Questions and answers on finance
Q1：False. Northern Rock did not have any subprime loans, and the loan quality of Northern Rock’s lending assets was good. Northern Rock ‘s explanation for loss is because Northern Rock ‘s wealth has concentrated entirely on mortgages, and deposits account for a competitively low proportion.
It has led to very weak resistance to the risk. Also, liquidity shock is difficult to withstand in stock market recession for Northern Rock, because it was highly dependent on financing from securities notes and low liquid assets (high subprime mortgages). So the argument is false.
Q2: False. Continental Illinois had fewer branches that led to lower operating volumes. Still, wholesale funding in Continental Illinois is costly because it is highly dependent on wholesale funding for the energy industry, which had a low net interest margin and a high annual interest rate. The high cost of financing increases funding costs.
Q3: False. In RAROC calculation, duration model is always used to assess the loan risk, but it cannot adjust the interest rate risk of the return. To assess the interest risk, the repricing model and the maturity model are used.
Q4: True. Class R is a residual CMO class. Upon the retirement of all other classes, owners have the right to residual collateral plus reinvestment revenues. Its duration is negative. When interest rises, the reinvestment income will rise, and class value will increase with the increase of interest.
Q5: False. FICO score is calculated in a credit report by many different credit dates; it includes owed amounts, payment history, new credit, length of credit history, credit mix. Salary is not a factor in determining a FICO score. So this statement is false.
Q6: False. FDIC is the Federal Deposit Insurance Corporation, an insurance company that provides ex-post deposit insurance to commercial savings customers, not insurance.
Q1
Financial institutions must meet many risks; the main risks include interest rate risk, market risk, credit risk, off-balance-sheet risk, foreign exchange risk, country or sovereign risk, technology risk, operating risk, liquidity risk and insolvency risk. They are not independent; they are interrelated and interdependent. For example, a failed investment in new technology for new systems. It may not produce anticipated cost savings so that it may increase operational risk. It can have significant consequences on business clients, triggering the volatility of the new program, and thereby growing the collateral risk and default risk of the lending organization. Technology risk can, therefore, influence the credit risk, default risk and operational risk of financing institutions. Because of the relationship between these risks, the financing institutions need to consider all risks and their relationship at any time.
Q2: Interest is restricted primarily to debt paid on the underlying mortgages. The formula is used to measure Pio
Discount effect and prepayment are two factors which have an impact on value. For the discount effect, the denominator in this formula will decrease when the interest rate decreases, leading to an increase in value. For prepayment effect, when the interest rate decreases, more people are willing to prepay the loan, so the interest income drops in the future, and the value decreases. In the following graph, when the current interest rate is lower than the coupon rate, the prepayment effect is dominated, so the relationship is positive. If the current interest rate is higher than the coupon rate, it is dominated by the discount effect, so there is a negative relationship between the IO bands and the current interest rate. Therefore, the relationship between the IO strips and the current interest rate is shown as the flowing graph.
Q3: The Z class of the CMO is a type bond that is the last tranche of the CMO, it is a stated coupon and has no value before the previous classes have been withdrawn, so it has the characteristics of a zero-coupon bond. Also, the Z-Class CMO has a nominated coupon rate because it is a stated coupon. Therefore, the Z class of the CMO has the characteristics of both a zero-coupon bond and a regular bond.
Q4: Without risk-based deposit insurance, banks can take undue risks because insurance companies providing deposit insurance will bear the costs. Deposit insurance promoted low-risk pricing and reduced discipline of depositors; depositors can only take care of the interest rate and ignore the risk due to the insurance. Additionally, for the deposit insurance, premiums not linked to risk, the bank with different risk pay the same. It triggered moral hazards. With risk-based deposit insurance, bank discipline is increased by banks taking excessive risk, banks with higher risk are required to pay more for deposit insurance than low-risk banks, banks are required to pay more attention to risk management. The risk-based deposit insurance program thus mitigates moral hazard.
Q1: Banks, especially in bad times, need capital. When the economy turns to the downturn, the banks have higher costs, because financing is difficult. They also have higher risk-adjusted assets, which are expected to fall in a recession due to asset value. Banks also need more capital because of the higher-risk adjusted assets, according to Basel iii. The decreased consent value could result in a low recovery ratio and fire sale.
Moreover, for borrowers, some small businesses shut down for a long time during the COVID-19 outbreak period, many workers are uncertain about when their next paycheck will arrive, decreasing revenue and decreasing asset value leading to high credit risk for banks. Also, many Americans were already overstretched before the pandemic, and this also leads to high default risk. Therefore, banks need to have higher lending standards to reduce credit risk and default risk when a recession occurs.
Q2: It exposes the bank to very high risk if the bank charges the riskier borrowers with a higher rate, and the total volume of loans will be large. The regulators are demanding more capital for banks, according to Basel III. In a recession, bank financing is tough and expensive. Furthermore, small businesses always have a high credit risk and default risk, and their asset values also fall in recession. This can lead to banks running once they default. Thus, banks might tighten the lending standard in recession to decrease the volume. Limiting loans to low-income groups can reduce the risk to banks, maintain the asset quality of the bank and reduce procyclical loans.
Q3: When the economy booms, the procyclical external rating will rise, banks willing to lend loans owing to the valued asset. It leads to a higher value loan. The changed business cycle, however, represents the potential risk. There is a high default risk with the decreasing income and asset value of the borrowers once the economy turns toward a downturn. Hence, the procyclical external rating can lead to ex-ante excessive risk-taking and bank losses ex-post downturn.
Furthermore, the capital requirement increases with the better economic environment according to Basel III. In a boom, the external procyclical rating is high, and the lending increases overall by banks, the regulation will demand more capital for banks. With the decreasing overall loan and low capital regulation, the capital requirement will decrease in regression in the opposite.
The requirement for countercyclical capital can reduce the potential risk from the external procyclic ratings. With high capital regulation, it can limit the overall loan and reduce ex-ante excessive risk and ex-pose downturn. It can also increase financial liquidity and limit banks’ incentive to seek high risk.
Comment: Liquidity coverage ratio refers to the proportion of financial institutions holding highly liquid assets. One of the main contents of the Basel agreement is the liquidity coverage ratio, which requires banks to hold an amount of unencumbered, high-quality liquid assets that are sufficient to fund cash outflow for 30 days. For WallsFather Bank, it has $245.5294m high-quality liquid assets, and its liquidity coverage ratio is 1353.71%, outdistance 100%. The WallsFather Bank, therefore, holds sufficient high-quality liquid assets and retains certain levels of fiscal solvency to survive a significant 30-day street scenario.
Customer deposit interest rates are rarely more than interest rates on bank loans and advances. The financing costs of Atom banks are high, as a burgeoning business model. It is hard to finance because it is a mobile-only bank. The high-interest rate on deposits is a way of getting deposits.
Q2:
The operating costs/Total assets ratio = ￡17,680,000/￡1,957,337,000= 0.9%
The operating cost / total asset ratio for Atom Bank is 0.9%, lower than for major UK banks. As the UK’s leading mobile-only bank, compared to traditional banks, it only operates online and has no offline branches, saving some operating costs, such as rentals. The ratio for Atom Bank is, therefore, lower than for the major UK banks.