EFI 2

Question 1

Ch11 - Q1
What are the benefits and costs to an FI of holding large amounts of liquid assets?
Why are Treasury securities considered good examples of liquid assets?

Answer 1

A major benefit to an FI of holding a large amount of liquid assets is that it can offset any
unexpected and large withdrawals without reverting to asset sales or emergency
funding. If assets have to be sold at short notice, FIs may not be able to obtain a fair
market value. It is more prudent to anticipate withdrawals and keep liquid assets to meet
the demand. On the other hand, liquid assets provide lower yields, so the opportunity
cost for holding a large amount of liquid assets is high. FIs taking conservative positions
by holding large amounts of liquid assets will therefore have lower profits.
Treasury securities are considered good examples of liquid assets because they can be
converted into cash quickly with very little loss of value from current market levels.

Question 2

Ch.11 - Q4
What concerns motivate regulators to require Depository Institutions to hold minimum amounts of liquid
assets?

Answer 2

• Regulators prefer DIs to hold more liquid assets because this ensures that they are
able to withstand unexpected and sudden withdrawals.

• In addition, regulators are able to conduct monetary policy by influencing the
money supply through liquid assets held by DIs.

• Finally, reserves held at the central bank by financial institutions also are a source of funds to regulators, since they pay little interest on these deposits. That is, a minimum required liquid asset reserve requirement is an indirect way for governments to raise additional “taxes” from DIs.
While these reserves are not official government taxes, having DIs hold cash in the vault or cash reserves at the central bank (when
there is only a small interest rate compensation paid requires DIs to transfer a resource to the central bank.

Question 3

Ch.11 Q7
Define the reserve computation period, the reserve maintenance period, and the
lagged reserve accounting system.

Answer 3

The reserve computation period is a two-week period over which the required reserves
are calculated. The actual reserve calculation is accomplished by multiplying the average
daily net transaction accounts balance over this 14-day period times the required reserve
ratio. The exact amount of this reserve calculation is not known with certainty until the end
of the computation period.
The reserve maintenance period is the 14-day period over which the average level of
reserves must equal or exceed the required reserve target.
The lagged reserve accounting system occurs when the reserve maintenance period
begins after the reserve computation period is completed. As long as these two periods do
not overlap, the DI should have little uncertainty regarding the amount of reserves
necessary to be in compliance with regulatory guidelines. (usually 30 days)

Question 4

Ch.12 Q1
What is a contagious run? What are some of the potentially serious adverse social
welfare effects of a contagious run? Do all types of FIs face the same risk of contagious
runs?

Answer 4

A contagious run is an unjustified panic condition in which liability holders
withdraw funds from an FI without first determining whether the institution is at
risk. This action usually occurs at a time that a similar run is occurring at a different
institution that is at risk. The contagious run may have an adverse effect on the level of
savings that may affect wealth transfers, the supply of credit, and control of the money
supply. Depository institutions and insurance companies face the most serious risk of
contagious runs.

Question 5

Ch.12 Q2

How does deposit insurance help mitigate the problem of bank runs?

Answer 5

Bank runs are costly to society since they create liquidity problems and can have a
contagion effect. Because of the first-come, first-serve nature of deposit liabilities, DI
depositors have incentives to run on the DI if they are concerned about solvency. As a
result of the external cost of runs on the safety and soundness of the entire banking
system, the most influential central banks in the world have put into place a safety net to
remove the incentives to undertake DI runs. The primary pieces of this safety net are
deposit insurance and other guaranty programmes that provide assurance that funds are
safe even in cases when the FI is in financial distress.

Question 6

Ch.12 Q3
Contrast the two views on, or reasons why, depository institution insurance funds can
become insolvent.

Answer 6

One view is that insolvency can be explained by external events in the financial
environment such as the rise in interest rates and oil prices that took place in the early
1980s or the crash of the housing market in the 2000s.
The other view is that deposit insurance brings about the types of behaviour that
lead to eventual insolvency. In particular, deposit insurance contributes to the moral
hazard problem whereby DI owners and managers are induced to take on risky projects
because the presence of deposit insurance substantially reduces the adverse
consequences to the depositors of such behaviour.

Question 7

Ch.12 Q4

What is moral hazard in the depository institution industry?

Answer 7

Moral hazard occurs in the depository institution industry when the provision of
deposit insurance or other liability guarantees encourages the institution to accept
asset risks that are greater than the risks that would have been accepted without
such liability insurance.

Question 8

Ch.12 Q5
How does a risk-based deposit insurance programme solve the moral hazard
problem of excessive risk taking by DIs? Is an actuarially fair premium for deposit
insurance always consistent with a competitive banking system?

Answer 8

A risk-based deposit insurance programme should deter FIs from engaging in excessive
risk-taking as long as it is priced in an actuarially fair manner, meaning that insurance
pricing is based on the perceived risk of the insured institution. Such pricing currently is
being practiced by insurance firms in the property-casualty sector. However, since the
failure of commercial banks can have significant social costs, regulators have a special
responsibility towards maintaining their solvency, even providing them with some form of
subsidies. In a completely free market system, it is possible that DIs located in sparsely
populated areas may have to pay extremely high premiums to compensate for a lack of
diversification or investment opportunities. These DIs may have to close down unless
subsidised by the regulators. Thus, a strictly risk-based insurance system may not be
compatible with a truly competitive banking system.
This suggests that, ideally, regulators should design the deposit insurance contract
with the trade-off between moral hazard risk and DI panic or run risk in mind.
For example, by providing 100 percent coverage of all depositors and reducing the
probability of runs to zero, the insurer may be encouraging certain DIs to take a significant
degree of moral hazard risk-taking behaviour. On the other hand, a very limited degree of
deposit insurance coverage might encourage runs and panics, although moral hazard
behaviour itself would be less evident.

Question 9

Ch.13 Q1

Identify and briefly discuss the importance of the five functions of an FI’s capital?

Answer 9

1. The primary means of protection against the risk of insolvency and failure is an FI’s capital. Capital is used to absorb unanticipated losses with enough margin to
   inspire confidence and enable the FI to continue as a going concern.
2. FIs need to hold enough capital to provide confidence to uninsured creditors that they can withstand reasonable shocks to the value of their assets. Thus, capital protects uninsured depositors, bondholders, and creditors in the event of insolvency, and liquidation.
3. The FDIC, which guarantees deposits, is concerned that sufficient capital is held so that their funds are protected, because they are responsible for paying insured depositors in the event of a failure. Thus, the capital of an FI offers protection to insurance funds and ultimately the taxpayers who bear the cost of insurance fund insolvency.
4. By holding capital and reducing the risk of insolvency, an FI protects the industry from larger insurance premiums. Such premiums are paid out of the net profits of the FI. Thus, capital protects the FI owners against increases in insurance premiums.
5. Capital also serves as a source of financing to purchase and invest in assets necessary to provide financial services.

Question 10

Ch.13 Q6

What is the Basel Agreement?

Answer 10

The Basel Agreement identifies risk-based capital ratios agreed upon by the
member countries of the Bank for International Settlements. The ratios are to be
implemented for all DIs under their jurisdiction. Further, most countries in the world now
have accepted the guidelines of this agreement for measuring capital adequacy.

(The Bank for International Settlements
is an international financial institution
owned by central banks which fosters
international monetary and financial
cooperation and serves as a bank for
central banks)

Question 11

Ch.13 Q7

What are the major features of the Basel III capital requirements?

Answer 11

The goal of Basel III is to raise the quality, consistency, and transparency of the
capital base of banks and to strengthen the risk coverage of the capital framework.
Specifically,

• Pillar 1 of Basel III calls for enhancements to the approach to calculating adequate capital.

• Pillar 2 calls for enhanced bank-wide governance and risk management to be put
in place, such as enhanced incentives for banks to better manage risk and returns over the long term, more stress testing, and implementation of sound compensation practices
.
• Pillar 3 calls for the enhanced disclosure of risks, such as those relating to securitisation exposures and sponsorship of off-balance-sheet vehicles.

Question 12

Ch.13 Q8

Under Basel III, what four capital ratios must DIs calculate and monitor?

Answer 12

Under Basel III, depository institutions must calculate and monitor four capital ratios:

• Common equity Tier I risk-based capital ratio = Common equity Tier I capital /credit risk-adjusted assets

• Tier I risk-based capital ratio =
Tier I capital (Common equity Tier I capital +additional Tier I capital) / credit risk-adjusted assets

• Total risk-based capital ratio = 
Total capital (Tier I + Tier II) / credit risk-adjusted assets

• Leverage ratio = Tier I capital / total exposure.

Question 13

Ch.13 Q9
Identify the five zones of capital adequacy and explain the mandatory regulatory actions
corresponding to each zone.

Answer 13

Zone 1: Well capitalised. The four ratios exceed 6.5%, 8%, 10%, and 5%, respectively.
No regulatory action is required.

Zone 2: Adequately capitalised. The four ratios exceed 4.5%, 6%, 8%, and 4%,respectively. Institutions may not use brokered deposits except with the permission of the
FDIC (Federal Deposit Insurance Corporation).

Zone 3: Undercapitalised. The four ratios are less than 4.5%, 6%, 8%, and 4% respectively.
This scenario requires a capital restoration plan.
Asset growth is restricted.
Approval is required for acquisitions, branching, and new activities. It is not allowed the
use of brokered deposits, and dividends and management fees are suspended.

Zone 4: Significantly undercapitalised. The four ratios are less than 3%, 4%, 6%, and 3%, respectively.
The actions required are the same as in zone 3, but here recapitalisation is mandatory, and there are restrictions on deposit interest rates, inter-affiliate transactions, and the pay level of officers.

Zone 5: Critically undercapitalised. Tangible equity to total assets is less than or equal to 2%. This scenario places the bank in receivership within 90 days, suspends payment on subordinated debt, and restricts other activities at the discretion of the regulator.

Question 14

Ch.14 Q7

What is the Herfindahl-Hirschman Index? How is it calculated and interpreted?

Answer 14

The Herfindahl-Hirschman Index (HHI) is a measure of market concentration whose
value can be 0 to 10,000. The index is measured by adding the squares of the percentage
market share of the individual firms in the market. An index value greater than 2,500
indicates a highly concentrated market, a value between 1,500 and 2,500 indicates a
moderately concentrated market, and an unconcentrated market would have a value less
than 1,500.

Question 15

Ch.14 q10
What factors other than market concentration does the Justice Department consider in
determining the acceptability of a merger?

Answer 15

Other factors considered by the Justice Department include:
• ease of entry;
• the nature of the product;
• the terms of sale of the product;
• market information about specific transactions;
• buyer market characteristics;
• conduct of firms in the market; and
• market performance.

Question 16

Ch.14 q12
What are the (six) major advantages of international expansion to FIs? Explain how each
advantage can affect the operating performance of FIs?

Answer 16

1. An FI can benefit from significant risk diversification, especially if the economies of
   the world are not perfectly integrated, or if different countries allow different banking
   activities.
2. An FI may benefit from economies of scale.
3. The returns from new product innovations may be larger if the market is
   international rather than just domestic.
4. The risk and cost of sources of funds both should be reduced.
5. FIs should be able to maintain contact with, and thus provide better service to, their
   international customers.
6. An FI may be able to reduce its regulatory burden by selectively finding those
   countries that have lower regulatory restrictions.

Question 17

Ch.14 q13
What are the difficulties of expanding globally? How can each of these difficulties
create negative effects on the operating performance of FIs?

Answer 17

1. The difficulties of international expansion include the higher cost of information collection and monitoring in many countries. Because the level of customer specific information may not be readily available, the absolute level of lending risk may be higher. Also, coordinating different regulatory rules and guidelines will increase thecost of regulation.
2. The political risk of nationalisation or expropriation may increase the costs to an FI from the loss of fixed assets to the legal recovery of deposits from such action.
3. The establishment of foreign offices may have large fixed costs.

Question 18

Ch.15 q1
What are derivative contracts? What is the value of derivative contracts to the managers
of FIs?

Answer 18

Derivatives are financial assets whose value is determined by the value of some underlying asset. As such, derivative contracts are instruments that provide the opportunity to take some action at a later date based on an agreement to do so at the
current time. Although the contracts differ, the price, timing, and extent of the later actions
are usually agreed upon at the time the contracts are arranged. Normally, the contract values depend on the activity of the underlying asset.
Derivative contracts have value to managers of FIs because of their ability to help in managing the various types of risk prevalent in the institutions. As of 2015 the largest category of derivatives in use by commercial
banks was swaps, followed by futures and
forwards, and then options.

Question 19

Ch.15 q7
What are the differences between a microhedge and a macrohedge for an FI? Why is it
generally more efficient for FIs to employ a macrohedge than a series of microhedges?

Answer 19

A microhedge uses a derivative contract such as a forward or futures contract to hedge the risk exposure of a specific transaction, while a macrohedge is a hedge of the duration gap of the entire balance sheet. FIs that attempt to manage their risk exposure by hedging each balance sheet position will find that hedging is excessively costly, because the use of a series of microhedges ignores the FI’s internal hedges that are already on the balance sheet. That is, if a long-term fixed-rate asset position is exposed to interest rate increases, there may be a matching long-term fixed-rate liability position that also is exposed to interest rate decreases. Putting on two microhedges to reduce the risk exposures of each of these positions fails to recognise that the FI has already hedged much of its risk by taking matched balance sheet positions. The efficiency of the macrohedge is that it focuses only on those mismatched positions that are candidates for off-balance-sheet hedging activities.

Question 20

Ch.15 q8

What are the reasons why an FI may choose to hedge selectively its portfolio?

Answer 20

Selective hedging involves an explicit attempt to not minimise the risk on the balance sheet.
An FI may choose to hedge selectively in an attempt to improve profit performance by accepting some risk on the balance sheet, or to arbitrage profits between a spot asset’s price movements and the price movements of the futures price.

This latter situation often occurs because of differential changes in interest rates caused in part by cross-hedging. For example, an FI manager may generate expectations regarding future interest rates before deciding on a futures position. As a result, the manager may selectively hedge only a proportion of its balance sheet position. Alternatively, the FI manager may decide to remain unhedged or even to overhedge by selling more futures than required by the cash position, although regulators may view this as speculative.

Thus, the fully hedged position – and the minimum risk portfolio – becomes one of several choices depending, in part, on managerial interest rate expectations, managerial objectives, and the nature of the return-risk trade-off from hedging.

Question 21

Ch.15 q9

What is meant by fully hedging the balance sheet of an FI?

Answer 21

Fully hedging the balance sheet involves using a sufficient number of futures
contracts so that any loss (or gain) of net worth on the balance sheet is just offset
by the gain (or loss) from the off-balance-sheet use of futures contracts for given
changes in interest rates. In this case, the FI reduces its interest rate or other risk
exposure to the lowest possible level by selling sufficient futures to offset the interest rate
risk exposure of its whole balance sheet or cash positions in each asset and liability.

Question 22

Ch.15 q10
What is the primary goal of regulators in regard to the use of futures by FIs? What
guidelines have regulators given banks for trading in futures and forwards?

Answer 22

Regulators of banks have encouraged the use of futures for hedging and have discouraged the use of futures for speculation. Banks are required:

1. to establish internal guidelines regarding hedging activity;
2. to establish trading limits;
3. to disclose large contract positions that materially affect bank risk to shareholders and outside investors.

Question 23

Ch.16 q1

How does using options differ from using forward or futures contracts?

Answer 23

Both options and futures contracts are useful in managing risk.
Other than the pure mechanics, the primary difference between these contracts lies in the requirement of what must be done on or before maturity
.
Futures and forward contracts require that the buyer or seller of the contracts must execute some transaction.

The buyer of an option has the choice to execute the option or to let it expire without execution. The writer of an option must perform a transaction only if the buyer chooses to execute the option.

An option is a contract that gives the holder the right (but not the obligation) to buy or sell the underlying asset at a specified price within a specified period of time.

Question 24

Ch.16 q2

What is a call option?

Answer 24

A call option gives the purchaser the right (but not the obligation) to buy the
underlying security at a pre-specified exercise price on or before a specified maturity
date.

Question 25

Ch.16 q3
What must happen to interest rates for the purchaser of a call option on a bond to make
money? How does the writer of the call option make money?

Answer 25

A call option on a bond allows the owner to buy a bond at a specific price.
For the owner of the option to make money, he/she should be able to immediately sell the bond at a higher price. Thus, for the bond price to increase, interest rates must decrease between the time the option is purchased and the time it is executed.

The writer of the call option makes a premium from the sale of the option. If the option is not exercised, the writer maximises profit in the amount of the premium. If the option is exercised, the writer stands to lose a portion or the entire premium and may lose
additional money if the price on the underlying asset moves sufficiently far.

Question 26

Ch.16 q4

What is a put option?

Answer 26

A put option is a contract that gives the owner the right (but not the obligation) to sell
the underlying asset to the writer of the option at the agreed exercise price on or before
a specified maturity date.

Question 27

Ch.16 q5
What must happen to interest rates for the purchaser of a put option on a bond to make
money? How does the writer of the put option make money?

Answer 27

The put option on a bond allows the owner to sell a bond at a specific price.

For the owner of the option to make money, he/she should be able to buy the bond at a lower price immediately prior to exercising the option.
Thus, for the bond price to decrease, interest rates must increase between the time the option is purchased and the time it is executed.

The writer of the put option makes a premium from the sale of the option. If the option is not exercised, the writer maximises profit in the amount of the premium. If the option is exercised, the writer stands to lose a portion or the entire premium, and may lose
additional money if the price on the underlying asset moves sufficiently far.

Question 28

Ch.16 q6
Consider the following:

a. What are the two ways to use call and put options on T-bonds to generate positive cash flows when interest rates decline?

b. Under what balance sheet conditions would an FI use options on T-bonds to hedge its
assets or liabilities against interest rate declines?

c. Is it more appropriate for FIs to hedge against a decline in interest rates with long
calls or short puts?

Answer 28

(a)
The FI can either:
• buy a call option or
• sell a put option
on interest-rate instruments, such as T-bonds, to generate positive cash flows in the event
that interest rates decline.
In the case of a call option, positive cash flows will increase as long as interest rates
continue to decrease.
The sale of a put option generates positive cash flows from the premium received.

(b)
An FI would use call options on T-bonds to hedge an underlying cash position that
decreases in value as interest rates decline. This would be true if, in the case of a
macrohedge, the FI’s duration gap is negative and the repricing gap is positive. In the
case of a microhedge, the FI can hedge a single fixed-rate liability against interest rate
declines.

(c)
An FI is better off purchasing calls as opposed to writing puts for two reasons:
- Regulatory restrictions limit an FI’s ability to write naked short options.
- Since the potential positive cash inflow on the short put option is limited to the size of the put premium, there may be insufficient cash inflows in the event of interest rate declines to offset losses in the underlying cash position.

Question 29

Ch.16 q8

What are caps? Under what circumstances would the buyer of a cap receive a payoff?

Answer 29

A cap is a call option on interest rates. If market interest rates rise above some stated
amount, the writer of the option pays to the holder the excess interest on some amount of
money. For this insurance, the buyer of the option pays a premium. This option would be
a valuable interest rate risk management vehicle for an FI that is borrowing money in the
variable rate market.

Question 30

Ch.16 q9

What are floors? Under what circumstances would the buyer of a floor receive a payoff?

Answer 30

A floor is a put option on interest rates. The buyer receives a minimum interest rate should market rates fall below some minimum level. This option would be a valuable interest rate risk management vehicle for an FI that is lending money in the variable ratemarket.

Question 31

Ch.16 q10

What are collars? Under what circumstances would an FI use a collar?

Answer 31

A collar is a combination of a cap and a floor. A collar occurs when an FI takes a simultaneous position in a cap and a floor, such as buying a cap and selling a floor. The idea here is that the FI wants to hedge itself against rising rates but wants to finance the cost of the cap.

One way to do this is to sell a floor and use the premiums on the floor to pay the premium on the purchase of the cap.

Question 32

Ch.18 q8

In addition to managing credit risk, what are some (five) other reasons for the sale of loans by FIs?

Answer 32

The reasons for an increase in loan sales, apart from hedging credit risk, include:

a. Removing loans from the balance sheet by sale without recourse reduces the amount
of deposits necessary to fund the FI, which in turn decreases the amount of regulatory reserve requirements that must be kept by the FI.

b. Originating and selling loans is an important source of fee income for the Fis.
c. One method to improve the capital ratio for an FI is to reduce assets. This approach often is less expensive than increasing the amount of capital.

d. The sale of FI loans to improve the liquidity of the FIs has expanded the loan sale market. This has made FI loans even more liquid and reduced FI liquidity risk even
farther. Thus, by creating the loan sales market, the process of selling the loans has improved the liquidity of the asset for which the market was initially developed.

e. Loan sales have been considered a substitute for securities underwriting.

Question 33

Ch.18 q9

What are the (three) factors that may deter the growth of the loan sale market in the future?

Answer 33

Several factors may deter the growth of the loans sales market
.
• First, because of the ability for large banks to underwrite commercial paper through
investment bank subsidiaries, the need to sell short-term bank loans as an imperfect substitute for commercial paper has decreased.

• Second, if customers perceive the sale of its loan by an FI as an adverse statement
about the customer’s value to the FI, the FI may choose to not sell the loan for fear of decreasing revenue from the customer relationships.

• Third, the distressed loan sale market has slowed because of legal implications from the sale of HLT (High Leveraged Transaction) loans. Other creditors have questioned whether the secured position of the FI is valid in the case of bankruptcy or other distressed-firm proceedings

Question 34

Ch.18 q10
In addition to hedging credit risk, what are the
(five) factors that are expected to encourage loan sales in the future?

Answer 34

The reasons for an increase in loan sales, apart from hedging credit risk, include:

• New capital requirements for credit risk, which suggests a further need for FIs to
reduce their risky portfolios and replace them with lower risk assets. This suggests increased loan sales activity.

• Loan sales as trading instruments, which make it attractive for commercial banks and investment banks to specialise in specific loan categories and to market them
effectively, since they require only brokerage functions as opposed to performing asset transformations.

• The increased involvement of governments in the loan sales market (through their direct purchases of distressed loans held by financial institutions) during the
financial crisis is seen as a reason for growth in the loan sale market.

• The ability to allocate loan credit ratings should cause more investors to enter the market.
• The growth of distressed loans in international markets should provide opportunities to enter this market at substantially reduced prices.

Question 35

Ch.19 q1
What has been the effect of securitisation on the asset portfolios of financial
institutions

Answer 35

In addition to serving as another mechanism to hedge interest rate exposure gaps, securitisation has provided a method to make asset portfolios more liquid, has
provided an important source of fee income, and has helped to reduce the effects of regulatory taxes.

(Securitisation is the packaging and selling of loans
and other assets backed by securities.)

Question 36

Ch.19 q2
What specific changes occur on the balance sheet at the completion of the securitisation process?
What adjustments occur to the risk profile of the FI?

Answer 36

At the conclusion of the securitisation process, the FI will have:

1. exchanged a loan balance for cash;
2. reduced significantly the duration of its assets, and likely the duration mismatch of the entire balance sheet;
3. reduced the regulatory tax burden.

The risk profile is potentially reduced in two ways:

• Exchanging loans for cash removes any risk-based capital requirements for the FI.
• If the cash is used to repay deposits, reserve requirements may be reduced.

Question 37

Ch.19 q4

What are the factors that allow assets to be securitised? What are the costs involved in the securitisation process?

Answer 37

In general the easiest assets to securitise are those that are homogenous and that can be valued with relative precision.
The homogeneity involves the characteristics of the
contracts, such as maturity, payment schedule, etc., while the valuation process is easiest if the underlying assets are traded in the market.

The costs of the securitisation process include:

• credit risk insurance,
• guarantees,
• over-collateralisation,
• valuation and packaging costs.

Question 38

Ch.19 q6

Can all assets be securitised? Summarise benefits and cost of securitisation.

Answer 38

Conceptually, all assets and loans can be securitised, as long as it is profitable to doso or the benefits outweigh the costs of securitisation. Below is a table summarising the benefits versus the costs of securitisation.

COSTS
-Cost of public / private credit risk insurance and
guarantees
-Cost of over-collateralisation
-Valuation and packaging costs (the cost of asset
heterogeneity)

BENEFITS
-New funding source (bonds versus deposits)
-Increased liquidity of FI loans
-Enhanced ability to manage the duration gap
-If off balance sheet, the issuer saves on reserve
requirements, deposit insurance premium, and capital
adequacy requirements

From the table, given any set of benefits, the more costly and difficult it is to find asset packages of sufficient size and homogeneity, the more difficult and expensive it is to securitise. Specifically, the harder it is to value a loan or asset pool, the higher the costs of securitisation due to the need for over-collateralisation or credit risk insurance.