Page 78 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

READING 17: ANALYSIS OF FINANCIAL INSTITUTIONS

MODULE 17.2: CAPITAL ADEQUACY AND ASSET QUALITY

Asset Quality

Derives from the processes of generating assets, managing
them, and controlling overall risk.

Evaluation of asset quality includes analysis of current and
potential credit risk associated with the bank’s assets.

Bank assets include loans (the largest component) and
investments in securities. While loans are generally carried on
the balance sheet at amortized cost (net of allowances), the
accounting treatment for investments in securities differs
between U.S. GAAP and IFRS.

Under IFRS 9, depending on the business model, debt securities
may be carried at amortized cost, fair value through OCI, or fair
value through profit or loss.

Equity securities are always carried at fair value (either through
OCI or through profit or loss). Under U.S. GAAP, equity
investments are carried at fair value through profit or loss, while
1. Total Tier 1 ratio for 20X7 = 4.26% + 1.81% = 6.07% debt securities can be carried at amortized cost (held-to-maturity
2. Total Tier 1 ratio for 20X8 = 3.67% + 1.84% = 5.51% classification), fair value through OCI (available for sale
3. Mega Bank’s Common Equity Tier 1 ratio is less than Basel III guideline of classification) or fair value through profit or loss (trading
4.5%. Furthermore, it has worsened from 20X7 to 20X8. Given that this is classification).
the most important component of capital, it should be a cause for concern for
the bank’s regulators. The bank’s total Tier 1 ratio was above the Basel III
guideline of 6% in 20X7, but it has fallen below the guideline for 20X8. The
total capital ratio is above the Basel III guideline of 8% for 20X7 but again
has fallen short in 20X8.