Capital Management: Wells Fargo vs. BoA.

Bank Management and Financial Services
Individual Assignment 2

Report of discussion about banking capital issuecompare 2 banks: Wells Fargo and Bank of America.

Prepared by Phan Ngọc Mẫn Student code: FB00422 Class: FB0605.

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Capital Management: Wells Fargo vs. BoA.

Content
Executive Summary----------------------------------------------------------------------------------3 I. Introduction-----------------------------------------------------------------------------------------------3 1. Theoretical Overview--------------------------------------------------------------------------------------3 a. Bank capital-------------------------------------------------------------------------------------------3 b. Capital Risk of banks---------------------------------------------------------------------------------4 c. Managing capital risk in commercial banks-------------------------------------------------------5 2. Banks’ Profile------------------------------------------------------------------------------------------6 a. Wells Fargo-----------------------------------------------------------------------------------------------6 b. Bank of America-----------------------------------------------------------------------------------------7 c. Differences in economic context-------------------------------------------------------------------7 II. Analysis and Findings-------------------------------------------------------------------------------------7 1. Capital Ratios--------------------------------------------------------------------------------------------7 2. Risk-weighted assets------------------------------------------------------------------------------------11 3. GFC and capital risk of the two banks-----------------------------------------------------------------16 III. Conclusion/ Recommendations--------------------------------------------------------------------------17 Reference----------------------------------------------------------------------------------------------------17

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Capital Management: Wells Fargo vs. BoA.

Executive Summary
Generally in banking sector, capital is one of the most important issues. Raising sufficient capital and retaining enough capital to protect the interests of customers, employees, owners and the general public is one of the challenges in the management of financial-service providers. In this report writer will focus on the main matters of banking management and concretized by facts and figures from 2 US typical commercial: Wells Fargo and Bank of America. The report will be divided into 3 main parts:    Introduction about theories and banks Analysis and findings Conclusions/recommendations

I.

Introduction

1. Theoretical Overview
a. Bank capital
The economists have given the concept of capital in a commercial bank as: “The capital of a commercial bank is monetary values which are created itself or mobilized used for making loans, investing or doing other business.” In both daily and long-run operation, capital has an essential role and performs many tasks as listing following:

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Capital Management: Wells Fargo vs. BoA. - To provide a cushion against the risk of failure by absorbing losses until management can solve problems and restore its liquidity - To provide funds needed to charter, organize and operate before other sources of funds com flowing in - To promote public confidence - To provide funds for developing new services and facilities - To serve as a regulator of growth and help to ensure that growth is sustainable in the long run - To limit how much risk exposure a bank can accept

b. Capital Risk of banks
Capital and risk are related to each other closely. Capital mainly comes from the funds distributed by owners so it can lead to the owner’s risk. When banks cannot earn enough as the expected return of owners, they can stop to invest in the banks. Thus, this part will point out some key risks in banking management concerning to the capital. Credit risk: This risk occurs when borrowers fail to make some or all of their promises to repay the loans, or when banks invest in the more risk securities and also receive nothing from it. These things will erode banks’ capital and at a point that banks cannot fend against, they will be gone bankrupt or merged. Liquidity risk: The danger of running out of cash when it is needed to cover deposit withdrawals and to meet credit requests from customers as well as to pay for operational expenses. If the bad situation occurs,

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Capital Management: Wells Fargo vs. BoA. banks will lose their public confidence and depositors will withdraw their money at the same time and cause the shortage of capital. Interest rate risk: The danger that revenues from earning assets will decline or the interest expenses will increase, the spread between revenues and expenses and therefore reduce net income. So it related closely to portfolio management decisions to reduce maximum loss for bank. Operational risk: This risk relates to the unexpected situations such as natural disasters, mistakes in operation system, etc. These changes will directly affect to the operating expenses lead to negative effects on revenue flows of banks. Exchange risk: It occurs when banks deal with foreign currency transactions. They cannot control over the price fluctuation of currency on its market. Therefore, they never can make sure that they will gain money from this kind of service. It always hidden potential risks causing the loss for banks. Crime risk: Fraud or embezzlement by employees or directors can lead to failures of banks. This kind of risk not only causes the losing money but also the damage of operation system and reputation as well.

c. Managing capital risk in commercial banks
Due to important roles as mentioned above and the relationships among risks, how to manage capital efficiently is an issue which bank managers need to concern about. Capital management can be understood as the way a bank maintains its capital structure, mobilizes 5|Page

Capital Management: Wells Fargo vs. BoA. and uses capital in making benefits. In conclusion, managing capital in a commercial

bank is an essential part of banking management with the following purposes: - To maximize exploit unused funds from society - To ensure the stable capital growth rate - To cover the bank’s liquidity and operate effectively

2. Banks’ Profile
a. Wells Fargo
Wells Fargo & Company is an American multinational banking and financial services holding company with operations around the world. Wells Fargo is the fourth largest bank in the U.S. by assets and the largest bank by market capitalization. Wells Fargo is the second largest bank in deposits, home mortgage servicing, and debit cards. In 2011, Wells Fargo was the 23rd largest company in the United States.

In 2012, Wells Fargo had more than 9,000 retail branches and over 12,000 automated teller machines in 39 states and the District of Columbia. A "Big Four bank", it has over 270,000 employees and over 70 million customers. As of July 12, 2013, Wells Fargo became the world's biggest bank by market capitalization, worth $236 billion, beating to ICBC.

b. Bank of America

Bank of America Corporation is an American multinational banking and financial services corporation headquartered in Charlotte, North Carolina. It is the second largest bank holding company in the United States by assets. As of 2010, Bank of America is the fifth-largest company in

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Capital Management: Wells Fargo vs. BoA. the United States by total revenue, and the third-largest non-oil company in the U.S. (after Walmart and General Electric). In 2010, Forbes listed Bank of America as the third biggest company in the world. Bank of America is all about providing people, companies and institutional investors the financial products and services they need to help achieve their goals at every stage of their financial lives. Consumer Banking is the largest division in the company, and provides financial services to consumers and small businesses. The acquisition of FleetBoston and MBNA significantly expanded its size and range of services, resulting in about 51% of the company's total revenue in 2005. It competes primarily with the retail banking arms of America's three other megabanks: Citigroup, JPMorgan Chase, and Wells Fargo. The Consumer Banking organization includes over 5,800 retail branches and over 18,000 ATMs across the United States.

c. The common contextual situation

The framework for managing risks may not be effective in mitigating risk and loss to them. Their risk management framework seeks to mitigate risk and loss to the. They have established processes and procedures intended to identify, measure, monitor, report and analyze the types of risk to which they are subject, including liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal and compliance risk, and reputational risk, among others. However, as with any risk management framework, there are inherent limitations to our risk management strategies s there may exist, or develop in the future, risks that we have not appropriately anticipated or identified.

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Capital Management: Wells Fargo vs. BoA. Interest rate risk, which potentially can have a significant earnings impact, is an integral part of being a financial intermediary. They are subject to interest rate risk because:

• Assets and liabilities may mature or reprice at different times (for example, if assets reprice faster than liabilities and interest rates are generally falling, earnings will initially decline)

Assets and liabilities may reprice at the same time but by different amounts (for example, when the general level of interest rates is falling, they may reduce rates paid on checking and savings deposit accounts by an amount that is less than the general decline in market interest rates);

• Short-term and long-term market interest rates may change by different amounts (for example, the shape of the yield curve may affect new loan yields and funding costs differently);

• The remaining maturity of various assets or liabilities may shorten or lengthen as interest rates change (for example, if long-term mortgage interest rates decline sharply, mortgage backed securities (MBS) held in the AFS securities portfolio may prepay significantly

earlier than anticipated, which could reduce portfolio income); or

• Interest rates may also have a direct or indirect effect on loan demand, credit losses, mortgage origination volume, the fair value of mortgage servicing rights (MSRs) and other

financial instruments, the value of the pension liability and other items affecting earnings. They perform a comprehensive analysis to determine the specific liquidity events expected to occur under the conditions specified in the scenario. In their analysis, they quantify the potential outflows of cash and the related impacts to interest income and expense that might arise by

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Capital Management: Wells Fargo vs. BoA. considering factors such as the runoff of consumer and commercial deposits, the nonrenewal of maturing wholesale funding sources, the drawdown of committed customer lines of credit, and the need for additional collateral requirements.

In 2010, the BCBS announced new regulatory capital requirements (commonly referred to as “Basel III”) aimed at substantially strengthening existing capital requirements,

through a combination of higher minimum capital requirements, new capital conservation buffers, and more stringent definitions of capital and exposure. Basel III would impose a new "Common Equity Tier 1" requirement of up to 7%, comprised of a minimum of 4.5% plus a capital conservation buffer of up to 2.5%. The BCBS has also stated that from time to time it may require an additional, counter-cyclical capital buffer on top of Basel III standards.

II.

Analysis and Findings

1. Capital Ratio
a. Bank of America ( BoA)

Bank of America ( BoA)built a fortress balance sheet that gives us the platform to accelerate business growth. They reduced long-term debt by nearly $100 billion from the end of 2011 while maintaining significant excess liquidity of $372 billion. The capital is at industry-leading levels. BoA ended the year with a Tier 1 common capital ratio under Basel 1 of 11.06 percent, a more than 3 percentage point improvement from three years ago. Although the industry has until 2019 to meet the more stringent requirements of the Basel 3 standards, their estimated Tier 1 common capital ratio under those standards today exceeds the minimum requirement —six years before full

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Capital Management: Wells Fargo vs. BoA. implementation. BoA simplified company and they have more than adequate capital to support the strategic plans. To meet minimum, adequately capitalized regulatory requirements, an institution must maintain a Tier 1 capital ratio of four percent and a Total capital ratio of eight percent. A “well capitalized” institution must generally maintain capital ratios 200 bps higher than the minimum guidelines. The risk-based capital rules have been further supplemented by a Tier 1 leverage ratio, defined as Tier 1 capital divided by quarterly average total assets, after certain adjustments. BHCs must have a minimum Tier 1 leverage ratio of at least four percent. National banks must maintain a Tier 1 leverage ratio of at least five percent to be classified as “well-capitalized.” Failure to meet the capital requirements established by the joint agencies can lead to certain mandatory and discretionary actions by regulators that could have a material adverse effect on the Corporation’s financial position. At December 31, 2012, the Corporation’s Tier 1 capital, Total capital and Tier 1 leverage ratios were 12.89 percent, 16.31 percent and 7.37 percent, respectively. The capital composition at December 31, 2012 and 2011 :

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Under Basel 1, Tier 1 common capital increased $6.7 billion in 2012 to $133.4 billion at December 31, 2012. The increase was primarily driven by earnings eligible to be included in capital, which positively impacted the Tier 1 common capital ratio by approximately 59 bps, including the impact of repurchases of certain of our debt and Trust Securities. The Tier 1 common capital ratio also benefited seven bps from the issuance of common stock in lieu of cash for a portion of employee incentive compensation. Total capital decreased $18.4 billion in 2012 to $196.7 billion at December 31, 2012 primarily due to a reduction in subordinated debt as a result of redemptions and a reduction in Trust Securities from redemptions and exchanges. The following table presents Bank of America Corporation’s capital ratios and related information in accordance with Basel 1 at December 31, 2012 and 2011.

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2. Risk-weighted assets
a. Wells Fargo

Risk-based capital Tier 1 capital Total capital Tier 1 Leverage Tier 1 common equity

Q3’ 2013 12.15% 15.14% 9.76% 16.64%

Q3’ 2012 11.50% 15.03% 9.40% 9.92%

Wells Fargo pro forma Tier 1 common equity to risk-weighted assets ratio declined 0.7% over the nine quarter test horizon reflecting both a cumulative reduction in Tier 1 common equity and assumed increases in risk-weighted assets by the end of the test horizon. Pro forma Tier 1 common equity declines primarily as a result of a

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Capital Management: Wells Fargo vs. BoA. combination of reduced income estimated under the Scenario conditions and mandated assumed capital distributions. The increase in pro forma risk-weighted assets by the end of the test horizon reflects both assumed balance sheet growth and a shift from assets that carry a higher risk weighting to assets with lower risk- weightings. Pro forma Tier 1 and Total risk-based capital ratios were projected to decline an additional 0.3% and 0.7%, respectively, by the end of the nine quarter period due to amortization of regulatory capital instruments. The 1.1% decrease in pro forma Tier 1 leverage ratio was due to the lower ending Tier 1 capital and assumed growth in average consolidated assets over the stress test horizon.

b. Bank of America

BANA’s Tier 1 capital ratio increased 70 bps to 12.44 percent and the Total capital ratio decreased 41 bps to 14.76 percent at December 31, 2012 compared to December 31, 2011. The Tier 1 leverage ratio decreased six bps to 8.59 percent at December 31, 2012 compared to December 31, 2011. The increase in the Tier 1 capital ratio was driven by earnings eligible to be included in capital of $12.3 billion and a decrease in risk weighted assets of $69.1 billion compared to the prior year, largely offset by dividends paid to the Corporation of $14.1 billion during 2012. The decrease in the Total capital ratio was driven by a $12.0 billion decrease in qualifying subordinated debt, partially offset by the net impact of earnings eligible to be included in capital and a decrease in risk-weighted 13 | P a g e

Capital Management: Wells Fargo vs. BoA. assets. The decrease in the Tier 1 leverage ratio was driven by a decrease in Tier 1 capital, partially offset by a decrease in adjusted quarterly average total assets. FIA’s Tier 1 capital ratio decreased 29 bps to 17.34 percent and the Total capital ratio decreased 37 bps to 18.64 percent at December 31, 2012 compared to December 31, 2011. The Tier 1 leverage ratio decreased 55 bps to 13.67 percent at December 31, 2012 compared to December 31, 2011. The decrease in the Tier 1 capital and Total capital ratios was driven by returns of capital of $6.6 billion to the Corporation during 2012, partially offset by earnings eligible to be included in capital of $4.2 billion and a decrease in risk-weighted assets primarily due to a decrease in loans. The decrease in the Tier 1 leverage ratio was driven by the decrease in Tier 1 capital, partially offset by a decrease in adjusted quarterly average total assets of $12.0 In 2011, the Basel Committee on Banking Supervision issued proposed guidance on capital requirements for global, systemically important financial institutions, including the methodology for measuring systemic importance, the additional capital required, and the arrangements by which the guidance will be phased in. On December 20, 2011, the Federal Reserve issued proposed rules to implement enhanced supervisory and prudential requirements, and the early remediation requirements established under the Financial Reform Act. The enhanced standards include liquidity standards, requirements for overall risk management, single-counterparty credit limits, stress test requirements and a debt-to-equity limit for certain companies determined to pose a threat to financial stability. Preparing for the implementation of the new capital rules is atop strategic priority, and to comply with the final rules when issued and effective. Based on Basel 2, the Market Risk Final Rule and the current understanding of the Basel 3 Advanced Approach issued by U.S. banking regulators, BoA estimated Basel 3 Advanced Approach Tier 1 common capital ratio, on a fully phased-in basis, to be 14 | P a g e

Capital Management: Wells Fargo vs. BoA. 9.25 percent at December 31, 2012. As of December 31, 2012, we estimated that our Tier 1 common capital would be $128.6 billion and total risk-weighted assets would be $1,391 billion, also on a fully phased-in basis. This assumes approval by U.S. banking regulators of our internal analytical models, but does not include the benefit of the removal of the surcharge applicable to the Comprehensive Risk Measure (CRM). The CRM is used to determine the risk-weighted assets for correlation trading positions. Under the Basel 3 NPRs, Tier 1 common capital includes components that exhibit heightened sensitivity to changes in interest rates, such as the cumulative change in the fair value of AFS debt securities and at least 10 percent of the fair value of MSRs recognized on the Corporation’s Consolidated Balance Sheet. Important differences between Basel 1 and Basel 3 include capital deductions related to BoA MSRs, deferred tax assets and defined benefit pension assets, and the inclusion of unrealized gains and losses on debt and equity securities recognized in accumulated OCI, each of which will be impacted by future changes in interest rates, overall earnings performance or other Corporate actions. The estimates under the Basel 3 Advanced Approach will be refined over time as a result of further rulemaking or clarification by U.S. banking regulators and as understanding and interpretation of the rules evolve. Basel 3 regulatory capital metrics are non-GAAP measures until they are fully adopted and required by U.S. banking regulators. Table 15 presents a reconciliation of our Basel 1 Tier 1 common capital and risk-weighted assets to our Basel 3 estimates at December 31, 2012, assuming fully phased-in measures according to the Basel 3 Advanced Approach.

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3. GFC and capital risk of the two banks
On October 28, 2008, Wells Fargo was the recipient of $25B of the Emergency Economic Stabilization Act Federal bail-out in the form of a preferred stock purchase. Tests by the Federal government revealed that Wells Fargo needs an additional 13.7 billion dollars in order to remain well capitalized if the economy were to deteriorate further under stress test scenarios. On May 11, 2009 Wells Fargo announced an additional stock offering which was completed on May 13, 2009.

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III.

Conclusion/ Recommendations
The similarities and differences between the distribution capital of two banks shown in above

comparison. This, however, should not be surprising since both systems are based on the same risk measure. Indeed, if we had arrayed banks by the amount of new capital they would have to raise, instead of by required levels, the rank orderings of banks in the two systems would have been identical. They differ in the arrangements shown only because some banks that would otherwise have higher risk hold more capital than required under the current system, and thus, would reduce their premiums. This does not mean that the two systems would have identical impacts on bank behavior or on overall system risk as argued earlier, the regulatory environment surrounding each system is likely to differ. If banks face prices for risk in the capital market different from those charged by the FDIC and HKMA, there will be inefficiencies in a risk-based capital standard that could produce different levels of system risk. The incentives for banks to alter their risk-taking activities are very likely to differ between the two systems. It is not clear, however, that the impact of such differences would be major. Both systems share a common basis in the principle of differentially regulating banks according to the risk

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Capital Management: Wells Fargo vs. BoA. they represent to society. Implementation of either type of system is likely to lead to significant progress in the battle to control bank risk

Reference
   Rose P. et al; 2010, Bank Management and financial services, McGraw Hill international edition. Investopedia’s defitions; available at http://www.investopedia.com/, [accessing date November 23rd]. Wells Fargo profile, available at https://www.wellsfargo.com/invest_relations/investment_profile, [accessing date November 24th]. Bank of America profile, available at https://www.bankofamerica.com/, [accessing date November 24th]. Financial crisis 2007-2008, available at http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308, [accessing date November 24th].

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