Chapter 7

Question 1

What is a credit rating? Who do these credit ratings get appointed to?

Answer 1

Credit ratings is the ability for the lender to pay back the amount borrowed. Credit rating score is based on the risk of you paying your sum borrowed back to the bank. The credit rating is given to both individuals and businesses.

Question 2

Name the 8 risks that financial institutions look at before giving someone a credit score

Answer 2

1) interest rate risk
2) market risk
3) credit risk
4) Off-balance sheet risk
5) foreign exchange risk
6) country or sovereign risk
7) technology, operational and FinTech risk
8) liquidity risk and insolvency risk

Question 3

Will the canadian government ever let one of the big 5 FI’s in canada go bankrupt

Answer 3

No, if one of them goes bankrupt, our whole system will colapse

Question 4

Does credit rating affect more a cooperative bank or a public bank?

Answer 4

It affects more the cooperative bank since the credit rating is directly related to how much a company can borrow along with their respective interest rate, a cooperative bank has no choice to issue debt for more capital whereas a public company can give up equity for capital

Question 5

What are interest rate risks? Give an example

Answer 5

It is the risk incurred by a FI when their assets and liabilties have mismatched maturities.
-Ex: FI receives deposit of $1 million from customer which will collect the money in 3 years. The FI then allocates that money to another party, however that party only wants it for 1 year. The maturities of the borrower and the lender are at two different points

Question 6

What is refinancing risk? Give an example

Answer 6

When you a FI is short on liabilities. You have people who are willing to borrow (assets) but deposits (liabilities) have already been pulled out.
-Ex: $1 million is deposited in the bank for a year, but you have people who are want to borrow $1 million for 3 years.

Question 7

What is reinvestment risk? Give an example

Answer 7

When a FI is short on assets. People have deposited their cash into the FI (liability) but the FI doesn’t have people who are willing to borrow it (assets)
-Ex: $1 million is deposited into the FI, however there is only $500k that is currently being borrowed

Question 8

What happens to the FI’s profits when there is periods of reinvestment and refinancing risk?

Answer 8

It will impact the money made by the FI. To get more people to deposit, they will need to offer better rate of returns on the deposits. To get more borrowing, they will need to offer less interest

Question 9

What are rate sensitive assets? Give an example

Answer 9

They are interest rates on assets that move with the market
-Ex: variable interest rate on a mortgage

Question 10

What is a non-rate sensitive asset? Give an example

Answer 10

They are interest rates on assets that do NOT fluctuate with the market
-Ex: fixed interest rate on a mortgage

Question 11

What are non-interest earning assets? Give an example

Answer 11

They are assets that don’t deal with loans and don’t generate interest
-Ex: IT equipment, property, supplies

Question 12

What is credit risk? Give an example

Answer 12

It revolves around default loans, where the person is not paying back their loan
-Ex: loan $100k to business but they stop paying after $50k

Question 13

What are charge-offs?

Answer 13

They are the same as write offs (default loans)

Question 14

What are firm specific credit risks? Give an example

Answer 14

When the bank itself miss-prices the credit risk of a customer
-Ex: me going to the bank to borrow $100k and the bank puts me in a AA credit rating but I am really a BB credit rating customer

Question 15

What is systematic credit risk? Give an example

Answer 15

It is the risk of default associated economy wide effecting EVERY borrower
-Ex: many more people are losing their job due to a recession, therefore customers are having a hard time paying their loans

Question 16

Are banks better at predicting firm specific credit risk or systematic credit risk? Why?

Answer 16

Banks are better at predicting firm specific risk since they can assess the personal risk of the customer, if they are not sure they can always ask for more collateral or increase the interest rate. As well, they have years of experience to know which customers tend to be the good ones. Therefore, they have much more control over firm specific credit risk than they do over systematic credit risk since they can’t control the economy

Question 17

What is liquidity risk? Give an example

Answer 17

It is the risk that all of a sudden, people start pulling their money out of the bank
-Ex: SVB where all depositors pulled out their money in just a few days which was a bank run

Question 18

What is foreign exchange risk?

Answer 18

The risk of exchange rate changing the value of the assets and liabilities

Question 19

What are sovereign risks? Give an example

Answer 19

They are risks associated with the government of the country in which the bank is owed money from steps in an interferes with that payment
-Ex: North Korea repaying a bank and their gov steps in, essentially interfering with the repayment

Question 20

What is market risk? Give an example

Answer 20

It is a result of systemic shock where the market prices assets differently based on economic conditions.
-Ex: Mortgage back securities value between 2007 and 2009 completely dropped cause of the global financial crisis

Question 21

What is off-balance sheet risks? Give an example

Answer 21

It is a risk taken on by the FI that is contingents to other assets or liabilities
-Ex: There is a line of credit approved for $500 but the customer has not borrowed that money yet. It is considered an off-balance sheet risk

Question 22

When do off-balance sheet risks go onto the balance sheet as assets? How much goes onto the balance sheet?

Answer 22

-Off-balance sheet risks go onto the balance sheet once the customer borrows that money or part of the money (ex: line of credit of $500 but only borrow $200. Then $200 goes onto the balance sheet and the $300 stays in the off-balance sheet risk)
-The amount borrowed goes onto the balance sheet, the non borrowed amount stays off the balance sheet

Question 23

What are technology risks? Give an example

Answer 23

It is a sub category of operational risk. It can include not following the new developments (softwares)
-Ex: A hacker gets ahold of all the accounts at the bank

Question 24

What is operational risks? Give examples

Answer 24

It is the risks that take part when operating a FI
-Ex: People drill into the safe overnight and steal all the money
-Ex: Employees make up fake accounts to make their quota, unlocking a bonus
-Ex: A friend of someone working at the bank comes in asking to borrow money however their credit is “junk”. Seeing as it is the friend of a worker, the worker allows the person to borrow the sum

Question 25

When does technology risk occur? Why?

Answer 25

When FI’s chase economies of scale and scope. Because technology allows for economies of scale which allows for these FI’s to offer more services to customers (economies of scope) but at a cost, which is operational risk

Question 26

What is insolvency risk?

Answer 26

The risk that the FI may go bankrupt

Question 27

What are interactions of risks? Give an example

Answer 27

Also known as counterparty risks or escalations risks. It is when one risk brings another risk into play
-Ex: insolvency risk was first cause by liquidity risks. Meaning, if people come pull out their money from the bank (liquidity), the risk of insolvency might come up (bankrupt).