Tier 3

[ahnnecabiles]

Hi David,

According to the Basel readings, Tier 3 capital is used to meet market risk capital requirements only. How then we compute for capital adequacy ratio with the inclusion of Tier 3 capital? If we are asked, what is the total capital per Basel II, do we automatically include Tier 3? Or we just offset the amount of Tier 3 from the market risk weighted assets?

Thanks

 

[David Harper CFA FRM]

Hi Chinquee,

This is nearest: "we just offset the amount of Tier 3..." But I would think of this in two layers (following Jorion Handbook)

http://learn.bionicturtle.com/images/forum/basel_capital_ratio.png

First, it's just a ratio (see above) of total eligible capital (Tier I + II + III) to risk-weighted assets (RWA) where market risk charge (MRC) and operational risk charge (ORC) are translated into RWA by MRC/8% or MRC*12.5. This keeps the thinking simple at the "first layer:" Basel II amount to elgible capital/RWA >= 8%.

Second, then the layer of capital eligibility. If eligible capital is $1 Billion, for example, it could all be Tier I. I would think of this as second-order criteria that put limits on Tier II and Tier III. If total capital is a pie, the Tier II wedge can cannot be larger than Tier I wedge (Tier I must be 50%), Tier III cannot be more than 2.5X Tier I. As Jorion sums up the situation: Eligible Tier I capital for MR + ALLOWED Tier 3 (or Tier 2) capital >= Market Risk Charge (MRC). So, for me, I can best keep the straight if i think of, first, capital as a pie (>= 8%), then, second, criteria that limit the size of the Tier II and Tier III wedges, if they are needed.

In practice (the exam), you are more likely to be asked about the MRC or the total capital. For example, there may be questions about getting MRC as function of VaR (without involving the capital ratio); e.g., what is the market risk charge given riskmetrics VaR. Or, at the total capital level, the questions are more likely to be about the Tier rules. A calculation involving the intersection is unlikely.

David