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Financial Economics Year 3 > 6. Risk Management in Banks > Flashcards

6. Risk Management in Banks Flashcards

1
Q

What do Banks do?

A
  • Typical financial intermediary.
  • Expertise in reducing transaction costs and asymmetric information.
  • Maturity transformation.
  • Liquidity transformation.
  • Risk transformation.
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2
Q

What are assets in a balance sheet for a commercial bank?

A
  • Use of funds
  • Loans
  • Reserves
  • Cash
  • Deposits at other financial institutions.
  • Advances
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3
Q

What are liabilities in a commercial bank balance sheet?

A
  • Source of Funds
  • Checkable Deposits
  • Equities
  • Non-transaction deposits.
  • Borrowing from other financial institutions.
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4
Q

What is Bank Capital?

A
  • Assets-Liabilities: Buffer to prevent bank failure
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5
Q

What the general principles of Bank Management?

A
  • Asset management: to ensure low risk and high return of asset acquisition.
  • Liability Management: To acquire fund at low cost.
  • Capital adequacy management: To balance between failure buffer and profitability.(ICARA used to be ICAAP)
  • Liquidity Management: To keep enough cash for obligation.
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6
Q

What are the main risks in bank management?

A
  • Credit risk: borrowers may default.
  • Liquidity risks: unable to meet cash commitments to lenders.
  • Interest rate risks: falling in net margins or asset values due to changes in interest rates.
  • Other market risks: losses due to changes in exchange rates, commodity prices etc.
  • Macro risks: losses due to institutional or policy risks.
  • Operational risks: losses caused by errors or damages by people, systems, data etc.
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7
Q

What are the associate risks of interest rate risks in a bank?

A
  • If a financial institution has more rate-sensitive liabilities than assets, a rise in interest rates will reduce the net interest margin and net worth of the institution, while a decline in interest rates will raise the margin and net worth.
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8
Q

What is income gap analysis?

A
  • Estimates the sensitivity of a bank’s current year net interest income (interest - cost) to changes in interest rate.
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9
Q

What is Duration Gap Analysis?

A
  • Estimates the sensitivity of the net worth of market values of a bank.
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10
Q

What does triangle I stand for in income gap analysis?

A
  • Change in net interest income
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11
Q

What does triangle I^A stand for in income gap analysis?

A
  • Change in interest income.
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12
Q

What does triangle I^L stand for in income gap analysis?

A

Change in interest payment.

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13
Q

What does RSA stand for in income gap analysis?

A

Rate sensitive assets.

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14
Q

What does RSL stand for in income gap analysis?

A

Rate sensitive liabilities.

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15
Q

What does change in i stand for in income gap analysis?

A
  • Change in net interest rate.
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16
Q

What does GAP stand for in income gap analysis?

A

= Rate-Sensitive Assets - Rate Sensitive Liabilities.

17
Q

Income Gap Analysis Formula

A

Change in Net Interest Income = (Rate-Sensitive Assets - Rate-Sensitive Liabilities) * Change in net interest rate

18
Q

What is the Macauley Duration?

A
  • Interest rate changes can affect longer-term net interest income and hence the net worth of a financial institution.
  • Duration (Frederick Macaulay) - the average lifetime of a debt security’s stream of payments.
  • A coupon bond pays back earlier than the same-valued zero-coupon bond with the same time to maturity.
  • Consider a series of zero-coupon bonds resembling the payment flow of a coupon bond.
  • Thus effective maturity of a coupon bond: presented-value weighted average of the time to maturity of those zero-coupon bonds.
19
Q

What are the properties of Duration?

A
  • All else being equal
  • Longer the term to maturity of a bond is, the longer the duration.
  • When interest rates rise, duration of a coupon bond falls.
  • Higher the coupon rate on the bond is, shorter is the duration of the bond.
  • Duration is additive: duration of a portfolio is the weighted-value average of the durations of the individual securities.
  • Greater the duration is, greater the interest rate risk.
20
Q

Evaluating Income and Duration Gap Analyses

A
  • To be completely immunised, manage DurationA and Duration L to let gaps - 0
  • Gaps analyses have problems - interest rates differ with time to maturity
  • Some judgmental rate-sensitive exposures.
21
Q

Alts Evaluation

A
  • Risk assessment: scenario analysis, value at risk or its improved measures.
  • Hedging: IR swaps and other financial derivatives to mitigate risks.
22
Q

Banks Assets

A
  • A banks asset can be a use of its funds.
23
Q

Types of Bank Capital Definition

A
  • Raised by selling new equity.
  • A cushion against a drop in the value of its assets.
  • Comes from retained earnings.
24
Q

When does a bank fail?

A
  • A bank fails when the value of its assets falls below the value of liabilities, causing the bank to become insolvent.
25
Q

When is adverse selection present in banks?

A
  • Banks face the problem of adverse selection in loan markets because bad credit risks are the ones most likely to seek banks loans.
26
Q

When do banks face the moral hazard problem?

A
  • Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks face the moral hazard problem.
27
Q

Diversification and Adverse Selection in Banks

A
  • From the standpoint of diversification, specialisation in lending is surprising but makes perfect sense when one considers the adverse selection problem.
28
Q

Rationing Credit in Banks

A
  • When a bank offers borrowers smaller loans than they have requested.
29
Q

What happens if a bank has more rate-sensitive liabilities than rate-sensitive assets?

A
  • An increase in interest rates will reduce bank profits.
30
Q

What is duration gap analysis to basic gap analysis?

A
  • A complement to basic gap analysis that accounts for the effect of interest rate changes on market value.
31
Q

Negative Duration Gap

A
  • A rise in interest rate causes the market value of a bank’s net worth to rise.

Financial Economics Year 3 (9 decks)

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