Exam 18: Capital Management and Adequacy

Correct Answer:

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FI's capital provides five main functions:
1. To absorb unanticipated losses with enough margin to inspire confidence and enable the FI to continue as a going concern.
2. To protect uninsured depositors, bondholders and creditors in the event of insolvency and liquidation.
3. To protect FI deposit insurance funds, deposit guarantee schemes and the taxpayers.
4. To protect the FI owners against increases in insurance premiums and lowering the cost of funds.
5. To fund the branch and other real investments necessary to provide financial services.
6. Tier 1 (going concern) capital is comprised of:
a) common equity Tier 1:
Common equity is the highest quality component of capital. It is subordinated to all other types of funding, absorbs losses, has full flexibility of dividend payments and has no maturity date.
b) additional Tier 1 capital:
The concept underlying additional Tier 1 capital is that non-common equity elements included in Tier 1 capital must be able to absorb losses while the DI remains a going concern. APRA requires that additional Tier 1 items are loss absorbent on a going-concern basis, subordinated, have fully discretionary non-cumulative dividends or coupons, and have neither a maturity date nor an incentive to redeem.
Tier 2 (gone concern) capital is used to provide loss absorption on a gone-concern basis and must be subordinated to depositors and general creditors and an original maturity of at least 5 years. For liabilities with a remaining maturity of less than 5 years, recognition in regulatory capital will be amortised on a straight-line basis over the final 5 years to maturity.