discuss and explain (10-15 marks) Flashcards
Discuss the main differences between commercial and investment banks’ financial statements. (Max 10 lines expected)
Commercial banks’ balance sheets typically show a larger portion of loans and deposits, representing their core business of taking deposits and lending money. Their income statements often reflect interest income and expenses as significant components.
On the other hand, investment banks, which primarily engage in trading, underwriting, and advisory services, typically show a greater balance of trading assets and securities. Their income statements often include significant revenue from fees, commissions, and trading gains.
Thus, while both types of banks record assets, liabilities, and equity on their balance sheets, the composition and proportion of these entries vary significantly, reflecting the variance in their operational activities and income sources
Discuss the main limitations of bank financial ratios. (Max 10 lines expected)
Bank financial ratios, although useful, have their limitations.
One key issue is comparability. Differences in accounting standards, regulations, and bank practices across regions can lead to inconsistencies, making comparisons unreliable.
Additionally, financial ratios are based on historical data and thus may not be indicative of future performance, particularly in rapidly changing economic environments.
They also often fail to fully capture the risk profile of a bank, especially off-balance sheet activities, which can be substantial for some banks.
Lastly, financial ratios do not consider qualitative factors like quality of management, customer service, and technological innovation, which can significantly impact a bank’s performance.
Therefore, while financial ratios can provide valuable insights, they should be used alongside other analysis tools and not relied upon solely in assessing a bank’s financial health or performance.
Explain the impact of recent interest rate increases on banks’ profitability (max 10 lines expected)
Interest rate hikes can potentially enhance banks’ profitability. Net interest income, a primary revenue source for banks, is influenced by the interest rate differential between their lending and deposit rates.
Higher rates can widen this spread, leading to greater net interest income.
However, higher rates also mean increased cost of funds, impacting banks’ net interest margins if lending rates can’t be raised proportionally.
This can restrict profit margins, particularly in competitive markets where raising loan rates might lead to loss of business.
Moreover, increased rates can lead to higher default rates, as borrowers struggle with pricier loan repayments, potentially increasing banks’ credit risk and provisioning costs.
Therefore, the impact of interest rate hikes on profitability is multifaceted – potentially beneficial, but also fraught with challenges, highlighting the need for sound interest rate risk management in banks.
Discuss the moral hazard problem posed by too-big-to-fail banks.
Too-big-to-fail (TBTF) banks pose a moral hazard due to the perceived government guarantee against bank failure.
This belief can lead bank managers to take on excessive risk, knowing the potential losses will be shouldered by taxpayers, not by the bank.
Additionally, this implicit guarantee can create an uneven competitive field, where TBTF banks, protected against failure, enjoy lower borrowing costs compared to smaller institutions.
This further incentivizes risk-taking and proves detrimental to market competition.
Government bailouts reinforce the notion that TBTF entities will be rescued, encouraging them towards riskier ventures.
The 2008 financial crisis illustrated the adverse effects of such incentives, with risky lending and speculative trading practices causing significant economic downturns.
To mitigate moral hazard, strategies such as stringent oversight, stricter capital requirements, and safe bank failure strategies become essential, balancing the need to prevent systemic failure while discouraging reckless risk-taking
Explain the logic behind the credit multiplier and the main limitations of the model. (Max 10 lines)
The credit multiplier refers to the mechanism by which deposits can expand to create an increase in the total money supply greater than the original deposit.
This occurs because banks typically only retain a fraction of deposits as reserves and lend out the remainder.
This loaned money eventually becomes a deposit in another bank, which is then partly loaned out again, continuing the process and expanding the money supply.
However, the model presumes all loaned money is re-deposited and loaned out again, which isn’t always realistic.
Additionally, it assumes that banks lend out all excess reserves, but banks’ lending decisions are influenced by various factors including risk appetite and creditworthiness of borrowers.
Furthermore, during times of economic uncertainty, banks may be stricter with lending, limiting the model’s applicability.
Discuss how financial intermediaries reduce transaction costs and information asymmetry problems. (Max 10 lines)
By aggregating funds from many savers and lending to many borrowers, intermediaries exploit economies of scale.
thereby reducing transaction costs for individual savers and borrowers who would otherwise have to negotiate and manage these relationships themselves.
Regarding information asymmetry, banks conduct credit assessments and continuous monitoring of borrowers, which individual savers would find costly and time-consuming.
However, financial intermediaries have the expertise to evaluate credit risks, thus reducing the problem of adverse selection before the loan agreement and moral hazard after the agreement, creating a more efficient allocation of resources in the financial system.
Define universal banking. Discuss the advantages and disadvantages of a universal banking model. How has the 2007-2008 financial crisis exposed the weaknesses of the universal bank business model? (Max 10 lines expected)
Universal banking refers to a banking system where institutions provide a variety of financial services ranging from retail banking, and commercial banking to investment banking.
Examples include banks such as JP Morgan Chase
Advantages include diversification of revenue sources, risk reduction, and customer convenience by serving all financial needs under one roof.
However, drawbacks include high systemic risk due to interconnectedness, management complexities from running varied businesses, and moral hazard issues stemming from the ‘too-big-to-fail’ syndrome.
The 2007-2008 financial crisis underlined these shortcomings, with some universal banks’ high-risk activities leading to huge losses, demonstrating the systemic risk associated with the business model and the need for improved risk management and regulatory oversight.
Explain co-operative banks (15 lines)
Co-operative banks are small financial institutions that offer lending facilities to small businesses in both urban and non-urban regions.
Like savings banks, have mutual ownership and offer retail and small business banking services, with a “local” strategic focus.
Their advantage is their resilience in crises due to their focus on long-term customer relationships and local knowledge.
However, their limited scale can present challenges in competing with larger commercial banks and in adapting to technological innovations.
They are an important part of the financial sector in Germany, Austria, Italy, France, Netherlands, Spain, and Finland.
In the last decade, a strong consolidation has created very large cooperative banks, also listed on the stock exchange (i.e., The Co-operative Bank (UK)).
Explain the two prohibitions of Islamic banking gharar and maysir and explain the mortgages in Islamic banking
Gharar means to unknowingly expose oneself or one’s property to risk. It refers to acts or conditions in contracts, the full implications of which are not fully understood by the parties.
This is very similar to the concept of “asymmetric information”.
maysir means gambling, Islam prohibits all kinds of gambling and games of chance.
Prohibition against forbidden (haram) activities: Islamic banks may finance only permissible (halal) activities.
In an Islamic mortgage, The bank and the customer jointly purchase the house. The ownership of the house is split between the bank and the customer.
It is agreed that the customer will purchase the bank’s share in the house gradually, thus making him the sole owner of the house after a specific period.
During this period the customer pays a rent to the bank.
Explain the concept of consumption of soothing (10 lines max)
This is an economic concept related to individuals trying to ensure a stable path of consumption.
The idea is that people prefer to maintain a stable level of consumption over time rather than experiencing significant fluctuations.
So, they save in times of high income, which they can then use in times of low income to balance things out.
An example of this might be a student who takes out loans to pay for education (thus, maintaining their consumption level), then repays those loans during their working years
From a financial perspective, this theory is the cornerstone of personal savings, borrowing, retirement planning and insurance decisions,
However, it requires access to credit and financial planning skills, which may not be available to all, influencing the effectiveness of consumption smoothing in practice.
Explain the transformation functions of banks (10 marks)
The brokerage function is when financial intermediaries match transactors and provide transactions and other services. As a result, they reduce transaction costs and remove information costs.
The asset transformation function is when financial institutions issue claims that are far more attractive to savers (in terms of lower monitoring costs, lower liquidity costs and lower price risk) than the claims issued directly by corporations.
However, these roles expose banks to various risks, including liquidity and credit risks.
Therefore, robust regulatory frameworks and risk management practices are essential to mitigate these risks
Explain the two main risk management strategies (10 marks)
There are two broad risk management strategies open to a financial institution.
Risk decomposition- identify risks one by one and handle each of them separately
Risk aggregation - reduce risks by being well-diversified.
Example for decomposition:
For example, the market risks incurred by the trading room of a UK bank.
The risks depend on the future movements in a multitude of market variables (exchange rates, interest rates, stock prices, and so on).
To implement the risk decomposition approach, the trading room is organized so that a trader is responsible for trades related to just one market variable or a small group of market variables.
Example for aggregation:
At the end of each day, the trader is required to ensure that certain risk measures are kept within limits specified by the bank (i.e., Value at Risk).
The risk managers will thus implement the risk aggregation approach for the market risk being taken by all the traders.
This involves calculating at the end of each day the total risk faced by the bank from movements in all market variables.
Credit risk is traditionally managed using risk aggregation.
Risk mitigation techniques include Guarantees, Derivatives and Insurance policies.
Explain the significance of financial ratios in analysing a bank’s performance (10 marks)
Financial Ratios are used both internally and externally to assess bank performance and can be used to identify early warning signals.
Financial ratios analysis investigates areas such as:
Profitability Ratios (e.g., Return on Assets or Net Interest Margin) provide insights about a bank’s ability to generate earnings relative to its assets, equity, and operational expenses.
Liquidity Ratios (e.g., Loan-to-Deposit Ratio) gauge a bank’s capacity to fulfill its short-term obligations, reflecting its ability to withstand liquidity crises.
Solvency Ratios (e.g., Capital Adequacy Ratio) measure a bank’s ability to meet all its liabilities and withstand losses, offering insights into its long-term stability.
Efficiency Ratios (e.g., Cost-to-Income Ratio) evaluate how efficiently a bank operates.
Lower ratios suggest higher operational efficiency.
However, it’s crucial to compare these ratios within the industry for meaningful insights, considering the different business models, regulatory environments, and macroeconomic factors banks operate in.
Explain bank runs and what regulations can be made to avoid them
A bank run occurs when many customers simultaneously withdraw their deposits due to fears that the bank might become insolvent.
As banks typically hold only a fraction of deposits as cash reserves and lend out the rest, they may be unable to fulfil all withdrawal requests immediately, escalating the situation.
Reports that a bank has become insolvent can spread fear that it will run out of cash and close its doors.
Examples include the Lehman Brothers failure.
Regulations to prevent bank runs include:
Deposit Insurance: By guaranteeing deposits up to a certain amount, deposit insurance assuages depositor fears about losing their money, even if a bank fails.
Capital Requirements: By maintaining a certain level of capital, banks have a buffer to absorb losses, reducing the risk of insolvency and boosting customers’ confidence.
Liquidity Requirements: Requiring banks to hold a certain level of high-quality liquid assets ensures they have enough cash to meet short-term obligations.
also, Macro-prudential regulation can help minimise the risk of bank runs.
It is Systemic regulation concerns mainly with the safety and soundness of the (whole) financial system.
While these measures can reduce the possibility of bank runs, the risk can’t be completely eliminated, highlighting the importance of robust risk management practices in banking.
Discuss the rationale for a regulation for pension funds.
Regulation of pension funds is essential for several reasons.
Primarily, it seeks to safeguard beneficiaries’ interests, given that pension funds manage retirement savings of individuals - mismanagement, fraud, or insolvency could lead to significant losses for retirees.
Regulations ensure prudent asset management, and risk control measures, and set out fiduciary duties for fund managers.
They also mandate transparency and regular disclosure, enabling beneficiaries to monitor fund performance.
Another critical aspect is solvency and funding regulations, ensuring pension funds maintain adequate assets against their pension liabilities.
Given pension funds’ sizeable share in the financial market, their practices can have systemic implications, making regulatory oversight important for maintaining overall financial stability.
Hence, the regulation of pension funds strikes a balance between risk control and operational flexibility, ultimately aiming to secure retirees’ financial well-being.
