Things That Ought To Be Remembered

Question 1

What are the main types of risk for a bank?

Answer 1

-credit risk
-interest rate risk
-liquidity risk
-market risk
-sovereign risk
-operational risk
-foreign exchange risk

Question 2

Why’s it important for banks to manage risk?

Answer 2

Risks increase the uncertainty of an FI’s capital and could lead to financial distress.
Also the costs are bourne by customers (deposit holders) not investors.

Question 3

What is credit risk?

Answer 3

The probability that a bank borrower or counterparty will fail to meet its obligations i.e. not pay in full

Counterparties are also important because you could have bought CDSs from other banks as insurance

Question 4

How do banks manage credit risk?

Answer 4

They choose a combination of assets with sufficient risk and they exploit their ability to monitor and screen borrowers

Question 5

How can credit risk actually be measured?

Answer 5

Qualitatively evaluate borrower specific factors
Credit scoring models

Question 6

What is interest rate risk?

Answer 6

Risk that arises when an FI has different asset and liability maturities and sensitivities to interest rates

Question 7

What are the two possible interest rate risk scenarios?

Answer 7

Refinancing risk (liabilities mature before asset)
Reinvestment risk (asset matures before liability)

Question 8

How can interest rate risk be measured?

Answer 8

Gap analysis
Duration model

Question 9

What is liquidity risk?

Answer 9

Arises when an FIs liability holders demand cash
Or when customers on asset size exercise their right to borrow through credit lines

Question 10

What regulation helps with liquidity risk?

Answer 10

BIS requires banks to have a liquidity coverage ratio (LCR) > 100% at all times.

LCR = liquid assets/exp.outflows next 30 days

Question 11

What can banks use to measure liquidity risk?

Answer 11

Liquidity index

This measures the potential losses an FI would suffer from the fire sale of assets

I = sum weighting(firesale/fair price)

Question 12

What is market risk and how do we measure it?

Answer 12

Arises when assets and liabilities are exposed to market risk.
VaR

Question 13

What is foreign exchange risk?

Answer 13

Changes to exchange rates can adversely affect the value of an FI’s assets and liabilities denominated in a foreign currency

Question 14

What is operational risk?

Answer 14

The risk of loss resulting from inadequate or failed internal processes. Includes technology risk

Question 15

What is gap analysis.

Answer 15

Looking at book value changes in assets and liabilities. We only look at rate sensitive assets and liabilities (floating rate)

Question 16

If you have more rate sensitive assets than liabilities, what happens if interest rates increase?

Answer 16

Your profits increase

Question 17

How can gap analysis be extended?

Answer 17

You can split assets and liabilities up according to maturity and compute a weighted gap

Question 18

What are the criticisms of GAP analysis?

Answer 18

-Fails to consider market value effect. Values change according to IR
-Suffers from over-aggregation even within buckets
-Fails to deal with run-offs
-Doesn’t deal with pre-payment risk

Question 19

What is duration analysis?

Answer 19

Looks at the sensitivity of bonds to changes in interest rate.

Change in asset value/change in IR

Question 20

What is the formula for duration?

Answer 20

D=1/V(1C1/1+r + 2C2+P/1+r^2)

Question 21

What are the flaws of the duration measure?

Answer 21

Convexity. The formula implies a linear relationship but it’s actually convex. This gets worse for bigger changes in IR

Data intensive

Question 22

How is market risk measured?

Answer 22

Value at risk (VaR)

This is the sensitivity of your asset to price changes. The maximum you could lose in a certain time period.

Question 23

What is the var formula?

Answer 23

Value of investment * z-score * sigma rt(days)