CH15 - Management of Capital (Reader)

Question 1

Why did the Basel committee put forward proposals?

Answer 1

To close the gap in international bank
supervision.

To ensure capital adequacy

To level the playing field regarding
internationally active banks

Question 2

What are documents of the Basel committee?

Answer 2

Principles for the Supervision of Banks’ Foreign Establishments (Basel Concordant)

International Convergence of Capital Measurements and Capital Standards (Capital Accord)

Amendments to the capital accord to incorporate market risks

Principles for the management of interest rate risk

Basel II: Revised international capital framework

Basel III: International regulatory framework for banks

Question 3

What is the fundamental object of the Basel II Accord?

Answer 3

This framework was intended to align
capital adequacy assessment more
closely with the key elements of banking
risks

To provide incentives for banks to
enhance their risk measurement and
management capabilities

Question 4

What are the three pillars of the Basel II Capital Accord?

Answer 4

– minimum capital requirements which seeks to develop and expand on the standardized rules
– a supervisory review of an institutions capital adequacy and internal assessment process
– effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices

Question 5

What is the underlying principle of Basel II framework?

Answer 5

Its underlying principles were intended to be suitable
for application to banks of varying levels of complexity
and sophistication

Question 6

How many countries have adopted the Basel II 1988 Accord?

Answer 6

More than 100 countries have adopted the
1988 Accord, and the Committee has consulted with supervisors
world-wide in developing the Basel II framework

Question 7

Why did the Basel committee consult with supervisors all around the world in developing the Basel II framework?

Answer 7

– to ensure that the principles embodied in the three
pillars of the new framework are generally suitable
to all types of banks around the globe.

– The Committee therefore expected the Basel II
Accord to be adhered to by all significant banks
after a certain period of time

Question 8

What is the First Pillar of Basel II?

Answer 8

Calculation of the total minimum capital requirements for Credit, Market and Operational risk

Question 9

What are the primary changes in Basel II?

Answer 9

• are in the approach to credit risk
• and in the inclusion of explicit capital requirements for operational risk

Question 10

List the three approaches under Credit Risk approach in Basel II

Answer 10

– the standardized approach
– the “foundation” / Securitisation Framework
– “advanced” internal ratings-based (IRB)
approaches

Question 11

Definition: Capital Adequacy Ratio (CAR)

Answer 11

the ratio of a bank’s capital in relation to its risk weighted assets and current liabilities

Question 12

What is the formula to calculate CAR?

Answer 12

Qualifying (Eligible) Regulatory Capital / Risk Weighted Assets

Question 13

What is the minimum requirement of CAR for Basel II?

Answer 13

8%

Question 14

Pillar 1: How many tiers are under Capital elements?

Answer 14

3 tiers

Question 15

Pillar 1: What elements are under tier 1?

Answer 15

Paid-up share capital / common stock
Disclosed reserves

Question 16

Pillar 1: What elements are under tier 2?

Answer 16

Undisclosed reserves
Asset revaluation reserves
General provisions
Hybrid (debit/equity) capital instruments
Subordinated debt

Question 17

Pillar 1: What elements are under tier 3?

Answer 17

Short-term subordinated debt

Question 18

List and explain what is included in tier 1?

Answer 18

Includes only permanent shareholders equity and disclosed reserves. In the case of consolidated accounts, this also includes minority interests in the equity of subsidiaries that are less than wholly owned

Question 19

Tier 2: Explain Undisclosed reserves

Answer 19

are eligible for inclusion within supplementary elements provided these reserves are accepted by the supervisor. Such reserves consist of that part of the accumulated after-tax surplus of retained profits which banks in some countries may be permitted to maintain as an undisclosed reserve

Question 20

Tier 2: Explain Revaluation reserve

Answer 20

Reflected in two ways

• In some countries, banks are permitted to revalue fixed assets, normally their own premises from time to time in line with the change in market values. These revaluations are reflected in the face of the balance sheet as revaluation reserve
• be present as a result of long-term holdings of equity securities valued in the balance sheet at the historic cost of acquisition

Question 21

Tier 2: Explain Hybrid (debit/equity) capital requirements

Answer 21

Includes a range of instruments that combine characteristics of equity capital and debit

Should meet these requirements
- they are unsecured, subordinated and fully paid up
- they are not redeemable at the initiative of the holder or without the
prior consent of the supervisory authority;
- they are available to participate in losses without the bank being
obliged to cease trading (unlike conventional subordinated debt)·

Question 22

Tier 2: Explain Subordinated term debt

Answer 22

include. conventional unsecured subordinated debt capital instruments with a minimum original fixed term to maturity of over five years and limited life redeemable preference shares. These instruments will be limited to a maximum of 50% of Tier 1

Question 23

List 4 conditions that Tier 3 capital will be subject to

Answer 23

a) It should have an original maturity of at least two years and will be limited to 250% of the bank’s tier l capital that is allocated to support market risk.

b) It is only eligible to cover market risk including foreign exchange risk and commodities risk.

c) Insofar as the overall limits in the 1988 Accord are not breached, tier 2 element may be substituted for tier 3 up to the same limit of 250%.

d) It is subject to a “lock-in” provision which stipulates that neither interest nor principal may be paid if such payment means that the bank’s overall capital would then amount to less than its minimum capita 1 requirement

Question 24

What are the advantages of using a risk ratio over the simpler gearing ratio approach?

Answer 24

o it provides a fairer basis for making international comparisons between banking systems whose structures may differ

o it allows off-balance-sheet exposures to be incorporated more easily into the measure

o it does not deter banks from holding liquid or other assets which carry low risk

Question 25

How does Basel II improve sensitivity to the risk of credit losses?

Answer 25

Basel II improves the capital framework’s sensitivity to the risk of credit losses generally by requiring higher levels of capital for those borrowers thought to present higher levels of credit risk

Question 26

Credit risk: Explain the standarised approach

Answer 26

• Similar to current Basel I approach where exposures are assigned to risk weight categories based on their characteristics
• Supported by external credit assessments
• Dependent on supervisory inputs to determine capital requirements

Question 27

What are the main categories under standarised approach?

Answer 27

claims on sovereigns
non-central government public sector entities
multilateral development banks
banks
corporate
retail loans
residential real estate
commercial real estate

Question 28

What is the weight of Retail exposures under standarised approach?

Answer 28

75%

Question 29

How does Basel II identify higher risk categories?

Answer 29

Basel II identifies certain higher risk assets which are weighted at 150%