Microsoft Word - Capital_Adequacy_Project

Questions: Calculate the banks:

1. a) Leverage ratio
2. b) Risk-adjusted asset value
3. c) CET1, Tier I and Total capital ratios?
4. d) What capital adequacy category does the bank fall under with respect to each ratio? What thebank?s overall capital adequacy categorization?
5. e) Briefly explain what each of the capital ratios tells you about the bank?s capital adequacy ? bespecific: what does each categorization tell you about how safe/risky the bank is in terms of capital and leverage ? hint: why are there 4 ratios how do they differ, what additional information does each offer?

Financial Institutions FNAN 321 Capital Adequacy Project Instructions 1. Work: to receive credit, you must show all of your work (for each calculation) in a complete, organized and legible fashion. You must work out each step for each calculation as discussed in class Each step must be clearly labeled and each calculation must be clearly demonstrated Do not present your work in table format!!! That is, any assignment that purely replicates the lecture slides with different numbers will receive half credit. To receive full credit you must label each step and clearly write out the calculations associated with the respective step. Furthermore, each calculation must also be labeled. Points will be deducted for calculations that are not clearly labeled. You will be graded on exposition, accuracy and completeness of your work. 2. Complete Assignment: to complete the assignment you must attempt all of the assigned problems/questions. If any of your answers are left blank or do not show sufficient effort the assignment will be marked incomplete. Incomplete assignments will receive no credit. 3. Answers: Your solutions must be clearly marked by placing a box or a circle around the final answer for calculation problems. 4. Format: homework must be hand written. Electronic copies of the assignment will receive no-credit 5. Submission: The assignment must be submitted in class on the due date. The due date for each assignment is one week after it is assigned. Any other form of submission including but not limited to: late assignments, emailed assignments, assignments dropped in my mailbox or the department drop box will receive no-credit. Total Possible Points = 285 Your Score = ________________ Capital Adequacy Project Solutions Sigma Bank has the following balance sheet in millions of dollars. ASSETS Current assets Cash Petty cash Marketable Securities Long-Term corp. bonds Residential Mortgages Commercial mortgages Prepaid insurance Total current assets Investments Sovereign bonds Loans to foreign banks Other investments Total Investment Property, plant & equipment Land Land improvements Buildings Equipment Less: accum. depreciation Prop, plant & equip - net Intangible assets Goodwill Trade names Total intangible assets Other assets Total assets $21 0.0001 8 40.5 31 3.8 1.5 106 10 11 9 30 5.5 6.5 169 201 -56 326 LIABILITIES Current liabilities Repo Agreements Commercial Paper Wages payable Interest payable Taxes payable Federal Funds Loans Unearned revenues Accrued income Total current liabilities $265 35.9 8.5 2.9 4.1 1.1 1.5 2.0 321 Long-term liabilities Senior Comm. Note payable Senior Notes payable Subordinate Notes Payable Perpetual Debt Convertible Notes Total Long-term Liabilities 110 236 19 20 5 390 STOCKHOLDERS' EQUITY Common stock Retained earnings Minority interest in subsidiaries Perpetual preferred stock (Qualified) Intermediate Preferred stock Less: treasury stock Total stockholders' equity 70 19 5 9 6 -50 59 21 284 305 3 $770 Total liab. & ' equity $770 Balance Sheet Notes: Note on hybrid securities Basel III provides guidelines for the type and amount of hybrid securities to be used in Teir I capital. For the purposes of this assignment, you can assume that Intermediate preferred stock is included but convertible debt is not. Note on Treasury stock CET1 Capital is calculated net of treasury stock. That is common stock less treasury stock Note on accumulated depreciation In the calculation of risk-adjusted assets, the value of fixed assets such as buildings, land, equipment, etc. is taken net of accumulated depreciation. Note on Marketable Securities Marketable securities can be treated like cash Notes on assets held: $10M of residential mortgages are category 2 with LTV greater than 90% The rest of residential mortgages are category 1 with LTV between 60% and 80% Note on Prepaid insurance Pre-paid insurance can be treated like cash Note on Commercial Mortgage The bank is restricted to lending only to corporations with an S&P credit rating of AA or better Note on Sovereign Debt 50% of sovereign debt has a CRC rating or 2 the rest has a CRC rating of 3 Note on foreign bank debt Foreign bank loans are all made to banks in countries with CRC rating of 4 Off Balance Sheet Items Off balance Sheet contingent guarantee contracts $40 million Direct-credit substitute standby letters of credit issued to a BBB+ rated U.S. Corp. $40 million commercial letters of credit issued to a BBB - -rated U.S. corporation Off-balance sheet derivatives $200 million 10-year interest rate swaps with a value of -50 mill to Sigma $100 million 2-year forward /$ contracts with a value of 20 mill to Sigma Questions: Calculate the banks: a) Leverage ratio (50 pts) b) Risk-adjusted asset value (125 pts) c) CET1, Tier I and Total capital ratios? (60 pts) d) What capital adequacy category does the bank fall under with respect to each ratio? What the bank's overall capital adequacy categorization?(25 pts) e) Briefly explain what each of the capital ratios tells you about the bank's capital adequacy - be specific: what does each categorization tell you about how safe/risky the bank is in terms of capital and leverage - hint: why are there 4 ratios how do they differ, what additional information does each offer? (25 pts) Capital adequacy 1 Class 12, Chap 20 Lecture outline 2 Purpose: Gain a general understanding of why equity capital is important, how it is measured and how it is regulated Introduction to capital adequacy- its pretty much what all banks worry about. What is it and why is it important What are the costs and benefits to regulation How to measure capital Calculation of Capital Ratios- these are what are regulated. Leverage Risk-based Tier I capital ratio Total capital ratio Why is Capital Adequacy Important? 3 What happens when banks are under capitalized? Should banks be forced to hold more capital? Problems: the more equity capital banks have to hold, then the less banks will lend out to the economy. Cost/Benefit of Regulating Capital 4 Economic Growth Economic Stability Increasing Capital Capital Requirements Lowers Insolvency Risk Absorbs unanticipated losses - equity capital acts as a buffer between the value of assets and liabilities. Losses in asset values decrease the value of equity. At zero equity value the firm is insolvent. Protects unsecured creditors against losses in the event of liquidation. Proceeds from the sale of assets will more likely cover creditor claims for firms with high equity capital Protects FDIC insurance fund DIF and tax payers Lower insolvency risk means fewer payouts from the FDIC insurance fund and lower likelihood of a tax-payer bailout of the FDIC Cost Benefit of Regulating Capital 5 Economic Growth Economic Stability Increasing capital requirements decreases the credit supply Banks are required to hold more capital on their balance sheet which decreases the lending capacity of banks Decreased credit supply reduces corporate investment activity, which slows economic growth. Increasing capital requirements can promote economic growth Increased stability increases consumer confidence which can promote growth More capital reduces FDIC Premiums which increases lending capacity 6 Measuring Equity Capital Book Value of Equity 7 Definition The historic value of assets/ liabilities. Reflects total purchase price of all assets on the balance sheet less the face value of liabilities Main Advantages Easy to measure Easy to observe (regulate) Main Disadvantages The book value may not reflect the current value of the asset i.e. What you could buy/sell it for Gives managers more discretion on when they report (realize) losses Does not consider off-balance sheet items Market Value of Equity 8 Definition: Difference between the market value of assets and liabilities. Market value of equity is the remaining value after assets have been liquidated at market price and all liabilities have been repaid (or repurchased in the market) Main Advantages: More current measure of liquidation value, this is current value of the company. Quick to adjust Main Disadvantage: Hard to measure especially for assets that do not have secondary markets Market prices do not always reflect the true (fundamental) asset value due to market imperfections - crisis Great in theory but you can't really calculate. Types of Capital (Basel III) 9 Common Equity Tier I (CET1) Tier I Capital Tier II Capital Common Equity Tier I (CET1) 10 Strict definition of capital, closely related to book value of common stock The contribution of DI owner's available to absorb losses (5) (4) (3) (1) (2) Regulatory Minority interest in Accumulated Common Retained + CET1 = consolidated + adjustments to - income and + stock + earnings common equity subsidiaries disclosure reserves Tier 1 (1) (2) (3) (4) (5) (6) (6) Goodwill Common shares issued and stock surplus that meets regulatory requirements Undistributed earnings Ex: losses on defined benefits pension obligations Shares issued by subsidiaries and held by a 3 rd party (50% ownership