Capital Considerations Including Continued Allowance of Trust Preferred Securities as Tier 1 Capital

Written by: Jason Dollar

The financial strength of a Bank has long been judged by its capital ratios, Tier 1, Tier 2, and so on. Tier 1 being equity capital such as common stock, surplus and retained earnings, and Tier 2 being these same factors in addition to adding back the allowance for loan losses. So why are capital ratios so important? To understand this, we must consider the origins of their use in evaluating financial institutions.

Before the 1930’s, United States banks were for the most part unregulated. After the stock market crash of 1929, this factor changed due largely in part because the crash caused many Banks to fail. Because of the massive losses suffered by depositors, Congress implemented the Federal Deposit Insurance Corporation, better known today as the FDIC. While this helped solve the problem of investor confidence, it created another. Because of the FDIC, an investor’s deposit was now insured at any Bank, so the customer no longer needed to consider the credit quality of the institution before investing his/her money there. The new regulatory system that arose from this occurrence was the need for minimum capital requirements.

Regulatory capital, whose purpose is to assess the overall capability of a bank to prosper, has now become the standard by which banks are judged. One must understand that regulatory capital is based on a model for how banks operate. This model assumes that the capital is a source of cash, and every time there is a problem or a need to absorb losses, the capital is there to do so. It does this in essence by affecting the retained earnings, which is affected by the income statement. If a bank’s capital ratios get to small, it may have to issue more stock in order to raise it back to a desired level. The problem here it that if the Bank is losing money and the retained earnings is dropping, who will want to invest?

What must be understood is that capital ratios are not the only tool that should be used in evaluating the financial viability of a Bank. One must also consider the assets, net income, net interest margin, and the ratio of loans to deposits. All of these factors combined can help one determine the long-term growth potential for a financial institution. Capital ratios are a good tool, but not the only tool out there for investors to consider.

With that being noted, the FDIC announced on June 30, 2005 in its Report Bulletin No. 3 that it would continue to allow outstanding and prospective Trust Preferred Securities to be included in the calculation of Tier 1 capital. Also from this report, “The Board also revised the quantitative limits applied to the aggregate amount of cumulative perpetual preferred stock, trust preferred securities and minority interests in the equity accounts of most consolidated subsidiaries included in the tier 1 capital of the bank holding companies.” The new limits will become effective after a transition period of 5 years.

For more information refer to:

• www.fdic.gov/regulations/laws/rules/bullet3.html
• www.riskexpertise.com/papers/Capital.pdf
  

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