Analysis of Financial Institutions

Question 1

Systemic risk definition

Answer 1

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.

Question 2

Basel III requirements

Answer 2

minimum capital requirement (risk-weighted assets), minimum liquidity (30-day liquidity stress scenario), and stable funding (liquidity needs over 1 year horizon).

Question 3

Capital adequacy components

Answer 3

Common equity tier 1 capital
Other tier 1 capital
Tier 2 capital

Question 4

Common equity tier 1 capital

Answer 4

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

Question 5

Other tier 1 capital

Answer 5

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

Question 6

Tier 2 Capital

Answer 6

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.

Question 7

Financial assets reporting categories (IFRS)

Answer 7

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).

Question 8

Equity investments (US GAAP)

Answer 8

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.

Question 9

Debt investments (US GAAP)

Answer 9

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).

Question 10

Asset quality

Answer 10

Investments in securities issued by other entities
Credit quality
— Credit risk exposure
— Counterparty credit risk

Question 11

CAMELS

Answer 11

C - Capital adequacy,
A - Asset quality,
M - Management capabilities,
E - Earnings sufficiency,
L - Liquidity position, and
S - Sensitivity to market risk.

Question 12

Management Capabilities

Answer 12

Governance structure
Internal controls, transparent management communication, and financial reporting quality
Risk management

Question 13

Earnings

Answer 13

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

Question 14

fair value hierarchy

Answer 14

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.

Question 15

The Liquidity Coverage Ratio (LCR)

Answer 15

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%

Question 16

Net Stable Funding Ratio (NSFR)

Answer 16

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.

Question 17

concentration of funding

Answer 17

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

Question 18

Allowance vs. provision for loan losses

Answer 18

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

Question 19

Premiums and floats

Answer 19

premiums - amounts paid by the purchaser of insurance products
floats - amounts collected as premium and not yet paid out as benefits

Question 20

2 types of insurance companies

Answer 20

Property and casualty (P&C)
Life and health (L&H)

Question 21

Property and casualty insurance

Answer 21

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

Question 22

2 methods of distributing insurance

Answer 22

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.

Question 23

Insurance combined ratio

Answer 23

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

Question 24

Combined ratio according to U.S. Statutory Accounting Practices

Answer 24

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

Question 25

net premiums written vs. net premiums earned

Answer 25

Net premiums written are an insurer’s direct premiums written, net of any such premiums ceded to other insurers. Premiums are usually billed in advance—for example, twice per year—and they are earned over the period of coverage provided by the insurance policy. Only the net premiums written that are earned over a relevant accounting period—for example, quarterly—are considered to be the net premiums earned

Question 26

Loss and loss adjustment expense ratio

Answer 26

Loss and loss adjustment expense ratio = (Loss expense + Loss adjustment expense)/Net premiums earned. This ratio indicates the degree of success an underwriter has achieved in estimating the risks insured.

The lower the ratio, the greater the success.

Question 27

Underwriting expense ratio

Answer 27

Underwriting expense ratio = Underwriting expense/Net premiums written. This ratio measures the efficiency of money spent in obtaining new premiums.

A lower ratio indicates higher success.

Question 28

Combined ratio

Answer 28

Combined ratio = Loss and loss adjustment expense ratio + Underwriting expense ratio. This ratio indicates the overall efficiency of an underwriting operation.

A combined ratio of less than 100 is considered efficient.

Question 29

Dividends to policyholders (shareholders) ratio

Answer 29

Dividends to policyholders (shareholders) ratio = Dividends to policyholders (shareholders)/Net premiums earned. This ratio is a measure of liquidity, in that it relates the cash outflow of dividends to the premiums earned in the same period.

Question 30

Combined ratio after dividends

Answer 30

Combined ratio after dividends = Combined ratio + Dividends to policyholders (shareholders) ratio. This ratio is a stricter measure of efficiency than the ordinary combined ratio, in that it takes into account the cash satisfaction of policyholders or shareholders after consideration of the total underwriting efforts. Dividends are discretionary cash outlays, and factoring them into the combined ratio presents a fuller description of total cash requirements.

Question 31

Fair value reporting (liquidity use-case)

Answer 31

Level 1 reported values are based on readily available prices for securities traded in liquid markets and thus indicate the most liquid of securities.

Level 2 reported values are based on less liquid conditions: Prices for such securities are not available from a liquid market and may be inferred from similar securities trading in an active market. Thus, these securities are likely to be less liquid than those reported as Level 1 securities.

Level 3 reported values are based on models and assumptions because there is no active market for the securities, implying illiquidity

Question 32

term life policy

Answer 32

provides a benefit if the insured dies within the fixed term of the contract but expires without value if the insured is still living at the end of the term

Question 33

Contract surrenders

Answer 33

provisions for the policyholder to cancel the contract before its contractual maturity and receive the accumulated cash value