Week 4 Deck

Question 1

What is credit risk?

Answer 1

• Credit risk is the risk that a contracted payment will not be made
• Markets put a price on this risk which is included in the markets purchase price for the contracted payment
The part of the price that is due to credit risk is the credit spread
• Banks and other financial institutions use various models to measure credit risk
• A typical credit risk model uses:
The conditions pf the general economy and those of the specific firm in question as inputs

Question 2

How do banks estimate the amount of ecnomic capital needed to support their credit risk activities?

Answer 2

Banks can employ an analytical framework that relates the required economic capital for credit risk to their portfolio’s probability density function (PDF) of credit losses

Question 3

What is a credit risk model generally used for

Answer 3

Used by a bank to estimate a portfolios PDF

Question 4

What are the two components of credit risk, and what is held to offset UL

Answer 4

Expected loss (EL)
Unexpected loss (UL)

Bank capital is held to offset UL

Question 5

What are the two problems that banks must overcome to manage their credit risk?

Answer 5

• Adverse selection
• Moral hazard

Therefore, banks and other financial institutions (FIs) use a number of principles for managing credit risk

Question 6

What are the principles that banks use to manage their credit risk?

Answer 6

1. Screening and monitoring:
   • Screening
   • Specialisation in lending
   • Monitoring and enforcement of restrictive covenants
2. Long-term customer relationships:
   • Reduce costs of information collection
   • Easier to screen bad credit risks
3. Loan commitments:
   • Promotes long-term relationships
   • Good for information gathering
4. Collateral and compensating balances:
   • Property promised in compensation if borrower defaults
   • Compensating balances often required
5. Credit rationing:
   • Lender refuses loan for any amount no matter what interest rate
     
     • Lender willing to loan less than borrower would like

Question 7

How will a rise/fall in interest rates effect a bank that has more sensitive liabilities than assets

Answer 7

• A rise in interest rate will reduce bank profits

- A decline in interest rates will raise bank profit

Question 8

What is gap analysis and the 3 variants?

Answer 8

• A method of measuring the sensitivity of a banks profit to changes in interest rate (interest rate risk)
• There are variants of gap analysis
  1. Basic gap analysis:
     • Amount of rate sensitive liabilities is subtracted from the amount of rate sensitive assets - the ‘gap’
     • (rate sensitive assets - rate sensitive liabilites) X change in interest rates = change in bank profit
  2. Maturity bucket approach:
     • Addresses the weakness the basic gap analysis
     • Measures the gap for several maturity subintervals, called maturity buckets
  3. Standardised gap analysis:
     • Also improves on the basic gap analysis
       Accounts for different degrees of rate sensitivity among rate sensitive asset and liabilities

Question 9

What is duration analysis? and write the equation

Answer 9

• Duration analysis: measures the sensitivity of the market value (MV) of the banks total assets and liabilities to changes in interest rates

Uses the weighted average duration of a financial institution’s assets and of its liabilities to see how net worth responds to a change in interest rates

see notes for equation

Question 10

How can a bank eliminate the interest rate risk? (2)

Answer 10

• shorten the duration of the assets or

- Lengthen the duration of its liabilities

Question 11

What are off-balance sheet activities?

Answer 11

• Off-balance sheet activities generate income for banks but do not appear on the balance sheets

	- Loan sales (secondary loan participation)
	- Generation of fee income. Examples:
		- Servicing mortgage backed securities
		- Creating SIVs (structures investment vehicles,) which can potentially expose banks to risk, as it happened in the global financial crisis
	- Trading activities and risk management techniques:
		- Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation
		- Principal-agent problem arises

Question 12

What are the Internal controls to reduce the principal-agent problem: (4)

Answer 12

• Separation of trading activities and bookkeeping
• Limits on exposure
• Value-at-risk
• Stress testing

Question 13

Rogue traders and the principal agent problem

Answer 13

• Rogue traders have bankrupt their banks due to a failure of banks maintaining proper internal controls• For instance, the demise of Barings, a venerable British bank more than a century old

Sad moral tale of how the principal agent problem operating through a rogue trader can take a financial institution that has a healthy balance sheet one month and turn it into an insolvent tragedy the next

Question 14

What are the two classifications of climate risk?

Answer 14

Climate risk classified into:

1. Physical risks - landslides, floods, wildfires, storms, etc
2. Transition risks - related to the process of adjustment towards a low carbon economy

Climate risk drivers:

1. Physical risks
2. Transition risks

Question 15

What are the banks financial assets (2) and physical assets (1)

Answer 15

→ Liquidity assets
Reserves, cash item in process of collection, deposits at other banks, securities

→ Customer assets (loans) - largest Commercial and industrial assets - real estate and other commercial assets, retail assets - mortgages and other retail assets

physical - Branches, call centres

Question 16

Explain a banks liabilities

Answer 16

1. Wholesale funding
   
   2. Customer deposits
   → Commercial deposits - including non transaction deposits
   → Retails deposits - including non transaction deposits
   → Customer deposits used to calculate a banks loan to deposit ratio base (LDR)· If LDR > 1–% - banks has loan book greater than its deposit base
   · If LDR < 100%$ - bank has loan book less than its deposit base
   · For mission bank, its LDR is 99% (395bn/400bn)
   Banks with high LDR are more reliant on wholesale borrowing

Question 17

How to calc bank capital (equity)

Answer 17

Assets - Liabilities

Question 18

Why do shareholders put themselves in a position where they are the first in line to absorb the losses from a banks bad debt

Answer 18

The answer lies in what is known as the net interest margin (NIM)
(different between the interest rate a bank pays on its liabilities and the interest rate it generates from its financial assets

Question 19

What is asset transformation

Answer 19

Selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics

Question 20

What are the four primary concerns of a bank manager

Answer 20

1. Liquidity Management
2. Asset Management
3. Liability Management
4. Capital adequacy Management

Question 21

What are the goals and tools of asset management?

Answer 21

Goals:

1. Seek highest possible returns on loans and securities
2. Reduce risk
3. Have adequate liquidity

Tools:

1. Find borrowers who will pay high interest rates and have low possibility of defaulting
2. Purchase securities with high returns and low risk
3. Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets

Question 22

What is liability management?

Answer 22

• The decision made by a bank in order to maintain liquid assets to meet the banks obligation to depositors
  
  • A phenomenon due to rise of money centre banks in 1960s
  • Expansion of overnight loan markets and new financial instruments (such as negotiable CDs)
  • Checkable deposits have decreased in importance as source of bank funds

Question 23

What are the 3 main reasons a bank holds bank capital?

Answer 23

1. Helps prevent bank failure
   
   2. The amount of capital affects return for the owners (equity holders) of the bank
      As a regulatory requirement

Question 24

What is ROA and how to calc

Answer 24

Return on assets (ROA:) Net profit after taxes per pound of assets
ROA = net profit after taxes / assets

Question 25

What is ROE and how to calc

Answer 25

Return on equity (ROE:) Net profit after taxes per pound of equity (Bank) capital
ROE = net profit after taxes / equity capital

Question 26

What is an equity multiplier?

Answer 26

Equity multiplier (EM:)the amount of assets per pound of equity capital. It expresses the relationship between ROA and ROE

Question 27

ROE Calc

Answer 27

ROE = ROA X EM

Question 28

What is the trade off between safety and returns to equity holders:

Answer 28

→ Benefits the owners of a bank by making their investment safe
→ Costly to owners of a bank because the higher the bank capital, the lower the return on equity
→ Choice depends on the state of the economy and levels of confidence

Question 29

Explain regulatory requirments

Answer 29

· Banks hold bank capital because it is a requirement by regulatory authorities

· Due to the high costs of holding bank capital, banks prefer to hold less bank capital relative to assets than is required by authorities

· Therefore, the amount of bank capital is determined by the bank capital requirements which takes a global approach

· The setting of a capital adequacy standards are coordinated at a global level by an organisation called the basel committee on banking supervision