Deck 20: Capital Adequacy

Question 1

Under International Financial Reporting Standards, FIs have flexible rules in recognizing the amount and timing of loan losses.

Answer 1

True

Question 2

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.

Answer 2

True

Question 3

An FI may be insolvent in market value terms even if the book value of equity is positive.

Answer 3

True

Question 4

Protecting FI insurance funds in the event of an FI failure is the responsibility of taxpayers.

Question 5

The book value of bank equity is the present value of assets minus the present value of liabilities.

Question 6

One function of capital is to provide funding for real assets, such as branches and technology that are necessary to provide financial services.

Question 7

The book value of bonds and loans reflects the market value of those assets when they were placed on the books of an FI.

Question 8

One function of bank capital is to protect uninsured depositors, bondholders, and creditors in the event of insolvency and liquidation.

Question 9

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.

Question 10

Equity holders absorb credit losses on the asset portfolio because liability holders are junior claimants.

Question 11

The primary role of capital for an FI is to assure the highest possible return on equity for its shareholders.

Question 12

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.

Question 13

The book value of equity is seldom equal to the market value of equity.

Question 14

Capital is the primary protection for an FI against the risk of insolvency and failure.

Question 15

The economic definition of the value of an FI's equity is the book value of assets minus the market value of liabilities.

Question 16

The market value of capital is equal to market value of assets minus the market value of liabilities.

Question 17

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.

Question 18

When a substandard loan is identified by a regulator, it is required that the loan immediately be charged off by the bank.

Question 19

The function of capital to serve as a source of funds is critical to regulators in setting risk-based deposit insurance premiums.

Question 20

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.

Question 21

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.

Question 22

Under Basel II (2006), operational risk can be measured by four different approaches.

Question 23

Book value accounting systems recognize the impact of interest rate problems sooner than credit risk problems.

Question 24

It is likely that the discrepancy between book value of equity and market value of equity will increase as volatility in interest rates increases.

Question 25

Basel III capital ratios will become fully effective for Canadian banks in 2016.

Question 26

Under Basel II (2006), regulatory minimum capital requirements for credit, market, and operational risks are covered in the first pillar of the regulation.

Question 27

Market value accounting is likely to increase the variability of earnings of an FI.

Question 28

Under Basel III a deposit-taking institution's capital is divided into five categories.

Question 29

Basel I (1993) requires banks in the member countries of the Bank for International Settlements to utilize risk-based capital ratios.

Question 30

Basel III capital ratios were enacted due to Basel II weaknesses exposed during the financial crisis of 2008-20009.

Question 31

The Tier I leverage ratio measures the amount of an FI's total capital relative to total assets.

Question 32

Market value accounting often is said to be difficult to implement because of the amounts of nontraded assets.

Question 33

More frequent regulatory examinations and stricter regulator standards will cause greater discrepancies in book value of equity and the market value of equity.

Question 34

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.

Question 35

Under Basel III, banks are allowed to use their internal estimates of borrower creditworthiness to assess credit risk subject to strict disclosure standards.

Question 36

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.

Question 37

Under Basel II (2006), total capital is equal to Tier I capital plus Tier II capital.

Question 38

The Asset to Capital Multiple does not account for the risks of off-balance- sheet activities.

Question 39

Under Basel III, OSFI requires Canadian banks to hold a total capital to credit risk-adjusted assets equal to 8 percent to be adequately capitalized.

Question 40

The greater the Tier I leverage using the Standardized Approach under Basel III, the more highly leveraged the bank.

Question 41

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 the interest rate or market risks.

Question 42

Basel II attempts to encourage market discipline by having banks disclose capital structure, risk exposures, and capital adequacy in a systematic manner.

Question 43

In determining the risk-adjusted value of the on-balance-sheet credit equivalent amounts of the contingent guarantee contracts, the risk weights are determined by the credit rating of the underlying counterparty of the off-balance-sheet activity.

Question 44

Under Basel III, OBS contingent guarantee contracts are assigned the same risk weights as on-balance-sheet principal items to determine their risk-adjusted asset values.

Question 45

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 DTIs are facing.

Question 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.

Question 47

Counterparty credit risk is the risk that the other party of a contract will default on contract obligations.

Question 48

The risk-adjusted asset values of OBS market contracts or derivative instruments are determined in a manner similar to the risk-adjusted asset values of contingent guarantee claims.

Question 49

Under Basel III, the credit risk-adjusted 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.

Question 50

In evaluating the risk-adjusted asset value of foreign exchange forward contracts, the value of the current exposure can be either positive or zero.

Question 51

Similar to Basel II, Basel III will require banks to assign on-balance-sheet assets to one of four categories of credit risk exposure.

Question 52

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.

Question 53

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.

Question 54

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.

Question 55

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.

Question 56

Operational risk has increased to a point that the Bank for International Settlements (BIS) requires DTIs to account for it in the capital adequacy standards under Basel II.

Question 57

Basel III guidelines for determining credit risk-adjusted on-balance-sheet assets relies more heavily on credit agency ratings than did Basel I.

Question 58

Determining risk-adjusted asset values for OBS market contracts requires multiplying the notional values by the appropriate risk weights.

Question 59

The Standardized Approach in calculating capital to cover operational risk requires DTIs to separate activities into business units from which a capital charge is determined based on the amount of operational risk in each unit.

Question 60

The determination of risk-adjusted on-balance-sheet assets under Basel III requires the segregation of assets into nine categories of credit risk exposure.

Question 61

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 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.

Question 62

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.

Question 63

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.

Question 64

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 centres across the world, and the more systematic accounting of credit risk differences.

Question 65

The risk-based capital ratio does account for loans made to companies with different credit ratings.

Question 66

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.

Question 67

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)adjusted book value of net worth.

Question 68

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.

Question 69

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.

Question 70

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.

Question 71

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.

Question 72

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 these.

Question 73

What is the impact on economic capital of a 25 basis point decrease in interest rates if the FI is holding a 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.

Question 74

The risk-based capital ratio fails to take into account the effects of diversification in the credit portfolio.

Question 75

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 these.

Question 76

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.

Question 77

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.

Question 78

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.

Question 79

The primary difference between Basel I and the proposed Basel III in calculating risk-adjusted 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 these.
E)that Basel II considers OBS assets, and a heavier reliance on the use of ratings by external credit rating agencies for the assignment of assets to weight classes.

Question 80

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.