Question

Assume that Bank A and Bank B have identical liabilities and equity and the following table depicts their assets: Amount (Sb) BANK A 4.5 5.5 190 60 150 410 Amount (Śb) BANK B Asset 45 ES funds T-notes and CG bonds Home loans (LVR 80%) Home loans (LVR > 85%) Business loans Total 100 60 150 410 Do they have identical solvency risk? Which bank should have a higher capital buffer? Yes, the total amount of assets is identically and since both banks have the same amount of equity, their solvency risk is identically No! Bank A's asset side contains more risky assets and therefore more default risk. Thus Bank A should maintain a higher capital buffer No! Bank B's asset side contains more risky assets and therefore more default risk. Thus Bank B should maintain a higher capital buffer

Answer 1

Solvency risk indicates the risk that a bank or financial institution carries of loosing the invested money from the borrower. As per the given data of Bank A and Bank B, it appears that Bank B has put a huge amount of money in the Exchange security fund and in the T-notes and Cg bonds, whereas the Bank A seems to have put a huge amount in money on Home loans. IN the banking business, it is safest to invest in those assets which have more chances of getting back the money back. In the case of T Notes, ES Funds and CG Notes, the money invested could be recovered at any point by the Bank, however, the money invested in the home loans carry more risk, therefore Bank A carries more risk of loosing the money. So, the correct answer would be No! Bank A’s asset side contains more risky assets and therefore more default risk. Therefore, Bank A should maintain more capital buffer.

Calculation of Risk Weighted Assets:

ES funds: Since the Risk Weight for the ES Funds is 0%, therefore the Risk Weighted Assets of the ES funds will be equal to nothing, i.e. answer is 0

T-notes and CG bonds: Since the Risk Weight for the T-notes and CG bonds is 0%, therefore the Risk Weighted Assets of the T-notes and CG bonds will be equal to nothing, i.e. answer is 0

Home loans (LVR <80%): Since the Risk Weight for the Home loans (LVR <80%) is 75%, therefore the Risk Weighted Assets of the Home loans (LVR <80%) will be = (75% of 190) = 142.5, i.e. answer is $ 142.5.5 Billion

Home loans (LVR > 85%): Since the Risk Weight for the Home loans (LVR > 85%) is 100%, therefore the Risk Weighted Assets of the Home loans (LVR > 85%) will be = (100% of 60) = 60, i.e. answer is $ 60 Billion

Business Loans: Since the Risk Weight for Business Loans is 100%, therefore the Risk Weighted Assets of the Business Loans will be = (100% of 150) = 150, i.e. answer is $ 150 Billion  

Calculation of Equity to Risk Weighted Assets:

ES funds: Since the Risk Weighted Assets of the ES funds is 0, therefore the Equity to Risk Weighted Assets of the ES funds will be equal to the total 20 b, i.e. answer is $ 20 b

T-notes and CG bonds: Since the Risk Weighted Asset for the T-notes and CG bonds is 0, therefore the Equity to Risk Weighted Assets of the T-notes and CG bonds will be equal 20, i.e. answer is $ 20 b

Home loans (LVR <80%): Since the Risk Weighted Asset for the Home loans (LVR <80%) is 142.5 b, therefore the Equity to Risk Weighted Assets of the Home loans (LVR <80%) will be = (75% of 190) * 20/100 = 142.5, i.e. answer is 28.5%

Home loans (LVR > 85%): Since the Risk Weighted Asset for the Home loans (LVR > 85%) is 100%, therefore the Equity to Risk Weighted Assets of the Home loans (LVR > 85%) will be = (100% of 60) * 20/100 = 60, i.e. answer is 12%

Business Loans: Since the Risk Weighted Asset for Business Loans is 100%, therefore the Equity to Risk Weighted Assets of the Business Loans will be = (100% of 150) * 20/100 = 150, i.e. answer is 30%  

Capital Adequacy ratio stands for the minimum amount of capital that the bank should posses which can be used in terms of a financial emergency of the Bank and more particularly when the ban is making losses. It is the percentage of the total assets of the Bank and its transactions. At preset the Capital Adequacy ratio is 8%. therefore, the correct answer is: No, it is violating the minimum capital adequacy ratio.