A PRACTICAL APPROACH TO CAPITAL STRUCTURE FOR BANKS

Journal of Applied Corporate Finance S P R I N G 1 9 9 7 V O L U M E 1 0 . 1

A Practical Approach to Capital Structure for Banks by Donald Davis and Kevin Lee,

Bank of America

33JOURNAL OF APPLIED CORPORATE FINANCE

A PRACTICAL APPROACHTO CAPITAL STRUCTUREFOR BANKS

by Donald Davis andKevin Lee,Bank of America

33BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

“RAROC”) method used by a number of moneycenter banks, including Bank of America.3 In prac-tice, the application of this sophisticated approachhas been limited mainly to the largest banks.

Second is the government regulator’s approachto “risk based capital.” This approach seeks to definerequired capital based on broad classifications of abank’s asset portfolio (including off-balance-sheetassets). It is a regulator’s “one size fits all” approachto risk based capital analysis that has been designedto be applied on a world-wide basis. In the U.S., theregulatory capital ratio guidelines are combined witha subjective examination process that aims to monitorthe “safety and soundness” of a bank’s operations.

Third is the “practical” approach. This ap-proach seeks to stay comfortably above regulatoryminimums and to balance a number of other fac-tors, notably:

common market practice as revealed by peergroup analysis;

a risk appetite that balances the specific assets,markets, and ownership of a bank; and

the benefits and costs of achieving a specific debtrating, provided your bank is large enough toqualify.

While using the economic risk approach leadsto one version of a target capital structure, theactual capital ratios we observe in the bankingindustry are more often determined by the abovenoted regulatory and practical considerations. Inthis article, we comment on the relevant issues andprovide a framework banks can use to establish atarget capital structure.

Applied Corporate Finance, Volume 10 No. 4 (Spring 1997). For a discussion of aneconomic approach to financial firms, see Robert Merton and Andre Perold, “TheTheory of Risk Capital for Financial Firms,” Journal of Applied Corporate Finance(Vol. 6 No. 3) Fall 1993.

3. For a description of this approach, see Edward Zaik, John Walter, GabrielaKelling, and Christopher James, “RAROC at Bank of America: From Theory toPractice,” Journal of Applied Corporate Finance, Vol. 9, No. 2 (Summer 1996).

1. At one end of the spectrum, almost all of the largest 25 U.S. banks havebuyback programs. At the opposite end, 52 banks with less than $3 billion in assetsannounced buyback programs last year (according to SNL Securities as reportedin American Banker).

2. An economic approach to capital structure for industrial corporations ispresented earlier in this same issue by Tim C. Opler, Michael Saron, and SheridanTitman, “Designing Capital Structure to Maximize Shareholder Value,” Journal of

capital structure is clearly reflected in their high levelof stock buybacks in the past year.1

Nevertheless, there are some important differ-ences between banks and industrial corporationsthat complicate the task of establishing appropriatelevels of capital for banks. In particular, banks’largest source of funds—their deposits—are effec-tively insured by the U.S. government. The cash costof this insurance is below an open-market rate; infact, since January 1996, this insurance has beenprovided “free” to those 95% of all commercial banksdeemed “well capitalized” (and classified in thestrongest Supervisory Risk subgroup) by U.S. bankregulators. But deposit insurance is a mixed blessingfor banks: The price of this federal subsidy isgovernment regulation, including required mini-mum capital levels, which can impose significantcosts on banks.

The process of developing an optimal capitalstructure for banks has three dimensions—threeaspects or sets of considerations that we will refer toas “economic risk,” “regulatory,” and “practical.”

First is the economic risk approach.2 Stated inbrief, this approach establishes an appropriate capi-tal level based on an evaluation of a bank’s creditrisks, market risks, business risks, and targetedequivalent bond rating. One specific implementa-tion of this approach for measuring capital require-ments is the Risk Adjusted Return on Capital (or

As in most industries, determining the“optimal” capital structure is an ongoingconcern of the banking community. And,as in many industries, banks’ attention to

34VOLUME 10 NUMBER 1 SPRING 1997

Before going further, it is important to distin-guish between the term “capital” as it is used inbanking and in industrial corporations. For indus-trial companies, capital is typically defined as alloutside sources of funding for a business—that is,total interest-bearing liabilities plus equity. Such adefinition facilitates calculation of the weightedaverage cost of capital (or “WACC”). For banks,however, capital is defined as “equity” or equitycapital equivalents such as preferred stock and, tosome extent, loss reserves and subordinated debt.4

Bank “capital” excludes core deposits and mostforms of debt funding.

THE ECONOMIC RISK APPROACH

As mentioned, one increasingly popular methodfor assessing economic risk capital requirements forfinancial institutions—particularly at large moneycenter banks—is RAROC. As practiced at Bank ofAmerica, the calculation of economic risk capital isa function of four sources of risk: credit risk, countryrisk, market risk, and business risk. Each of these foursources of risk is quantified for each business, assetclass, and individual asset to determine the contribu-tion of the business (or asset) to the volatility of themarket value of the bank’s assets.

On this basis, levels of economic risk capital areassigned to all assets and business units. Whenaggregated across the entire bank, the total of suchcapital requirements represents an estimate of thelevel of capital necessary to guarantee the solvencyof the bank at some defined confidence level. AtBank of America, that confidence level is set at99.97%, a level that implicitly capitalizes each of thebusiness units at a level consistent with maintaininga AA credit rating on senior debentures.

This approach also enables management toexamine the economic return of each of its busi-ness units, and to ensure that each is generating areturn sufficient to compensate investors for therisk that the business contributes to the bank’sportfolio of businesses.5 Economic capital is thus atheoretical construct that allows management to

measure the contribution to shareholder value ofeach asset or business unit. The challenge foroperating management, however, is to translateeconomic capital into specific instruments and bal-ance sheet amounts.

THE REGULATORY APPROACH

Bank regulation has a profound impact on thelevel and kinds of banks’ capital. While banks gainthe benefit of FDIC deposit insurance, they also havethe added cost associated with regulation and theregulator’s preemptive actions prior to financialdistress. The establishment of standards for capitallevels is a primary tool of bank regulation.

Governments have a strong incentive to controlthe risk of banks. First, they are the guarantor of asignificant portion of the banking industry’s liabili-ties (i.e. deposits). Second is their concern for thesocial impact of bank failures. The failure of a largemoney center bank can reverberate throughout theentire economy. The failure of small or regionalbanks can have major effects on local economies. Itis in the government’s interest to ensure the “safetyand soundness” of individual banks as well as theentire U.S. banking system.

Government controls come in the form of bothrequired capital ratios and regular examinationsdesigned to evaluate a bank’s safety and soundnessusing the so-called CAMELS system (the acronymstands for Capital adequacy, Asset quality, Manage-ment, Earnings, Liquidity, and Sensitivity to marketrisk6). Responding to concerns about high leverageand in an effort to unify standards among countries,the Group of 10 countries established the “BasleAccord” on risk based capital, which took full effectin 1992. In the United States, the FDIC ImprovementAct of 1991 (also known as “FDICIA”) implementedthe Basle Accord. FDICIA created a series of criteria,or “trigger points,” requiring “prompt correctiveaction” by the regulators. One important trigger forthese “prompt corrective actions” would be thefailure of a bank (or bank holding company) to meetspecified levels of capital.

4. In a recent article entitled “The Role of Capital in Financial Institutions”(Journal of Banking & Finance, Vol. 19 1995), Allen Berger, Richard Herring, andGiorgio Szego argue that instruments that qualify as regulatory capital should havethree main characteristics. They should be (1) junior to those of the deposit insurer(i.e. the FDIC), (2) “patient money,” and (3) reduce the “moral hazard” incentivesto exploit the protection of the safety net by undertaking excessive portfolio orleverage risk.

5. There are two ways to accomplish the same objective in measuringperformance: Either capitalize all business units with the same leverage and varythe cost of capital, or vary the level of capital assigned to each business and usea consistent cost of capital.

6. Sensitivity to market risk was added in 1997 to the former CAMEL system.


The regulators’ objective is to ensure that banksmaintain an adequate cushion for depositors andsenior lenders against loss in asset value. Whileexplicit confidence ratios are not attached to thespecified levels of capital (such as those considered“well capitalized”), the regulators’ intent is thesame as that of users of the concept of economiccapital—namely, to define a level of capital thatwill ensure solvency. FDICIA’s implementation ofthe Basle Accord established two definitions ofcapital and the use of three different capital ratios,each of which is outlined in Table 1. (For fulldetails, see Appendix II.)

The two “risk based capital” ratios reflectregulators’ acknowledgment that certain assetshave more risk than others. (This is the samebasic insight that underlies the calculations ofeconomic capital and RAROC described above.)For regulatory simplicity, all on- and off-balancesheet assets are divided into one of four catego-ries with different percentage risk weightings.The book value of each asset is then multipliedby its percentage “risk weighting” to determineits risk adjusted value. For example, cash held inthe bank is accorded a zero weighting, and thus

cash is not included in risk weighted assets.Consumer mortgages are accorded a 50% riskweighting, and commercial loans are given a full100% risk weighting.

The risk categories are broad, and somewhatarbitrary. For example, a 364-day commitment haszero risk and needs no capital reserved against it,while a 366-day commitment has a risk equal tohalf of its face value, and a loan once drawn has a100% risk value. In addition to these simplificationsof economic reality, the risk weightings also makeno attempt to adjust for the degree of concentration(or, conversely, diversification) in banks’ asset port-folios. Nor is there any attempt to distinguish amongthe quality of assets (high or low risk; performing,substandard, or doubtful) within the same broadrisk category.

As Nobel laureate Merton Miller put it, “Surelyno private lending institution using anything asarbitrary as the definitions under the Basel Accordscould hope to survive long as a major player in acompetitive lending market.”7 But, for all theirshortcomings, the new capital standards represent astep forward. To paraphrase Winston Churchill’scomment about democracy, it may be the worst of

TABLE 1 Type of Capital Definition

Tier I Capital Common stockless goodwillplus certain preferred stock

Total Capital Tier I capitalplus loss reserves equal to up to 1.25% of risk adjusted assets,plus some portion of convertible and subordinated debta,plus certain preferred stock.

Measurement Ratio “Adequately” Capitalized “Well” Capitalized

Tier 1 Leverage:Tier 1 Capital/average tangible assets 4% 5%

Tier 1 Risk Based Capital RatioNet Tier 1 Capital/“risk based capital” 4% 6%

Total Risk Based Capital RatioTotal Regulatory Capital/“risk based capital” 8% 10%

a. Convertible and subordinated debt is credited as capital at 100% of value if it has more than 5 years of remaining maturity,and lower percentages if there is a shorter remaining maturity.

7. “Do the M&M Propositions Apply to Banks?” Merton H. Miller, Journal ofBanking & Finance 19 (1995) 483-489.


all possible systems, except for anything else that hasbeen tried.8

The Response of U.S. Banks toCapital Requirements

Full implementation of the Basle Accord, whichtook place over the period 1988-1992, coincidedwith an increase in banks’ capital ratios (see Figure1). Although such increases were clearly facilitatedby the improved economic climate and higherbank earnings of the 1990s, there are three possibleexplanations for this increase. First, the prior levelwas the “natural” level, and the increase was causedby regulatory contraints. Second, after the bankingcrisis of the ’80s, the market demanded higherlevels. Third, something fundamental in U.S. bank-ing changed—either the level of risk increased, orthe market’s appreciation of or sensitivity to therisk increased—causing banks to increase theircapital levels.

A number of academic studies have attemptedto determine whether the increase in capital ratios

represented primarily a bank response to the newregulatory requirements, or to market demands forincreased capital levels after the bank failures of themid-1980s. The consensus seems to be that of thetwo factors, regulatory and market, the introductionof regulatory requirements has been responsible fora greater share of the increase in bank capitalratios.9,10 Overall risk levels are considered to havebeen stable (if not declining), especially consideringthe positive economic environment.

There are several reasons why most bankschoose to keep levels of capital that are above the“well capitalized” regulatory minimums. Theyinclude:

Operating below “well capitalized” levels meansrunning the risk of “prompt corrective action,” whichcould impose costs in the form of increased oversightand restriction of bank activities.

A higher capitalization may be necessary to obtainor maintain a desired senior debt rating. This wouldgive the bank a lower cost of borrowed funds, andcould be necessary to support rating-sensitive cus-tomers or other off-balance sheet activities.11

FIGURE 1EQUITY RATIO TREND*

*Equity/Total Assets, per “Statistics on Banking: A Statistical History of the United States Banking Industry” The Federal DepositInsurance Corporation 1934-1994, Volume II, A-84

8. In fairness to the regulators, there are ongoing adjustments to the regulatoryprocess. As noted, sensitivity to market risk was added to the U.S. bank examinationprocedure in 1996. Also, the Basle Accord has been amended (and adapted by theU.S. bank regulatory agencies) to incorporate market risk. As of 1998, banks (orbank holding companies) whose trading activity equal 10% or more of total assets,or $1 billion or more, will have to measure their market risk and hold capital againstthat risk. A new layer of capital “Tier 3” and set of formulas have been created toaccommodate this measurement.

9. Larry D. Wall and David R. Peterson “Bank Holding Company CapitalTargets in the Early 1990s: The Regulators versus the Markets,” Journal of Banking& Finance 19 (1995) 563-574; and Larry D. Wall and Pamela P. Peterson, “BanksResponses to Binding Regulatory Capital Requirements,” Federal Reserve Bank ofAtlanta Economic Review (March/April 1996) 1-17.

10. But if the new capital requirements have likely caused banks to hold highercapital ratios at the margin, it is also clear that the regulatory ratios can createincentives for banks to increase the economic as opposed to the regulatory risk oftheir assets. For example, by substituting higher-risk (“lower quality”) loans for

lower-risk loans, banks can increase their expected returns without affecting theirregulatory capital ratios.

One dynamic model of the banking environment built to study the problemfound that a poorly capitalized (severely undercapitalized) bank will add risk togamble its way out of its problems, a moderately capitalized bank will beconservative, and a well capitalized large bank can afford to take more risk. “Thisresult suggests that moral hazard is a serious problem among banks near toinsolvency; thus, it provides a formal rationale for the prompt corrective provisionsof FDICIA.” See Paul S. Calem and Rafael Rob, “The Impact of Capital-BasedRegulation on Bank Risk-Taking: A Dynamic Model,” Federal Reserve System,Finance and Economics Discussion Series, Working Paper 96-12, 1996

11. However, it should be noted that a long-term bond rating is relevant onlyfor banks above $2 billion since financial institutions below this size cannotgenerally obtain a “major” (that is, S&P or Moody’s) investment grade rating. Theneed for a high bond rating to support off-balance sheet activity such as swaps isrelevant for only the largest 15 or so U.S. financial institutions.


The regulators might have “suggested” the desir-ability of a higher capital level for an individual bank,given the bank’s risk profile. Alternatively, theregulators may have indicated that if the bank wereto engage in certain new activities (or a prospectivemerger requiring regulatory approval), a highercapital level would be required.

Finally, the regulator’s risk based capital calcula-tions are, as suggested, at best crude indicators of thelevel of risk associated with their assets. Individualinstitutions may conclude that their “true” risk levelis different.

Peer Group Analysis of Capital Levels

One starting point for examining levels ofbank capital is to observe how capital ratios varywith the size of the institutions. Table 2 providesdata on a nationwide basis for the highest levelbank holding company of a group of banks or, incases where there is no higher level holding com-pany, individual commercial banks. (Thrifts, creditunions and monoline credit card banks are ex-cluded from the analysis.)12

As the table shows, banks carry more capitalthan required by the regulators, and this tendency toexceed regulatory capital levels is especially pro-nounced for smaller institutions. Some other obser-vations from the above are:

For the smaller banks, there is a proportionallylarger difference between Tier 1 Leverage and Tier1 Risk Adjusted Leverage (the same numerator, butwith a risk-adjusted denominator). This derives fromthe fact that smaller banks have a higher percentageof assets in cash or in securities portfolios—assetsthat have zero or low risk weightings. Even the off-balance-sheet risk assets that larger banks carry donot overcome this effect.13

Smaller banks rarely use subordinated debt. Theycan obtain this funding only from local communityprivate placements or expensive “public” offeringswhose distribution is geographically limited. There-fore, when they use only equity and reserves toestablish a margin above the well capitalized level,smaller banks implicitly hold an even greater marginover the Leverage and Tier 1 ratios. Larger banks canobtain public bond ratings and issue public, institu-tionally placed, subordinated debt to fill out any

TABLE 2 Well1996 Asset Size ($Bn): $.5-1 $1-2 $2-5 $5-10 $10-30 >$30 Capitalized

Number of BHC’s 175 95 60 33 32 29CB’s without a BHC 28 17 5 0 0 0

Total 203 112 65 33 32 29

Tier I Leverage 8.58 8.57 7.80 8.46 7.50 7.14 5%Spread above “well capitalized” 72% 71% 56% 69% 50% 43%

Difference BetweenNet Average Assets andNet Risk Adj Assets: 35% 33% 35% 30% 28% 15%

Tier I Risk Adj Capital Ratio 13.29 12.86 12.05 12.07 10.40 8.39 6%Spread above “well capitalized” 122% 114% 101% 101% 73% 40%

Assume Max Permissible Tier IICapital from Loss Reserves: 1.18 1.25 1.25 1.25 1.25 1.25

Implied Tier II Capital fromSubord Debt or Pfd Stock: .00 .12 .16 .43 1.60 3.16

Total Risk Adj Capital Ratio 14.47 14.23 13.46 13.75 13.25 12.80 10%Spread above “well capitalized” 45% 42% 35% 38% 33% 28%

12. Median data for each group, as of Dec. 31, 1996 for Bank HoldingCompanies and Commercial Banks excluding Credit Card Banks, from Sheshunoffvia OneSource. For ratio definitions, see Appendix II.

13. For some small banks, the securities portfolio may also be deliberately heldas a liquidity reserve against their higher risk profile. For others it may reflect aninability to identify sufficient lending opportunities.

Banks carry more capital than required by the regulators, and this tendency toexceed regulatory capital levels is especially pronounced for smaller institutions.


desired spread between equity plus reserves and thewell capitalized level.

Therefore, for smaller banks, the constrainingfactor is generally the Total Risk Ratio—that is, thisis the ratio for which there is the least “excesscapital” relative to the well-capitalized level. Forlarger banks with access to subordinated debt andpreferred stock, the Tier 1 ratios are generally thecontrolling factor.

As noted, the amounts by which capital levelsexceed the regulatory minimum are particularlylarge in the case of smaller banks. One likelyexplanation for such differences has to do withdifferences in operating characteristics between largerand smaller banks—differences that in turn translateinto different risk profiles.

While smaller banks have the highest proportionof the lowest-risk assets (such as cash, mortgages,and marketable securities), they also have a muchgreater degree of concentration (and co-variance)among their riskier assets. Especially in the case ofcommunity banks of $2 billion or less in assets,there is far less diversity both geographically andby type of loan. This lack of diversification maylogically drive them to maintain greater capitalratios for safety.

Also, smaller banks also have more “businessrisk,” a reflection of their more limited managementdepth, lower financing flexibility, and difficulty incompeting with the services and products providedby larger banks, particularly in the new electronicenvironment.

Still another business risk factor is the general lackof access of smaller banks to “non-interest” or “fee”income. Fee income is generally considered as astabilizing factor in earnings (since it is generallysubject to business risk, but rarely to credit risk),besides adding more diversification to earnings.Whereas the median bank over $30 billion reported38% of total revenues from non-interest income, thecorresponding figure for banks from $500 million to$1 billion was only 18%.

Finally, one might also expect smaller banks, withconcentrated local ownership and owner-managers,to be more risk averse than larger institutions run byoutside professional managers.

Beyond issues of risk, there is another pos-sible factor. The capital ratios of privately held, orclosely held, banks may also be affected by thepersonal cash flow and tax considerations of theirowners. If these owners do not want dividends,

and there are insufficient local lending opportu-nities, a profitable bank can experience a build-up of capital.

In sum, the empirical evidence is that smallerbanks hold more capital as a percentage of totalassets. Assuming that the patterns described abovereflect rational behavior by bank managers in re-sponse to market-wide pressures, the implication isthat there is more inherent risk in community banks.While community banks may have proportionallymore low-risk assets by virtue of their securitiesportfolios, this risk-reducing effect is overwhelmedby the larger operating risks of these institutions.They have no access to diversification of loans,whether by geography or types of lending, and theyhave limited diversity in their funding sources—risksthat are not picked up in the regulators’ risk-basedcapital ratios.

Thus, when conducting peer group analysis fora specific bank, a peer group is more properlychosen by considering not just asset size on anationwide basis, but also factors such as:

the asset mix of the bank—securities vs. loans,types of loans, and so forth;

the relative level and volatility of risk in the loanportfolio;

the degree of concentration in the loan portfolio;the level of loan loss reserves;the ability of the bank to generate consistent non-

interest income; andthe local regional economy.

A PRACTICAL APPROACH TO CAPITALSTRUCTURE IN BANKS

We believe the practice that should be followedby most banks is essentially as follows. First, ifavailable, a sophisticated, RAROC-type process shouldbe used to quantify the risks faced by a bank and theamount of economic capital required as a cushionagainst those risks. This process will produce a lowerbound on the bank’s targeted level of capital. Thenext step is to compare economic risk capital againstregulatory well-capitalized ratios, a level that mostmanagements will want to exceed by a comfortablemargin. Finally, there is a balancing of several otherjudgment factors, including:

common market practice, as derived from peergroup analysis;

a risk appetite that balances the specific assets,markets, and ownership of a bank; and


a desire to achieve a specific debt rating, providedthe bank is large enough to qualify.14

Based on the decision-making sequence de-scribed above, the capital planning process might beformalized to include the following steps:

1. Start with the Economic Risk Approach. If thebank has access to such models, use a RAROC-typeof economic approach to determine the requiredlevel of economic capital, given a specific level of risktolerance. Then, in order to arrive at an economic riskbased target structure for regulatory Total Risk Capi-tal, management must first answer two questions:

What are the appropriate levels of loan lossreserves (which are part of Total Capital), given thesize and credit risk profile of the bank; and

How much risk of regulatory “corrective action” orbusiness disruption is the management of a bankwilling to accept? While a major setback may not create

insolvency, it might cause a ratings downgrade thatcould have significant secondary effects on the busi-ness (or on the cost of capital, including effective lossof the tax deductibility of interest expense). Given thevolatility and risk associated with its operations, doesmanagement wish to achieve protection against thepossibility of significant business disruption that reachesa 95% confidence level? A 99.7% level?

Such an economic approach is designed toproduce a theoretically optimal level. In practice, how-ever, most banks choose to maintain capital ratios that arehigher than the levels suggested by the economic riskmodel. Even putting regulatory guidelines aside, thestock market may effectively require higher levels ofcapitalization (by assigning lower P/E ratios to banksthat are “undercapitalized” relative to their peers).15

2. Keep an Eye on Regulatory Ratios. Thestandard RAROC model generates a level of capital

14. At year end 1996, there were approximately 4,800 separate commercialbanking organizations (bank holding companies, or indepndent banks) in the U.S.Of these, only 271 were above $1 billion in assets, and of this smaller number, lessthan 150 had long-term debt ratings from one or the other of the two major ratingagencies.

15. Also, if the risk and capital analysis is done on a “bottom-up” basis (thatis, by building a total from an analysis of the individual components), there maybe an inherent downward bias in the calculation. Operating units allocated a “high”level of capital will try to lower their allocation, and units given a “low” allocationof economic capital will certainly not object.

THE ROLE OF CAPITAL IN DEBT RATING PROCESS (AND VICE VERSA)

regulators. Their analysis of capital ratios includes theuse of “stress tests” of capital levels and active probingof management’s attitudes toward risk and capitaladequacy.

For most community banks, a major bond rating isirrelevant—they can’t get an investment-grade ratinganyhow, and the small depositor (the dominant sourceof funds at community banks) generally isn’t con-cerned since his or her claims are covered by FDICinsurance. The small depositor generally will not beaware of a bank’s regulatory status—even if the bankis subject to regulatory oversight.

Another source of funds for community banks—brokered deposits—is also somewhat “immune” toratings, since these deposits are arranged in a mannerso as to be FDIC insured. However, banks that are notwell capitalized generally will not be able to access thebrokered deposit market.

The one exception to the above would occur whena community bank seeks to be the depository for cityor other government funds. In this case, there may beresolutions that require the bank to have an issuer orshort term rating, such as a Thomson Bank Watchrating, to receive government deposits.

or most industrial companies, the bond ratingprocess has a high component of quantitative

analysis. Key ratios are published for different indus-try groups, and it is possible to achieve a very strongstatistical correlation between the bond rating pre-dicted by an analysis of financial statements andactual ratings. Indeed, for some industries, quantita-tive analytical techniques can achieve R-squared sta-tistics in excess of 90%!

For banks, however, there is a far more tenuousrelationship between financial ratios and debt ratings.S&P does not publish compilations of ratios corre-sponding to debt ratings for banks. In fact, quantitativeanalytical techniques can generally get no closer thanan R-squared statistic of 80%, with asset size as the mostsignificant determinant of the rating. After size, themost significant factors in the debt rating process areasset strength and credit quality, geographic and fund-ing diversity, and earnings. Capital ratios, while afactor, are clearly secondary.

Nevertheless, capital ratios are important. The rat-ing agencies use their own “risk based assets” analysis,one that is more sophisticated (for example, it adjustsfor the effect of securitizations) than that of the

While smaller banks have the highest proportion of the lowest-risk assets (such ascash, mortgages, and marketable securities), they also have a much greater degree ofconcentration (and co-variance) among their riskier assets. Especially in the case ofcommunity banks, there is far less diversity both geographically and by type of loan.

F


to protect against “insolvency.” It is not a “given” thatthis level of economic capital will be below the “wellcapitalized” regulatory level. Economic capital takesinto account credit risks, market risks, country risks,business risks, and the risks associated with intan-gible assets that the accounting-based regulatorycalculation does not explicitly consider. For somebanks, particularly those targeting a high confidencelevel equivalent to an AA bond rating, it is possiblefor economic capital to exceed the “well capitalized”regulatory capital level.

Regardless of the outcome of an economiccapital analysis, most managers prefer to maintain acomfortable margin above “well capitalized.” Thevolatility revealed by the RAROC model can help todefine this comfort margin. Also, as noted earlier,regulators may suggest to a bank that a higher levelis advisable if the bank will be seeking regulatorypermission to undertake certain activities.

3. “Reality Check” with a Peer Group Compari-son. After the economic and regulatory analysis, itwould be wise to evaluate those results against thecapital ratios of comparable banks. For one bank todrop significantly below its peers could invite con-cern about its relative ability to weather an economicdownturn, with potentially negative impacts on theshareholder value and stock price. In constructing apeer group for comparison, it is important to con-sider the variables noted above such as asset mix,loan concentration, and the regional economy.

4. Consider Future Prospects and Needs. It isalso important to make sure that the resulting capitalratio target will accommodate the individual bank’sspecific growth plans.

Internal capital generation capability—a quick short-hand for this is to look at the ROE of the firm multipliedby the earnings retention rate (or 1 – the dividendpayout rate). The result is retained ROE, which is alsothe annual growth rate of the equity base. This equitygrowth rate can be compared to the anticipated assetgrowth rate to see if there is “excess” capital genera-tion—that is, more than the equity that is required tomaintain a constant leverage ratio.

Potential investment opportunities—if acquisi-tions are a strategic imperative, and if it is likely theywill be executed as purchases rather than poolings,then equity may need to be reserved to support thepremium over book that will be paid. If equity is not

kept in reserve, an economically advantageousacquisition may have to be forgone because itsgoodwill would create too large a reduction inregulatory capital ratios.

5. Consider Rating Agency Requirements. If anincrease in leverage, for example, through a stockrepurchase, results in a drop in a bank’s bond rating,the repurchase could end up increasing rather thanreducing the bank’s cost of capital. For a rated bank,the rating agencies should be considered, andperhaps consulted, before taking any action. This isparticularly so if the bank in question feels that it isat the lower end of its rating range, or anticipatespublic debt issuance in the near or intermediateterm. However, as previously noted, the ratingagencies are generally more concerned with long-term operating performance prospects than specificcapital ratio coverages.

6. Finally, establish a mix of “capital.” Theabove analysis focuses on levels of capital, butwithout distinguishing among the different kinds—debt and preferred, as well as equity. Managementmust consider the optimal mix as well as the level ofcapital while remaining within the limited definitionof bank capital.

Once an equity level is defined, Total RegulatoryCapital requirements should be examined. If re-quired, and available, preferred stock or subordi-nated debt can be added to the capital provided byloss reserves to achieve the desired total. Availabilityis generally a function of the size of the institution.

The selection of preferred stock vs. subordinateddebt to “top off” required Total Capital amounts isgenerally a relative cost calculation.

CONCLUSION

A rigorous quantitative approach such as RAROCcan be used to establish a theoretical required capitallevel. But this result must be tempered by a varietyof practical, qualitative considerations before it canbe translated into a target capital structure. Therelative importance of these considerations will varyfrom one bank to another, and include such factorsas management’s risk tolerance, regulatory con-straints, market pressures (as reflected in peer groupcapital levels), future prospects and plans, and, forlarger banks, rating agency requirements.


APPENDIX I MANAGING “EXCESS CAPITAL”

There are two kinds of excess capital. First is theamount by which a bank’s regulatory capital exceedsits targeted level. If there are no profitable growthopportunities for deploying this capital, manage-ment should consider repurchasing its stock toreduce capital.

A second kind of excess capital—call it “cushioncapital”—is created when the target level of regula-tory capital for a given business or class of assetsexceeds the amount of economic capital manage-ment feels is necessary to support that business orasset class. In such cases, management shouldconsider selling, syndicating, or securitizing assetsfor which the target regulatory capital requirementis higher than the calculated economic capital re-quirement. These actions can have the benefit ofreducing regulatory capital more than economiccapital. The released regulatory capital can be rede-ployed or used to buy back stock, either of which canincrease shareholder value.

Stock Buybacks as Means of Reducing“Excess” Total Capital

One of the most dramatic, and direct, ways toadjust leverage is through stock repurchase. Almostall of the 25 largest U.S. banks currently have stockbuyback programs. Corporate finance theory givesseveral reasons for stock repurchase:

A desire to adjust the capital ratios to reach adefined target.

A management view that marginal investmentopportunities are below the relevant cost of capital,and that undertaking them would reduce the valueof the firm. Therefore, capital that cannot be appro-priately employed should be returned to the share-holders.

A management view that the current stock price isundervalued. Even if equity capital might be neededin a few years, if management can repurchase stocktoday at $25 per share, and believes that it can issuestock in two years when it is needed at $33 or $36per share, then there is a 15%-20% return oninvestment in the transaction. The key ismanagement’s confidence in the future stock price,given the many systemic factors affecting stockprices (such as the overall economic environmentand the level of interest rates) that are beyondmanagement’s control.

A desire to drive out “weak holders”—a prelimi-nary form of takeover defense.

A desire to increase EPS and ROE.The equity markets are generally most focused

on operating prospects. However, a sharp change inleverage changes financial risk and earnings volatil-ity, which may be reflected in a higher risk premiumattached to the company’s stock price. Nevertheless,for a bank whose capital ratio is comfortably abovelevels considered “well capitalized,” excess capital isa drag on ROE and, by implication, shareholdervalue and stock price.

Selling or Securitizing Assets to Manage“Cushion” Capital

Economic capital requirements can be belowrequired minimal levels of regulatory capital, andthese in turn can be below the target level ofregulatory capital. A large spread (“cushion”) be-tween economic capital and target capital is aninefficient use of capital.

For example, assume a bank has $1.5 billion inbook assets and an economic capital requirement of4%, or $60 million. It has $1 billion in net riskweighted assets and a target Tier 1 Risk Adjustedcapital ratio of 10%, for a target regulatory capitallevel of $100 million. The difference between thetwo capital requirements, $40 million, can be called“cushion” capital. Assuming a 13% cost of capital, ina simplistic analysis this cushion results in $5.2million more in annual capital costs than is economi-cally “necessary” (i.e., $40 million at 13%).

Securitization is generally thought of as a methodof freeing up capital, and of increasing capital ratios.However, if the freed capital is efficiently rede-ployed, then there can also be a movement towardsa more optimal capital structure, which has a netpositive effect on shareholder value. The redeploy-ment could be either through support for additionalgrowth in assets or, if that is not economicallyavailable, through a stock buyback.

The following example has simplifying assump-tions to illustrate the management of cushion capital.(Note also that consumer mortgages have a 50%regulatory risk weighting.)

When whole loans or mortgages are securitized orsold, the major portion of the net economic earningsare monetized by the selling bank, and the major

The standard RAROC model generates a level of capital to protect against insolvency.Most managers, however, are likely to prefer to maintain a comfortable margin

above “well capitalized.”


increase in economic leverage has an effect on theoverall cost of capital.

As a further complication, the above simplifica-tion assumed that there is no change in the neteconomic benefit retained by the bank. In practice,a calculation of this retained benefit must be made,and compared to the capital benefit of securitization.Other factors to consider would be the all-in fundingcosts (as impacted by the minimum economic sizefor a transaction needed for efficient pricing, front-end costs, perceived strength of the bank as aservicer, etc.); administrative issues relating to ser-vicing a securitized portfolio; creation or eliminationof funding gaps or funding basis risk; or the use ofavailable bank liquidity facilities if a conduit is used.

Finally, the above focuses on optimizing regu-latory capital. Neither the rating agencies nor themarket will be oblivious to the effective increase inleverage of the bank, as the cushion above economiccapital is reduced. Each might impose a penalty inthe form of a downgrade or reduced P/E levels.

The above simplified example shows part of thethought process, and is provided to show some ofthe multiple issues involved in these decisions. Afterconsidering all of the relevant factors, managementmay conclude that although the securitization has apositive EPS or ROE effect, it may end up having anegative effect on economic or shareholder value.

(APPENDIX I CONT.)

portion of the credit risk can be transferred. Forpurposes of the example below, assume that 100%of the economic earnings are monetized, and 100%of the credit risk is transferred.

While credit cards can be securitized, this is oftenprimarily a funding mechanism and matter of account-ing, with the major portion of the economic risks andreturns of credit cards retained by the bank. Forpurposes of the example below, assume that 100% ofthe economic earnings are retained, and 100% of thecredit risk is also retained (i.e., $0 change in the NetEconomic Balance Sheet). Further assume that afterapplying the new 1997 GAAP and capital reportingrules,1 75% of the risk weighted capital is removed(i.e., a reduction in regulatory risk weighted assetsequal to 75% of net value of the assets securitized.)

Assuming that the target capital released isredeployed for a stock buyback, there is a reductionin the annual cost of the cushion. In the sale of loansexample above, the simple analysis concludes thatthe annual cost of the cushion capital is reduced by$780,000. A more complete analysis would note thata securitization to execute a stock buyback is func-tionally equivalent to incurring debt to execute astock buyback. The “cost savings” is not a 100%reduction in cost of capital, but rather the differencebetween the cost of equity and the cost of debt. Thisthen begs the question of whether the effective

Target Regulatory Capital Economic Capital Capital Cushion

NetNet Risk Target Economic Economic AnnualWeighted Capital Balance Capital Required2 Capital Cost

$ Millions Assets at 10% Sheet % $ Cushion at 13%

Bank Before Transactions $1,000 $100 $1,500 4% $60 $40 $5.2

Marginal Effects:(a) Sell or syndicate loans –100 –10 –100 4% –4 –6 –0.8

Result 900 90 1,400 56 34 4.4

(b) Securitize Mortgages –50 –5 –100 2% –2 –3 –0.4Result 950 95 1,400 58 37 4.8

(c) Securitize Credit Cards –75 –8 0 5% 0 –8 –1.0Result 925 93 1,500 60 33 4.2

1. Effective in 1997, banks are preparing their financial “call reports” on a GAAP basis. Securitization in accordance with FAS 125 removes assets from the GAAP balancesheet. However, for calculation of risk based capital, regulators are requiring adjustments for assets such as credit cards, adding back to total risk based assets an off-balance sheet risk component.2. Representative percentages for illustrative purposes only.


DONALD DAVIS

is a Managing Director of Corporate Finance in Bank ofAmerica’s Financial Institutions Group.

Equity Capital

A COMMON EQUITYTotal per statements.

B – UNREALIZED MARK TO MARKETUnrealized Gains (Losses) on available for sale securities.

C – GOODWILL AND INTANGIBLESOther than “grandfathered” intangibles.

D + QUALIFIED PMSRS AND PCCRSPMSRs and PCCRs at greater of book value, discountedvalue, or 90% of PMV, but not more than 50% of equityless intangibles for PMSRs, 25% for PCCRs, and 50% ofequity less intangibles for the combined total.

E – DISALLOWED DEFERRED TAX ASSETSAmounts in excess of regulatory limits.

F + QUALIFIED PREFERRED STOCKCumulative perpetual preferred, but not more thanone-third of common equity. (For banks this is non-cumulative.)

G + MINORITY INTEREST IN CONSOLIDATED SUBS.

H TIER 1 CAPITAL

I – 50% OF INVEST. IN UNCONSOL. BANK AND FIN. SUBS.

J NET TIER 1 CAPITAL

K + ELIGIBLE LOAN LOSS RESERVEMaximum of 1.25% of gross risk weighted assets.

L + QUALIFIED PREFERRED STOCK“Maturity adjusted” value of limited life preferred,plus perpetual preferred in excess of Tier 1 limits.

M + CONVERTIBLE AND SUBORDINATED DEBT“Maturity adjusted” value of qualified debt, but notmore than 50% of Net Tier 1 Capital.

N – 50% OF INVEST. IN UNCONSOL. BANK AND FIN. SUBS.

O TOTAL (TIER 1 + TIER 2) CAPITALCannot exceed twice Net Tier 1 Capital.

APPENDIX II REGULATORY CAPITAL RATIOS FOR BANK HOLDING COMPANIES

Assets

P MOST RECENT QUARTER AVERAGE TOTAL ASSETS

Q – INELIGIBLE INTANGIBLESTotal of items (C) and (D).

R – DISALLOWED DEFERRED TAX ASSETSSame as (E).

S NET AVERAGE ASSETS

T GROSS RISK ADJUSTED ASSETSTangible on and off balance sheet assets, multipliedby 0%, 20%, 50% or 100% risk weighting factors.

U – INELIGIBLE INTANGIBLESTotal of items (C) and (D).

V – DISALLOWED DEFERRED TAXESSame as (E).

W – INELIGIBLE CONVERT. AND SUB. DEBTConvertible and subordinated debt in excess of 50%of Net Tier 1 Capital.

X – EXCESS TIER 2 CAPITALAmount by which (K + L + M + N) exceeded NetTier 1 Capital.

Y – INVEST. IN UNCONSOL. SUBS.

Z NET RISK ADJUSTED ASSETS

KEVIN LEE

is a Corporate Finance Associate in Bank of America’sFinancial Institutions Group.

Minimum Levels

Regulatory Ratio “Adequately” Capitalized “Well” Capitalized

TIER 1 LEVERAGE RATIO Tier 1 Capital (H) / Net Average Assets (S) 4% 5%

TIER 1 CAPITAL RATIO Net Tier 1 Capital (J) / Net Risk Adjusted Assets (Z) 4% 6%

TOTAL CAPITAL RATIO Total Capital (O) / Net Risk Adjusted Assets (Z) 8% 10%

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