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Capital is a key requirement for successfully operating financial institutions, representing the commitment of money and property that the bank's owners have made to their institution. And based on their long experience, regulators note that capital is essential for the long-term success of an institution's operations.
Capital supports all aspects of the operations of an institution, and minimum levels of capital are mandated by laws and regulation. One of these laws defines prompt corrective action (PCA) on the part of the regulators if capital levels are not maintained, and it mandates minimum levels of capital during the ongoing operations of the bank. Other capital restrictions relate to specific circumstances, such as initial capital, investments in bank premises, and the payment of dividends.
Because capital is considered so vital to the safe operation of a financial institution, raising capital is a key step in the ultimate success of a new bank. The amount of capital necessary for any bank will be influenced by several factors, including the bank's prospects for growth, as well as its mission. Traditional sources of bank capital include funds raised from the founders group, from the foundation of a bank holding company, from supporting financial institutions, and also from special sources of funding available for community development banks.
The process of capital offering is very important to a new bank. One initial important step is to seek competent legal counsel. The chartering and regulatory process is very complex, and sound advice will make the process easier.
Generally, the new community bank or MOI will directly issue common stock. However, the bank may have a more complex capital issuance if it involves a holding company formation at the time the bank is opened. Occasionally, the new bank will propose that the founding group receive initial stock options in the form of organizer warrants at favorable terms, compared with other stockholders. Organizers should be aware of FDIC policies, which generally discourage these types of options.
The size of the offering is generally determined by the proposed growth and development plan of the bank. The offering should be large enough to capitalize the bank for the scope of its initial operations and those in the foreseeable future.
In the case of a new bank with significant growth opportunities that seeks to raise large amounts of capital from a sizable group, the new bank will use an underwriting firm. These firms offer shares of the new bank to investors on one of two bases: either as a "commitment" or as "best efforts." The commitment method requires the underwriter to sell a fixed number of shares, frequently at a fixed price. If investors fail to purchase the required amount of stock, the underwriter remains obligated to buy the remaining shares. The best efforts method, on the other hand, does not require the underwriting firm to buy unsubscribed stock. Thus, the best efforts approach, while considerably less expensive for the stock issuer, does not ensure that the required amount of stock will be issued. In either case, a new stock issuer should be cognizant of SEC and state securities rules.
The Bank Holding Company Act provides rules that govern the investment in bank and bank holding company stock by corporations, trusts, and certain other companies.
If a company owns or controls 25 percent or more of the total equity capital of a bank or BHC (even nonvoting stock), the investing company is deemed to have a controlling influence over the bank/BHC. There have been exceptions where the Federal Reserve has permitted a company to own more than 25 percent of the total equity of an MOI/BHC without being considered as controlling it. The Federal Reserve will continue to show flexibility for allowing nonvoting equity investments between 25 and 50 percent, particularly in troubled situations, but with requisite conditions. When the Federal Reserve permits nonvoting equity investments above 25 percent, it may require passivity commitments, no interlocks, and limited business relationships.
The law commonly known as the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, establishes certain minimum capital standards for financial institutions. The purpose of these minimums is to require regulators to take prompt action in closing distressed institutions. Prompt closure preserves the FDIC's insurance funds and prevents essentially bankrupt financial institutions from making imprudent financial decisions.
The statute calls for regulators to take specific regulatory action or impose restrictions on a bank's ability to operate when a bank is less than "well-capitalized." The law defines different capital levels: well-capitalized, adequately capitalized, undercapitalized, and significantly undercapitalized.
FDICIA defines well-capitalized as meeting the minimum thresholds of several capital ratios. In general, the ratios required consist of two parts: a capital amount and an asset base.
The FDICIA prompt corrective action (PCA) system uses the definitions of capital and assets found in the Board of Governors Capital Adequacy Guidelines, which offers guidance on the classification of equity and debt instruments considered capital and the weighting for various asset classes. The capital adequacy guidelines and their application involve many different treatments and weightings.
While it is an oversimplification, capital in Basel I accords consists of two parts:
The calculations use two different asset bases: total assets and risk-weighted assets.
In order to operate without regulatory restrictions, an institution must be well-capitalized. To be well-capitalized, a bank must have:
The minimum capital ratio described in the prompt corrective action guideline is not applied directly to de novo banks. At inception, before accepting deposits and other funds, the bank has a 100 percent tier 1 leverage ratio. This makes the dollar amount of initial capitalization more important. The views of the chartering authorities, the state, and the Office of the Comptroller of the Currency (OCC) will be important, as will the views of the other federal financial institution regulators, especially the bank regulators the Federal Reserve System and the FDIC.
As described more fully in De Novo Bank Application Process, the location, growth prospects, and risk profile of the bank will all affect the initial capital requirement. Generally speaking, a charter in an urban area where projections and market studies indicate significant growth prospects will require a larger initial capital base than a new bank in a more slowly growing or less populous area.
In general, new banks will incur losses in their initial operating periods, and the initial capital should be sufficient to allow the bank to grow its operations to a sustainable level. Normally, bank regulators look at a three-year period as sufficient for a bank to establish itself.
Also, all regulators expect capital to be higher for de novo banks for the first three years. Among federal financial regulators, the new bank must project to have and maintain a leverage capital ratio of 8–9 percent of total assets for the first three years of operation.1
A well-rated and well-capitalized bank may invest an amount that is 150 percent or less of the amount of: (1) its perpetual preferred stock and related surplus and (2) its common stock and surplus.2
Three major federal statutory limitations govern the payment of dividends by banks. These limitations, included in Sections 1831o, 56, and 60 of title 12 of the United States Code (12 USC 1831o, 56, and 60), apply to cash dividends or property dividends. Stock dividends may be paid regardless of the statutory limitations, since such dividends do not reduce the bank's capital. For additional detail, see Section 4070.1 of the Commercial Bank Examination Manual.
A bank's capital structure can include various types of capital instruments, including common and perpetual preferred stock, limited life capital instruments (e.g., limited life preferred stock), and some senior class debt instruments (e.g., subordinated debt). Bank regulators consider the type and amount of the various types and classes of stock and look for a substantial amount of capital in the form of common stock.3
Bank holding companies are corporations, trusts, and certain other groups and entities that own the stock of a bank or other bank holding company. The Federal Reserve System is the sole federal regulator of bank holding companies. The FRS closely monitors the financial structure of these companies, reviews the debt-to-equity of these entities, and monitors — and in some cases restricts — the scope of the nonbanking activities that a bank holding company performs.4
Bank holding companies are useful in the capital issuance process, since they can issue equity capital debt instruments that provide the benefits of capital but may not dilute the ownership of the founding group. A relatively new type of capital instrument that can be used to raise new capital is trust preferred securities. Trust preferred securities can be sold to outside parties without yielding control of voting stock or diluting the percentage of ownership. Groups have been formed to pool the trust preferred stock issued by a number of small bank holding companies. This pooling reduces the risk of the stock of these companies to the holder of the ownership interests in the pool.
As the regulator of bank holding companies, the Federal Reserve System oversees these instruments by determining the terms and conditions under which they will count as elements of capital at the bank holding company. The Federal Reserve System has issued final rules on trust preferred securities, describing the appropriate terms and conditions.5
Some capital programs exist for banks with specialized focus. Through its Community Development Financial Institutions (CDFI) initiative, the Federal National Mortgage Corporation, or Fannie Mae, provides investment capital to community-based financial institutions and intermediaries that directly support affordable housing development.
Certain institutions have special rights that enhance their ability to raise capital stock. For example, community development banks (CDBs) can qualify for the right to issue equity stock that has tax benefits for the purchaser. This makes it a better after-tax investment for the purchaser and easier for the CDB to sell equity. The new markets tax credit program offers information on becoming a CDB.