MASTER OF BUSINESS ADMINISTRATION

SEMESTER 02 / 2017

BMBM 5103

BANK MANAGEMENT

MATRICULATION NO : CGS01332701
IDENTITY CARD NO. : 920914-01-6888
TELEPHONE NO. : +6012-7801409
E-MAIL : priyagnaeswaran@yahoo.com
LEARNING CENTRE : JOHOR LEARNING CENTER
TABLE OF CONTENT

NO TITLE PAGES

1 INTRODUCTION 3

2 BANK CAPITAL REQUIREMENT 5

3 CONSTITUTE BANK CAPITAL 6

4 COMPONENT OF PRIMARY AND SECONDARY 7

CAPITAL

5 FUNCTION OF BANK CAPITAL 9

6 CAPITAL IS ADEQUATE IN BANKING 11

ENVIRONMENT IN MALAYSIA

7 WHY MOST BANKS PREFER TO OPERATE 14

WITH LESS CAPITAL?

8 REFERENCES 15

Page 2
BMBM 5103 BANK MANAGEMENT
INTRODUCTION

Bank capital requirements should be hold by bank in order to control this risk. The
reserve acts as a buffer against potential losses. The bank capital controls the extent of
risk taking by restricting too much growth, and gives banks the ability to obtain liquidity
needs via access to the financial markets. Banks categorised as well-capitalised are not
subjected to any restrictions from the regulators, whilst institutions in the adequately
capitalised category although considered to have strong capital bases, are restricted in
their ability to secure brokered deposits.

Page 3
BMBM 5103 BANK MANAGEMENT
 1.0 BANK CAPITAL REQUIREMENT

Banks and investment banks must maintain a set minimum amount of capital requirement
at all times. Minimum capital requirements are introduced as an important entry and
ongoing requirements to ensure a banking institution maintains a minimum size of capital
to operate and perform its intermediation function effectively, said Bank Negara
Malaysia (BNM) in its policy document on capital funds (MALAYSIA, 2017) .

Regulatory capital requirements seek to ensure that risk exposures of a financial

institution are backed by an adequate amount of high quality capital which absorbs losses
on a going concern basis. This ensures the continuing ability of a financial institution to
meet its obligations as they fall due while also maintaining the confidence of customers,
depositors, creditors and other stakeholders in their dealings with the institution.

Capital Requirements Composition

Tier 1 (Core) Equity: Common shareholders

Non-cumulative preference shares

Minority interests in equity

Less: Goodwill, intangible asset disallowed, and deferred taxes

disallowed

Tier 2 (Supplementary) Cumulative preference shares

Page 4
BMBM 5103 BANK MANAGEMENT
 Auction rate and similar preference shares

Hybrid capital instruments

Subordinated term debt

Allowance allocated for potential loan and lease losses

Tier 3 (Allocation for Applicable to banks that are exposed to market risk capital guidelines
Market Risk)

Definition of Capital under Risk-based Approach

Regulators in the banking industry tend to focus on the difference between book value of
assets and liabilities which yields the book value of equity. The total capital of a bank is
then classified into a broader definition of capital consisting of Tier 1 and 2. Tier 2
basically includes long-term subordinated debt. Table above illustrates both definitions of
capital under the risk-based approach to classifying capital.

Page 5
BMBM 5103 BANK MANAGEMENT
2.0 CONSTITUTE BANK CAPITAL

THE BASEL Minimum requirement of capital is reflective of the riskiness

AGREEMENT of individual banks

The requirement is therefore a function of the credit risk

which is a reflection of the composition of asset quality

This approach also prioritizes shareholders equity which is

classified as the most critical category of capital. Thus, the
minimum amount of equity capital required is determined by
the credit risk.

RISK BASED Bank managers adopt the following steps to determine the minimum
APPROACH capital requirements under the risk-based approach:

(a) Assets are classified into categories based on the collateral or

guarantor or obligator

(b) Off-balance sheet commitments are converted to equivalent

balance sheet values in order to assign risks

(c) Assign risk weight which is then multiplied by the Ringgit value
of the asset in each risk category. This yields the asset which is risk-
weighted

Page 6
BMBM 5103 BANK MANAGEMENT
3.0 COMPONENT OF PRIMARY AND SECONDARY CAPITAL

PRIMARY It should be fully paid-up and permanently available

CAPITAL - TIER 1
It should be freely available and not earmarked to
particular assets or banking activities

It should be able to absorb losses occurring in the course

of ongoing business

Items which qualify as Tier 1 capital are as follows:

i) Ordinary paid-up share capital

ii) Share premium

iii) Statutory reserve fund

iv) General reserve fund

Retained profits brought forward from previous

financial year as in last audited accounts less any
accumulated losses, including current unaudited losses

Less: Goodwill, intangible asset disallowed, and

deferred taxes disallowed

SECONDARY Government grants and subsidies

CAPITAL - TIER 2
Debt divide equity capital instruments

Subordinated term debt, subject to the prescribed limit

Page 7
BMBM 5103 BANK MANAGEMENT
 Reserves arising from the revaluation of premises,
provided it is approved by the Bank, subject to the
following conditions:

a. Based on excess of forced sale value over net book value,

or 50% of the excess of fair market value over net book
value, whichever is lower;

b. Revaluation is permitted only after a period of 10 years

from the date of purchase or from the date of last
revaluation, whichever is later; and

Allowance allocated for potential loan and lease losses

Page 8
BMBM 5103 BANK MANAGEMENT
4.0 FUNCTION OF BANK CAPITAL

Bank Negara Malaysia (the Central Bank of Malaysia), is a statutory body which started
operations on 26 January 1959. Bank Negara Malaysia is governed by the Central Bank
of Malaysia Act 2009. The role of Bank Negara Malaysia is to promote monetary and
financial stability.
Absorbing Losses Cushion against losses arising from problematic assets
- It reduces the potential outflows in the event of failure.
Banks with higher proportions of equity capital have the
capability to issue new debt or make further share issues to
replace depleted cash inflows.
- It allows the bank to buy time to correct issues arising from
Problematic assets.
Financial It allows banks to access financial markets.
Markets It has ability to increase its capability to give out loans
during periods of shrinking deposits.
- The access to financial markets allows it to borrow in the
long term in an uninsured form, as well as, issue equity to
raise capital
The borrowing costs of banks are reduced due to capital
buffers
- Banks would be able to issue further debt to overcome
liquidity problems because the market value remains
positive.

Regulation Promote financial sector stability through the progressive

development
- It promotes financial infrastructure and enabling a

Page 9
BMBM 5103 BANK MANAGEMENT
 competitive local financial industry to be resilient against
the changing future environment
- initiatives to enhance access to financing

Page 10
BMBM 5103 BANK MANAGEMENT
5.0 CAPITAL IS ADEQUATE IN BANKING ENVIRONMENT IN MALAYSIA

Capital requirement provides a scenario of conflicting interests. Banks are inclined to

reduce capital reserve which allows them to increase the equity multiplier via the use of
higher levels of leverage. The higher equity multiple would lead to a bank with a normal
level of ROA to have a high level of ROE. It leads to a more stable financial system with
a safer banks and viable insurance funds.

LIMITATIONS
Formal Standards Mainly looks at the market risk and credit risk aspect, as the
official capital requirements is dependent on the asset mix
Book Value of Equity approach adopted is susceptible to manipulation by banks via
use of accounting approaches and it will overvalue the true
market

THE EFFECT OF CAPITAL REQUIREMENT ON BANK ENVIRONMENT

The effect of capital requirements has generally very limited impact on the operations of
large banks because of their reputation and ability to access financial markets to raise
funds via equity issues, as well as, subordinated liabilities.

Limitation on Generating greater levels of fee income or increasingly

growth accepting riskier loans in their portfolio
Banks would then be able to offset any potential future losses
and higher capital requirements from the higher expected profits
Internally generated surpluses to support capital requirements
are constrained by capital requirements.
Captures the relationship between required levels of earnings
and dividend pay-outs and additional share issues

Page 11
BMBM 5103 BANK MANAGEMENT
Capital Mix Alter the capital mix by raising capital from external sources
Smaller banks often sell their shares to a larger financial
holding company which would provide it greater access to
financial markets in order to obtain funds.
Larger banks thus resort to issuing long term convertible debt
securities.

Asset The response to the risk-based capital requirements from banks

Composition has been mixed. Risk-adverse bank managers opted to reduce
riskiness by changing the asset composition to lower overall
risk which has in turn reduced profitability and the ability to
generate internally sourced capital.
Other banks responded by pursuing higher risk portfolios or
shifting high risk assets off their balance sheets. This has
increased overall riskiness of the banking sector.
If the central bank tightens its monetary policy, it would lead to
lowered profitability for banks which limits its capital
accumulation and thus raising its riskiness.
Banks with limited ability to issue new shares would resort to
reduced lending to meet capital requirements set by the
regulator.

Pricing Re-pricing of riskier assets to compensate for higher levels of

capital requirements
Banks were forced to raise rates for loans which are considered
to be high risk and lower rates for lower risk loans
Banks have the advantage of specialising in giving loans to
problematic customers

Size Reduction in the size of banks because the capital requirement

has resulted in shrinking of asset base

Page 12
BMBM 5103 BANK MANAGEMENT
 The requirement has witnessed banks which face difficulty in
raising capital merging with stronger banks in order to survive.

Page 13
BMBM 5103 BANK MANAGEMENT
6. 0 WHY MOST BANKS PREFER TO OPERATE WITH LESS CAPITAL?

Banks have several reasons to prefer high leverage, or less capital.

a) Bankers Pay

It is a measure of a banks profitability is its return on equity. It is divided by banks

profit and equity. Bankers can improve the return on equity either by increasing profits or
reducing the equity, or doing both. By reducing equity, bank will increase return on
equity even if profits are flats. Bank employees have an in-built incentive to cut equity
wherever they can.

b) Buy Bank Debts

Some investors who buy bank debt, for example bank bonds, expect large banks to be
bailed out by the government if they get into difficulty. This implicit guarantee acts as an
indirect subsidy to large banks by making their debt funding cheaper than it should be. It
encourages banks to load up with as much debt as they can instead of comparatively
more expensive equity.

c) Forecasted pro-forma balance sheets and income statements

The statements are prepared based on an assumed retention ratio. This allows for the
planning of risks and returns. The planning process allows managers to identify any
potential gaps in funding to finance future asset growth. The gap then has to be filled via
external source of capital. Managers also plan for flexibility by varying the external
sources of capital which reduces limitations on further issues to raise capital from a
particular source.

Page 14
BMBM 5103 BANK MANAGEMENT
d) Sound capital planning

Sound capital planning allows management to sustain asset growth whilst managing
liability needs. However, the planning process is severely limited because earnings are
often overstated which allows banks to meet capital requirements without much
difficulty. Regulators would have to intervene and make recommendations for
adjustments in order to negate the deficiency in capital requirements.

Page 15
BMBM 5103 BANK MANAGEMENT
7.0 REFERENCES
1. (n.d.). Retrieved from Basel Committee on Banking Supervision - overview:
https://www.bis.org/bcbs/

2. (n.d.). Retrieved from The Basel Committee on Banking Supervision (BCBS):

http://www.europarl.europa.eu/RegData/etudes/BRIE/2017/587390/IPOL_BRI(2
017)587390_EN.pdf

3. Ashcraft, A. B. (2001). New evidence on the lending channel. Federal Reserve Bank of
New York. , 136.

4. Azman bin Othman Luk, K. F. (n.d.). Retrieved from

https://uk.practicallaw.thomsonreuters.com/w-008-
0538?transitionType=Default&contextData=(sc.Default)&firstPage=true&bhcp=1

5. Bolton, P., & Freixas, X. (2001). Corporate finance and the monetary transmission
mechanism. Discussion paper series 2982. CEPR.

6. Bankscope Database. (n.d.). Retrieved from https://bankscope.bvdinfo.com/ version-

20161117/home.serv?product=scope2006

7. Diamond, D. (1984). Financial intermediation and delegated monitoring, Review of

Economic Studies , 51, 393-414.

8. Idris, A. N. (2017, MAY 04). Retrieved from Minimum capital funds requirements
introduced for banks: http://www.theedgemarkets.com/article/minimum-capital-
funds-requirements-introduced-banks

9. James, C. (1991). The losses realized in bank failures. Journal of Finance , 46,
12231242.

10. MALAYSIA, B. N. (2017, MAY 3). Retrieved from

http://www.bnm.gov.my/index.php?ch=57&pg=137&ac=590&bb=file

Page 16
BMBM 5103 BANK MANAGEMENT
 Page 17
BMBM 5103 BANK MANAGEMENT