Buying Protection for the Portfolio from Another Bank

Tables 59.4-59.6 provide the calculations of capital, earnings and return on capital for the initial bank portfolio. The protection acquired matches the total portfolio and reduces both earnings and capital of the bank. Note that the calculation of capital now uses a capital charge with a risk weight of only 20%. By buying protection, the exposure remains 1000, but has a reduced risk weight. We substitute the new capital to the initial capital because we substitute entirely the exposure to the bank to the exposure to the corporation. The new earnings combine algebraically the initial revenue with the cost of the hedge. Finally the return on capital has improved, moving from 25% to 50%.

TABLE 59.4 Buying protection: capital

TABLE 59.5 Buying protection: earnings

TABLE 59.6 Buying protection: economic income statement

Under a more realistic calculation, we would substitute actual risk weights under Basel 2, which now depend on the ratings assigned to the corporation and the bank. Depending on these ratings and the associated risk weights, and on the actual cost of protection, the return on capital might increase or decrease, but the sequence of calculations would be the same.