A bank uses a capital charge of 3.0%for revolving credit facilities with a loan equivalent factor of 0.4 assigned to the undrawn portion in calculating its risk-adjusted return on capital.A risk manager of the bank has become concerned that the protective covenants embedded in these loans are weak and may not prevent customers from drawing on the facilities during times of stress.As such,the manager has recommended increasing the loan equivalent factor to 0.85.This recommendation has been met with resistance from the loan origination team,and senior management has asked the risk manager to quantify the impact of the recommendation.For a typical facility that has an original principal of USD 1 billion and is 35%drawn,how much additional economic capital would have to be allocated if the loan equivalent factor is increased from 0.4 to 0.85?
A.USD 3.500 million
B.USD 6.195 million
C.USD 8.775 million
D.USD 18.300 million
Where:Credit commitment=COM=USD 1 billion
Drawn amount=Drawn=35%*COM=0.35*USD 1 billion=USD 350 million
Undrawn amount=UnDrawn=COM–Drawn=65%*COM=USD 650 million
Loan equivalent factor=LEF=0.4 Capital factor(capital charge)=CF=3.0%
Therefore the initial required economic capital is calculated as follows:
Required Capital=[350+(650*0.4)]*0.03=USD 18.3 million,and the required capital if the change is implemented would be:[350+(650*0.85)]*0.03=USD 27.075 million.
Hence the additional required economic capital would be 27.075–18.3=USD 8.775 million