Week 4 Deck Flashcards
What is credit risk?
• 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
How do banks estimate the amount of ecnomic capital needed to support their credit risk activities?
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
What is a credit risk model generally used for
Used by a bank to estimate a portfolios PDF
What are the two components of credit risk, and what is held to offset UL
Expected loss (EL) Unexpected loss (UL)
Bank capital is held to offset UL
What are the two problems that banks must overcome to manage their credit risk?
- Adverse selection
- Moral hazard
Therefore, banks and other financial institutions (FIs) use a number of principles for managing credit risk
What are the principles that banks use to manage their credit risk?
- Screening and monitoring:
- Screening
- Specialisation in lending
- Monitoring and enforcement of restrictive covenants
- Long-term customer relationships:
- Reduce costs of information collection
- Easier to screen bad credit risks
- Loan commitments:
- Promotes long-term relationships
- Good for information gathering
- Collateral and compensating balances:
- Property promised in compensation if borrower defaults
- Compensating balances often required
- Credit rationing:
- Lender refuses loan for any amount no matter what interest rate
- Lender willing to loan less than borrower would like
- Lender refuses loan for any amount no matter what interest rate
How will a rise/fall in interest rates effect a bank that has more sensitive liabilities than assets
- A rise in interest rate will reduce bank profits
- A decline in interest rates will raise bank profit
What is gap analysis and the 3 variants?
- A method of measuring the sensitivity of a banks profit to changes in interest rate (interest rate risk)
- There are variants of gap analysis
- 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
- Maturity bucket approach:
- Addresses the weakness the basic gap analysis
- Measures the gap for several maturity subintervals, called maturity buckets
- Standardised gap analysis:
- Also improves on the basic gap analysis
Accounts for different degrees of rate sensitivity among rate sensitive asset and liabilities
- Also improves on the basic gap analysis
- Basic gap analysis:
What is duration analysis? and write the equation
• 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
How can a bank eliminate the interest rate risk? (2)
- shorten the duration of the assets or
- Lengthen the duration of its liabilities
What are off-balance sheet activities?
• 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
What are the Internal controls to reduce the principal-agent problem: (4)
- Separation of trading activities and bookkeeping
- Limits on exposure
- Value-at-risk
- Stress testing
Rogue traders and the principal agent problem
- 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
What are the two classifications of climate risk?
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
What are the banks financial assets (2) and physical assets (1)
→ 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
Explain a banks liabilities
- Wholesale funding
- Customer 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
How to calc bank capital (equity)
Assets - Liabilities
Why do shareholders put themselves in a position where they are the first in line to absorb the losses from a banks bad debt
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
What is asset transformation
Selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics
What are the four primary concerns of a bank manager
- Liquidity Management
- Asset Management
- Liability Management
- Capital adequacy Management
What are the goals and tools of asset management?
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
What is liability management?
- 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
What are the 3 main reasons a bank holds bank capital?
- Helps prevent bank failure
- The amount of capital affects return for the owners (equity holders) of the bank
As a regulatory requirement
- The amount of capital affects return for the owners (equity holders) of the bank
What is ROA and how to calc
Return on assets (ROA:) Net profit after taxes per pound of assets
ROA = net profit after taxes / assets
