Question33 Suppose that homeowners pay back $12 million of residential mortgages, and the bank uses the proceeds to finance a new bridge of a BB- rated borrower. Will this transaction affect capital levels? [select: , Yes, No]. ResetMaximum marks: 3 Flag question undefined多重下拉选择题
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Question

Question33 Suppose that homeowners pay back $12 million of residential mortgages, and the bank uses the proceeds to finance a new bridge of a BB- rated borrower. Will this transaction affect capital levels? [select: , Yes, No]. ResetMaximum marks: 3 Flag question undefined多重下拉选择题

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BlackTom AI · Accepted Answer

Question restatement: The scenario asks whether the bank’s capital levels are affected when homeowners repay $12 million of residential mortgages, and the bank uses those proceeds to fund a new bridge loan to a BB- rated borrower. Answer choices: ["", "Yes", "No"].

Option 1: Yes. To analyze, consider how capital is measured in banking regulation. Capital levels (in terms of regulatory capital) depend on risk-weighted assets (RWAs) and the amount of capital held relative to those RWAs. When the $12 million is received from mortgage repayments, the bank’s balance sheet shifts: residential mortgage assets decline by $12 million, while cash/liquidity increases. Then the bank lends $12 million to a BB- rated borrower, creating a new loan asset. The two-stage flow changes the composition of assets and the associated risk weights.

Importantly, a BB- rated borrower typically carries a higher risk weight (often 100% or close to it) than plain-vanilla residential mortgages, which can have a lower risk weight depending on product and guarantees. If the RWAs rise due to the new BB- loan and the bank’s Tier 1 capital remains unchanged, the capital ratio could deteriorate, signaling an effect on capital adequacy. Additionally, even if total capital (in dollars) stays the same, the mix of assets has changed in a way that regulatory capital metrics would respond to. Therefore, it is reasonable to conclude that this transaction can affect capital levels.

Option 2: No. This would be the case only if RWAs and total regulatory capital remained perfectly unchanged by the swap, which is unlikely given the higher risk weight of a BB- loan relative to a standard mortgage, and the fact that the loan activity converts one asset into another with a different risk profile. Since the risk profile changes, capital adequacy metrics are typically affected, making this option incorrect.

Summary: The correct interpretation is that there is a potential impact on capital levels due to the change in risk-weighted assets from funding a BB- rated loan with repayments of residential mortgages. The No option fails to account for the altered risk weights and the consequent effect on regulatory capital metrics.