Question

Assume a bank’s assets are as follows:

Asset	Book value	Weight
Residual mortgage loans	200 million	50%
Treasury bills	100 million	0%
Commercial loans	200 million	100%
Total	500 million

The minimum capital requirement is as follows:

Tier I should be greater than 4% of the total book value.

Tier I + Tier II capital should be greater than 8% of the risk weighted assets.

1. Assume the bank’s Tier I capital is 20 million and Tier II capital is 5 million. Does the bank meet the capital standards? Yes or No

2. Assume the bank’s Tier I capital is 15 million and Tier II capital is 5 million. If the bank sells 100 million in commercial loans will the capital standards be met? Yes or No

Answer 1

Given that the minimum capital requirements of bank as:

Tier I capital should be greater than 4% of the total book value.

Tier I + Tier II capital should be greater than 8% of risk weighted assets.

Total Book value of assets from the given data = 500 million

Total Risk wighted assets from the given data = 50% of 200 million + 100% of 200 million

= 300 million

1. Given that Tier I capital = 20 million

Tier II capital = 5 million

Calculate Tier I capital as per requirement = 4% of book value

= 4% of 500 million

= 20 million

Calculate Tier I+Tier II capital as per requirement = 8% of risk weighted assets

= 8% of 300 million

= 24 million

or we can also solve in another way

Capital adequacy ratio = Tier I capital + Tier II capital / Risk Weighted Assets

= ( 20 m + 5 m ) / 300 m

= 8.33%.

The minimum capital requirement of Tier I capital (20 million) was not greater than 4% of book value (20 million)

even the Tier I + Tier II capital requirements ( 20+5 = 25 million) was fulfilled which is greater than 8% of risk weighted assets (24 million).

Therefore the bank doesn't meet the capital standards. The correct answer is No.

But the capital adequacy ratio required as per standards should be greater than 8% which was 8.33%

2. Given that the Tier I capital is 15 million and Tier II capital is 5 million

Total Book value of assets from the given data = 400 million

Total Risk wighted assets from the given data = 50% of 200 million + 100% of 100 million

= 200 million

Since the bank sells 100 million in commercial bank loan.

Calculate Tier I capital as per requirement = 4% of book value

= 4% of 400 million

= 16 million

Calculate Tier I+Tier II capital as per requirement = 8% of risk weighted assets

= 8% of 200 million

= 16 million

or we can also solve in another way

Capital adequacy ratio = Tier I capital + Tier II capital / Risk Weighted Assets

= ( 15 m + 5 m ) / 200 m

= 10.00%.

The minimum capital requirement of Tier I capital (15 million) was not greater than 4% of book value (16 million)

even the Tier I + Tier II capital requirements ( 15 +5 = 25 million) was fulfilled which is greater than 8% of risk weighted assets (16 million) of 10.00%.

Therefore the bank doesn't meet the capital standards. The correct answer is No.

But the capital adequacy ratio required as per standards should be greater than 8% and actually its was 10.00% since the bank sells 100 million in commercial bank loan.

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