Capital Reserve Requirements

Question 1

Deficiencies in Capital Reserve Requirements

Answer 1

.1. Definition of Capital was diluted. Regulators allowed other instruments other than common stock in tier 1 Capital.

2. Tier 2 capital included hybrid instruments which have equity and debt characteristics (reserve, Convertible bonds)
3. Regulators allowed financial institutions to use their own internal risk parameters to calculate their risk adjusted capital ratio without any supervision. By doing so they assumed low correlation among assets on their B/S.
4. Recognition of off-balance sheet activity - Financial institutions exploited balance sheet activity by transfering their risk, as result they can reduce the capital requirements.
5. lack of reserve reuirements on Liquidity risk - Regulators and market assumed that MM funds always be available. However last crisi proved it can freeze.
6. Procyclicality of capital the capital reserve framework.

Question 2

Potential improvements on Capital Reserve Requirements

Answer 2

1. Stricter definition of capital, stricter parameter ranges for calculating risks that used in valuation models
2. reduce flexibility of internal valuation and capital ratio
3. Identifying off-balance sheet risk movements
4. introduce charge on a systemic risk
5. charge on a liquidity risk
   6, make the framework more anicyclical

Basel 3 Improvements
1. Introduced internationally harmonised leverage ratio

2. Increasing the level of transparency by requiring detailed disclosure about internal valuation measure assumption and calculations