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Chapter 20 Capital Adequacy.docx

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Ryerson University
FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 20 Capital Adequacy INTRODUCTION  Functions of capital: 1. Absorb unanticipated losses with enough margin to inspire confidence and enable FI to continue as going concern 2. Protect uninsured depositors, bondholders, and creditors in the event of insolvency, and liquidation 3. Protect FI insurance funds and the tax payers 4. Protect FI owners against increases in insurance premiums 5. To fund brand and other real investments necessary to provide financial services CAPITAL AND INSOLVENCY RISK Capital  Net worth – measure of FI’s capital that is equal to the difference between the market value of its assets and market value of its liabilities  With the exception of investment banking industry, regulatory-defined capital and required leverage ratios are based in whole or in part on historical or book value accounting concepts The Market Value of Capital Market Value of Capital and Credit Risk  Loss of asset value is charged against the equity owners’ capital or net worth because debt holders legally are senior claimants and equity holders are junior claimants to an FI’s assets o Only after equity holders are wiped out do the liability holders begin to lose  The larger the FI’s net worth relative to the size of its assets, the more insolvency protection or insurance there is for liability holders and liability guarantors such as CIDC Market Value of Capital and Interest Rate Risk  Loss of asset values due to adverse interest rate changes are borne first by the equity holders; only after equity holders are wiped out do the liability holders begin to lose  Market valuation of balance sheet can produce an economically accurate picture of the net worth and solvency position of the FI  Canadians GAAO require securities to be classified as trading (the trading book) or other than trading (the banking book) o Trading securities – securities held for a short time and carried at market value o Available-for-sale securities – securities carried at fair value whose gains (losses) are charged to the OCI account until sold o Held-to-maturity securities – securities carried at cost  Available-for-sale securities are recorded at market value and unrealized gains and losses charged to other comprehensive income (OCI) as part of shareholder’s equity The Book Value of Capital  Book value of capital may have the following components for an FI o Preferred shares – ranked ahead of common shares and may be considered equivalent of fixed rate debt, but dividends are not deductible for tax purposes  For market-to-book value, preferred shares are usually considered as debt and therefore are excluded o Common shares – book value of common shares is their issue price times the number of shares issued o Contributed surplus – difference between price public paid for common shares when originally offered and their par values times the number of shares outstanding o Retained earnings – accumulated value of past profits not yet paid out in dividends to shareholders o Foreign currency translations adjustments – unrealized gains (losses) that arise from the translation of investments in foreign operations into Canadian dollars  Book value of capital equals sum of preferred shares plus common shares plus contributed surplus plus retained earnings plus foreign currency translation adjustment Book Value of Capital and Credit Risk  GAAP have greater discretion in reflecting or timing problem loan loss recognition on their balance sheet and can control the impact of such losses on capital FIN701 Financial Institutions Management o When loans declared substandard by examiners, they may remain on the balance sheet at book value  Until actual loan loss occurs, amount would be recognized in contra account and total loans would be reported as “loans less allowance for impairment” on balance sheet Book Value of Capital and Interest Rates  In book value accounting, when all assets and liabilities reflect their original cost of purchase, the rise in interest rates has no effect on the value of assets, liabilities, or the book value of equity; balance sheet remains unchanged The Discrepancy between the Market and Book Values of Equity  Degree to which the book value of an FI’s capital deviates from its true economic market value depends on two factors 1. Interest rate volatility – higher the interest rate volatility, the greater the discrepancy 2. Examination and enforcement – more frequent the on-site and off-site examinations and stiffer the examiner/regulator standards regarding charging off problem loans, the smaller the discrepancy  Market value of equity per share  Historical or book value of FI’s common equity per share (BV)  Market-to-book ratio – ratio showing discrepancy between stock market value of an FI’s equity and book value of its equity o The lower this ratio, the more book value of capital overstates the true equity or economic net worth position of an FI as perceived by investors in the capital market Arguments against Market Value Accounting  Market value (MV) accounting is difficult to implement especially for smaller FIs with large amounts of non-traded assets such as small loans on their balance sheet (greater chances of error)  MV accounting introduces unnecessary degree of variability into FI’s earnings – and this net worth – because paper capital gains and losses on assets are passed through FI’s income statement
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