Capital Adequacy Verified Test Bank Ch.21 - Financial Institutions 10e Complete Test Bank by Anthony Saunders. DOCX document preview.
Chapter 21 Capital Adequacy
KEY
1. Capital is the primary protection for an FI against the risk of insolvency and failure.
2. The primary role of capital for an FI is to assure the highest possible return on equity for its shareholders.
3. Protecting FI insurance funds in the event of an FI failure is the responsibility of taxpayers.
4. One function of bank capital is to protect uninsured depositors, bondholders, and creditors in the event of insolvency and liquidation.
5. The book value of bank equity is the present value of assets minus the present value of liabilities.
6. One function of capital is to provide funding for real assets, such as branches and technology that are necessary to provide financial services.
7. The function of capital to serve as a source of funds is critical to regulators when setting risk-based deposit insurance premiums.
8. The economic definition of the value of an FI's equity is the book value of assets minus the market value of liabilities.
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.
10. 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.
11. 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.
12. The market value of capital is equal to market value of assets minus the market value of liabilities.
13. The book value of equity is seldom equal to the market value of equity.
14. An FI may be insolvent in market value terms even if the book value of equity is positive.
15. Equity holders absorb credit losses on the asset portfolio because liability holders are junior claimants.
16. 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.
17. The book value of bonds and loans reflects the market value of those assets when they were placed on the books of an FI.
18. 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.
19. Under Generally Accepted Accounting Principles, FIs have flexible rules in recognizing the amount and timing of loan losses.
20. When a substandard loan is identified by a regulator, it is required that the loan immediately be charged off by the bank.
21. Book value accounting systems recognize the impact of interest rate problems sooner than credit risk problems.
22. It is likely that the discrepancy between book value of equity and market value of equity will increase as volatility in interest rates increases.
23. More frequent regulatory examinations and stricter regulator standards will cause greater discrepancies in book value of equity and the market value of equity.
24. 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.
25. Market value accounting often is said to be difficult to implement because of the amount of assets that are not actively traded.
26. Market value accounting is likely to increase the variability of earnings of an FI.
27. 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.
28. The SEC requires securities firms to follow capital rules that utilize market value accounting.
29. FDICIA required that banks and thrifts adopt the same capital requirements.
30. Basel III capital ratios were enacted due to Basel II weaknesses exposed during the financial crisis of 2008-2009.
31. Under Basel III a depository institution's capital is divided into five categories.
32. The greater the Tier I leverage using the Standardized Approach under Basel III, the more highly leveraged the bank.
33. The Tier I leverage ratio measures the amount of an FI's total capital relative to total assets.
34. 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.
35. Under FDICIA, regulators are required to take prompt corrective action steps when a DI falls outside of Zone 1.
36. The leverage ratio specified under FDICIA does not account for the risks of off-balance-sheet activities.
37. Basel I (1993) requires banks in the member countries of the Bank for International Settlements to utilize risk-based capital ratios.
38. Under Basel II (2006), total capital is equal to Tier I capital plus Tier II capital.
39. 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.
40. Under Basel III, banks must hold a total capital to risk-weighted assets equal to 8 percent to be adequately capitalized.
41. Under Basel II (2006), regulatory minimum capital requirements for credit, market, and operational risks are covered in the first pillar of the regulation.
42. Under Basel III, banks are allowed to use their internal estimates of borrower creditworthiness to assess credit risk subject to strict disclosure standards.
43. Under Basel II (2006), operational risk can be measured by four different approaches.
44. 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.
45. Basel II attempts to encourage market discipline by having banks disclose capital structure, risk exposures, and capital adequacy in a systematic manner.
46. 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.
47. The determination of risk-weighted on-balance-sheet assets under Basel III requires the segregation of assets into nine categories of credit risk exposure.
48. 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.
49. 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.
50. Similar to Basel II, Basel III will require banks to assign on-balance-sheet assets to one of four categories of credit risk exposure.
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.
52. 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.
53. 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.
54. Basel III guidelines for determining risk-weighted on-balance-sheet assets relies more heavily on credit agency ratings than did Basel I.
55. Counterparty credit risk is the risk that the other party of a contract will default on contract obligations.
56. 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.
57. 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.
58. Determining risk-weighted asset values for OBS market contracts requires multiplying the notional values by the appropriate risk weights.
59. In evaluating the risk-weighted asset value of foreign exchange forward contracts, the value of the current exposure can be either positive or zero.
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.
61. 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.
62. 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.
63. 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.
64. The risk-based capital ratio fails to take into account the effects of diversification in the credit portfolio.
65. The risk-based capital ratio does account for loans made to companies with different credit ratings.
66. The capital requirements for broker-dealers include a net worth market value to assets ratio of at least 2 percent.
67. Broker-dealers make very few adjustments to the book value net worth to reach an approximate market value net worth.
68. The risk-based capital model in the life insurance industry includes asset risk, business risk, insurance risk, and interest rate risk.
69. In the life insurance model, morbidity risk differs from mortality risk by the circumstances surrounding the actual death event.
70. 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.
71. 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.
72. In the property-casualty insurance model, risk-based capital is a function of six different risk categories.
73. 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.
74. The stress tests run by firms and the Federal Reserve Board apply five scenarios: underperforming, poor, baseline, adverse, and severely adverse.
75. The risk-weighted assets represent the denominator of the risk-based capital ratios
76. All banks regardless of size are required to follow the same risk-weighting guidelines.
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.
78. 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.
79. 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.
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.
81. Under market value accounting methods, FIs
A. must write down the value of their assets to fully reflect market values.
B. have a great deal of discretion in timing the write downs of problem loans.
C. must conform to regulatory write-down schedules.
D. have an incentive to fully reflect problem assets as they become known.
E. are required to invest in expensive computerized bookkeeping systems.
82. Losses in asset values due to adverse changes in interest rates are borne initially by the
A. equity holders of an FI.
B. liability holders of an FI.
C. regulatory authorities.
D. taxpayers.
E. insured depositors.
83. Through August 2015, which of the following approximates the amount of funds paid back to the U.S. Treasury as part of the TARP Capital Purchase Program?
A. $192.1 billion.
B. $120.0 billion.
C. $236.5 billion.
D. $26.9 billion.
E. $19.6 billion.
84. Through August 2015, which of the following approximates the amount of dividends and assessments that the U.S. Treasury has received from entities participating in the TARP Capital Purchase Program?
A. $20.1 billion.
B. $1.2 billion.
C. $34.6 billion.
D. $16.0 billion.
E. $26.25 billion.
85. What is the impact on economic capital of a 25 basis point decrease in interest rates if the FI is holding a 20-year, fixed-rate, 11 percent annual coupon bond selling at a par value of $100,000?
A. A decrease of $250.
B. An increase of $250.
C. An increase of $2,024.
D. A decrease of $1,959.
E. No impact on capital since the book value is unchanged.
Feedback: Fair market value of bond:
$102,023.82 − $100,000 ≈ +$2,024
86. From a regulatory perspective, what is the impact on book value capital of a 25 basis point decrease in interest rates if the FI is holding a 20-year, fixed-rate, 11 percent annual coupon $100,000 par value bond?
A. A decrease of $250.
B. An increase of $250.
C. An increase of $2,023.
D. A decrease of $1,959.
E. No impact on capital since the book value is unchanged.
87. The FASB set its guidelines to allow for the valuation of assets to be based on
A. prices at the discretion of the DI's management.
B. book values rather than market values.
C. market values that existed when the assets were last marked to market.
D. prices that would be received as part of a forced liquidation.
E. prices that would be received in an orderly market.
88. Under historical accounting methods for the market value of capital, FIs
A. must write down the value of their assets to fully reflect market values.
B. have a great deal of discretion in timing the write downs of problem loans.
C. must conform to regulatory write-down schedules.
D. have an incentive to fully reflect problems in the asset portfolio as they become known.
E. invest in expensive computerized bookkeeping systems.
89. During the financial crisis of 2008-2009, the FASB provided guidance on asset valuation that allowed
A. DI management to use internal cash flow models and assumptions to estimate fair value when there is limited market data available.
B. regulatory capital of banks to deviate from industry norms.
C. excess reserves with the Fed to be included as regulatory capital.
D. DIs to choose either book value treatment or market value treatment of asset valuation.
E. DI management the option to postpone asset write-downs until adequate capital was available.
90. Using a strict market value accounting might cause regulators to
A. revert to book value accounting in order to determine net worth.
B. close banks too early under prompt corrective action requirements.
C. exempt Dis from prompt corrective action.
D. allow banks to operate without oversight even with negative net worth.
E. suspend regulatory capital requirements during temporary spikes in interest rates.
91. Those regulatory agencies that have adopted some form of book value accounting standard to measure an FI's capital include all of the following except
A. The Securities and Exchange Commission (SEC).
B. The Federal Reserve.
C. The Office of the Comptroller of the Currency (OCC).
D. The FDIC.
E. State regulatory agencies.
92. Which of the following is NOT a typical argument against market value accounting?
A. Market value accounting introduces an unnecessary degree of variability into an FI's earnings.
B. The use of market value accounting may reduce the willingness of FI's to invest in longer-term assets.
C. FI's are increasingly trading, selling, and securitizing assets.
D. Market value accounting is difficult to implement.
E. Market value accounting may interfere with an FI's special functions as lenders and monitors of credit.
93. The U.S. banking industry built up record levels of capital in the early 2000s because
A. the economy went through a downturn.
B. problem loans increased.
C. the regulators required higher amounts of equity sales.
D. of record high levels of profitability.
E. of mergers between large banks.
94. Bank regulators set minimum capital standards to
A. inhibit rapid growth rate of bank assets.
B. protect shareholders from managerial fraud or incompetence.
C. protect creditors from decreases in asset values.
D. force banks to follow socially desirable policies.
E. make work for regulators.
95. The concept of prompt corrective action refers to the requirement
A. that bank managers must address problems in the loan portfolio when they are first identified.
B. that regulators must take specific actions when bank capital levels fall outside the well-capitalized category.
C. that a receiver must be appointed when a bank's book value of capital to assets falls below 2 percent.
D. that regulators must take specific actions when bank capital levels fall outside the well-capitalized category and that a receiver must be appointed when a bank's book value of capital to assets falls below 2 percent.
E. that all of the options are correct.
96. The Basel capital requirements differ from previous capital standards in all except one of the following ways?
A. More stringent capital standards for large banks than for small banks.
B. Inclusion of off balance sheet assets in the asset base.
C. Restrictions on the amount of goodwill that can be counted towards primary or Tier I capital.
D. Risk weighting of assets on the basis of credit risk exposure.
E. Risk weighting of off balance sheet contingencies.
97. The Basel capital requirements are based upon the premise that
A. banks with riskier assets should have higher capital ratios.
B. banks with riskier assets should have lower capital ratios.
C. banks with riskier assets should have lower absolute amounts of capital.
D. banks with riskier assets should have higher absolute amounts of capital.
E. there is no relationship between asset risk and capital.
98. The Basel I capital requirements as currently implemented include
A. different credit risks of on-balance-sheet assets.
B. different credit risks of off-balance-sheet assets.
C. the consideration of market risk in 1998.
D. All of the options.
E. Only two of the options.
99. The Basel II Accord effective at year-end 2007 in the United States
A. includes provisions covering minimum capital requirements for credit, market, and interest rate risk.
B. stresses the regulatory supervisory process by requiring regulators to be more involved in evaluating the bank's specific risk profile and environment.
C. requires only banks on the regulatory problem bank list to disclose publicly the degree and depth of problem issues as well as their capital adequacy.
D. All of the options.
E. stresses the regulatory supervisory process by requiring regulators to be more involved in evaluating the bank's specific risk profile and environment and requires only banks on the regulatory problem bank list to disclose publicly the degree and depth of problem issues as well as their capital adequacy.
100. The measurement of credit risk under the Basel II Accord allows banks to choose between
A. a standardized approach similar to that used under Basel I.
B. a basic indicator approach that will cause banks to hold an additional 12 percent of capital.
C. an internal rating system in which they must adhere to strict methodological and disclosure standards.
D. All of the options.
E. a standardized approach similar to that used under Basel I and an internal rating system in which they must adhere to strict methodological and disclosure standards.
101. The bank is considering changing its asset mix by moving $100 million of commercial loans into Treasury securities. If it does change the asset mix and capital remains the same, the risk-based capital ratio
A. will not change because the total assets have not changed.
B. will decrease because the earnings rate on Treasuries is less than on loans.
C. will increase by 16.67 percent.
D. will increase because the assets will have less risk.
E. will change, but the direction cannot be determined with the information given.
102. Which of the following is not a category of capital under Basel III?
A. Tier III capital.
B. Tier II capital.
C. Common Equity Tier I.
D. Total risk-based capital.
E. Tier I capital.
103. Which of the following assets is deducted from Common Equity Tier I capital?
A. Trademarks.
B. Goodwill.
C. Patents.
D. Bank premises.
E. None of the options.
104. Which of the following is not included in the Common Equity Tier I capital under Basel III?
A. Retained earnings.
B. Par value of common shares issued by the bank.
C. Par value of noncumulative perpetual preferred stock.
D. Paid-in excess (surplus) of common stock.
E. Common shares issued by consolidated subsidiaries of the bank.
105. Which of the following statements best describes the treatment of adjusting for credit risk of off-balance-sheet activities?
A. All OBS activities are treated equally in making credit-risk adjustments.
B. Standby letter of credit guarantees issued by banks to back commercial paper have a 50 percent conversion factor.
C. The credit or default risk of over-the-counter contracts is approximately zero.
D. The current exposure component of the credit equivalent amount of OBS derivative contracts reflects the credit risk if the contract counterparty defaults.
E. The treatment of interest rate forward, option, and swap contracts differs from the treatment of contingent or guarantee contracts.
106. A criticism of the Basel I risk-based capital ratio is
A. the incorporation of off-balance-sheet risk exposures.
B. the application of a similar capital requirement across major banks in international banking centers across the world.
C. the more systematic accounting of credit risk differences.
D. the lack of appropriate consideration of the portfolio diversification effects of credit risk.
E. the application of a similar capital requirement across major banks in international banking centers across the world and the more systematic accounting of credit risk differences.
107. Which of the following is NOT a criticism of the Basel I risk-based capital ratio?
A. All commercial loans are given equal weight regardless of the credit risk of the borrower.
B. The ratio incorporates off-balance-sheet risk exposures.
C. Grouping assets into different risk categories may encourage balance sheet asset allocation games.
D. The treatment does not include interest rate or foreign exchange risk.
E. The weights in the four risk categories imply a cardinal measurement of relevant risk between each category.
108. The primary difference between Basel I and the proposed Basel III in calculating risk-weighted assets is
A. that Basel II considers OBS assets.
B. the use of only three weight classes rather than four classes.
C. a heavier reliance on the use of ratings by external credit rating agencies for the assignment of assets to weight classes.
D. All of the options.
E. that Basel II considers OBS assets as well as a heavier reliance on the use of ratings by external credit rating agencies for the assignment of assets to weight classes.
109. The primary difference between Basel I and the proposed Basel III in converting OBS
values to on-balance-sheet credit equivalent amounts is
A. the use of credit ratings in Basel III to assign credit risk weights on the OBS activities.
B. the use of six weight classes by Basel III rather than four classes.
C. the use of the underlying counterparty activity in Basel II to assign credit risk weights on the OBS activities.
D. All of the options.
E. a heavier reliance on the use of ratings by external credit rating agencies for the assignment of assets to weight classes and the use of the underlying counterparty activity in Basel II to assign credit risk weights on the OBS activities.
110. Counter party credit risk in OBS contracts
A. is the risk that the counterparty will likely default when he is in the money on a contract position.
B. refers to the risk that a counterparty will default when suffering large actual or potential losses on its position.
C. requires the counterparty to return to the market and replace contracts at less favorable terms.
D. All of the options.
E. None of the options.
111. The potential exposure component of the credit equivalent amount of OBS derivative items reflects
A. the probability of an adverse price movement in contracts.
B. the cost of replacing a contract if a counterparty defaults today.
C. the probability today of a counterparty contract default in the future.
D. the maximum price loss for any given position.
E. the probability of an adverse price movement in contracts and the maximum price loss for any given position.
112. The current exposure component of the credit equivalent amount of OBS derivative items reflects
A. the probability of an adverse price movement in contracts.
B. the cost of replacing a contract if a counterparty defaults today.
C. the probability today of a counterparty contract default in the future.
D. the maximum price loss for any given position.
E. future volatility of the underlying.
113. The calculation of the risk-weighted asset values of OBS market contracts
A. nearly always equals zero because the exchange over which the contract initially traded assumes all of the risk.
B. requires multiplication of the credit equivalent amounts by the appropriate risk weights.
C. requires the calculation of a conversion factor to create credit equivalent amounts.
D. All of the options.
E. requires multiplication of the credit equivalent amounts by the appropriate risk weights and the calculation of a conversion factor to create credit equivalent amounts.
114. The buffer proposed by Basel III that is designed to ensure that DIs build up a capital surplus outside of periods of financial distress is called the
A. Capital conservation buffer.
B. Countercyclical buffer.
C. Leverage buffer.
D. Tier II buffer.
E. CET1 capital buffer.
115. The purpose of the countercyclical buffer proposed by Basel III is to
A. expose those banks with inadequate capital to survive economic downturns.
B. assist insolvent banks build capital during economic expansions.
C. protect the banking system and reduce systematic exposures to economic downturns.
D. enhance global movement of funds to those countries experiencing excess aggregate credit growth.
E. force DIs to immediately adjust capital to meet the 2.5 percent level of buffer capital required.
116. Failure to meet the capital conservations buffer and the countercyclical buffer guidelines instituted under Basel III will result in limits to all of the following except
A. bonuses paid to executives of the institution.
B. regularly scheduled dividends paid to stockholders.
C. special dividends meant to distribute retained earnings to stockholders.
D. lending to international entities.
E. buyback programs of common stock.
117. How many institutions are currently listed as Global Systematically Important Banks (G-SIBs)?
A. 12.
B. 18.
C. 30.
D. 36.
E. 45.
118. Under Basel III, Globally Systematically Important Banks (G-SIBs) were identified by the Bank for International Settlements (BIS) by all of the following indicators except:
A. Size.
B. Lack of substitutes for the institution's services.
C. Cross-jurisdictional activity.
D. Interconnectedness with other institutions.
E. Ability to obtain insurance or other guarantees on deposits.
119. Calculation of the "add-on" to the risk-based capital ratio to measure market risk
A. may be done using the Basic Indicator Approach.
B. may be done using the standardized model proposed by regulators.
C. may be done using the DI's own internal market risk model.
D. may be done using the Basic Indicator Approach and the standardized model proposed by regulators.
E. may be done using the standardized model proposed by regulators and the DI's own internal market risk model.
120. Calculation of the "add-on" to the risk-based capital ratio to measure operational risk
A. may be done using the Basic Indicator Approach.
B. may be done using the Standardized Approach.
C. may be done using the Advanced Measurement Approach.
D. All of the options.
E. may be done using the Basic Indicator Approach and the Standardized Approach.
121. Which approach used in calculating capital to cover operational risk allow banks to rely on internal data for the calculation of regulatory capital requirements?
A. Standardized approach.
B. Advanced measurement approach.
C. Basic indicator approach.
D. Internal ratings-based approach.
E. All of the options.
122. In calculating the net capital for a securities firms, which of the following is NOT an adjustment to the book value of net worth?
A. Aggregate indebtedness
B. Unrealized profits
C. An adjustment for certain tax provisions
D. Deferred tax provisions
E. Unrealized losses
123. Broker-dealers must ensure that aggregated indebtedness is not less than
A. 15 times larger than liquid assets.
B. 15 times larger than equity.
C. 25 percent of net worth.
D. 2 percent of equity.
E. 8 percent of equity.
124. Which of the following risk categories is NOT covered by the risk-based model for the life insurance industry?
A. Interest rate risk.
B. Business risk.
C. Asset risk.
D. Foreign exchange risk.
E. Insurance risk.
125. In the NAIC model for life insurance companies, which risk covers the amount of capital necessary to meet the maximum contribution that an insurance company may need to make to the state guarantee fund?
A. Interest rate risk.
B. Business risk.
C. Asset risk.
D. Foreign exchange risk.
E. Insurance risk.
126. In the NAIC model for life insurance companies, which risk captures the risk of adverse changes in mortality risk and morbidity risk?
A. Interest rate risk.
B. Business risk.
C. Asset risk.
D. Foreign exchange risk.
E. Insurance risk.
127. In the NAIC model for life insurance companies, this risk measures the liquidity of liabilities for given rate changes.
A. Interest rate risk
B. Business risk
C. Asset risk
D. Foreign exchange risk
E. Insurance risk
128.
How would regulators characterize this FI based on the Standardized Approach leverage ratio zones of Basel III?
A. Well capitalized
B. Undercapitalized
C. Severely undercapitalized
D. Overcapitalized
E. Insolvent
Feedback: 
LR = $35/(250 + 760) = 35/1,010 = 0.03465 ≈ 3.47 percent
Well-capitalized = 5 percent
Adequately-capitalized = 4 percent
129.
If problem loans reduce the market value of the loan portfolio by 25 percent, what is the value of regulatory defined (book value) capital?
A. $35 million.
B. -$155 million.
C. $7 million.
D. -$7 million.
E. $0.
Feedback: Loan portfolio × reduction percentage = decrease in market value of loan portfolio
$760 × (−0.25) = −$190
The decrease in the market value of the loan portfolio has no effect on book value, so there is no change in the capital: $35
130.
If problem loans reduce the market value of the loan portfolio by 25 percent, what is the market value of capital?
A. $35 million.
B. -$155 million.
C. $7 million.
D. -$7 million.
E. $0.
Feedback: Loan portfolio × reduction percentage = decrease in market value of loan portfolio
$760 × (−0.25) = −$190
Under market value accounting, the $35 million in capital will be reduced by $190 million.
MV capital = $35 − $190 = −$155
131.
Given that 25 percent of the loans have been identified as problem loans, and if historical cost accounting methods allow the bank to write down only 10 percent of the problem loans, what will be the book value of capital?
A. $35 million.
B. -$155 million.
C. $16 million.
D. -$7 million.
E. $0.
Feedback: Loan portfolio × reduction percentage × write-down percentage = decrease in reported value of loan portfolio
$760 × (−0.25) × 0.10 = −$19
Under market value accounting, the $35 million in capital will be reduced by $19 million.
MV capital = $35 − $19 = −$16
132.
If the loan portfolio consists of a five-year, 10 percent annual coupon loan selling at par, what is the market, or economic, value of capital if interest rates increase 1 percent?
A. $35 million.
B. -$155 million.
C. $7 million.
D. -$7 million.
E. $0.
Feedback: MV with rate increase
Change in market value of loans = $732 − $760 = −$28
Change in economic value of capital = $35 − $28 = $7 million
133.
If the loan portfolio consists of five-year, 10 percent annual coupon par value loans, what is the market, or economic, value of capital if interest rates decrease 2 percent?
A. $35 million.
B. $96 million.
C. $60 million.
D. -$7 million.
E. $0.
Feedback: MV with rate decrease
Change in market value of loans = $820 − $760 = +$61
Change in economic value of capital = $35 + $61 = $96 million
134.
Note: The residential mortgages all have a loan-to-value of between 60 and 80 percent.
If the bank has capital of $50 million, what is the leverage ratio using the standardized approach?
A. 5.00 percent.
B. 8.33 percent.
C. 25.0 percent.
D. 50.0 percent.
E. None of the options.
Feedback: Total Assets = 100 + 100 + 200 + 600 = $1,000
Total Capital = $50
LR = 50/1,000 = 0.05 = 5.0 percent
135.
Note: The residential mortgages all have a loan-to-value of between 60 and 80 percent.
What is the amount of risk-weighted assets?
A. $1,000 million.
B. $720 million.
C. $900 million.
D. $600 million.
E. $700 million.
Feedback: Risk-Weighted Assets =
136.
Note: The residential mortgages all have a loan-to-value of between 60 and 80 percent.
What is the ratio of capital to risk-weighted assets, if the bank has capital of $50 million?
A. 5.00 percent.
B. 5.56 percent.
C. 6.94 percent.
D. 8.33 percent.
E. 6.25 percent.
Feedback: Capital to risk-weighted assets: $50/$720 = 0.0694
137. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
What is Sigma Bank's risk-weighted assets as defined by the Basel standards for its on-balance-sheet assets only?
A. $400 million.
B. $360 million.
C. $310 million.
D. $287 million.
E. $236 million.
Feedback: 
138. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
What is the minimum required Tier I and Total risk-based capital for the on-balance-sheet assets in order for the DI to be adequately capitalized?
A. $8 million; $8 million.
B. $16.87 million; $16.87 million.
C. $17.22 million; $22.96 million.
D. $22.96 million; $28.70 million.
E. $10.8 million; $8 million.
Feedback: In order to be adequately capitalized, Tier I capital must be 6.0 percent and Total Risk-based capital is to be 8.0 percent.
Recall that total risk based capital will include the preferred stock as Tier II capital.
Tier I capital = $287 million × 0.06 = $17.22 million.
Total Risk Based Capital = $287 × 0.08 = $22.96 million.
Tier 1 capital includes only equity: $10 million.
Total risk-based capital is equity + perpetual preferred: $10 + $20 = $30 million.
139. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
Is the bank adequately capitalized for its on-balance-sheet assets based on the Basel standards?
A. Yes, because both Tier I and Tier II capital each exceed the required minimum.
B. Yes, because both the Tier I and Tier II combined exceeds the required minimum.
C. No, because both Tier I and Tier II capital each are below the required minimum.
D. No, because Tier I is below the required minimum while Tier II exceeds the required minimum.
E. No, because Tier I is above the required minimum while Tier II is below the required minimum.
Feedback: Tier 1 capital includes only equity: $10 million.
Amount of Tier I capital required to be adequately capitalized: $17.22.
Total risk-based capital includes equity and perpetual preferred: $10 + $20 = $30 million.
Amount of total risk-based capital required to be adequately capitalized: $22.96 million.
140. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
What is the credit equivalent amount of the off-balance-sheet letters of credit, both standby and commercial?
A. $9.6 million.
B. $16.0 million.
C. $48 million.
D. $72 million.
E. $80 million.
Feedback: Refer to Table 20-10
Direct-credit substitute standby letters of credit conversion factor = 100 percent
Commercial letters of credit conversion factor = 20 percent
Risk weights of each is 100%
Credit equivalent amount = (Face Value OBS item × conversion factor)
CEA = ($40 standby letter × 1.00) + ($40 commercial letter × 0.20)
CEA= $40 + $8 = $48 million
141. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
What is the minimum total risk-weighted capital (Tier I + Tier II) required for both of the off-balance-sheet letters of credit under the Basel II standards?
A. $3.84 million.
B. $3.68 million.
C. $3.20 million.
D. $4.80 million.
E. $6.40 million.
Feedback: On-BS asset value of Off-BS item = (Credit equivalent amount × risk weight)
On-BS asset value of Off-BS item = [(FV of OBS item × CF) × RW]
On-BS asset value = [($40 × 1.00) × 1.00] + [$40 × 0.20) + 1.00] = $48 million
In order to be adequately capitalized, total risk-based capital must be at least 8.0 percent.
CEA of OBS = $48 × 0.08 = $3.84 million
142. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
What is the credit equivalent amount of the off-balance-sheet interest rate swaps if it is in-the-money by $1 million?
A. $1.0 million.
B. $2.0 million.
C. $3.0 million.
D. $4.0 million.
E. $5.0 million.
Feedback: Refer to Table 20-11
10-year interest rate swap credit conversion factor = 1.5 percent
Credit equivalent amount = (Notational value × Potential exposure conversion factor) + replacement cost if greater than zero.
CEA= ($200 × 0.015) + $8 = $3 million + $1 million = $4 million
143. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
What is the credit equivalent amount of the off-balance-sheet foreign exchange contracts if it is out-of-the-money by $4 million?
A. $1.0 million.
B. $2.0 million.
C. $5.0 million.
D. $6.0 million.
E. $9.0 million.
Feedback: Refer to Table 20-11
One to 5 year foreign exchange rate contract credit conversion factor = 5.0 percent
Credit equivalent amount = (Notational value × Potential exposure conversion factor) + replacement cost if greater than zero.
CEA= ($100 × 0.05) + $0 = $5 million + $0 = $5 million
144. Sigma Bank has the following balance sheet in millions of dollars. Unless mentioned otherwise, all assets are associated with corporate customers (not governments or sovereigns). Values are in millions of dollars. Refer to table 20-8 for appropriate risk weights.
Off balance sheet contingent liabilities (Refer to Table 20-10)
$40 million direct-credit substitute standby letters of credit issued to a U.S. corporation.
$40 million commercial letters of credit issued to a corporation
Off-balance sheet derivatives (Refer to Table 20-11)
$200 million 10-year interest rate swaps
$100 million 2-year forward DM contracts
What is the minimum total capital (Tier I + Tier II) required to be adequately capitalized for the off-balance sheet derivative contracts (both interest rate swaps and foreign exchange forwards) under Basel II?
A. $0.24 million.
B. $0.36 million.
C. $0.72 million.
D. $0.60 million.
E. $0.48 million.
Feedback: Both interest rate and FX contracts carry a risk weight of 100%
Total capital needed = [(CEA of swap × RW) + (CEA of FX × RW)] × 0.08
Total capital needed = [($4 million + $5 million) × 0.08] = $0.72 million
145. Fifth Bank has the following balance sheet with values stated in millions of dollars. All assets are associated with corporate customers (not governments or sovereigns). Refer to Table 20-8 for associated risk weights.
In addition, Fifth Bank has off-balance sheet items as follows: (Refer to Tables 20-10 and 20-11)
$50 million in commercial letters of credit (LCs),
$300 million in 3-year interest rate swaps that are in-the-money by $2 million
$50 million in 4-year forward FX contracts that are out-of-the money by $2 million
What is the amount of risk weighted on-balance-sheet assets of the bank as defined under the Basel II standards?
A. $130.0 million.
B. $685.0 million.
C. $720.0 million.
D. $630.0 million.
E. $900.0 million.
Feedback: Risk-Weighted Assets =
146. Fifth Bank has the following balance sheet with values stated in millions of dollars. All assets are associated with corporate customers (not governments or sovereigns). Refer to Table 20-8 for associated risk weights.
In addition, Fifth Bank has off-balance sheet items as follows: (Refer to Tables 20-10 and 20-11)
$50 million in commercial letters of credit (LCs),
$300 million in 3-year interest rate swaps that are in-the-money by $2 million
$50 million in 4-year forward FX contracts that are out-of-the money by $2 million
Is Fifth Bank currently over or under capitalized for on-balance-sheet assets in order to be considered well capitalized according to Basel III?
A. Overcapitalized for both Tier I and Total capital standards.
B. Overcapitalized for Tier I standard; Undercapitalized for Total standard.
C. Undercapitalized for Tier I standard; Overcapitalized for Total standard.
D. Undercapitalized for both Tier I and Total capital standards.
E. Unable to determine.
Feedback: In order to be well capitalized, Tier I capital must be 8.0 percent and Total Risk-based capital must be 10.0 percent.
Tier I capital required = $630 million × 0.08 = $50.40 million
Total risk-based capital required = $630 × 0.10 = $63.00 million
For Tier I standard, Fifth Bank is ($60 − $50.40) = $9.6 million OVER the minimum capital required.
For Total risk-based capital standard, Fifth Bank is ($60 − $63.0) = $3.0 million UNDER the minimum capital
147. Fifth Bank has the following balance sheet with values stated in millions of dollars. All assets are associated with corporate customers (not governments or sovereigns). Refer to Table 20-8 for associated risk weights.
In addition, Fifth Bank has off-balance sheet items as follows: (Refer to Tables 20-10 and 20-11)
$50 million in commercial letters of credit (LCs),
$300 million in 3-year interest rate swaps that are in-the-money by $2 million
$50 million in 4-year forward FX contracts that are out-of-the money by $2 million
What are, respectively, the credit equivalent value of the letters of credit, interest rate swaps, and FX contracts?
A. $10.0 million; $3.5 million; $5.0 million.
B. $50.0 million; $300 million; $50.0 million.
C. $5.0 million; $1.5 million; $5.0 million.
D. $10.0 million; $1.5 million; $5.0 million.
E. $5.0 million; $3.5 million; $5.0 million.
Feedback: Letter of Credit
Refer to Table 20-10
Commercial letters of credit conversion factor = 20 percent
Credit equivalent amount = (Face Value OBS item × conversion factor)
CEAlc= $50 × 0.20 = $10 million
Interest rate swap
Refer to Table 20-11
3-year interest rate swap credit conversion factor = 0.5 percent
Credit equivalent amount = (Notational value × Potential exposure conversion factor) + replacement cost if greater than zero.
CEAswap= ($300 × 0.005) + $2 = $1.5 million + $2 million = $3.5 million
FX forward contract
Refer to Table 20-11
One to 5 year foreign exchange rate contract credit conversion factor = 5.0 percent
Credit equivalent amount = (Notational value × Potential exposure conversion factor) + replacement cost if greater than zero.
CEAFX= ($100 × 0.05) + $0 = $5 million + $0 = $5 million
148. Fifth Bank has the following balance sheet with values stated in millions of dollars. All assets are associated with corporate customers (not governments or sovereigns). Refer to Table 20-8 for associated risk weights.
In addition, Fifth Bank has off-balance sheet items as follows: (Refer to Tables 20-10 and 20-11)
$50 million in commercial letters of credit (LCs),
$300 million in 3-year interest rate swaps that are in-the-money by $2 million
$50 million in 4-year forward FX contracts that are out-of-the money by $2 million
What are the total risk-weighted off-balance-sheet assets of the bank as defined under the Basel II standards?
A. $400 million.
B. $16.5 million.
C. $11.5 million.
D. $13.5 million.
E. $18.5 million.
Feedback: All of these OBS items carry a risk weight of 100%
Total on-balance sheet asset value equivalents = [(CEAlc × RWlc) + (CEAswap × RWswap) + (CEAFX × RWFX]
Total on-balance sheet asset value equivalents = [(10 × 1.00) + (3.5 × 1.00) + (5 × 1.00)] = $18.5 million
149. Fifth Bank has the following balance sheet with values stated in millions of dollars. All assets are associated with corporate customers (not governments or sovereigns). Refer to Table 20-8 for associated risk weights.
In addition, Fifth Bank has off-balance sheet items as follows: (Refer to Tables 20-10 and 20-11)
$50 million in commercial letters of credit (LCs),
$300 million in 3-year interest rate swaps that are in-the-money by $2 million
$50 million in 4-year forward FX contracts that are out-of-the money by $2 million
What is the minimum Tier 1 and Total risk-based capital Fifth Bank needs in order to be considered adequately capitalized under Basel III capital requirements for both on-balance sheet and off-balance sheet items?
A. $40.71 million; $63.0 million.
B. $38.91 million; $51.88 million.
C. $51.88 million; $64.85 million.
D. $50.40 million; $67.5 million.
E. $38.91 million; $50.40 million.
Feedback: Total Risk-Weighted Assets = Risk-Weighted On- and Off-Balance sheet assets
Total = 630 + 18.5 = $648.5 million.
In order to be adequately capitalized, Tier I capital must be 6.0 percent and Total Risk-based capital must be 8.0 percent.
Tier I capital required = $648.5 million × 0.06 = $38.91 million
Total risk-based capital required = $648.5 × 0.08 = $51.88 million
150. A property-casualty (P-C) insurance firm has estimated the following risk-based capital charge for its individual risk classes:
Risk | Description | RBC Charge |
R0 | Affiliated P-C | $6.0 million |
R1 | Fixed-income assets | $2.0 million |
R2 | Common Stock | $1.0 million |
R3 | Reinsurance | $3.0 million |
R4 | Loss Adjustment Expense | $1.0 million |
R5 | Written Premiums | $2.0 million |
R6 | Hurricane | $1.0 million |
R7 | Earthquake | $0.5 million |
Total | $16.50 million |
Using the model recommended by the National Association of Insurance Commissioners (NAIC), what is the total risk-based capital charge for the P-C firm?
A. $4.36 million.
B. $10.00 million.
C. $10.50 million.
D. $12.50 million.
E. $15.00 million.
Feedback:
151. A property-casualty (P-C) insurance firm has estimated the following risk-based capital charge for its individual risk classes:
Risk | Description | RBC Charge |
R0 | Affiliated P-C | $6.0 million |
R1 | Fixed-income assets | $2.0 million |
R2 | Common Stock | $1.0 million |
R3 | Reinsurance | $3.0 million |
R4 | Loss Adjustment Expense | $1.0 million |
R5 | Written Premiums | $2.0 million |
R6 | Hurricane | $1.0 million |
R7 | Earthquake | $0.5 million |
Total | $16.50 million |
Is the firm adequately capitalized if it has total capital and surplus of $10 million?
A. No, its total risk-based capital charge is higher than $10 million.
B. No, its total risk-based capital charge is lower than $10 million.
C. Yes, its total risk-based capital charge is higher than $10 million.
D. Yes, its total risk-based capital charge is lower than $10 million.
E. No, its total risk-based capital charge is greater than 0.
152. The risk-based capital requirements have received several types of criticism. Please match the criticism headings below (as stated in the text) with the appropriate criticism.
1. Pillar 2 may ask too much of regulators
2. Portfolio aspects
3. Competition
4. Risk weights based on external credit rating agencies
5. DI specialness
6. Risk weights
7. Other risks
8. Impact on capital requirements
9. Excessive complexity
Because of different tax, accounting, and safety-net rules and the application of the new Basel III rules to different industries, a level playing field across banks in different countries will not occur. 3
Because DIs may have little incentive to make high risk commercial loans, one important aspect of intermediation may be somewhat curtailed. 5
The benefits may not support the significant cost of developing and implementing new risk management systems. 9
Banks in the U.S. likely would need additional capital to meet the new minimum standards. 8
Interest rate and liquidity risks are not yet included in the proposed Basel III plan. 7
Regulators may not be trained or willing to make the necessary decisions that may rely heavily on judgment. 1
The BIS plans largely ignore the covariance among asset risks between different parties. 2
The four (five) risk weight categories in Basel I (Basel II) may not reflect the true credit risk. 6
Because rating agencies often lag rather than lead the business cycle, risk weights based on a loan's credit rating may not accurately measure the relative risk exposure of individual borrowers. 4