Did you know that on this day in 1935, the first-ever automatic parking meter was installed in a US city? Well it was, and we can all thank Oklahoma City for educating all other cities in the value of draining spare change out of the pockets of the parking public all over this great country of ours. As you ponder whether or not you forgot to feed the meter this morning, we shift gears in order to educate about the value of a very topical issue - capital.
Broadly speaking, capital represents the cushion by which creditors would be covered if a bank's assets were liquidated. On the Call Report the total bank equity capital number is reported. That number includes preferred stock, common stock, surplus, any undivided profits and any non-controlling interests in consolidated subsidiaries. Banks are required to hold enough capital that the board or banking regulators consider satisfactory according to the level of risk taken. Regulatory minimums are stated; however requirements can vary from bank to bank depending on risk profile.
Perpetual preferred stock is preferred stock that does not have a stated maturity date or that cannot be redeemed at the option of the holder. It also includes those issues of preferred stock that automatically convert into common stock at a stated date. Meanwhile, common stock is stock issued by the bank.
Surplus gets a little trickier. Surplus is the portion of a bank's capital that is received for shares of stock that are sold in excess of par value, but excludes surplus related to preferred stock. The most common ways surplus capital is created are when stock is issued at a premium, from the proceeds of stock repurchased and then sold again, from donated stock, as a result of an acquisition of a bank that has a capital surplus and due to a reclassification of capital stock.
There is also a little more than meets the eye related to undivided profits. Such profits are really the accumulated net profits of the bank which have not been paid out in dividends or transferred to surplus. These include not only undivided profits in the truest sense, but also any reserves for loan losses, plus net unrealized holdings gains or losses on available-for-sale securities, other equity capital components and accumulated gains or losses on cash flow hedges.
Next, we move to non-controlling (minority) interests in consolidated subsidiaries, equity capital component. This one gets a bit funky, but some structures that bankers may be familiar with include forming an LLC subsidiary that is 100% controlled by the bank. The subsidiary might then issue non-cumulative, perpetual preferred securities to other parties, which show as a minority interest on the bank's consolidated financial statements. The subsidiary might invest 95% of the proceeds of its securities into a subordinated debenture issued by the bank and 5% of the proceeds in other assets that meet credit and maturity criteria. The preferred securities issued by the subsidiary are usually only redeemable by the subsidiary with regulatory approval.
From a regulatory viewpoint, 12 CFR 3 establishes the components of Tier 1 capital, which include: (1) common stockholder's equity, (2) noncumulative perpetual preferred stock and related surplus, and (3) minority interests in the equity account of consolidated subsidiaries. In addition, the Bank for International Settlement (BIS) rules set out requirements for two categories of capital, Tier 1 capital and Total capital. Tier 1 capital is essentially the bank's common stock plus retained earnings. Tier 2 capital includes loan loss reserves (up to 1.25% of RWA) + subordinated debt (portion not allowed as Tier I). Finally, total bank capital is calculated by adding together Tier 1 and Tier 2 capital. In addition to the BIS capital requirements, the US also imposes a separate leverage requirement on banks. The leverage capital ratio is a minimum ratio of core (Tier 1) capital expressed as a percentage of quarterly average total assets, adjusted for deductions from regulatory capital. It is designed to provide additional protection for interest rate, operational, concentration and liquidity risks not picked up by the risk-based capital ratios. The risk-based capital ratios in turn, exist in an effort to measure capital relative to the bank's overall risk profile.
We hope this primer helps bankers revisit some key aspects of capital. Like the parking meter, running out of capital at the wrong time can also result in an "Expired" flag no one wants to see, so we thought it was worth the reminder.