Capital Requirements for Banks

Tier 1 capital is related to common stocks, non-cumulative perpetual preferred stocks, and disclosed reserves

Tier 2 capital represents debts with fixed or cumulative costs, such as cumulative preferred stocks, convertible debts, redeemable preferred shares, subordinated debts, and general provisions; and,

Tier 3 capital represents short-dated subordinated debentures retained to support the trading desk and market risks associated with derivatives transactions.

Qualifying Capitals

The Basle Accord further imposes limits on the amount of qualifying capital for the banks, i.e.,

For example, Tier 2 capital may not exceed 100 percent of Tier 1 capital, and subordinated debt may not amount to more than 60 percent of Tier 1 capital.

Tier 3 capital that is retained to support the market risk associated with trading desk may not exceed 250 percent of a bank’s tier 1 capital.

Furthermore, general provisions included in Tier 2 capital should not be greater than 1.25 percent of risk weighted assets

A bank’s capital adequacy requirement for the assets held in the bank book is estimated by the ratio of total qualifying Tier 1 and Tier 2 capital over the risk-weighted value of assets, both on and off-balance sheet.

The risk-weighted value of the bank assets is calculated as the product of the principal amount of the asset weighted by the risk weighting of an associated counterparty.

Based on the Basle Accord, banks are required to maintain a minimum capital/risk asset ratio of eight percent

Historical Simulations

The historical simulation method takes historical movements in the risk factors to simulate potential future movements.

Assume that on December 31,1998, XYZ has a forward contract to buy £10 million in exchange for delivering $16.5 million in 3 month.

XYZ Bank One$1.65/£

Spot rate