Chapter 20: Capital Adequacy Flashcards
Identify and briefly discuss the importance of the five functions of an FI’s capital.
Capital serves as a primary cushion against operating losses and unexpected losses in the value of assets (such as the failure of a loan). FIs need to hold enough capital to provide confidence to uninsured creditors that they can withstand reasonable shocks to the value of their assets. In addition, CDIC, which guarantees deposits, is concerned that sufficient capital is held so that its funds are protected, because they are responsible for paying insured depositors in the event of a failure. This protection of CDIC’s funds includes the protection of the FI owners against increases in insurance premiums. Finally, capital also serves as a source of financing to purchase and invest in assets.
What are the differences 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.
Why is the market value of equity a better measure of a bank’s ability to absorb losses than book value of equity?
The market value of equity is more relevant than book value because in the event of a bankruptcy, the liquidation (market) values will determine the FI’s ability to pay the various claimants.
Identify and discuss the weaknesses of the ACM as a measure of capital adequacy.
First, closing a bank when the assets to capital multiple exceeds 20 percent does not guarantee that the depositors are adequately protected. In many cases of financial distress, the actual market value of equity may be significantly negative by the time the leverage ratio reaches 20 percent. Second, using total assets as the numerator does not consider the different credit and interest rate risks of the individual assets. Third, the ratio does not capture the contingent risk of all of the off-balance sheet activities of the bank.
What is the Basel Agreement?
The Basel Capital Accord identifies the risk-based capital ratios agreed upon by the member countries of the Bank for International Settlements. The ratios are to be implemented for all DTIs under their jurisdiction. Further, most countries in the world now have accepted the guidelines of this agreement for measuring capital adequacy.
Explain how OSFI evaluates the capital adequacy of a DTI.
OSFI evaluates a DTI’s capital as Strong, Acceptable, Needs Improvement, or Weak by considering whether the capital is adequate given an FI’s complexity, its internal risk management (capital management policies and practices), and the oversight of its capital adequacy by senior management and board of directors.
Explain how off-balance-sheet market contracts, or derivative instruments, differ from contingent guarantee contracts?
Off-balance-sheet contingent guarantee contracts in effect are forms of insurance that FIs sell to assist customers in the financial management of the customers’ businesses. FI management typically uses market contracts, or derivative instruments, to assist in the management of the FI’s asset and liability risks.
