Chapter 20 - Capital Adequacy

Chapter Twenty
Capital Adequacy

True/False

20-1 Capital is the primary protection for an FI against the risk of insolvency and failure.
Answer: T

20-2 The primary role of capital for an FI is to assure the highest possible return on equity for
its shareholders.
Answer: F

20-3 Protecting FI insurance funds in the event of an FI failure is the responsibility of

taxpayers.
Answer: F

20-4 One function of bank capital is to protect uninsured depositors, bondholders, and
creditors in the event of insolvency and liquidation.
Answer: T

20-5 The book value of bank equity is the present value of assets minus the present value of
liabilities.
Answer: F

20-6 One function of capital is to provide funding for real assets, such as branches and
technology, that are necessary to provide financial services.
Answer: T

20-7 The function of capital to serve as a source of funds is critical to regulators in setting
risk-based deposit insurance premiums.
Answer: F

20-8 The economic definition of the value of an FI’s equity is the book value of assets minus
the market value of liabilities.
Answer: F

20-9 Market value of equity is better than book value of equity at reflecting changes in the
credit risk and interest rate risk of an FI.
Answer: T

20-10 If the value of equity is less than zero on a mark-to-market accounting basis, liquidation
of the FI would result in losses to the shareholders.
Answer: T

20-11 If the value of equity is less than zero on a mark-to-market accounting basis, liquidation
of the FI may result in losses to the depositors or creditors.

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Answer: T

20-12 The market value of capital is equal to market value of assets minus the market value of
liabilities.
Answer: T

20-13 The book value of equity is seldom equal to the market value of equity.
Answer: T

20-14 An FI may be insolvent in market value terms even if the book value of equity is
positive.
Answer: T

20-15 Equity holders absorb credit losses on the asset portfolio because liability holders are
senior claimants.
Answer: T

20-16 If an FI were closed by regulators before its economic net worth became zero, neither
liability holders nor those regulators guaranteeing the claims of liability holders would
stand to lose.
Answer: T

20-17 The book value of bonds and loans reflects the market value of those assets when they
were placed on the books of an FI.
Answer: T

20-18 Except in cases of extreme credit risk shocks or interest rate risk shocks, the book value
of equity is equal to the economic or market value of equity.
Answer F

20-19 Under Generally Accepted Accounting Principles, FIs have flexible rules in recognizing
the amount and timing of loan losses.
Answer: T

20-20 When a substandard loan is identified by a regulator, it is required that the loan
immediately be charged off by the bank.
Answer: F

20-21 Book value accounting systems recognize the impact of credit risk problems sooner than
interest rate risk problems.
Answer: T

20-22 It is likely that the discrepancy between book value of equity and market value of equity
will increase as volatility in interest rates increases.
Answer: T

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20-23 More frequent regulatory examinations and stricter regulator standards will cause greater
discrepancies in book value of equity and the market value of equity.
Answer: F

20-24 A market to book ratio greater than one indicates that the book value of equity is
overstated.
Answer: F

20-25 Market value accounting often is criticized because the error in market valuation of
nontraded assets likely will be greater than the error using the original book valuation.
Answer: F

20-26 Market value accounting often is said to be difficult to implement because of the amounts
of nontraded assets.
Answer: T

20-27 Market value accounting is likely to increase the variability of earnings of an FI.
Answer: T

20-28 The implementation of true market value accounting for FIs may have adverse effects on
small business finance and economic growth because of the hesitancy of FIs to invest in
long-term assets.
Answer: T

20-29 The SEC requires securities firms to follow capital rules that utilize market value
accounting.
Answer: T

20-30 FDICIA required that banks and thrifts adopt the same capital requirements.
Answer: T

20-31 The greater is the leverage ratio, the more highly leveraged is the bank.
Answer: F

20-32 The leverage ratio measures the amount of an FI’s core capital relative to total assets.
Answer: T

20-33 Under FDICIA, the ability for regulators to show forbearance is limited by a set of
mandatory actions for each level of capital that an FI achieved as measured by the
leverage ratio.
Answer: T

20-34 Under FDICIA, regulators are required to take prompt corrective action steps when a DI
falls outside of Zone 1.
Answer: T

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20-35 The leverage ratio specified under FDICIA protects the depositors and the insurance fund
from the effects of risk that may cause the market value of assets to be negative.
Answer: F

20-36 The leverage ratio specified under FDICIA does not account for the risks of off-balance-
sheet activities.
Answer: T

20-37 Basel I requires banks in the member countries of the Bank for International Settlements
to utilize risk-based capital ratios.
Answer: T

20-38 Under Basel II, total capital is equal to Tier I capital plus Tier II capital.
Answer: T

20-39 Under Basel II, the credit risk and interest rate risk of assets on the balance sheet as well
as off the balance sheet are differentiated.
Answer: F

20-40 Under Basel II, Tier I capital measures the market value of common equity plus the
amount of perpetual preferred stock plus minority equity interest held by the bank in
subsidiaries minus goodwill.
Answer: F

20-41 Under Basel II, banks must hold a total capital to credit risk-adjusted assets equal to 8
percent to be adequately capitalized.
Answer: T

20-42 Under Basel II, regulatory minimum capital requirements for credit, market, and
operational risks are covered in the first pillar of the regulation.
Answer: T

20-43 Under Basel II, banks are allowed to use their internal estimates of borrower
creditworthiness to assess credit risk subject to strict disclosure standards.
Answer: T

20-44 Under Basel II, operational risk can be measured by four different approaches.
Answer: F

20-45 In addition to establishing minimum capital requirements, Basel II proposed procedures

to ensure that sound internal process are used to assess capital adequacy and to set targets
that are commensurate with the risk profile and environment.
Answer: T

20-46 Basel II attempts to encourage market discipline by having banks disclose capital
structure, risk exposures, and capital adequacy in a systematic manner.

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Answer: T

20-47 The use of risk-based capital measures under Basel I effectively mark-to-market the
bank’s on- and off-balance-sheet for the purpose of reflecting credit and market risk.
Answer: T

20-48 The determination of risk-adjusted on-balance-sheet assets under Basel II requires the
segregation of assets into five categories of credit risk exposure.
Answer: T

20-49 Under Basel II, the credit risk-adjusted value of the bank’s on-balance-sheet assets can be
found by adding the products of the risk weights for each asset times the market value of
each asset.
Answer: F

20-50 As compared to Basel I, the standardized approach of Basel II is designed to produce

capital ratios that are more in line with the actual economic risks that the DIs are facing.
Answer: T

20-51 Similar to Basel I, Basel II will require banks to assign on-balance-sheet assets to one of
four categories of credit risk exposure.
Answer: F

20-52 Under the 2008-2009 TARP Capital Purchase Program, senior preferred shares of stock
purchased by the U.S. Treasury are classified as Tier II Capital.
Answer: F

20-53 The evaluation of credit risk of off-balance-sheet assets under Basel II requires that the
notional amount of OBS items be converted to credit equivalent amounts of on-balance-
sheet items.
Answer: T

20-54 Under Basel II, OBS contingent guaranty contracts are assigned the same risk weights as
on-balance-sheet principal items to determine their risk-adjusted asset values.
Answer: T

20-55 In determining the risk-adjusted value of the on-balance-sheet credit equivalent amounts
of the contingent guaranty contracts, the risk weights are determined by the credit rating
of the underlying counterparty of the off-balance-sheet activity.
Answer: T

20-56 Basel II guidelines for determining credit risk-adjusted on-balance-sheet assets relies
more heavily on credit agency ratings than did Basel I.
Answer: T

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20-57 Counterparty credit risk is the risk that the other party of a contract will default on
contract obligations.
Answer: T

20-58 Counterparty credit risk is more prevalent for exchange-traded derivatives than over-the-
counter (OTC) contracts because the bank has more control of its OTC contracts.
Answer: F

20-59 The risk-adjusted asset values of OBS market contracts or derivative instruments are
determined in a manner similar to the risk-adjusted asset values of contingent guarantee
claims.
Answer: F

20-60 Determining risk-adjusted asset values for OBS market contracts requires multiplying the
notional values by the appropriate risk weights.
Answer: F

20-61 In evaluating the risk-adjusted asset value of foreign exchange forward contracts, the
value of the current exposure can be either positive or zero.
Answer: T

20-62 A deficiency of the risk-based capital ratio is that it measures the ability of a bank to
meet both the on- and off-balance-sheet credit risk, but not the interest rate or market
risks.
Answer: T

20-63 Operational risk has increased to a point that the BIS will require DIs to account for it in
the capital adequacy standards under Basel II.
Answer: T

20-64 The Basic Indicator Approach in calculating capital to cover operational risk requires
banks to hold 12 percent of total assets in capital to cover operational risk exposure.
Answer: F

20-65 The Standardized Approach in calculating capital to cover operational risk requires DIs
to separate activities into business units from which a capital charge is determined based
on the amount of operational risk in each unit.
Answer: T

20-66 The risk-based capital ratio fails to take into account the effects of diversification in the
credit portfolio.
Answer: T

20-67 The risk-based capital ratio does account for loans made to companies with different
credit ratings.
Answer: F

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20-68 The capital requirements for broker-dealers include a net worth market value to assets
ratio of at least 2 percent.
Answer: T

20-69 Broker-dealers make very few adjustments to the book value net worth to reach an
approximate market value net worth.
Answer: F

20-70 The risk-based capital model in the life insurance industry includes asset risk, business
risk, insurance risk, and interest rate risk.
Answer: T

20-71 In the life insurance model, morbidity risk differs from mortality risk by the
circumstances surrounding the actual death event.
Answer: F

20-72 In the life insurance model, the ratio of total surplus and capital to the risk-based capital
calculation must be greater than or equal to 1.0 for the insurance company to be
satisfactorily capitalized.
Answer: T

20-73 In the property-casualty insurance model, risk-based capital is a function of six different
risk categories.
Answer: T

Multiple-Choice

20-74 The difference between the market value of assets and liabilities is the definition of the
a. accounting value of capital.
b. regulatory value of capital.
c. economic value of capital.
d. book value of net worth.
e. adjusted book value of net worth.
Answer: C

20-75 Regulatory-defined capital and required leverage ratios are based in whole or in part on
a. market value accounting concepts.
b. book value accounting concepts.
c. the net worth concept.
d. the economic meaning of capital.
e. None of the above.
Answer: B

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20-76 Each of the following is a function of capital EXCEPT

a. funding the branch and other real investments to provide financial services.
b. protecting the insurance fund and the taxpayers.
c. assuring the highest possible return on equity for the shareholders.
d. protecting uninsured depositors in the event of insolvency and liquidation.
e. absorbing losses in a manner that allows the FI to continue as a going concern.
Answer: C

20-77 Under market value accounting methods, FIs

a. must write down the value of their assets to fully reflect market values.
b. have a great deal of discretion in timing the write downs of problem loans.
c. must conform to regulatory write-down schedules.
d. have an incentive to fully reflect problem assets as they become known.
e. are required to invest in expensive computerized bookkeeping systems.
Answer: A

20-78 Losses in asset values due to adverse changes in interest rates are borne initially by the
a. equity holders of an FI.
b. liability holders of an FI.
c. regulatory authorities.
d. taxpayers.
e. insured depositors.
Answer: A

20-79 Through August 2009, approximately which of the following indicates the amount of
funds paid back to the U.S. Treasury as part of the TARP Capital Purchase Program?
a. $192 billion.
b. $120 billion.
c. $72 billion.
d. $26 billion.
e. $19 billion
Answer: C

20-80 Through August 2009, approximately which of the following indicates the amount of
dividends and assessments that the U.S. Treasury has received from entities participating
in the TARP Capital Purchase Program?
a. $ 2.1 billion.
b. $ 1.2 billion.
c. $12.2 billion.
d. $16.0 billion.
e. $ 9.5 billion
Answer: E

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20-81 What is the impact on economic capital of a 25 basis point decrease in interest rates if the
FI is holding a 20-year, fixed-rate, 11 percent annual coupon bond selling at a par value
of $100,000?
a. A decrease of $250.
b. An increase of $250.
c. An increase of $2,024.
d. A decrease of $1,959.
e. No impact on capital since the book value is unchanged.
Answer: C

20-82 From a regulatory perspective, what is the impact on book value capital of a 25 basis
point decrease in interest rates if the FI is holding a 20-year, fixed-rate, 11 percent annual
coupon $100,000 par value bond?
a. A decrease of $250.
b. An increase of $250.
c. An increase of $2,023.
d. A decrease of $1,959.
e. No impact on capital since the book value is unchanged.
Answer: E

20-83 Which of the following statements is true?

a. The book value of equity always equals the market value of equity.
b. The book value of equity always equals the market value of equity minus surplus
value.
c. The book value of equity equals par value plus surplus value plus retained
earnings plus the loan loss reserve.
d. The book value of equity equals par value plus surplus value plus the loan loss
reserve.
e. The book value of equity equals the market value of equity plus par value plus
surplus value plus retained earnings.
Answer: C

20-84 Which of the following is not a component of the book value of capital for an FI?
a. Net worth.
b. Common stock at par value.
c. Paid in surplus in excess of par.
d. Retained earnings.
e. Loan loss reserves.
Answer: A

20-85 The par value of shares is

a. the face or stated value of shares issued upon establishment of the FI.
b. the difference between the market price at the time of issue and the face value of
the shares.
c. the value of the shares if interest rates are constant.
d. the book value of the shares outstanding.

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e. the face value of the shares plus accumulated past earnings.

Answer: A

20-86 The surplus value of shares is

a. the face value of shares issued upon establishment of the FI.
b. the difference between the market price at the time of issue and the face value of
the shares.
c. the value of the shares if interest rates are constant.
d. the book value of the shares outstanding.
e. the face value of the shares plus accumulated past earnings.
Answer: B

20-87 Retained earnings

a. are not included in equity because they are accumulations of past earnings.
b. are included in equity because they could have been paid out in the form of
dividends.
c. are included in equity since they are a special set-aside that adjusts with
adjustments in the market value of assets.
d. are not included in equity since they are a special set-aside that adjusts with
adjustments in the market value of liabilities.
e. are not included in equity since they are a contra-asset entry to the balance sheet.
Answer: B

20-88 Loan loss reserves are

a. not included in equity because they are accumulations of past earnings.
b. included in equity because they were not paid out in the form of dividends.
c. included in equity since they are a special set-aside that adjusts with adjustments
in the market value of assets.
d. not included in equity since they are a special set-aside that adjusts with
adjustments in the market value of liabilities.
e. not included in equity since they are a contra-asset entry to the balance sheet.
Answer: C

20-89 Under historical accounting methods, FIs

a. must write down the value of their assets to fully reflect market values.
b. have a great deal of discretion in timing the write downs of problem loans.
c. must conform to regulatory write-down schedules.
d. have an incentive to fully reflect problems in the asset portfolio as they become
known.
e. invest in expensive computerized bookkeeping systems.
Answer: B

20-90 Which ratio shows degree of discrepancy between the market value of an FI’s equity
capital as perceived by investors in the stock market and the book value of capital on its
balance sheet?
a. Total risk–based capital ratio.

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b. Core capital ratio.

c. Market to book ratio.
d. Book value of capital to assets ratio.
e. Current ratio
Answer: C

20-91 Simulate Bank has 2 million shares of stock that currently are trading at $40 per share.
The shares have a par value of $2.00, and the bank’s balance sheet shows a surplus value
of $36,000,000, retained earnings of $56,000,000, and loans loss reserve of $9,000,000.
What is the value of the bank’s market to book ratio?
a. 2.00.
b. 0.83.
c. 1.31.
d. 0.76.
e. 1.20.
Answer: D

20-92 According to FDICIA, a bank’s leverage ratio must be greater than _______ to be
considered well-capitalized.
a. 8 percent
b. 2 percent
c. 3 percent
d. 12 percent
e. 5 percent
Answer: E

20-93 Which of the following is NOT a typical argument against market value accounting?
a. Market value accounting introduces an unnecessary degree of variability into an
FI’s earnings.
b. The use of market value accounting may reduce the willingness of FI’s to invest
in longer-term assets.
c. FI’s are increasingly trading, selling, and securitizing assets.
d. Market value accounting is difficult to implement.
e. Market value accounting may interfere with an FI’s special functions as lenders
and monitors of credit.
Answer: C

20-94 The U.S. banking industry built up record levels of capital in the early 2000s because
a. the economy went through a downturn.
b. problem loans increased.
c. the regulators required higher amounts of equity sales.
d. of record high levels of profitability.
e. of mergers between large banks.
Answer: D

20-95 Bank regulators set minimum capital standards to

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a. inhibit rapid growth rate of bank assets.

b. protect shareholders from managerial fraud or incompetence.
c. protect creditors from decreases in asset values.
d. force banks to follow socially desirable policies.
e. make work for regulators.
Answer: C

20-96 The concept of prompt corrective action refers to the requirement

a. that bank managers must address problems in the loan portfolio when they are
first identified.
b. that regulators must take specific actions when bank capital levels fall outside the
well-capitalized category.
c. that a receiver must be appointed when a bank’s book value of capital to assets
falls below 2 percent.
d. that b and c above are correct.
e. that all of the above are correct.
Answer: D

20-97 Which of the following is NOT a criticism of the leverage ratio as a measure of capital?
a. Capital is not required to be held to meet the risks of off-balance-sheet activities.
b. The ratio sends a definitive signal of the level of capital adequacy according to
FDICIA.
c. The ratio fails to take into account the different degrees of credit and interest rate
risk of the assets.
d. A positive leverage ratio could occur even with a negative economic value of net
worth.
e. Answers A and C only.
Answer: B

20-98 The Basel capital requirements differ from previous capital standards in all except one of
the following ways?
a. More stringent capital standards for large banks than for small banks.
b. Inclusion of off balance sheet assets in the asset base.
c. Restrictions on the amount of goodwill that can be counted towards primary or
tier I capital.
d. Risk weighting of assets on the basis of credit risk exposure.
e. Risk weighting of off balance sheet contingencies.
Answer: A

20-99 The Basle capital requirements are based upon the premise that
a. banks with riskier assets should have higher capital ratios.
b. banks with riskier assets should have lower capital ratios.
c. banks with riskier assets should have lower absolute amounts of capital.
d. banks with riskier assets should have higher absolute amounts of capital.
e. there is no relationship between asset risk and capital.
Answer: D

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20-100 The Basel I capital requirements as currently implemented include

a. different credit risks of on-balance-sheet assets.
b. different credit risks of off-balance-sheet assets.
c. the consideration of market risk in 1998.
d. All of the above.
e. Only two of the above.
Answer: D

20-101 The Basel II Accord effective at year-end 2007 in the United States
a. includes provisions covering minimum capital requirements for credit, market,
and interest rate risk.
b. stresses the regulatory supervisory process by requiring regulators to be more
involved in evaluating the bank’s specific risk profile and environment.
c. requires only banks on the regulatory problem bank list to disclose publicly the
degree and depth of problem issues as well as their capital adequacy.
d. All of the above.
e. Answers B and C only.
Answer: B

20-102 The measurement of credit risk under the Basel II Accord allows banks to choose
between
a. a standardized approach similar to that used under Basel I..
b. a basic indicator approach that will cause banks to hold an additional 12 percent
of capital.
c. an internal rating system in which they must adhere to strict methodological and
disclosure standards.
d. All of the above.
e. Answers A and C only.
Answer: E

20-103 The bank is considering changing its asset mix by moving $100 million of commercial
loans into Treasury securities. If it does change the asset mix and capital remains the
same, the risk-based capital ratio
a. will not change because the total assets have not changed.
b. will decrease because the earnings rate on Treasuries is less than on loans.
c. will increase by 16.67 percent.
d. will increase because the assets will have less risk.
e. will change, but the direction can not be determined with the information given.
Answer: D

20-104 Which of the following statements best describes the treatment of adjusting for credit risk
of off-balance-sheet activities?
a. All OBS activities are treated equally in making credit-risk adjustments.
b. Standby letter of credit guarantees issued by banks to back commercial paper
have a 50 percent conversion factor.

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c. The credit or default risk of over-the-counter contracts is approximately zero.

d. The current exposure component of the credit equivalent amount of OBS
derivative contracts reflects the credit risk if the contract counterparty defaults.
e. The treatment of interest rate forward, option, and swap contracts differs from the
treatment of contingent or guarantee contracts.
Answer: E

20-105 Broker–dealers must calculate a market value for their net worth on a day-to-day basis
and ensure that their net worth–assets ratio
a. exceeds 1 percent.
b. is at least 2 percent.
c. exceeds 5 percent.
d. is less than 1 percent.
e. is greater than or equal to 1 percent.
Answer: B

20-106 A criticism of the Basel I risk-based capital ratio is

a. the incorporation of off-balance-sheet risk exposures.
b. the application of a similar capital requirement across major banks in
international banking centers across the world.
c. the more systematic accounting of credit risk differences.
d. the lack of appropriate consideration of the portfolio diversification effects of
credit risk.
e. Answers B and C only.
Answer: D

20-107 Which of the following is NOT a criticism of the Basel I risk-based capital ratio?
a. All commercial loans are given equal weight regardless of the credit risk of the
borrower.
b. The ratio incorporates off-balance-sheet risk exposures.
c. Grouping assets into different risk categories may encourage balance sheet asset
allocation games.
d. The treatment does not include interest rate or foreign exchange risk.
e. The weights in the four risk categories imply a cardinal measurement of relevant
risk between each category.
Answer: B

20-108 The primary difference between Basel I and the proposed Basel II in calculating risk-
adjusted assets is
a. that Basel II considers OBS assets.
b. the use of only three weight classes rather than four classes.
c. a heavier reliance on the use of ratings by external credit rating agencies for the
assignment of assets to weight classes.
d. All of the above.
e. Answers A and C only.
Answer: C

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Chapter 20 - Capital Adequacy

20-109 The primary difference between Basel I and the proposed Basel II in converting OBS
values to on-balance-sheet credit equivalent amounts is
a. the use of credit ratings in Basel II to assign credit risk weights on the OBS
activities.
b. the use of six weight classes by Basel II rather than four classes.
c. the use of the underlying counterparty activity in Basel II to assign credit risk
weights on the OBS activities.
d. All of the above.
e. Answers A and C only.
Answer: A

20-110 Counter party credit risk in OBS contracts

a. is the risk that the counterparty will likely default when he is in the money on a
contract position.
b. refers to the risk that a counterparty will default when suffering large actual or
potential losses on its position.
c. requires the counterparty to return to the market and replace contracts at less
favorable terms.
d. All of the above.
e. None of the above.
Answer: B

20-111 The potential exposure component of the credit equivalent amount of OBS derivative
items reflects
a. the probability of an adverse price movement in contracts.
b. the cost of replacing a contract if a counterparty defaults today.
c. the probability today of a counterparty contract default in the future.
d. the maximum price loss for any given position.
e. Answers A and D only.
Answer: C

20-112 The current exposure component of the credit equivalent amount of OBS derivative items
reflects
a. the probability of an adverse price movement in contracts.
b. the cost of replacing a contract if a counterparty defaults today.
c. the probability today of a counterparty contract default in the future.
d. the maximum price loss for any given position.
e. future volatility of the underlying.
Answer: B

20-113 The calculation of the risk-adjusted asset values of OBS market contracts
a. nearly always equals zero because the exchange over which the contract initially
traded assumes all of the risk.
b. requires multiplication of the credit equivalent amounts by the appropriate risk
weights.

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c. requires the calculation of a conversion factor to create credit equivalent amounts.

d. All of the above.
e. Answers B and C only.
Answer: E

20-114 Calculation of the “add-on” to the risk-based capital ratio to measure market risk
a. may be done using the Basic Indicator Approach.
b. may be done using the standardized model proposed by regulators.
c. may be done using the DI’s own internal market risk model.
d. Answers A and B only.
e. Answers B and C only.
Answer: E

20-115 Calculation of the “add-on” to the risk-based capital ratio to measure operational risk
a. may be done using the Basic Indicator Approach.
b. may be done using the Standardized Approach.
c. may be done using the Advanced Measurement Approaches.
d. All of the above.
e. Answers A and B only.
Answer: D

20-116 Which approach used in calculating capital to cover operational risk allow banks to rely
on internal data for the calculation of regulatory capital requirements?
a. Standardized approach.
b. Advanced measurement approach.
c. Basic indicator approach.
d. Internal ratings–based approach.
e. All of the above.
Answer: B

20-117 In calculating the net capital for a securities firms, which of the following is NOT an
adjustment to the book value of net worth?
a. The market value of net worth is calculated on a day-to-day basis.
b. A series of adjustments are made to reflect unrealized profits and losses,
subordinated liabilities, deferred taxes, options, and futures.
c. The amount of securities that cannot be publicly sold are subtracted.
d. All assets not readily converted into cash are subtracted.
e. Haircuts to reflect potential market value fluctuations in asset values are
deducted.
Answer: A

20-118 Which of the following risk categories is NOT covered by the risk-based model for the
life insurance industry?
a. Interest rate risk.
b. Business risk.
c. Asset risk.

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d. Foreign exchange risk.

e. Insurance risk.
Answer: D

20-119 In the NAIC model for life insurance companies, which risk covers the amount of capital
necessary to meet the maximum contribution that an insurance company may need to
make to the state guarantee fund?
a. Interest rate risk.
b. Business risk.
c. Asset risk.
d. Foreign exchange risk.
e. Insurance risk.
Answer: B

20-120 In the NAIC model for life insurance companies, which risk captures the risk of adverse
changes in mortality risk and morbidity risk?
a. Interest rate risk.
b. Business risk.
c. Asset risk.
d. Foreign exchange risk.
e. Insurance risk.
Answer: E

20-121 In the NAIC model for life insurance companies, this risk measures the liquidity of
liabilities for given rate changes.
a. Interest rate risk
b. Business risk
c. Asset risk
d. Foreign exchange risk
e. Insurance risk
Answer: A

Matching

The risk-based capital requirements have received several types of criticism. Please match the
criticism headings below (as stated in the text) with the appropriate criticism
explanations in questions 20-122 to 20-130.

a. Competition
b. DI specialness
c. Excessive complexity
d. Impact on capital requirements
e. Other risks
f. Pillar 2 may ask too much of regulators

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g. Portfolio aspects
h. Risk weights
i. Risk weights based on external credit rating agencies

20-122 The four (five) risk weight categories in Basel I (Basel II) may not reflect the true credit
risk.
Answer: H

20-123 Because rating agencies often lag rather than lead the business cycle, risk weights based
on a loan’s credit rating may not accurately measure the relative risk exposure of
individual borrowers.
Answer: I

20-124 The BIS plans largely ignore the covariance among asset risks between different parties.
Answer: G

20-125 Because DIs may have little incentive to make high risk commercial loans, one important
aspect of intermediation may be somewhat curtailed.
Answer: B

20-126 The benefits may not support the significant cost of developing and implementing new
risk management systems.
Answer: C

20-127 Interest rate and liquidity risks are not yet included in the proposed Basel II plan.
Answer: E

20-128 Banks in the U.S. likely would need additional capital to meet the new minimum
standards.
Answer: D

20-129 Because of different tax, accounting, and safety-net rules and the application of the new
Basel II rules to different industries, a level playing field across banks in different
countries will not occur.
Answer: A

20-130 Regulators may not be trained or willing to make the necessary decisions that may rely
heavily on judgment.
Answer: F

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Multiple Part Questions

Use the following information to answer the next six (6) questions

Securities (at par) $250 Deposits $975

Loans (at par) $760 Capital $ 35

20-131 How would regulators characterize this FI based on the leverage ratio zones of FDICIA?
a. Well capitalized.
b. Undercapitalized.
c. Severely undercapitalized.
d. Overcapitalized.
e. Insolvent.
Answer: B

20-132 If problem loans reduce the market value of the loan portfolio by 25 percent, what is the
value of regulatory defined (book value) capital?
a. $35 million.
b. -$155 million.
c. $7 million.
d. -$7 million.
e. $0.
Answer: A

20-133 If problem loans reduce the market value of the loan portfolio by 25 percent, what is the
market value of capital?
a. $35 million.
b. -$155 million.
c. $7 million.
d. -$7 million.
e. $0.
Answer: B

20-134 Given that 25 percent of the loans have been identified as problem loans, and if historical
cost accounting methods allow the bank to write down only 10 percent of the problem
loans, what will be the book value of capital?
a. $35 million.
b. -$155 million.
c. $16 million.
d. -$7 million.
e. $0.
Answer: C

20-135 If the loan portfolio consists of a five-year, 10 percent annual coupon loan selling at par,
what is the market, or economic, value of capital if interest rates increase 1 percent?

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a. $35 million.
b. -$155 million.
c. $7 million.
d. -$7 million.
e. $0.
Answer: C

20-136 If the loan portfolio consists of five-year, 10 percent annual coupon par value loans, what
is the market, or economic, value of capital if interest rates decrease 2 percent?
a. $35 million.
b. $96 million.
c. $60 million.
d. -$ 7 million.
e. $0.
Answer: B

Use the following information to answer the next three (3) questions

Cash and Treasury securities $100 million

Fed Funds Sold $100 million
Residential Mortgages 1–4 family $200 million
Commercial Loans, BB + rated $600 million

20-137 If the bank has capital of $50 million, what is the leverage ratio?
a. 5.00 percent.
b. 8.33 percent.
c. 25.0 percent.
d. 50.0 percent.
e. None of the above.
Answer: A

20-138 What is the amount of risk-adjusted assets?

a. $1,000 million.
b. $720 million.
c. $900 million.
d. $600 million.
e. $700 million.
Answer: E

20-139 What is the ratio of capital to risk-adjusted assets, if the bank has capital of $50 million?
a. 5.00 percent.
b. 5.56 percent.
c. 7.14 percent.
d. 8.33 percent.
e. 6.25 percent.

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Answer: C

Use the following information to answer the next eight (8) questions

Sigma Bank has the following balance sheet in millions of dollars. The risk weights as
specified by the Basel capital standards are given in parentheses. Unless mentioned
otherwise, all assets are held by corporate customers in millions of dollars.

Cash (0 percent) $40 Deposits $370

Municipal General (20 percent) $60
Obligation Bonds
Residential Mortgages (50 percent) $100 Perpetual Preferred $20
1–4 family Stock (Nonqualifying)
Commercial loans (100 percent) $200 Equity $10
BB + rated
Total Assets $400 $400

Off balance Sheet

$40 million Direct-credit substitute standby letters of credit issued to a BBB + -rated
U.S. corporation.
(credit conversion factor = 100 percent)
$40 million commercial letters of credit issued to a BBB - -rated U.S. corporation
(credit conversion factor = 20 percent)

Off-balance sheet derivatives

$200 million 10-year interest rate swaps
(credit conversion factor for potential exposure = 1.5%)
$100 million 2-year forward DM contracts
(credit conversion factor for potential exposure = 5%)

20-140 What is the bank’s risk-adjusted assets as defined by the Basel standards for its on-
balance-sheet assets only?
a. $400 million.
b. $360 million.
c. $310 million.
d. $262 million.
e. $236 million.
Answer: D

20-141 What is the required Tier I and Tier II capital for the on-balance-sheet assets?
a. $8 million; $8 million.
b. $16 million; $16 million.
c. $10.48 million; $10.48 million.
d. $8 million; $16 million.
e. $10.8 million; $8 million.

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Answer: C

20-142 Is the bank adequately capitalized for its on-balance-sheet assets based on the Basel
standards?
a. Yes, because both Tier I and Tier II capital each exceed the required minimum.
b. Yes, because both the Tier I and Tier II combined exceeds the required minimum.
c. No, because both Tier I and Tier II capital each are below the required minimum.
d. No, because Tier I is below the required minimum while Tier II exceeds the
required minimum.
e. No, because Tier I is above the required minimum while Tier II is below the
required minimum.
Answer: D

20-143 What is the credit equivalent amount of the off-balance-sheet letters of credit, both
standby and commercial?
a. $9.6 million.
b. $16.0 million.
c. $48 million.
d. $72 million.
e. $80 million.
Answer: C

20-144 What is the minimum total capital (Tier I + Tier II) required for the off-balance-sheet
letters of credit under the Basel II standards?
a. $3.84 million.
b. $3.68 million.
c. $3.20 million.
d. $4.80 million.
e. $6.40 million.
Answer: A

20-145 What is the credit equivalent amount of the off-balance-sheet interest rate swaps if it is
in- the-money by $1 million?
a. $1.0 million.
b. $2.0 million.
c. $3.0 million.
d. $4.0 million.
e. $5.0 million.
Answer: D

20-146 What is the credit equivalent amount of the off-balance-sheet foreign exchange contracts
if it is out-of-the-money by $4 million?
a. $1.0 million.
b. $2.0 million.
c. $5.0 million.
d. $6.0 million.

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e. $9.0 million.
Answer: C

20-147 What is the minimum total capital (Tier I + Tier II) required for the off-balance sheet
derivative contracts (both interest rate swaps and foreign exchange forwards) under Basel
II?
a. $0.24 million.
b. $0.36 million.
c. $0.72 million.
d. $0.60 million.
e. $0.48 million.
Answer: C

Use the following information to answer the next two (2) questions:

A property-casualty (P-C) insurance firm has estimated the following risk-based capital
charge for its individual risk classes:

Risk Description RBC Charge

R0 Affiliated P-C $6.0 million
R1 Fixed income assets $2.0 million
R2 Common Stock $1.0 million
R3 Reinsurance $3.0 million
R4 Loss Adjustment expense $1.0 million
R5 Written premiums $2.0 million
Total $15.0 million

20-148 Using the model recommended by the National Association of Insurance Commissioners
(NAIC), what is the total risk-based capital charge for the P-C firm?
a. $4.36 million.
b. $10.00 million.
c. $10.36 million.
d. $12.50 million.
e. $15.00 million.
Answer: C

20-149 Is the firm adequately capitalized if it has total capital and surplus of $10 million?
a. No, its total risk-based capital charge is higher than $10 million.
b. No, its total risk-based capital charge is lower than $10 million.
c. Yes, its total risk-based capital charge is higher than $10 million.
d. Yes, its total risk-based capital charge is lower than $10 million.
e. No, its total risk-based capital charge is greater than 0.
Answer: A

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Additional Problem and Solution

Fifth Bank has the following balance sheet in millions of dollars with the risk weights in
parentheses. All assets are held by corporate customers.

Cash (0 percent) $10 Deposits $190

Municipal General (20 percent) $20
Obligation Bonds
Residential Mortgages (50 percent) $80 Long-Term Debt $5
1–4 family
Commercial loans (100 percent) $90 Equity $5
BB + rated
Total Assets $200 $200

In addition, the bank has over $50 million in commercial letters of credit (LCs), $50 million in
4-
year forward FX contracts that are out-of-the money by $2 million, and $300 million in 3-year
interest rate swaps that are in-the-money by $2 million. Credit conversion factors are as follows:

Performance related standby LCs 50%

1-5 year foreign exchange contracts 5%
1-5 year interest rate swaps 0.5%
5-10 year interest rate swaps 1.5%

a. What is the amount of risk adjusted on-balance-sheet assets of the bank as defined under
the Basel II standards?

Risk-adjusted on-balance-sheet assets:

Cash 0 x 10 = $0
Municipal G.O. bonds 0.20 x 20 = $4
Residential 1–4 family mortgages 0.50 x 80 = $40
Commercial loans, BB + rated 1.00 x 90 = $90
Total risk-adjusted assets = $134

b. What are the total risk-adjusted off-balance-sheet assets of the bank as defined under the
Basel II standards?

Standby LCs $50m x .20 = $10 = $10.00

Foreign exchange contracts

Potential exposure $50 x 0.05 = $2.5
Current exposure out-of-the-money = $0.0
Interest rate swaps
Potential exposure $300 x 0.005 = $1.5
Current exposure in-the money = $2.0

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= $6 x 1.00 = $6.00
Total risk-adjusted off-balance-sheet assets = $16.00

c. What is the total capital required for both off- and on-balance-sheet assets?

Total risk-adjusted on-balance-sheet assets = $134.00

Total risk-adjusted off-balance-sheet assets = $16.00
Total risk-adjusted on- and off-balance-sheet assets = $150.00
x 0.08
Total capital required = $12.00

d. Does the bank have enough capital to meet the Basel II requirements? If so, what is the
amount of excess capital? If not, what is the minimum Tier 1 or Tier 2 capital it needs in
order to meet the requirement?

No, the bank does not have sufficient capital to meet the Basel II requirements. In fact, it
needs Tier 1 = 150 x 0.04 = $6.00m and a similar amount for Tier 2.

e. What would be the new balance sheet if the bank just met the capital requirements?
Assume that any excess or additional capital adjustment would be made to the cash
account on the asset side of the balance sheet.

The required capital amounts would result in the following balance sheet.

New balance sheet

Cash $12 Deposits $190
Municipal General $20
Obligation Bonds
Residential Mortgages $80 Long-Term Debt $6
1–4 family
Commercial loans $90 Equity $6
BB + rated
Total Assets $202 $202

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