Question

Third Bank has the following balance sheet (in millions), with the risk weights in parentheses.

              Assets                                                                        Liabilities and Equity

Cash                                (0%)   K70               Deposits                                     K175

OECD Interbank deposits (20%) K25               Subordinated debt (2.5 years)       K3

Mortgage loans               (50%)   K70              Cumulative preferred stock             K5

Consumer loans             (100%) K20              Equity                                             K2

Total Assets                                K185             Total Liabilities & Equity             K185

        

The cumulative preferred stock is qualified and perpetual. In addition, the bank has K30 million in performance-related standby letters of credit (SLCs), K40 million in two-year forward FX contracts that are currently in the money by K1 million, and K300 million in six-year interest rate swaps that are currently out of the money by K2 million. Credit conversion factors follow:

         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%

REQUIRED:

1. What are the risk-adjusted on-balance-sheet assets of the bank as defined under the Basel Accord III?   
2. What is the total capital required for both off- and on-balance-sheet assets?

  

3. Does the bank have enough capital to meet the Basel requirements? If not, what minimum Tier 1 or total capital does it need to meet the requirement?           

Answer 1

ANSWER

A . What are the risk-adjusted on-balance-sheet assets of the bank as defined under the Basel Accord III ?

Risk-adjusted assets:

Cash 0 x 70 = $0

OECD interbank deposits 0.20 x 25 = $5

Mortgage loans 0.50 x 70 = $35

Consumer loans 1.00 x 20 = $20

Total risk-adjusted assets = $60

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

Standby LCs: $30 x 0.50 = $15 = $15

Foreign exchange contracts:

Potential exposure $40 x 0.05 = $2

Current exposure in the money = $0

Interest rate swaps:

Potential exposure $300 x 0.015 = $4.5

Current exposure Out-of-the money = $2

= $8.5 x 0.50 = $4.25

Total risk-adjusted on- and off-balance-sheet assets = $79.25 ( $60 + $15 +$4.25 ) x 0.08

Total capital required = $6.34

C . Does the bank have enough capital to meet the Basel requirements? If not, what minimum Tier 1 or total capital does it need to meet the requirement?      

No, the bank does not have sufficient capital to meet the Basel requirements. It

needs total capital of $6.34, of which Tier 1 must be at least $79.25 x 0.04 =

$3.17. Further, since perpetual preferred stock is limited to 25 percent ($0.792

million) of Tier 1, the bank needs at least $2.38 million of equity capital. Thus an

additional $.38 million of equity is necessary to satisfy the Tier 1 requirements.

If Tier I actually equals $3.17, the required Tier II capital also will be $3.17. Of

this amount, the remaining perpetual preferred stock is counted,

which leaves $0.792 million of subordinated debt that can be used to satisfy the Tier

II requirement. This amount is available and satisfies the limit of 50% of Tier I

rule.

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