Financial Management Part I: What You Need to Know About Capital

By Chris Bledsoe, Banker’s Dashboard

In this first of a four-part series on financial management, we’re going to highlight what directors need to know in order to regularly assess capital. Directors don’t often think about how the quality of “its” management affects capital and what influence this crucial area has on the bank’s overall performance. Here’s what you need to consider before heading into your next board meeting.

The Magic Question: How Much Capital is Necessary?
Everything that impacts an institution impacts its need for more or less capital. And the amount of capital a bank must maintain depends upon its risk profile – the higher the risk, the greater the level of support required. The FDIC has identified seven factors* that directors must take into account within this risk context when determining how much capital is enough for your bank:

The quality, type, and diversification of assets – If your bank has high levels of classifications, sub-prime loans, high or unmonitored concentrations, aggressive underwriting, etc., you’ll need higher levels of capital.

The quality of management – If your bank operates with bare minimum staffing levels or lower quality management, the risk profile is higher, requiring higher levels of capital.

The quantity and quality of earnings available for capital augmentation – When examiners talk about the quality of earnings, they consider whether earnings are from core banking operations or from anomalies such as gains on the sale of assets. The quality and quantity of earnings are important because they are concerned with the bank’s ability to augment capital via retained earnings.

Exposure to changing interest rates – Higher/lower interest rate risk impacts the risk profile and thus the need for more or less capital.

Anticipated growth (strategic plan/budget) – Regulators are concerned with what the capital needs will be going forward. This is assessed relative to earnings available for augmentation, as well as existing levels of capital.

Local economic conditions – If the bank’s market is limited to one economic area or one industry, the risk profile is greater. The greater the diversification, the lower the risk.

Dividend requirements to shareholders or a holding company – Examiners are interested in what’s available for capital augmentation to support growth and the risk profile.

Know the Risk-Based Capital Ratios
There are also some important quantitative factors that you need to include as you assess capital adequacy. The regulators use the following ratios to measure capital relative to the bank’s risk profile.

1. Tier 1 Leverage Capital ratio (Tier 1 Capital/Average Assets)

2. Tier 1 Risk-Based Capital ratio (Tier 1 Capital/Risk Weighted Assets)

3. Total Risk-Based Capital ratio (Total Capital/Risk Weighted Assets)  

These three ratios should adjust for different risk profiles. Without delving into the details of the calculations, what’s particularly important for directors to understand is that they must adjust for portfolio risk. You must know where your bank’s three ratios are and how they compare to the institution’s peers. You should also be tracking the trends – where each ratio has been and where it is now? Which of the three ratios has shown the most deterioration? And, as opposed to peers?  

Examiners expect directors to know all of this. It should be detailed and presented in a graphic format by senior management as a component of your board package. If you aren’t receiving this degree of insight now, ask for it.

Your Homework Assignment
From an examiner’s perspective, it’s your responsibility to know what the minimum capital level is to attain a well-capitalized status and how much cushion your bank really has. You need to press senior management on why the bank is above or below that cushion, and ask what options they are exploring for capital solutions if the cushion isn’t big enough.

Now, for your homework…Think about the information presented in this column – before heading into the next board meeting – and request that senior management provide you with the level of detail you need to truly understand the bank’s capital position at all times. At the top of the list is knowledge of the risk-based capital ratios and, more importantly, the ability to easily monitor their trends. This preparedness will enable you to better fulfill your role in helping the bank proactively and prudently manage this key financial area.

*Source: San Francisco Directors College FDIC Training Material

 <back to May 2011 Directors Digest>