Deck 4: Risk of Financial Institutions

Question 1

Which of the following are typical operational risk sources?

A)employee fraud
B)back-office failures
C)general technological glitches
D)All of the listed options are correct.

Answer 1

D

Question 2

Why are depository institutions and life insurance companies more exposed to credit risk than, for instance, money market managed funds and general insurance companies?

A)Because the average maturities of their assets are longer than those of money market managed funds/general insurance companies.
B)Because the average maturities of their assets are shorter than those of money market managed funds/general insurance companies.
C)They are not exposed to more risk.
D)Because they are not specialised in credit risk management.

Answer 2

A

Question 3

An FI that invests $100 million into corporate bonds is exposed to the following risks:

A)credit and interest rate risk.
B)liquidity and technology risk.
C)solvency and technology risk.
D)off-balance-sheet and interest rate risk.

Answer 3

A

Question 4

What does systematic credit risk mean?

A)The risk of default of the borrowing firm that arises from the borrowing firm's specific projects.
B)The risk of default associated with micro economic conditions affecting some borrowers.
C)The risk of default associated with general macroeconomic conditions affecting all borrowers.
D)The risk of default associated with general macroeconomic conditions affecting some borrowers.

Question 5

A decrease in interest rates means that the discount rate on cash flows is:

A)decreased and thus the market value of an FI's assets and liabilities decreases.
B)increased and thus the market value of an FI's assets and liabilities decreases.
C)increased and thus the market value of an FI's assets and liabilities increases.
D)decreased and thus the market value of an FI's assets and liabilities increases.

Question 6

What type of risk focuses upon future contingencies?

A)liquidity risk
B)interest rate risk
C)credit risk
D)off-balance-sheet risk

Question 7

Market risk is defined as the risk:

A)incurred by granting loans to companies that do not hold a large market share.
B)incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates and other asset prices.
C)that a sudden surge in liability withdrawals may require FIs to liquidate assets at less than fair market prices.
D)that an FI loses market share.

Question 8

What are the major objectives of technological expansion?

A)To lower operating costs, increase profits and capture new markets.
B)To stabilise operating costs, increase profits and capture new markets.
C)To lower operating costs, stabilise profits and capture new markets.
D)To lower operating costs, increase profits and stabilise the existing market share.

Question 9

Which of the following is a suitable description of the term 'economies of scope'?

A)The use of several inputs to produce one common output.
B)The ability to generate cost savings by producing more than one output with the same inputs.
C)The ability to lower average operating costs by expanding the number of outputs.
D)The ability to lower average operating costs by lowering the number of outputs.

Question 10

Sovereign risk refers to the risk that repayments from:

A)local borrowers are interrupted because of interference from foreign governments.
B)foreign borrowers are interrupted because of interference from local governments.
C)foreign borrowers are interrupted because of interference from foreign governments.
D)None of the listed options are correct.

Question 11

An example of refinancing risk is a case in which an FI:

A)funds 2-year maturity assets with 1-year maturity liabilities.
B)funds 1-year maturity assets with 2-year maturity liabilities.
C)funds 2-year maturity assets with 2-year maturity liabilities
D)None of the listed options are correct.

Question 12

A high-quality loan book for Australian banks during the global financial crisis (GFC) meant that:

A)their non-performing loans as a percentage of their total domestic loan portfolio fell during the GFC.
B)their non-performing loans as a percentage of their total domestic loan portfolio increased above 2 per cent during the GFC.
C)Australian banks' profitability fell and Australian FIs were severely impacted by the GFC.
D)Australian banks' profitability was maintained and Australian FIs were not severely impacted by the GFC.

Question 13

The major difference between firm-specific credit risk and systematic credit risk is that:

A)FIs can diversify systematic credit risk, while firm-specific credit risk cannot be diversified.
B)FIs can diversify firm-specific credit risk, while systematic credit risk cannot be diversified.
C)None of the listed options are correct, as FIs can diversify both types of credit risk.
D)None of the listed options are correct, as FIs cannot diversify either type of credit risk.

Question 14

The market risk of an FI increases with:

A)increasing volatility of asset prices.
B)increasingly large unhedged short positions in bonds, equities and other commodities.
C)increasingly large unhedged long positions in bonds, equities and other commodities.
D)All of the listed options are correct.

Question 15

Non-performing loans are defined as loans that:

A)are either in default or close to being in default and are at least 90 days in arrears.
B)have been written off and loans that are at least 80 days in arrears.
C)are either in default or close to being in default and are at least 60 days in arrears.
D)have been written off and loans that are at least 60 days in arrears.

Question 16

An FI that holds more short-term assets relative to long-term liabilities is:

A)exposed to refinancing risk.
B)exposed to restructuring risk.
C)exposed to reinvestment risk.
D)not exposed to any risks.

Question 17

An Australian FI that invests €50 million in 3-year maturity loans and partially funds these loans with €30 million 1-year deposits is exposed to the following risks.

A)A depreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone.
B)An appreciation of the euro against the Australian dollar plus credit risk plus refinancing risk, such as increasing interest rates in the Eurozone.
C)A depreciation of the euro against the Australian dollar plus credit risk plus reinvestment risk, such as decreasing interest rates in the Eurozone.
D)A depreciation of the euro against the Australian dollar reinvestment risk, such as increasing interest rates in the Eurozone.

Question 18

If an FI is long-funded it means that the:

A)maturity of assets equals the maturity of liabilities.
B)bank holds more long-term assets than short-term assets.
C)maturity of liabilities is less than the maturity of assets.
D)maturity of liabilities is longer than the maturity of its assets.

Question 19

In which of the following situations is an Australian FI exposed to a depreciation of the euro against the Australian dollar?

A)The FI holds €100 million in assets and €70 million in liabilities.
B)The FI holds €100 million in assets and €100 million in liabilities.
C)The FI holds €70 million in assets and €100 million in liabilities.
D)The FI does not hold any assets or liabilities in euros, but considers doing so in the future.

Question 20

Which of the following are typical off-balance-sheet activities?

A)letters of credit
B)loan commitments
C)forward contracts, swaps and other derivative securities
D)All of the listed options are correct.

Question 21

The risk that a debt security's price will fall, subjecting the investor to a capital loss is:

A)credit risk.
B)political risk.
C)currency risk.
D)market risk.

Question 22

A bank has liabilities of $4 million with an average maturity of two years paying interest rates of 4 per cent annually.It has assets of $5 million with an average maturity of 5 years earning interest rates of 6 per cent annually.To what risk is the bank exposed?

A)reinvestment risk
B)refinancing risk
C)interest rate risk
D)refinancing risk and interest rate risk

Question 23

The risk that borrowers are unable to repay their loans on time is called:

A)credit risk.
B)sovereign risk.
C)currency risk.
D)liquidity risk.

Question 24

Unanticipated diseconomies of scale and scope are a result of:

A)technology risk.
B)interest rate risk.
C)foreign exchange risk.
D)credit risk.

Question 25

An FI that finances a German euro loan with US dollar deposits is exposed to:

A)technology risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.

Question 26

The collapse of the US bank, IndyMac Bank was an example of:

A)market risk.
B)operational risk.
C)insolvency risk.
D)insolvency and liquidity risk.

Question 27

A letter of credit is:

A)a credit guarantee issued by an FI's customer to pay a pre-determined amount of money to the FI at a future point in time.
B)an on-balance-sheet transaction for the issuing FI.
C)a credit guarantee issued by an FI on which payment is contingent on some future event occurring.
D)None of the listed options are correct.

Question 28

An example of a discrete risk is sudden changes in:

A)the interest rate.
B)banking regulations.
C)foreign exchange rates.
D)commodity prices.

Question 29

Technological risk:

A)can only lead to an FI's short-term distress.
B)refers to the scenario that technological investments produce the anticipated cost savings.
C)can result in major losses and the long-term viability of the FI.
D)refers to the scenario that technological investments do not produce the anticipated savings, and can cause major losses and impact on the viability of the FI.

Question 30

Matching the foreign currency book protects the FI from:

A)sovereign country risk.
B)interest rate risk.
C)liquidity risk.
D)foreign exchange risk.

Question 31

A mortgage loan officer is found to have provided false documentation that resulted in a lower interest rate on a loan approved for one of her friends.The loan was subsequently added to a loan pool, securitised and sold.Which of the following risks applies to the false documentation by the employee?

A)Market risk.
B)Credit risk.
C)Operational risk.
D)Technological risk.

Question 32

An FI with a low level of leverage, such as a high level of capitalisation:

A)is generally less profitable.
B)is better able to withstand losses.
C)has improved ability to remain solvent.
D)All of the listed options are correct.

Question 33

The risk that interest income will increase at a slower rate than interest expense is:

A)credit risk.
B)political risk.
C)currency risk.
D)interest rate risk.

Question 34

During periods of high and volatile inflation, an FI's:

A)interest rate risk exposure and credit risk exposure tends to decrease.
B)interest rate risk exposure and credit risk exposure tends to increase.
C)interest rate risk exposure and credit risk exposure tends to be unaffected.
D)None of the listed options are correct.

Question 35

Event risks such as earthquakes, fraud and theft:

A)do not have an impact on an FI's performance.
B)are easy to measure and to predict.
C)form a normal cost of doing business for FIs.
D)may have a significant and negative impact on an FI's performance but are difficult to measure and to predict.

Question 36

The Bank for International Settlements:

A)defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events.
B)does not include technology risk in its categorisation of operational risk.
C)is the principal organisation of central banks in the minor economies of the world.
D)All of the listed options are correct.

Question 37

The major source of risk exposure resulting from issuance of standby letters of credit is:

A)technology risk.
B)interest rate risk.
C)
C)credit risk.
D)off-balance-sheet risk.

Question 38

Politically motivated limitations on payments of foreign currency may expose the FI to:

A)sovereign or country risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.

Question 39

Which of the following are effective measures for claimholders if a foreign government prohibits repayment of debt obligations to an international lender?

A)The claimholder can recover its outstanding debt through local courts.
B)The claimholder can recover its outstanding debt through international courts
C)The claimholder cannot do anything.
D)The claimholder has limited recourse through normal legal channels but may exert leverage if it has control over future loans or supply of funds.

Question 40

Credit risk puts both the principal loaned and expected interest payments at risk.As a result FIs issue financial claims that have a risk-return profile with:

A)high probability of fixed upside return.
B)high probability of large downside risk.
C)low probability of large downside risk.
D)both high probability of fixed upside return and low probability of large downside risk.

Question 41

The BIS definition 'the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events' encompasses which of the following risks?

A)credit risk and liquidity risk
B)operational risk and technology risk
C)credit risk and market risk
D)technology risk and liquidity risk

Question 42

A 'fire-sale' means that an FI increases its liquidity position by selling part of its assets at the assets' fair market values.

Question 43

Matching the foreign currency book does not protect the FI from:

A)sovereign country risk.
B)interest rate risk.
C)liquidity risk.
D)foreign exchange risk.

Question 44

An Australian FI that holds a net short asset position in $US is exposed to foreign exchange rate risk if the $US appreciates against the $A over the investment period.

Question 45

Economies of scope imply an FI's ability to lower its average cost by expanding its output of financial services.

Question 46

The increased opportunity for a bank to securitise loans into liquid and tradable assets is likely to affect which type of risk?

A)sovereign risk
B)market risk
C)insolvency risk
D)technological risk

Question 47

Technological failure, employee fraud and employee errors are all sources of operational risk.

Question 48

A short-funded FI is exposed to increasing interest rates.

Question 49

The major source of risk exposure resulting from issuance of standby letters of credit is:

A)interest rate risk.
B)credit risk.
C)foreign exchange risk.
D)balance sheet risk.

Question 50

An FI that only operates domestically is never exposed to foreign exchange rate risk.

Question 51

The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as:

A)liquidity risk.
B)reinvestment risk.
C)credit risk.
D)foreign exchange risk.

Question 52

Firm-specific credit risk can be eliminated by diversification.

Question 53

Which of the following may occur when a sufficient number of borrowers are unable to repay interest and principal on loans, thus causing an FI's equity to approach zero?

A)insolvency risk
B)sovereign risk
C)currency risk
D)liquidity risk

Question 54

Which of the following situations pose a refinancing risk for an FI?

A)An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity.
B)An FI issues $10 million of liabilities of two-year maturity to finance the purchase of $10 million of assets with a two-year maturity.
C)An FI issues $10 million of liabilities of three-year maturity to finance the purchase of $10 million of assets with a two-year maturity.
D)An FI matches the maturity of its assets and liabilities.

Question 55

The potential exercise of unanticipated contingencies can result in:

A)technology risk.
B)interest rate risk.
C)credit risk.
D)off-balance-sheet risk.

Question 56

A small local bank failed because of a housing market collapse following the departure of the area's largest employer.What type of risk applies to the failure of the institution?

A)firm-specific risk
B)technological risk
C)operational risk
D)insolvency risk

Question 57

When analysing an FI's performance, it is not important to consider its off-balance-sheet activities as they have no current or future impact on the FI's financial standing.

Question 58

Which function of an FI involves buying primary securities and issuing secondary securities?

A)brokerage
B)asset transformation
C)investment research
D)trading

Question 59

An FI that matches the maturities of its assets and liabilities is perfectly hedged against interest rate risk.

Question 60

Credit risk refers to the possibility that promised cash flows on financial claims such as loans and securities are not paid in full.

Question 61

The Reserve Bank of Australia believes that operational risk could lead to severe financial distress for FIs.Outline what is meant by operational risk and how it can impact on a financial institution.In particular, illustrate your answer with recent cases of bank operational risk, for example: retail bank system failures, trading loss fraud and Ponzi scheme fraud.

Question 62

Based on the case of Indymac Bank, explain how liquidity risk and insolvency risk caused a bank failure despite deposit insurance.Outline the chain of events that led to this financial institution's illiquidity and eventual closure.

Question 63

Many of the various risks, such as interest rate risk, market risk, credit risk and off-balance-sheet risk, faced by an FI often are interrelated with each other.

Question 64

One of the most striking trends for many modern FIs has been the growth in their off-balance-sheet activities and thus their off-balance-sheet risk.Explain what is meant by off-balance-sheet activities and the risk associated with it using an example.

Question 65

Sovereign risk involves the inability of a foreign corporation to repay the principal or interest on a loan because of stipulations by the foreign government that are out of the control of the foreign corporation.

Question 66

FIs that make loans or buy bonds with long maturity liabilities are more exposed to interest rate risk than FIs that make loans or buy bonds with short maturity liabilities.

Question 67

Assume that you are a financial advisor to ABC Bank.The bank wishes to invest $50 million in loans with an average maturity of 3 years.The average interest rate on these loans is 12 per cent p.a.The bank can either grant the loans at a variable rate or at a fixed rate for the time of the investment.ABC Bank has the choice of funding these loans through either at-call deposits or through 5-year maturity term deposits.Explain the different types of risks that ABC Bank faces when funding its loans.