BUS307 Topic 5 - Topic 5 Capital Adequacy BUS307 Commercial Banking 1.0 Purpose of capital Capital ratio The bank’s choice of ratio The regulator’s

BUS307 Topic 5 - Topic 5 Capital Adequacy BUS307 Commercial...

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Topic 5 Capital Adequacy BUS307 Commercial Banking
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1.0 Purpose of capital Capital ratio The bank’s choice of ratio The regulator’s requirements Sources of capital Internal capital and constraints on growth External capital
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1.1 Defining Capital Equity approach Capital = net worth = assets – liabilities Regulatory approach Capital = defined items consisting of Tier 1: core capital Tier 2: supplementary capital
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1.2 Functions of Capital To absorb risk Protects depositors and liability holders from loss Contributes to community confidence Commitment of shareholders reassuring to other claimants Source of investment funds For expansion or acquisition
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1.3 Target Capital Level Trade-off theory Bankruptcy costs vs. Tax benefit of debt Pecking order theory Managers should prefer internal capital, then debt, then equity In practice Risk-return trade-off, and Regulatory requirements
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1.4 Risk-Return Trade-Of Capital risk will decrease if Probability of loss decreases Proportion of capital increases To maximise shareholder value either Reduce risk, or Increase expected return
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1.5 Leverage Higher leverage means Higher returns for shareholders Higher capital risk Excessive leverage limited by Market discipline Increased costs of financial distress Regulatory capital rules
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2.0 Capital Adequacy Requirements (C.A.R.) Minimum capital ratio of 8% of risk-weighted assets (RWA) Higher risk attracts higher capital requirement Off-balance-sheet exposures included in RWA Supplementary capital included Consistent with international standards Must be met at consolidated group level as well as by stand-alone bank
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2.1 Outline of Capital Regulations Regulatory capital includes Tier 1 (core capital) Tier 2 (supplementary capital) Assets adjusted for Credit risk of both on-balance-sheet and off-balance-sheet items Market risk (risk of price changes)
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2.1.1 Tier 1 (Core) Capital Paid-up ordinary shares Non-repayable share premium account General reserves Retained profits Non-cumulative irredeemable preference shares Minority interests in subsidiaries Other instruments as approved by APRA
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2.1.2 Tier 2 (Supplementary) Capital Upper General provision for doubtful debts Asset revaluation reserves Cumulative irredeemable preference shares Mandatory convertible notes Perpetual subordinated debt Lower Limited-life redeemable preference shares Term subordinated debt
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2.2 Calculating the Capital Adequacy Ratio (CAR) 1. Calculate Tier 1 and Tier 2 capital 2. Calculate credit risk-weighted assets On-balance-sheet items: assign risk-weight to each item Off-balance-sheet: convert to on-balance-sheet equivalent before assigning risk-weight 3. Calculate market risk-weighted assets using value at risk approach 4. Tier 1 + Tier 2 capital must be at least 8% of risk- weighted assets.
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  • Summer '19
  • Saunders, Capital requirement, Tier 1 capital, standby letter, Cornett, loan commitments

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