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Banking & Asset Management > Session3 - Value Creation in banking and impacts of Basel II & III > Flashcards

Session3 - Value Creation in banking and impacts of Basel II & III Flashcards

1
Q

What is seen as a performative level of the “Cost-to-Income-ratio”?

A

Below 50%

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2
Q

How is the “deposits-to-loans-ratio” interpreted?

A

How it should be interpreted: deposits are seen as a stable source of funding - faces a lower liquidity risk if the bank is funded by deposits instead of loans. A higher ratio means a lower liquidity risk.

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3
Q

What is the main point of the Kaupthing-story?

A

1) They didn’t generate value since operating cash flow was negative.
2) They put deposits into the Operating cash flow - Rember, OP CF generates dividends, deposits should not, which was the case here!
3) They also put Loans in the OP CF which is wrong - loans are taken to finance the activity of the firm.

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4
Q

According to IAS 7, what is the definition of Operating CF?

A

Schmidt: Primarily derived from the revenue-producing activities of the entity. They generally result from the transactions and other events that enter into the determination of P&L.

IAS: Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.

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5
Q

According to IAS 7, what is the definition of Investment CF?

A

Schmidt: Cash-flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

IAS: Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

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6
Q

According to IAS 7, what is the definition of Financing CF?

A

Schmidt: Claims on future cash flows by providers of capital to the entity (Cash proceeds from issuing shares, debentures, loans, bonds, ST and LT borrowings, etc)

IAS: Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.

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7
Q

In terms of generating value, is there any relation between ROE and Operating CF?

A

NO!! accounting profitability does not mean the ability to generate value.

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8
Q

In terms of Cash Flow, what’s a big difference between US and Europe?

A

The big difference between EU and US- in EU we can specify how we would like to classify our cash flows, not the case in the US

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9
Q

When valuing a company, what should we look at?

A

1) What is the business model?

2) How does it generate money for the shareholders?

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10
Q

What are the 9 rules of Risk Management?

A
  1. There is no return without risk
  2. Be transparent
  3. Seek experience
  4. Know what you don’t know
  5. Communicate
  6. Diversify
  7. Show discipline
  8. Use common sense
  9. Return is only half the equation
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11
Q

What is the prudential regulation a regulation of? 3 reasons

A
  1. Deposit-taking institutions
  2. SUPERVISION of the conduct of these institutions
  3. SET DOWN requirements that limit their risk-taking
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12
Q

What are the 3 objectives of the Basel Committee?

A
  1. SAFETY: Protect depositors against systematic risk
  2. SOUNDNESS: Ensure stability, Instill confidence in the banking system and prevent gambling.
  3. EFFICIENCY: Set capital as a function of bank risk and ensure banks operate at least cost.
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13
Q

What is the definition of “Agency Relationship”?

A

Agency relationship: ‘contract’ whereby the principal engages the agent to carry out work on behalf of him and delegation of decision-making powers to the agent [Jensen and Meckling (1976)]. E.g.: shareholder: agent when he borrows money

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14
Q

What is the definition of “Moral Hazard”?

A

Moral hazard: the parties to the agreement engages in actions that the other party cannot observe, even though these actions influence the benefits accrued to both parties.

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15
Q

What kind of conflicts can arise from Agency relationships and Moral Hazard issues?

A

Conflicts of interests may arise, leading to a poor allocation of resources. This inefficiency is subsumed under the concept of ‘agency costs’ (increase when financial distress is incurred).

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16
Q

There are 3 kinds of laws in EU, what are they and what do they mean?

A
  1. Primary legislation, i.e. the Treaties and other agreements possessing similar status;
  2. Secondary legislation, i.e. the regulations, directives, decisions, recommendations and opinions based upon the Treaties (see below);
  3. Case law, i.e. judgements of the European Court of Justice and of the Court of First Instance.
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17
Q

What is mean by ‘Acquis communautaire’?

A

Acquis communautaire - if a new country wants to “join” the club then they have to accept these standards, directives and so on.

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18
Q

What are the 2 ways of mitigating agency costs?

A

Negative covenants - prohibiting actions that the company may take:
» Limitation of payout
» Firm may not pledge any of its assets to other lender
» No sell or lease its major assets without approval
» No issue of additional debt

Positive covenants specify an action that a company agrees:
» Maintain working capital at a minimum level
» Periodical reporting

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19
Q

What is the definition of “Regulations”?

A

Regulations: binding and directly applicable in all Member States without any implementing national legislation

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20
Q

What is the definition of “Directives”?

A

Directives: binding on the Member but with the choice of method of implementation left to the Member States. Enforcement is normally the responsibility of the national authorities.

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21
Q

What is meant by “Decision” in relation to Second law?

A

Decisions: may be issued either by the Council or by the Commission and are binding upon those to whom they are addressed, normally a Member State or a commercial enterprise. No national implementing legislation is required.

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22
Q

What is meant by “Recommendations and Opinions” in relation to Second law?

A

Recommendations and Opinions: have no binding effect, and may be issued either by the Council or by the Commission.

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23
Q

Why do we have a Confidence Interval of 99.99% and not 100% in the VaR?

A

1) Because then we would have to have a capital requirement that increases the holdings in equity to an unlogical amount.
2) Also, We use the CI to find all possible solutions and we have no use of taking 100% CI.

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24
Q

What is the formula for the capital requirement?

A

RWA * EAD * Minimum required percentage rate of capital

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25
Q

If we have a probability of default at 100%, how much should be saved to cover the losses?

A

0% because there is nothing that can be saved.

26
Q

What are the 3 approaches of Pillar 1?

A
  1. Standardised Approach
  2. IRB Foundation Approach
  3. IRB Advanced Approach
27
Q

What is the difference between the IRB Foundation Approach and the IRB Advanced Approach?

A

1) All institutions using the IRB approach will be allowed to determine the borrowers’ probabilities of default
2) while those using the advanced IRB approach will also be permitted to rely on own estimates of loss given default and exposure at default on an exposure-by-exposure basis.

28
Q

In terms of VaR, what is meant by PD?

A

1) probability of default (PD) per rating grade

2) which gives the average percentage of obligors that default in this rating grade in the course of one year

29
Q

In terms of VaR, what is meant by EAD?

A

exposure at default (EAD), which gives an estimate of the amount outstanding (drawn amounts plus likely future drawdowns of yet undrawn lines) in case the borrower defaults

30
Q

In terms of VaR, what is meant by LGD?

A

1) Loss Given Default (LGD) - the percentage of exposure the bank might lose in case the borrower defaults.
2) These losses are usually shown as a percentage of EAD, and depend, amongst others, on the type and amount of collateral as well as the type of borrower and the expected proceeds from the work-out of the assets.

31
Q

What is the formula for EL (Expected Losses)?

A

EL = PD * EAD * LGD

32
Q

What is meant by Pillar 1 of Basel II?

A

Pillar I provides methodologies for the calculation of capital requirements to cover credit risk, operational risk and market risk.

33
Q

What is meant by Pillar 2 of Basel II?

A

1) It’s about the relationship between financial institutions and supervisor.

2) This includes the rules for internal process, risk control and internal governance, like:
- How should we govern the financial institutions from a risk perspective?
- What are the roles and responsibilities of each parties in the company, from the board, executive management, senior management, junior management all employees, etc.?

3) Everyone has a rule in risk management.

34
Q

What is meant by Pillar 3 of Basel II?

A

Pillar III aims at enhancing market discipline in the financial sector by providing information to external stakeholders.

35
Q

With Basel III, there is generally supervision on an individual basis BUT supervision could also be done on an consolidated basis if….?

A

1) There is no foreseable impediment to the prompt transfer of own funds or repayment of liabilities by the parent undertaking
2) The parent undertaking manages the subsidiary prudently and guarantees the commitments of the subsidiary
3) The risk evaluation, measurement and control procedures of the parent undertaking cover the subsidiary
4) The parent undertaking holds more than 50 % of the voting rights within the subsidiary

36
Q

With Basel III, there are 2 big pilars, which ones?

A

1) The Reinforcement of the Capital requirement - solvency ratio
2) Liquidity ratios

37
Q

What kind of capital is “Common Tier Equity 1”?

A

Tier 1 Capital = Liabilities that looks like Common Equity 1, > 5 years.

Should be seen as long term capital used for financing

38
Q

What is meant by a “Conservation Buffer”?

A

1) In periods of better times we should set aside capital, 0 - 2.5%, for bad times.
2) If we do not meet this requirement then there is a huge limitation of dividends being paid out.

39
Q

What is meant by a “Countercyclical Buffer”?

A

1) Says that, in next year (for example) we need this amount of capital, so this amount of capital has to be put aside from assets.
2) depends on the national regulators who can chose between 0,5 to 2,5% of the RWA depending on the economic situation of the country. The regulatory capital is now, with Basel 3, 12-13% of the RWA, instead of 8%.

40
Q

What are the 2 objectives of “The Leverage ratio”?

A

1) Constrain build-up of leverage in the banking sector

2) Complement risk-based requirements with non-risk based “backstop” measures

41
Q

What does RAROC stand for and how is it calculated?

A

It’s the Risk Adjusted Return on Capital. Derived by:

RAROC = [(Net Revenues - Expected Loss )/(Economic Capital)]

42
Q

What is meant by “Economic Capital”?

A

1) Economic capital - the kind of capital that we need to cover our risk, given a certain time horizon at a certain confidence level.
2) Expect it to be in order with the regulatory capital.

43
Q

What’s the idea with the Mindset of Corporate Finance?

A

1) To generate value and to calculate to what extent value is generated,
2) by measuring the market value, has to do with the discounted free cash flows,
3) which has to do with how we split/distribute the cashflows between shareholders and debtholders.

44
Q

What impact has the regulation of Basel III, in terms of the capital requirement, on RAROC/ROE if Pricing Margin is constant?

A

The ratio decreases.

45
Q

What impact has the regulation of Basel III, in terms of the capital requirement, on Pricing Margin if RAROC/ROE is constant?

A

The pricing margin increases.

46
Q

What could be the side effect of having increased the Capital Requirement?

A

In order for bank to meet the new requirement they either have to increase their Risk-Weight (RW) or they have to increase Assets (A).

  • increase RW –> More risk
  • Increase A –> May have to borrow money –> More risk
47
Q

What should be the focus when we asses a business?

A

Focus on value and how that is generated.

48
Q

There exists 2 liquidity standards, which ones?

A

1) the Liquidity Coverage Ratio (LCR)

2) The Net Stable Funding Ratio (NSFR)

49
Q

When does liquidity risk arise?

A

Asset liquidity risk arises when:

1) a transaction cannot be conducted at previling market prices due to the size of the position relative to normal trading lots.
2) Funding risk: unable to meet obligations
3) (CF risks): Maturity mismatch

50
Q

What is the definition of LCR?

A

Stock of high-quality liquid assets / Total net cash outflows over the next 30 calender days > 100%

51
Q

What is the objectives of LCR?

A

According to Schmidt: To see to what extent we have assets that can be turned into liquidity to meet our liquidity needs.

to the slides: 
• Ensure that a bank maintains an adequate level of 
     » Unencumbered
     » High-quality 
     » Liquid assets

• that can be converted into cash
» To meet its liquidity needs
» For a 30 calendar day time horizon
» Under a significantly severe liquidity stress scenario.

52
Q

What are the Fundamental and Market characteristics of High-quality liquid assets (HQLA)?

A 
Fundamental: 
• Low credit and market risk
• Ease and certainty of valuation
• Low correlation with risky assets
• Listed on a developed and recognized exchange market
Market: 
• Active and sizeable market
• Presence of committed market makers
• Low market concentration 
• Flight to quality
53
Q

Give some examples of HQLA

A

Level 1 Assets:
Cash
Central Bank reserve
Sovereign bonds

Level 2 Assets:
Claims on or guaranteed by sovereigns
Corporate and covered bonds

54
Q

How is the denominator, in LCR, calculated?

A

Outflows - MIN of (inflows; 75% of outflows)

I.e, can’t be lower than 25% of the outflows.

55
Q

What are the objectives of NSFR?

A
  • To ensure that long-term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles;
  • To limit over-reliance on short-term wholesale funding and encourage better assessment of liquidity risk across all on- and off-balance sheet items.
56
Q

What is the definition of NSFR?

A

Available amount of stable funding / Required amount of stable funding > 100%

Moreover, Sources of funding / Uses of funding

57
Q

What are the Liquidity metrics?

A 
» Contractual maturity mismatch 
» Concentration of funding
» Available unencumbered assets 
» LCR by significant currency
» Market-related monitoring tools
58
Q

When is there a supervision of a singel liquidity group?

A

» The parent institution “monitors at all times the liquidity positions” of all institutions within the group;

» The institutions making up the sub-group have entered into “contracts that provide for the free movement of funds between them” to enable them to meet their individual and joint obligations as they come due;

» There are “no foreseable impediments” to the fulfilment of the above contracts.

59
Q

The consolidated supervision requires international agreement on….

A

» The adequacy of the organisation and the treatment of liquidity risk;

» The distribution of amounts, location and ownership of the required liquid assets to be held within the sub-group;

» Minimum amounts of liquid assets to be held by each institution;

60
Q

What are some potential impacts of the liquidity standards?

A

Leasing - Increase of high liquid assets; decrease lending capacity

Tier 2 capital - Higher quality and quantity of resources

Debt - Higher maturity

61
Q

Accounting solvability is the ability to generate value, YES or NO?

A

NO!

» Accounting solvability does not mean ability to generate value

Just an accounting metric

Banking & Asset Management (11 decks)

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