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CFA Level II > Financial Institutions > Flashcards

Financial Institutions Flashcards

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1
Q

What do Financial institutions do

A
  • Provide a range of products and services including Serving as an intermediary between providers and users of capital
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2
Q

Why are financial institutions important

A
  • Systematic Importance
    ○ Interdependencies introduce a system-wide risk of failure when one member fails - a contagion effect
    ○ To avoid financial contagion, bank deposits are often insured up to a certain limit by the government
    • Regulated
      ○ Highly regulated and include minimum capital requirements, minimum liquidity requirements, and limits on risk-taking
    • Assets
      Financial assets such as loans and securities that are reported at FMV
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3
Q

What are Key Aspects of financial regulations of financial institutions

A
  • Financial contagion may spread beyond a single economy
    • To manage global systemic risk, global and regional regulatory bodies coordinate rules and oversight.
      Uniformity in standards also prevents regulatory arbitrage
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4
Q

What is the Basel Committee on Banking Supervision

A
  • committee develops the regulatory framework for banks (currently Basel III) to increase the banking sector’s ability to absorb economic and financial shocks
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5
Q

What are the 3 Pillars of Basel III

A
  1. Minimum capital requirements - based on the risk of the bank’s assets. Riskier the assets, the higher the required capital.
    1. Minimum liquidity - hold enough liquid assets to meet demands under a 30-day liquidity stress scenario
    2. Stable funding - stable funding required relative to liquidity needs over a 1-tear horizon.
      • proportional to the tenor of the bank deposits(dependent on the type of deposit)
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6
Q

What are Other global organizations that coordinate regulations

A
  • Financial stability Board
    ○ Coordinate actions of participating jurisdictions in identifying and managing systemic risks
    • International Association of Deposit insurers (
      ○ Improve the effectiveness of deposit insurance systems
    • International Organization of Securities Commissions (IOSC)
      ○ Promote fair and efficient security markets
    • International Association of Insurance Supervisors (IASC)
      Improve supervision of insurance industry
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7
Q

What is CAMELS

A
  • CAMELS approach is a six-factor analysis of a bank
    Capital adequacy
    Asset quality
    Management
    Earnings
    Liquidity
    Sensitivity
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8
Q

What does it mean that capital adequacy

A
  • To prevent financial insolvency, a bank must maintain adequate capital to sustain business losses.
    -Based on risk-weighted Assets (RWAs), more risky assets require a higher level of capital
  • RWAs specified by individual regulators
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9
Q

How does Basel III define a bank’s capital in a tiered, hierarchical approach

A

○ Tier 1 Capital
§ Common Equity Tier 1 Capital
□ Common stock, additional PUC, RE and OCI less intangibles and deferred tax assets
§ Other Tier Capital
□ Subordinated instruments with no specified maturity and no contractual dividends
○ Tier 2 Capital
§ Subordinated instruments with original maturity of more than 5 years
* Tier 1 capital plus Tier 2 capital makes up the total capital of a bank.

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10
Q

what are the Basel III guidelines

A
  • Minimum Common Equity Tier 1 capital of 4.5% of RWA
    • Minimum total Tier 1 capital of 6% of RWA
    • Minimum total capital of 8% of RWA.
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11
Q

What are Loan Loss Provisions and How are they evaluated

A
  • Credit quality of loans and loss provisions are critical in evaluating the bank’s financial position and performance
    Allowance for loan losses - contra asset account to loans and is the result of provision for loan losses and expense subject to management discretion
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12
Q

How is credit Risk analysis done under CAMELS

A
  • Nature of bank’s business entails a large exposure to credit risk
    • Credit risk is in debt securities that the bank invests in
      Provide key insights into the bank’s solvency and future profitability.
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12
Q

What is Asset Quality under CAMELS

A
  • Derives process from the processes of generating assets, managing them and controlling overall risks
    *Evaluation of asset quality include analyses of current and potential credit risks associated with bank assets
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13
Q

What are the Types of inputs for earnings?

A
  • Level 1 - quoted market prices of identical assets
    • Level 2 - observable but not quoted prices of identical assets
  • Level 3 - Non-observable and subjective

Banks use the FV hierarchy to label their assets or label their valuation methodology
Subjective estimates affects the quality of a bank’s earnings

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13
Q

What does a bank balance sheet contain?

A

○ Reverse repurchase agreements - bank loans advances under a repurchase agreement
○ Assets held for sale - discontinued operations whose value in the balance sheet assumes disposition
* Bank Assets include:
○ Loans - amortized costs
○ Investments in securities
§ Under GAAP
- Equity Investments: Carried at FV through profit or loss
- Debt Securities: carried at amortized cost, FV through OCI and FV through P&L
§ IFRS
- Debt Securities: Carried at amortized cost, FV through OCI and FV through P&L
- Equity Securities: carried at FV

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13
Q

What is management capabilities under CAMELS

A
  • Quality of a bank management influences the success which bank is able to exploit profitable opportunities and control risk level
    • Risk management and control is critical
      ○ Identification adn control of different types of risk
    • Internal control and governance systems ensure that managers do not take undue risks or engage in self-serving behaviour.
    • BOD sets max allowable risks for managers
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14
Q

What are Earnings under CAMELS

A
  • Considered high quality if they are adequate as well as sustainable.
    • Trend in earnings should be positive and underlying accounting estimates should be unbiased and earnings should be derived from recurring sources.
    • Major source of earnings - investment in securities
      ○ Estimates used in valuation may lead to biased earnings
      Use the concept of FV hierarchy based on types of inputs
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15
Q

What are Major sources of earnings for a bank

A

Major sources of earnings for a bank
* Net interest income
* Service income
* Trading income - volatile year-to-year
Banks with higher net interest and service income have more sustainable earning

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16
Q

How does Government Support impact financial institutions

A

Government Support
* Serves as a backstop against bank failure due to the systemic importance of the banking sector
* Expected level of government support is related to the inter-linkages in the banking sector.
* Larger the bank, more interlinked it is and more likely its failure will have a contagion effect.
* Current status of the banking sector in the country should be considered.
Implicit support level is inversely related to the overall health of the banking sector; during good times, support levels are low

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17
Q

How does Government Ownership impact financial institutions

A

Government Ownership
* Public ownership due to strategic importance of banks in promoting economic development.
* Absent government ownership depositors may not have faith in the sector.
Public ownership increases faith in a the bank and vise versa.

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18
Q

What is a Bank’s Mission

A
  • Banks may pursue other objectives apart from profit making such as community development
    • If a community is dependent on a primary industry, it may lead to concentration of risks in a bank’s asset portfolio
19
Q

What is a culture of financial inst.

A

Culture
* Influences its propensity to seek risky investments
* Relatively conservative culture may result in calculated risk-taking
Too risk averse, it may fail to provide an adequate ROI

20
Q

How is the Culture of a Financial Inst. evaluated

A

Evaluation of culture based on a review of
1. Diversity of a bank’s assets
2. Accounting restatements due to failures of internal controls pertaining to FS reporting
3. Management compensation
4. Speed with which a bank adjusts its loan loss provisions relative to actual loss behavior. Slower response rate generally indicates aggressive accounting practices and risk taking culture.

General factors that are relevant to analysis of any company
* Competitive environment
Off balance sheet assets/liabilities

21
Q

How is sensitivity to market risks evaluated for financial inst.

A
  • Bank earnings are affected by various market risks (volatility of security prices, interest rates and currency values)
  • Most critical risk is interest rate risk
  • Bank’s interest rate risk = differences in maturity, rates and reprising frequency between bank’s assets and liabilities.
  • Banks respond to opportunities presented in the market and alter their balance sheets
  • Impact of change in the shape of a yield curve differs among banks based on the differences in composition of their assets and liabilities
  • MD&A has disclosures for banks exposure to wide variety of market and non-market risks
    Impact of the marker risks can be captured by value at risk (VaR).
22
Q

What are the liquidity standards for banks

A

Liquidity Coverage Ration (“LCR”)
Net Stable funding ratio (“NSFR”)
Concentration of funding and maturity mismatch

23
Q

How is Liquidity for Financial inst. measured under Liquidity Coverage Ration (“LCR”)

A

High liquid assets/expected cash outflows
○ High-liquid assets are those that are easily convertible into cash
○ Expected cash flows are estimated one-month liquidity needs in a stress scenario
○ Minimum LCR of 100% recommended

24
Q

How is Liquidity for Financial inst. measured under Net Stable funding ratio (“NSFR”)

A

Available stable funding/required stable funding
○ Available stable funding (“ASF”) is a function of the composition and maturity distribution of a bank’s funding sources
○ Required Stable funding is a function of the composition and maturity distribution of a bank’s asset base
○ ASF is determined based on an ASF factor assigned to each funding source
○ NSFR relates the liquidity needs of a bank’s assets to the liquidity provided by the bank’s liabilities
§ Longer-dated liabilities are considered more stable and more suitable to fund assets with longer maturities.
§ Deposits from retail and small business clients are considered more stable than deposits from corporate clients
Recommended Min NSFR = 100%

25
Q

How is Liquidity for Financial inst. measured under Concentration of funding and maturity mismatch

A

○ Other liquidity monitoring metrics
○ Low-concentrated funds indicate the bank’s reliance on relatively few funding sources
§ Lack of diversification may be resulting in a heightened liquidity risk for the bank
○ Maturity Mismatch
§ Occurs when asset maturities differ from meaningfully from maturity of liabilities (funding sources)
The higher the mismatch, the higher the liquidity risk for the bank

26
Q

What is sensitivity to market risks in CAMELS re: financial inst.

A
  • Bank earnings are affected by various market risks (volatility of security prices, interest rates and currency values)
  • Most critical risk is interest rate risk
  • Bank’s interest rate risk = differences in maturity, rates and reprising frequency between bank’s assets and liabilities.
  • Banks respond to opportunities presented in the market and alter their balance sheets
  • Impact of change in the shape of a yield curve differs among banks based on the differences in composition of their assets and liabilities
  • MD&A has disclosures for banks exposure to wide variety of market and non-market risks
    Impact of the marker risks can be captured by value at risk (VaR).
27
Q

What is the impact of government support on Banks

A
  • Serves as a backstop against bank failure due to the systemic importance of the banking sector
    • Expected level of government support is related to the inter-linkages in the banking sector.
    • Larger the bank, more interlinked it is and more likely its failure will have a contagion effect.
    • Current status of the banking sector in the country should be considered.
    • Implicit support level is inversely related to the overall health of the banking sector; during good times, support levels are low
28
Q

What is the impact of government ownership on Banks

A

Government Ownership
* Public ownership due to strategic importance of banks in promoting economic development.
* Absent government ownership depositors may not have faith in the sector.
Public ownership increases faith in a the bank and vise versa.

29
Q

What is the impact of bank mission on Banks

A
  • Banks may pursue other objectives apart from profit making such as community development
    If a community is dependent on a primary industry, it may lead to concentration of risks in a bank’s asset portfolio
29
Q

What are P&C insurance sources of income and profitability?

A

P&C Insurance Companies
* Premium income - the source of income
Profitability dependent on
a. Pricing of adequate premium’s for bearing risks
b. Diversification of risks
Done through reinsure some risks
Short policy periods with premiums received at the beginning of the period invested during the float period
Claim events are defined

30
Q

What is the impact of culture on Banks

A

Culture
* Influences its propensity to seek risky investments
* Relatively conservative culture may result in calculated risk-taking
Too risk averse, it may fail to provide an adequate ROI

31
Q

How to evaluate the culture of a bank

A

Evaluation of culture based on a review of
1. Diversity of a bank’s assets
2. Accounting restatements due to failures of internal controls pertaining to FS reporting
3. Management compensation
4. Speed with which a bank adjusts its loan loss provisions relative to actual loss behavior. Slower response rate generally indicates aggressive accounting practices and risk taking culture.

General factors that are relevant to analysis of any company
* Competitive environment
Off balance sheet assets/liabilities

32
Q

What are the differences between P&C and L&H insurance?

A
  • Insurance company revenues include premium income and income on float
    • Property and casualty (P&C) insurers differ from life and health (L&H) insurers in terms of variability of claims and contract duration
    • Claims for P&C tend to be lumpier and L&H are relatively stable and predictable
    • Policy period for L&H are longer than P&C
33
Q

What are the profitability cycles of P&C

A
34
Q

What is capitalization req related to insurers?

A
  • No-global risks based capital requirement standards for insurers
    ○ EU has Solvency II standards
    NAIC in US specified min capital levels based on size and risk
34
Q
A
35
Q

What is dividends to policy holders

A
  • Dividends to Policyholders (shareholders) ratio - liquidity measure - cash outflow on account of dividends relative to premium income
    Dividends to Policyholders ratio = Dividends to Policyholders (Shareholders)/Net Premiums earned
35
Q

What is CRAD and how to calculate it?

A
  • Combined ratio after Dividends (CRAD) - Measures total efficiency and more comprehensive than the combined ratio
      CRAD = Combined Ratio + dividends to policy shareholders ratio
	
      = [Loss expense + Loss adjustment Expense + Claims Paid + Change in loss reserve +
Dividends to Policyholders (Shareholders)] / Net Premiums Earned
36
Q

What is combined RAtio?

A
37
Q

What is the loss adjustment expense ratio (re: insurance companies)

A
  • Loss and loss adjustment expense ratio - Measures relative success in estimation of risks insured
    Loss and Loss adjustment expense ratio =[ Loss Expense + Loss adjustment Expense ]/Net premiums earned
38
Q

What is the soft pricing period

A
  • Soft pricing period - price cutting to obtain new business leads to slim or negative margins
    ○ Leads to losses adn shrinking capital base for many insurers
    ○ Makes insurers to leave the industry or stop underwriting new policies
    ○ Resulting reduction in competition leadings to a healthier pricing environment (hard pricing period)
39
Q

What is the hard pricing period

A
  • Hard Pricing Period
    ○ Results in fatter margins
    Attracts new competition- perpetuating the cycle
40
Q

What drives soft and hard pricing and expenses

A
  • Major expenses for P&C insurers include claims expense and expense of obtaining new policy business
    ○ Cost of writing new policies depends on whether the insurer uses direct to customer model or agency model
    • Soft or hard pricing driven by the industry’s combined ratio (total insurance expenses/ net premiums earned)
      When the ratio is low, its is hard market and vise versa.
41
Q

What is the combined Ratio

A
  • Combined Ratio per statutory accounting practices : Underwriting loss ratio + expense ratio

Underwriting loss ratio = [Claim Paid + change in loss reserve ]/Net Premium earned

Measures the relative efficiency of the company’s underwriting standards

Also called loss and loss adjustment expense

42
Q

What is the Expense Ratio and what does it measure?

A

Expense Ratio = [Underwriting Expenses including commissions ]/ Net Premiums Written

Measures efficiency of the company operations

Also called underwriting expense ratio

43
Q

What is the loss Reserve?

A
  • Loss Reserve is an estimated value of unpaid claims.

○ Subject to management discretion in measurement, loss reserve is highly material amount

○ Usually revised when more information becomes available

§ Downward revisions indicate the company was conservative in estimating their losses

Upward revisions indicate aggressive profit booking, a warning sign

44
Q

What are 5 characteristics of L&H Insurance companies?

A
  • Revenue Diversification:
    Income generated can vary over time and among insurers
    Premium income tends to be more stable overtime relative to other sources

Earnings Characteristics:

Investment Returns:
1.Longer float period than P&C insurers,
2. Investment returns are key components of the insurer’s profitability
3. Large portion of the portfolio is long-term debt
4. Duration of mismatch between A&L is an area of concern

  • Liquidity:
    1. Liquidity needs are fairly predictable - excess liquidity is not much of a concern
    2. Analysis of liquidity includes analyzing insurers investment portfolio
    3. Non-investment grade bonds and equity real estate are relatively illiquid
  • Capitalization -
    1. No global minimum capitalization standards
    2. Domestic regulators specify risk adjusted min capital requirements.

CFA Level II (7 decks)

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