Chapter 20

Capital Adequacy

20-1
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Multiple Choice Questions

74. 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.

75. 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
above.

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77. 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.

81. 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.

Fair market value of bond:

$102,023.82 - $100,000 ≈ +$2,024

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82. 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.

84. 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.

86. 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.

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88. 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.

89. 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.

90. 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.

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91. 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 b and c above are
correct.
E. that all of the above are
correct.

93. 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.

94. 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
above.
E. Only two of the
above.

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95. 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
above.
E. Answers B and C
only.

96. 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
above.
E. Answers A and C
only.

97. 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.

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98. 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.

100. 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.

101. 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.

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102. 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. Answers B and C
only.

103. 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.

104. 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 the
above.
E. Answers A and C
only.

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105. 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
above.
E. Answers A and C
only.

107. 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. Answers A and D
only.

108. 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.

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109. The calculation of the risk-adjusted 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
above.
E. Answers B and C
only.

110. 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.

111. 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.

20-11
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112. 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.

114. 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.

116. 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
above.
E. Answers A and B
only.

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117. 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
above.

124. How would regulators characterize this FI based on the Standardized Approach
leverage ratio zones of Basel III?

A. Well
capitalized.
B. Undercapitaliz
ed.
C. Severely
undercapitalized.
D. Overcapitaliz
ed.
E. Insolven
t.

LR = $35/(250 + 760) = 35/1,010 = 0.03465 ≈ 3.47 percent

Well-capitalized = 5 percent
Adequately-capitalized = 4 percent

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125. 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
.

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

126. 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
.

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

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127. 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
.

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

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128. 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
.

MV with rate increase

Change in market value of loans = $732 - $760 = -$28

Change in economic value of capital = $35 - $28 = $7 million

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129. 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
.

MV with rate decrease

Change in market value of loans = $820 - $760 = +$61

Change in economic value of capital = $35 + $61 = $96 million

Note: The residential mortgages all have a loan-to-value of between 60 and 80

percent.

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130. 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
above.

Total Assets = 100 + 100 + 200 + 600 = $1,000

Total Capital = $50

LR = 50/1,000 = 0.05 = 5.0 percent

20-18
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131. What is the amount of risk-adjusted assets?

A. $1,000
million.
B. $720
million.
C. $900
million.
D. $600
million.
E. $700
million.

Risk-Adjusted Assets =

132. What is the ratio of capital to risk-adjusted 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.

Capital to risk-adjusted assets: $50/$720 = 0.0694

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 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

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133. What is Sigma Bank's risk-adjusted 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.

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134. 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.

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.

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135. 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.

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.

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136. 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.

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

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137. What is the minimum total risk-adjusted 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.

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

138. 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.

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) + $1 = $3 million + $1 million = $4 million

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139. 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.

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

140. 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.

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

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 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

141. What is the amount of risk adjusted 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.

Risk-Adjusted Assets =

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142. 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.

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

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143. 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.

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

20-29
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144. What are the total risk-adjusted 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.

All of these OBS items carry a risk weight of 100%

Total on-balance sheet asset value equivalents = [(CEAl c × 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

145. 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.

Total Risk-Adjusted Assets = Risk-Adjusted 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

20-30
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McGraw-Hill Education.
 20-31
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McGraw-Hill Education.