Analysis of Financial Institutions Flashcards
Systemic risk definition
a risk of disruption to financial services that is (i) caused by an impairment of all or parts of the financial system and (ii) has the potential to have serious negative consequences for the economy as a whole.
Basel III requirements
minimum capital requirement (risk-weighted assets), minimum liquidity (30-day liquidity stress scenario), and stable funding (liquidity needs over 1 year horizon).
Capital adequacy components
Common equity tier 1 capital
Other tier 1 capital
Tier 2 capital
Common equity tier 1 capital
includes common stock, issuance surplus related to common stock, retained earnings, accumulated other comprehensive income, and certain adjustments including the deduction of intangible assets and deferred tax assets
Other tier 1 capital
includes other types of instruments issued by the bank that meet certain criteria. The criteria require, for example, that the instruments be subordinate to such obligations as deposits and other debt obligations, not have a fixed maturity, and not have any type of payment of dividends or interest that is not totally at the discretion of the bank
Tier 2 Capital
includes instruments that are subordinate to depositors and to general creditors of the bank, have an original minimum maturity of five years, and meet certain other requirements.
Financial assets reporting categories (IFRS)
The financial asset’s category specifies how it is subsequently measured (either amortized cost or fair value) and, for those measured based on fair value, how any changes in value are reported–either through other comprehensive income (OCI) or through profit and loss (PL).
(1) measured at amortized cost,
(2) measured at fair value through other comprehensive income (FVOCI), and
(3) measured at fair value through profit and loss (FVTPL).
Equity investments (US GAAP)
measured at fair value with changes in fair value recognized in net income.
Another exception to fair value measurement is that an equity investment without a readily determinable fair value can be measured at cost minus impairment.
Debt investments (US GAAP)
the three categories used to classify and measure investments apply only to debt securities:
(1) held to maturity (measured at amortized cost),
(2) trading (measured at fair value through net income), and
(3) available for sale (measured at fair value through other comprehensive income).
Asset quality
Investments in securities issued by other entities
Credit quality
— Credit risk exposure
— Counterparty credit risk
CAMELS
C - Capital adequacy,
A - Asset quality,
M - Management capabilities,
E - Earnings sufficiency,
L - Liquidity position, and
S - Sensitivity to market risk.
Management Capabilities
Governance structure
Internal controls, transparent management communication, and financial reporting quality
Risk management
Earnings
High-quality earnings - accounting estimates are unbiased and the earnings are derived from sustainable rather than non-recurring items
Loan impairment allowances
Earnings composition:
(a) net interest income (the difference between interest earned on loans minus interest paid on the deposits supporting those loans),
(b) service income, and
(c) trading income
fair value hierarchy
Level 1 inputs are quoted prices for identical financial assets or liabilities in active markets.
Level 2 inputs are observable but are not the quoted prices for identical financial instruments in active markets. Level 2 inputs include quoted prices for similar financial instruments in active markets, quoted prices for identical financial instruments in markets that are not active, and observable data such as interest rates, yield curves, credit spreads, and implied volatility. The inputs are used in a model to determine the fair value of the financial instrument.
Level 3 inputs are unobservable. The fair value of a financial instrument is based on a model (or models) and unobservable inputs.
The Liquidity Coverage Ratio (LCR)
minimum percentage of a bank’s expected cash outflows that must be held in highly liquid assets. For this ratio, the expected cash outflows (the denominator) are the bank’s anticipated one-month liquidity needs in a stress scenario, and the highly liquid assets (the numerator) include only those that are easily convertible into cash. The standards set a target minimum of 100%
Net Stable Funding Ratio (NSFR)
the minimum percentage of a bank’s required stable funding that must be sourced from available stable funding.
required stable funding (the denominator) is a function of the composition and maturity of a bank’s asset base, whereas available stable funding (the numerator) is a function of the composition and maturity of a bank’s funding sources (i.e., capital and deposits and other liabilities).
Under Basel III, the available stable funding is determined by assigning a bank’s capital and liabilities to one of five categories presented in Exhibit 8, shown below. The amount assigned to each category is then multiplied by an available stable funding (ASF) factor, and the total available stable funding is the sum of the weighted amounts.
concentration of funding
Concentration of funding refers to the proportion of funding that is obtained from a single source. Excessive concentration of funding exposes a bank to the risk that a single funding source could be withdrawn
Allowance vs. provision for loan losses
Allowance for loan losses - A balance sheet account; it is a contra asset account to loans (often netted from total loans).
Provision for loan losses - An income statement expense account that increases the amount of the allowance for loan losses.
Net charge-offs and NPL are good proxies for determining loan quality.
* The ratio of the allowance for loan losses to non-performing loans (a.k.a. non accrual loans)
* The ratio of the allowance for loan losses to net loan charge-offs
* The ratio of the provision for loan losses to net loan charge-offs
Premiums and floats
premiums - amounts paid by the purchaser of insurance products
floats - amounts collected as premium and not yet paid out as benefits
2 types of insurance companies
Property and casualty (P&C)
Life and health (L&H)
Property and casualty insurance
Property - protect against loss or damage to property—buildings, automobiles, environmental damage, and other tangible objects of value
Casualty insurance - aka liability insurance; protects against a legal liability related to an insured event. Casualty insurance covers the liability to a third party, such as passengers, employees, or bystanders
2 methods of distributing insurance
Direct writing - Direct writers of insurance have their own sales and marketing staff. Direct writers also may sell insurance policies via the internet; through direct response channels, such as mail; and through groups with a shared interest or bond, such as membership in a profession
Agency writing - use independent agents, exclusive agents, and insurance brokers to sell policies.
Insurance combined ratio
the total insurance expenses divided by the net premiums earned
If low, it indicates a hard insurance market, attracting new entrants who cut prices and push the cycle downward.
If high, it indicates a soft insurance market (The effect can be seen in the denominator of the combined ratio: The lower prices for premiums decreases the total net premiums earned, and the combined ratio increases, indicating a soft market | competitors leave the market)
if more than 100% - indicates an underwriting loss
Combined ratio according to U.S. Statutory Accounting Practices
Combined ratio = underwriting ratio + expense ratio
The underwriting loss ratio = [claims paid plus (ending loss reserves minus beginning loss reserves)] divided by net premiums earned - quality indicator. Underwriting activities include decisions on whether to accept an application for insurance coverage and decisions on the premiums charged for any coverage extended.
The expense ratio (underwriting expenses, including sales commissions and related employee expenses, divided by net premiums written) efficiency indicator of a company’s operations in acquiring and managing underwriting business
