L11 Revision Questions
1
Question 1
Why is the market value of equity a better measure of a
bank's ability to absorb losses caused by credit risk than book
value of equity?
2
Question 1
ANS: The market value of equity is more relevant than book value because in
the event of a bankruptcy, the liquidation (market) values determine the
bank's ability to pay various claimants.
The loss in value caused by credit risk is borne first by the equity holders, and
then by the liability holders. With market value accounting, the adjustments to
equity value are made simultaneously as the losses due to credit risk occur.
In contrast, book value accounting recognizes the value of assets and liabilities
at the time they were placed on the books. Losses are not recognized until the
assets are sold or regulatory requirements force the firm to make balance
sheet accounting adjustments. In the case of credit risk, these adjustments
usually occur after all attempts to collect or restructure the loans have
occurred.
3
Question 2‐3
Use the following information to answer questions 2‐3. ABC Bank has
the following balance sheet (in millions), with the risk weights in parentheses.
Assets
Liabilities and Equity
Cash (0%)
$21
Deposits
$176
OECD interbank
25
Subordinated
2
(20%)
debt (5 years)
Mortgage loans (50%)
70
Cumulative
2
Consumer loans (100%)
70
preferred stock
Common equity
5
Reserve for loan losses
(1)
Total Assets
$185 Total L+E
$185
4
Question 2
What are the risk‐adjusted on‐balance‐sheet assets of
the bank as defined under the Basel Accord?
5
Question 2
What are the risk‐adjusted on‐balance‐sheet assets of
the bank as defined under the Basel Accord?
ANS: Risk‐adjusted assets:
Cash:
0 x 21
=
$0
OECD interbank deposits
0.20 x 25
=
$5
Mortgage loans
0.50 x 70 =
$35
Consumer loans
1.00 x 70 =
$70
Total risk‐adjusted assets
=
$110
6
Question 3
To be adequately capitalized, what are the CET1, Tier I, and
total capital required for on‐balance‐sheet assets? Does this
bank satisfy the requirement?
7
Question 3
To be adequately capitalized, what are the CET1, Tier I, and total capital
required for on‐balance‐sheet assets? Does this bank satisfy the
requirement?
Total risk‐adjusted on balance‐sheet assets = $110
CET1 capital required 110x 0.045 =$4.95
Tier I capital required 110x 0.06 =$6.60
Total capital required 110x 0.08 =$8.80
And CET1, Tier 1, and total capital for this bank are 5 (common equities,
goodwill is 0), 7 (CET1 + preferred stock), and 8 (Tier 2 has 0 convertible
debt, and 1 from reserve loan loss), respectively. So this bank does not
satisfy the total capital ratio requirement.
8
Question 4
How would the liquidity coverage ratio impact a banks one
year cumulative repricing gap?
9
Question 4
How would the liquidity coverage ratio impact a banks one
year cumulative repricing gap?
ANS: Banks are required to hold more short maturity liquid
assets, such as treasury bills. To the extent that banks shift
their assets away from longer maturity fixed rate loans, the
liquidity coverage ratio should increase the one year re‐
pricing gap.
10
Question 5
How would the liquidity coverage ratio impact a banks
duration gap?
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Question 5
How would the liquidity coverage ratio impact a banks
leverage adjusted duration gap?
ANS: Banks are required to hold more short maturity liquid
assets, such as treasury bills. To the extent that banks shift
their assets away from long maturity fixed rate loans towards
liquid, short maturity treasury bills, the liquidity coverage
ratio should decrease the leverage adjusted duration gap.
This is because the duration of assets should decrease.
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