chapter 12

Question 1

purpose of bank capital?

Answer 1

for bank:reduce risk of failure by acting as a cushion against losses, providing access to financial markets to meet liquidity needs, and limiting growth
for regulators: protect deposit insurance fund in case of bank failures

Question 2

basel 1

Answer 2

only focused on credit risk
linked minimum requirements to credit risk
increased to 8% total capital to risk adjusted assets
stockholders equity is the most valuable type of capital
capital requirements were standardized among countries to level the playing field

Question 3

risk based elements of basel 1

Answer 3

1. classify assets into one of 4 baskets
2. classify off balance sheet commitments int the appropriate risk baskets
3. muliply $ amount of assets in each basket by risk weight
   * this equals risk weighted assets*
4. multiply risk weighted assets by minimum capital % (currently 4% for tier 1 and *% for total capital)

Question 4

tier 1 vs tier 4

Answer 4

tier 1 is safest (cash) tier 4 is most risky (commercial loans)

Question 5

what constitutes bank capital?

Answer 5

cumulative value of assets minus cumulative value of liabilities
represents ownership interest in a firm

Question 6

total equity capital equals sum of

Answer 6

1. common stock
2. surplus
3. undivided profits (RE)
4. net unrealized gains/losses on available for sale securities
5. preferred stock

Question 7

tier 1 (core) capital

Answer 7

sum of:

1. common equity
2. non-cumulative perpetual preferred stock

divident payments dont accumulate if you miss any

Question 8

tier 2 (supplementary) capital

Answer 8

sum of:

1. cumulative perpetual preferred sotck
2. long term preferred stock
3. limited amounts of term subordinated debt

Question 9

leverage capital ratio

Answer 9

tier 1 capital/ TA
3% leverage capital ratio requirement to prevent a bank from acquiring all low risk assets so that risk-based capital requirements would be zero

Question 10

ssubordinated debt

Answer 10

adv: interest payments are tax-deductible; no dilution of ownership interest; generates additional profits for shareholders as long as EBIT exceed interest payments
dis: doesn’t qualify as tier 1; payments are mandatory

Question 11

common stock

Answer 11

adv: tier 1; no fixed maturity (permanent); divident payments are discretionary
dis: dividends are not tax deductible; transaction costs on new issues exceed comparable costs on debt; often not viable for smaller banks

Question 12

preferred stock

Answer 12

form of equity in which investors claims are senior to those of common stockholders
dividends are not tax deductible
investors pay taxes on only 20% of dividends

Question 13

trust preferred stock

Answer 13

hybrid of equity capital at banks
dividends are tax deductible
counts as tier 1

Question 14

basel 2

Answer 14

brings in other risk factors
applies more to larger banks
3 pillars:
1. credit, market, operational risk
2. supervisory review of capital adequacy
3. market discipline through enhanced public disclosure

Question 15

equation (change in total bank assets)

Answer 15

change in total assets/TA¡=ROA(1-DR) + change in EC/TA2
divided by
EQ¡/TA¡

Question 16

risk categories

Answer 16

1. well capitalized
2. adequately capitalized
3. undercapitalized
4. significantly undercapitalized
5. critically undercapitalized