BANK

MANAGEMENT
CHAPTER 5
BANK CAPITAL
MANAGEMENT

INTRODUCTION

Capital refers principally to funds

contributed by the banks owners (the
stockholders), which takes the form of
purchases of stock and annual earnings
that the owners reinvest in the bank
(retained earnings) to build up reserves so
that the owners future returns can be
increased.
Bank capital performs functions such as:
1. Supplying

resources to start a new bank

2. Creating a base of resources for future growth
3. Providing a cushion of protection against risk
4. Promoting public confidence
2

THE IMPORTANCE OF BANK

CAPITAL
1.

2.

3.

Provides a cushion against the risk of failure

by absorbing financial and operating losses
until management can address the banks
problems and restore its profitability.
Provides the funds needed to charter,
organize, and operate the bank before
deposits come flowing in.
Promotes public confidence in a bank and
reassures its creditors (including the
depositors) of the banks financial strength.
3

Cont
4.

5.

6.

Provides funds for the organizations

growth and the development of new
services and facilities.
Serves as a regulator of bank growth,
helping to ensure that growth is
sustainable in the long run.
Capital regulation by the bank
regulatory agencies has become an
increasingly important tool to limit
how much risk exposure banks can
accept.
4

BANK CAPITAL AND RISK

Bank capital and risk are intimately

related to each other.
Capital itself is mainly the funds
contributed by the owners of a bank that
have been placed there at the owners
risk the risk that the bank will earn a
less-than-satisfactory return on the
owners funds or may even fail, with the
stockholders recovering little or nothing.
5

Cont

The risks facing the owners of a

bank are substantial, they include:
Credit risk
Liquidity risk
Interest rate risk
Operating risk
Exchange risk
Crime risk
6

Bank Defenses Against

Risk

There are several rings of defense

that the banks owners can rely upon
to protect their institutions financial
position. Among them are:
Quality management
Diversification
Deposit insurance
Owners capital
7

1. Quality Management

The ability of top-notch managers

to move swiftly to deal with
problems before they overwhelm a
bank.

2. Diversification

Banks generally strive to achieve two

types of risk-reducing diversification:
1. Portfolio diversification
Spreading out a banks credit
accounts and deposits among a wide
variety of customers, including large
and small business accounts,
different industries and households
with a variety of sources of income
and collateral
9

Cont
2.

Geographic diversification
Refers to seeking out
customers located in different
communities or countries,
which presumably will
experience different economic
conditions

10

3. Deposit Insurance

Design to promote public confidence in the

banking system
Deposit insurance might not stop banks
from failing but it appears to have stopped
runs on neighboring banks when any
particular bank fails
Moreover, its power to examine banks,
issue cease and desist orders, levy civil
money penalties, and seek criminal
prosecution of violators of banking laws
inhibits much risk taking by bank
11
management and shareholders

Cont

Perbadanan Insurans Deposit Malaysia

(PIDM) or Malaysia Deposit Insurance
Corporation (MDIC) was launched on 1
September 2005 under the Malaysia
Deposit Insurance Act 2005 to administer
the deposit insurance system in Malaysia.
The deposit insurance system will
strengthen incentives for financial
institutions to adopt sound financial and
business practices and enhance public
confidence in the financial system by
providing explicit protection of deposits.
12

Cont

Under the deposit insurance system,

eligible deposits will be insured up to
the prescribed limit of RM250,000 per
depositor inclusive of principal and
interest.
PIDMs mandate is to:
provide insurance against loss of part
or all deposits.
provide incentives for sound risk
management in the financial industry.
promote and contribute to the stability
of the financial system.
13

4. Owners Capital

When all else fails, it is owners capital

(net worth) that forms the ultimate
defense against risk in banking
last line of defense against failure
Owners capital absorbs losses from bad
loans, poor securities investments, crime,
and management misjudgment so that the
bank can keep operating until its problems
are corrected and its losses are recovered .
The greater the risk of failure, the more
capital a bank should hold
14

Types of Bank Capital

1.

Common stock measured by the

par value of common equity shares
outstanding, which pay a variable
return depending on banks profit.

2.

Preferred stock measured by

the par value of any shares

outstanding that promise to pay a
fixed rate of return (dividend rate).
15

Cont
3.

4.

Surplus representing the excess

amount above each share of stocks

par value paid in by the banks
shareholders (or the excess value of a
bank stock at the time it was issued
above its par value).
Undivided Profits representing
the net earnings that have been
retained in the business rather than
being paid out as dividends.
16

Cont
5.

6.

Equity reserves representing funds set

aside for contingencies such as legal action
against bank, as well as providing a
reserve for dividends expected to be paid
but not yet declared and a sinking fund to
retire stock or debt in the future.
Subordinated debentures representing
long-term debt capital contributed by
outside investors, whose claims legally
follow the claims of depositors; these debt
securities may carry a convertibility
feature, permitting their future exchange
17
for shares of stock.

Cont
7.

8.

Minority interest in
consolidated subsidiaries
where the bank or other financial
firm holds ownership shares in
other businesses.
Equity commitment notes
which are debt securities repayable
only from the sale of stock.
18

Reasons for Capital

Regulation
1.
2.
3.

To limit the risk of bank failure

To preserve public confidence
To limit losses to federal
government arising from deposit
insurance claims

19

MEASURING SIZE OF BANK

CAPITAL

Prior to 1989, there was no standard

capital adequacy framework for all
banking institutions in Malaysia.
Commercial banks were required to
maintain a minimum free capital
adequacy ratio of 4% for domestic
banks and 6% for branches of foreign
banks.
The free capital ratio = capital funds
__________________________________

total assets

20

Cont

Capital funds = paid-up capital,

reserves, subordinated loans, general
provisions, and long term loans to
finance fixed assets.
Following the introduction of Basel
Capital Accord in 1988, BNM had
streamlined the capital adequacy
framework for commercial banks,
finance companies, and merchant banks
21

Cont

The Basel capital rules were designed to:

1. encourage leading banks around the world
to keep their capital positions strong.
2. reduce inequalities in capital
requirements among different countries to
promote fair competition.
3. catch up with recent changes in financial
services and financial innovation.

22

Cont

The current Basel capital standards are

known today as Basel I. Under the
terms of Basel I, the various sources of
bank capital were divided into two
tiers:
2 Sources of Capital:
Tier 1 Capital (Core Capital)
Tier 2 Capital (Supplemental Capital)

23

Cont
In Malaysia

Tier 1 Capital

Paid-up share capital

2. Share capital
3. Reserves
4. Minority interest
5. Treasury shares
Less: Goodwill
Less: Deferred tax assets, net
1.

24

Cont

Tier 2 Capital
1. General provisions for bad and
doubtful debts (Allowance for loan
losses)
2. Subordinated obligations/debts

Total Capital = Tier 1 + Tier 2

Capital Base = Total
Investment in

capital
companies

subsidiary
25

Cont
The capital requirement for a bank to
qualify as adequately capitalized are:
1. The ratio of core capital (Tier 1) to
total risk-weighted assets must be at
least 4%.
2. The ratio of total capital (Tier 1 +
Tier 2) to total risk-weighted assets
must be at least 8%.

26

Cont

The capital requirement for a bank to

qualify as adequately capitalized are:
1. The ratio of core capital (Tier 1) to
total risk-weighted assets must be
at least 4%.
2. The ratio of total capital (Tier 1 +
Tier 2) to total risk-weighted assets
must be at least 8%.
27

Capital Adequacy Ratio

(CAR)

Under BAFIA 1989, financial institutions

have to maintain a minimum risk
weighted capital ratio (RWCR) of 8%.

RWCR =

Total capital

_______________________________________________________________________________________________________________

Total risk weighted assets

Total risk weighted assets = Balance

sheet item + (Off-balance-sheet item x
conversion factor) x credit risk weights.
28

Credit Risk Categories for

Bank Assets on the Balance
Sheet
Credit Risk Weight Types of Bank Assets
0%Cash, Deposits at BNM,
Government
securities, T- Bills.
20%
Cash item in the process of
collection,
interbank deposits,
bonds and notes issued by
states and local govt., and
deposit due from other
banks
or institutions.
29

Cont
Credit Risk Weight
Assets
50%

Types of Bank

Residential (home)

selected
housing loans that
and perform

mortgage loans,
multifamily
are well secured

adequately.
100%
Commercial and industrial (business)
loans, credit card
loans, real property,
investments
in bank subsidiary companies,
and all other assets not listed
previously.

30

Cont
Conversion
factor

Credit risk
weights

Types of Off-Balance Sheet

Items

0%

Loan Commitments with less than

1 year to go, guarantees of federal
govt borrowings

0.20

20%

Standby credit letters backing the

issue of state and local govt bonds.

0.20

100%

Trade-based commercial letters of

credit and bankers acceptances.

0.50

100%

Standby credit letters

guaranteeing a customers future
performance and unused bank loan
commitments covering periods
longer than a year.

1.00

100%

Standby credit letters issued to

back the repayment of commercial
paper.
31

How to calculate RWCR?

Risk Weight
(1)

Amount
(2)

Risk Weighted Assets

(1) X (2)

123

20%

716

Treasury bills

654

Government
securities

987

Residential loans

50%

3000

1500

Business loans

100%

30987

30987

Assets
Cash
Deposit balances due
from other banks

TOTAL

143.2

32630.2

On balance sheet items

32

Off balance sheet items

Item

Standby
credit letters

Risk weight

Conversion
factor

Amount

Risk
Weighted
asset

100%

80

80

TOTAL

80

Let say total bank capital = 2345

RWCR =
Total capital
Total risk weighted assets
RWCR =
2345
= 7.17%
32630.2 + 80

33

Minimum Capital Requirements

across Capital Categories
Total Risk-Based
Ratio

Tier 1 RiskBased Ratio

10%

6%

Adequately
capitalized

8%

4%

Undercapitalize
d

6%

3%

Significantly
undercapitalize
d

<6%

<3%

Well Capitalized

34

Criticisms of the riskbased capital ratio

1. Risk weight
Unclear how closely the 4 risk weight
categories reflect true credit risk
2. Balance sheet incentive problems
Different assets have different risk weight
which may induce bankers to engage in
balance sheet allocation
3. Portfolio aspects
Ignores credit risk portfolio diversification
opportunities
35

Cont
4. Bank specialness
Private sector commercial loans has the highest
credit risk weight; may reduce the incentives
for banks to make loans relative to holding
other assets
5. All commercial loans have equal weights
Loans made to AAA-rated company have a
same credit risk weight to loans made to CCCrated
company
Ignores credit quality differences
6. Other risks
Ignores other risks such as foreign exchange
risk, asset concentration risk and operating risk
36