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Solutions for End-of-Chapter Questions and Problems: Chapter Twenty
1. Identify and briefly discuss the importance of the five functions of an FI’s capital?
2. Why are regulators concerned with the levels of capital held by an FI compared with those
held by a nonfinancial institution?
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3. What is the difference between the economic definition of capital and the book value
definition of capital?
The book value definition of capital is the value of assets minus liabilities as found on the
balance sheet. This amount often is referred to as accounting net worth. The economic definition
of capital is the difference between the market value of assets and the market value of liabilities.
a. How does economic value accounting recognize the adverse effects of credit risk?
b. How does book value accounting recognize the adverse effects of credit risk?
4. Why is the market value of equity a better measure of an FI‘s ability to absorb losses than
book value of equity?
5. State Bank has the following year-end balance sheet (in millions):
Assets Liabilities and Equity
Cash $10 Deposits $90
Loans 90 Equity 10
Total assets $100 Total liabilities and equity $100
The loans primarily are fixed-rate, medium-term loans, while the deposits are either short-
term or variable-rate deposits. Rising interest rates have caused the failure of a key
industrial company, and as a result, 3 percent of the loans are considered uncollectable and
thus have no economic value. One-third of these uncollectable loans will be charged off.
Further, the increase in interest rates has caused a 5 percent decrease in the market value of
the remaining loans. What is the impact on the balance sheet after the necessary
adjustments are made according to book value accounting? According to market value
accounting?
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Education.
Under book value accounting, the only adjustment is to charge off $1 million (0.03 x 1/3) percent
of the loans. Thus, the loan portfolio will decrease by $0.90million ($90m x 0.03 x 1/3) and a
corresponding adjustment will occur in the equity account. The new book value of equity will be
$9.10 million. We assume no tax affects.
Under market value accounting, the 3 percent decrease in loan value will be recognized, as will
the 5 percent decrease in market value of the remaining loans. Thus, equity will decrease by 0.03
x $90m + 0.05 x $90m(1 – 0.03) = $7.065 million. The new market value of equity will be
$2.935 million.
6. What are the arguments for and against the use of market value accounting for DIs?
7. What is the significance of prompt corrective action as specified by the FDICIA
legislation?
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8. What is the Basel Agreement?
9. What are the major features of the Basel III capital requirements?
10. What are the definitional differences between CET1, Tier I and Tier II capital?
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Education.
Tier I capital is the primary capital of the DI plus additional capital elements. Tier I capital is the
sum of CET1 capital and additional Tier I capital. Included in additional Tier I capital are other
options available to absorb losses of the bank beyond common equity. These consist of
instruments with no maturity dates or incentives to redeem, e.g., noncumulative perpetual
preferred stock. These instruments may be callable by the issuer after 5 years only if they are
replaced with “better” capital.
Tier II capital is supplementary capital. Tier II capital is a broad array of secondary “equity like”
capital resources. It includes a DI’s loan loss reserves assets plus various convertible and
subordinated debt instruments with maximum caps.
11. Under Basel III, what four capital ratios must DIs calculate and monitor?
12. What are the credit risk-adjusted assets in the denominator of the common equity Tier I
(CET1) risk-based capital ratio, the Tier I risk-based capital ratio, and the total risk-based capital
ratio?
13. How is the leverage ratio for an FI defined?
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14. Identify the five zones of capital adequacy and explain the mandatory regulatory actions
corresponding to each zone.
15. Explain the process of calculating credit risk-adjusted on-balance-sheet assets.
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16. Under Basel III, how are residential 1-4 family mortgages assigned to a credit risk class?
17. Under Basel III, how are risk weights for sovereign exposures are determined?
Risk weights for sovereign exposures are determined using OECD Country Risk Classifications
(CRCs). A sovereign is a central government (including the U.S. government) or an agency,
18. National Bank has the following balance sheet (in millions) and has no off-balance-sheet
activities.
Assets Liabilities and Equity
Cash $20 Deposits $960
Treasury bills 40 Subordinated debentures 25
Residential mortgages Common stock 45
(category 1; loan-to-value Retained earnings 40
ratio = 70%) 600 Total liabilities and equity $1,090
Business loans 430
Total assets $1,090
a. What is the CET1 risk-based ratio?
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b. What is the Tier I risk-based capital ratio?
c. What is the total risk-based capital ratio?
d. What is the leverage ratio?
e. In what capital risk category would the bank be placed?
19. What is the capital conservation buffer? How would this buffer affect your answers to
question 18?
Basel III introduced a capital conservation buffer designed to ensure that DIs build up a capital
surplus, or buffer, outside periods of financial stress which can be drawn down as losses are
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20. What is the countercylical capital buffer? If the home country set a countercyclical capital
buffer of 1.5 percent, how would this buffer affect your answers to question 18?
21. Onshore Bank has $20 million in assets, with risk-adjusted assets of $10 million. CET1
capital is $500,000, additional Tier I capital is $50,000 and Tier II capital is $400,000. How
will each of the following transactions affect the value of the Tier I and total capital ratios?
What will the new value of each ratio be?
a. The bank repurchases $100,000 of common stock with cash.
b. The bank issues $2 million of CDs and uses the proceeds to issue category 1 mortgage
loans with a loan-to-value ratio of 80 percent.
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c. The bank receives $500,000 in deposits and invests them in T-bills.
d. The bank issues $800,000 in common stock and lends it to help finance a new shopping
mall.
e. The bank issues $1 million in nonqualifying perpetual preferred stock and purchases
general obligation municipal bonds.
f. Homeowners pay back $4 million of category 1 mortgages with loan-to-value ratios of
40 percent and the bank uses the proceeds to build new ATMs.
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22. Explain the process of calculating risk-adjusted off-balance-sheet contingent guaranty
contracts?
a. What is the basis for differentiating the credit equivalent amounts of contingent
guaranty contracts?
b. On what basis are the risk weights for the credit equivalent amounts differentiated?
23. Explain how off-balance-sheet market contracts, or derivative instruments, differ from
contingent guaranty contracts.
a. What is counterparty credit risk?
b. Why do exchange-traded derivative security contracts have no capital requirements?
c. What is the difference between the potential exposure and the current exposure of over-
the-counter derivative contracts?
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Education.
The potential exposure is the portion of the credit equivalent amount that would be at risk if the
counterparty to the contract defaulted in the future. The current exposure is the cost of replacing
the contract if the counterparty defaulted today.
d. Why are the credit conversion factors for the potential exposure of foreign exchange
contracts greater than they are for interest rate contracts?
e. Why do regulators not allow DIs to benefit from positive current exposure values?
24. What are G-SIBs? How do capital ratio requirements differ for these FIs?
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25. Identify and discuss the problems in the risk-based capital approach to measuring capital
adequacy.
First the risk weights may not be true representations of the correct or necessary weights, or they
may not be in the correct proportion to each other. For example, does a weight of 100 percent
imply twice as much risk as a weight of 50 percent? Further, under Basel III all business loans
are given a single 100 percent risk weight regardless of the risk of the business. Thus, loans
made to AAA rated companies are assigned a credit risk weight of 1, as are loans made to CCC
rated companies. That is, within a broad risk weight class, such as commercial loans, credit risk
quality differences are not recognized. This may create perverse incentives for DIs to pursue
lower quality customers thereby increasing the risk of the DI.
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26. What is the contribution to the credit risk-adjusted asset base of the following items under
Basel III requirements?
Risk
weight
a. $10 million cash reserves. 0% $0
b. $50 million 91-day U.S. Treasury bills 0 $0
c. $25 million cash items in the process
of collection. 20 $5 million
d. $5 million U.K. government bonds,
OECD CRD rated 1 0 $0
e. $5 million French short-term
government bonds, OECD CRD rated 2 20 $1 million
f. $1 million general obligation municipal
bonds 20 $200,000
g. $40 million repurchase agreements
(against U.S. Treasuries) 20 $8 million
h. $2 million loan to foreign bank, OECD rated 3 50 $1 million
i. $500 million 1-4 family home mortgages, 50 $250 million
category 1, loan-to-value ratio 80%