Professional Documents
Culture Documents
TRM Tut 2
TRM Tut 2
Which is the most important component on the asset side and which one on the liability
side? Explain why.
Assets
- All assets should be divided into current and noncurrent assets. An asset is considered
current if it can reasonably be converted into cash within one year. Cash, inventories,
and net receivables are all important current assets because they offer flexibility and
solvency.
- Cash is the headliner. Companies that generate a lot of cash are often doing a good job
satisfying customers and getting paid. While too much cash can be worrisome, too little
can raise a lot of red flags. However, some companies require little to no cash to
operate, choosing instead to invest that cash back into the business to enhance their
future profit potential.
Liabilities
- Like assets, liabilities are either current or noncurrent. Current liabilities are obligations
due within a year. Fundamental investors look for companies with fewer liabilities than
assets, particularly when compared against cash flow. Companies that owe more money
than they bring in are usually in trouble.
- Items on the balance sheet are used to calculate important financial ratios, such as the
quick ratio, the working capital ratio, and the debt-to-equity ratio.
- Common liabilities include accounts payable, deferred income, long-term debt, and
customer deposits if the business is large enough. Although assets are usually tangible
and immediate, liabilities are usually considered equally as important, as debts and other
types of liabilities must be settled before booking a profit.
Equity
- Equity is equal to assets minus liabilities, and it represents how much the company's
shareholders actually have a claim to. Investors should pay particular attention to
retained earnings and paid-in capital under the equity section.
- Paid-in capital represents the initial investment amount paid by shareholders for their
ownership interest. Compare this to additional paid-in capital to show the equity premium
investors paid above par value. Equity considerations, for these reasons, are among the
top concerns when institutional investors and private funding groups consider a business
purchase or merger.
- Retained earnings show the amount of profit the firm reinvested or used to pay down
debt, rather than distributed to shareholders as dividends.
Q2 It is said that ALM in Banking is a liability driven process. Discuss the reasons
A bank's capital consists of tier 1 capital and tier 2 capital, and these two primary types of
capital reserves are qualitatively different in several respects (there was formerly a third type,
conveniently called tier 3 capital).
- Tier 1 capital is a bank's core capital and includes disclosed reserves—that appears on
the bank's financial statements—and equity capital. This money is the funds a bank uses
to function on a regular basis and forms the basis of a financial institution's strength.
- Tier 2 capital is a bank's supplementary capital. Undisclosed reserves, subordinated
term debts, hybrid financial products, and other items make up these funds.
A bank's total capital is calculated by adding its tier 1 and tier 2 capital together. Regulators use
the capital ratio to determine and rank a bank's capital adequacy.
- Tier 1 Capital
Tier 1 capital consists of shareholders' equity and retained earnings—disclosed on their
financial statements—and is a primary indicator to measure a bank's financial health. These
funds come into play when a bank must absorb losses without ceasing business operations.
Tier 1 capital is the primary funding source of the bank. Typically, it holds nearly all of the bank's
accumulated funds. These funds are generated specifically to support banks when losses are
absorbed so that regular business functions do not have to be shut down.
Ex: Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the
bank's tier 1 capital by its total risk-weighted assets (RWA). RWA measures a bank's exposure
to credit risk from the loans it underwrites.
For example, assume a financial institution has US$200 billion in total tier 1 assets. They have a
risk-weighted asset value of $1.2 trillion. To calculate the capital ratio, they divide $200 billion by
$1.2 trillion in risk for a capital ratio of 16.66%, well above the Basel III requirements.
Also, there are further requirements on sources of the tier 1 funds to ensure they are available
when the bank needs to use them.
- Tier 2 Capital
Tier 2 capital includes undisclosed funds that do not appear on a bank's financial statements,
revaluation reserves, hybrid capital instruments, subordinated term debt—also known as junior
debt securities—and general loan-loss, or uncollected, reserves. Revalued reserves is an
accounting method that recalculates the current value of a holding that is higher than what it
was originally recorded as such as with real estate. Hybrid capital instruments are securities
such as convertible bonds that have both equity and debt qualities.
Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. It is more
difficult to accurately measure due to its composition of assets that are difficult to liquidate.
Often banks will split these funds into upper and lower level pools depending on the
characteristics of the individual asset.
Ex: In 2019, under Basel III, the minimum total capital ratio is 12.9%, which indicates the
minimum tier 2 capital ratio is 2%, as opposed to 10.9% for the tier 1 capital ratio
Assume that same bank reported tier 2 capital of $32.526 billion. Its tier 2 capital ratio for the
quarter was $32.526 billion/$1.243 trillion = 2.62%. Thus, its total capital ratio was
16.8%(14.18% + 2.62%). Under Basel III, the bank met the minimum total capital ratio of 12.9%.
Question 4 List the 7 sources of Interest rate risk and give examples on each of them.
Question 5 A bank makes a $10,000 four2year car loan to a customer at a fixed rate of
8.5%. The bank
initially funds the car loan with a one2year $10,000 CD at a cost of 4.5%. The bank’s initial
spread is 4%.
a. What is the bank’s one year gap?
b. What would happen to the bank’s balance sheet when the interest rate rises/falls in
one year?
Question 6
Consider the following balance sheet