Deck 21: Capital Adequacy

Question 1

Capital is the primary protection for an FI against the risk of insolvency and failure.

Answer 1

True

Question 2

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 2

False

Question 3

The book value of bank equity is the present value of assets minus the present value of liabilities.

Answer 3

False

Question 4

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.

Question 5

Protecting FI insurance funds in the event of an FI failure is the responsibility of taxpayers.

Question 6

The market value of capital is equal to market value of assets minus the market value of liabilities.

Question 7

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.

Question 8

The book value of bonds and loans reflects the market value of those assets when they were placed on the books of an FI.

Question 9

Market value of equity is more appropriate than book value of equity at reflecting changes in the credit risk and interest rate risk of an FI.

Question 10

The primary role of capital for an FI is to assure the highest possible return on equity for its shareholders.

Question 11

Under Generally Accepted Accounting Principles, FIs have flexible rules in recognizing the amount and timing of loan losses.

Question 12

An FI may be insolvent in market value terms even if the book value of equity is positive.

Question 13

Equity holders absorb credit losses on the asset portfolio because liability holders are junior claimants.

Question 14

One function of capital is to provide funding for real assets, such as branches and technology that are necessary to provide financial services.

Question 15

The economic definition of the value of an FI's equity is the book value of assets minus the market value of liabilities.

Question 16

The book value of equity is seldom equal to the market value of equity.

Question 17

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.

Question 18

One function of bank capital is to protect uninsured depositors, bondholders, and creditors in the event of insolvency and liquidation.

Question 19

The function of capital to serve as a source of funds is critical to regulators when setting risk-based deposit insurance premiums.

Question 20

When a substandard loan is identified by a regulator, it is required that the loan immediately be charged off by the bank.

Question 21

It is likely that the discrepancy between book value of equity and market value of equity will increase as volatility in interest rates increases.

Question 22

Basel III capital ratios were enacted due to Basel II weaknesses exposed during the financial crisis of 2008-2009.

Question 23

Basel I (1993) requires banks in the member countries of the Bank for International Settlements to utilize risk-based capital ratios.

Question 24

Under Basel III a depository institution's capital is divided into five categories.

Question 25

Under Basel II (2006), total capital is equal to Tier I capital plus Tier II capital.

Question 26

FDICIA required that banks and thrifts adopt the same capital requirements.

Question 27

The leverage ratio specified under FDICIA does not account for the risks of off-balance-sheet activities.

Question 28

Market value accounting often is said to be difficult to implement because of the amount of assets that are not actively traded.

Question 29

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.

Question 30

Under Basel III, 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.

Question 31

Book value accounting systems recognize the impact of interest rate problems sooner than credit risk problems.

Question 32

Under Basel III, banks must hold a total capital to risk-weighted assets equal to 8 percent to be adequately capitalized.

Question 33

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.

Question 34

The SEC requires securities firms to follow capital rules that utilize market value accounting.

Question 35

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.

Question 36

The greater the Tier I leverage using the Standardized Approach under Basel III, the more highly leveraged the bank.

Question 37

More frequent regulatory examinations and stricter regulator standards will cause greater discrepancies in book value of equity and the market value of equity.

Question 38

Under FDICIA, regulators are required to take prompt corrective action steps when a DI falls outside of Zone 1.

Question 39

Market value accounting is likely to increase the variability of earnings of an FI.

Question 40

The Tier I leverage ratio measures the amount of an FI's total capital relative to total assets.

Question 41

The use of risk-based capital measures under Basel I (1993) effectively mark-to-market the bank's on- and off-balance-sheet for the purpose of reflecting credit and market risk.

Question 42

Basel III guidelines for determining risk-weighted on-balance-sheet assets relies more heavily on credit agency ratings than did Basel I.

Question 43

Under Basel II (2006), regulatory minimum capital requirements for credit, market, and operational risks are covered in the first pillar of the regulation.

Question 44

Counterparty credit risk is the risk that the other party of a contract will default on contract obligations.

Question 45

Under Basel II (2006), operational risk can be measured by four different approaches.

Question 46

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.

Question 47

In evaluating the risk-weighted asset value of foreign exchange forward contracts, the value of the current exposure can be either positive or zero.

Question 48

Similar to Basel II, Basel III will require banks to assign on-balance-sheet assets to one of four categories of credit risk exposure.

Question 49

Determining risk-weighted asset values for OBS market contracts requires multiplying the notional values by the appropriate risk weights.

Question 50

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

Question 51

The evaluation of credit risk of off-balance-sheet (OBS) assets under Basel III requires that the notional amount of OBS items be converted to credit equivalent amounts of on-balance-sheet items.

Question 52

The risk-weighted asset values of OBS market contracts or derivative instruments are determined in a manner similar to the risk-weighted asset values of contingent guarantee claims.

Question 53

Under Basel III, banks are allowed to use their internal estimates of borrower creditworthiness to assess credit risk subject to strict disclosure standards.

Question 54

Under Basel III, the risk-weighted 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.

Question 55

The determination of risk-weighted on-balance-sheet assets under Basel III requires the segregation of assets into nine categories of credit risk exposure.

Question 56

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.

Question 57

As compared to Basel I, the standardized approach of Basel III is designed to produce capital ratios that are more in line with the actual economic risks that the DIs are facing.

Question 58

Under Basel III, OBS contingent guaranty contracts are assigned the same risk weights as on-balance-sheet principal items to determine their risk-weighted asset values.

Question 59

In determining the risk-weighted 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.

Question 60

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 interest rate risk and market risks.

Question 61

The stress tests run by firms and the Federal Reserve Board apply five scenarios: underperforming, poor, baseline, adverse, and severely adverse.

Question 62

Broker-dealers make very few adjustments to the book value net worth to reach an approximate market value net worth.

Question 63

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.

Question 64

The risk-weighted assets represent the denominator of the risk-based capital ratios

Question 65

The ratio of the common equity Tier 1 capital to the risk-weighted assets of the DI is defined as a CETI 1 risk-based capital ratio.

Question 66

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)weighted book value of net worth.

Question 67

All banks regardless of size are required to follow the same risk-weighting guidelines.

Question 68

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 options.

Question 69

The risk-based capital model in the life insurance industry includes asset risk, business risk, insurance risk, and interest rate risk.

Question 70

In the life insurance model, morbidity risk differs from mortality risk by the circumstances surrounding the actual death event.

Question 71

The risk-based capital ratio fails to take into account the effects of diversification in the credit portfolio.

Question 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.

Question 73

In the property-casualty insurance model, risk-based capital is a function of six different risk categories.

Question 74

Operational risk increased to a point that the Bank for International Settlements (BIS) required DIs to account for the risk in the capital adequacy standards under Basel II.

Question 75

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.

Question 76

The risk-based capital ratio does account for loans made to companies with different credit ratings.

Question 77

Which of the following statements regarding leverage ratio framework are untrue?

A)The leverage ratio complements the risk-weighted capital requirements by providing a safeguard against unsustainable levels of leverage.
B)The leverage ratio complements the risk-weighted capital requirements by mitigating gaming and model risk across both internal models and standardized risk measurement approaches.
C)The leverage ratio G-SIB buffer must be met with Tier 5 capital and is set at 10% of a G-SIB's risk weighted higher-loss absorbency requirements.
D)The leverage ratio buffer takes the form of a capital buffer akin to the capital buffers in the risk-weighted framework.
E)all of the above statements are true.

Question 78

A life insurance company that is a parent company is not required to hold an equivalent amount of risk-based capital to protect against financial downturns of affiliates.

Question 79

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

Question 80

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.