FINAN 4300 Problem Set 13

Identify the differences between Tier 1 and Tier 2 capital.

Tier 1 (Core Capital) consists of common equity, retained earnings, and qualifying non-cumulative perpetual preferred stock. It is high -quality, permanent capital that absorbs losses.

Tier 2 (Supplemental Capital) includes subordinated debt, hybrid instruments, limited allowances for loan losses, and mandatory convertible debt. It is lower quality and less permanent.

What is the reserve computation period, and what is its duration?

The reserve computation period is the two-week interval used to calculate average deposits, which determines required reserves. Banks then maintain those reserves in the following maintenance period.

Name the three types of curves that may be seen in a yield curve and what they tell you about the future.

The three curves are:

• upward -sloping (normal, long -term rates > short -term; signals growth/inflation)

• flat (rates nearly equal; signals uncertainty)

• inverted (short-term rates > long -term; signals recession and squeezed NIMs).

Is the issuance of loans to borrowers considered a cash inflow or a cash outflow?

Issuing a loan is a cash outflow, since funds leave the bank. The inflows occur later through repayments.

Identify two risk mitigation tools that could be used to minimize interest rate risk and briefly explain how they are used.

• interest rate swaps (exchange fixed/floating payments to manage mismatches)

• loan sales/securitization (removes interest -sensitive assets from the balance sheet).

What is the primary difference between the Tier 1 capital ratio and the leverage ratio?

The Tier 1 capital ratio = Tier 1 ÷ risk -weighted assets // it adjusts for asset risk.

The leverage ratio = Tier 1 ÷ total assets // it ignores risk -weighting and acts as a backstop

What was the primary focus(es) of Basel III?

Basel III focused on:

• stronger capital and liquidity standards: stricter CET1 definitions

• capital conservation and countercyclical buffers

• liquidity standards (LCR, NSFR)

• leverage ratio requirement.

What is meant by hot money in the liquidity management approach?

Hot money is highly interest -sensitive short -term deposits or borrowings likely to leave quickly if better rates appear. It is unreliable as a stable funding source.

What are the components of the net liquidity position calculation?

Net Liquidity Position = supplies of cash demands for cash. Supplies include deposit inflows, loan repayments, borrowings; demands include loan disbursements, withdrawals, dividends, and debt repayment.

What is the primary comparative interest rate metric used to manage interest rate performance?

The Interest Sensitivity Ratio (ISR). ISR = rate-sensitive assets ÷ rate-sensitive liabilities. ISR > 1 means asset-sensitive (profits rise when rates rise). ISR < 1 means liability-sensitive (profits fall when rates rise).

A bank with $100 million in risk-weighted assets and $8 million in Tier 1 capital has met the Basel minimum capital ratio requirement.

True

Basel requires a minimum total capital ratio of 8%, and in this case Tier 1 capital is exactly 8% of risk -weighted assets. This meets the threshold, though in practice regulators often expect buffers above the minimum.

The leverage ratio is always higher than the Tier 1 capital ratio because the leverage ratio ignores risk weights.

Uncertain

The leverage ratio and Tier 1 ratio measure capital strength differently. If a bank holds many low -risk assets, its Tier 1 ratio could be higher than the leverage ratio; if it holds high -risk assets, the leverage ratio could be higher.

If a bank funds itself mostly with hot money deposits, its liquidity position is stable because the deposits can be rolled over at maturity

False

Hot money is highly interest -sensitive and unstable. It is likely to leave quickly if competitors offer slightly better rates, making the bank s liquidity position fragile rather than stable.

Reserve requirements ensure that banks always have enough cash to meet unexpected withdrawals.

Uncertain

Reserve requirements provide a basic liquidity cushion but do not guarantee banks can meet unexpected withdrawals. In crises, customers may withdraw much more than reserves, forcing banks to rely on liquid assets and emergency funding.

If cash inflows equal $50 million and cash outflows equal $45 million, the bank’s net liquidity position is positive.

True

With inflows of 50million and outflows of 45 million, the bank has a net positive liquidity position of $5 million. This means sources exceed uses of funds, leaving a surplus.

Basel III introduced liquidity requirements such as the LCR and NSFR, in addition to strengthening capital adequacy rules.

True

Basel III was designed after the global financial crisis to make banks more resilient. In addition to higher quality capital standards, it introduced two liquidity metrics: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).

The difference between Tier 1 and Tier 2 capital is that Tier 2 capital can include subordinated debt, while Tier 1 is primarily equity

True

Tier 1 capital is primarily common equity and retained earnings, which are permanent and high quality.

Tier 2 capital includes subordinated long -term debt and other supplemental items, which are less permanent and absorb losses only in certain conditions.

If a bank has $200 million in deposits, with $100 million exempt, $50 million subject to a 3% reserve requirement, and $50 million subject to a 10% reserve requirement, then total required reserves equal $6.5 million.

True

Exempt deposits require no reserves. The $50 million subject to 3% requires $1.5 million, and the $50 million subject to 10% requires $5 million. Total reserves required = $6.5 million, which matches the stated figure.

A bank with $100 million in expected 30-day net cash outflows and $120 million in high-quality liquid assets meets the Liquidity Coverage Ratio (LCR) requirement.

True

The Liquidity Coverage Ratio (LCR) requires high -quality liquid assets to be at least equal to projected 30 -day net cash outflows. With $120 million in HQLA against $100 million in outflows, the ratio is 120%, which is above the100%minimum,sothebankmeetstherequirement.

What is another name for Tier 2 capital?

Supplemental capital

The ratio of core capital to average total assets is called the:

Leverage ratio

Federal regulators have initiated a concept called PCA in the evaluation of adequate capital coverage. What does PCA stand for, AND what is one of the restrictions the regulator can impose to restrict certain activities?

Prompt corrective action; paying dividends and other capital distributions

The Federal Reserve Bank requires that member banks maintain, on deposit, a sufficient amount of funds on reserve. The bank cannot use these funds for investment purposes. Generally, what is the percentage that must be maintained at the Fed?

10% over $127.5 million, + 3% between $16.9 million and $127.5 million

The risk that a financial institution may be forced to borrow emergency funds to cover its immediate cash needs is known as:

Liquidity risk

Which of the following is not a demand for cash?

The bank sells one of its properties that it repossessed

What is the major difference between Tier 1 and Tier 2 capital?

Long-term debt

What is the primary difference between the Tier 1 capital ratio and the leverage ratio?

Risk-weighted assets

What was the primary focus(es) of Basel III?

Capital and liquidity

What are the components of the net liquidity position calculation?

Cash inflows – cash outflows