20 - Chapter Twenty Capital Adequacy Chapter Outline...

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Chapter Twenty Capital Adequacy Chapter Outline Introduction Capital and Insolvency Risk Capital The Market Value of Capital The Book Value of Capital The Discrepancy between the Market and Book Values of Equity Arguments against Market Value Accounting Capital Adequacy in the Commercial Banking and Thrift Industry Actual Capital Rules The Capital-Assets Ratio (or Leverage Ratio) Risk-Based Capital Ratios Calculating Risk-Based Capital Ratios Capital Requirements for Other Fis Securities Firms Life Insurance Property-Casualty Insurance Summary Appendix 20A: Internal Ratings Based Approach to Measuring Credit Risk-Adjusted Assets 235
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Solutions for End-of-Chapter Questions and Problems: Chapter Twenty 1. Identify and briefly discuss the importance of the five functions of an FI’s capital? Capital serves as a primary cushion against operating losses and unexpected losses in the value of assets (such as the failure of a loan). FIs need to hold enough capital to provide confidence to uninsured creditors that they can withstand reasonable shocks to the value of their assets. In addition, the FDIC, which guarantees deposits, is concerned that sufficient capital is held so that their funds are protected, because they are responsible for paying insured depositors in the event of a failure. This protection of the FDIC funds includes the protection of the FI owners against increases in insurance premiums. Finally, capital also serves as a source of financing to purchase and invest in assets. 2. Why are regulators concerned with the levels of capital held by an FI compared to a non- financial institution? Regulators are concerned with the levels of capital held by an FI because of its special role in society. A failure of an FI can have severe repercussions to the local or national economy unlike non-financial institutions. Such externalities impose a burden on regulators to ensure that these failures do not impose major negative externalities on the economy. Higher capital levels will reduce the probability of such failures. 3. What are the differences between the economic definition of capital and the book value definition of capital? The book value definition of capital is the value of assets minus liabilities as found on the balance sheet. This amount often is referred to as accounting net worth. The economic definition of capital is the difference between the market value of assets and the market value of liabilities. a. How does economic value accounting recognize the adverse effects of credit and interest rate risk? The loss in value caused by credit risk and interest rate risk is borne first by the equity holders, and then by the liability holders. In market value accounting, the adjustments to equity value are made simultaneously as the losses due to these risk elements occur. Thus economic insolvency may be revealed before accounting value insolvency occurs. b.
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20 - Chapter Twenty Capital Adequacy Chapter Outline...

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