Deck 5: Depository Institution Capital Management

Question 1

Define capital. Explain several roles capital plays for a financial institution.

Answer 1

Capital provides an equity cushion protecting against potential losses on a financial institution's assets, as well as other operating losses. Capital also provides protection against insolvency, since Equity capital is equal to Total Assets less Total liabilities, for a firm to be solvent its total assets must be greater than its total liabilities (i.e. Positive Equity Capital). Hence, capital provides insurance in the event of losses, ensuring the integrity of the payments system and provides long-term funds for long-term investments and growth and provides confidence for uninsured deposits and debt-holders. Capital also provides protection against regulatory interferences, allows for higher credit ratings and provides extra borrowing capacity, and is part of an optimal capital structure that allows for a lower weighted average cost of capital.

Question 2

During the U.S. Subprime Loan Crisis and the following Global Great Recession, many financial institutions had inadequate capital to cover the losses they experienced including financial institutions that were systemically important. Discuss an example of a financial institution that experienced severe financial difficulties and had inadequate capital at this time.

Answer 2

Lehman Brothers is one example of a very large, internationally active financial institution that did business in 40 countries and 650 legal entities outside the U.S. and was also counterparty to many other financial institutions that was inadequately capitalized. In addition, Lehman Brothers had a huge derivative book, large involvement with collateralized debt obligations associated with subprime mortgages. Lehman Brothers also used wholesale, short-term funding, and when confidence was lost for Lehman in the financial markets, sources of short-term funding refused to renew that financing. Lehman' Brothers capital ratio (Tier 1 and Tier 2 relative to risk weighted assets) in 2007 was also only about 7.27% (compared to a 9.87% ratio earlier in 2003), which was insufficient to cover its losses, contributing to its bankruptcy.

Question 3

How is total regulatory capital for depository institutions often different from equity capital, and what are the pros and cons for this?

Answer 3

Regulatory Capital is different. For depository institutions, regulators have often allowed some long-term debt and other items that have claims below insured deposit funds as secondary capital for regulatory purposes. Since capital also provides a role in protecting a federal insurer (and hence taxpayers) from having to pay out for insured deposits, long-term claims by debt holders is subordinated to depositors in case of insolvency. Pros for including longer term capital as Tier 2 capital are that by encouraging the use of subordinated debt financing, uninsured debt holders are more likely to monitor a bank and provides additional, cheaper capital that adds protection against losses for deposit insurance funds. Some financial economists have proposed mandating that banks hold a minimum level of subordinated debt and be required to roll over the debt on a regular basis to bring about greater market discipline, especially for very large financial institutions, such as a higher cost of subordinated debt (risk premium imposed) or risk of a lower credit rating for debt helping to discourage large banks from taking on too much risk.
Cons for using subordinated debt as regulatory capital are that subordinated debt is not truly permanent capital and bondholders could sell off their bonds in the event a bank has large losses or other problems, similar to uninsured deposit runs. If a large bank failed, this could hasten its insolvency and could lead to contagion for other banks with large amounts of subordinated debt increasing liquidity problems. Bank equity would have an advantage during times of financial stress, since dividends on common stock do not have to be paid while debt payments need to be made. Because of this, bank supervisors have the power to suspend interest payments for subordinated debt under policies for prompt corrective action.

Question 4

What are the advantages and disadvantages for market value versus book value of capital for financial institutions?

Question 5

Describe some of the capital regulations changes under Basel III and new U.S. Regulatory Capital Requirements based on Basel III.

Question 6

Which of the following stakeholders associated with a financial institution generally prefer high financial leverage (lower equity to total assets) ratios?

A) Managers
B) External Stockholders
C) Regulators
D) Uninsured deposits and other debt-holders

Question 7

The difference between the Market Value of Equity versus the Book Value of Equity for a depository institution is influenced by which of the following factors?

A) Changes in the market value of assets and liabilities with changes in interest rates
B) Changes in the market value of assets and liabilities with changes in foreign exchange rates
C) Changes in the replacement cost of fixed assets
D) All of the above

Question 8

Which of the following under Basel III are not included in the new Common Equity Tier 1 (CET 1) Risk-Based Capital for a depository institution?

A) Common stock (par and surplus)
B) Retained earnings (undivided profits)
C) Accumulated other comprehensive income and other disclosed reserves
D) Subordinated debentures with a life of 5 years or more

Question 9

Under Basel III, Tier 2 (non-equity capital) for U.S. insured banks includes limited allowance for loan and lease losses and preferred and subordinated debt with previous limits under Basel II eliminated on subordinated debt, limited preferred stock, and the amount of Tier 2 Capital included in total capital.

Question 10

As of 2016, under FDIC rules phasing in Basel II in the U.S., the regulatory minimum for being adequately capitalized includes which of the following:

A) Tier 1 Leverage Capital Ratio of 4% or higher
B) CET1 to Risk-Based Asset Ratio of 4.5% or higher
C) Tier 1 Capital to Risk-Based Asset Ratio of 6% or higher
D) Total Tier 1 and Tier 2 Capital to Risk-Based Asset Ratio of 8% or higher
E) All of the above

Question 11

Which of the following statement(s) are true concerning RAROC (risk-adjusted return on capital)?

A) Under RAROC each particular asset is given a capital charge based on the amount of capital needed to be held according to an asset's risk, with a higher equity to asset % allocated to more risky types of assets.
B) With RAROC an extra capital charge will be added to the price of assets, such as loans to cover the capital that has to be held given that asset's risk.
C) Higher capital requirements for more risky types of assets at times make them less attractive versus other types of activities.
D) All statements above are true.

Question 12

Basel III requirements will have the effect of reduce the capital that banks hold relative to total average assets.

Question 13

Under Basel III as of 2016 for FDIC insured banks, a bank is considered to be well capitalized if its Tier 1 Leverage ratio is 5% or greater, its CET1 to risk based assets capital ratio is 6.5% or greater, its Tier 1 capital to risk based assets is 8% or greater, and its total Tier 1 and Tier 2 capital to risk based assets is greater than 10%.

Question 14

Capital fulfills several roles in a financial institution, including which of the following:

A) Providing access to liquidity by giving uninsured depositors confidence that their funds are safe.
B) Providing a source of funds for financing growth.
C) Helping to enhance a financial institution's credit rating.
D) Helping to protect against insolvency if the FI has significant losses.
E) All of the above.

Question 15

Profitable financial institutions can help to reverse a decline in the equity to total assets ratio by which of the following:

A) Lowering the dividend payout rate.
B) Increasing the interest rate on deposits.
C) Increasing the Burden %.
D) Paying out more dividends.
E) Having an equity growth rate less than the asset growth rate.

Question 16

Relatively high levels of capital may reduce the moral hazard problem of manager/owners taking on greater risks for a depository insurance system in that:

A) Having a higher equity may encourage managers to make better investment decisions on behalf of shareholders, since shareholders have more to lose from bad decisions.
B) Higher levels of capital may increase incentives for insured depositors to monitor their depository institution.
C) Higher levels of capital encourage managers to take greater risks.
D) All of the above.

Question 17

According to Buser, Chen, and Kane's theoretical model for banks' capital structure with and without deposit insurance, banks would have lower optimal debt to asset ratios, (i.e. higher equity to asset ratios) since uninsured depositors and other debt holders would demand a risk premium for banks having higher financial leverage, with regulators offsetting incentives for higher financial leverage with deposit insurance by having regulatory minimum capital ratios.

Question 18

If a bank has an estimated cost of equity capital of 12% (average ROE), and the bank allocates equity capital equal to 10% of its commercial loans value as a cushion against losses (i.e. equity to assets of 10%), and a marginal tax rate of 30%, what is the bank's capital charge after taxes and before tax RAROC capital charge?

A) 1.80% capital charge after taxes and 3% before taxes
B) 1.20% capital charge after taxes and 1.71% before taxes
C) 12% capital charge after taxes and 17.14% before taxes
D) None of the above

Question 19

If a bank has a before tax capital charge of 1.5%, a cost of liabilities to fund a loan of 5%, a required loan loss provision of 1.25%, another direct cost expense of 0.80%, and indirect expense of 0.40%, and an overhead expense of 0.50%, what will be the total required loan rate for this loan?

A) 10.75%
B) 12.60%
C) 9.45%
D) 8.60%

Question 20

Which of the following is true about the capital conservation buffer added under Basel III?

A) It is added to Basel III to ensure that large international banks
Build up a capital buffer in favorable periods that can be drawn upon later in unfavorable periods when losses occur.
B) When large international banks draw down on this buffer, banks are required to rebuild it by reducing distributions of earnings that are discretionary, such as reducing dividend payments, or bonus payments to managers and staff or raising new external equity capital.
C) The Basel III capital conservation buffer of 2.5% phased in by January 1, 2019 comprised of Common Equity Tier 1 capital provides a regulatory minimum capital requirement as a buffer against losses in addition to other capital requirements.
D) All of the above.

Question 21

Which of the following statements are true about Basel I?

A) Basel I set up new higher capital requirements including a leverage ratio, Tier 1 and Tier 2 capital and Tier 1 and Tier 1 & Tier 2 capital ratios as a % of risk-weighted assets.
B) Risk-weighted assets are based on how much capital must be held for particular types of assets with lower capital required for less risky types of bank assets.
C) Under Basel I off-balance sheet items are converted to risk-based assets that are also given weights and included for total risk-based assets.
D) Some analysts criticize overly simple rules for the buckets for risk-based assets under Basel I, such as subprime mortgage loans being put in a 50% risk category as mortgage loans allowing less capital to be held for them.
E) All of the above.

Question 22

Basel II included which of the following:

A) Capital charges against market, operational, and credit risk
B) An effective supervisory review process
C) Market discipline and transparency
D) Permitted large international banks to use advanced internal risk based measures to calculate credit risks and accordingly capital charges.
E) All of the above

Question 23

Basel III addresses the shortcoming of Basel II by:

A) Enhancing minimum capital and liquidity requirements that includes a higher overall capital requirement, a narrower definition of qualifying regulatory capital, higher capital charges for banking book and trading book exposures, a new leverage ratio, and a liquidity coverage ratio and net stable funding ratio
B) Enhanced Supervisory Review Process for firms with risk management and capital planning
C) Enhanced risk disclosure and market discipline
D) Redefining common equity Tier 1 (CET 1) capital, and additional Tier 1 capital, implementing a new capital conservation buffer requirement and increasing capital requirements for banks and making certain bank activities more capital intensive than in the past
E) All of the above

Question 24

Which of the following statements is false about Globally Systematically Important Banks Holding (GSIBs)?

A) All large international banks are GSIBs
B) GSIBs are determined by their size (total exposure), interconnections across the financial system, substitutability, complexity, and cross-jurisdictional activity
C) Designated GSIBs in the U.S. are required by the Federal Reserve Board to hold additional minimum capital and a liquidity coverage ratio
D) None of the above

Question 25

Changes in risk-weighted buckets under Basel III do not include weights for high volatility commercial real estate (HVCRE), past-due asset exposures, securitizations (structured investments), equity exposures to investment funds for on balance sheet assets, and certain credit conversion factors for off-balance sheet items, and a risk-weighting substitution for collateralized and guaranteed exposures.