M&A and Basel

Question 1

5 risk classes of basel 1 and their weightings

Answer 1

Assets are divided into 5 risk classes, each assigned different ‘risk-weights’
(ri)
(i) No risk: r1 = 0% (e.g. cash)
(ii) Very low risk: r2 = 10% (e.g. government debt)
(iii) Low risk: r3 = 20% (e.g. short-term claims; maturity <1 year)
(iv) Moderate risk: r4 = 50% (e.g. mortgages)
(v) Standard risk: r5 = 100% (e.g. commercial loans)

Question 2

RWA calculation- basel 1

Answer 2

Total Risk-Weighted Assets: RW A =
∑5
i=1 αi ∗ ri,

Question 3

capital requirement of basel 1 and tier 1 weighting

Answer 3

Minimum Capital Requirement = RW A∗ 8% (e.g. £2,000m∗0.08=£160m)
3. Basel definition of capital is made by two elements:
◦ Tier 1 or Core Capital: equity (common stock) and disclosed reserves
◦ Tier 2 or Supplementary Capital: preferred stock, hybrid instruments,
undisclosed reserves etc.
4. At least 50% of the Capital Base should be in Tier 1 form
(e.g. £160m*0.5=£80m)

Question 4

free rider problem and ways to remove

Answer 4

Takeovers are less effective due to a free-rider problem
* For a bid to be successful at price Vb where Vm < Vb < Vt, a sufficient #
of shareholders must sell their shares to the bidder
◃ Selling is not a Nash equilibrium as Vb < Vt → Shareholders free-ride on the
willingness of others to sell
I Ways to remove the free-riding problem
(a) Setting Vb = Vt does not cover bidder’s costs becoming informed about
target’s value under new management
(b) Bidder announces intention to takeover after secretly acquiring a large
fraction of the target firm
* Bidder pays Vm to secretly acquire a fraction β of the outstanding shares
and bids Vt for the remaining
◦ Shareholders willing to sell at Vt
◦ Bidder’s revenue should be greater than costs involved

Question 5

basel 3 changes

Answer 5

(i) Higher Tier 1 capital requirement to 6% by 2015 comprised predominately
of common equity (min 4.5%) and retained earnings
(ii) New capital conservation buffer 2.5% in common equity (restrictions on
dividends, share buy-backs, bonuses)
(iii) Counter-cyclical buffer 0 to 2.5% in common equity (depends on national
regulators); prevent excessive credit growth in upturns and promote credit
growth in downturns
(iv) Minimum total capital ratio remains at 8% of RWA
(b) Liquidity: several banks experienced a liquidity crisis in 2008 and after
* Maturity transformation leaves banks prone to liquidity problems
(c) Leverage Ratio = Total Exposure/Tier 1 Capital ≤ 1/3%
* Leverage is a measure of profitability and risk
* Banks with IRA attached lower risk-weights to certain assets
⇒ Non-risk-based ‘backstop’ measure to limit risk taking
Global Systematically Important FIs/Banks (G − SIF Is and G − SIBs)
are subject to higher capital requirements and additional supervision

Question 6

market ir calculation

Answer 6

• Increase in the desire to Invest: ↓ P, ↑ r
• Increase in the desire to Save: ↑ P, ↓ r

Question 7

explain the liquidity requirement of basel 111

Answer 7

b) Liquidity: several banks experienced a liquidity crisis in 2008 and after
* Maturity transformation leaves banks prone to liquidity problems
Liquidity Coverage Requirement (LCR): enough liquidity (High Quality Liquid
Assets - HQLA) for 30 day liquidity stress scenario
LCR =
Stock of HQLA
Total net outflows of 30 days
≥ 100%
◦ HQLA = Level 1 (cash, CB reserves, sovereign bonds) + Level 2 (e.g.
government securities, corporate debt; no more than 40% of HQLA)
◦ Total net outflows = Total expected cash outflows − Min {Total
expected cash inflows; 75% of Total expected cash outflows}