Chapter 13 Homework Questions
13. Under Basel III, what four capital ratios must DIs calculate and monitor?
. Under Basel III, depository institutions must calculate and monitor four capital ratios: common equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, total risk-based capital ratio, and Tier I leverage ratio. i) Common equity Tier I risk-based capital ratio = Common equity Tier I capital/Credit risk-adjusted assets ii) Tier I risk-based capital ratio = Tier I capital (Common equity Tier I capital + Additional Tier I capital)/Credit risk-adjusted assets iii) Total risk-based capital ratio = Total capital (Tier I + Tier II)/Credit risk-adjusted assets iv) Tier I leverage ratio = Tier I capital / Total exposure
1. What forms of protection and regulation are imposed by regulators of CBs to ensure their safety and soundness?
1. Regulators have issued several guidelines to ensure the safety and soundness of CBs: i. CBs are required to diversify their assets. Banks are prohibited from making loans exceeding 15 percent of their own equity capital funds to any one company or borrower. ii. CBs are required to maintain minimum amounts of capital to cushion any unexpected losses. The higher the proportion of capital contributed by owners, the greater the protection against insolvency risk for liability claimholders, such as depositors. iii Guaranty funds, such as the Depositors Insurance Fund (DIF) have been established to mitigate a rational incentive depositors otherwise have to withdraw their funds at the first hint of trouble. iv. Regulators also engage in periodic monitoring and surveillance, such as on-site examinations, and request periodic information from the CBs.
16. What are the definitional differences between Common Equity Tier 1, Tier 1, and Tier 2 capital?
CET1 is primary or core capital of the DI. CET1capital is closely linked to a DI's book value of equity, reflecting the concept of the core capital contribution of a DI's owners. CET1 capital consists of the equity funds available to absorb losses. Basically, it includes the book value of common equity plus minority equity interests held by the DI in subsidiaries minus goodwill. Goodwill is an accounting item that reflects the amount a DI pays above market value when it purchases or acquires other DIs or subsidiaries. Tier I capital is the primary capital of the DI plus additional capital elements. Tier I capital is the sum of CET1 capital and additional capital elements. Included in additional Tier I capital are other options available to absorb losses of the bank beyond common equity. These consist of instruments with no maturity dates or incentives to redeem, e.g., noncumulative perpetual preferred stock. These instruments may be callable by the issuer after 5 years only if they are replaced with "better" capital. Tier II capital is supplementary capital. Tier II capital is a broad array of secondary "equity like" capital resources. It includes a DI's loan loss reserves assets plus various convertible and subordinated debt instruments with maximum caps.
12. What is the significance of prompt corrective action as specified by the FDICIA legislation?
Since December 18, 1992, under the FDICIA legislation, regulators must take specific actions−prompt corrective action (PCA)−when a DI falls outside the zone 1, or well-capitalized, category. Table 13-4 summarizes these regulatory actions. Most important, a receiver must be appointed when a DI's tangible equity to total assets ratio falls to 2 percent or less. That is, receivership is mandatory even before the book value ratio falls to 0 percent. The idea behind the mandatory and discretionary set of actions to be taken by regulators for each of the five capital adequacy zones is to enforce minimum capital requirements and limit the ability of regulators to show forbearance to the worst capitalized DIs.
10. What is the major feature in the estimation of credit risk under the Basel capital requirements?
The 1993 Basel Agreement explicitly incorporated the different credit risks of assets (both on and off the balance sheet) into capital adequacy measures.
9. What is the Basel Agreement?
The Basel Agreement identifies the risk-based capital ratios and explicitly incorporates the different credit risks of assets (both on and off the balance sheet) into capital adequacy measures. The new capital ratios were agreed upon by the member countries of the Bank for International Settlements. The ratios were to be implemented for all Chapter 13 - Regulation of Commercial Banks HWSolutions_FMI_Saunders7e_Ch13 4 of 5 depository institutions under their jurisdiction. Further, most countries in the world now have accepted the guidelines of this agreement for measuring capital adequacy.
11. What is the difference between Basel I, Basel II, and Basel III?
The FDIC Improvement Act (FDICIA) of 1991 required that banks and thrifts adopt risk-based capital requirements. Consistent with this act, U.S. DI regulators formally agreed with other member countries of the Bank for International Settlements (BIS) to implement new risk-based capital ratios for all depository institutions under their jurisdiction. The BIS phased in and fully implemented these risk-based capital ratios on January 1, 1993, under what has become known as the Basel (or Basle) Agreement (now called Basel I). The 1993 Basel Agreement explicitly incorporated the different credit risks of assets (both on and off the balance sheet) into capital adequacy measures. In 2001, the BIS issued a Consultative Document, "The New Basel Capital Accord," that proposed the incorporation of operational risk into capital requirements and updated the credit risk assessments in the 1993 agreement. The new Basel Accord or Agreement (called Basel II) allowed for a range of options for addressing both credit and operational risk. Two options were for the measurement of credit risk. The first is the Standardized Approach and the second is an Internal Ratings-Based (IRB) Approach. The Standardized Approach was similar to that of the 1993 agreement, but was more risk sensitive. Under the IRB Approach, DIs were allowed to use their internal estimates of borrower creditworthiness to assess credit risk in their portfolios (using their own internal rating systems and credit scoring models) subject to strict methodological and disclosure standards, as well as explicit approval by the DI's supervising regulator. Basel III was passed in 2010 (fully effective in 2019). The goal of Basel III is to raise the quality, consistency, and transparency of the capital base of banks to withstand credit risk and to strengthen the risk coverage of the capital framework. Advanced (IRB) approaches may be used by institutions with consolidated assets of $250 billion or more or with consolidated on-balance-sheet foreign exposures of $10 billion or more (approximately 20 of the largest U.S. banking organizations). All other depository institutions use the Standardized Approach for calculating capital adequacy.
4. What insurance activities are permitted for U.S. commercial bank holding companies?
The Financial Services Modernization Act of 1999 completely changed the landscape for insurance activities as it allowed bank holding companies to open insurance underwriting affiliates and insurance companies to open commercial bank as well as securities firm affiliates through the creation of a financial service holding company. With the passage of this act banks no longer have to fight legal battles to overcome restrictions on their ability to sell insurance. The insurance industry also applauded the act, as it forced banks that underwrite and sell insurance to operate under the same set of state regulations (pertaining to their insurance lines) as insurance companies operating in that state. Under the new act, a financial services holding company that engages in commercial banking, investment banking, and insurance activities is functionally regulated. This means that the holding company's banking activities are regulated by bank regulators (such as the Federal Reserve, FDIC, OCC), its securities activities are regulated by the SEC, and its insurance activities are regulated by up to 50 state insurance regulators. Further, in July 2010, the Wall Street Reform and Consumer Protection Act established a new office at the Treasury (the Office of National Insurance) that monitors the insurance industry and helps decide if an insurer is big enough to warrant tighter oversight. The act established a Financial Stability Oversight Council that has authority to review both banks and nonbank companies, including insurance companies, to see if they pose a threat to the overall financial system.
2. How has the separation of commercial banking and investment banking activities evolved through time? How does this differ from banking activities in other countries?
The United States has experienced several phases of regulating the links between the commercial and investment banking industries. After the 1929 stock market crash, the United States entered a major recession and approximately 10,000 banks failed between 1930 and 1933. A commission of inquiry (the Pecora Commission) established in 1932 began investigating the causes of the crash. Its findings resulted in new legislation, the 1933 Banking Act, or the Glass Steagall Act. The Glass Steagall Act sought to impose a rigid separation between commercial banking - taking deposits and making commercial loans - and investment banking - underwriting, issuing, and distributing stocks, bonds, and other securities. The act defined three major exemptions to this separation. First, banks were allowed to continue to underwrite new issues of Treasury bills, notes, and bonds. Second, banks were allowed to continue underwriting municipal general obligation (GO) bonds. Third, banks were allowed to continue engaging in private placements of all types of bonds and equities, corporate and noncorporate. For most of the 1933-1963 period, commercial banks and investment banks generally appeared to be willing to abide by the letter and spirit of the Glass Steagall Act. Between 1963 and 1987, however, banks challenged restrictions on municipal revenue bond underwriting, commercial paper underwriting, discount brokerage, managing and advising open and closed end mutual funds, underwriting mortgage backed securities, and selling annuities. In most cases, the courts eventually permitted these activities for commercial banks. With this onslaught and the de facto erosion of the Glass-Steagall Act by legal interpretation, the Federal Reserve Board in April 1987 allowed commercial bank holding companies to establish separate Section 20 securities affiliates as investment banks. Through these Section 20 affiliates, banks can conduct all their "ineligible" or Chapter 13 - Regulation of Commercial Banks HWSolutions_FMI_Saunders7e_Ch13 2 of 5 "gray area" securities activities, such as commercial paper underwriting, mortgage backed securities underwriting, and municipal revenue bond underwriting. Significant changes occurred in 1997 as the Federal Reserve and the Office of the Comptroller of the Currency (OCC) took action to expand bank holding companies' permitted activities. In particular, the Federal Reserve allowed commercial banks to directly acquire existing investment banks rather than establish completely new investment bank subsidiaries. The result was a number of mergers and acquisitions between commercial and investment banks in 1997 through 2000. In 1999, after years of "homemade" deregulation by banks and securities firms, regulators passed the Financial Services Modernization Act, which repealed the GlassSteagall barriers between commercial banking and investment banking. The bill allowed for a "financial services holding company" that could engage in banking activities and securities underwriting. The bill also allowed large national banks to place certain activities, including some securities underwritings, in direct bank subsidiaries regulated by the Office of the comptroller of the Currency. Thus, after nearly 70 years of partial or complete separation between investment banking and commercial banking, the Financial Services Modernization Act of 1999 opened the door for the creation of the full-service financial institutions in the United States similar to those that existed in the United States pre-1933 and that exist in many other countries today. After the passage of FSMA, the two industries came together to a degree. Commercial banks like Bank of America and Wachovia tried to build up their own investment banking operations, but they did not have much success in eating into the core franchises of the five big independent investment banks: Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns. Generally, the investment banks, which were not subject to regulation by the Federal Reserve and did not have to adhere to as strict capital requirements, remained the major investment banking financial institutions. However, the financial crisis changed the landscape dramatically. In March 2008, the Federal Reserve helped J.P. Morgan acquire Bear Stearns as the investment bank faced bankruptcy. This was seen as a controversial decision and cost the Federal Reserve $30 billion. However, the Fed defended the move as essential. In September 2008, Lehman Brothers was allowed to fail and Merrill Lynch was purchased by Bank of America. Of the five major independent investment banks that existed a year earlier, only two─ Goldman Sachs and Morgan Stanley─ remained. Even Goldman Sachs and Morgan Stanley were facing a severe liquidity crisis during the weekend of September 20-21, 2008. To address the crisis, one week after the closure of Lehman Brothers and the sale of Merrill Lynch to Bank of America, the Federal Reserve granted a request by the last two major investment banks to change their status to bank holding companies. By becoming bank holding companies, the firms agreed to significantly tighter regulations and much closer supervision by bank examiners from several government agencies rather than only the Securities and Exchange Commission. With the conversion, the investment banks would look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking. In exchange for subjecting themselves to more regulation, the companies would have access to the full array of the Federal Reserve's lending Chapter 13 - Regulation of Commercial Banks HWSolutions_FMI_Saunders7e_Ch13 3 of 5 facilities. For example, as bank holding companies, Morgan and Goldman will have greater access to the discount window of the Federal Reserve, which banks can use to borrow money from the central bank. While they were allowed to draw on temporary Fed lending facilities in recent months, they could not borrow against the same wide array of collateral that commercial banks could. Further, they had enhanced potential access to TARP money. These events on Wall Street—the failure or sale of three of the five largest independent investment banks and the conversion of the two remaining firms from investment banks to commercial banks—effectively turned back the clock to the 1920s, when investment banks and commercial banks functioned under the same corporate umbrella. As part of the increased authority given to the Federal Reserve in the 2010 Wall Street Reform and Consumer Protection Act, the Fed proposed in late 2011 that net credit exposures between any two of the nation's six largest financial firms would be limited to 10 percent of the company's regulatory capital. Other financial firms would be subject to a 25 percent limit, which was required by the 2010 act. The proposed Fed rule aims to reduce the interconnectedness of financial institutions in the U.S. financial system and reduce the ability of any single financial firm to damage the financial system and the broader economy—as happened when Lehman Brothers was allowed to fail. The result of the new rules is that big U.S. banks could be forced to return to a more traditional banking model that revolves around deposit taking and making loans. This could result in smaller capital markets and less securities lending.
17. What components are used in the calculation of credit risk-adjusted assets?
The two components are credit risk-adjusted on-balance-sheet assets and credit riskadjusted off-balance-sheet assets.
14. How is the Tier 1 leverage ratio for an FI defined under Basel III?
Under the Standardized Approach, the Basel III leverage ratio is defined as the ratio of Tier 1 capital to on-balance-sheet assets. Under the Advanced Approach, Basel III leverage ratio is defined as the ratio of Tier I core capital divided by the book value of total exposure. Total exposure is equal to the DI's total assets plus off-balance-sheet exposure. For derivative securities, off-balance-sheet exposure is current exposure plus potential exposure as described above. For off-balance-sheet credit (loan) commitments a conversion factor of 100 percent is applied unless the commitments are immediately cancelable. In this case, a conversion factor of 10 percent is used. Once Basel III is fully phased in, to be adequately capitalized, a DI must hold a minimum leverage ratio of 4 percent.
