P2.T7.

Operational & Integrated Risk

Management

Bionic Turtle FRM Practice Questions

Mark Carey, “Solvency, Liquidity and Other

Regulation After the Global Financial Crisis,” GARP
Risk Institute
By David Harper, CFA FRM CIPM
www.bionicturtle.com
Mark Carey, “Solvency, Liquidity and Other Regulation After the Global Financial Crisis”

P2.T7.20.9. SOLVENCY, LIQUIDITY & OTHER REGULATION AFTER THE GLOBAL FINANCIAL CRISIS (1
OF 2) ....................................................................................................................................... 3
P2.T7.20.10. SOLVENCY, LIQUIDITY AND OTHER REGULATION AFTER THE GLOBAL FINANCIAL CRISIS
(2 OF 2) ................................................................................................................................... 6
P2.T7.520. BASEL 2.5 WITH STRESSED VAR, IRC AND CRM ..................................................... 9
P2.T7.521. BASEL III REGULATORY CAPITAL REQUIREMENTS.....................................................13
P2.T7.522. BASEL III: LEVERAGE RATIO, LIQUIDITY COVERAGE RATIO AND NET STABLE FUNDING .16

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Mark Carey, “Solvency, Liquidity and Other Regulation After
the Global Financial Crisis”
P2.T7.20.9. Solvency, liquidity & other regulation after the global financial crisis (1 of 2)
P2.T7.20.10. Solvency, liquidity & other regulation after the global financial crisis (2 of 2)
P2.T7.520. Basel 2.5 with stressed VaR, IRC, and CRM
P2.T7.521. Basel III regulatory capital requirements
P2.T7.522. Basel III: leverage ratio, liquidity coverage ratio, and net stable funding

P2.T7.20.9. Solvency, liquidity & other regulation after the global

financial crisis (1 of 2)
Learning objectives: Describe and calculate the stressed VaR introduced in Basel 2.5 and
calculate the market risk capital charge. Explain the process of calculating the
incremental risk capital charge for positions held in a bank’s trading book. Describe the
comprehensive risk (CR) capital charge for portfolios of positions that are sensitive to
correlations between default risks. Define in the context of Basel III and calculate where
appropriate: Tier 1 capital and its components; Tier 2 capital and its components;
Required Tier 1 equity capital, total Tier 1 capital and total capital.

20.9.1. A bank is using the VaR and stressed VaR (SVaR) market risk framework according to
the Basel 2.5 guidelines. The bank’s internal models for market risk have generated the
following risk measures for the current trading book positions (VaR and SVaR are in USD
millions):

The supervisor has set both multiplication factors, m and m(S), to 3.0. What is the correct
capital requirement for general market risk for the bank under Basel 2.5?1

a) $630.0 million
b) $810.0 million
c) $1,230.0 million
d) $2,154.0 million

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This question inspired by Question 42 of GARP's 2020 Part 2 Practice Exam

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20.9.2. In regard to the incremental risk charge (IRC) in Basel 2.5, each of the following is true
EXCEPT which is false?

a) The incremental risk charge (IRC) is calculated as the one-year 99.9% confident value at
risk (VaR) to credit instrument losses in the trading book
b) The incremental risk charge (IRC) is designed to account for correlation risks in the
correlation book, which includes securitizations and re-securitizations
c) The incremental risk charge (IRC, itself an amended IDRC) was motivated by a reaction
to regulatory arbitrage; consequently required capital in the trading book is the greater of
market risk capital and banking book capital
d) In addition to default risk, via its rebalancing "constant level of risk" assumption, the
incremental risk charge (IRC) provides a measure of credit deterioration (i.e., including
ratings downgrade and/or credit spread widening) and/or loss of liquidity

20.9.3. The Chief Risk Officer (CRO) of LGX is preparing a report to the directors on the bank's
capital adequacy. In the upper panel below, the bank's most recent key balance sheet accounts
(e.g., total assets) and capital accounts (e.g., CET1 capital) are displayed. In the lower panel
below, Basel's regulatory capital requirements (for selected items) are displayed; because these
regulatory capital requirements were phased in, they are shown for each of the three years
ending 2019.

The bank is only concerned with its fully

phased-in compliance such that only the
regulatory requirements in 2019 are relevant
(the bold column, so you can ignore 2017
and 2018, as they are shown merely to
illustrate the phase-in concept); e.g., CCB of
2.50%, GIB surcharge of 1.50%. The
directors are expecting that the bank is
compliant with respect to the following: CET
ratio, Tier 1 ratio, total capital ratio, and
leverage ratio.

In regard to these four regulatory ratios vis-

a-vis the most recent (2019) requirements,
for which does the bank meet the minimum
requirements? (note: this question inspired
by Question 70 of GARP's 2020 Part 2
Practice Exam).

a) Leverage and Total Capital ratio are sufficient, but CET1 and Tier 1 ratios are too low
b) Tier 1 ratio and Leverage are sufficient, but CET1 and Total Capital ratios are too low
c) Only CET1 ratio is sufficient, but the others (Tier 1, Total Capital, and Leverage) are too
low
d) All four ratios (including CET1, Tier 1, Total Capital, and Leverage) are sufficient

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Answers:

20.9.1. C. True: $1,230.0 million

The Basel 2.5 market risk capital requirement requires a 99.0% confidence level and is given
by: MRC = max[VaR(t-1), m*VaR(60-day avg)] + max[SVaR(t-1), m(S)* SVaR(60-day avg)].

In this case, MRC = max[185.0, 3.0*140.0] + max[360.0, 3.0* 270.0] = $1,230.0 million.

20.9.2. B. False. The IRC estimates the default and migration risk of unsecuritized credit
products in the trading book. The Comprehensive Risk Measure (CRM) estimates risks in the
correlation trading portfolio including correlation, spread, basis recovery, and default risks.

In regard to (A), (C) and (D), each is TRUE:

 True: The incremental risk charge (IRC) is calculated as the one-year 99.9% confident
value at risk (VaR) to credit instrument losses in the trading book
 True: The incremental risk charge (IRC, itself an amended IDRC) was motivated by a
reaction to regulatory arbitrage; consequently required capital in the trading book is the
greater of market risk capital and banking book capital
 True: In additional to default risk, via its rebalancing "constant level of risk" assumption
the incremental risk charge (IRC) provides a measure of credit deterioration (i.e.,
including ratings downgrade and/or credit spread widening) and/or loss of liquidity

20.9.3. A. True: Leverage and Total Capital ratio are sufficient, but CET1 and Tier 1 ratios
are too low

Please note the phased-in 2019 regulatory capital requirements are provided by the question:
 The CET1 ratio must be 8.50% but this bank's CET1 ratio is only 2.40 ÷ 36.00 = 6.67%
 The Leverage ratio must be 4.0% and this bank's leverage ratio is (2.40 + 0.90) ÷ 65.0 =
5.08%
 The Tier 1 Capital ratio must be 10.0% but this bank's Tier 1 Capital ratio is only (2.40 +
0.90) ÷ 36.0 = 9.17%
 The Total Capital must be 12.0% and this bank's Total Capital is (2.40 + 0.90 + 1.70) ÷
36.0 = 13.89%

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p2-t7-20-9-solvency-

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P2.T7.20.10. Solvency, liquidity and other regulation after the global
financial crisis (2 of 2)
Learning objectives: Describe the motivations for and calculate the capital conservation
buffer and the countercyclical buffer, including special rules for globally systemically
important banks (G-SIBs). Describe and calculate ratios intended to improve the
management of liquidity risk, including the required leverage ratio, the liquidity coverage
ratio, and the net stable funding ratio. Describe the mechanics of contingent convertible
bonds (CoCos) and explain the motivations for banks to issue them. Explain motivations
for “gold plating” of regulations and provide examples of legislative and regulatory
reforms that were introduced after the 2007-2009 financial crisis.

20.10.1. The central feature of Basel III's first pillar is the regulatory capital (i.e., CET1, Tier 1,
and total capital) requirements which require minimum fractions of risk-weighted assets (RWA).
In addition to these minimums, as of early 2019 (when the buffers were fully phased in), Basel
specifies three buffers: the capital conservation buffer (CCB), the G-SIB buffer, and the
countercyclical buffer (CCyB). This is all very confusing, so you ask your colleague Mary to
summarize these additional buffers and their motivations. She makes the following five points:

I. For all three, the additional buffer must be CET1

II. For all three, breach of the buffer requirements implies the bank's ability to pay dividends
will be restricted
III. The CCB requires an additional 2.5% of CET1 capital and is meant to ensure that banks
have an additional layer of usable capital that can be drawn down when losses are
incurred.
IV. The additional G-SIB requirement includes five buckets {1.0%, 1.5%, 2.0%, 2.5%, or
3.5%} https://www.bis.org/fsi/fsisummaries/g-sib_framework.htm and is meant to reduce
the likelihood and severity of the failure of a global systemically important financial
institution
V. The CCyB requirement varies between zero and 2.5% and is meant to protect the
banking sector from periods of excess aggregate credit growth that have often been
associated with the build-up of system-wide risks

Is Mary correct in her summary?

a) No, unfortunately, none of her statements is correct

b) I. and II. are correct, but the others (III., IV., and V.) are wrong
c) III., IV., and V. are correct, but the others (I. and II.) are wrong
d) Yes, all five statements are correct

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20.10.2. Below is a summary balance sheet of Acme Bank, but in addition to the typical
accounts (assets, liabilities, and equities), there are four additional columns to assist in
ascertaining whether the bank satisfies Basel III's liquidity risk requirements:

For purposes of estimating the bank's liquidity coverage rate (LCR), the following columns are
included: HQLA factors, HQLA, Runoff rate, and Net cash outflows. For purposes of estimating
the net stable funding ratio (NSFR), the following columns are included: RSF factor, required
stable funding, ASF factor, and available stable funding. Does Acme Bank meet the LCR and
NSFR requirements?

a) Neither LCR nor NSFR is met

b) LCR is met, but NSFR fails to meet the minimum
c) NSFR is met, but LCR fails to meet the minimum
d) Both LCR and NSFR are met

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20.10.3. The Basel regulations (via their various implementations by national authorities) was
hardly the only high-level effort by regulators (not to mention legislators) in response to the
global financial crisis (GFC) of 2007-08. For example, as Mark Carey explains "Banks will fail in
the future in spite of Basel I, II, III and later reforms. To limit the disruptions caused by such
failures, the FSB [Financial Stability Board, https://www.fsb.org/] agreed in 2014 that national
resolution regimes for G-SIBs would have 12 key attributes and that each G-SIB should have
sufficient total loss absorbing capacity (TLAC) to enable it to recapitalize itself. Recapitalization
might be accomplished by causing convertible bonds to become equity or by bail-in, in which
certain whole-sale debt liabilities are either written down or converted to equity."2

In regard to this and other reforms, which of the following statements is TRUE?

a) Coco bonds contain an embedded put option that gives the buyer the right, but not the
obligation, to purchase equity at a predetermined conversion (aka, exercise or strike)
price
b) Coco bonds are attractive to banks because they do not decrease return on equity
(ROE) prior to conversion, and they are also attractive to regulators because they
absorb losses, when triggered, if distress occurs
c) Gold plating is when a national regulator (aka, supervisor) applies a less onerous (i.e.,
lower) regulatory capital ratio to their domestic banks, thus giving them a "gold plated"
competitive advantage against international banks
d) The total loss-absorbing capacity (TLAC) minimums developed by Financial Stability
Board (FSB) will be gradually phased-out and replaced by the leverage and liquidity
ratios in Basel IV as they are phased-in

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2020 FRM Part II: Operational Risk and Resiliency, 10th Edition. Pearson Learning Solutions, 10/2019

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P2.T7.520. Basel 2.5 with stressed VaR, IRC, and CRM
Learning Objectives: Describe and calculate the stressed value-at-risk measure
introduced in Basel 2.5, and calculate the market risk capital charge. Explain the process
of calculating the incremental risk capital charge for positions held in a bank’s trading
book. Describe the comprehensive risk measure (CRM) for positions which are sensitive
to correlations between default risks.

520.1. As a risk manager for Transworld Financial Bank, Roger needs to calculate the market
risk capital requirement for the bank's trading book. He needs to comply with Basel 2.5.
Consequently, he needs to include stressed value at risk (sVar) in addition to the usual VaR. He
has calculated the following value at risk (VaR) measures:
 The 95.0% one-day VaR on the previous day is $20,000
 The average 95.0% one-day VaR over the last 60 trading days is $12,000
 The 95.0% one-day stressed VaR (sVaR) on the previous trading day is $188,000
 The average 95.0% one-day stressed VaR (sVaR) over the last 60 trading days is
$50,000
Both multiplication factors, m(c) and m(s), are set at the minimum of 3.0. Roger also assumes
the return of the bank's trading portfolio is normally distributed. For example, the 10-day 99.0%
VaR(t-1) = $20,000 * 2.326/1.645 * SQRT(10) = $89,449. Which is nearest to the market capital
requirement?

a) $161,000
b) $188,000
c) $840,800
d) $1.0 million

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520.2. About Basel 2.5, Hull says "During the credit crisis, it was recognized that some changes
were necessary to the calculation of capital for market risk in the Basel II framework. These
changes are referred to as 'Basel 2.5' ... There are three changes involving: 1. The calculation
of a stressed VaR; 2. A new incremental risk charge; and 3. A comprehensive risk measure for
instruments dependent on credit correlation. The measures have the effect of greatly increasing
the market risk capital that large banks are required to hold."3

In regard to the incremental risk charge (IRC) each of the following is true EXCEPT which
statement is untrue about the IRC?

a) The IRC was introduced because instruments in the trading books often required less
regulatory capital than equivalent instruments in the banking book
b) The IRC is calculated as the one-year 99.9% value at risk (VaR) for losses from credit
instruments in the trading book
c) The IRC excludes ratings changes or migrations because a rating change does not itself
lead to default within the one-year horizon
d) The constant level of risk assumption assumes that the bank will have the opportunity to
rebalance its portfolio during the course of the year so that default risk is mitigated

520.3. According to Hull3, each of the following is true about the comprehensive risk measure
(CRM) EXCEPT which is not accurate?

a) The CRM is a single capital charge replacing the incremental risk charge and the
specific risk charge for instruments dependent on credit correlation
b) The CRM can be calculated using a standardized approach which determines a charge
based on the credit rating (e.g., BBB+ to BBB-) of the securitization or re-securitization
c) The maximum capital charge under the standardized approach is 28.0% which applies
securitization with the lowest credit rating
d) The Basel Committee allows banks, with supervisory approval, to use their internal
models to calculate the CRM for unrated positions, but the models developed by banks
have to be sophisticated in order to be approved by bank supervisors.

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John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)

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Answers:

520.1. D. $1.0 million

Requirement for VaR = MAX{20,000; 12,000*3} = 36,000. Scaling from 95% one-day to 99%,
10-day VaR = 36,000 * 2.33/1.64 * SQRT(10) = $161,009

Requirement for stressed VaR (sVaR) = MAX{188,000; 50,000*3} = 188,000. Scaling from 95%
one-day to 99%, 10-day VaR = 188,000 * 2.33/1.64 * SQRT(10) = $840,824

The total capital requirement (c) = MAX {VaR(t-1); m(c)*VaR(60-day avg)} + MAX {sVaR(t-1);
m(s)*sVaR(60-day avg)} = $161,009 + 840,824 = $1,000,833

520.2. C. False. The IRC explicitly includes rating changes and migrations; this is part of
its intention!

Hull: "Regulators proposed an “incremental default risk charge” (IDRC) in 2005 that would be
calculated for with a 99.9% confidence level and a one-year time horizon for instruments in the
trading book that were sensitive to default risk. This meant that the capital requirement for an
instrument in the trading book would be similar to the capital requirement if had been in the
banking book. In 2008, the Basel Committee recognized that most of the losses in the credit
market turmoil of 2007 and 2008 were from changes in credit ratings, widening of credit
spreads, and loss of liquidity, rather than solely as a result of defaults. It therefore amended its
previous proposals to reflect this and the IDRC became the “incremental risk charge” (IRC)."4

In regard to (A), (B) and (D), each is TRUE.

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John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)

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520.3. C. False. The maximum charge is 100.0% which is the effective charge for a
"deduction" and applies to securitization or re-securitizations that are either rated below
BB- or unrated.

Hull5: "The comprehensive risk measure (CRM) is designed to take account of risks in what is
known as the “correlation book.” This is the portfolio of instruments such as asset-backed
securities (ABSs) and collateralized debt obligations (CDOs) that are sensitive to the correlation
between the default risks of different assets. These instruments were discussed in Chapter 6.
Suppose a bank has a AAA-rated tranche of an ABS. In the normal market environment, there
is very little risk of losses from the tranche. However, in stressed market environments when
correlations increase, the tranche is vulnerable—as became apparent during the 2007–2009
crisis.

The CRM is a single capital charge replacing the incremental risk charge and the specific risk
charge for instruments dependent on credit correlation. A standardized approach for calculating
the CRM has been specified and is summarized in Table 13.1. Given the experience of the
securitization market during the crisis (see Chapter 6), it is not surprising that capital charges
are higher for resecuritizations (e.g., ABS CDOs) than for securitizations (e.g., ABSs). A
deduction means than the principal amount is subtracted from capital, which is equivalent to a
100% capital charge.

... The Basel Committee allows banks, with supervisory approval, to use their internal models to
calculate the CRM for unrated positions. The models developed by banks have to be quite
sophisticated to be approved by bank supervisors. For example, they must capture the
cumulative impact of multiple defaults, credit spread risk, the volatility of implied correlations, the
relationship between credit spreads and implied correlations, recovery rate volatility, the risk of
hedge slippage, and potential hedge rebalancing costs. A routine and rigorous program of
stress testing is also required. The U.S. is attempting to come up with its own CRM rules
because Dodd-Frank does not allow ratings to be used in setting capital requirements."5

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p2-t7-520-basel-2-5-

with-stressed-var-irc-and-crm-hull.8503/

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John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)

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P2.T7.521. Basel III regulatory capital requirements
Learning Objectives: Define in the context of Basel III and calculate where appropriate:
Tier 1 capital and its components; Tier 2 capital and its components; Required Tier 1
equity capital, total Tier 1 capital, and total capital. Describe the motivations for and
calculate the capital conservation buffer and the countercyclical buffer introduced in
Basel III.

521.1. John Hull's6 summary of Basel III includes this introduction, "Following the 2007–2009
credit crisis, the Basel Committee realized that a major overhaul of Basel II was necessary.
Basel 2.5 increased capital requirements for market risk. The Basel Committee wanted to
increase capital requirements for credit risk as well. In addition, it considered that ... regulations
were needed to address liquidity risk. Basel III proposals were first published in December
2009. Following comments from banks, a quantitative impact study, and a number of
international summits, the final version of the regulations was published in December 2010.

There are six parts to the regulations:

1. Capital Definition and Requirements
2. Capital Conservation Buffer
3. Countercyclical Buffer
4. Leverage Ratio
5. Liquidity Risk
6. Counterparty Credit Risk.

The regulations are being implemented gradually between 2013 and 2019 ... Under Basel III, a
bank’s total [regulatory] capital consists of:
1. Tier 1 equity capital
2. Additional Tier 1 capital
3. Tier 2 capital. There is no [longer any] Tier 3 capital."6

About the bank's total regulatory capital, each of the following is true EXCEPT which is false?

a) Tier 1 equity capital (aka, core Tier 1 capital) includes share capital and retained
earnings
b) Tier 1 equity capital (aka, core Tier 1 capital) excludes goodwill and deferred tax assets
c) Additional Tier 1 capital (i.e. non-core) consists of items such as non-cumulative
preferred stock that are not common equity (but were previously in Basel II considered
Tier 1)
d) Tier 2 capital is "going-concern capital" that must be equity, cannot be debt, and that
ranks above depositors in a liquidation and also consists of items such as non-
cumulative preferred stock

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John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)

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521.2. As of full implementation in 2019, each of the following regulatory capital requirements
under Basel III is accurate EXCEPT which is not?

a) Core Tier 1 equity capital must be at least 4.5% of risk-weighted assets; including the
capital conservation buffer, the core Tier 1 requirement is 7.0%
b) Total Tier 1 capital (Tier 1 equity capital plus additional Tier 1 capital) must be at 6.0% of
risk-weighted assets at all times
c) Tier 2 capital must be at least 5.5% of risk-weighted assets; capital conservation buffer
can be counted toward Tier 2 capital
d) Total capital (total Tier 1 plus Tier 2) must be at least 8.0% of risk-weighted assets at all
times. Including the capital conservation buffer, the minimum total capital requirement is
10.5%

521.3. Suppose that the Tier 1 equity ratio for a bank is 6.0%. What is the maximum dividend,
as a percent of earnings, that can be paid if (i) there is no countercyclical buffer and (ii) there is
a 2.5% countercyclical buffer? (source: Hull question 13.7)7

a) No dividend can be paid in either case

b) If there is no countercyclical buffer, 40% of retained earnings can be paid as a dividend;
if there is a 2.5% countercyclical buffer, then only 20% of retained earnings can be paid
c) If there is no countercyclical buffer, only 10% of retained earnings can be paid as a
dividend; if there is a 2.5% countercyclical buffer, then 80% of retained earnings can be
paid
d) 100% of retained earnings can be paid as a dividend in both cases

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John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)

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Answers:

521.1. D. False. Tier 2 equity capital is "gone-concern capital" that ranks below
depositors in a liquidation and includes debt that is subordinated to depositors with an
original maturity of five years.

In regard to (A), (B) and (C), each is TRUE.

Hull:8 "Capital Definition and Requirements: Under Basel III, a bank’s total capital consists
of: 1. Tier 1 equity capital, 2. Additional Tier 1 capital, and 3. Tier 2 capital. There is no Tier 3
capital. Tier 1 equity capital (also referred to as core Tier 1 capital) includes share capital and
retained earnings but does not include goodwill or deferred tax assets. It must be adjusted
downward to reflect defined benefit pension plan deficits but is not adjusted upward to reflect
defined benefit plan surpluses. (See Section 3.12 for a discussion of defined benefit plans.)
Changes in retained earnings arising from securitized transactions are not counted as part of
capital for regulatory purposes.

The same is true of changes in retained earnings arising from the bank’s own credit risk. (The
latter is referred to as DVA and will be discussed in Chapter 17.) There are rules relating to the
inclusion of minority interests and capital issued by consolidated subsidiaries. The additional
Tier 1 capital category consists of items, such as non-cumulative preferred stock, that were
previously Tier 1 but are not common equity. Tier 2 capital includes debt that is subordinated to
depositors with an original maturity of five years. Common equity is referred to by the Basel
Committee as “going-concern capital.” When the bank is a going concern (i.e. has positive
equity capital), common equity absorbs losses. Tier 2 capital is referred to as “gone-concern
capital.” When the bank is no longer a going concern (i.e., has negative capital) losses have to
be absorbed by Tier 2 capital. Tier 2 capital ranks below depositors in a liquidation. While Tier 2
capital remains positive, depositors should in theory be repaid in full."8

521.2. C. False. Basel III does not have a specific Tier 2 minimum, rather Tier 2
contributes to the Total capital requirement. Further, capital conservation does not
contribute to Tier 2 nor does Tier 2 qualify as a capital conservation buffer. The capital
conservation buffer must be core Tier 1 equity capital which is why the fully implemented core
Tier 1 equity capital requirement is 7.0% = 4.5% + 2.5%.

In regard to (A), (B) and (D), each is TRUE.

521.3. B. If there is no countercyclical buffer, 40% of retained earnings can be paid as a

dividend; if there is a 2.5% countercyclical buffer, then only 20% of retained earnings can
be paid. Tables 13.2 and 13.3 clearly do not need to be memorized. This question can be
answered by elimination; e.g., answer (C) does not make sense.8

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John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)

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P2.T7.522. Basel III: leverage ratio, liquidity coverage ratio, and net
stable funding
Learning Objectives: Describe and calculate ratios intended to improve the management
of liquidity risk, including the required leverage ratio, the liquidity coverage ratio, and
the net stable funding ratio. Describe the mechanics of contingent convertible bonds
(CoCos) and explain the motivations for banks to issue them.

522.1. What is the key difference between the Basel III leverage ratio and the other regulatory
ratios (i.e., core Tier 1 equity capital ratio, total Tier 1 capital ratio, and total capital ratio)?

a) The numerator of the leverage ratio is not regulatory capital, rather it is adjusted for the
risk of the funding source
b) The denominator of the leverage ratio is assets on the balance sheet without risk
weighting (plus some off-balance-sheet items such as loan commitments)
c) The leverage ratio is defined in terms of cash inflows and cash outflows and therefore
provides an additional buffer against liquidity risk
d) There is no difference in the definition of the ratio; instead, the leverage ratio is simply
the "placeholder ratio" which applies until the other regulatory ratios are fully phased-in
in order to guard against systemic risk

522.2. In regard to the liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and the
credit value adjustment (CVA), each of the following is true EXCEPT which is not accurate?

a) The liquidity coverage ratio is the ratio of high-quality liquid assets to net cash outflows
during a stressed period of 30 days
b) The net stable funding ratio is the ratio of a weighted sum of the items on the “liabilities
and net worth” side of the balance sheet divided by a weighted sum of the items on the
“assets” side of the balance sheet
c) The net stable funding ratio will increase if retail deposits are replaced by wholesales
deposits and if marketable securities are replaced by residential mortgages
d) The credit value adjustment (CVA) is a charge to income reflecting expected costs from
counterparty defaults in derivatives transactions; Basel III requires the exposure of CVA
to credit spreads to be included in the calculation of market risk capital

522.3. Which of the following is TRUE about contingent convertible (CoCo) bonds?

a) A drawback of CoCo bonds is that, prior to conversion, then hurt the bank's return on
equity (ROE)
b) A popular trigger for CoCo bonds is the ratio of Tier 1 equity capital to risk-weighted
assets
c) Regulators do not like CoCo bonds because they encourage regulatory arbitrage
d) CoCo bonds are NOT attractive to banks because they increase the odds of a public
sector bailout if the bank experiences financial difficulty

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Answers:

522.1. B. The denominator of the leverage ratio is assets on the balance sheet without
risk weighting (plus some off-balance-sheet items such as loan commitments)

Hull: "In addition to the capital requirements based on risk-weighted assets, Basel III specifies a
minimum leverage ratio of 3%. This leverage ratio is the ratio of capital to total exposure. A final
decision on the definition of capital for the purposes of calculating the leverage ratio was not
made at the time the Basel III rules were published in 2010. Total exposure includes all items on
the balance sheet (without any risk weighting) and some off-balance-sheet items such as loan
commitments. The leverage ratio is expected to be introduced on January 1, 2018, after a
transition period."9

522.2. C. False. The net stable funding ratio will DECREASE if retail deposits are replaced
by [less stable] wholesales deposits and if marketable securities are replaced by [less
liquid] residential mortgages

In regard to (A), (B) and (D), each is TRUE.

522.3. B. A popular trigger for CoCo bonds is the ratio of Tier 1 equity capital to risk-
weighted assets

Hull:9 "An interesting development in the capitalization of banks has been what are known as
contingent convertible bonds (CoCos). Traditionally, convertible bonds have been bonds issued
by a company where, in certain circumstances, the holder can choose to convert them into
equity at a predetermined exchange ratio. Typically the bond holder chooses to convert when
the company is doing well and the stock price is high. CoCos are different in that they
automatically get converted into equity when certain conditions are satisfied. Typically, these
conditions are satisfied when the company is experiencing financial difficulties.

CoCos are attractive to banks because in normal times the bonds are debt and allow the bank
to report a relatively high return on equity. When the bank experiences financial difficulties and
incurs losses, the bonds are converted into equity and the bank is able to continue to maintain
an equity cushion and avoid insolvency. From the point of view of regulators, CoCos are
potentially attractive because they avoid the need for a bailout. Indeed, the conversion of CoCos
is sometimes referred to as a “bail-in.” New equity for the financial institution is provided from
within by private sector bondholders rather than from outside by the public sector.

A key issue in the design of CoCos is the specification of the trigger that forces conversion and
the way that the exchange ratio (number of shares received in exchange for one bond) is set. A
popular trigger in the bonds issued so far is the ratio of Tier 1 equity capital to risk-weighted
assets. Another possible trigger is the ratio of the market value of equity to book value of
assets."9

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John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)

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