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Q.1 (a) What do you understand by Capital Adequacy Ratio?

(b) What are the most common parameters of ALM in Banks?


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Q.1 (a) What do you understand by Capital Adequacy Ratio?

(b) What are the most common parameters of ALM in Banks?


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Q.1 (a) What do you understand by Capital Adequacy Ratio?

Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR), is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements. It is a measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.
This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors
. Capital adequacy ratio is the ratio which determines the bank's capacity to meet the time liabilities and other risks such as credit risk, operational risk, etc. In the most simple formulation, a bank's capital is the "cushion" for potential losses, and protects the bank's depositors and other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.
CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-equity; since assets are by definition equal to debt plus equity, a transformation is required). Unlike traditional leverage, however, CAR recognizes that assets can have different levels of risk.
Capital adequacy ratios ("CARRR") are a measure of the amount of a bank's core capital expressed as a percentage of its risk-weighted asset.
Formula
Capital adequacy ratio is defined as
{CAR} = {Tier 1 capital + Tier 2 capital} / {Risk weighted assets}
TIER 1 CAPITAL - (paid up capital + statutory reserves + disclosed free reserves) - (equity investments in subsidiary + intangible assets + current & b/f losses)
TIER 2 CAPITAL -A)Undisclosed Reserves, B)General Loss reserves, C) hybrid debt capital instruments and subordinated debts
where Risk can either be weighted assets (\,a) or the respective national regulator's minimum total capital requirement. If using risk weighted assets,
{CAR} = {T1 + T2}/{a} ≥ 10%
The percent threshold varies from bank to bank (10% in this case, a common requirement for regulators conforming to the Basel Accords) is set by the national banking regulator of different countries.
Two types of capital are measured: tier one capital (T_1 above), which can absorb losses without a bank being required to cease trading, and tier two capital (T_2 above), which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

(b) What are the most common parameters of ALM in Banks?

In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities (debts and assets) of the bank. This can also be seen in insurance.

Banks face several risks such as the liquidity risk, interest rate risk, credit risk and operational risk. Asset liability management (ALM) is a strategic management tool to manage interest rate risk and liquidity risk faced by banks, other financial services companies and corporations.

Banks manage the risks of asset liability mismatch by matching the assets and liabilities according to the maturity pattern or the matching the duration, by hedging and by securitization. Much of the techniques for hedging stem from the delta hedging concepts introduced in the Black–Scholes model and in the work of Robert C. Merton and Robert A. Jarrow. The early origins of asset and liability management date to the high interest rate periods of 1975-6 and the late 1970s and early 1980s in the United States. Van Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.

Modern risk management now takes place from an integrated approach to enterprise risk management that reflects the fact that interest rate risk, credit risk, market risk, and liquidity risk are all interrelated. The Jarrow-Turnbull model is an example of a risk management methodology that integrates default and random interest rates. The earliest work in this regard was done by Robert C. Merton. Increasing integrated risk management is done on a full mark to market basis rather than the accounting basis that was at the heart of the first interest rate sensivity gap and duration calculations.


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