Question

You are the employed by the First National Bank. This bank has $5 million in capital. They have $100 in checkable deposits. Of that they keep only the 10% required reserves and loan the rest out. In $45 million in business loans and $50 million in residential mortgages. How well capitalized is First National Bank? Calculate the risk weighted level of assets and risk weighted leverage ratio. Why are leverage (capital) ratios important for financial regulators and institutions?

Answer 1

To know how well the bank is capitalized we need to calculate the Capital-To-Risk Weighted Assets .

Capital-To-Risk Weighted Assets = (Tier 1 Capital + Tier 2 Capital / Risk-Weighted Assets)

Tier 1 capital is core capital comprising equity and reserves

Tier 2 capital is subordinated debt and supplemented reserves.

Here Tier 1 capital is (5+10)= $15 million. $5 million is the capital. 10% of $100 million is the reserves.

Risk weighted assets are the loans given out to earn interest income which is $95 million

Capital to Risk weighted assets= (15/95)=0.1578= 15.78%

Ratio of above 11% is considered to be good. Hence bank is weel capitalized.

Risk weighted level of assets is same as capital to risk weighted level of assets.

Risk weighted leverage ratio= Tier 1 capital/Average assets of the bank= 15.78%=(15/95)*100

A bank's risk-weighted assets are its assets weighted by their riskiness used to determine the minimum amount of capital that must be held to reduce its risk of insolvency. These items can all be found on a bank's financial statements

Why leverage ratios are important?

The financial crisis of 2007 and 2008 was driven by financial institutions investing in subprime home mortgage loans that had a far higher risk of default than bank managers and regulators believed to be possible. When consumers started to default on their mortgages, many financial institutions lost large amounts of capital.

Basel III set forth certain guidelines to avoid this problem moving forward. Regulators now insist that each bank must group its assets together by risk category so that the amount of required capital is matched with the risk level of each asset type.The goal is to prevent banks from losing large amounts of capital when a particular asset class declines sharply in value.

That is why these ratios are important.