Risk Management Manual of Examination Policies - FDIC

CAPITAL Section 2.1
from minimum leverage and risk-based standards and the
"Well Capitalized" and "Adequately Capitalized"
definitions that are used in the PCA regulations and certain
other capital-based rules. The minimums set forth in the
leverage and risk-based capital standards apply to sound,
well-run institutions. Most banks do, and generally are
expected to, maintain capital levels above the minimums,
based on the institution's particular risk profile. In all
cases, institutions should maintain capital commensurate
with the level and nature of risks to which they are
exposed, including the volume and severity of adversely
classified assets.
The capital adequacy of an institution is rated based upon,
but not limited to, an assessment of the following
evaluation factors:
The Level and Quality of Capital and the Overall
Financial Condition of the Institution
Capital, like all of the CAMELS components, cannot be
reviewed in a vacuum. The institution’s overall condition
is vitally important to the assessment of capital adequacy.
Asset quality problems can quickly deplete capital. Poor
earnings performance can hinder internal capital formation.
Examiner judgment is required to review capital adequacy
in relation to the institution’s overall condition.
Additionally, all capital is not created equally. While two
institutions may have very similar regulatory capital ratios,
the composition of such capital is important. For instance,
all things being equal, voting common equity is a preferred
capital source compared to hybrid capital instruments
given the debt-like features inherent in the latter.
The Ability of Management to Address Emerging
Needs for Additional Capital
Management’s ability to address emerging needs for
additional capital depends on many factors. A few of these
factors include earnings performance and growth
prospects, the financial capacity of the directorate, and the
strength of a holding company. A combination of ratio
analysis and examiner judgment is required to address this
evaluation factor.
The Nature, Trend, and Volume of Problem Assets, and
the Adequacy of the ALLL and Other Valuation
Reserves
The nature, trend, and volume of problem assets (including
off-balance sheet activity) and the ALLL adequacy are
vital factors in determining capital adequacy. The
examiner should reference prior Reports of Examination
and Uniform Bank Performance Report ratios to perform a
level and trend analysis. The review of the nature of
problem assets will require a careful analysis of
examination findings. The examiner may find the optional
Analysis of Loans Subject to Adverse Classification page
of the Report helpful in performing this analysis. In
reviewing the ALLL adequacy, the examiner will review
the bank’s ALLL methodology in accordance with
outstanding regulatory and accounting pronouncements.
Balance Sheet Composition, Including the Nature and
Amount of Intangible Assets, Market Risk,
Concentration Risk, and Risks Associated with
Nontraditional Activities
The quality, type, and diversification of on- and offbalance
sheet items are important with respect to the
review of capital adequacy. Examiners should ensure that
management identifies, measures, monitors, and controls
the balance sheet risks and that the economic substance of
the risks are recognized and appropriately managed. Riskweighted
capital ratios will help the examiner to a degree,
but judgment is required to adequately address capital
adequacy. Specifically, a portfolio of 100 percent riskweighted
commercial loans at two different institutions
may have different risk characteristics depending on the
risk tolerance of the management teams. Additionally,
regulatory capital ratios alone do not account for
concentration risk, market risk, or risks associated with
nontraditional activities on the balance sheet. Examiner
judgment is integral in assessing both the level of risk and
management’s ability to adequately manage such risk.
Risk Exposure Represented By Off-Balance Sheet
Activities
The risk exposure from off-balance sheet activities will
vary between institutions, but must be considered in the
capital evaluation. The volume and nature of business
transacted in a fiduciary capacity can be significant in the
assessment of capital needs. Contingencies where the bank
is acting in a fiduciary or nontraditional banking capacity
can expose the bank to surcharges and therefore,
operations, controls, and potential exposures must be
carefully appraised. Similarly, lawsuits involving the bank
as defendant or any other contingent liability, such as offbalance
sheet lending, may indicate a need for a greater
level of capital protection. Refer to the Contingent
Liabilities and Off-Balance Sheet Activities sections for
additional discussion.
The Quality and Strength of Earnings, and the
Reasonableness of Dividends
A bank's current and historical earnings record is one of the
key elements to consider when assessing capital adequacy.
Good earnings performance enables a bank to fund asset
Capital (12-04) 2.1-14 DSC Risk Management Manual of Examination
Policies
Federal Deposit Insurance Corporation