CASE Overall Assessment of Capital Adequacy First National Bank (FNB) had maintained its capital ratios according to Basel Agreement standards in the past. That is, it never had fallen below the minimum total risk-based cap- ital ratio of 8 percent, the Tier 1 risk-adjusted ratio of 4 per- cent, or the leverage ratio (or Tier 1 to total assets) of 3 percent. However, in recent years the bank's capital ratios decreased to the point where its capital position was mar- ginal or near the borderline. Jack Mead was a bank examiner reporting to the Federal Reserve district office in the region. He had received news yesterday that FNB was coming up for review by his staff next month. In preparation for the upcoming on-site visit, he had gone over a chart of FNB's capital ratios and was concerned about their trends. Peer group banks did not exhibit similar downward trends, indeed, strong economic growth in the region had contributed to strengthening capital ratios at some of FNB's competitors. He decided to call the CEO to discuss the timing of the review and express some preliminary concerns about FNB's capital adequacy. The CEO's attitude was positive and a copy of management's strategic plan was faxed to Jack to help him better understand the bank's goals, objectives, and business conditions. Jack brought the plan home with him that evening to begin reviewing the situation. His first reaction to seeing the concise and well-organized five-page strategic plan was one of relief. Effective strategic plans enable management to be proactive rather than reactive in responding to market forces. Such plans are long-term in nature and integrate a variety of management areas, including asset deployment, funding sources, capital for- mation, management, marketing, operations, and information systems. They serve not only to provide management direction and leadership but to communicate bank goals and objectives throughout the organization. In the capital section of the plan, Jack noted the following key areas and related discussion: Growth: The bank sought to keep pace with the region's strong economic growth by rapidly expand- ing the loan portfolio. Many new credit opportuni- ties were opening up due to the bank's ability to offer a wider menu of financial services to its customers under the new Financial Services Modernization Act of 1999. There was some evidence that loan concen- tration had increased, especially with respect to cer- tain local industries that had been particularly successful and subsequently, had increased their credit lines with the bank. Bank management appeared to have become more risk tolerant in light of the long period of good economic times. Dividends: The bank is owned by a bank holding company and was dedicated to paying substantial dividends to fund the holding company's expan- sion goals. The bank holding company was attempting to expand beyond its traditional home state into adjacent states. Access to additional capital: Since the bank was rel- atively small, its access to capital markets was lim- ited. However, this limitation was not considered to be restrictive due to the fact that the bank holding company could be relied upon to assist them with capital funds. The bank indicated that it was sensi- tive to current shareholders' desire to avoid the dilut- ing effect of new capital. Under Federal Reserve policy, the bank holding company is expected to be a source of strength in terms of liquidity or capital funds for subsidiary banks. Earnings: Net interest margins (NIMs) had been exceptionally high from an historical standpoint. The NIM had been favorably affected by low inter- est rates and strong loan demand that allowed them to widen the spread over interest costs. Nonetheless, NIM and the rate of return on assets (ROA) had fluctuated more than peer group banks over the last five years. The bank had recently pur- chased interest-only strips (IOS) and principal- only strips (POs), which have more price risk than other assets in order to better hedge the interest rate risk on balance sheet. Also, in an effort to address ROA volatility, the bank had strengthened its collateral and guarantees to upgrade the credit quality of its loan portfolio. Finally, the bank had increased its allowance for loan and lease losses in the last two years. Bank stock prices: FNB's stock price relative to book value was below its peer group by about 25 percent. Management made clear that it believed the stock was undervalued, as opposed to low-valued due to a lack of investor confidence. Fixed bank assets: The bank had a central location for its main office plus three local branch offices. All facilities were refurbished in recent years by the bank holding company and electronic payments services installed to ensure that the bank could offer a full array of banking, securities, and insurance services. Given this preliminary information, step into Jack's role and write a report for his staff prior to their visit to the bank. The report should cover each of the above strategic plan areas and provide an evaluation of capital strengths and weaknesses implied by the plan. Most importantly, it should set the stage for their overall assessment of FNB's capital adequacy. CASE Overall Assessment of Capital Adequacy First National Bank (FNB) had maintained its capital ratios according to Basel Agreement standards in the past. That is, it never had fallen below the minimum total risk-based cap- ital ratio of 8 percent, the Tier 1 risk-adjusted ratio of 4 per- cent, or the leverage ratio (or Tier 1 to total assets) of 3 percent. However, in recent years the bank's capital ratios decreased to the point where its capital position was mar- ginal or near the borderline. Jack Mead was a bank examiner reporting to the Federal Reserve district office in the region. He had received news yesterday that FNB was coming up for review by his staff next month. In preparation for the upcoming on-site visit, he had gone over a chart of FNB's capital ratios and was concerned about their trends. Peer group banks did not exhibit similar downward trends, indeed, strong economic growth in the region had contributed to strengthening capital ratios at some of FNB's competitors. He decided to call the CEO to discuss the timing of the review and express some preliminary concerns about FNB's capital adequacy. The CEO's attitude was positive and a copy of management's strategic plan was faxed to Jack to help him better understand the bank's goals, objectives, and business conditions. Jack brought the plan home with him that evening to begin reviewing the situation. His first reaction to seeing the concise and well-organized five-page strategic plan was one of relief. Effective strategic plans enable management to be proactive rather than reactive in responding to market forces. Such plans are long-term in nature and integrate a variety of management areas, including asset deployment, funding sources, capital for- mation, management, marketing, operations, and information systems. They serve not only to provide management direction and leadership but to communicate bank goals and objectives throughout the organization. In the capital section of the plan, Jack noted the following key areas and related discussion: Growth: The bank sought to keep pace with the region's strong economic growth by rapidly expand- ing the loan portfolio. Many new credit opportuni- ties were opening up due to the bank's ability to offer a wider menu of financial services to its customers under the new Financial Services Modernization Act of 1999. There was some evidence that loan concen- tration had increased, especially with respect to cer- tain local industries that had been particularly successful and subsequently, had increased their credit lines with the bank. Bank management appeared to have become more risk tolerant in light of the long period of good economic times. Dividends: The bank is owned by a bank holding company and was dedicated to paying substantial dividends to fund the holding company's expan- sion goals. The bank holding company was attempting to expand beyond its traditional home state into adjacent states. Access to additional capital: Since the bank was rel- atively small, its access to capital markets was lim- ited. However, this limitation was not considered to be restrictive due to the fact that the bank holding company could be relied upon to assist them with capital funds. The bank indicated that it was sensi- tive to current shareholders' desire to avoid the dilut- ing effect of new capital. Under Federal Reserve policy, the bank holding company is expected to be a source of strength in terms of liquidity or capital funds for subsidiary banks. Earnings: Net interest margins (NIMs) had been exceptionally high from an historical standpoint. The NIM had been favorably affected by low inter- est rates and strong loan demand that allowed them to widen the spread over interest costs. Nonetheless, NIM and the rate of return on assets (ROA) had fluctuated more than peer group banks over the last five years. The bank had recently pur- chased interest-only strips (IOS) and principal- only strips (POs), which have more price risk than other assets in order to better hedge the interest rate risk on balance sheet. Also, in an effort to address ROA volatility, the bank had strengthened its collateral and guarantees to upgrade the credit quality of its loan portfolio. Finally, the bank had increased its allowance for loan and lease losses in the last two years. Bank stock prices: FNB's stock price relative to book value was below its peer group by about 25 percent. Management made clear that it believed the stock was undervalued, as opposed to low-valued due to a lack of investor confidence. Fixed bank assets: The bank had a central location for its main office plus three local branch offices. All facilities were refurbished in recent years by the bank holding company and electronic payments services installed to ensure that the bank could offer a full array of banking, securities, and insurance services. Given this preliminary information, step into Jack's role and write a report for his staff prior to their visit to the bank. The report should cover each of the above strategic plan areas and provide an evaluation of capital strengths and weaknesses implied by the plan. Most importantly, it should set the stage for their overall assessment of FNB's capital adequacy