Question

*NOTE : iNFO Basel Accord in table at bottom of provided Question sheet. Thank you.

QUESTION 17: SOLVENCY AND CAPITAL REGULATION "Third Bank" has the following balance sheet (in millions of dollars) with the risk weights in parentheses. | $175 Assets Cash (0%) Interbank deposits with AA rated banks (20%) Standard residential mortgages non- insured with LVR of 85% (50%) Business loans to BB rated borrowers (100%) Total assets Liabilities and equity $20 Deposits Subordinated debt (5 years) (Tier 2 capital) 70 Cumulative preference shares (Tier 1) 70 Common equity (Tier 1) $185 Total liabilities and equity | $185 In addition, the bank has $30 million in performance-related standby letters of credit (SLCs), $40 million in two-year forward FX contracts that are currently in the money by $1 million, and $300 million in six-year interest rate swaps that are currently out of the money by $2 million. (a) What are the risk-adjusted on-balance-sheet assets of the bank as defined under the Basel Accord? Calculation Risk Weighted value Cash Interbank deposits Mortgage loans Business loans Total risk-adjusted assets (b) Discuss briefly under which circumstances the two-year forward FX contracts and the interest rate swaps introduce an additional risk for the bank. (c) Presume that the off-balance sheet risk is evaluated at $19.25 million. What is the total amount of risk-adjusted on and off-balance-sheet assets? (d) Calculate the actual capital ratios of Third Bank and identify if it is sufficient to meet the regulatory capital requirements? If not, which type of capital does it need to raise in order to meet the requirement? Basel III ratios Capital ratio, per cent Common All Tier 1 Total equity capital capital Minimum 4.5% 6.0% 0.096 Conservation 2.596 Minimum plus conservation buffer 7.0% 8.59 10.5% Countereyclical buffer 0-2.54 • Common equity or other fully loss-absorbing capital

Answer 1

a. Risk-adjusted assets on balance sheet assets under Basel accord:

Risk adjusted assets	Calculation	Risk weighted value
Cash	0 * 20	$0
OECD interbank deposits	0.2 * 25	$5
Mortgage loans	0.5 * 70	$35
Consumer loans	1 * 70	$70
Total risk-adjusted assets		$110

b. It depends if the bank has used derivatives as a hedging instrument for the on balance sheet risk or for speculation purposes. If it is used as a hedging instrument, the risk faced by bank stands to be reduced. But if held for speculation purposes, it would add the risk. For example if the bank has FX exposure on the balance sheet and an exact opposite FX exposure off the balance sheet, the net FX exposure will be zero. But if these two exposures are not opposite to each other, the bank may go out of money and face large losses due to movements in FX.

c. Total risk-adjusted on and off balance sheet assets

Total risk-adjusted on balance sheet assets (from a)	$110
Total risk-adjusted off balance sheet assets (given)	$19.25
Total risk-adjusted on and off balance sheet assets	$129.25

d. Total capital required = Total risk-adjusted on and off balance sheet assets * 8%

= $129.25 * 8%

= $10.34 million

No, the bank does not have sufficient total capital to meet regulatory capital requirements. The capital requirements of the bank can be summarized as below:

Total capital required		$10.34 million
Common Equity required	$129.25 million * 4.5%	$5.81625 million
All Tier 1 capital	$129.25 million * 6%	$7.755 million
Current common equity		$2 million
Current all Tier 1 capital	$2 million + $5 million	$7 million

The bank has to issue $3.81625 million ($5.81625 million - $2 million) of common equity and $0.755 million ($7.755 million - $7 million) of Tier 1 capital. The total capital of the bank will be $13.57125 million ($5.81625 million + $7.755 million).