Question:

(a) Briefly define capital risk and explain how a negative leverage-adjusted duration gap can contribute to an adverse impact on capital. (4 marks)

(b) List and briefly discuss three main functions of bank capital (6 marks)

(c) Sao Paolo Bank (BBB rated) has the following balance sheet (in millions of dollars) with the counterparty credit ratings and risk weights in parentheses. Answering parts (i) through (v).

Assets

Liabilities and equity

Cash

$10

Deposits

$194

Government bonds (rated AA, 0% risk weight)

20

Subordinated debt (>10 years)

1

Interbank deposits, 2-month (rated AA+, 20% risk-weight)

25

Non-Cumulative irredeemable preference shares

5

Corporate loans (rated A-, 50% risk weight)

80

Ordinary shares

4

Fixed assets (100% risk weight)

70

Retained earnings

1

Total assets

205

Total liabilities and equity

$205

In addition, the bank engages in the following off-balance activities:

$40 million in performance-related standby letters of credit to BBB rated corporations (SLCs) (100% risk weight)

$100 million in three-year forward FX contracts that are currently out of the money by $2 million

$200 million in four-year interest rate swaps that are currently out of the money by $2 million

$200 million in exchange-traded currency futures that are currently in the money by $1 million.

All derivatives are written on B rated counterparties (150% risk weight).

Credit conversion factors follow:

Performance-related SLoC

50%

Trade-related dLoC

20%

1 year loan commitment

20%

> 1 year loan commitment

50%

1-5 year foreign exchange contracts

5%

1-5 year interest rate swaps

0.5%

5-10 year interest rate swaps

1.5%

1-5 year equity contracts

8%

i. What are the risk-adjusted on-balance-sheet assets of the bank as defined under the Basel III Accord? (2 marks)

ii. What are the risk-adjusted off-balance-sheet assets of the bank as defined under the Basel Accord and the total credit risk-adjusted assets? (3 marks)

iii. What is the Common Equity Tier 1, Total Tier 1 capital and Total capital? (1 mark)

iv. Using the minimum required capital amounts, does the bank have enough capital to meet the regulatory capital requirements? (3 marks)

v. What minimum common equity Tier, Total Tier 1 or Total capital does it need to meet the requirement? (1 mark)