Ch 20 fully revised 2011

Ch 20 fully revised - 1 Chapter 20 Capital Adequacy 1 2 Overview • This chapter Capital Adequacy Functions of capital Different measures of

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Unformatted text preview: 1 Chapter 20 Capital Adequacy 1 2 Overview • This chapter: Capital Adequacy ▫ Functions of capital. ▫ Different measures of capital adequacy. ▫ Current and proposed capital adequacy requirements. ▫ Advanced approaches to calculate adequate capital according to internal rating-based models. 2 3 Importance of Capital Adequacy • The Functions of Capital: ▫ Absorb unanticipated losses and preserve confidence in the FI. ▫ Reduce moral hazard incentives created by deposit insurance and too-big-to-fail policies. ▫ Protect uninsured depositors and other stakeholders. ▫ Protect deposit insurance funds and taxpayers. ▫ To fund the branch and other real investments that are necessary in order to provide financial services. 3 4 Two Concepts of Capital • Capital: ▫ Market value. ▫ Book value. 4 5 Market Value of Capital • Market value of capital. ▫ Incorporates credit risk gains & losses. ▫ Incorporates interest rate risk gains & losses. ▫ Exemption from mark-to-market for some of the banks’ securities losses. h During financial crisis, FASB clarified position on market value accounting and allowed management to exercise greater discretion for pricing illiquid assets. 5 6 Book Value of Capital • Book value of capital – sum of four values. ▫ Par value of shares. h The face value of the common stock shares issued by the FI (usually $1 per share) times the number of shares outstanding. ▫ Surplus value of shares. h The difference between the price the public paid for the shares and their par value times the number of shares outstanding. ▫ Retained earnings. ▫ Loan loss reserve. h Reserves set aside out of retained earnings to meet expected and actual losses on the portfolio. 6 7 Arguments Against Book Value Accounting • Ignores credit risk gains and losses. ▫ Creates a tendency to defer write-downs. • Ignores interest risk gains and losses. ▫ These can be substantial (recall the S&L industry in the 1980s). 7 8 Arguments Against Market Value Accounting • Difficult to implement, especially for small banks with many non-traded assets & liabilities. ▫ However, market values can be estimated even when an item is not traded. • Increase in volatility of earnings, which will not be realized if the assets & liabilities are not sold but held until maturity. ▫ Could force premature closure under prompt corrective action. • Bias against long term assets. ▫ FIs will be less willing to accept longer-term asset exposures, which are more sensitive to interest rate changes. h This may lead to credit crunches in some types of loans. 8 9 Capital Adequacy: Commercial Banks & Thrifts • Actual capital rules. • Capital-assets ratio (or Leverage ratio)....
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This note was uploaded on 07/02/2011 for the course FINA 465 taught by Professor Berger during the Spring '11 term at South Carolina.

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Ch 20 fully revised - 1 Chapter 20 Capital Adequacy 1 2 Overview • This chapter Capital Adequacy Functions of capital Different measures of

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