Financial Institutions

Question 1

What do Financial institutions do

Answer 1

• Provide a range of products and services including Serving as an intermediary between providers and users of capital

Question 2

Why are financial institutions important

Answer 2

• Systematic Importance
  ○ Interdependencies introduce a system-wide risk of failure when one member fails - a contagion effect
  ○ To avoid financial contagion, bank deposits are often insured up to a certain limit by the government
  
  • Regulated
    ○ Highly regulated and include minimum capital requirements, minimum liquidity requirements, and limits on risk-taking
  • Assets
    Financial assets such as loans and securities that are reported at FMV

Question 3

What are Key Aspects of financial regulations of financial institutions

Answer 3

• Financial contagion may spread beyond a single economy
  
  • To manage global systemic risk, global and regional regulatory bodies coordinate rules and oversight.
    Uniformity in standards also prevents regulatory arbitrage

Question 4

What is the Basel Committee on Banking Supervision

Answer 4

• committee develops the regulatory framework for banks (currently Basel III) to increase the banking sector’s ability to absorb economic and financial shocks

Question 5

What are the 3 Pillars of Basel III

Answer 5

1. Minimum capital requirements - based on the risk of the bank’s assets. Riskier the assets, the higher the required capital.
   
   2. Minimum liquidity - hold enough liquid assets to meet demands under a 30-day liquidity stress scenario
   3. Stable funding - stable funding required relative to liquidity needs over a 1-tear horizon.
      
      • proportional to the tenor of the bank deposits(dependent on the type of deposit)

Question 6

What are Other global organizations that coordinate regulations

Answer 6

• Financial stability Board
  ○ Coordinate actions of participating jurisdictions in identifying and managing systemic risks
  
  • International Association of Deposit insurers (
    ○ Improve the effectiveness of deposit insurance systems
  • International Organization of Securities Commissions (IOSC)
    ○ Promote fair and efficient security markets
  • International Association of Insurance Supervisors (IASC)
    Improve supervision of insurance industry

Question 7

What is CAMELS

Answer 7

• CAMELS approach is a six-factor analysis of a bank
  Capital adequacy
  Asset quality
  Management
  Earnings
  Liquidity
  Sensitivity

Question 8

What does it mean that capital adequacy

Answer 8

• To prevent financial insolvency, a bank must maintain adequate capital to sustain business losses.
  -Based on risk-weighted Assets (RWAs), more risky assets require a higher level of capital
• RWAs specified by individual regulators

Question 9

How does Basel III define a bank’s capital in a tiered, hierarchical approach

Answer 9

○ Tier 1 Capital
§ Common Equity Tier 1 Capital
□ Common stock, additional PUC, RE and OCI less intangibles and deferred tax assets
§ Other Tier Capital
□ Subordinated instruments with no specified maturity and no contractual dividends
○ Tier 2 Capital
§ Subordinated instruments with original maturity of more than 5 years
* Tier 1 capital plus Tier 2 capital makes up the total capital of a bank.

Question 10

what are the Basel III guidelines

Answer 10

• Minimum Common Equity Tier 1 capital of 4.5% of RWA
  
  • Minimum total Tier 1 capital of 6% of RWA
  • Minimum total capital of 8% of RWA.

Question 11

What are Loan Loss Provisions and How are they evaluated

Answer 11

• Credit quality of loans and loss provisions are critical in evaluating the bank’s financial position and performance
  Allowance for loan losses - contra asset account to loans and is the result of provision for loan losses and expense subject to management discretion

Question 12

How is credit Risk analysis done under CAMELS

Answer 12

• Nature of bank’s business entails a large exposure to credit risk
  
  • Credit risk is in debt securities that the bank invests in
    Provide key insights into the bank’s solvency and future profitability.

Question 12

What is Asset Quality under CAMELS

Answer 12

• Derives process from the processes of generating assets, managing them and controlling overall risks
  *Evaluation of asset quality include analyses of current and potential credit risks associated with bank assets

Question 13

What are the Types of inputs for earnings?

Answer 13

• Level 1 - quoted market prices of identical assets
  
  • Level 2 - observable but not quoted prices of identical assets
• Level 3 - Non-observable and subjective

Banks use the FV hierarchy to label their assets or label their valuation methodology
Subjective estimates affects the quality of a bank’s earnings

Question 13

What does a bank balance sheet contain?

Answer 13

○ Reverse repurchase agreements - bank loans advances under a repurchase agreement
○ Assets held for sale - discontinued operations whose value in the balance sheet assumes disposition
* Bank Assets include:
○ Loans - amortized costs
○ Investments in securities
§ Under GAAP
- Equity Investments: Carried at FV through profit or loss
- Debt Securities: carried at amortized cost, FV through OCI and FV through P&L
§ IFRS
- Debt Securities: Carried at amortized cost, FV through OCI and FV through P&L
- Equity Securities: carried at FV

Question 13

What is management capabilities under CAMELS

Answer 13

• Quality of a bank management influences the success which bank is able to exploit profitable opportunities and control risk level
  
  • Risk management and control is critical
    ○ Identification adn control of different types of risk
  • Internal control and governance systems ensure that managers do not take undue risks or engage in self-serving behaviour.
  • BOD sets max allowable risks for managers

Question 14

What are Earnings under CAMELS

Answer 14

• Considered high quality if they are adequate as well as sustainable.
  
  • Trend in earnings should be positive and underlying accounting estimates should be unbiased and earnings should be derived from recurring sources.
  • Major source of earnings - investment in securities
    ○ Estimates used in valuation may lead to biased earnings
    Use the concept of FV hierarchy based on types of inputs

Question 15

What are Major sources of earnings for a bank

Answer 15

Major sources of earnings for a bank
* Net interest income
* Service income
* Trading income - volatile year-to-year
Banks with higher net interest and service income have more sustainable earning

Question 16

How does Government Support impact financial institutions

Answer 16

Government Support
* Serves as a backstop against bank failure due to the systemic importance of the banking sector
* Expected level of government support is related to the inter-linkages in the banking sector.
* Larger the bank, more interlinked it is and more likely its failure will have a contagion effect.
* Current status of the banking sector in the country should be considered.
Implicit support level is inversely related to the overall health of the banking sector; during good times, support levels are low

Question 17

How does Government Ownership impact financial institutions

Answer 17

Government Ownership
* Public ownership due to strategic importance of banks in promoting economic development.
* Absent government ownership depositors may not have faith in the sector.
Public ownership increases faith in a the bank and vise versa.

Question 18

What is a Bank’s Mission

Answer 18

• Banks may pursue other objectives apart from profit making such as community development
  
  • If a community is dependent on a primary industry, it may lead to concentration of risks in a bank’s asset portfolio

Question 19

What is a culture of financial inst.

Answer 19

Culture
* Influences its propensity to seek risky investments
* Relatively conservative culture may result in calculated risk-taking
Too risk averse, it may fail to provide an adequate ROI

Question 20

How is the Culture of a Financial Inst. evaluated

Answer 20

Evaluation of culture based on a review of
1. Diversity of a bank’s assets
2. Accounting restatements due to failures of internal controls pertaining to FS reporting
3. Management compensation
4. Speed with which a bank adjusts its loan loss provisions relative to actual loss behavior. Slower response rate generally indicates aggressive accounting practices and risk taking culture.

General factors that are relevant to analysis of any company
* Competitive environment
Off balance sheet assets/liabilities

Question 21

How is sensitivity to market risks evaluated for financial inst.

Answer 21

• Bank earnings are affected by various market risks (volatility of security prices, interest rates and currency values)
• Most critical risk is interest rate risk
• Bank’s interest rate risk = differences in maturity, rates and reprising frequency between bank’s assets and liabilities.
• Banks respond to opportunities presented in the market and alter their balance sheets
• Impact of change in the shape of a yield curve differs among banks based on the differences in composition of their assets and liabilities
• MD&A has disclosures for banks exposure to wide variety of market and non-market risks
  Impact of the marker risks can be captured by value at risk (VaR).

Question 22

What are the liquidity standards for banks

Answer 22

Liquidity Coverage Ration ("LCR") Net Stable funding ratio ("NSFR") Concentration of funding and maturity mismatch

Question 23

How is Liquidity for Financial inst. measured under Liquidity Coverage Ration ("LCR")

Answer 23

High liquid assets/expected cash outflows ○ High-liquid assets are those that are easily convertible into cash ○ Expected cash flows are estimated one-month liquidity needs in a stress scenario ○ Minimum LCR of 100% recommended

Question 24

How is Liquidity for Financial inst. measured under Net Stable funding ratio ("NSFR")

Answer 24

Available stable funding/required stable funding ○ Available stable funding ("ASF") is a function of the composition and maturity distribution of a bank's funding sources ○ Required Stable funding is a function of the composition and maturity distribution of a bank's asset base ○ ASF is determined based on an ASF factor assigned to each funding source ○ NSFR relates the liquidity needs of a bank's assets to the liquidity provided by the bank's liabilities § Longer-dated liabilities are considered more stable and more suitable to fund assets with longer maturities. § Deposits from retail and small business clients are considered more stable than deposits from corporate clients Recommended Min NSFR = 100%

Question 25

How is Liquidity for Financial inst. measured under Concentration of funding and maturity mismatch

Answer 25

○ Other liquidity monitoring metrics ○ Low-concentrated funds indicate the bank's reliance on relatively few funding sources § Lack of diversification may be resulting in a heightened liquidity risk for the bank ○ Maturity Mismatch § Occurs when asset maturities differ from meaningfully from maturity of liabilities (funding sources) The higher the mismatch, the higher the liquidity risk for the bank

Question 26

What is sensitivity to market risks in CAMELS re: financial inst.

Answer 26

* Bank earnings are affected by various market risks (volatility of security prices, interest rates and currency values) * Most critical risk is interest rate risk * Bank's interest rate risk = differences in maturity, rates and reprising frequency between bank's assets and liabilities. * Banks respond to opportunities presented in the market and alter their balance sheets * Impact of change in the shape of a yield curve differs among banks based on the differences in composition of their assets and liabilities * MD&A has disclosures for banks exposure to wide variety of market and non-market risks Impact of the marker risks can be captured by value at risk (VaR).

Question 27

What is the impact of government support on Banks

Answer 27

* Serves as a backstop against bank failure due to the systemic importance of the banking sector * Expected level of government support is related to the inter-linkages in the banking sector. * Larger the bank, more interlinked it is and more likely its failure will have a contagion effect. * Current status of the banking sector in the country should be considered. * Implicit support level is inversely related to the overall health of the banking sector; during good times, support levels are low

Question 28

What is the impact of government ownership on Banks

Answer 28

Government Ownership * Public ownership due to strategic importance of banks in promoting economic development. * Absent government ownership depositors may not have faith in the sector. Public ownership increases faith in a the bank and vise versa.

Question 29

What is the impact of bank mission on Banks

Answer 29

* Banks may pursue other objectives apart from profit making such as community development If a community is dependent on a primary industry, it may lead to concentration of risks in a bank's asset portfolio

Question 29

What are P&C insurance sources of income and profitability?

Answer 29

P&C Insurance Companies * Premium income - the source of income Profitability dependent on a. Pricing of adequate premium's for bearing risks b. Diversification of risks Done through reinsure some risks Short policy periods with premiums received at the beginning of the period invested during the float period Claim events are defined

Question 30

What is the impact of culture on Banks

Answer 30

Culture * Influences its propensity to seek risky investments * Relatively conservative culture may result in calculated risk-taking Too risk averse, it may fail to provide an adequate ROI

Question 31

How to evaluate the culture of a bank

Answer 31

Evaluation of culture based on a review of 1. Diversity of a bank's assets 2. Accounting restatements due to failures of internal controls pertaining to FS reporting 3. Management compensation 4. Speed with which a bank adjusts its loan loss provisions relative to actual loss behavior. Slower response rate generally indicates aggressive accounting practices and risk taking culture. General factors that are relevant to analysis of any company * Competitive environment Off balance sheet assets/liabilities

Question 32

What are the differences between P&C and L&H insurance?

Answer 32

* Insurance company revenues include premium income and income on float * Property and casualty (P&C) insurers differ from life and health (L&H) insurers in terms of variability of claims and contract duration * Claims for P&C tend to be lumpier and L&H are relatively stable and predictable * Policy period for L&H are longer than P&C

Question 33

What are the profitability cycles of P&C

Question 34

What is capitalization req related to insurers?

Answer 34

* No-global risks based capital requirement standards for insurers ○ EU has Solvency II standards NAIC in US specified min capital levels based on size and risk

Question 35

What is dividends to policy holders

Answer 35

* Dividends to Policyholders (shareholders) ratio - liquidity measure - cash outflow on account of dividends relative to premium income Dividends to Policyholders ratio = Dividends to Policyholders (Shareholders)/Net Premiums earned

Question 35

What is CRAD and how to calculate it?

Answer 35

* Combined ratio after Dividends (CRAD) - Measures total efficiency and more comprehensive than the combined ratio CRAD = Combined Ratio + dividends to policy shareholders ratio = [Loss expense + Loss adjustment Expense + Claims Paid + Change in loss reserve + Dividends to Policyholders (Shareholders)] / Net Premiums Earned

Question 36

What is combined RAtio?

Answer 36

Question 37

What is the loss adjustment expense ratio (re: insurance companies)

Answer 37

* Loss and loss adjustment expense ratio - Measures relative success in estimation of risks insured Loss and Loss adjustment expense ratio =[ Loss Expense + Loss adjustment Expense ]/Net premiums earned

Question 38

What is the soft pricing period

Answer 38

* Soft pricing period - price cutting to obtain new business leads to slim or negative margins ○ Leads to losses adn shrinking capital base for many insurers ○ Makes insurers to leave the industry or stop underwriting new policies ○ Resulting reduction in competition leadings to a healthier pricing environment (hard pricing period)

Question 39

What is the hard pricing period

Answer 39

* Hard Pricing Period ○ Results in fatter margins Attracts new competition- perpetuating the cycle

Question 40

What drives soft and hard pricing and expenses

Answer 40

* Major expenses for P&C insurers include claims expense and expense of obtaining new policy business ○ Cost of writing new policies depends on whether the insurer uses direct to customer model or agency model * Soft or hard pricing driven by the industry's combined ratio (total insurance expenses/ net premiums earned) When the ratio is low, its is hard market and vise versa.

Question 41

What is the combined Ratio

Answer 41

* Combined Ratio per statutory accounting practices : Underwriting loss ratio + expense ratio Underwriting loss ratio = [Claim Paid + change in loss reserve ]/Net Premium earned Measures the relative efficiency of the company's underwriting standards Also called loss and loss adjustment expense

Question 42

What is the Expense Ratio and what does it measure?

Answer 42

Expense Ratio = [Underwriting Expenses including commissions ]/ Net Premiums Written Measures efficiency of the company operations Also called underwriting expense ratio

Question 43

What is the loss Reserve?

Answer 43

* Loss Reserve is an estimated value of unpaid claims. ○ Subject to management discretion in measurement, loss reserve is highly material amount ○ Usually revised when more information becomes available § Downward revisions indicate the company was conservative in estimating their losses Upward revisions indicate aggressive profit booking, a warning sign

Question 44

What are 5 characteristics of L&H Insurance companies?

Answer 44

* Revenue Diversification: Income generated can vary over time and among insurers Premium income tends to be more stable overtime relative to other sources Earnings Characteristics: Investment Returns: 1.Longer float period than P&C insurers, 2. Investment returns are key components of the insurer's profitability 3. Large portion of the portfolio is long-term debt 4. Duration of mismatch between A&L is an area of concern * Liquidity: 1. Liquidity needs are fairly predictable - excess liquidity is not much of a concern 2. Analysis of liquidity includes analyzing insurers investment portfolio 3. Non-investment grade bonds and equity real estate are relatively illiquid * Capitalization - 1. No global minimum capitalization standards 2. Domestic regulators specify risk adjusted min capital requirements.