Banks capitalization, financial distress and effect on the US dollar-Canadian dollar exchange rate.

• Author: Nezerwe, Yvan

1. INTRODUCTION, DEFINITION AND MOTIVATION

   The topic of "exchange rate" is very important in the field of International Finance. International transactions or trades involve multiple currencies. The exchange rate between two currencies specifies how much one currency is worth in terms if the other. An exchange rate system is a set of rules organizing the determination of exchange rates among currencies. There are two types of exchange rate systems:

   * The fixed exchange rate system in which exchange rates are set at official per values by international monetary agreement. There are specific assets that serve as official reserve assets. The post-World war II Bretton Woods system is a good example of fixed exchange rate system. This system, which collapsed in 1971, sets a par value for the dollar in terms of gold.

   * The managed float system in which the exchange rate is allowed to move in response to market forces. The Central Bank can however intervene in preventing undesirable movements in exchange rates.

   Banks are required to keep a margin of assets as reserve. The United States have adopted the capital requirements established by the Bank for International Settlements. Each type of bank asset has a weighted-risk percentage. The assets are cash, government securities, interbank loans, mortgage loans, ordinary loans and standby letters of credit. There are two categories of capital:

   * Tier 1 capital which includes the book value of stocks and retained earnings. It must be at least 4% of total risk-weighted assets.

   * Tier 2 capital which includes the loan-loss reserves and long term debts.

   The total capital (Tierl and Tier 2) must be at least 8% of total risk-weighted assets. The current financial crisis has seen many banks struggling with their capital requirements. The struggle with capital requirements is because of the fact that most banks have been exposed to subprime mortgage loans. Publicly traded banks issued new stocks in trying to meet the standard capital requirements. Smaller banks reduced their assets (in trying to improve the capital ratios) or merged with financially stronger banks. In this paper, I will focus on Tier 1 capital and its effects on the US Dollar-Canadian Dollar exchange rate.

   The US Treasury Secretary Timothy Geithner recently unveiled a broad plan in which the government would buy toxic assets (including subprime mortgage loans) from struggling banks. Banks should start lending again and hopefully the economy will start growing again.

   The banks capitalization regulations are really broad. The current financial crisis will actually bring more regulations by the federal government. Just recently, the US Treasury secretary Timothy Geithner requested more powers for the government in regulating the financial sector. Many leaders are calling for tough regulations so that the current financial crisis does not happen again. The banks executives have recently engaged in many risky and questionable practices that have significantly shattered the American financial system.

   The current financial crisis started in the financial sector. The motivation of this study is to link the banks' capitalization to the financial distress and analyze the potential...