Sigma Bank has the following balance sheet in millions of dollars. The risk weig

Question

Sigma Bank has the following balance sheet in millions of dollars. The risk weights as specified by the Basel capital standards are given in parentheses. Unless mentioned otherwise, all assets are held by corporate customers in millions of dollars. Under the new Basel standards, we require 6% of Tier 1 and 8% of Tier 1+1. Is the bank in compliance with both ratios? $188.0 S 20 $ 30 $50 $100 Deposits Cash (0%) Muni Bonds (20%) Mortgage loans (50%) Consumer Loans (100%) Total Assets Tier II Capital Tier 1 Capital $2.0 $10.0 $200 $200

Explanation / Answer

The risk weighted capital required by the bank for its assets is as below:

Cash - 0%

Muni Bonds - 20%: which is 20% * 30 = 6

Mortgage Loans - 50%: which is 50% * 50 = 25

Consumer Loans - 100%: which is 100% of 100 = 100

Hence the total risk weighted assets are (6+25+100) = $ 131 million

Thus to comply with the Basel requirements, the capital required is Tier I = 6% * 131 = $ 7.86 million

Tier (I + II) capital required is 8% which is 8% * 131 = $10.48 million

Since the Tier I capital is $10 million and Tier I+II is $12 million, the bank is in compliance with the Basel requirements.

Now if the bank replaces the Muni bonds (20% risk weight) and Mortgage Loans (50% risk weight) with high interest commercial loans (100% risk weight) the risk weighted assets will increase from $131 million to $ 180 million

Tier I capital required will be = 6%*180 = $10.8 million

Tier I+II capital required will be = 8% * 180 = $14.4 million

Thus we see that in second case, if the bank replaces Muni Bonds and Mortgage Loans with commercial loans, it will be not in compliance with the Basel capital requirements

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