Ch 20 2012 - 1 Chapter 20 Capital Adequacy 1 2 Overview •...

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Unformatted text preview: 1 Chapter 20 Capital Adequacy 1 2 Overview • This chapter: Capital Adequacy ▫ Review of the role of capital in the recent financial crisis. ▫ 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 The Role of Capital in the Recent Financial Crisis • During the crisis, many banks ran low on capital because of losses on real estate-related assets. • Recall that most large banks raised more capital than they lost on their books (although they likely lost a lot more in market value terms). • The government stepped in anyway to restore public confidence with TARP and injected preferred equity into all of the largest banks and many small banks. 3 4 Importance of Capital Adequacy • The Functions of Capital: ▫ Provide a cushion to absorb unanticipated losses. ▫ Reduce moral hazard incentives created by deposit insurance and too-big-to-fail policies. ▫ Preserve confidence in the FI, and avoid runs by depositors. ▫ 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. 4 5 Two Concepts of Capital • Capital: ▫ Market value. ▫ Book value. • The current accounting system for commercial banks is a mix of book values and market values. ▫ Some assets and off-balance sheet items are marked to market, and others are kept at the historical basis. 5 6 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. During financial crisis, FASB clarified position on market value accounting and allowed management to exercise greater discretion for pricing illiquid assets. Essentially moved backwards from market value accounting. 6 7 Book Value of Capital • Book value of capital – sum of four values. ▫ Par value of shares. 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. 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. Reserves set aside out of retained earnings to meet expected and actual losses on the portfolio. 7 8 Arguments Against Book Value Accounting • Ignores credit risk gains and losses. ▫ Creates a tendency to defer write-downs....
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This note was uploaded on 02/17/2012 for the course FINA 465 taught by Professor Berger during the Spring '11 term at South Carolina.

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Ch 20 2012 - 1 Chapter 20 Capital Adequacy 1 2 Overview •...

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