Commercial Bank Management

Question 1

Week 1:
Why do banks exist? provide two reasons.
What do banks do?
What is the key issue of banking?

Answer 1

1: Intermediation between parties i.e. matching borrowers and lenders.
2: Manage the mismatches between the preferences of depositors and borrowers by transforming maturity, amount, and risk… remember that borrowers want long periods with low interest and lenders want short periods with high interest.

banks accept deposits from the public and facilitate lending. In making credit available, banks are rendering a great social service

Key issue = Banks are a public trust. This means there is the issue of defaulting on loans.

Question 2

Week 1:
Why are banks heavily regulated?
Who regulates banks?

Answer 2

Heavy regulation = because of their importance in the economy. Regulation is in play to sustain and support banks, not oppress them. As well as to protect the safety of public savings, promote confidence in the financial system, control the money supply and growth of the economy, provide government with tax revenues and other services.

Regulates banks = Council of Financial Regulators (CFR) = consists of RBA, APRA, ASIC, Australian Treasury.

Question 3

Week 1:
What is the net interest rate?
What is an NCD?
What is a bill of exchange?

Answer 3

Net interest rate margin = difference between the average interest rate earned and the average interest rate paid by ADIs on their funds. This has declined over the years.

NCD = negotiable certificate of deposit = basically for wholesale depositors (big businesses) who deposit money for a fixed amount of time at an agreed interest rate and cannot withdraw the money, however can trade the rights to the money so as to have liquidity.

Bill of exchange = promise by borrower to pay bills face value at the specified future date

Question 4

Week 2:
When is the financial system considered efficient?
What is the role of banking in an economy (4)

Answer 4

Efficient = when transaction costs are low = good for economy

Role:

1. Financial intermediation = channelling funds from savings sector to borrowing sector at low cost
2. Payment services = cheque clearing, transfer of currencies…
3. Risk protection services
4. Liquidity services

Question 5

Week 2:

What are the four main categories of Australian Banks?

Answer 5

1. Major Banks
2. Other domestic banks (locally owned banks excluding the big 4)
3. Foreign subsidiary banks (foreign banks authorised to carry on banking business in Australia through a locally incorporated subsidiary
4. Foreign bank branches (foreign banks licensed to conduct banking business in Australia through branches, subject to a condition which specifically restricts the acceptance of retail deposits)

Question 6

Week 2:

What are some trends affecting banks?

Answer 6

1. Government concern with risks banks have taken
2. Globalisation
3. Technology
4. Service proliferation (more and more services becoming available)
5. Rising competition with other financial service firms proliferating their service offerings
6. government deregulation and then re-regulation

Question 7

Week 2:

Explain securitisation and what benefits a bank draws from the process.

Answer 7

Securitisation = Bank originates assets, typically loans. Then combines the loans into pools with similar features and sells them through “Pass through” certificates. Pool is secured by interest and principal payments on the original loans. Originating bank collects interest and principal payments on the loans, passes through cash flows to the certificate holders. There maybe a fee for managing the certificates to the bank.

Benefits

1. Reduces banks capital requirements
2. reduces assets (this is good because regulators view loans as “risky assets” and so impose capital requirements
3. Increases fee income
4. Reduces loss provisions (an expense set aside as an allowance for uncollected loans and loan payments)
5. eliminate interest rate risk

Question 8

Week 2:

Provide 5 reasons as to why banks are regulated

Answer 8

1. Protect the safety of public savings
2. Control the money supply and growth of the economy
3. Promote public confidence in the financial system
4. Facilitate the orderly payment for goods and services
5. Provide government with tax revenues and other services

Question 9

Week 2:
What is the relevance of the Wallis Committee to the modern structure of bank regulation?

What is the Australian treasury responsible for?

Answer 9

Wallis Committee = in 1990, the committee recommended the introduction of APRA, ASIC, and RBA, each with specific functional responsibilities

APRA = Responsible for the prudential regulation and supervision of the financial services industry = maintain the safety and soundness of financial institutions to instill confidence

ASIC = responsible for market integrity and consumer protection across the the financial system = sets standards for financial market behaviour with the aim to protect investors and consumer confidence = administers the Corporations Law to promote honesty and fairness in companies and markets.

RBA = conducts monetary policy, aimed at maintaining a strong financial system and issuing the nations banknotes = aim of monetary policy is to achieve low and stable inflation over the medium term = lender of last resort function = responsible for overall financial system stability, promoting the efficiency of the payment system and promoting competition for payment services

Australian treasury = responsible for economic policy, fiscal policy, market regulation, and the Australian federal budget)

Question 10

Week 2:

Explain the difference between consolidation and convergence

Answer 10

Consolidation refers to increase in the size of financial institutions. The number of small, independently owned financial institutions is declining and the average size of individual banks, as well as securities firms, credit unions, finance companies, and insurance firms, has risen significantly = mergers and acquisitions

Convergence = the bringing together of firms from different industries to create conglomerate firms offering multiple services.

Question 11

Week 2:

How do banks solve the issue associated with maturity intermediation and what is the issue?

Answer 11

The issue = Banks borrow short term funds and lend for the long term = there is a maturity mismatch

The fix = Banks can attempt to purchase assets with similar maturities to their liabilities

Why banks use maturity intermediation = banks profit off of maturity intermediation because short term borrowing provides a low interest rate return to the lenders, whereas long term lending provides a large amount of interest for the bank

Question 12

Week 2:
What is a financial intermediary?
What important role do financial intermediaries play within the financial system?

Answer 12

Financial intermediary = facilitator of funds from surplus units to deficit units within the economy

Importance = accelerate economic growth by expanding available pool of savings, increasing productivity of savings and investments, satisfying the need for liquidity, evaluation of financial information, lower risk of investments through diversification

Question 13

Week 2:
What is the effect of the RBA increasing the cash rate?
What is the effect of the RBA increasing the reserve requirement?
What is the effect of the RBA selling securities?

Answer 13

Cash rate up = market interest rates up
Reserve requirement = banks have to take a percentage of all deposits and put it into the central reserve = if the RBA increases the amount of each deposit that banks have to put into the reserve then the banks will have less lending money and thus require greater interest on their lending.
RBA sells securities = money supply decreases (as the RBA will be holding money now) = interest rates rise

Question 14

Week 3:
For a bank outline the use of the following Assets:
Cash
Trading and investment securities
Loans, advances and other receivables

For a bank outline the use of the following Liabilities:
Issued debt
Shareholders equity

Answer 14

Cash = primary liquidity reserve
Trading and investment securities = generates additional income for bank
Loans, advances and other receivables = main earning assets of bank

Issued debt = used to supplement deposits and provide additional liquidity
Shareholders equity = represents difference between book value of bank’s assets and liabilities AND acts as a buffer against losses in the income statement

Question 15

Week 3:
How do we calculate Net loans and leases?
How do we change our provision for bad and doubtful debts each period? (Side note: this will usually sit at around 1% of total loans)

What is subordinated debt and what does it include?

Answer 15

Net loans and leases = Total loans and leases - unearned revenue - provision for doubtful debts

Bad and doubtful debts period change = opening balance + this periods provision allowances - any write offs + recoveries from previously charged-off loans (yes we ADD these back)

Subordinated debt = a debt owed to an unsecured creditor that in the event of a liquidation can only be paid after the claims of secured creditors have been met = capital notes, special bonds and debenture issues

Question 16

Week 3:

What is included in an income statement for a bank?

Answer 16

Interest income
- Interest expenses
= Net interest income
\+ Net non-interest income
= Net interest income + net non-interest income
- Operating expense
- Loan loss provisions
= Pretax net operating income
- Taxes
\+ Gains/losses from securities trading 
= Net income

Question 17

Week 3:
What factors into Non-interest revenue and why is Non-interest revenue traditionally earned Vs why it is becoming increasingly earned?

How do we calculate non-interest income?

Answer 17

Non-interest revenue:

1. Fees, charges and commissions = traditionally used to maintain deposit and loan accounts AND now increasingly as a means to expand revenue
2. Net revenue from off-balance sheet business and for provision of specialist services and advice = includes fees for fund management services + insurance commissions + profits on FX trading + realised gains/losses on sales of securities

Off-balance sheet activities = A part of Non-interest income = Activities that generate income and/or expenses without creating an underlying asset or liability or a potential future asset or liability(e.g. fees for cash handling) = may create an asset or liability in the future (e.g. in the case of a derivative leading to a payment obligation)

off-balance sheet items:

1. Direct credit substitutes
2. Trade and performance related items (contingencies dependant upon performance which may lead to a liability)
3. Commitments
4. Other commitments
5. Foreign exchange, interest rate, and other market related transactions

Non-interest income = Non-interest revenue - Non-interest expenses - provision for loan losses

Question 18

Week 3:

What are the sources of Operating expenses?

Answer 18

Operating expenses:

1. Salaries, wages and benefits
2. Equipment and occupancy expenses (depreciation, rent, payments on leased equipment)
3. Other operating expenses = advertising, audit and accounting fees, computing costs, directors’ fees, supplies

Question 19

Week 3:
What are the two key elements of profit maximisation?

What are three issues associated with ratio analysis?

Answer 19

Profit maximisation = invest in high yield assets + keep costs down

Issues of ratio analysis:

1. Accounting = use of alternative accounting techniques AND inconsistency between accounting and economic asset valuation AND prevalence of off balance sheet business
2. Statistical = high degree of correlation between components of ratios
3. Interpretation = only a number is given = all a matter of judgement

Question 20

Week 3:
What is trend analysis?
What is cross-sectional analysis?

Answer 20

Trend analysis = comparison of various ratios over time = identification and evaluation of trends = early warning signal
Cross-sectional analysis = comparison of ratios with other banks or the industry average

Question 21

Week 3:
What is ROE a measure of?
Explain each component of ROE

Answer 21

ROE = measures the amount of net income after tax for each dollar of equity capital = good when high, however to increase ROE equity capital must drop and this leads to risk of bankruptcy as equity capital is used as a reserve

Component 1: Profit margin = Net income / Total revenue = Net income per dollar of total revenue = measures the banks ability to control expenses or reduce taxes (higher is better) = check for non-recurring extraordinary items and remove them

Component 2: Asset utilisation = Total revenue / total assets = represents the gross yield on assets = Good for this to increase, however must be aware that increasing asset utilisation shows increased risk taking (due to use of riskier assets) (look at ROA to understand if increasing AU is due to excessive risk)

Component 3: Leverage (equity multiplier) = Total assets / Equity capital = both a profit and a risk measure

• Risk measure: Provides how much of the assets can go into default before bank becomes insolvent = indicates capital risk (risk of insolvency)
• Profit measure: High multiplier raises ROE when net income is positive

Question 22

Week 3:

What is the Net interest margin?

Answer 22

NIM = Net interest income / Earning assets = important in evaluating a banks ability to manage interest rate risk = representation of bank’s intermediation function

Question 23

Week 3:

What are the four major influences on bank performance?

Answer 23

1. Economic influences (GDP, etc.)
2. Regulatory
3. Technological change
4. Competition

Question 24

Week 3:

What are 5 Liquidity risk measures?

Answer 24

Liquidity risk = The risk associated with not having enough liquidity to meet demands

1. Liquidity sources / Liquidity needs
2. Short term securities / Deposits
3. Borrowing / Deposits or Capital
4. Cash / Total assets
5. Securitisation

Question 25

Week 3: | What are some interest rate risk measures?

Answer 25

Interest rate risk = impact of changing interest rates on a financial institutions margin of profit 1. Interest sensitive assets / Interest sensitive liabilities 2. Gap analysis: Interest sensitive assets - Interest sensitive liabilities 3. What hedging procedures does the bank employ if any?

Question 26

Week 3: | What are 5 credit risk measures?

Answer 26

Credit risk = The probability that some of a financial institutions assets, especially its loans, will decline in value and perhaps become worthless 1. Loans / Assets 2. Classified Loans / Loans 3. Past due loans / Loans 4. Provision for losses / Loans 5. Provision Loan Loss / Non performing loans

Question 27

Week 3: | What are 3 capital risk measures?

Answer 27

Capital risk = not entirely sure (ask tutor) 1. Equity capital / total assets 2. Equity capital / Risk assets or loans (Risk assets = assets likely to decline in value) 3, Growth in assets Vs Growth of loans

Question 28

Week 3: | What are the four most important components of ROA?

Answer 28

ROA can be broken down into four components which are: 1) Net interest margin = (Interest income - interest expense) / total assets + 2) Non-interest income margin = (non interest income - non-interest expense)/ total assets - 3) provisions for loss / Total assets - 4) Tax / Total assets ``` 1 = measures a banks success at intermediating funds between borrowers and lenders 2 = indicates the ability of management to control salaries and wages and other noninterest costs and generate fee income 3 = measures management ability to control lossess 4 = is an index of tax management effectiveness ```

Question 29

``` Week 4: Contrast lending to the following: 1. Large corporations 2. Medium corporations 3. Small corporations ```

Answer 29

1. Large corporations = large volume, use syndicated loans, key is price, large competition between banks (therefore why price is key) 2. Medium corporations = price is less important (than in the case of large corporations), service and products offered are key, security and cash flows are very important from banks side 3. Relationship is very important, customer seek advice, customer loyalty is key, less sensitive to interest rates, higher risk for banks

Question 30

Week 4: What are the major types of business loans banks undertake? (6 short term and 5 long term) What are 5 types of business loan facilities?

Answer 30

Short term 1. Self liquidating inventory loans = self explanatory 2. Working capital = loan that is taken to finance a company's everyday operations 3. Interim (short-term) construction loans = used to support the construction of homes, apartments, shopping centres, and other permanent structures 4. Syndicated loan = loan offered by a group of lenders (syndicate) to one borrower 5. Asset based loans = credit secured by the shorter-term assets of a firm that are expected to roll over into cash in the future e.g. Accounts Receivable 6. Retailer and equipment financing = loan made to support instalment purchases of automobiles, home appliances, furniture, business equipment and other durable goods = floor panning ( lender extends credit to dealer to place an order to ship goods for resale) Long term 1. Term Loans = used to fund long-term business investments, such as the purchase of equipment or construction of physical facilities 2. Revolving credit = allow customer to borrow up to a pre-specified limit, repay all or a portion of borrowing, and re-borrow as necessary until credit line matures 3. Project loans (riskiest of all) (used to finance the construction of fixed assets designed to generate a flow of revenue in future periods) 4. Bridging loans = funds to buy new asset/subsidiary while attempting to sell old asset/subsidiary 5. Leveraged buyout = small group of investors require funds for a buyout (they use debt (a loan) hence why its called a leveraged buyout) 6. Security dealer financing = credit to add bonds (other securities too) to securities portfolio Loan facilities 1. Corporate credit cards = used for purchases related to business activities 2. Overdrafts = allow borrower to continue withdrawing money even if account has no funds 3. Commercial bills = borrower commits to repay face value at maturity, or roll over the bill and commit to pay difference between FV and discount amount of new bill passed on prevailing interest rates) 4. Leasing = finance company is legal owner of asset and lease it out to lessee (lessee typically becomes owner at end of lease) (for example a mortgage) 5. Factoring = A type of debtor finance in which a business sells its accounts receivable to a third party (called a factor) at a discount

Question 31

Week 4 What is a Loan Policy for a bank? What is the aim of a banks loan policy? What will lead to changes in bank loan policy? Elaborate on the relationship between the loan division and the credit department?

Answer 31

Loan policy = gives loan officers and management specific guidelines in making individual loan decisions and in shaping overall loan portfolio - sets overall lending strategy for bank - sets risk profile for bank Aim of policy = to manage credit risk Changes in policy = cultural and economic shifts Relationship = The loan division will take potential loans to the credit department for assessment and subsequent acceptance or rejection of the loan. Within the credit department operate credit committees for assessing loans over a particular value.

Question 32

Week 4 What is a credit line? What does drawing down mean? How does bank make money on a credit line? What are two preferable forms of collatoral?

Answer 32

Credit line = allows borrower to borrow up to a specified limit concerning a period of years Drawing down = refers to withdrawals made from the credit line which in essence 'draw down' the amount available Bank revenue = the bank will receive a fee for having the credit line available to a borrower + will receive interest on the amount that is drawn down Preferable collateral = security over land and buildings AND a guarantee (from a creditworthy individual)

Question 33

Week 4 In regards to credit analysis what are three key factors the analyst must determine? Elaborate on the 6 C's considered when making a loan What influences the scope of the credit investigation ( 5 6's) and what activities are undertaken?

Answer 33

1. Degree of risk and amount of credit to provide 2. terms and conditions which will be acceptable 3. Price at which to offer the credit Character: Willingness to repay (assess individual) (honesty, integrity, morality) = makes use of past records Capacity: Legal capacity to enter contract (age, sound mind, authority (does individual have authority to apply for a loan for a business)) Cash flow: Ability to generate cash flow to repay debt (sources of cash equity or debt) Collateral: Availability and worth of collateral (conditions, longevity, etc) Conditions: Assessment of economic/industry conditions (as well as internal conditions of business = is business reliant on one major supplier or client? is production capacity alright? is business moving with the times?) Control: concerns whether or not the loan meets lenders standards or regulatory authority standards as well as whether changes in laws and regulation could adversely affect the borrower Scope of investigation = influenced by size, previous dealings, perceived risk, collateral Activities: 1. Interview of loan applicant 2. Inspection of business place

Question 34

Week 4 What are workout arrangements and why are they important to banks? What do workout arrangements comprise?

Answer 34

Workout arrangement = arrangements made when a borrower is unable to pay Importance = Banks need to retain customers. In order to do so they must avoid problems (failure to pay) Workout arrangements comprise: 1) Providing advice on borrowers ability to create/earn income 2) Extending or redrawing the loan agreement (reduce payments) 3) Requiring borrower to seek assistance/advice from external consultants

Question 35

Week 4 | How do we apply the cost-plus loan pricing method?

Answer 35

Step 1: Simply calculate (in percentage terms) the weighted average cost of funds (from sources such as securities, bonds, bills) Step 2: add (in percentage terms) the cost of processing the loan Step 3: add any risk premium and/or profit margin

Question 36

Week 5 | Identify the types of loans granted to individuals and families

Answer 36

1. Residential loans = Credit to finance purchase of homes or fund improvements on a private residence = long-term = typically 15-30 years = secured by property (fixed or variable (changes with market yield on government bonds)) 2. Nonresidential loans: - Installment loans = short to medium term = principle reduced through progressive payments over life of loan = frequently for automobiles, furniture, etc. - Noninstallment loans = short-term = repayable as lump sum = vacations, medical, home appliances, auto and home repair 2. Credit card Loans and revolving credit = installment or noninstallment repayment depending on individuals choosing. if miss noninstallment period then monthly finance charge based on annual interest rate applied = usually variable interest = installment payment are more profitable = Two issues: 1) delinquent borrowers and 2) card fraud

Question 37

Week 5 | Outline the Credit Card Accountability, Responsibility and Disclosure Act (CARD)

Answer 37

CARD: 1. Restricts credit card issuers from raising Annual Percentage rates unless adequate notice of a rate change is given 2. Must tell customer reasons for why credit terms are changed 3. Companies must post contracts on internet for customers to 'shop around' (reason is to stimulate competition) 4. Must send cardholders periodic billing statements 3 weeks before monthly payments due. 5. On billing statement must state amount of interest being paid + warn about only paying minimum amount each period.

Question 38

Week 5 | Outline the characteristics of Consumer Loans

Answer 38

Consumer Loans (most costly and risky for banks) 1. Priced well above cost of funding them 2. Significant interest risk (as contract interest rates don't readily change with market conditions) 3. Cyclically sensitive (lots of withdrawals with economic expansion, less with contraction) Additional risk stems from consumers ability to hide information , as opposed to a bank, as well as consumer sensitivity to illness, injury, or financial setback (fines, unforeseen bills, etc.) Risk managed by = size of loans usually small and collateral is used (such as an automobile)

Question 39

Week 5 What factors improve the likelihood of being granted a consumer loan? What is predatory lending? What is an offset account?

Answer 39

1. Home ownership 2. Maintenance of strong deposit balances 3. Truthfulness and accuracy of information provided Predatory lending = a lending practice that imposes unfair or abusive terms on a borrower Offset account = an account in which its balance is subtracted from the outstanding balance of the mortgage. and borrowers only pay interest on this difference.

Question 40

Week 5 What is the key to profitability in the consumer loans component of bank lending? how do we calculate customer churn? What factors influence growth in home loans?

Answer 40

Key to profitability = volume of customers = need many customers as opposed to business loans (large in value and so less customers needed) Customer churn = Number of customers lost in period / number of customers at start of period Home loan growth: 1. Increasing desire to own home 2. Can be seen as form of retirement savings 3. Government policies (tax incentives) 4. Interest rates (lower rates = more attractive)

Question 41

Week 5 | What is negative gearing?

Answer 41

Negative gearing = person buys home (using mortgage) and rents the home out. The rental income is less than the monthly interest payments and costs of insurance (etc.) This means the individual pays x amount for a home being rented out that they don't even live in... weird, right? However, benefits exist: 1. Limited own contribution, the individual pays considerably less than the interest payments and so limits their own contribution to eventually owning the home. 2. Losses may be claimed as income tax deduction 3. The individual will likely home for appreciation of the property to result in capital gains one day.

Question 42

Week 5 How do we calculate loan to value ratio? how was this influenced by the GFC? How do we calculate home equity? What is a home equity loan? What is the critical assumption behind home equity loans and 2 subsequent results of this assumption? What has led to growth in home equity loans? What is the central difference between a Hire Purchase and Consumer mortgage?

Answer 42

Loan to value ratio = Loan value / value of security = prior to GFC ratio could be over 1. Regulation has since restricted this, typically it stands at 0.8 Home equity = Market value - mortgage debt = borrowing base Home equity loans = can use the borrowing base as an equity loan in two forms: 1) Traditional = borrowing base used as collateral to draw on for home improvements (specified period) 2) lines of credit = Percentage * mkt value - mortgage debt = amount of credit line available to customer for any legitimate purpose (not just renovations) (amount adjusted as mortgage debt paid off) Critical assumption = home value will appreciate subsequent results = lower loan rate than other forms of credit + extra security afforded through home as collateral Growth in home equity loans: 1) changes in capital adequacy (statutory minimum reserves of capital which a bank or other financial institution must have available) 2) cost competitiveness Hire Purchase v CM = ownership retained by lender until final payment (under Hire Purchase)

Question 43

Week 5 | Outline the consumer loan lending process

Answer 43

1. Determine loan purpose and amount 2. Obtain information - Character and purpose = purpose of loan and ability to repay and judgement of character (credit rating) - Income levels = size and stability of income - Deposit balances = indirect measure of size and stability + right of offset (ability of lender to seize deposits after giving 10 days notice) - Employment and residential stability = duration of employment + length of residence (at address = indicates stability) - Pyramiding of debt = where individual draws credit at one institution to pay another. 3. investigate and verify 4. Negotiate with applicant and agree loan terms 5. Price and structure the credit 6. Arrange signing of loan agreement

Question 44

Week 5 | What are the two golden rules of consumer credit?

Answer 44

1. Down payment/deposit should be sufficiently large to establish buyers equity in merchandise and feeling of ownership 2. Instalments paid should be sufficient to increase equity established at faster rate than merchandise depreciates

Question 45

Week 5 What is a credit scoring system? If a loan application scores below the cut off of a scoring system, will a loan be improved? What are two errors made in evaluating loan applications?

Answer 45

Credit scoring system = Tool that statistically evaluates applications by weighting characteristics and assigning scores = requires high volume of applicants to establish scoring system = expensive to make and continuously validate = NOT FULL PROOF (bad loans still happen) Below cut-off = The loan may still be approved given how low score is below cut-off + consideration of other factors unique to individual (scoring system may not factor all aspects) Errors made: (Need acceptable trade-off to minimise losses as well as loss of opportunity) 1. Accepting bad loans (system too loose) 2. Rejecting good loans (system too strict)

Question 46

Week 5 | Contrast the advantages and disadvantages of professional judgement vs use of credit scoring system.

Answer 46

Disadvantages CSS: 1. Historically looking (may be obsolete for current creditworthiness) 2. Data only consists of loan applications that have been accepted (rejected applications that may have been good are not factored) Disadvantages PJ: 1. Bias 2. Mental calculation limited to relatively few factors Advantages CSS: 1. Consider multiple factors simultaneously 2. Remove bias Advantages PJ: 1. Consider certain non-quantifiable factors 2. Consider future and present changes

Question 47

Week 6 How do banks fund their activities on the asset side of things? (go in order of least costly to most costly funding). What do we mean by the term 'sticky'? Where would we use this term? Why is funding from wholesale markets more expensive?

Answer 47

Funding: In terms of cost to the bank we start at least costly (customer deposits) and move to most costly (equity) 1: Customer deposits - Demand deposits = allow instant withdrawal for customers = 1 day term in theory, however from the banks perspective this is much longer because customers tend to remain wit the bank and continue to top-up their accounts - Term deposits = funds deposited for a fixed term 2: Balance due to banks = inter-bank funding (wholesale funding) = fixed maturity 3: Long-term debt (non-subordinated) (receive payment before subordinated) 4: Long-term debt (subordinated) 5: Central Bank funding = typically avoided and comes into play more when in distress. 6: Equity Sticky = we use this term when talking about customer deposits. The term refers to customers being sticky i.e. not likely to change bank or withdraw funds at short notice Wholesale funding vs customer deposits = wholesale tends to be more expensive due to greater competition, more sophisticated depositors, and less 'sticky' funds

Question 48

Week 6 | Outline the various costs for a bank (5 categories)

Answer 48

Expense structure 1: Operating costs (property, wages, etc.) 2: Liquidity costs (opportunity cost of holding cash instead of investing) 3: Risk cost - lending = provision for losses and bad debts + cost of carrying bad loan + early repayment of fixed rate lending 4: Risk cost - borrowing = customers wanting funds back early (expensive because may need to source additional funding at expensive price from wholesale market to make repayments) 5: Regulatory costs and capital costs = Required ROE + equity issuance and dividend costs

Question 49

Week 6 What is the objective of bank loan pricing? How do banks price products (5)?

Answer 49

Loan pricing purpose = to achieve an acceptable rate and generate return for shareholders How banks price products: 1: Follow-the-leader = matching prices with those of market leader 2: Pricing to achieve market share = aggressive pricing to win deposit business 3: Target ROE pricing = use ROE to calculate what pricing needs to be 4: Market skimming = bank sets loan rates at highest possible level for which there are clients. Once these clients are secured (locked into contracts) the bank will lower the rate slightly to secure new clients. The process continues on and on 5: Mark-up or "cost plus" pricing (we use this method so always assume we are using it when thinking about a question involving price and cost) = add all expenses together then add a profit margin to determine final price

Question 50

Week 6 What are two methods for measuring the cost of funds for use in determining the price of loans? Why is the marginal method preferred over the historical method?

Answer 50

Methods for measuring cost of funds when determining price for loans: 1: Historical cost = Simply carry forward the historical cost of funds into the present. 2: Marginal cost (preferred) = Simply use the present cost of funds as per the market HOWEVER, banks typically fund the loans they make with multiple sources of funds (deposits, debt, etc.). Therefore it is best to calculate our cost of funds (under either method) as a weighted average. (You should remember how to calculate a weighted average easily). The following terms are used in reference to historical cost vs marginal cost (when weighted) - Historical average cost - Weighted Marginal Cost of Total Funds (WMCTF) Preference for marginal = because average method looks to the past it does not reflect the present cost of funds. If bank prices assets (loans to borrowers) based on historical cost then if interest rates rise for the bank (borrowing for bank becomes more expensive) profitability falls. And if interest rates decline then the bank becomes uncompetitive because other banks will be setting the price of their assets (loans to borrowers) at a lower price. If interest rates rise, marginal costs exceed historical costs If interest rates fall, marginal costs are lower

Question 51

Week 6 | What problem arises when using marginal cost to price loans?

Answer 51

Basically, using historical average is not favourable for pricing loans because it looks to the past. marginal cost, on the other hand, looks to the present. However, marginal cost (like historical cost) cannot look to the future. This is problematic because a bank will not simply use a single source of funds over the course of a loan. The bank will probably generate funds from multiple sources at different times throughout the loan. Therefore the marginal cost will keep changing, however the price the bank set the loan at will remain constant. In order to generate the profit desired when the bank set the price of the loan to its customer it will need to accurately predict the marginal cost for each upcoming time it is required to generate funds from the market. In essence, it will need to accurately forecast the marginal cost. Problems in accurately identifying marginal costs are as follows: 1. Marginal costs include both interest and non-interest costs 2. Estimates of non-interest costs for each source of debt may be erroneous 3. Forecast of interest rates are susceptible to interest rate volatility 4. Disagreement if equity costs are relevant: how to measure equity costs? Additional problem for WMCTF = composition of fund sources may change over time

Question 52

Week 6 What happens if a bank sets its deposit rate too high? What happens if a bank sets its loan rate too high?

Answer 52

Deposit rate too high = Here the bank is setting the rate it pays borrowers high. 1) This means the bank will be incurring a high cost. Higher costs translate to less profitability. 2) Additionally, this would require the bank to set the rate it makes loans at even higher. This would result in nobody wanting to loan from the bank. consequently profitability drops even further. Loan rate too high = 1) Nobody will want to make loans with the bank as they could simply take a loan from a competitor. 2) Additionally, customers who do still take out loans will be more susceptible to default. This could result in default risk rising.

Question 53

Week 6 Discuss the downwards spiral resulting from an increase in costs for funding (where the increase in costs is not offset by an increase in revenue) i.e. assume Bank x has all floating rate sources of funds and all the loans it has made are at a fixed rate.

Answer 53

Costs up = profit down = less retained profits to grow capital= increased use of debt to fund capital growth = increased leverage and risk = perceived safety of bank declines and so customer interest drops off = the spiral starts over again like a loop.

Question 54

Week 6 There will likely be a question pertaining to this information in the final exam. What are various alternative sources of funds a bank may utilise?

Answer 54

Federal funds = banks must hold a certain amount of money as a federal deposit. These deposits earn little to no interest. Therefore any excess stored with the fed should be put to better use elsewhere. For this reason inter-bank borrowing and lending of these funds occurs. The type of borrowing is short-term borrowings of immediately available money = helps with liquidity needs. Cost = low Interest rate = low, due to short maturity. But very sensitive to interest rate change due to short term maturity (overnight to 14 days) Regulation = low Amount raised = low, limited borrowing capacity ``` Repurchase Agreements (RA) = Similar to Fed Funds, Repurchase agreements take place through the Fed Wire system (almost instantaneous borrowing/lending system which uses a banks federal reserves). The only difference here is that highly liquid securities are traded as collateral to protect the lender from credit risk. i.e. Federal funds with collateral in the form of securities Cost = moderate, due to use of collateral Interest rate = low, due to short maturity Regulation = low amount raised = low, limited borrowing capacity ``` Borrowing from Federal Reserve Banks = Instead of borrowing funds from other banks reserve funds, a bank may borrow from the reserves of a central bank. The interest rate will be set as the discount window. Similar to an RA collateral must be provided = may apply for primary, secondary, and seasonal credit (different terms, interest rates, and conditions) (secondary = highest interest rate). Cost = moderate, due to use of collateral Interest rate = moderate, due to medium maturity Regulation = high amount raised = moderate NCD = (TEND TO BE SHORT-TERM) = issuer receives funds for set period of time at set interest rate. Funds from anyone with excess funds to lend.. Credit risk due to no collateral. Cost = high, due to paper work Interest rate = high, scales with maturity Regulation = high amount raised = high Eurodollar deposits = dollar-denominated deposits placed in bank offices outside the U.S. = not subject to the same degree of regulation and hence costs are kept low, however additional risk present. both fixed and variable rate options. Cost = low, due to low regulation (this offsets high interest rates) Interest rate = High Regulation = low, this may result in additional risk amount raised = High ``` Commercial paper = short-term notes Cost = high, due to paper work Interest rate = high, scales with maturity Regulation = high amount raised = high ```

Question 55

Week 6 This is a likely question in the final exam. Answer this question using the format recommended (The spiral effect format) If a bank uses the historical cost for loan pricing and interest rates have risen what is the effect? if a bank uses the historical cost for loan pricing and interest rates have declined what is the effect?

Answer 55

Interest rates risen = Reduced profit margin due to under-priced loans. In essence the banks loans will be cheaper than other banks. Increased demand will result. Bank will need to borrow more to fund demand. However the cost of funding will have been increased due to rising rates. Interest margins will be low and profitability will fall. Share price will suffer. Overall risk increases. This indicates poor management Interest rates declined =More expensive loans than other banks. Supply will move downwards. Good borrowers will go to competitors. The bank will end up with low credit quality borrowers. Potentially more problem loans. Higher loan loss provisions would result. Lower profit and share price as end result.

Question 56

Week 6 | Why would a fixed interest rate source of funding still be considered interest rate sensitive?

Answer 56

This is because even though the interest rate is fixed, renewing the source of funding at the end of the maturity term will require lock in of a new interest rate. Therefore, need to consider the term of the funding source. Very low term results in higher interest rate sensitivity (CD's with 1 month, 3 month, etc) (even more so for federal funds with overnight option)

Question 57

Week 7 Discuss rate sensitivity in regards to Loans and Deposits. What does interest rate risk stem from? More specifically, what is the interest rate risk problem faced by banks?

Answer 57

Rate sensitivity: Loans (asset) = have long maturity, therefore they are repriced later = less rate sensitive Deposits (liability) = have short maturity, therefore repriced earlier = more rate sensitive Interest rate risk stems from = change in absolute level of interest rates, spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. Interest rate risk problem faced by banks: - Having one side of the balance sheet (liabilities) as largely rate sensitive (floating rates) and the other side (assets) as rate insensitive (fixed rate)

Question 58

Week 7 What are the 'Direct risks' of a change in interest rate? Outline the relationship between Bond price and Interest rates. How does this impact a bank? What about the relationship between share price and interest rates? How do we calculate the GAP? When does a positive/negative GAP exist? Which type is more common? How does an increasing negative GAP impact share price? How do interest rate changes effect the GAP?

Answer 58

Direct Risks = when an interest rate change occurs: 1) A banks assets will change in value (Bonds, as discussed below) 2) The interest margin will change (GAP, as discussed below) These directly impact the share price of the bank Interest rate Vs bond price: Interest rate up = Bond price down Interest rate down = Bond price up Therefore, a change in interest rates will impact the value of a Banks bond assets. Share price and interest rate = same relationship as with bonds, because we value share price through dividends which are discounted to PV. If the interest rate (discounting rate) goes up then the share price goes down (simple PV discount formula) GAP = Rate Sensitive Assets - Rate Sensitive Liabilities If > 0 = positive GAP If < 0 = negative GAP if a negative GAP increases due to a bank undertaking additional deposits, without matching additional short term variable rate securities, then the bank will have more interest rate risk = share price down Negative GAP is more common because banks typically have more rate sensitive liabilities (deposits at variable rate) than assets (short term securities at variable rates) For a Negative GAP bank an interest rate increase will result in proportionally more interest expense than interest income = interest margin will decrease

Question 59

Week 7 | What are the 'Indirect risks' of a change in interest rates?

Answer 59

Indirect risks = stem from customer reactions, for example fixed rate borrowers and lenders try to change payment scheme when rates move against them. Another example would be less deposits coming in because of lower interest rates.

Question 60

Week 7 What does it mean when a bank takes a 'position'? Why would a bank on the verge of failure assume a strong position? What does use of fixed vs floating rates imply?

Answer 60

Position = a bank structures its assets and liabilities based upon its assumptions about interest rate movements. This is risky and requires large amounts of capital. Assume strong position amidst failure = because of moral hazard which stems from the fact that some institutions are so large that the government will not let them fail = nothing-to-lose Fixed rates = taken a definite view and assumed risk. However, if rates change will not be able to exploit it Floating rates = taken an indifferent view and assumed no position

Question 61

Week 7 | What does a Banks ALCO do? What is the aim of a banks ALCO?

Answer 61

ALCO = Asset/Liability management committee = measures and monitors interest rate risk and recommends pricing and investment activities and funding and market strategies. Aim = protect profitability and maintain liquidity whilst increasing shareholder returns without adding to risk = Achieve desired trade-off between risk and expected return

Question 62

Week 7 Outline the static Gap method for managing interest rate risk How do interest rate swaps assist Gap goals?

Answer 62

Method 1: Static Gap - Focus = short run Objective = measure possible changes in expected net interest income (then identify strategies to manage it) STEPS: Step 1: Assort RSA and RSL into there maturity buckets Step 2: For each maturity bucket calculate Gap = RSA - RSL Step 3: Assess each buckets Gap individually as well as assess the buckets Gaps cumulatively (starting with earliest maturity first). The Individual assessment will allow you to understand interest changes which would be positive/negative to the bucket. The cumulative assessment will allow you to understand the overall position of the bank at each point in time. Step 4: Adjust Gap depending on aim - Reduce volatility: Identify the maturity period this applies to and then simply adjust Gap value to 0 OR take off-balance sheet positions (forwards, futures, options and interest rate swaps) - Take advantage of rate changes: Increase the Gap or flip the Gap (negative/positive) OR take off-balance sheet positions (forwards, futures, options and interest rate swaps) Interest rate swaps = agreement with a bank to pay either a floating/fixed rate in exchange for the opposite rate = can be used to minimise risk or to take a position. For example: If a bank had a Floating position (out) and it wanted to minimise risk it would utilise an interest swap in which it pays a fixed rate (out) to a counterparty and receives a floating rate (in) from the counterparty. This way the floating rate (in) will be the amount required to make the floating position (out) payments the bank had agreed to in the first place - In essence, two parties exchange their risks.

Question 63

Week 7 | What are the advantages and disadvantages of Static Gap analysis?

Answer 63

Advantages: 1. Easy to calculate and understand 2. Provides a single number for each period 3. Time buckets indicate relevant amount and timing of interest rate risk over distinct maturities 4. Suggests the magnitude of portfolio changes necessary to alter risk 5. Identifies specific balance sheet items responsible for the risk Disadvantages: 1. Provides no measure of basis risk (we can quantify the impact of interest rate change, but we do not know how likely interest rate changes will be) 2. Examines balance sheet at a point in time - only a snapshot 3. Does not provide information on the interest rate payments stream 4. Many measurement errors, e.g. liabilities tied to base rate 5. Ignores the Time Value of Money (TVM) 6. Ignores cumulative impact of interest rate changes on risk 7. ignores liabilities that pay no interest 8. Does not capture risk associated with options embedded in securities or loans, e.g. deposit with early repayment option 9. (MOST IMPORTANT) Interest rates do not change by equal amounts for all assets and liabilities.

Question 64

Week 7 Outline the Dynamic Gap method for managing interest rate risk Outline the prepayment option considerations of Dynamic Gap Outline the withdrawal option considerations of Dynamic Gap

Answer 64

Method 2: Dynamic Gap Focus = same as Static Gap, however pays attention to the level of rates and direction in which rates move Ultimately, the Dynamic Gap follows the same steps as the Static Gap, however it also allows assets and liabilities to differ in their rate sensitivity by recognising any constraints or options that influence rate sensitivity (for example some rates may rise but not fall or vice versa) Prepayment option = When rates fall fixed borrowers will repay early. They do this because they can pay off the loan at the higher rate and simply take out the same amount of loan at the lower rate the next day. - Issue: The bank will receive payment early which limits default risk (good) but will have to reinvest that money at a lower rate which increases interest rate risk (bad) = Assets more rate sensitive than implied by static gap - Consideration of Dynamic Gap analysis: Withdrawal option = Debt with call provisions may be liquidated early (for example CD's are for a fixed term however the bank can trade them to liquidate them early) - Issue: These assets are in fact rate sensitive = Liabilities more sensitive than static gap implies

Question 65

Week 7 Match the following Micro and Macro hedge, Duration and Gap. What is Duration?

Answer 65

Micro hedge = Gap Macro hedge = Duration Duration = a value and time weighted measure of maturity that considers all cash inflows from earning assets and all cash outflows associated with liabilities = measures price sensitivity and not rate sensitivity

Question 66

Week 7 How do we calculate 'Relative' rate sensitive gap? How do we calculate Rate sensitivity ratio?

Answer 66

Relative rate sensitive Gap = Simply divide the calculated Gap by total bank size (total assets) Rate sensitivity ratio = RSA / RSL

Question 67

Week 8 What is liquidity? What are several examples of liquid assets for a Bank? Why do banks need liquidity?

Answer 67

Liquidity = a measure of the ability and ease with which assets can be converted to cash without significant loss of value. Common liquid assets = Cash, Due from banks, Balance held with central bank, government investments (bonds) Why banks need liquidity: 1. Cover customer withdrawals 2. Comply with regulation 3. Facilitate transfers on behalf of others (A bank can be instructed through trade letters to make a payment on behalf of another institution. For this purpose they require cash on hand) 4. For the check clearing process (Similar to customer withdrawal. However, here a third party will be withdrawing funds from the customers account because the customer owes the third party). 5. Demonstrate to the market place (risk-averse) the bank is safe and capable of repaying borrowings 6. Show the ability to meet prior loan commitments 7. Avoid unprofitable sale of assets 8. Reduce the default risk premiums the bank must pay for borrowings 9. Avoid the use of the lender of last resort (Central bank) = results in 'balance due to central bank' liability (does NOT look good on a balance sheet) which can tarnish reputation ALSO borrowing from CB is costly.

Question 68

Week 8 Why would a manager not want to have excessive liquidity? What are some desirable characteristics of liquid assets? Bank confidence is the key for liquidity management. What is bank confidence a function of?

Answer 68

Excessive or even high liquidity = not optimal because there is a trade-off between liquidity and profitability. Liquid funds (cash, etc.) do not generate income (opportunity cost). Desirable characteristics of liquid assets: 1. Minimal interest and credit risk 2. Well established market where it can be traded Bank confidence is a function of: - Net worth (capital strength) - Earnings stability and quality of information - Government guarantees

Question 69

Week 8 Concerning regulation and liquidity what must a bank do? What are some consequences of a bank failing to maintain adequate liquidity? What regulation is imposed regarding LCR? What regulation is imposed regarding NSFR?

Answer 69

Regulation = bank must maintain adequate liquidity to enable it to respond swiftly and effectively to demand for funds Consequences: 1. Fines and penalties, which can lead to 2. a squeeze on earnings, which can lead to 3. a capital shrinkage, or 4. a dramatic outflow of funds, generally referred to as a 'run' on the bank (because word of mouth spreads about the banks liquidity issues) (Word of mouth may also leave individuals withdrawing rapidly from other banks as they misconstrue the event as a macro event) LCR = (High quality liquid assets)/(net liquidity outflow 30 days) must be greater than 100% = in essence, 100% of 30 day liability held in the form of high-quality liquid assets NSFR = Net Stable Funding Ratio = (available amount of stable funding)/(Required amount of stable funding) must be greater than 100%

Question 70

Week 8 What are some causes of liquidity risk stemming from the asset side? What are some causes of liquidity risk stemming for the liability side? What are Net deposit drains?

Answer 70

Asset side liquidity risk: 1. Risk from OBS loan commitments and other credit lines. For example if a bank had preapproved an OBS credit line and was contractually obliged to extend the credit then there cash would drop by the amount of the credit line used. The banks loans would go up in value, however its liquid assets would drop in value. 2. Problems associated with 'quick' asset sales/fire-sales - High cost of turning liquid assets into cash - Low sales price; in worst case, fire-sale price - further exacerbated by foreign currency exchange rate if the bank has an international portfolio of loans (illiquid assets) Liability side liquidity risk: 1. Depositors and other claimholders decide to cash in their financial claims immediately, the claims exceed liquid assets. This will in fact instigate problem number 2 from the above Asset side liquidity risk. That is to say that the bank will then need to liquidate illiquid assets and will incur costs in doing so. This will bring down profits. Net deposit drains = the difference between deposit withdrawals and deposit additions on any specific banking day = banks need to predict this.

Question 71

Week 8 | What is the LDR?

Answer 71

LDR = Loan to deposit ratio = measures liquidity = what portion of our deposits are we lending out = if too high then we are essentially lending out all of our deposits and may not be holding enough liquid assets. However, if too low then we may not be making enough profitable investments = ignores the amount of assets that a bank does in fact have in liquid form.

Question 72

Week 8 | What is the flow approach to measuring liquidity?

Answer 72

Under the flow approach to liquidity we are less concerned with what a bank has at a point in time (as per the other approaches) and are more concerned with a banks abilities (what it could achieve in the future). - Measure ability to convert liquid assets into cash (asset side). From most to least liquid the assets are: 1. Cash 2. Short term government securities 3. Commercial Bills 4. High quality longer term government securities 5. Investments 6. Loans or assets 7. Fixed assets (probably in serious trouble) - Measure ability to borrow (liability side). From most to least cost efficient: 1. Use a Repo (Where a bank borrows money from another bank and pledges ST-government securities as collateral. A short while later the bank will repurchase the ST-govies. This allows the bank to generate short term cash without having to actually sell off assets) 2. Inter bank market (unsecured) 3. Public deposits 4. Sell certificates of deposits (wholesale) 5. Borrow debt internationally (Eurodollar) 6. Borrow from central bank - Measure ability to generate cash flow from operations (liability side)

Question 73

Week 8 What are liquidity needs a function of? How can we go about estimating liquidity needs?

Answer 73

Liquidity needs are a function of = size of deposits, size of loan demand and also economic factors (fires, floods, unusual economic or political development) Estimating liquidity needs: 1. Analyse Loans (what is max line of credit that can be withdrawn for each loan, etc.) 2. Review banks operations on a seasonal basis trying to identify trend effects (time series analysis, short-term cyclical trends) 3. Correlation patterns between deposit flows and selected indicators ( economic recession or boom, interest rate ceiling, etc.) 4. Vulnerability to deposit outflows and lack of confidence by lenders (could bad publicity send away many customers or just a handful?) 5. Seasonal short-term liquidity needs (can be predictable, such as Christmas period, or may be unpredictable, such as disproportionate large borrowers and depositors) 6. Cyclical liquidity needs (liquidity needs that vary with business cycle = difficult to predict) 7. Trend liquidity needs = associated with particular customers and predictable over longer time horizon (inventory or purchase of PPE by particular customers) 8. Contingent liquidity needs = liquidity needs necessary to meet an unforeseen event (impossible to predict = why we have regulation)

Question 74

Week 8 | What are the requirements of Basel III?

Answer 74

Basel III = Imposes the LCR and requires banks to hold sufficient high-quality assets to withstand a 30 day period of acute stress. Need to fund match assets and liabilities

Question 75

Week 8 How do we calculate the liquidity gap? How do we interpret the gap?

Answer 75

Liquidity gap = Sources of funds - uses of funds Interpret: 1. Negative gap = deficit of funds = cant cover liquidity needs = leads to incurring additional costs, bad reputation, loss of customers etc. (spiralling effect) 2. Positive gap = surplus of funds = also not optimal = need to be investing in earning assets

Question 76

Week 8 What are the principal sources of liquidity demand for a financial firm? How may a bank deal with a liquidity deficit? How may a bank deal with a liquidity surplus?

Answer 76

Demand: 1. Customers withdrawing money from their deposits and from credit requests. 2. Repayment of non-deposit borrowings, operating expenses and taxes payable 3. Payment of a cash dividend to stockholders. Supply: 1. Incoming deposits 2. Sales of bank assets, particularly money market securities, 3. Repayments of loans. 4. Sale of non-deposit services 5. Borrowings from the money market LIQUIDITY DEFICI 1. aggressive advertising to attract NEW deposits 2. issuing negotiable CDs in the money market 3. if they have a holding company, the holding company could sell commercial paper and pass the proceeds through to the bank subsidiary 4. borrowing Federal funds 5. borrowing from the Federal Reserve district bank (although this is not a likely alternative for most banks) 6. selling securities under agreements to repurchase 7. selling some of their loans 8. selling some of their securities 9. a combination of a number of these alternatives LIQUIDITY SURPLUS 1. aggressively pursue new loans, 2. invest in various money market instruments, such as Treasury securities, or, 3. a combination of these alternatives.

Question 77

Week 9 What are the main reasons for holding capital? What are the main functions of capital? Does equity capital add to liquidity risk?

Answer 77

Main reasons: 1. Ensure stability in banks operations 2. Ensure safety of depositors funds 3. Maintain public confidence in banking system 4. Reduce likelihood of bank failure 5. Reduce cost to taxpayer in a bailout Main functions: 1. Absorb unanticipated losses (cushion for losses) 2. Protect depositors against losses (promote confidence) 3. Protect taxpayers 4. Finance infrastructure 5. Contribute to profitability and returns to shareholders 6. Promote willingness for investors to contribute funds 7. Provide funds free of a fixed financing cost Equity capital and liquidity risk = No, it does not. This is because equity capital does not require payments (dividends are not mandatory)

Question 78

Week 9 The definition of capital depends on who you ask. Outline the market and economic definition as well as the regulators definition.

Answer 78

Market and economic definition = difference between market value of assets and liabilities (economic net worth) Advantages: 1. Accurately reflects risk changes (changes in credit risk and IRR) Disadvantages: 1. Difficult to implement 2. Large amounts of non-traded assets: how to value? (e.g. a mortgage to John and Jane doe) 3. Introduces unnecessary degree of variability into bank earnings (because we are constantly implementing market changes into profit and loss when we revalue things) 4. Most banks hold assets to maturity (never actually realise gains or losses) Regulators: look at historical or book value of equity (but these figures can be misleading) Advantages: Disadvantages: 1. Book value is a lagging measure and does not accurately reflect risk changes

Question 79

Week 9 How does credit risk impact MV of capital? How does interest rate risk impact MV of capital? How does credit risk impact BV of capital? How does IRR impact BV of capital?

Answer 79

Credit risk impact on MV of capital = Remember that credit risk is just the risk of asset value declining = if asset value drops then equity absorbs these losses. Debt will not absorb these losses, debt remains the same. Evidently credit risk impacts MV of capital (equity) Interest rate risk impact on MV of capital = Here we need to consider that IRR effects both the asset and liability side of things. So calculate the net change and simply analyse how that impacts equity Assets: 1. Bonds at mkt. = as we know IR up = bond value down 2. Loans at fixed rate = same relationship as bonds = if interest up the loan will be earning less interest then a new loan could be, therefore mkt value down 3.Loans at variable rate = no change, because adjusts to IR to reflect current market conditions (therefore not better or worse then market = no change) Liabilities: 1. Deposits at fixed rate = same as loans at fixed rate 2. Deposits at variable rate (assume this if not specified) = same as loans at variable rate 3. Debt = same as loans at variable rate Credit risk on BV's = effect only witnessed when bank has to record changes (even in doing this creative accounting can limit impacts) IRR risk on BV's = no effect, BV remains the same. (BV records value to company, not MV value). However some items such at Bonds at mkt value will be revalued (however, this is done only on a 3 month basis, therefore lagging)

Question 80

Week 9 What constitutes Tier 1 and Tier 2 capital?

Answer 80

Tier 1 capital: (no cash outflow) 1. Paid up ordinary shares 2. Non-repayable share premium account 3. General reserves 4. Retained earnings 5. Non-cumulative irredeemable preference shares 6. Minority interests in subsidiaries Tier 2 capital: 1. General provisions for doubtful debts 2. Asset revaluation reserves 3. Cumulative irredeemable preference shares 4. Mandatory convertible notes and similar capital instruments (debt which, given certain circumstances, is converted into equity) 5. Perpetual subordinated debt 6. Redeemable preference shares and term subordinated debt

Question 81

Week 9 | Contrast Basel I, II and III

Answer 81

Basel I: - only assessed credit risk - procedures were unsophisticated - assessed from regulatory rather than economic Basel II: - capital allocation for products, require sophisticated systems - models of default and value at risk require sophisticated modelling and history Basel III: - like Basel II but higher capital levels, inclusion of liquidity requirements, and more details

Question 82

Week 9 What other factors besides gearing ratios and capital do regulators look at? If a bank had an insufficient capital adequacy ratio how could they go about increasing their capital?

Answer 82

Regulators assess: 1. Quality of management 2. Adequacy of liquidity 3. Quality of assets (loans) 4. Earnings performance insufficient capital adequacy ratio: - Increase total capital = issue shares (ordinary (tier 1) or preferred (tier 2)), cut dividends, issue subordinated debts - Decrease risk-weighted assets = sell assets, invest in less risky assets

Question 83

Week 9 What are the capital adequacy qualifying requirements as per Basel III, how about as per PCA? How do we calculate internal capital growth rate? What do we use this for? How do we calculate the leverage ratio

Answer 83

Requirements as per Basel III: (most likely tested on this) - T1/RWA >=6%, TC/RWA >=8%, Common Equity T1 / RWA => 4.5% Requirements as per PCA : Well capitalised = T1/RWA >=6%, TC/RWA >=10%, T1/Total assets >=5% Adequately capitalised = T1/RWA >=4%, TC/RWA >=8%, T1/Total assets >=4% Internal capital growth rate = PM x AU x EM x Net earnings retention ratio = used for assessing how fast assets can grow without reducing equity capital to total assets Retention ratio is calculated as = (net income - dividends) / net income Leverage ratio = Tier 1 / total assets

Question 84

Week 9 What two components does RWA comprise? What are the 2 aspects of the 2nd component? What are the RWA factors for: 1. Cash/ government securities 2. Certain public debt 3. Interbank loans 4. Residential mortgages 5. Private sector debt

Answer 84

RWA = On-BS + Off- BS Off-BS = guaranty contracts + derivative contracts 1. guarantee contracts = standby and commercial letters of credit, loans commitment - RWA of guarantee contracts = value * conversion factor * risk-weight Asume: Conversion factor of 100% for standby letters and 50% for commitments 2. derivative contracts = forwards, futures, swaps, options - RWA of derivative contracts = (potential exposure + current exposure) * risk-weight, where potential exposure = contract value * conversion factor Note: If out of the money then just $0 for current exposure RWA factors: 1. Cash/ government securities = 0% 2. Certain public debt = 10% 3. Interbank loans = 20% 4. Residential mortgages = 50% 5. Private sector debt = 100%

Question 85

Week 10 A currency's value may be derived from simple free economy laws of supply and demand, or alternatively it may be pegged to another country's currency. How does the currency peg work? What are the advantages and disadvantages of a currency peg?

Answer 85

Currency peg: The country basically buys or sells its own currency to ensure the value remains at the desired ratio of another country's currency - if supply of currency > demand, then price will drop. So the country will use foreign reserves to buy its currency and hence increase the price - if supply of currency < demand, then price will rise. So the country will sell its currency by buying foreign reserves and hence lower the price back Advantages: stable environment, virtually no exchange rate risk Disadvantages: government needs to hold large foreign currency reserves to maintain the peg

Question 86

Week 10 How does arbitrage work in the FX market? Why are arbitrage profits limited? Why do banks deal in FX?

Answer 86

Arbitrage: Often quotes vary from country to country, therefore dealers can exploit these differences for a riskless profit opportunity. Arbitrage profits limited: Transaction costs are involved. These costs limit any profits. Additionally, time may manipulate margins. For example purchasing gold cheap in sydney and then selling it for more in NY will require time for the purchase and then sale to be finalised. i.e. the rates at the inception of the arbitrage opportunity will change with time. Banks reason for FX involvement: 1. Income from sale and purchase of currencies 2. To facilitate customer requirements (e.g. a customer decides to go on holiday) 3. Act as market intermediary (removes the problem of counterparty creditworthiness 4. arrange smooth and timely settlement of FX transactions (no legal international clearing system required)

Question 87

``` Week 10 In the FX market contrast the following participants: 1. Dealers 2. Brokers 3. Corporate 4. Speculators 5. Regulators ```

Answer 87

1. Dealers (Banks) - trade on behalf of themselves and are the price setters 2. Brokers - trade on behalf of others 3. Corporations - drive the supply and demand for currencies 4. Speculators - trade on their own behalf, however they take a position. 5. Regulators - monitor transactions and protect the market (from things like currency manipulation)

Question 88

Week 10 | In regards to importers and exporters, which is preferable a currency appreciation or depreciation?

Answer 88

Importers = appreciation = you will be buying foreign goods and paying in that countries currency. Therefore if your currency goes up in value you can buy more of their currency and hence more goods Exporters = depreciation = People will be buying goods from you. So if their currency goes up in value they will be able to buy more goods. Demand for your product will henceforth increase without having to lower your prices.

Question 89

Week 10 | How may a bank mitigate FX risk?

Answer 89

Mitigate FX risk: 1. Match foreign currency assets and liabilities to reduce risk exposure to 0 2. Avoid the risk altogether by not dealing in FX 3. Take out a position - Forward contracts (obligation): buy or sell on specific date (or withing range of dates) at specified forward rates - Currency futures (obligation): exact same as above except standardised product (whereas Forwards are sold OTC) - Cross currency swaps (obligation): agreement between two parties where interest payments and principal in one currency exchanged for equally valued payments in different currency - Options (No obligation): security allowing currency traders to realise gain without having to purchase underlying currency pair

Question 90

Week 10 | What are the types of FX risk?

Answer 90

1. Transactional risk = results from time lag between placing order and order being executed/received 2. Translation risk = Annual reports 3. Economic risk = competitive position (if AUD appreciated drastically then our steel exports would decline = not good for steel exporters)

Question 91

Week 10 (Fundamental analysis for FX) Outline how the following may impact FX 1. Interest rates 2. Inflation 3. Unemployment 4. Trade results What is Technical analysis in relation to FX changes?

Answer 91

1. Interest rates = The level of interest rate may attract or repel foreign investment. For example a high interest rate on a US deposit account would attract many Australians. the Australians would need to buy USD to deposit. Therefore increased USD demand would result in appreciation 2. Inflation = high inflation results in currency erosion therefore depreciation will result 3. unemployment = lowers economic activity and hence there would be less desire for foreign involvement. Therefore a currency depreciation would occur 4. Trade results = consider importing and exporting and the effect on supply and demand Technical analysis = analysis of historical trading action of a market and identification of major trends and trend lines

Question 92

Week 10 Outline the following Random walk theory Purchasing Power Parity

Answer 92

Random walk theory = no way of predicting short term exchange rate changes because news is available to all interested parties and participants immediately and efficiently analyse and act on new information = assumption of an efficient exchange market and no government control (for example where a currency peg is used there is government control and therefore the random walk theory does not apply) Purchasing Power Parity = a product will have the same price in different countries when the exchange rates among the various currencies are allowed for

Question 93

Week 10 outline the idea of Interest Rate Parity

Answer 93

IRP (SLIDE 14 WEEK 11) = a theory in which there is an offsetting relationship between interest rate differentials and differentials in the forward spot exchange market Therefore, the exchange rate should appreciate or devalue at such a rate as to equalise effective realised interest rates between countries = no arbitrage opportunity available

Question 94

Week 11 What is a sovereign debt crisis What is contagion risk?

Answer 94

Sovereign debt crisis = A sovereign debt crisis is generally defined as economic and financial problems caused by the (perceived) inability of a country to pay its public debt. This usually happens when a country reaches critical high debt levels and suffers from (perceived) low economic growth. Contagion risk = a major issue for banks stemming from international banking = contagion risk is the effect of a financial crisis in one region or country spreading to another = failure of one bank could lead to failure of many banks

Question 95

Week 11 Explain the risk links between parties to a syndicated loan

Answer 95

Syndicated loan risk links = Here the lenders have direct risk links to the company they have made the loan to as well as indirect links to one another. the indirect links comes in the form of contagion risk in that the borrowing company may default on a payment to one of the bank which may have ramifications for all of the other banks (a domino effect of sorts)

Question 96

Week 11 outline the following structures a bank may utilise for operating internationally: 1. Representative office 2. Offshore banking units 3. Shell branch 4. Foreign subsidiaries 5. Foreign affiliates 6. Foreign branches 7. Correspondent banks

Answer 96

Representative office (Not ADI's) = cannot conduct banking transactions, can only provide information and assist parent bank's clients = usually used to establish presence in a foreign country (may be restrictions on setting up actual bank) Offshore banking units = foreign bank branch in another country (limited access to country's domestic market = used for 1) tax effective presence in time zone / geographic region, 2) conducting international business, including FX, 3) establishing presence where restrictive regulations are placed on foreign banks 3. Shell branch (easiest and cheapest way to enter international banking) = pretty much just a 'booking office' located in a foreign country (no contact with public and no staff = all electronic) = main activity is inter-bank money market transactions 4. Foreign subsidiaries = separately incorporated as a domestic bank owned entirely or in part by a foreign bank = provides identity and visibility of local bank in eyes of potential customers in host country = management mostly local nationals (provides strong access to local business community) 5. Foreign affiliates = very similar to subsidiaries, except one difference = owns only 0-49% of shares 6. Foreign branches = legal and operational part of parent bank = creditors have full legal claim on assets of branch (this means that, unlike a foreign sub or aff, the parent of a foreign branch can essentially redirect all of the branches assets back to the parent in a state of emergency) = subject to two sets of banking regulation (those of domestic country and those of host country) = major advantage is worldwide name identification with parent bank. Major disadvantage are the costs of establishment and legal limits on activities 7. Correspondent banks = business arrangement between two banks = correspondent bank agrees to provide respondent bank special services such as payment clearing = services typically revolve around paying or collecting international funds for trade transactions = fee revenue generated

Question 97

Week 11 How may banks expand internationally?

Answer 97

Acquisitions: - D: Large costs, differing internal cultures, quality of customers/loans acquired - A: Ready client base Set up new branch/subsidiary: - D: very expensive and slow process in obtaining customers and regulatory issues - A: some countries may welcome and invite foreign banks

Question 98

Week 11 ``` What is a Euro market? What are the advantages? What is a Euro bank? What is a Euro credit? Why do multiple Euro Banks typically consolidate into a banking syndicate? What is LIBOR? ```

Answer 98

Euro market = where currencies are lent and borrowed outside their country of origin Advantages = free from regulation of national authorities so very flexible and innovative in meeting depositor and borrower needs Euro bank = financial institution that accepts foreign currency denominated deposits and makes foreign currency loans (for example, a US bank making a loan in Japanese yen) in essence, once we are dealing in more than one currency on our balance sheet then we are within the definition of a euro bank Euro credit = loans made by Euro Banks Banking syndicate = to spread risk and because loans may be too large for one party to handle London Inter Bank Offer Rate = common rate at which banks lend to one another = determined upon interest rates banks utilised throughout the day which are provided to a central body

Question 99

Week 11 International banking imposes additional risks on a bank. Discuss the following: 1. Currency risk 2. Regulatory risk 3. Political risk 4. Sovereign risk / country risk (what are cross-default provisions?)

Answer 99

Currency risk = pretty much same points as discussed with FX Regulatory risk = possibility the country may impose additional regulations or change existing regulations - reserve requirements - capital asset ratios - currency restrictions - special taxes - other regulations that would hamper baking activities = can manage by passing costs onto borrower Political risk (similar to regulatory risk but more broad) = uncertainty arising from political and economic developments within a host country - change in political parties and policies - Unfavourable changes in government attitude - Restriction on import/export of goods ``` Sovereign risk (country risk) = the risk that a government could default on its debt (sovereign debt) or other obligations. Also, the risk generally associated with investing in a particular country, or providing funds to its government = Debt repudiation becomes central issue (Deny repayment of debt), however more recently debt rescheduling is used (renegotiation of terms) Cross-default provisions = if country defaults on one lone, all its other outstanding loans will be deemed default ```

Question 100

Week 11 What are the disadvantages associated with preventing the default of a FI or a country through intervention (bailouts, etc.) How is Credit risk evaluated? How may a bank protect against risk arising from default? What are the disadvantages associated with this?

Answer 100

The central disadvantage here is that if FI's and countries are not ultimately punished, they will have no incentives to avoid similar risks in the future Credit risk = similar to credit scoring system = Euromoney Index, Economist Intelligence Unit (EIU), institutional Investor Index OR could use external appraisal service (view slides 47 and 48 for types of economic ratios used) Protect against default = take out insurance - D: Moral hazard = investors become less prudent in avoiding the risks because they have insured a project

Question 101

Week 11 All in all, how may a bank mitigate the risk associated with exposure to a country? Would exposure impact share price and shareholder confidence?

Answer 101

Prior to distress: 1. Utilise syndicated loan arrangement 2. Purchase insurance 3. Ensure adequate collateral Amidst distress 1. Negotiate terms (debt rescheduling over debt repudiation) 2. Sell part of position if feasible 3. Absorb loss on asset side by increasing capital buffer (reduce dividend or investments or issue shares) 4. Take control of collateral Share price = yes most certainly as the absorption of asset losses will move equity downwards or the issuance of shares will dilute shares Shareholder confidence = Yes, if the bank did not take adequate preventative measures then shareholder confidence will decline = may have further implications for share price as a sell off would lead to oversupply and thus prices dropping to suffice the demand function