Financial Institutions Study Guide of Final
Financial Institutions Study Guide of Final BU.231.710.W4.SP16
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Date Created: 05/03/16
FINAL CHAPTER 20 Capital Adequacy Chapters 7 through 17 examined the major areas of risk exposure facing an FI manager. These risks can emanate from both on- and off-balance-sheet (OBS) activities and can be either domestic or international in source. To ensure survival, an FI manager needs to protect the institution against the risk of insolvency, that is, shield it from risks sufficiently large to cause the institution to fail. The primary means of protection against the risk of insolvency and failure is an FI’s capital. This leads to the first function of capital, namely: 1. To absorb unanticipated losses with enough margin to inspire confidence and enable the FI to continue as a going concern. In addition, capital protects nonequity liability holders—especially those unin- sured by an external guarantor such as the FDIC—against losses. This leads to the second function of capital: 2. To protect uninsured depositors, bondholders, and creditors in the event of insolvency, and liquidation. When FIs fail, regulators such as the FDIC have to intervene to protect insured claimants (see Chapter 19). The capital of an FI offers protection to insurance funds and ultimately the taxpayers who bear the cost of insurance fund insolvency. This leads to the third function of capital: 3. To protect FI insurance funds and the taxpayers. During the financial crisis, the FDIC’s DIF incurred losses to the extent that the fund’s balance was negative. As a result, the FDIC imposed a special assess- ment fee on the FIs it insured and required them to prepay 13 quarters worth of deposit insurance premiums. By holding capital and reducing the risk of insol- vency, an FI protects the industry from larger insurance premiums. Such premi- ums are paid out of the net profits of the FI. Thus, a fourth function of capital is as follows: 4. To protect the FI owners against increases in insurance premiums. Finally, just as for any other firm, equity or capital is an important source of financing for an FI. In particular, subject to regulatory constraints, FIs have a choice between debt and equity to finance new projects and business expansion. Thus, the traditional factors that affect a business firm’s choice of a capital structure— for instance, the tax deductibility of the interest on debt or the private costs of failure or insolvency—also interpose on the FI’s capital decision. This leads to a fifth function of capital: 5. To fund the branch and other real investments necessary to provide financial services.1 Part of the TARP program of 2008–09 was the Capital Purchase Program intended to encourage U.S. financial institutions to build capital needed to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Under the program, the Treasury purchased more than $200 billion of preferred equity securities issued by FIs. The senior preferred shares qualified as Tier I capital and ranked senior to common stock. Financial institu- tions had to meet certain standards, including: (1) ensuring that incentive com- pensation for senior executives did not encourage unnecessary and excessive risks that threatened the value of the financial institution; (2) required payback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains, or other criteria that were later proven to be materially inaccu- rate; (3) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. In addition to capital injections received as part of the Capital Purchase Program, TARP provided additional emergency fund- ing to Citigroup ($25 billion) and Bank of America ($20 billion). Through August 2012, $245 billion of TARP capital injections had been allocated to DIs, of which $234 billion had been paid back plus a return of $26.25 billion in dividends and assessments. In the following sections, we focus on the first four functions concerning the role of capital in reducing insolvency risk and in particular the adequacy of capital in attaining these functional objectives. Specifically, we examine the different mea- sures of capital adequacy used by FI owners, managers, and regulators, and the argument for and against each. We then look at capital adequacy requirements for depository institutions, securities firms, and insurance companies set by U.S. (and, in some cases, international) regulators such as the Bank for International Settle- ments (BIS). Appendix 20A to the chapter describes the foundations and advanced approaches used to calculate adequate capital according to internal ratings–based models of measuring credit risk that are currently used by the BIS for banks. This chapter reviewed the role of an FI’s capital in insulating it against credit, interest rate, and other risks. According to economic theory, capital or net worth should be measured on a market value basis as the difference between the market values of assets and liabilities. In actuality, regulators use book value accounting rules. While a book value capital adequacy rule accounts for credit risk exposure in a rough fashion, it overlooks the effects of interest rate changes and interest rate exposure on net worth. We analyzed the specific and proposed capital rules adopted by the regulators of banks and thrifts, insurance companies, and securities firms and discussed their problems and weaknesses. In particular, we looked at how bank, thrift, PC, and life insurance regulators are now adjusting book value– based capital rules to account for different types of risk as part of their imposition of risk-based capital adequacy ratios. As a result, actual capital requirements in banks, life insurance companies, PC insurance companies, and thrifts are moving closer to the market value–based net worth requirements of broker–dealers.
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