Performance , Liquidity and Capital and credit risk Management

What does transforming assets mean?

Issuing liabilities (like deposits) and buying assets (like loans): borrowing short (to pay less interest) and lending long (to earn more interest)

What are the two basic functions of a bank?

Transforming assets and providing a set of services

How do banks make a profit?

By producing desirable services at low cost and earning income on assets.

How is bank profitability generally measured?

Rate of return on average assets (ROAA), rate of return on average equity (ROAE), and net interest margin (NIM). These measure how much profit bank management can generate with a given amount of assets

What is the major source of income for banks?

Interest income on loans.

What are some examples of non-interest income for banks?

ATM surcharges, credit card fees, managed fund sales fees, trust operations, investment services, and insurance.

What are common bank operating expenses?

Interest payments, non-interest expense (salaries, rent, equipment), and provisions for loan loss.

What is a loan loss provision?

Money set aside for loans that may become bad debts.

how can banks increase profit?

By taking on more risk (credit risk, interest rate risk, liquidity risk).

What is the trade-off banks must balance?

Profitability versus safety (liquidity and solvency).

Who do banks have to balance demands between?

Shareholders, depositors, and regulators.

What are the two basic tools banks use to maintain liquidity during deposit outflows?

Asset management and liability management.

What is asset management?

Maintaining enough cash and assets that can quickly be converted to cash while pursuing low risk.

What is liability management?

Acquiring funds from the liability side (like borrowings) at low cost.

What are the four groups of bank assets in asset management?

Primary reserves, secondary reserves, bank loans, and investments.

What are primary reserves?

Assets immediately available for liquidity needs, like vault cash, deposits at correspondent banks and deposits held at the central bank

What are secondary reserves?

Assets providing extra liquidity while earning some interest, like Treasury bills and short-term government securities.

When are bank loans undertaken?

After satisfying liquidity needs.

What investments do banks make after loan demand is met?

Open market investments: Long-term Treasury securities, state/local government bonds, and corporate bonds.

How does liability management attract funds?

By increasing interest rates on interest-sensitive securities like CDs, repos, and commercial paper.

Why is liability management useful?

It offsets sudden deposit outflows, meets increased loan demand, and funds off-balance-sheet activities.

What should a bank do if a liquidity problem appears after deposit outflows?

Use asset management, liability management, and capital adequacy management.

What are excess reserves?

Insurance banks hold against the costs of deposit outflows.

How do costs of deposit outflows affect excess reserves?

The higher the costs, the more excess reserves banks want to hold.

What are the main roles of bank capital?

Provides a financial cushion, maintains public confidence, protects depositors, and funds expansion.

Why is a minimum amount of bank capital required?

To reduce the chance of insolvency (not having enough assets to cover liabilities).

What does Basel I introduce to measure bank capital needs?

Risk-weighted assets (RWA): assets weighted by risk to set capital minimums. minimum levels of capital are a % RWA.

What did Basel II (2004) require from large banks?

Use sophisticated models to measure credit, market, and operational risks for capital requirements.

Why was Basel II criticised?

Models were too complex and caused volatile capital requirements.

What is Basel III?

A set of international rules developed after the financial crisis to improve bank capital and liquidity.

What are the three types of capital under Basel III?

Common Equity, Tier 1 Capital (common equity + retained earnings/reserves), Tier 2 Capital (other capital items).

What is the Liquidity Coverage Ratio (LCR) in Basel III?

Requires banks to hold enough high-quality liquid assets to survive a 30-day stress funding scenario.

What is the primary risk banks have traditionally faced?

The risk of loan defaults.

What system is used to assess the overall quality of a bank’s condition?

The CAMELS rating system.

What does CAMELS stand for?

Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk.

How are CAMELS components rated?

On a scale from 1 (best) to 5 (worst), plus a composite score based on all six components.

When a loan is made, banks must monitor its performance. What are signs of a problem loan?

Missed payments, worsened credit rating, lower deposit balances, sales and earnings, or delayed documents.

What are two main ways banks manage the credit risk of their loan portfolios?

Diversify loans and use credit derivatives.

What do banks use to measure the risk of loan portfolios?

Internal credit risk ratings.