topic 13 - capital adequacy

Question 1

what are the functions of capital?

Answer 1

1. absorb unanticipated losses & preserve confidence in the FI
2. protect uninsured depositors & other stakeholders
3. protect FI insurance funds & taxpayers
4. protect FI owners against increases in insurance premiums
5. fund branch & other real investments necessary to provide financial services

Question 2

the larger the FI’s net worth relative to its assets:

Answer 2

the more insolvency protection/insurance there is for liability holders & guarantors, such as the FDIC

Question 3

what is net worth?

Answer 3

a measure of a FI’s capital
net worth = MV of assets - MV of liabilities

Question 4

what are the pros/cons of using MV accounting?

Answer 4

pros:
MV produces a more economically accurate picture of FI’s net worth than does BV

cons:
- difficulty of implementation
- increase in volatility of earnings
- FI’s less willing to accept LT asset exposure

Question 5

where does Basel Agreement (Basel I) came from?

Answer 5

FDIC Improvement Act (FDICIA) of 1991 required banks & thrifts adopt risk-based capital requirements

Question 6

what did New Basel Accord (Basel II) of 2006 incorporated?

Answer 6

operational risk & updated credit risk assessment

Question 7

what are the 3 pillars of Basel II?

Answer 7

1. regulatory minimum capital requirements for credit, market & operational risks
2. specifies importance of regulatory review to ensure sound internal processes to manage capital adequacy & set appropriate targets
3. specifies detailed guidance on disclosure of capital structure, risk exposure, & capital adequacy - focus on market discipline

Question 8

what was the biggest weakness of Basel II?

Answer 8

capital adequacy formula for credit risk was pro cyclical revealed in 2008-09 financial crisis

Question 9

what was the goal of passing Basel III?

Answer 9

raise quality, consistency, & transparency of capital base of banks

Question 10

what are the 4 ratios that DIs must calculate & monitor?

Answer 10

1. common equity Tier 1 (CET1) risk-based capital (RBC) ratio
2. Tier 1 risk-based capital (RBC) ratio
3. total risk-based capital (RBC) ratio
4. Tier 1 leverage ratio

Question 11

what is a prompt corrective action?

Answer 11

mandatory action that have to be taken by regulators as a DI’s capital ratios fall

Question 12

what is CET1 capital?

Answer 12

consists of equity funds available to absorb losses

Question 13

what is Tier I capital?

Answer 13

sum of CET1 capital & additional Tier 1 capital

Question 14

what is Tier II capital?

Answer 14

broad array of secondary “equity-like” capital resources

Question 15

what are risk-weighted assets (RWA)?

Answer 15

on-and-off-balance sheet assets whose values are adjusted for approximate credit risk

Question 16

T/F All banks regardless of size are required to follow the SAME risk-weighting guidelines

Answer 16

TRUE

Question 17

T/F weights of RWA are typically higher than 1

Answer 17

FALSE, LOWER than 1

Question 18

what are the 3 types of RWAs?

Answer 18

1. credit RWA
   *generally the most important
2. market RWA
3. operational RWA

Question 19

Since 2017, under Basel III, the minimum RBC may depend on whether the bank is considered a ____________ bank or not

Answer 19

systemic

Question 20

why was Basel I criticized?

Answer 20

individual risk weights depend on a broad borrower categories

Question 21

risk-based capital ratio is adequate only as long as the DI is not exposed to:

Answer 21

1. undue interest rate risk
2. market risk

Question 22

since 1998, DIs are required to calculate an:

Answer 22

add-on to 8% RNC ratio to reflect exposure to market risk