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

Ans. (a).

Calculation of Risk Weighted Assets

Asset	Calculation	Risk Weighted Value
Cash	= $20 x 0%	0
Inter-bank Deposits	= $25 x 20%	$5 million
Mortgage Loans	= $70 x 50%	$35 million
Business Loans	= $70 x 100%	$70 million
		$110 million

Ans. (b). Two year Forward FX contract and the interest rate swaps will introduce an addition risk to the Bank when they materialize and the results of such contracts are unfavorable to the bank.

Ans. (c). On-Balance-Sheet risk weighted assets = $110 millions Off-Balance-Sheet risk weighted assets = $110 millions + $19.25 millions = $129.25 millions

Ans. (d). Capital Adequacy Ratio = (Tier I Capital + Tier II Capital) / Risk Weighted Assets = ($2 millions + $5 millions + $3 millions) / $129.25 millions = 0.077 or 7.7%

The minimum CAR is 8% as per Basel III. So the bank need to increase its Tier II Capital.