Lecture 3

Question 1

What is the Market value of equity and its disadvantage?

Answer 1

A bank’s ability to repay claimants in case of forced liquidation (-) volatile

Question 2

Why is the Book value of equity prefered?

Answer 2

It is less volatile and it has more stable assessment.

Question 3

What is Netting?

Answer 3

Netting is a way of calculating th off-balance sheet RWA,using the original exposure method. If there are several contracts with the same counterparty, but the one party wins on contract X, but loses on contract Y, the position can be net out.

Question 4

What are the disadvantages of Basel 1?

Answer 4

1. Only credit risk is considered 2.Weighting scheme 3.Covernance not considered 4.Cubing market monitoring 5. Regulatory arbitrage

Question 5

What are the types of regulatory arbitrage?

Answer 5

1. maturity arbirtage (because of not including market risk) 2. asset class arbitrage (taking the riskiest assets within the same category) 3. securitization (sell assets to ad-hoc created vehicles)

Question 6

What improved through the 1996 Amendment?

Answer 6

it includes now the market risk for trading assets. Using two approaches: Standardized and internal

Question 8

What is the internal approach based on the Amendment of basel 1?

Answer 8

It is a method to calculate market risk, it uses the VaR with 99% confidence level, (-) possible manipulation, it first computes capital requirements and the RWA

Question 9

What is VaR?

Answer 9

VaR shows the (negative) return such thta there is only 1% chance of observing even worse return (losses)

Question 10

What is the standardized approach based on Basel 2?

Answer 10

Calculation for credit risk. The weights now depend on asset class and rating. Rating based on actual bank’s rating or on bank’s country

Question 11

What is the Foundation Internal Rating approach?

Answer 11

Calculation for credit risk. Banks independently estimate the PD for the Exposed Assets to Default. Takes into consideration the correlations and promises enough capital to absorb unexpected lossesk. PD is the only parameter set by regulators.

Question 12

What are the disadvantages of Basel 2?

Answer 12

1.Many different weights, complicated calculation of RWA 2.IRB vs Standard approach lead to non-sophisticated banks using IRB 3.Pro-cyclicality 4. Political pressure

Question 13

What are the capital requirements of Basel 1?

Answer 13

Tier 1 / RWA > 4% and (Tier 1 + Tier 2) / RWA > 8%

Question 14

What are the types of RWA?

Answer 14

On- balance sheet assets and off-balance sheet assets

Question 15

How are the credit equivalent asset is calculated?

Answer 15

1. Current Exposure method 2. Original Exposure method 3. Original exposure method with netting

Question 16

What are the types of calculating operational risk based on Basel 2?

Answer 16

1. Basic indicator 2. Standardized method (this is the only one used) 3. Advanced measurements

Question 17

What are the types of calculating credit risk based on Basel 2?

Answer 17

1. Standardized approach 2. Foundatoin IRB 3. Advanced IRB

Question 18

What is included in Tier 1 capital?

Answer 18

Common Equity Shares
Disclosed Reserves
Retained Earnings
▪ Minority interests in consolidated subsidiaries
▪ Non-cumulative preferred stocks
▪ Goodwill (-)
▪ Other deductions (-)

Question 19

What is included in Tier 2 capital?

Answer 19

Cumulative preferred stocks (+)
▪ Loan loss allowance (+)
▪ Undisclosed reserves (+)
▪ Revaluation reserves (discounted) (+)
▪ Convertible bonds (+)
▪ Debt subordinated to depositors with original life > 5 years

Question 20

One possible reason why equity value could be a better measure of regulatory capital?

Answer 20

With efficient markets, the market value of equity represents in principle the amount of liquidity that the bank would be able to raise by selling its assets while still keeping the value
of the remaining assets above the value of its debt & deposits.