FMP1 - Banks

Question 1

Identify major risks faced by banks and explain ways these risks can arise

Answer 1

1. market risks arise from exposure to market variables
2. credit risks arise from borrowers not being able to repay their loans
3. operational risks is loss arising from inadequate or failed internal processes, people, systems, or external events

Question 2

Distinguish between economic capital and regulatory capital

Answer 2

Regulatory capital is minimum required by regulators, economic capital is bank’s own estimate of what is required

Question 3

Summarise Basel Committee regulations for regulatory capital and their motivations

Answer 3

• All countries capital requirements calculated in the same way
• Require banks to calculate capital required for market, credit, and operational risk
• Going to include equity capital in Basel III
• Motivation is bank trading activities increased in 90s, then revisions due to 2007-08 financial crisis

Question 4

Describe distinctions between the banking book and the trading book of a bank

Answer 4

Trading book is assets and liabilities held for trading, subject to market risk requirement calculations. Banking book is assets and liabilities held to maturity, subject to credit risk requirement calculations.

Question 5

Explain how deposit insurance gives rise to a moral hazard problem

Answer 5

Could encourage banks to take on risks they normally would not if insurance was not in place

Question 6

Describe investment banking financing arrangements including private placement, public offering, best efforts, firm commitment, and Dutch auction approaches

Answer 6

• Private placement is where securities sold with a small number of large institutional investors, firm received agreed price
• Public offering is where securities go on sale to general public, firm receives money on best effort / firm commitment basis
• Best efforts is where bank tries to sell at an agreed price but no guarantee of it, bank paid a fee if successful
• Firm commitment is where bank buys all securities at agreed price and sells them on for profit
• Dutch auction is where all investors invited to submit bids for how many shares they want and at what price. Order bids by number of shares requested smallest to largest - price set where cumulative shares = shares available, everyone up to there gets that price

Question 7

Explain the originate-to-distribute banking model and discuss its benefits and drawbacks

Answer 7

Bank will originate a loan and then sell it on to an investor. Means banks remove loans from their balance sheets but the investors then carry credit risk

Question 8

Describe potential conflicts of interest among commercial banking, securities services, and investment banking divisions of a bank and recommend solutions to these problems

Answer 8

Use of confidential information across divisions to influence decisions etc, use Chinese Walls