Analysis of Financial Institutions

Question 1

What is the liquidity coverage ratio

Answer 1

Cash / One month liquidity needs

LCR is expressed as the minimum % of a bank expected cash outflows that must be held in highly liquid assets.

Has to equal 100% or more.

Question 2

What is the 3 main requierments of BASEL

Answer 2

Minimum Capital Requierment

Minimum Liquidity Requierment

Stable funding

Question 3

What is the Minimum Capital Requierment: for BASEL 3?

Answer 3

The minimum percentage of risk-weighted assets that a bank must fund with equity capital.

Prevents the bank from assuming too much financial leverage that it is unable to withstand losses. The riskier the assets, the higher capital requierment.

Question 4

What is the Minimum Liquidity for BASEL 3?

Answer 4

Banks should hold enough liquid assets to mark demands under a 30-day liquidity stress scenario.

Question 5

What is the Stable Funding for BASEL 3?

Answer 5

Minimum amount of stable funding relative to the liquidity needs over a one-year horizion.

Question 6

What is CAMELS Approach?

Answer 6

A banker examines using CAMELS approach to evaluate a bank conducts an analysis and assigns a numerical rating of 1 (best rating) through 5 (worst rating) to each component.

Question 7

What does CAMLES stand for?

Answer 7

• Capital Adequacy
• Asset Quality
• Management Capabilities
• Earnings
• Liquidity Position
• Sensitivity to Market Risk

Question 8

What does “C” Stand for in C.A.M.E.L.S

Answer 8

Capital Adequacy
To prevent financial insolvency, a bank must maintain adequate capital to sustain business losses.
Capital adequacy is based on Risk-Weighted Assets (RWA).
Lower the risk weighting, lower the risk and higher the risk weighting, higher the risk. Basel III defines a bank’s capital in a hierarchical approach.

Question 9

What is “Common Equity Tier 1 Capital”

Answer 9

This is the most important component. It is widely recognized as the most loss-absorbing form of capital.

E.g. Common Stock, Additional Paid-in-Capital, Retained Earnings and OCI - Intangible Assets and Deferred Tax Assets.

Has to make up 4.5% or more of Risk Weighted Assets.

Question 10

What is “Other Tier 1 Capital”

Answer 10

Subordinated instruments with no specified maturity and no contractual dividends.

E.g. Preferred Stock with discretionary dividends.

Question 11

What is Tier 2 Capital.

Answer 11

Subordinated instruments with original (i.e. when issued) maturity of more than 5 years

Question 12

What is Total Tier 1 Capital

Answer 12

Common Equity Tier 1 Capital + Other Tier 1 Capital

Has to equal 6% or more Of Risk Weighted Assets.

Question 13

Sum of total capital

Answer 13

Total Capital (Tier 1 and Tier 2): 8% of RWA

Question 14

What does “A” Stand for in C.A.M.E.L.S

Answer 14

Pretains to amount of credit risk associated with the assets.

asset quality derives from the processes of generating assets, managing them and controlling overall risk.

Bank assets include loans (the largest component) and investments in securities; while loans are generally carried on the balance sheet at amortized cost, net of allowances.

Question 15

What does “M” Stand for in C.A.M.E.L.S

Answer 15

A strong governance structure with an independent board that avoids excessive compensation or self-dealing is also critically important.

Sound internal controls, transparent management communication
and financial reporting quality are indicators of management effectiveness

Question 16

What does “E” Stand for in C.A.M.E.L.S

Answer 16

Earnings

We want high quality earnings, sustainable, and trending upwards.

There are 3 types of earnings

• Net Interest Income
• Service Income
• Trading Income

Question 17

What does “L” Stand for in C.A.M.E.L.S

Answer 17

Liquidity Positions

The impact of a bank’s failure to honor a current liability could affect an entire economy.
Deposits in most banks are insured upto some specified amount by government insurers.

Two most important ratios are “Liquidity coverage ratio” and “Net stable funding ratio”

Question 18

What are the two minimal liquidity ratios standards in “Liquidity positions”

Answer 18

Two most important ratios are “Liquidity coverage ratio” and “Net stable funding ratio”

Question 19

Formula for “Net Stable Funding Ratio”

Answer 19

Avaliable stable funding / Required stable funding

has to be greater than 100%

Question 20

The 3 levels of Fair Value hierarchy

.

Answer 20

1. Inputs are qouted prices
2. Observable, but not the qouted prices for identical instruments in active markets.
   May be similar or actual instruments to active prices in inactive markets.
3. Unobservable. FV is based on model

Question 21

What does “S” Stand for in C.A.M.E.L.S

Answer 21

Sensitivity to Market Risk

Bank earnings are affected by various market risks e.g. volatility of security prices, currency values and interest rates.
The most critical of these is interest rate risk. A bank’s interest rate risk is the result of differences in maturity, rates and repricing frequency between the bank’s assets and its liabilities.

For example, in a rising interest rate scenario, if the assets are repriced more frequently than liabilities, the bank’s net interest income would increase. The impact of market risk can be captured by Value at Risk (VaR).

In the MD&A section, banks disclose information about the sensitivity of earnings to different market conditions, namely, the earnings impact of a shift up or down in some market

Question 22

Earnings characteristics of insurance companies

Answer 22

Soft pricing : When premiums goes down. downward sloping. Profitability decreases

Hard pricing: When preimiums goes up. Upward sloping, increasing profitability

Question 23

Formula for combined ratio

Answer 23

Total insurance expense / Net premiums earned.

Combined Ratio = Underwriting Loss Ratio + Expense Ratio

Low: Hard pricing market.
High: soft pricing market

Question 24

Formula for Loss ratio

Answer 24

Losses and loss adjusted expense / Net premiums earned

Its a indicator of quality of underwriting activity

Question 25

Formula for expense ratio

Answer 25

Underwriting expense / Net premium written

Indicator of efficiency of a companys operation in acquiering and managing underwriting business

Question 26

Formula for Loss and loss adjustment expense ratio

Answer 26

(Loss expense + Loss adjusted expense) / Net premium earned.

Degree of success in estimating risk insured.

The lower the value, the better.

Question 27

Underwriting expense ratio

Answer 27

Underwritng expense / Net premium earned

The underwriting expense ratio is an indicator of the efficiency of money spent on obtaining new premiums. The underwriting loss ratio is an indicator of the quality of a company’s underwriting activities—the degree of success an underwriter has achieved in estimating the risks insured.

Lower = better

Question 28

Dividends to policy holder ratio

Answer 28

Dividends / Net premiums earned

Question 29

Investment performance ratio

Answer 29

Total investment income / Invested assets

Question 30

An assessment in the strength of the overall risk managment process by which a bank are generated and managed would be shown up in…

Answer 30

Asset quality

Question 31

Contractual maturity mismatch refers to …

Answer 31

to the maturity dates of a bank’s assets compared to the maturity dates of a bank’s funding sources. In a normal yield curve environment, where long-term interest rates are higher than short-term rates, a bank can maximize its net interest income—all else equal—by borrowing short term and lending long term.

In doing so, the bank would minimize the interest paid to its depositors and maximize interest earned on its loan assets.

However, this creates a liquidity risk.

Question 32

What does it mean if we have a combined ratio over 100%?

Answer 32

It indicates an underwriting loss

Question 33

What are the four specific analytical considerations that are not addressed in CAMELS?

Answer 33

• Government support
• Government ownership
• Mission of the banking entity
• Corporate culture

Question 34

How do changes in Level 1 assets affect the quality of Fair Value (FV) earnings?

Increase in Level 1 Assets

Answer 34

Explanation: Level 1 assets are based on observable market prices (e.g., stocks traded on an exchange). Higher proportions of Level 1 assets improve FV earnings quality because they are more reliable and transparent, reducing estimation uncertainty.

Impact: Supports higher quality of FV earnings in both Other Comprehensive Income (OCI) and the Income Statement (IS).

Question 35

How do changes in Level 2 assets affect the quality of Fair Value (FV) earnings?

Decrease in Level 2 Assets

Answer 35

Explanation: Level 2 assets rely on observable inputs other than quoted prices, like market interest rates or yield curves, which are slightly less transparent.

A decrease in these assets suggests a shift toward more reliable assets (like Level 1), further enhancing FV earnings quality.

Impact: Also supports higher quality of FV earnings in OCI and the IS

Question 36

How do changes in Level 3 assets affect the quality of Fair Value (FV) earnings?

Decrease (or lower levels) of Level 3 Assets

Answer 36

Explanation: Level 3 assets rely on unobservable inputs, often using complex models, making them the least transparent and most subjective.

A reduction in Level 3 assets suggests a reduction in FV estimation risk, improving earnings quality.

Impact: Generally leads to a lower quality of FV earnings if these assets increase, as they add estimation risk.

Question 37

What does the combine ratio measure?

Answer 37

is a measure of the efficiency of an underwriting operation. A combined ratio of less than 100% is considered efficient; a combined ratio greater than 100% indicates an underwriting loss.

Question 38

What does the loss ratio measure?

Answer 38

The loss and loss adjustment expense ratio indicates the degree of success an underwriter has achieved in estimating the risks insured. A lower ratio indicates greater success in estimating insured risks.