Deck 19: Types of Risks Incurred by Financial Institutions

Question 1

Second Bank now offers web banking services. Last week a computer glitch posted all web deposit transfers to the wrong accounts. This is an example of

A) credit risk.
B) liquidity risk.
C) stupidity risk.
D) technological risk.
E) operational risk.

Answer 1

E

Question 2

Rising interest rates decrease the value of fixed-income assets and increase the value of fixed-income liabilities.

Answer 2

False

Question 3

Repurchase agreements (repos) are used extensively to finance security holdings. In 2007, many investment banks and other financial institutions were unable to roll over their maturing repurchase agreements during the subprime mortgage crisis. This inability to get new repo financing is an example of

A) credit risk.
B) liquidity risk.
C) sovereign risk.
D) technological risk.
E) operational risk.

Answer 3

B

Question 4

The risk that an FI may not have enough capital to offset a sudden decline in the value of its assets is called operational risk.

Question 5

A bank has total assets of $620 million and $68.2 million in equity. The managers of the bank realize that $18.6 million of its $372 million loan portfolio will not be repaid. After the bank charges off these unexpected bad loans the bank's equity to asset ratio will be __________________.

A) 11.00%
B) 10.64%
C) 9.77%
D) 8.25%
E) 8.00% (620M - 18.6M)/(68.2M - 18.6M) = 8.25%

Question 6

A bank that has made floating rate loans funded by longer maturity deposits is at risk from falling interest rates.

Question 7

The subprime crisis is a good example of the credit risk faced by financial institutions.

Question 8

Breakdowns of ATMs and fraudulent use of information stored on a bank's computer system are examples of operational risk.

Question 9

A U.S. bank has £700 million in loans it has made to corporate customers and it has £850 million in deposits. The net foreign exchange exposure from these accounts may be hedged by selling 150 million pounds forward.

Question 10

Interest rate risk is probably greatest at which of the following intermediaries?

A) Commercial banks
B) Savings institutions
C) Life insurers
D) Pension funds

Question 11

The risk that an unanticipated increase in liability withdrawals may cause an FI to have to sell assets at fire sale prices is an example of

A) credit risk.
B) liquidity risk.
C) interest rate risk.
D) sovereign risk.
E) technology risk.

Question 12

Many intermediaries, such as banks, cannot be asset transformers and match maturities of their assets and liabilities.

Question 13

MONDEX spent $50 million to develop the Smart Card, but tests of prototypes in New York and Canadian cities revealed very little consumer interest. This is an example of

A) credit risk.
B) liquidity risk.
C) stupidity risk.
D) technological risk.
E) operational risk.

Question 14

Risk arising from unhedged positions in securities, currencies, and derivatives is called market risk.

Question 15

Assets in a bank's trading book tend to be held for a longer time than assets held in the banking book.

Question 16

Maintaining a diversified loan portfolio helps a bank reduce systematic credit risk.

Question 17

A U.S. bank has £900 million in loans it has made to corporate customers and it has £750 million in deposits when the exchange rate is £1 = $1.98. The bank will have a net foreign exchange loss on these accounts if the exchange rate moves to £1 = $1.95.

Question 18

Rank order the net charge-off rates from high to low for the following loan types:
I) C&I loans.
II) credit card loans.
III) real estate loans.

A) I, II, III
B) I, III, II
C) II, I, III
D) II, III, I
E) III, I, II

Question 19

A corporate borrower failing to repay a loan on time due to equipment breakdowns is an example of firm specific credit risk.

Question 20

Loan charge-offs do not lead to insolvency risk because when loans are written off both loans and liabilities are reduced.

Question 21

If a bank is exposed to refinancing risk, its profitability is reduced if interest rates __________________ and if it is exposed to reinvestment risk, its profitability is reduced if interest rates ________________.

A) rise; fall
B) rise; rise
C) fall; rise
D) fall; fall
E) rise; stay the same

Question 22

The Fed allowed nonbank financial institutions to borrow money from the discount window during the mortgage crisis and even allowed nonbanks to swap mortgages for Treasury securities. This was an attempt by the Fed to reduce ________________ at institutions.

A) operational risk
B) technological risk
C) liquidity risk
D) foreign exchange risk
E) diversifiable risk

Question 23

CHIPS and ACH are

A) potato products of Frito Lay.
B) check clearing systems run by the Federal Reserve.
C) retail payment systems used in Europe.
D) international bank regulators.
E) wholesale electronic payment systems.

Question 24

A bank invests $250 million to add the ability to provide online bill paying for its customers. Usage of the new service is at about 50% of expected usage. This is an example of

A) technological risk.
B) operational risk.
C) market risk.
D) credit risk.
E) derivative risk.

Question 25

A thrift makes long-term fixed-rate mortgages funded with short-term deposits and then interest rates rise. Which of the following is true?

A) Profitability would decline.
B) Profitability would increase.
C) The market value of equity increases.
D) Interest income would fall.
E) Both B and C would occur.

Question 26

In October 2005, the Bankruptcy Reform Act was signed into law. This law primarily

A) made it easier for many debtors to receive bankruptcy protection.
B) made it more difficult for many debtors to receive bankruptcy protection.
C) applied only to corporations.
D) applied only to corporations and financial institutions.
E) made it easier for foreign debtors to seek debt relief under U.S. law.

Question 27

Which of the following would normally be banking book assets rather than trading book assets?

A) Capital
B) Short position in bonds
C) FX forward contracts
D) Long-term loans
E) Options on interest rates

Question 28

A guarantee issued by an FI that obligates the FI to pay if the purchaser of the letter defaults on a debt is called a

A) loan commitment.
B) forward rate agreement.
C) credit swap agreement.
D) collar.
E) none of the above

Question 29

A bank has book value of $5 million in liquid assets and $95 million in nonliquid assets. Large depositors unexpectedly withdraw $9.5 million in deposits. To cover the withdrawals the bank sells all of its liquid assets at book value. To raise the additional funds needed the bank sells the necessary amount of nonliquid assets at 80 cents per dollar of book value. As a result, the bank's equity will _____________.

A) remain unchanged
B) fall $4.5 million
C) fall $3.6 million
D) fall $1.4 million
E) fall $5.0 million (9.5M - 5M) x 80% = 3.6M

Question 30

The £ is worth 1.2569 euros and the euro is worth $1.5568. Statistical analysis indicates that when the euro rises 1% against the dollar, the pound rises 0.5% against the euro and vice versa. A U.S. bank has assets of £40 million that mature in one year funded with liabilities of €55 million due in 6 months. The bank would be hurt by:
I) an increase in the value of the euro against the dollar.
II) a decrease in the value of the euro against the dollar.
III) an increase in euro interest rates relative to pound interest rates.
IV) an increase in pound interest rates relative to euro interest rates.

A) I only
B) I and II only
C) I and III only
D) II and IV only
E) II and III only The euro value of the assets = £40 x 1.2569 = €50.277 M, so the bank has a net euro liability exposure that puts it at risk from an increase in the value of the euro against the dollar. Because the pound assets mature in one year and the euro liabilities mature in six months, the bank is at risk from rising euro interest rates relative to pound interest rates.

Question 31

Which one of the following intermediaries is likely to engage in more asset liability maturity matching?

A) Banks
B) Savings associations
C) Savings banks
D) Life insurers

Question 32

Regulator's overall evaluation of the riskiness of a depository institution is measured by the _______________.

A) Basel Accord
B) CRA rating
C) CAMELS rating
D) Exposure scale
E) FFIEC score

Question 33

Having longer maturity assets than liabilities causes banks to bear which of the following risks?
I) Interest rate risk
II) Liquidity risk
III) Credit risk

A) I only
B) I and II only
C) I and III only
D) II and III only
E) I, II, and III

Question 34

A bank has invested in U.S. Treasury investments that mature in 2 years. They will be held until maturity. The investments are funded with 3-year maturity time deposits. The primary risk this bank faces is

A) refinancing risk.
B) reinvestment risk.
C) liquidity risk.
D) credit risk.
E) off-balance-sheet risk.

Question 35

A bank has on-balance-sheet assets with a book value of $940 million and a market value of $985 million and on-balance-sheet liabilities with a book value of $900 million and a market value of $930 million. The bank also has off-balance-sheet assets currently valued at $150 million and off-balance-sheet liabilities worth $160 million. Stockholder's net worth should be valued at _________________ million.

A) $30
B) $40
C) $45
D) $50
E) $55 (985M + 150M) - (930M + 160M) = 45M

Question 36

In year one, a bank facing reinvestment risk earns 11% on its assets and pays 10% on its liabilities. In year two, the bank had a negative profit spread of 100 basis points. Which of the following is true? In year two,

A) rates rose 100 basis points.
B) rates rose 200 basis points.
C) rates fell 100 basis points.
D) rates fell 200 basis points.
E) none of the above

Question 37

In May 2007, the largest known credit card theft was discovered when it was revealed that 200 million card numbers were stolen from TJX Company. This is an example of

A) credit risk.
B) operational risk.
C) liquidity risk.
D) technological risk.
E) regulatory risk.

Question 38

Present value uncertainty is the risk that

A) the market value of equity will decline if interest rates change.
B) interest income will rise by more than interest expense when rates increase.
C) assets will be insufficient to cover loan losses.
D) bank capital will be insufficient to cover loan losses.
E) real interest rates will exceed nominal rates.

Question 39

Argentina has refused to pay loans made to it by foreign institutions three times. This is an example of

A) operational risk.
B) liquidity risk.
C) foreign exchange risk.
D) sovereign risk.
E) insolvency risk.

Question 40

The terrorist attacks on the World Trade Center in 2001 are an example of ______________.

A) regulatory risk
B) liquidity risk
C) credit risk
D) insolvency risk
E) event risk

Question 41

Why do banks continue to make credit card loans even though credit card default rates are often at least twice as high as other loan types?

Question 42

Characterize each of the following according to the type of risk it primarily represents:
I. loan default
II. unexpected deposit withdrawals
III. losses on foreign currency holdings
IV. losses on standby letters of credit
V. reduction in earnings after an interest rate increase
Indicate which of the risks could cause insolvency of the FI.

Question 43

Why would an FI be willing to issue a letter of credit guarantee to a municipal bond issuer?

Question 44

What is insolvency risk? How can liquidity risk and credit risk cause insolvency? What are the two best protections against insolvency at an FI?

Question 45

What is sovereign risk? How is this different from credit risk on a domestic loan? How can sovereign risk be limited?

Question 46

A bank has $150 million in 1-year loans earning a fixed rate equal to 4.75%. The assets are funded by $150 million in liabilities that have a cost of 4.25% and a maturity of 3 years. If all interest rates are projected to fall 100 basis points by next year, by how much will the bank's profits and loan NIM change in year two? Does this bank face refinancing risk or reinvestment risk? Explain.

Question 47

In general terms explain why certain types of derivatives such as options, futures, swaps, and other exotic contracts can generate such catastrophically large losses and even insolvency for users at times. Does this mean that corporate or institutional use of derivatives should be limited or otherwise regulated? Explain.

Question 48

Should regulators of FIs be concerned about the increased trading activity of FIs?

Question 49

How does foreign exchange risk arise for an FI?