118. Finance Questions
Answer the following 7 questions and show your work and calculations
Use the following information for questions 1 – 6.
Question 1. How much Tier 1 capital does the bank have?
Question 2. What is the minimum leverage capital for this bank?
Question 3. What is the amount of risk-adjusted assets for the bank?
Question 4. What is the minimum Tier 1 capital for this bank is?
Question 5. What is the minimum total capital for this bank?
Question 6. What is the total amount of the bank’s regulatory capital?
Question 7 If customer is granted credit for a $2,000 loan to be repaid in 12 equal monthly installments. The interest is quoted as 10% an add-on rate, what are the total payback cash flows from the loan?
e. Cannot be determined
General Class Notes
Managing the bank’s capital
This topic is in Chapter 12 in the textbook
Capital requirements for starting a bank in the US
In the United States $2 million are needed to start the bank. Regulation requires that $1 million be available for opening the bank and the other $1 million must become available within the first year of operation. However, in practice, opening a bank requires more than $2 million at the beginning of operations. Undercapitalizing a bank is not a reliable way to ensure its failure.
Structure of risk based capital standards at U.S. commercial banks
Historically, the amount of capital that banks were required to hold was a percentage of total assets on the balance sheet. Bank capital had to equal 8% of total assets. There were no capital requirements against off-balance sheet items. Off-balance sheet items represent a large percentage of bank operations and in some cases may be as large as on balance sheet items. Off-balance sheet items are known as contingent claims. Contingent claims are claims that can become on balance sheet subject to a certain event.
Let us look at off-balance sheet items in more detail. An example of off-balance sheet items is loan guarantees. A loan guarantee is when the bank acts as a surety or an absolute surety for a loan. Occasionally, instead of making a lone, a bank acts as a guarantor for a borrower so that this borrower can borrow from another bank. Banks do that for a fee. The reason they do it is that they may not have enough loanable funds, but they get the fee revenue. In this case, if the borrower defaults, this off-balance-sheet loan guarantee becomes a bank liability and it becomes an on-balance sheet item. Off-balance sheet items include long guarantees, letters of credit, bankers’ acceptances, and derivatives.
Currently, banks have to hold capital against all risk items. That includes off-balance sheet as well as on-balance sheet items. Effective in 1992, U.S. commercial banks have been required to meet risk based capital standards that require:
1) At least 4% tier 1 capital, primarily stockholders’ equity
2) At least 8% total capital (tier I + tier 2 capital), primarily stockholders’ equity, a portion of loan loss reserves and qualifying subordinated debt, as a fraction of risk assets to be adequately capitalized. These standards will soon change per the implementation of Basel II capital requirements.
We will look at the off-balance sheet items in greater detail later, and also we will look at calculating capital requirements in more detail. The main idea is to translate off-balance sheet items into on-balance items. Basically, we use translation tables to calculate them on-balance sheet equivalents.
The function of bank capital from the view of bank regulators and bank managers
Bank capital serves to reduce risk by:
1) Providing a cushion against losses, and thus lowering the risk of failure. When a bank experiences losses due to defaults. These defaults reduce the bank’s capital. If the loss is large enough, then the bank will not fail. However, if capital is not adequate, charging losses against it will eliminate it. This causes the bank to stop operating. An example of this is the credit crunch of 2008. When banks experienced large losses due to bad mortgages, the charge-offs against capital caused the bank’s capital to drop so low that banks were unable to operate anymore.
2) Providing access to financing via the money and capital markets. When addition capital is needed, it can be arranged by issuing new equity or new debt.
3) Limiting a bank’s ability to grow rapidly. Banks with limited amounts of capital can grow only at low rates, which restricts risk taking. The way capital regulates bank growth is by having minimum legal requirements. As the assets grow, capital must also grow. If assets are growing faster than capital, then the capital would become inadequate. At this point, the bank’s growth halts. Therefore, the banks either grow slowly or raise more capital to support their high growth.
The influence of regulatory capital requirements on bank operating policies
Regulatory capital requirements affect bank operating policies by:
1) Limiting growth in assets. This was discussed above.
2) Forcing banks that choose to grow to obtain capital externally when sufficient internally-generated funds are not available. The bank’s net income is distributed to two parts. One part is paid out as dividends to the shareholders. The other part is reinvested in the bank as additions to return earnings or undistributed profits. The additions to return earnings are increases in the bank’s net wealth or total equity. This is what we mean by internally-generated funds. If capital needs to grow at a higher rate, then the bank has to issue new equity.
3) Changing asset composition. The allowance for loan losses is a contra account against the bank’s capital. Therefore, if the bank’s capital is close to the legal limit, the bank would change the composition of its assets to lower risk ones. Lower risk assets require lower provision for loan losses and, therefore, lower allowance for loan losses. The impact of such a change in asset composition is reduced profitability.
4) Changing the pricing of loans and certain securities. The reason a bank will change the pricing of loans and certain securities is to implement what was discussed in item 3 above. If the bank wishes to reduce the allowance for loan losses, it will increase interest rates on high-risk loans and reduce interest rates on low-risk loans to influence the market demand for them. However, if capital is more than adequate, the bank would do the opposite pricing movements to increase the demand for high risk loans and increase its profitability.
Components of bank capital (This information is taken from your textbook)
Components of capital Minimum requirements
Tier 1 or Core Capital
Common stockholders’ equity Must equal or exceed 4% of risk-weighted assets
Noncumulative perpetual preferred stock and any related surplus No limit; regulatory caution against undue reliance
Minority interests in equity capital accounts of consolidated subsidiaries
Less: goodwill, other disallowed intangible assets, and disallowed deferred tax assets, and any other amounts that are deducted in determining Tier 1 capital in accordance with the capital standards issued by the reporting bank’s primary federal supervisory authority No limit; regulatory caution against undue reliance.
Tier 2 or Supplementary Capital
Cumulative perpetual preferred stock and any related surplus Total of Tier 2 is limited to 100% of Tier 1
(Amounts in excess of limitations are permitted but do not qualify as capital)
Long-term preferred stock (original maturity of 20 years or more) and any related surplus (discounted for capital purposes as it approaches maturity) No limit within Tier 2
Auction rate and similar preferred stock (both cumulative and noncumulative) No limit within Tier 2
Hybrid capital instruments (including mandatory convertible debt securities) Subordinated debt and intermediate-term preferred stock are limited to 50% of Tier 1, amortized for capital purposes as they approach maturity.