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Ch 20 fully revised 2011

Ch 20 fully revised 2011 - 1 Chapter 20 Capital Adequacy 2...

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1 Chapter 20 Capital Adequacy
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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.
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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.
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4 Two Concepts of Capital Capital: Market value. Book value.
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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.
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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.
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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).
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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.
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9 Capital Adequacy: Commercial Banks & Thrifts Actual capital rules. Capital-assets ratio (or Leverage ratio). L = Core capital/Assets The higher the ratio, the less levered the bank is.
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