This problem focuses on bank capital management and various capital ratio measur

Question

This problem focuses on bank capital management and various capital ratio measures. Following are recent balance sheet accounts for Prime First National Bank. Cash assets $ 17 million Demand deposits $50 million Loans secured by Time & savings real estate 40 deposits 66 Commercial loans 45 Federal funds purchased 15 Government Trust-preferred securities owned 16 securities 2 Goodwill 5 Bank fixed assets 15 Owners capital 5 Total assets $138 million Total liabilities $138 million and owners capital All amounts are in millions of dollars. Note: The bank has loan-loss reserves of $10 million. The real estate and commercial loans shown on the balance sheet are net of the loan-loss reserves. a. Calculate the equity capital ratio. How could the bank increase its equity capital ratio? b. Risk-adjusted assets are estimated using the following weightings process: cash and government securities _.00; real estate loans _.50; commercial and other loans _ 1.00. Calculate the risk-adjusted assets amount for the bank. c. Calculate the Tier 1 Ratio based on the information provided and the risk-adjusted assets estimate from Part b. d. Calculate the Total Capital (Tier 1 plus Tier 2) Ratio based on the information provided and the risk-adjusted assets estimate from Part b. e. What actions could the bank management team take to improve the banks Tier 1 and Total Capital ratios?

Explanation / Answer

he standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit Insurance Corporation or Federal Reserve Board. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals. Also known as "regulatory capital". A vital element of the work of any industry regulator is to ensure that the firms operating in the industry are prudently managed. The aim is to protect the firms themselves, their customers and the economy, by establishing rules and principles that should ensure the continuation of a safe and efficient market, able to withstand any foreseeable problems. The Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements, sets a framework on how banks and depository institutions must calculate their capital. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I. This framework has been replaced by a significantly more complex capital adequacy framework commonly known as Basel II. After 2012 it will be replaced by Basel III.[2] Another term commonly used in the context of the frameworks is Economic Capital, which can be thought of as the capital level bank shareholders would choose in absence of capital regulation. For a detailed study on the differences between these two definitions of capital, refer to.[3] The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Basel II requires that the total capital ratio must be no lower than 8%. Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework. Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate. The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital- have been replaced by one single criterion. While the international standards of bank capital were laid down in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement. Examples of national regulators implementing Basel II include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy. In the United States, depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB).[4] These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report. Although Tier 1 capital has traditionally been emphasized, in the Late-2000s recession regulators and investors began to focus on tangible common equity, which is different from Tier 1 capital in that it excludes preferred equity.[5]

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