Chapters 8-11 Q&A

Question 1

1. Give some important differences between the balance sheet of a commercial bank and a manufacturing firm.

Answer 1

Banks’ short-term assets and debt/equity ratio is relatively larger; and fixed assets, stocks, own capital is relatively smaller.

Question 2

2. Who are interested in the bank performance and in which financial market?

Answer 2

Shareholders, bondholders; direct competitors, financial markets ; regulators; depositors; credit rating companies. See. p.212-213.

Question 3

3. What are the differences between the money and the capital market?

Answer 3

The money market is a short-term financial market usually involving large-value (wholesale) assets with less than one year to maturity. Ex. Treasury bills

The capital market is a market where capital funds (debt and equity) are issued and traded. longer than 1 year maturity. Ex. term loans, financial leases, corporate equities, and bonds. Important elements of the capital market are the organized security exchanges and the over-the-counter (OTC)-markets.

Question 4

4. What is the difference between primary and secondary financial market?

Answer 4

Primary market: market in which securities are traded between issuers and investors, thereby raising additional funds for the issuing firm. A market is primary if the proceeds of sales go to the issuer of the securities sold. This is part of the financial market where enterprises issue their new shares and bonds.
Secondary market: the market in which previously issued securities are traded or where securities are traded after they are initially offered in the primary market. Examples are the New York Stock Exchange (NYSE), bond markets, over-the-counter markets, residential mortgage loans, governmental guaranteed loans etc.

Question 5

5. Explain the trade-off between solvency and profitability?

Answer 5

A higher capital adequacy means less money to make make profits off of. (c.p.)

Question 6

6. Why a loan classified as Non-Performing Loan (NPL) or ‘bad debt’ does not necessarily lead to losses?

Answer 6

If there is adequate collateral, losses might not occur (see p.217, box 8.4).

Question 7

7. Give some differences between commercial and investment banks’ financial statements with regard to the balance sheet structure and with regard to the income statement (or profit and loss account).

Answer 7

If we compare investment banks with commercial banks: on-balance-sheet securities play a more significant role on both the assets and liabilities side, while liquidities and (retail) deposits play a less significant role (see p. 197 and 209). The income-statement is mainly fee-based and includes more wholesale lending activity of the bank. On the costs side, the most important item is interest expenses that can be relatively high, while the bulk of operating expenses relates to staff costs (see p.210).

Question 8

8. Give two bank profitability ratios and explain the relation between the net interest margin (NIM) and the competition between banks.

Answer 8

ROE, ROA and NIM. NIM measures the banks’ spread. A fall reflects increasing competition.

Question 9

9. C/I = net-interest expenses/(total income) is a financial ratio which measures the degree of efficiency of a bank. What does a low C/I-ratio mean for banks?

Answer 9

A low C/I ratio indicates that the bank is operating in a more efficient way.

Question 10

10. (a) Under what condition is shareholder value created when a bank is considering making a strategic investment in another country? (b) How the cost of capital can be calculated through the Capital Asset Pricing Model (CAPM) as a widely used tool for business decision making and what is the meaning of the risk-free rate (Rf), the equity risk premium (Rm – Ri) and beta (β)?

Answer 10

(a) When the return on capital in this investment is larger than the cost of capital to the bank;
(b) The required rate of return on an investment is Ri = Rf + β(Rm - Rf).
Rf= risk-free rate- usually bonds interest rate
Rm= market return.
(Rm – Rf) is the equity risk premium to compensate for holding equity over bonds.
Beta measures the volatility or the riskiness of the company’s equity relative to the overall market. See p.218.

Question 11

11. What are the main limitations of bank financial ratios?

Answer 11

Generally one year’s figures are insufficient to evaluate the performance of banks; precise comparisons between similar banks may be difficult as they often compete in different markets, have varying product features and customer bases etc. Ratios do not stand in isolation, they are interrelated; figures in the financial statements may be manipulated

Question 12

12. Explain why asset-liability management (ALM) has become a more significant part of the banks’ businesses?

Answer 12

The composition of banks’ balance sheets have been affected by a growing importance of the liability side with the development of CD markets

Question 13

13. What is meant with the following key terms in banking: arbitrage and hedging?

Answer 13

Arbitrage: the simultaneous buying and selling of a commodity, or a security, in different markets to take advantage of price differentials.
Hedging: reducing risk by taking a position that offers existing or expected exposures. Hedging is avoidance of risk by arranging a contract at specified prices which will yield a known return. See p.230.

Question 14

14. What are main features of financial derivatives?

Answer 14

Tradable (liquid) market for underlying assets; transfer of risk; volatile or changeable in price dependent on value of underlying assets;

Question 15

15. What is a financial future and forward contract? Give two differences between future and forward contracts.

Answer 15

These are contracts to deliver and pay for a real or financial asset (e.g. real estate, shares or bonds) on a prearranged date in the future for a specific price.
Futures are traded on an official organised FX (futures exchange) so they carry standardised terms, amounts and maturities, while forwards are traded on the OTC market, which is tailored exactly to their required quantity and maturity. Futures are highly liquid because they can be sold and bought in the secondary market, while forward contracts are highly illiquid and not negotiable, there is no secondary market.

Question 16

16. What is an essential difference between interest rate swap and currency swap?

Answer 16

for an interest rate swap, only interest payments are swapped so there is no exchange of principal versus an currency swap, where there is an exchange of principal amounts of two currencies at the spot exchange rate (see p.242).

Question 17

17. What is the difference between official (organized) and over-the-counter market? Give an advantage of trading in an organised exchange and an advantage of trading in an over-the-counter (OTC) market. In which of these markets are financial futures, forwards and options contracts traded?

Answer 17

An official market is an organized exchange market with official quotations, while the OTC-market is an informal dealer-based market.
Advantages official (organized) market: guaranteed every contract: counterparty risk of default is reduced (better documentation);  more transparency.
Advantages OTC-market: contracts more customizable to preferences of investors; less volatile prices
Futures are traded on organised markets, forwards on OTC-markets and options on both. See p.232.

Question 18

18. US banks are increasingly undertaking a wide range of securities transactions both on- and off-balance sheet.
    a. What is meant with off-balance sheet activities? Give some examples.
    b. What is meant with mortgage-backed securities and how have they partly caused the US subprime crisis in August 2007?
    c. Give two reasons why investment banks are involved in securitisation.

Answer 18

a) Business, often fee-based, that does not generally involve booking assets and taking deposits. Examples are swaps, options, FX futures, standby commitments and LCs.
b) Securities (e.g. mortgages) traded mainly in the USA which pay interest on a semi-annual basis and repay principal either periodically or at maturity, and where the underlying collateral is a pool of mortgages. They have partly caused the US subprime crisis since they were sold at a time of low interest rates and stable house prices (2001-2002), but gradually the poor creditworthiness of the buyers of these houses became more apparent when the house prices and interest rates started to rise till 2007.
c) To diversify their financial risks; to get liquidity out of the market (through the secondary market) and to improve their capital requirement (more involved in risk management). See p.409.

Question 19

19. (a) What is meant with the process of deconstruction of lending activity and name a consequence of this process? (b) What is meant with asset-backed securities?

Answer 19

(a) A bank originates a loan in exchange for a fee and then transfers it to another bank, which will provide funding and servicing for the loan. See p.248, box 9.8
(b) Bonds or notes that are backed by the assets they represent

Question 20

20. What is the difference between reinvestment and refinancing risk as two types of interest rate risks that banks may have to face?

Answer 20

Reinvestment risk is the risk that the returns on funds to be reinvested will fall below the cost of the fund. In this situation banks can be viewed as ‘long-funded’.
Refinancing risk is the risk the cost of re-borrowing funds will rise above the returns being earned on asset investments. In this situation banks can be viewed as ‘short-funded’.

Question 21

21. Regulatory authorities monitor banks’ behaviour and try to ensure that they achieve a good CAMELS rating. Which elements are included in CAMELS rating?

Answer 21

Adequate capital (C); good asset quality (A); competent management (M); good earnings (E); sufficient liquidity (L); and sensitivity to market risk (S).

Question 22

22. What is meant with Gap approach and what are the main limitations?

Answer 22

Gap analysis is an interest rate risk management technique that refers to the difference between interest rate sensitive assets (RSA) and interest rate sensitive liabilities (RSL) over a specific time-horizon. GAP = RSA – RSL. If RSL > RSA, then an increase in interest rates will reduce a bank’s profit and vice versa. See p.291-292.
Main limitations are fails to take into account the market value effect; suffers from over aggregation

Question 23

23. What are the central components of market risk management? Explain.

Answer 23

Risk-Adjusted Return on Capital (RAROC) is an adjustment to the return on an investment that accounts for the element of risk.
Value-at-Risk (VaR) is used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame.

Question 24

24. What DOES the Risk-Adjusted-Return on Capital (RAROC) and Value-at-Risk (VaR) measure and how it is used in the context of the Basle II framework?

Answer 24

RAROC measures the risk inherent in each banking activity taking into account the asset price volatility, calculated on historical data.
VaR provides an estimate of the potential loss on the current portfolio from adverse market movements.
In the Basle II context the RAROC and VaR can help bank managers to assess in what areas they should allocate more capital. See p.299.

Question 25

25. Why should prudent banks seek to minimise the volatility ratio? What are the main techniques used to manage a bank’s liquidity exposure?

Answer 25

Prudent banks will try to reduce the volatile liabilities to manage risk. Techniques used are cash flow projections of daily liquidity positions and sources; scenario analysis and simulation models and liquidity gap analysis. See p.297.