core banking organizations would be required to
enhance the measurement and management of their risks, including credit risk and operational
risk, through the use of advanced approaches for calculating risk-based capital requirements.

Core banking organizations also would be required to have rigorous processes for assessing their
overall capital adequacy in relation to their total risk profile and to publicly disclose information
about their risk profile and capital adequacy. Under Basel II, risk-based capital requirements will
vary on the basis of a banking organization’s actual risk profile and experience, which should
lead institutions to make better decisions about extending credit, mitigating risks, and
determining overall capital needs. Banking organizations with a higher risk profile will have
higher regulatory capital requirements than those with a lower risk profile.

The new U.S. Basel II rule is technically consistent in most respects with international
approaches and includes a number of prudential safeguards as originally proposed in September
2006. These safeguards include a requirement that banking organizations satisfactorily complete
a four-quarter parallel run period before operating under the Basel II framework, a requirement
that an institution satisfactorily complete a series of transitional periods before operating under
Basel II without floors, and a commitment by the agencies to conduct ongoing analysis of the
framework to ensure Basel II is working as intended. Importantly, Basel II in the United States
will be implemented with retention of the leverage ratio and prompt corrective action (PCA)
requirements, which will continue to bolster capital and complement risk-based measures.

Following a successful parallel run period, a banking organization would have to progress
through three transitional periods (each lasting at least one year), during which there would be
floors on potential declines in risk-based capital requirements.

Those transitional floors would limit maximum cumulative reductions of a banking
organization’s risk-based capital requirements to 5 percent during the first transitional floor
period, 10 percent during the second transitional floor period, and 15 percent during the third
transitional floor period. A banking organization would need approval from its primary federal
regulator to move into each of the transitional floor periods, and at the end of the third
transitional floor period to move to full Basel II. The federal banking agencies will publish a
study after the end of the second transition year that examines the new framework for any
material deficiencies.

“To ensure that banks maintain strong capital ratios, we will diligently monitor Basel II during
every step of its implementation,” Governor Kroszner said. “Our goal is for banks to have strong
risk-based capital ratios that are substantially more representative of risk profiles, and more
sensitive to changes in those risk profiles than they are today. If our analysis shows that any part
of this goal is not being met, we will consider ways to improve the framework.”

As the federal banking agencies said in July, the agencies intend to issue a proposed rule that
would provide all non-core banking organizations, which are not required to adopt Basel II’s
advanced approaches, with the option to adopt a standardized approach under Basel II. The

proposed rule is intended to be finalized before the core banking organizations may start their
first transition period year under Basel II.

Excerpts from Press Release on June 26, 2008

The Federal Reserve Board proposed a rule for public comment that would implement certain of
the less-complex approaches for calculating risk-based capital requirements that are included in
the international Basel II capital accord.

The proposal, known as the standardized framework, would be available for banks, bank holding
companies, and savings associations not subject to the advanced approaches of Basel II. Under
the advanced approaches rule, which took effect April 1, 2008, and is mandatory only for large,
internationally active banking organizations, banking organizations are required to develop
rigorous risk-measurement and risk-management techniques as part of a new risk-sensitive
capital framework. The standardized framework also seeks to more closely align regulatory
capital requirements with institutions' risk and should further encourage improvements in their
risk-management practices.

 "The increased risk sensitivity of the standardized framework is aimed at both enhancing safety
and soundness for the wide range of institutions that will not be adopting the advanced
approaches of Basel II and fostering competitive equity for these institutions," said Federal
Reserve Board Governor Randall S. Kroszner. "Recognizing the diversity of banking
organizations in the United States, we want to provide these banks the option of using a more
updated capital framework without unduly increasing regulatory burden."

The proposed standardized framework addresses a number of areas including:

Expanding the number of risk-weight categories to which credit exposures may be assigned.

Using loan-to-value ratios to risk weight most residential mortgages to enhance the risk
sensitivity of the capital requirement.

Providing a capital charge for operational risk using the Basic Indicator Approach under the
international Basel II capital accord.

Emphasizing the importance of a bank’s assessment of its overall risk profile and capital

Providing for comprehensive disclosure requirements to complement the minimum capital
requirements and supervisory process through market discipline.

Organizations and persons have 90 days from publication of the proposed rule to make
comments. The proposed rule may be found at

VaR Example from OCC’s Quarterly Report on Bank Trading and Derivatives Activities
Second Quarter 2008

Market Risk
Banks control market risk in trading operations primarily by establishing limits against potential
losses. Value at Risk (VaR) is a statistical measure that banks use to quantify the maximum loss
that could occur, over a specified horizon and at a certain confidence level, in normal markets. It
is important to emphasize that VaR is not the maximum potential loss; it provides a loss estimate
at a specified confidence level. A VaR of $50 million at 99% confidence measured over one
trading day, for example, indicates that a trading loss of greater than $50 million in the next day
on that portfolio should occur only once in every 100 trading days under normal market
conditions. Since VaR does not measure the maximum potential loss, banks stress test their
trading portfolios to assess the potential for loss beyond their VaR measure.
The large trading banks disclose their average VaR data in published financial reports. To
provide perspective on the market risk of trading activities, it is useful to compare the VaR
numbers over time and to equity capital and net income.

As shown in the table below, market risks reported by the three largest trading banks, as
measured by VaR, are small as a percentage of their capital.
$ in millions            JPMorgan & Co. Citigroup Inc.              Bank of America Corp.
Average VaR Q2 '08       $150                       $255                    $88
Average VaR 2007         $107                       $142                    $53
06-30-08 Equity Capital $133,176                    $136,405                $162,691
2007 Net Income          $15,365                    $3,617                  $14,982
Avg VaR Q2 '08/Equity 0.11%                         0.19%                   0.05%
Avg VaR Q2 '08/
 2007 Net Income           0.98%                    7.05%                   0.58%
Data Source: 10K & 10Q SEC Reports.

To test the effectiveness of their VaR measurement systems, trading institutions track the number
of times that daily losses exceed VaR estimates. Under the Market Risk Rule that establishes
regulatory capital requirements for U.S. commercial banks with significant trading activities, a
bank’s capital requirement for market risk is based on its VaR measured at a 99% confidence
level and assuming a 10-day holding period. Banks back-test their VaR measure by comparing
the actual daily profit or loss to the VaR measure. The results of the back-test determine the size
of the multiplier applied to the VaR measure in the risk-based capital calculation. The multiplier
adds a safety factor to the capital requirements. An “exception” occurs when a dealer has a daily
loss in excess of its VaR measure. Some banks disclose the number of such “exceptions” in their
published financial reports. Because of the unusually high market volatility and large write-
downs in CDOs in the recent quarters, as well as poor market liquidity, a number of banks
experienced back-test exceptions and therefore an increase in their capital multiplier.
Concentrations in illiquid ABS CDOs, as well as non-normal market conditions, have caused
several large dealer institutions (both bank and non-bank) to incur significant trading losses in
the past four quarters. Historically, these ABS CDOs had not exhibited significant price

variability given their “super senior” position in the capital structure, so measured risk in VaR
models was very low. However, rapidly increasing default and loss estimates for subprime
mortgages caused abrupt and significant reassessments of potential losses, in these super senior
ABS CDOs, that continue to play out. Because VaR models rely on historical price movements
and assume normal market conditions, this particular risk measurement tool may not have fully
captured the effect of severe market dislocations. As such, the OCC advocates the use of
complementary risk measurement tools such as stress testing and scenario analysis.

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