Risk Management

This article discusses the importance of Tier 1 capital ratio for banks in measuring their financial strengths and the implications of failing the advanced stress test. It also provides recommendations for improving the situation.

Running head: RISK MANAGEMENT
Risk Management
Name of the Student:
Name of the University:
Authors Note:

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Contents
Introduction:....................................................................................................................................2
Tier 1 capital ratio and CET 1 capital ratio:....................................................................................2
Critical evaluation of implications on RBS of the failure of the bank to pass the advanced stress
test to prove its financial strength:...................................................................................................4
Impact of stress test failure of RBS on its ability to raise capital and steps to be taken by the
management to improve the situation:.............................................................................................9
Recommendations of steps to be taken by the management:........................................................10
Conclusion:....................................................................................................................................11
References:....................................................................................................................................12

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Introduction:
Equity capital and disclosed reserves are the core capital of a bank and is referred to as tier 1
capital for banks. Tier 1 capital ratio thus, measures, bank’s core capital to its total risk weighted
assets. Basel III Accord specifies use of Tier 1 capital ratio for measurement of financial
strengths of banks. Thus, the importance of core tier 1 capital for banks to measure its financial
strengths is clear from the fact that it has been specifically mentioned by the Basel III Accord on
core baking regulations.
Tier 1 capital ratio and CET 1 capital ratio:
Core equity capital of a bank against all the assets held by the bank is systematically measured
using Tier 1 capital ratio. Thus, the financial strengths of banks can be effectively measured
using the Tier 1 capital ratio. Weightage are assigned to different assets held by a bank to
calculate Tier 1 capital ratio; for example cash in hand and government securities will be
assigned 0% weightage whereas the mortgage loans provided by the banks will be assigned 50%
weightage. In short the financial strengths of a bank will be effectively measured by using Tier 1
capital ratio (Alajmi and Alqasem, 2015).
As per the information provided in the document Royal Bank of Scotland (RBS) has passed the
Tier 1 capital ratio requirements as well as the minimum requirement of CET 1 capital ratio.
Thus, the bank has minimum financial strength to continue its banking operations however, a
bank which is listed in a recognized stock exchange and is subjected to the market fluctuations
must also satisfy number of other criterions to have positive effects on the shareholders and other
stakeholders of the bank (Balasubramanyan, 2014). However, RBS has not passed the more
advance systematic reference point to prove its financial strengths in case there is any systematic

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risk in the market such as collapse of the economy, recession and other such risks which have
adverse effects on the ability of a bank to continue its operations. System reference point is an
advanced benchmark used to measure the ability of a bank to continue its operations without any
difficulty even at the time when systemic risks such as severe recession is experienced by an
economy.
Advanced systematic reference point:
Financial Services Act 2012 provides that the banks in England should use advanced benchmark
system to prove their financial strengths to show their ability to continue banking operations
when the economic conditions extremely negative. Testing the financial strengths of banks under
extreme economic conditions such as severe recession, economic slowdown and other such
situations will give the stakeholders of the banks including the shareholders huge amount of
confidence. Thus, a bank that passes the systemic reference point test will have much more
positive perspective towards the market as compared to the banks that have not passed systemic
reference point.
Hence, it is clear from the above that a bank in addition to the Tier 1 capital and CET 1 capital
ratios which are minimum requirements for banks to comply with to have minimum financial
strengths to continue functioning in the monetary market must also look to fulfil the
requirements of more advanced benchmark testing of financial strength by using systematic
reference point. A bank which is operating in the market and is exposed to the market risk will
be adversely affected if the bank fails to pass the advanced bench mark testing to prove that it
has necessary buffer in case any untoward situation emerge in the future (Balasubramanyan,
2014).

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Critical evaluation of implications on RBS of the failure of the bank to pass the advanced
stress test to prove its financial strength:
As already mentioned that banks and financial institutions in the United Kingdom are subjected
to strict rules and regulations which they must follow in order to continue their financial services
in the monetary market in the country. The Financial Policy Committee established under the
Bank of England Act 1998 has the supreme authority to frame rules and regulations governing
the banking sector in the country provide these are not in contravention with provisions of Bank
of England Act 1998 and Financial Services Act 2012. The committee, i.e. the Financial Policy
Committee (FPC) has provided that banks must satisfy the minimum capital and liquidity
requirements to show that they have necessary capital and liquidity to continue in the market.
Thus, banks have to pass the Tier 1 capital ratio and CET 1 capital ratio in order to pass the
minimum requirements to continue their banking operations in the future. The above ratio
measures the core capital of the bank against the assets held by the bank using weightage
assignment method. The core financial strengths is the minimum requirements for banks and
financial institutions to comply with. Without complying with these requirements a bank or a
financial institution will not be allowed to continue their operations in the monetary market.
Considering that RBS has passed the minimum requirements by complying with the CET 1
capital and Tier 1 capital ratio there is no risk of bank not being allowed to operate in the
monetary market by the Financial Services Committee (Borzykh, 2017).
However, the bank has failed to comply with the more advanced stress test by failing to comply
with the stress test of systematic reference point. Considering that it measures the extra leverage
or buffer a bank has to deal with adverse economic conditions such as severe recession,
economic slowdown and other such negative economic conditions, the failure of the bank to pass

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the systematic reference point will certainly affect the views of the stakeholders of the bank. In a
day and age of public corporations where the equity of public is being used to finance different
projects of an organization various matters such as the financial position and performance of an
organization directly affects the share prices, bond values in both short and long run of a banking
organization. However, before getting into detailed discussion about these let us have the
financial statements of RBS to understand its financial performance and position as on the date
of such statements.
INCOME STATEMENT OF THE ROYAL BANK OF SCOTLAND GROUP PLC
GBP in millions 2014-12 2015-12 2016-12 2017-12 2018-12
Revenue
Income from interest
Interest income gross 13,079.
00
11,925.
00
11,258.
00
11,034.
00
11,049.
00
Interest expense
Other expense 3,821.
00
3,158.
00
2,550.
00
2,047.
00
2,393.
00
Total interest expense 3,821.
00
3,158.
00
2,550.
00
2,047.
00
2,393.
00
Net interest income 9,258. 8,767. 8,708. 8,987. 8,656.

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00 00 00 00 00
Noninterest revenue
Commissions and fees 3,539.
00
2,933.
00
2,535.
00
2,455.
00
2,357.
00
Securities gains (losses) 179.
00
428.
00
311.
00
26
.00
Insurance premium 357
.00
Other income 1,699.
00
929.
00
1,473.
00
963.
00
1,945.
00
Noninterest revenue in total 5,417.
00
4,290.
00
4,008.
00
3,729.
00
4,685.
00
Total net revenue 14,675.
00
13,057.
00
12,716.
00
12,716.
00
13,341.
00
Noninterest expenses
Tech, communication and
equipment
4,568.
00
6,288.
00
8,745.
00
3,323.
00
3,372.
00
Amortization of intangibles 259.
00
204.
00
222.
00

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Other special charges 174.
00
1,606.
00
285.
00
(284.
00)
59
.00
Other expenses (5,001.
00)
(7,894.
00)
(9,234.0
0)
(3,261.
00)
(3,431.
00)
Total noninterest expenses
Earnings / (loss) from cont ops
before taxes
14,675.
00
13,057.
00
12,716.
00
12,716.
00
13,341.
00
Provision (benefit) for taxes 1,909.
00
23
.00
1,166.
00
824.
00
1,275.
00
Other income (expense) (12,092.
00)
(16,169.
00)
(16,808.0
0)
(10,512.
00)
(9,974.
00)
Earnings from discontinued ops (3,445.
00)
1,541.
00
Net earnings (2,771.
00)
(1,594.
00)
(5,258.0
0)
1,380.
00
2,092.
00
It is clear from the financial performance of the company that in recent years the performance of
the company has declined significantly. Especially the amount gross interest income of the bank
has declined at a constant pace since 2014. This is certainly a matter of concern for the bank
considering that the gross revenue from interest is the primary source of income for the bank.

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The char below shows how the revenue from interest has declined each year since 2014
(Giuliana, 2017).
2014-12 2015-12 2016-12 2017-12 2018-12
10,000.00
10,500.00
11,000.00
11,500.00
12,000.00
12,500.00
13,000.00
13,500.00
Interest income gross
It is very clear from the above chart that the financial performance of the bank especially the
ability of the bank to earn interest income has deteriorated significantly over the years. The net
earnings of the bank has also under gone huge fluctuations over the years as can be seen from the
above income statement. The net earnings of the bank over the last five years are showed in the
form of graphical representation below to understand the fluctuations better.

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2014-12 2015-12 2016-12 2017-12 2018-12
(6,000.00)
(5,000.00)
(4,000.00)
(3,000.00)
(2,000.00)
(1,000.00)
-
1,000.00
2,000.00
3,000.00
Net earnings
As is clear from the above graphic that the net earnings of the bank in 2014 was negative which
continued to be in negative till 2016. However in last two years, i.e. in 2017 and 2018 the bank
has earned positive income as is visible in the above graph (Glasserman and Nouri, 2010).
Considering the financial performance of the bank it is clear that the shareholders and other
stakeholders of the bank would emphasis on the stress tests to be relatively confident in the
ability of the bank to continue its operations in the long run. Thus, the stock price, bond values in
the long and short run will obviously be adversely affected as the bank has failed to pass the
systematic reference point test to prove its financial strengths in addition to the lackluster
financial performance of the bank in recent years (MADSEN, MISHRA and SMYTH, 2011).
Impact of stress test failure of RBS on its ability to raise capital and steps to be taken by
the management to improve the situation:
As already mentioned in the above discussion that the value of stock as well as value of bonds
both in long and short run shall be adversely affected with the news of failure of the bank to pass
systematic reference point test. As the value of stocks and bonds of the banks would be adversely

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affected subsequent to the news of systematic reference point test failure of the bank the ability
of the bank to raise capital from issuing stock and bonds would also be negatively hampered.
This is simply because the bank would struggle to sale the bonds and stock of the bank once the
news of the bank’s stress test failure will come to light. In addition the financial performance of
the bank has also not been good in recent years with its gross interest revenue declining at a
constant pace each year since 2014 (Ojo, 2014).
Further once the news that RBS has failed to pass advanced stress test to prove its ability to
continue under extreme economic condition such as severe recession and other such conditions
will came to light the stock and bond prices will decline significantly. Thus, once the value of
stock and bonds go down the bank will have to sale higher number of bond and stock to raise
capital which would have been possible to raise by issuing less number of stock and bond before
the decline in the value of these instruments (Stress Test Model for Measuring the Effects of the
Economic Crisis on the Capital Adequacy Ratio, 2015).
Recommendations of steps to be taken by the management:
The bank needs to come out of the situation as soon as possible as such situation hampers the
ability of the bank to conduct its operations in the future. The management needs to necessary
steps to improve the situation to help the bank to get rid of its problems in the future. The
following steps must be taken:
Improvement of capital adequacy ratio:
The management should take immediate steps to improve the capital adequacy ratio in the future.
Increasing the core capital:

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The management should take necessary steps to increase the core capital of the bank such as
equity by issuing additional equity shares.
Liquidity position:
The bank should improve its liquidity position by ensuring that it has necessary current assets to
meet its current liabilities and time demand.
Financial performance:
Improving the financial performance will help the bank to improve its financial position
including improvement in capital ratios (Ahmet Büyükşalvarci, 2011).
Conclusion:
Taking into consideration above discussion it is clear that a bank in addition to passing the
minimum requirements of CET1 capital ratio and Tier 1 capital ratio must passing the advanced
bench mark to show its ability to continue under adverse economic situation will increase the
trust of the stakeholders. This will positively influence the value of stock and bonds of the bank1
and its ability to raise capital from the market. Exactly opposite would be the case if the bank
fails to pass the stress tests as is the case with RBS. Thus, necessary steps shall be taken
immediately to improve the financial strength of the bank.

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References:
Ahmet Büyükşalvarci (2011). Determinants of capital adequacy ratio in Turkish Banks: A
panel data analysis. AFRICAN JOURNAL OF BUSINESS MANAGEMENT, 5(27), pp.17-21.
Alajmi, M. and Alqasem, K. (2015). DETERMINANTS OF CAPITAL ADEQUACY
RATIO IN KUWAITI BANKS. Journal of Governance and Regulation, 4(4), pp.140-187.
Balasubramanyan, L. (2014). Differential Capital Requirements: Leverage Ratio versus
Risk-Based Capital Ratio from a Monitoring Perspective. SSRN Electronic Journal, 2(2),
pp.18-36.
Balasubramanyan, L. (2014). Differential Capital Requirements: Leverage Ratio versus
Risk-Based Capital Ratio from a Monitoring Perspective. SSRN Electronic Journal, 2(7),
pp.196-287.
Borzykh, O. (2017). The impact of banks’ capital adequacy ratio on bank lending channel of
monetary transmission in Russia. Voprosy Ekonomiki, 7(7), pp.62-78.
Giuliana, R. (2017). The Impact of Capital Purchase Program on the Capital Ratio of U.S.
Banks. SSRN Electronic Journal, 1(1), p.17.
Glasserman, P. and Nouri, B. (2010). Contingent Capital with a Capital-Ratio
Trigger. SSRN Electronic Journal, 17(18), pp.23-31.
MADSEN, J., MISHRA, V. and SMYTH, R. (2011). IS THE OUTPUT-CAPITAL RATIO
CONSTANT IN THE VERY LONG RUN?*. The Manchester School, 80(2), pp.210-236.

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Ojo, M. (2014). Leverage Ratio Comparisons: Basel III International Leverage Ratio and
the U.S Leverage Ratio, Tier One Capital and Leverage Ratios. SSRN Electronic Journal,
1(2), pp.17-21.
Stress Test Model for Measuring the Effects of the Economic Crisis on the Capital
Adequacy Ratio. (2015). Acta Polytechnica Hungarica, 12(5), pp.87-91.